This article first appeared in Capital, The Edge Malaysia Weekly on October 3, 2022 - October 9, 2022

THE rise of the US dollar index to its highest in two decades on the back of aggressive US Federal Reserve interest rate hikes is causing turmoil in financial markets, with most major currencies weakening by a huge magnitude against the greenback.

Some quarters have even warned that the sharp fall in the pound sterling, which is almost at parity with the US dollar, could be an early sign of a potential currency crisis. However, the economists and foreign exchange (forex) strategists The Edge spoke to do not see the persistent decline in major currencies triggering a crisis, at least in Asia.

Dr Yeah Kim Leng, professor of economics at Sunway University Business School, believes that most Asian countries are not in the vulnerable position experienced during the 1997/98 Asian financial crisis (AFC).

“Their economic fundamentals are relatively stable. More importantly, they have restructured their banking and financial systems, and have accumulated adequate levels of foreign reserves,” he points out.

“The currency crisis in the 1990s stemmed from the individual country’s vulnerabilities as well as economic and financial weaknesses, especially their overdependence on foreign capital. When foreign capital pulled out and the currencies were subject to speculative attacks, then you had the AFC.”

Calling it a global common factor as a result of the strengthening US dollar due to the aggressive interest rate hikes undertaken to combat inflation, Yeah says Asian countries have to bear with the strong greenback until early next year.

“The currency turmoil will continue until US interest rates stabilise and inflation is tamed. The increase in interest rates is already having a dampening effect on US economic growth. The recession risk has increased. So, the question is, how long does it take for the US slowdown to bring down inflation?

“When the Fed holds off on its interest rate increases, only then can we see some normalcy in the currencies. For now, inflation and interest rate divergence will have a debilitating impact because of a strong US dollar, which is creating havoc in the real economies of most countries.”

He says the ringgit may weaken further to 4.70-4.80 against the US dollar, depending on how aggressive and how high the Fed will raise interest rates. Nonetheless, he points out the ringgit has been relatively stable in terms of real effective exchange rates (REER), which is a better measure of the impact from currency movements.

“Up to the first three weeks of September 2022, it [the ringgit] actually shows an appreciation of 2% over the same period last year and a 1% increase over the same period last month. This means the ringgit has been stable against all of our trading partners. So, it does not suggest a crisis. If there were a crisis, our currency would depreciate sharply against all the other currencies,” says Yeah.

REER is a geometric average of a country’s bilateral exchange rate deflated by relative inflation rates.

MIDF Research economist Zafri Zulkeffeli notes that depreciation of the ringgit is less of a concern to the Malaysian economy as government debt is mostly denominated in the local currency at 97%, compared with 70% in previous crises.

Based on the latest projection by the US central bank, Zafri sees the ringgit hovering at 4.55-4.60 until November, before appreciating to 4.45-4.50 thereafter. The year-end target for the local currency is 4.45, giving it a full-year average of 4.40. However, he doesn’t rule out the ringgit weakening further if US economic data remains strong, which will result in a prolonged rate hike cycle.

The ringgit fell to a new low of 4.6475 against the US dollar at 5pm last Thursday.

For Maybank Group regional head of forex research Saktiandi Supaat, the biggest concerns for now are the impact of global recession and inflation risks.

“We have not seen any systemic financial stability risks intensify globally and the macro fundamentals of the regional economies are still quite resilient … The sharp depreciation of currencies in the region against the US dollar was not triggered by a balance of payments crisis or a market meltdown and currency liability mismatches, which happened during the AFC,” he says.  

However, he cautions that the decline in the currencies may have a significant impact on capital markets and lead to capital outflows if the UK risks cascade into global financial markets due to financial systemic inter-relationships. “For now, it still seems limited to the UK and pound sterling assets,” he adds.

Christopher Wong, an FX strategist at OCBC Bank, says that while there may be some similarities with the AFC — such as how the yen was trading and the subsequent intervention of the Bank of Japan (BoJ) — the current situation is different.

“Back then, several exchange rates in Asia were pegged to the US dollar — and in some instances, at unsustainable levels — complicating policy responses. There was also heavy reliance on foreign short-term borrowings and current account balances were in deficit then. For instance, short-term debt as a percentage of forex reserves were at 134.5%, 140% and 189% respectively for the Philippines, Thailand and Indonesia in 1997, but about 12.9%, 29% and 33% in 2020,” he tells The Edge.

“The current account picture for this part of the world, including South Korea, Thailand and Indonesia, were deficits during the AFC days. But this has improved [and turned] into surpluses, though one may argue that that current account surplus for some countries in the region, such as Thailand and Japan, may have deteriorated. But this was partly due to the decline in inbound tourism, revenue and exports.”

Wong highlights that foreign investors have less heavy positions in bond holdings in this part of the world, with foreign holdings of local currency bonds in Thailand, Indonesia and Malaysia at about 13%, 16% and 23% respectively, making them less vulnerable to sudden outflows of funds.

