Bangkok--Mar 28--Aziam Burson
Malaysia's economy is robust
Malaysia's GDP grew by 7.1% last year. Exports are being underpinned by an increasingly competitive exchange rate, oil revenues (Malaysia is one of the few Asian countries to be a net exporter of oil), surging tourist arrivals, and strong demand from China. Meanwhile, domestic demand is being buoyed by loose macro policies (the short-term interest rate is 2.7%, or just 0.3% in real terms), a low unemployment rate of 3.4%, and rapid household credit growth. We forecast 6.0% GDP growth this year.
Fundamentally, the ringgit is undervalued
The current account surplus is massive, and FX reserves have soared
Malaysia has a massive current account surplus (13.5% of GDP) which,
together with strong net capital inflows, has resulted in its foreign exchange (FX) reserves soaring to a record US$72bn in February, from US$49bn a year ago. With most of the world's other major currencies strengthening against the US$, the ringgit (which is pegged to the US$ at 3.8) has weakened significantly against a trade-weighted basket of currencies.
Already, for Malaysia's nominal trade-weighted exchange rate index (TWI) to return to the level prevailing when the peg was introduced in September 1998, we estimate the ringgit would need to be revalued to 3.43 MYR/USD, based on the current levels of other currencies. Moreover, based on our forecasts of a continued fall in the US$, by December 2005 for Malaysia's nominal TWI to return to its level in September 1998 would require the ringgit to be revalued to 3.17 per US$.
Domestic liquidity is piling up
Scaled by GDP, Malaysia's FX reserve accumulation is the most significant
in Asia Because of heavy FX intervention to maintain the peg, Malaysia's FX
reserves are skyrocketing, reaching a record US$72bn in February . Relative to the size of Malaysia's economy, the pace of reserve accumulation in Malaysia is the most significant in Asia. This outcome increasingly reflects "hot money" inflows, driven by speculation that Malaysia will have to abandon, or at least revalue, the ringgit peg.
In this kind of situation, the authorities risk losing domestic monetary
control. Indeed, the flipside of massive FX reserve accumulation is a boom in domestic liquidity, which Bank Negara is struggling to "mop up". M2 money supply growth shot up to 25% y-o-y in January (Chart 3). With too much money chasing too few goods, the danger would be a breakout of CPI inflation, asset price bubbles, or simply credit being misallocated. Indeed, inflationary pressures appear to be building As is prone to happen in this kind of situation, there is a growing risk of a vicious spiral developing: increasing signs of a loss of domestic monetary control heightens speculation that the ringgit is undervalued, fuelling more hot
money inflows, thereby exacerbating the problem of there being too much domestic liquidity.
More pragmatic leadership
As well as the economics, the politics may be more conducive now to making a change to the exchange rate mechanism. The new prime minister, Mr
Abdullah Badawi, seems to be setting a new tone and course for policy, moving to crack down on corruption and corporate cronyism, and generally opening up the economy to market forces. This has resonated well with domestic and foreign investors. Foreign direct investment was RM13.3bn in Jan-Sep 2004, already surpassing the total of RM9.4bn for the whole of 2003. The move to a more flexible exchange rate regime would be in line with the emerging free market principles of the post-Mahathir government. And because the ringgit peg was introduced under PM Mahathir's watch, there would be fewer "loss of face" problems in changing it now. In fact, last year ex-PM Mahathir himself hinted that the ringgit peg might need to be changed.
In our view, the main risk to our forecast would be that the authorities
stick to the peg but, given the pressures that are building, are forced into imposing capital controls again. However, such a move seems unlikely under the new government.
Our base case is that Malaysia will abandon the ringgit peg some time in 2H 2005 (and perhaps earlier) and move to managing the ringgit against a trade-weighted basket of currencies, Singapore-style. Under a more flexible exchange rate, we forecast the ringgit to appreciate to 3.4 MYR/USD by December 2005. End.