This article first appeared in The Edge Malaysia Weekly, on January 25 - 31, 2016.

JUST as speculation mounts over the contents of Thursday’s revision of Budget 2016, Bank Negara Malaysia surprisingly trimmed its statutory reserve requirement (SRR) by 50 basis points to 3.5%, effective Feb 1.

The reduction was the central bank’s first since it was raised from 3% to 4% in July 2011, and economists do not rule out further cuts in the SRR, a policy instrument to manage liquidity by determining the amount banking institutions are required to retain with the central bank. A cut is usually seen as a sign of monetary easing, and Bank Negara said the reduction was to ensure there is sufficient liquidity and to support the orderly functioning of the domestic financial system.

It is worth noting that the last time Bank Negara trimmed the SRR was before the Asian financial crisis in 1998 and during the global financial crisis in 2008. In 1998, the SRR was slashed from 13.5% in February to 4% in September. In December 2008, the rate was cut further to 3.5% before it was trimmed to 1% in March 2009.

Will the central bank cut its key overnight policy rate (OPR) next?

Bank Negara stressed that the SRR is an instrument to manage liquidity and the move is not a signal on the stance of monetary policy.

Even so, economists agree that domestic liquidity has become tighter in recent times as investors withdrew large amounts of capital from emerging markets, including Malaysia, last year. The capital outflow also came as a result of the diverging monetary policies by the advanced economies, and the fall in commodity prices compounded the situation, says Hong Leong Investment Bank Research economist Sia Ket Ee.

United Overseas Bank (M) Bhd economist Julia Goh says the evidence of the tightening domestic liquidity can be seen from the rise in interbank rates in the final quarter of 2015. Klibor rates moved from 3.74% to 3.84% during the quarter.

At least two foreign banks in Malaysia have reportedly raised base rates despite Bank Negara keeping its OPR at 3.25%.

“Recently, the cost of funding increased due to tighter liquidity. From our estimates, cutting the SRR by 50 basis points will lead to additional liquidity in the market of 

RM6.18 billion. It will marginally help banks that are facing tighter liquidity currently, hence putting a cap on the upward pressure on interest rates,” says an economist with MIDF Research.

Yet, economists opine that the 50-basis-point cut in the SRR is only a short-term measure and will not be enough to replenish the liquidity that has left the domestic market over the last year.

Normally, a liquidity boost in the market is followed by an interest rate cut, which causes a currency to weaken. But as the SRR reduction was not coupled with an OPR cut, there was no added blow to the already weak ringgit.

“The linkage between SRR cuts and exchange rates is not significant as compared to that between the OPR and the exchange rate. Given that the OPR has not been reduced, the interest rate differential between advanced economies and Malaysia is still the same. I don’t think that there will be any impact on the ringgit,” Sia explains.

UOB’s Goh reckons that any policy movements can be “neutral to positive” on the ringgit “if it is well communicated and seen as a growth supportive move”.

“Our year-end target for the ringgit against the US dollar is 4.20,” she adds.

At the time of writing, the ringgit strengthened slightly against the greenback to 4.28 from 4.38 a day earlier.

While Bank Negara was careful to highlight that the SRR is only an instrument to manage liquidity, some economists are not ruling out an interest rate cut in the near future.

Goh’s view is that given the central bank’s more dovish statement and the higher downside risk to growth, the odds of an OPR cut have increased.

MIDF Research’s economist opines that an interest rate cut will ultimately depend on economic development. “If the underlying economic data in the first half is worse than Bank Negara’s initial expectation, then a rate cut is possible,” he says.

For Sia, the possibility of an interest rate cut could depend on market acceptance of the Budget 2016 revision on Jan 28. “Within the policy space of the Malaysian authorities, it seems that the monetary policy is the only tool left to support growth,” he says.

“So, it is crucial ... what types of cuts the government will undertake and whether they will be higher than expected, which could lead to a contraction in gross domestic product (GDP) growth.”

Despite the recent revision of global economic growth by the International Monetary Fund to 3.4% from 3.6% for 2016, most economists have yet to revise their GDP forecasts, pending the budget revision.

The median consensus view for GDP growth is 4.5%, the mid-point between the 4% and 5% growth projected when Budget 2016 was tabled last October with a US$48 a barrel oil price assumption. Brent crude last week skidded to as low as US$27 a barrel but was hovering at US$31 at the time of writing.

The latter indicates a RM5 billion gap needs to be plugged either by cutting spending or raising revenue, given that every US$1 drop in oil price is estimated to cost Malaysia about RM300 million.

Expectations are that Malaysia could cut its GDP growth projection for 2016. Sia, who still has a 4.5% GDP projection, pending the budget revision, reckons that the government will revise the official 2016 GDP growth projection closer to 4% rather than 5%.

The MIDF Research economist opines that if Malaysia experiences significantly lower nominal GDP growth of below 4%, both the fiscal deficit to GDP and debt to GDP ratios will likely be impacted. “We are currently at risk of breaching the 55% debt to GDP limit. If that happens, our sovereign credit rating will be at risk,” he says.

That puts the spotlight back on the Budget 2016 revision and how well the government communicates the rationale behind every change and if it can win buy-in.

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.