How did we survive the dollar swing?

Wong Chin Yoong

The writer says if Malaysia wants to survive the next bigger dollar swing, addressing financial market imperfections that prevent floaters from enjoying full insulation tops the to-do list. – The Malaysian Insight file pic, April 27, 2023.

MACROECONOMIC instability is now largely in the rear-view mirror. Growth has been returning and inflation is easing.

When soaring crude oil and food prices, interest rate hikes and dollar appreciation hit the globe last year – each capable of striking a crisis in the past – few would have expected the world to ride the rollercoaster so safely.

Yes, soaring food prices brought about a food supply crisis, but it didn’t bring down the poor and developing economies. Yes, historically dramatic interest rate hikes sent shock waves throughout financial prices all over the world, but unlike the 1980s, “the lost decade” for any countries or regions remains largely out of sight, and the United States is keeping a good chance of soft landing.

Yes, commodity prices volatility has brought Sri Lanka to her knees, but it was the last straw that broke the camel’s long broken back, not the stick that beats her to death; and yes, interest rate hikes were the main culprit to the collapse of US regional banks, but fear of systemic contagion was contained by the regulatory body’s prompt actions. Fears quickly evaporated.

Make no mistake, all these resiliencies are not purely of good luck, but the result of years of structural and monetary reforms, however gradual, in responding to past episodes of crises.

There was once upon a time a popular term describing the attitude of monetary authorities in the developing world in the 1990s towards exchange rates: the fear of floating.

Driven by the intolerance of currency volatilities and not knowing what volatilities could bring to the economy, developing countries in the 80s and 90s were inclined to maintain currency pegs, soft or hard.

Argentina opted for a currency board, Indonesia for a crawling peg, Malaysia for managed floating and hard peg, you name it.

Alas, there is no such thing as a free lunch, not even the maintenance of currency stability, which often ends with either a recession or capital control. Neither of these is desirable.

Here goes the intuition underlying the undesirability. If you view an exchange rate as the price ratio of two different financial assets denominated in respective national currencies, the ratio must then be driven by portfolio capital flows crossing borders to take advantage of the return differentials of the two assets.

Should there be an arbitrage on financial assets, currencies are to be traded.

So, when the Fed raises the funds rate to tame the inflationary forces, be it in 1980, 1995, or 2022, it is simply rationale for global investors to reshuffle their portfolios towards dollar assets that offer increasing returns.

The dollar goes north, and the rest of the world’s currencies go south. And tightening your seatbelt for a one-way ride of dollar appreciation and others’ depreciation if the financial market anticipates a path towards multiple interest rate hikes in the future.

Whether currency volatilities can be kept at bay without putting the economy at risk, however, the domestic monetary authority’s reaction is all that matters.

A panicked central banker who rushes to raise interest rates in tandem with the Fed’s hike upon the ground of currency stabilisation is going to send a chill down the economy, especially when the internal economy doesn’t require a hike.

Worse still, if the central banker doubles down and raises the interest rates multiple times to mimic the Fed’s path without a good cause other than stabilising the currency, a recession is the only outcome waiting at the end of the tunnel. Have we not learned from the 1997/1998 Asian financial crisis?

Recall what happened to ringgit when we kept increasing interest rates to defend the peg during the crisis?

The more we increased, the more slippery the slope of the ringgit became, because interest rate hikes were at odds with what the internal economy needed then.

When the market doesn’t expect the interest rate hikes to be sustainable, any contemporaneous hikes are meaningless for strengthening the currency.

As it is, why not let the central bankers redirect interest rate policies towards the internal economy – raise rates for inflation and cut rates during a slowdown – while allowing the exchange rates to float accordingly to insulate the economy from external shocks?

The developing world learnt its lesson. So did Bank Negara Malaysia. Floating has long been favoured, not feared, while inflation and growth are all that enter the equation.

That to a great extent explains why we can still record the fastest growth rate in decades while keeping inflation in check last year, despite the dramatic ringgit depreciation.

We can bury the thought of a currency peg for good and be a proud floater.

Should we want to survive the next bigger dollar swing, addressing financial market imperfections that prevent floaters from enjoying full insulation tops the to-do list. – April 27, 2023.

* Wong Chin Yoong is a professor of economics at Universiti Tunku Abdul Rahman, Kampar campus.

* This is the opinion of the writer or publication and does not necessarily represent the views of The Malaysian Insight. Article may be edited for brevity and clarity.

Sign up or sign in here to comment.