Bank Negara Malaysia (BNM) wisely maintained the overnight policy rate (OPR) at 3 per cent during their Monetary Policy Committee meeting last September. I agree with their decision not to increase the interest rate, even if it might weaken the ringgit.
Let me explain. Interest rates represent the cost of borrowing money, and it would be shortsighted to ignore their impact on exchange rates. Like any asset, we hold a currency with the expectation of profiting from it, primarily through earning a return on savings deposits (the interest rate) or through foreign exchange movements (when the currency appreciates). Naturally, we also hold currency for transactional purposes, such as paying for goods and services, and there are costs associated with holding different currencies.
Chart 1: Ringgit weakness is driven, in part, by falling interest rate differentials against US dollar and Singapore dollar.
Currently, the interest income that can be earned on deposits in US dollars and Singapore dollars far exceeds that for ringgit deposits (refer to the table). Therefore, it is not surprising that the ringgit has been depreciating against both currencies (refer to Chart 1). Keep in mind that exchange rates reflect the relative external value of a currency, shaped by market demand and supply dynamics. When demand falls, the currency depreciates, and when it rises, the currency appreciates.
Even with a hypothetical increase in the OPR, let’s say by 25 or even 50 basis points, I remain sceptical about how much difference it would make for those seeking to profit from interest rate differentials. The returns on the ringgit would still be lower than those for deposits in US dollars and Singapore dollars at prevailing interest rates. To have a meaningful and impactful effect, the OPR hike would need to be substantially more than 50 bps, as I have conveyed to the central bank.
It’s also important to note that the interest rate differential is not the sole driver of exchange rates. Other key factors include inflation expectations, the fiscal deficit and public sector debt, the current account surplus/deficit, and crucially, confidence in the nation’s economic performance and competitiveness. Many of these factors are influenced by perceived political stability and governance, which affect critical national decision-making and policies.
My historical analysis indicates that certain factors have been more influential than others in driving the exchange rate at different times. A review of the long-term charts for the ringgit against both currencies clearly shows that the correlation between exchange rates and interest rate differentials varies over time (refer to Chart 2).
Chart 2: Correlation between exchange rates and interest rates varies at different times.
So far this year, a reduced current account surplus, which signals lower demand for the ringgit and is down sharply from the second half of 2022, has likely also contributed to the prevailing weakness of the ringgit (refer to Chart 3). Exports of both commodities and manufactured goods have decreased in the first half of 2023 compared to the second half of 2022. Oil and crude palm oil (CPO) prices are significantly below their 2022 peaks, and exports of electrical and electronic goods, along with other manufactured products, have declined due to weaker global demand.
Despite an increase in net exports, this has not translated into higher international reserves at BNM. This indicates that there was no corresponding increase in demand for the ringgit from the conversion of these foreign exchange earnings. Exporters have chosen to retain their earnings in foreign currencies instead of converting them to ringgit, raising questions about their reluctance. Factors such as interest rate differentials, confidence levels, and concerns about potential capital control measures are likely to influence their decisions.
A mitigating factor has been the lower outflow in income repatriation, which saw a significant increase in 2021-2022.
Chart 3: Sharply lower current account surplus results in less demand for the ringgit.
On the other hand, a higher OPR would negatively impact heavily indebted households and businesses, as well as government finances. For instance, unlike in the United States, where most mortgages are long-term fixed rates, in Malaysia, they are predominantly variable-rate. Consequently, any OPR increase would immediately result in higher monthly mortgage payments for households, which, given the relatively low household incomes and rising cost of living, could significantly dampen consumption. In other words, the average Malaysian has a low savings buffer against the higher cost of borrowing.
Similarly, government debt and liabilities now amount to approximately RM1.45 trillion, nearly 81 per cent of the Gross Domestic Product (GDP). Over recent years, an increasingly larger portion of government revenue has been allocated to servicing this growing debt. Escalating interest rates would only worsen the already substantial fiscal deficit.
Taking these factors into consideration, I anticipate that BNM will maintain a steady OPR during the MPC meeting scheduled for November 1 to 2, to safeguard the broader economy while allowing the value of the ringgit to be determined by the free market.
Every decision in life inevitably involves a trade-off. With an unchanged OPR, the ringgit may continue to be weak. However, there is a silver lining: an increase in exports, perhaps driven by rising commodity prices or rebounding global demand, could provide a much-needed boost to the currency.
