ECON-templation: The cost of a pegged exchange rate regime

This article first appeared in Forum, The Edge Malaysia Weekly, on June 20, 2022 - June 26, 2022.
ECON-templation: The cost of a pegged exchange rate regime
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Malaysia is one of 63 countries that practise a floating exchange rate regime, which inevitably makes our currency susceptible to volatility in the global financial markets. When the ringgit hit its weakest level in two years against the US dollar last month, it sparked concerns about the potential downward spiral of the currency and erosion of purchasing power, especially amid the current upward trend in the prices of goods and services.

A frequent question I have been asked is this: “Why don’t the authorities intervene in the market and peg the ringgit at a stronger level? Problem solved?”

Unfortunately not.

The decision to strengthen and peg the ringgit would come at a substantial cost to the economy.

First, let’s look at the monetary cost. It is an expensive exercise to artificially strengthen the ringgit and peg it at the desired level. The central bank would need to intervene in the foreign exchange market by spending its foreign exchange reserves to lift the ringgit’s value against the greenback. Following that, more reserves would have to be continually exhausted to maintain the currency at its high level. As such, there is only a finite period that the peg can be defended as it is constrained by the amount of central bank reserves available.

The resultant thinning of reserves would make Malaysia highly susceptible to currency speculators betting on any signs of vulnerability or the collapse of the currency peg. As such, this policy cannot be sustained over the long term.

Maintaining a fixed exchange rate on a sustainable basis would mean giving up on other policy flexibilities that we currently enjoy. Based on the fundamental theory of international finance, a country can only achieve two of the three possible policy outcomes at any given time: (i) free capital mobility; (ii) independent monetary policy; and (iii) a fixed exchange rate.

Under the current scenario (see The Policy Trilemma infographic), Malaysia would have to pay the opportunity cost or forgo the benefits with the prioritisation of fixed exchange rates.

For one, forsaking free capital mobility would mean the imposition of capital controls, a move that would significantly discourage foreign capital and investments in Malaysia. As the largest bond market in Southeast Asia and the third largest in Asia, this will set us back as a key investment destination in this region. Such restrictions will also severely hamper foreign direct investment inflows that are crucial for driving domestic economic development. The market’s disdain for capital controls was evident in November 2016, during the clampdown on ringgit non-deliverable forward (NDF) trades. Viewed as a form of capital control, this triggered a RM62.7 billion bond market outflow over five months, while the ringgit weakened beyond 4.45 against the US dollar.

Alternatively, choosing to relinquish monetary policy independence would limit our options in prescribing appropriate policies across different economic cycles. This flexibility is crucial in the current post-pandemic recovery, which has so far lagged behind developed markets. This autonomy has allowed domestic monetary policy to remain supportive of growth despite the aggressive rate hikes in the US. That said, this differing pace of monetary policy normalisation had played a major role in the recent fall in the ringgit’s value against the dollar.

Ultimately, artificially pegging the ringgit to a stronger than market-determined rate would not address the biggest concern of the man on the street — the rapidly rising prices of goods and services. The current inflation pressure is primarily due to the sharp climb in global prices of goods and services, and not the weaker US dollar/ringgit exchange rate. For instance, global food prices have risen 26.2% up to April and May from a year ago. In comparison, the ringgit depreciated against the US dollar by some 4.8% compared with a year ago.

While one can argue that having a fixed currency would have its advantages, such as exchange rate stability and eliminating business uncertainties, the costs are very likely to far outweigh the potential 

benefits given Malaysia’s position in the current globalised economy. Malaysia would be better off maintaining the current flexible exchange rate policy and addressing the current inflationary pressure through other more targeted policy measures.

Woon Khai Jhek is a senior economist and co-head of the Economic Research department at RAM Rating Services Bhd

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