Link to Farqani Mohd Noor’s LinkedIn Homepage

I am delighted to host another student guest post by Farqani Mohd Noor. This is the 5th student guest post of this semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link.

The other day, my brother, a dentist, was furious on Whatsapp, complaining about the depreciating Ringgit. He said, “80% of my dental materials are imported, and they’re 25% more expensive now. But the government is not increasing allocation of funds for them. How am I supposed to give my services to the people?!”

Commodity-exporting countries are facing depreciating currencies due to the current economic landscape; US interest rates are uncertain, China is combating a housing bubble and a stock market crash, and commodity prices are fluctuating. These factors are affecting the supply and demand for currencies. Malaysia, one of the affected countries, is now selling $ 4.4 Malaysian Ringgit (MYR) for $1 USD.

My brother continued, “At this rate we will reach $5 MYR for 1 USD. Why not peg the currency?”

I fell silent, trying to formulate a witty economic response. I recall reading Milton Friedman. He said, “A country that pegs the exchange rate is essentially committing itself to adopt the economic policies of the country whose currency it is pegged to.”

The idea of pegging MYR to the USD is familiar to Malaysians as Dr. Mahathir, the former Malaysian Prime Minister, banned offshore market trading of the ringgit and pegged it to $3.8 USD during the 1997 Asian Financial Crisis. Consequently, the country recovered from the crisis faster than our Southeast Asian peers (Indonesia and Thailand). This unorthodox method was successful with the help of the central bank.

The central bank has control over MYR through foreign reserves. The $95 billion USD of foreign currency reserves in Malaysia will not sufficient to peg the currency in the long run; they will eventually run out of ammunition. The central bank will have to borrow foreign currency in efforts to meet the demand for foreign currency. Shrinking of the foreign reserves and the cost of accumulating them means more RISK in the economy. Therefore, I conclude that foreign reserves serve as an instrument for the central bank to smooth the currency but not to fix them at a certain rate.

In order to face these risks during the 1997 Asian Financial Crisis, Dr. Mahathir implemented selective capital controls in order to circulate MYR within the country. For example, investments above $10000 MYR to non-residents will require permission from the central bank. Dr. Mahathir also implemented in an expansionary fiscal policy worth $2 billion MYR for consecutive years until 2002. This was coupled with low interests rates from 11% in mid 1998 to 3% in the December 1999. These were efforts to stimulate spending during the times of recession and prevent MYR from leaving the country.

However, pegging currencies in current economic landscapes exposes Malaysia to different risks than that of 1997. Since fiscal policies are expensive, the government has to think twice of increasing spending. The government debt is much higher now than it was in 1997; it stands at more than 50% of GDP. With the introduction of Goods & Services Tax (VAT equivalent) and rationalization of subsidies, Malaysia has been going through a transitional period and prices have only begun to stabilize. Introducing more fiscal spending now will be counterintuitive to the efforts done to reduce the debt. But how will the Malaysian economy run under capital control with limited stimulus packages?

External landscapes, on the other hand, like Europe and China are also different from that of 1997. Europe is going through a difficult period, with the Greece Debt Crisis occurring during these last couple of months. China’s maturing economy is facing a sharp slowdown in exports and growth. These external economic landscapes matter because Malaysia is an exporting country – exports of goods and services measured by the World Bank is at 80% of GDP in 2014. Currently, US currency rates are appreciating against all other major currencies (not only MYR). If Malaysia’s currency is pegged against the USD, this will also appreciate the MYR against other currencies in the world. The appreciated currency will reduce major exports and destroy manufacturing businesses (main export sector) like electrical & electronic products (35% of Malaysia’s total exports), as prices will be more expensive than competitors in Thailand, Indonesia and China

Finally, The US Fed also plans on tightening monetary policies and increasing fed interest rates. These are policies that will prevent Malaysia from stimulating the country’s economy, if it decides to peg the MYR to USD. In the end, Malaysia will find itself facing a technical recession just like how Chile, and Argentina did when they pegged their currencies against USD. Malaysia needs monetary independence in order to face its own economical challenges that are different from the US. Moreover, in 1997, currency speculation created the Asian Financial Crisis. However, currently, political scandals and economical challenges are depreciating the MYR. Thus, we need policies to solve our problems and not limit them.

Given what I’ve said, Malaysia’s economic fundamentals are much stronger than it was in 1997. Thus, while pegging the currency might not be an option, I hope Malaysia can adjust to the supply and demand of MYR in the market. It’s been almost two decades since 1997, during which Malaysia has survived, recovered, and grown through the 2008 financial crisis.

But I did not have time to formulate these thoughts in a text message due to the need to write this post for class! So I replied to my brother’s comments, “Economies are cyclical. There’s a boom and a bust. Be patient in face of economic slowdown because no currency can defy economic principles especially not the MYR.”