[1798] Of a case against pegging the ringgit

Any policy which pays too much attention to the symptoms of an issue while ignoring its root cause only deserves outright rejection. The Malaysian government’s typical response to shortage of goods is one such policy. The shortage is unambiguously caused by a price and supply control mechanism, which prevents prices from adjusting according to prevailing supply and demand, as well as incorporating other relevant information. Yet, time and again, the authorities blame smugglers for the problem. Not that smugglers deserve any defending, but they are but a mere symptom of a control regime. Addressing a symptom is an ineffective way of solving a problem. Another policy which conflates symptoms with root cause is the pegging of the Malaysian ringgit to some currencies.

The rationale of the proposed policy is simple: It is aimed to stop the ringgit from weakening further vis-à-vis other currencies.

The root cause of a weakening ringgit is the economy itself. Although I am unable to exactly pinpoint the causes, I do have a list of suspects and three of them are political uncertainty, fiscal deficit and windfall tax.

The political uncertainty which we are experiencing so far has a lot to do with it. After all, Credit Suisse did advise investors to stay clear of Malaysia due to the political turmoil. Apart from Pakatan Rakyat’s increasingly tiring poker face with respect to their claim of entering Putrajaya, the recent use of ISA continues to send unhelpful signals to local and foreign investors. As a result, money flows out.

The fiscal deficit of the Malaysian government is yet another factor which may encourage capital outflow. Several economists, among them Salant and Krugman, did suggest that persistent deficit may cause capital flight.

This happened to the Indonesian rupiah several years ago as the size of the fuel subsidy ballooned into the Indonesian fiscal deficit. The rupiah dropped to a frightening level and it only recovered after the Indonesian government decided to dramatically cut the size of the fuel subsidy. Unrest ensued, but in the eyes of advocates of the peg, the rupiah was saved.

Another reason for the lackluster performance of the ringgit might be the imposition of the windfall tax. Earlier, the government imposed significant windfall tax on independent power producers. The imposition is no laughing matter because approximately a fifth of the local bond market is made up of papers issued by the power producers.

Such a tax naturally spooked the bond market, shooing investors away together with their money. In the typical fashion of the current administration, however, the windfall tax was scrapped and replaced with something else. While the U-turn was celebrated, the damage had already been done.

Indeed, Malaysia is not the only destination for investment. Once the money is out, there is little reason for it to come back, especially when there are far better options out there. The financial fortresses of Singapore and Hong Kong are not too far away, if distance is an issue at all in this age of light speed communication.

All of the factors need to be addressed if the strength of the ringgit is an issue. A peg, however, does little to address these issues.

A peg basically acts like a wall. Unless the push factors are addressed, pressure against the wall would build up and it would depend on the strength of the wall to prevent a terrible flood. That wall is the reserve of the central bank.

In the case of the peg, the central bank would have to maintain a position with respect to the currencies which the ringgit is pegged against. In times of a weakening ringgit, the bank would need to shore the ringgit up to the predetermined level by reducing the quantity of money circulated in the market. In effect, this would raise interest rates.

During a period of economic crisis, it is typical for a central bank to lower the interest rates by providing liquidity to promote growth in general, or at least to cushion the effect of a downturn. A peg, however, does exactly the opposite.

Borrowing will become more expensive and create an environment not conducive for greater economic activities, with all else being equal. Whereas consumption is required to fuel a flattering economy, a signal for greater savings and delayed investment is sent instead.

Increased savings will, of course, bring the interest rates back down if it gets to the necessary level, but by the time that happens, the economy would probably find itself in better health, removing the urgency for greater consumption.

Besides, a peg assumes that a particular level or band of ringgit vis-à-vis some currencies is more favorable than any other for everybody on average. Though mainstream economics has been accused of simplifying the world through its models, this assumption goes frighteningly further by committing a hasty generalization.

An economy does not comprise of homogeneous members. A strong currency is not necessarily good for everybody just as a weak currency is not necessarily good at all. Exporters for instance would love a relatively weak currency while importers would love a strong currency. It really depends on which side one is on.

The best way to balance the competing demands of various players within the economy is to allow the market to consider all variables to churn out the right answer. Within this context, Governor Zeti Akhtar Aziz rightly dismissed the call to peg the ringgit to the dollar or any other currencies.

A version of this article was published in The Malaysian Insider.