The Malaysian ringgit (MYR) has fallen to 4.7 to the US dollar, one of the lowest rates since 1997. The ringgit was recently named one of the worst performing Asian currencies, second only to the Japanese yen. This has left many Malaysians worried about rising prices and questioning if Malaysia’s economy is truly strong. Can the government stabilize the currency? What is actually happening and how does it impact average Malaysians and Malaysian businesses?
In this article, we’ll break down the economic theory behind currency exchange rates, analyze the ringgit’s devaluation, discuss potential positive outcomes, and explain if government intervention could help strengthen the MYR.
The Ringgit’s Devaluation is Not Entirely the Ringgit’s Fault
Malaysia’s currency devaluation is largely driven by external factors instead of domestic economic weakness. The US Federal Reserve has been aggressively raising interest rates to fight inflation. Higher US rates attract investment dollars away from countries like Malaysia and into US dollar-denominated assets to earn better returns. This results in investors selling ringgit to buy US dollars, pushing the MYR lower.
But if the issue is the surging US dollar, why has the ringgit fallen more than regional peers like the Singapore dollar?
The Impossible Trinity Explains Exchange Rate Tradeoffs
This brings us to the economic theory known as the Impossible Trinity. The impossible trinity states that countries must prioritize two out of the following three policy goals when managing their economy and currency:
- A stable, fixed foreign exchange rate
- An independent monetary policy with flexibility to set domestic interest rates
- Free cross-border capital flows and investment
Unfortunately, no country can have all three simultaneously. Tradeoffs must be made. This constrained choice is likened to being able to pick only two options out of good grades, enough sleep, and an active social life during university.
Let’s examine these three policy options further:
Fixed Foreign Exchange Rates Require Currency Intervention
Pegging your currency to another currency or pegging it within a tight trading band provides exchange rate certainty. However, the central bank must then be prepared to intervene in currency markets continuously by buying and selling reserves to maintain the peg or band.
For example, if hot money flows push the ringgit too high above the pegged rate, Bank Negara would sell ringgit reserves to bring its value back down. Conversely, if panic selling sinks the ringgit too low, reserves would be deployed to buy ringgit to prop up its value.
Independent Monetary Policy Necessitates Variable Exchange Rates
An independent monetary policy allows a central bank to set benchmark interest rates and stimulate growth during economic slowdowns. However, active rate adjustments cause currencies to fluctuate as capital flows react to changing rate differentials. Higher rates attract investment inflows, lifting the currency. Rate cuts spur outflows as investors chase better returns elsewhere, weakening the currency.
With independent policies, currencies float based on market supply and demand. Central banks surrender direct control over exchange rates.
Open Capital Flows Create Currency Volatility
Free movement of cross-border capital enables foreign investment in domestic assets. However, speculative inflows or outflows in reaction to changing financial or economic conditions creates exchange rate volatility.
Without capital controls, interest rate shifts and exchange rate movements become heavily interdependent. This presents challenges for central banks seeking to influence both simultaneously.
Why the Impossible Trinity Means No Perfect Solution Exists
No country can maintain a stable, fixed exchange rate and independent control of interest rates while allowing unfettered cross-border money flows. When two policy priorities are selected, the third must be forfeited.
To understand why the impossible trinity makes choosing all three impossible, consider the following examples:
- Fixed Rates + Monetary Independence = No Open Capital Flows
A country could choose a pegged currency and autonomy to adjust rates, but would then need strict capital controls. Without such restrictions, rate moves would trigger destabilizing capital flows.
- Open Capital + Monetary Independence = No Fixed Rates
Conversely, a free capital flow paired with independent rate setting necessarily means a floating currency. Market forces instead of official intervention would dominate exchange rate movements.
- Open Capital + Fixed Rates = No Monetary Independence
Finally, unrestricted cross-border money flows could coexist with a pegged rate, but forfeits control of interest rates to maintain the peg against speculative capital flows.