Although in the interim, the greenback may continue to benefit from safe-haven demand and the allure of higher interest rates and yields in the US, Wong believes the US dollar should see a turnaround at some stage, possibly in early 2023 if there are more convincing signs of inflationary pressures slowing. Other signposts he is looking for include the phasing out of China’s zero-Covid policy and a ceasefire between Russia and Ukraine.

He points out that the recovery momentum in Malaysia — driven by domestic demand amid the reopening of the economy and a current account surplus — has helped buffer its economy against more extensive drags as seen in the baht and Philippine peso.

“Malaysia’s trade picture remains promising with both exports and imports sustaining double-digit growth so far this year. That said, in the face of dominant US dollar strength, most Asia ex-Japan currencies, including the ringgit, may continue to stay under pressure,” says Wong.

“Levels beyond here are really uncharted territories, with 4.62 and 4.65 being the next resistance levels. If the US dollar and treasury yield do turn lower, then we can expect a breather for the ringgit.”

Peter Chia, senior FX strategist at United Overseas Bank, expects the US dollar index to reach a peak in 1Q2023 when the US Fed funds target rate (FFTR) reaches its terminal rate of 4.5%-4.75% in February 2023. Having said that, he stresses that the path to an eventual peak is fraught with uncertainties if the string of recent policy surprises is any indication.

“Already in September, the BoJ intervened to prop up the yen for the first time since 1998 while the pound sterling crashed to a fresh record low after the UK government announced sweeping tax cuts that led to questions about the sustainability of the UK’s finances,” he adds.

Chia says Asian currencies are unlikely to turn the corner anytime soon as risks to the Chinese economy and the yuan still have a downside bias. “Unlike their developed peers, there is still no light at the end of the tunnel for Asian currencies, at least for the next couple of quarters. While the Fed may start to slow its rate hikes in 1Q2023, Asian currencies are unlikely to regain their rate advantage just yet due to a very gradual rate normalisation trajectory adopted by most central banks in the region.

“Portfolio outflows are still likely to continue and in response, Asian central banks could draw down their ample forex reserves to smooth out the volatility in their currencies.”

As the worst-performing Group of 10 currency, the pound sterling depreciated to a record low of 1.03 against the US dollar last week.

Chia says, “Given the UK macroeconomic instability, it is likely that the pound sterling will be the escape valve. We now expect a further decline in the pound sterling trade-weighted index towards the Brexit low of about 73 in 2016 from 76 currently, which in turn would drive another leg lower in the pound sterling versus US dollar.”

For the ringgit, he is of the view that the local currency will continue to be weaker against the US dollar if the Fed stays the course with its outsized rate hikes in the coming months, and China concerns persist. His ringgit forecasts are 4.63 in 4Q2022, 4.67 in 1Q2023 and 4.69 in 2Q2023.

Yeah observes that global funds are increasing their cash positions in view of the uncertainties ahead until there is a clearer outlook for US growth and inflation trajectory. “Higher US interest rates will result in a reversal of capital flows from emerging markets, including Malaysia, back to the US.”

Zafri believes capital outflows from the local market are temporary, as Malaysia’s economic fundamentals remain solid. With Petroliam Nasional Bhd (Petronas) doubling its dividend payout to RM50 billion, it will be strong enough for the government to pump more money into the economy next year, he says.

“As the general election is around the corner, we believe government expenditure will focus more on consumer-related items as well as the revival of infrastructure projects,” he adds.

According to MIDF Research, foreign funds were net sellers of local equities for the third consecutive week after offloading RM562.61 million in the week ended Sept 23.

Yeah notes that the “unequal effect” arising from the currency adjustments will become more pronounced. “In the real economy, exporters will benefit from the weak ringgit, while importers will face higher import costs and margin squeeze. Those that have high foreign currency-denominated borrowings may encounter some financial distress.”

When asked about Bank Negara Malaysia’s monetary policy, he thinks it should be determined independently based on the domestic conditions. “We are seeing rising inflation and strengthening demand, suggesting that the central bank will still need to continue its normalisation, but at a gradual pace in order to be less disruptive.”

To help businesses that are severely impacted by the currency depreciation, Yeah suggests the government offer standby facilities and loan subsidies to help them cope with the difficulties.

“Having commodities has made adjustments easier for Malaysia. We have substantial exports, particularly contributions from oil exports. The government has to weigh its capacity to mull another expansionary budget to enable the economy to withstand the impact from the currency depreciation and strengthen the fundamentals,” he adds.

“If the budget is crafted to achieve a lower fiscal deficit while reducing the government debt-to-GDP ratio, then it would be a prudent fiscal stance given that the economy is in recovery mode. We don’t want to add impetus to domestic demand that will contribute to higher demand-pull inflation.

“At the same time, the government needs to embark on both fiscal consolidation and targeted subsidies so that it will reduce inefficiencies associated with subsidies. It can create a more sustainable public finance given that the huge subsidies are unsustainable.”

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