This opinion article appeared on the 08 June 2004 edition of the New Straits Times on page B2.

Fixing true value of the ringgit
By G. SIVALINGAM

THERE have been calls to remove the ringgit peg at US$1 to RM3.80 because
it is undervalued. However, the calls heard so far to revalue the ringgit
do not say much as to how the true value of the ringgit should be allowed
to be determined.

There are three basic options, that is, a fixed exchange rate, a
flexible exchange rate and a floating exchange rate.

Some have argued that to overcome the problem of being undervalued, the
ringgit should be revalued and fixed at RM3.50 or RM3.30 to the US dollar.

However, how this figure has been derived is not clear and has not been
elaborated upon. Some have suggested a fixed exchange rate should be one
that generates an equilibrium in the current account or the current plus
capital account. If this occurs then the foreign reserves of the country
will not grow. However, what rate will equilibrate the balance of
payments is not known especially in a dynamic external environment.

One way to fix the exchange rate is to calculate the long-run real
equilibrium exchange rate of the ringgit. Some researchers have done this
for several years before the 1997 crisis and during the crisis year and
found that the ringgit was only overvalued by about 6-7 per cent and yet
it depreciated by more than 50 per cent. How does then one explain the
large and sudden depreciation by 50 per cent when the ringgit was only
overvalued or misaligned by 6-7 per cent and hence, only expected to
depreciate by 6 per cent or 7 per cent?

Several observers, including former Prime Minister Tun Dr Mahathir
Mohamad, have commented that the unexplained sudden and large devaluation
was caused by currency speculators as predicted by the second-generation
model of currency crises. According to this second-generation model, a
currency crisis need not be based on economic fundamentals. It can be
triggered by both objective and subjective expectations of the future
growth prospects of the economy. If a country is on a fixed exchange rate
and exports are not growing and the current account surplus is tending
towards the negative, then that news will trigger a speculative attack on
the ringgit.

Malaysia’s current fixed exchange rate regime has generated huge
current account surpluses due to two central factors, that is, the
competitive fixed exchange rate and the increased demand from the world
economy for Malaysian manufactured exports. The vastly increased current
account surplus and foreign reserves have led some, including the
London-based Economist magazine,to comment that the opportunity cost of a
large foreign reserve is immense and reflects foregone opportunities.
However, what is forgotten is that the large reserves are necessary to
defend the ringgit from another speculative attack.

Some recollection will indicate that the Singapore dollar and the yuan
were not subject to a speculative attack in 1997 because both the
countries had large foreign exchange reserves. Thailand abandoned its
managed float regime because it had run out of reserves and Malaysia
followed soon after. History has taught us one lesson, that is, not to be
caught without sufficient reserves to defend the value of the ringgit.
This is one aspect of exchange rate management that the “undervalued
ringgit” school of thought has ignored.

If one is to recollect, the Singapore dollar was not internationalised
in 1997 but the ringgit was. This led to speculation of the true value of
the ringgit in offshore markets and caused a free fall and multiple
equilibria in the value of the currency. Once capital controls and a
fixed exchange rate were implemented and the ringgit was
de-internationalised the speculative activities on the currency ceased.
The speculative activities had nothing to do with discovering the
intrinsic value of the ringgit but had all to do with extracting
financial rents from the East Asian countries.

Coming back to the current debate on the value of the ringgit, some
institutes have suggested that the managed float is the best exchange
rate regime because it means that the value of the currency can be
allowed to appreciate when its demand goes up. The demand for the ringgit
is a derived one because it depends on the demand for Malaysia’s exports.
So the proponents of the “undervalued ringgit” school are suggesting that
when the demand for Malaysia’s exports go up, the ringgit can be allowed
to appreciate and vice-versa. However, the danger here is that when the
demand for the country’s exports decline, it may trigger a speculative
attack that is likely to be successful because it is staged when exports
are declining and hence, reserves are declining. If reserves decline it
implies that there may not be sufficient reserves to defend the ringgit.
So allowing the ringgit to fluctuate in value as Malaysian exports
fluctuate has in-built dangers of generating a speculative attack, which
Bank Negara Malaysia, the central bank cannot easily ward off because it
will not have sufficient reserves.

There are, therefore, dangers in tinkering with the exchange rate
regime because it may lead to speculative attacks. Also it is difficult
to estimate the long-run equilibrium exchange rate as it keeps changing
with economic fundamentals. The best way to allow the exchange rate to
reflect its long-run equilibrium value is to adopt a flexible exchange
rate regime. Under the flexible exchange rate regime, however, the
exchange rate may fluctuate violently as it did during the 1997-1998
crisis, when Bank Negara abandoned the managed float regime because of
insufficient reserves and allowed the ringgit to float to find its true
value. The exchange rate overshot and did not settle at a rate that was
stable until a fixed exchange rate regime was implemented.

It should be pointed out that there is perhaps only one country that
has adopted a flexible exchange rate regime and that is the US. It is a
relatively large economy which is not so dependent on international
trade. The external trade of the US only amounts to about 10 per cent of
its gross domestic product. The value of the US dollar has fluctuated and
declined considerably in the recent past, and this has created concern to the
“undervalued ringgit” school.

However, to remove the peg is not an easy task because most of the
exports are generated in the foreign enclave sector, which is dominated
by American investments. The multinationals (MNCs) find the current fixed
exchange rate competitive as evidenced by the burgeoning foreign
reserves. Furthermore, the payments system is denominated in US dollars
and abandoning the peg with the US dollar seems impracticable. What is
often ignored is that there is already some partial dollarisation of the
Malaysian economy.

The “undervalued ringgit” school is concerned that the current fixed
exchange rate is causing the import bill to rise, especially for imported
inputs for the Proton and Perodua cars. Also middle-class consumer goods
are getting expensive and affecting the lifestyle of the middle-class. On
the other hand, an overvalued ringgit will increase imports after a lag
and cause exports to decline, which will cause the current account
balance to deteriorate and foreign reserves to decline, and this will in
turn create a depreciation of the ringgit and we may end up where we
first started or possibly be worse off.

What is needed is perhaps a more diversified economy to reduce
Malaysia’s vulnerability to fluctuations in the external demand for its
manufactured goods, especially electronics and electrical goods.

The current effort to diversify into high value-added electronics and
manufactured goods, biotechnology and agriculture may do more to
strengthen the ringgit and ensure its stability than any effort to tinker
with the exchange rate regime. Diversified sources of exports will also
provide more assurance that the ringgit will not come under a speculative
attack. A diversified export base will ensure lower risks and higher
returns to holding the ringgit.

Furthermore, the capital controls are effective because some countries
like India have been able to avert financial crises because they did not
implement capital account convertibility as recommended by the
International Monetary Fund. This implies that long-term sustainable
capital flows will be encouraged while short-term bank loans and foreign
portfolio investments will be discouraged.

Therefore, there are still good reasons to maintain the fixed exchange
rate at the present level and regulate the flow of short-term speculative
capital.

The writer is Professor and Head, Department of Finance and Banking,
Faculty of Business, University of Malaya.

  

Posted on June 8th, 2004 by jl
Filed under: Intl Currency