The Impossible Trinity Forces Policy Tradeoffs
Facing the impossible trinity, each country chooses its preferred policy pair based on unique economic priorities and conditions. The United States emphasizes capital mobility and domestic control of rates, allowing market forces to set its exchange rate. China prefers a managed currency and domestic monetary control, imposing strict capital restrictions. Other nations select different combinations along this triangle of constrained choices.
Malaysia: Managed Float + Open Capital Flows
Malaysia values openness to foreign investment flows while retaining some domestic monetary policy flexibility. This leads Malaysia to allow a managed float of the ringgit’s exchange rate instead of a fixed peg. Capital can flow freely across borders, though some macroprudential curbs exist to avoid volatile short-term flows.
Conversely, Singapore prioritizes exchange rate stability through proactive currency intervention while permitting free cross-border capital flows. Monetary independence is largely surrendered, with Singapore not actively setting benchmark interest rates.
Could Malaysia Mimic the Singapore Model?
Given Singapore’s success maintaining a steady currency value, should Malaysia adopt the same policy mix? In theory, yes – Singapore’s approach controls volatility. In practice, the answer is far more complex with macroeconomic tradeoffs beyond any single column writer’s expertise.
Ultimately currency regimes reflect complex historical, institutional and structural factors unique to each nation. Singapore benefits from entrenched confidence in its financial markets, naturally attracting offsetting capital flows during periods of weakness. Whether Malaysia could operate an equivalent currency regime remains debated.
Potential Silver Linings of a Weaker Ringgit
While a falling ringgit brings unease today, it may deliver long term gains if properly leveraged. Here are three potential positives:
- Stronger Exports, Corporate Profits and Worker Bonuses
A weaker MYR makes Malaysian exports more competitive globally. This could boost overseas demand for Malaysian products. In turn, higher sales and profitability for exporters may translate into fatter year-end bonuses or dividend growth.
- Import Substitution Benefits Local Brands
As imported goods become pricier, consumers switch to cheaper local alternatives. Local brands have a chance to gain market share. Firms relying on imported inputs may also onshore production with local suppliers.
- Sparks Homegrown Innovation
Scarcity spurs human creativity. Priced-out consumers deprived of once-affordable imports will clamor for local innovators and manufacturers to deliver Malaysian-made solutions. Some may prove good enough to eventually export.
While adverse impacts exist, downturns contain seeds of opportunity. With the right policy support, Malaysia could leverage this crisis into catalyst for export growth, import substitution and commercial innovation.
Can Government Stabilize the Ringgit: Tools and Tradeoffs
Stabilizing Malaysia’s managed float requires addressing root causes instead of mere symptoms. As the ringgit’s slide is US dollar-driven, directly defending the exchange rate through heavy market intervention provides only temporary relief while rapidly depleting reserves.
Instead, policy must tackle deteriorating fundamentals and bearish market sentiment:
Fiscal Rebuilding Instills Confidence
A credible path to budget surplus would signal fiscal prudence, easing market fears over debt obligations. This supports growth, credit ratings and investor confidence. But austerity risks near-term pain.
Pro-Growth Reform Restores Competitiveness
Structural reforms would modernize the economy, tackle bottlenecks and bolster productivity. This drives organic growth, backed by market confidence and foreign direct investment. Yet vested interests may resist disruption.
Independent Institutions Check Corruption
Strengthening governance and rule of law to combat graft reassures investors that returns are secure from arbitrary policy shifts. But corrupt actors work tirelessly to undermine reforms that threaten their illicit gains.
While solutions exist, they require short-term sacrifices and confrontation with entrenched interests. This demands skilled economic management and principled political leadership – both in scarce supply nowadays.
Conclusion
In summary, no ideal policy mix exists for exchange rates, interest rates and cross-border money flows. Choices involve complex tradeoffs, guided by national priorities. Malaysia now faces reckoning for past economic mismanagement but also potential opportunities. While the ringgit may remain under pressure for some time amid external headwinds, the right policy reforms and crisis response could transform short-term pain into long-term gains.