KEYPOINTS

• The temporary relief for the ringgit appears short lived in spite of US Fed’s decision to delay its policy rate hike as negative investor sentiment outweighs fundamentals
• The prospect of Fed rate normalisation and China’s yuan’s recent devaluation would continue to exert pressure on EM as well as the commodity exporting currencies
• Those with political and governance issues tend to suffer more. MYR is the new member of EM currencies’ worst performers consisting of Brazil’s real, Turkey’s lira, and Russia’s ruble. While easing of intervention and re-assurance of no capital controls and re-peg of currency makes ringgit more vulnerable to market forces, political and governance issues adds to higher volatility and downside risk.
• Having punched through the 4.40-level, the implied probability that the USDMYR would exceed 4.50 and 4.70 by end of this year are 0.46 and 0.29 respectively based on the 3-month NDF contract.
• As uncertainty and risk are expected to remain elevated in the next three to six months the USDMYR is expected to trade between 4.30 and 4.70 during the period. We are revising our year-end USDMYR target to 4.48 from 4.18 and the year’s average to around 4.00 (Prev: 3.91).

Biggest regional loser. In spite of the US Federal Reserve decision to postpone its much-awaited policy rate hike, the pace and speed of ringgit’s (MYR) depreciation gains traction. In less than two weeks after the Fed’s decision on Sep 17 the MYR fell the most on Sep 29 or about 5.6% to 4.4570 to the US dollar. Comparatively, MYR’s decline is much sharper than other regionals, AUD (-2.8%), THB (-2.5%), SGD (-1.9%) and IDR (-1.9%). This poses some concern because investors seem to ignore Malaysia’s long-term fundamentals and are more eager to punish misdeeds while the financial markets somewhat eager to see the US Federal Reserve use the window of opportunity to end its zero interest rate policy (ZIRP) before its growth momentum fizzles out.

September’s rout. The end of September marks one of MYR’s worst performing months, shaving off 5.3% compared to -8.9% in August and -1.7% in July. August was by far the worst month for the MYR, following China’s 3.0% yuan devaluation over Aug 11 & 12, its biggest single move since 1994. It sends shockwaves to the regional markets as it has been widely perceived as the opening salvo in a fresh round of global currency wars. Though the MYR rebounded by almost 1.0% to 4.3950 on Sep 30 from the new USDMYR post Asian Financial Crisis high of 4.4570 on Sep 29 it still depreciated by 14.4% in 2Q15, the highest quarterly loss since 4Q97 (-21.7%). It remains the biggest loser among the regional and major currencies in terms of year-to-date and 12-month performance (Graph 2) vis-à-vis USD.

The side-effect of resurgent USD. The rule of thumb is that the dollar would start to rise on the expectation of a Fed rate hike. And it seemed that the Federal Reserve has set in motion the likelihood that it would raise its short term interest rate by end of the year. With two more meetings to go (Oct 27- 28 and Dec 15-16) it doesn’t take much reasoning to expect EM currencies to continue depreciating while commodity exporters especially of oil and gas would take the bigger brunt of US dollar rise. Malaysia falls under both category.

Hawkish Fed-speak trigger USD rally. Meanwhile dollar continued to rally strongly for the most part since the last FOMC meeting on Sep 17 thanks largely to Fed’s Chairman Janet Yellen reminder on Sep 24 in a long official speech that a rate hike this year is still the most likely scenario, barring a significant economic surprise. This adds to hawkish Fed-speak made by five Fed’s Presidents (John Williams, James Bullard, William Dudley, Jeffrey Lacker and Dennis Lockhart) post FOMC convincing many investors to re-position USD longs for an eventual December rate hike. As a result, the dollar index DXY has crawled back up to 96.32 on Sep 29 near the month’s high of 96.41 (Sep 3) after it fell to 94.55 on Sep 17 following FOMC’s policy decision to remain status quo. Meanwhile, the Dollar index DXY and Broad Dollar Index has increased by 12.0% and 14.0% respectively over the past 12 months (Graph 3).

Growing negative perception. To aggravate the already weakening MYR, talks of sovereign rating downgrade re-emerged. Following Brazil’s downgrade to junk-status by Standard & Poor’s investors turned to credit-default-swaps for clues of possible sovereign downgrade. Most developing nations including Malaysia are facing similar domestic issues that reduced Brazil’s investment-grade rating to junk - plunging commodity prices, weakening fiscal balance, rising debt levels, lack of corporate governance, and political instability. Rising external risk factors such as the impact of impending US Fed rate hike and China’s sputtering economic growth further raised concern of more downgrades across emerging markets. This has prompted CDS investors to punish other emerging markets facing similar challenges, sending their implied ratings at least five levels below their official grades. While Moody’s LT sovereign debt rating on Malaysia is A3, CDS traders see it six levels lower at Ba3 based on Moody’s implied-ratings model that tracked CDS prices of 65 borrowers on Sep 21.

Rising unquantifiable risk. It’s relatively hard to quantify the impact of political and governance issues but it does have a significant bearing on investors’ sentiment which in turn reflected in the value of the ringgit and performance in the bond and share market. Top among the list of growing concerns among investors are alleged misappropriation of large funds by state-run investment company 1MDB, investigations of huge sums of political donations transferred into the Prime Minister’s personal account and the internal rift within the ruling UMNO party. The by-product of all these issues could culminate into political instability and possibly lead to racial and religious tensions. As for now we believe the situation is still under control but the public in general are justifiably nervous.

Punishing bad politics. Nevertheless it explains why Malaysia appeared to be lumped together with other major EM losers namely Russia, Turkey, and Brazil each with somewhat similar investment theme – bad politics. This exclusive club’s rites of passage require record loss in currency value (see Graph 4) as a result of capital flight. These countries have an exceptional political and governance issue that is detrimental to their current state of investment and business affairs. In fact, political issues are a key hindrance to investors’ perception of emerging-market creditworthiness. If the international community does not punish them directly in the form of boycotts or trade sanctions the punishment would be meted out in the form of financial asset selloff resulting in sharp currency depreciation. Or sometimes both as in the case of Russia. It’s a confidence issue and often long term economic fundamentals are virtually ignored. Although fundamentally each country is different, the adverse outcome of their respective financial market and currencies are relatively the same.

Fundamentals ignored. Investors take bad news especially anything that could jeopardise political stability will always trump economic fundamentals. In view of this, the first thing that foreign investors would put under the microscope would be the country’s fiscal health and to determine whether the government has the capacity to repay debt and support economic growth. The implementation of GST and savings from removal of fuel subsidy is expected to take up the slack of oil and gas contribution which account for about 30% of total revenue. Hence, the fiscal deficit is expected to be manageable and able to achieve the official target of 3.2% of GDP this year. Furthermore, as of 2Q15 public debt is still just a tad higher (55.6%) than the self-imposed 55.0% of GDP ceiling and we expect it to revert back to below that level by year-end as long as the government is committed on fiscal consolidation and GDP growth remains around 5.0%. Even if there is a full blown bailout to cover all the contingent liabilities, which is highly unlikely, it may only jack up public debt to slightly above 70.0% of GDP. This is still relatively manageable given that the economy is expected to grow at an annual average of about 5.0% over the next five years, barring any unforeseen macroeconomic shocks.

Relatively stronger now. It is not entirely wrong to say that Malaysia comes from a position of strength after what it had gone through in the past. There are several factors that have made the financial market and economy less vulnerable than the last Asian currency crisis in 1997 or the recent Global financial recession of 2008: low inflation, larger forex reserves, banks are sound and well capitalized with low NPLs and the financial markets especially that of equity and bonds are more robust and aren't as rigid as in the past. Furthermore, the Government has initiated the Economic Transformation Programme in 2011 which among others to diversify Malaysia’s export and commodity dependent economy and to embark on a massive multi-billion ringgit urban redevelopment programme to improve transportation infrastructure that will span till 2030.

Confirmation bias at play. However, amidst the growing noise of market pessimism it’s all too easy to conclude that the ringgit is doomed to weaken further in the near term. This is common fallacy of human thinking as there is the tendency to filter disconfirming evidence (evidence to the contrary) and focus on the conventional wisdom and selective evidence to confirm popular perception. The most popular is to postulate that Malaysia’s fiscal balance would deteriorate sharply as oil and gas revenue shrinks, or the current account is expected to turn into deficit on declining exports, or public debt would balloon because of large contingent liabilities, rising household debt would be out of control, so on and so forth. It’s easier and intuitive to lean towards market’s perception and let confirmation bias take over rational or balance thinking. And with the help of both mainstream and social media spread it as Gospel truth. More often it becomes a self-fulfilling prophecy.

Outlook

Rising uncertainty and vulnerability. The combined factors that have been adversely affecting the EM currencies have created an unprecedented level of uncertainty as well. This explained the faster tempo of ringgit depreciation against the US dollar since early August compared to the first half of the year. Though BNM may have allayed some concern by announcing that it would not re-impose capital controls and re-peg the ringgit it only adds to the volatility and unpredictability of the ringgit. Adding to the vulnerability of the MYR is the fact that BNM is seen to have considerably eased its intervention effort to defend the ringgit. 

Source: Kenanga Research - 2 Oct 2015