Monetary Conditions To Be Normalised At A Measured Pace And The Ringgit Will Likely Fluctuate At RM3.20-3.30/US$

◆ Countries across the Asia Pacific have stepped up their efforts to normalise their monetary conditions. The normalisation of monetary conditions, in our view, aims to prevent asset prices and financial imbalances from building up in some countries and to address rising inflationary pressures in others.

◆ To be ahead of the curve, Bank Negara Malaysia also started to normalise the country’s monetary conditions by raising the overnight policy rate by 25 basis points to 2.25% on 4 March.

◆ Major economies like the US, Euroland and Japan, on the other hand, lagged behind in policy normalisation. This is to be expected given that these countries are facing with high fiscal deficit and public debt as well as unemployment.

◆ In anticipation of emerging and developing economies normalising their monetary conditions at a faster pace than that of developed economies and improving currency yields, Asian ex-Japan currencies have been appreciating against the US dollar.

◆ Among the regional currencies, the ringgit is running ahead, as Bank Negara Malaysia was the first country in this region that has started to normalise its monetary conditions and investors are expecting more to come.

◆ Given that Malaysia is already ahead of the curve, we believe Bank Negara Malaysia will not be in a hurry to increase its interest rates further. Future rate hike will likely occur at a measured pace. As a result, we expect the Central Bank to pause in May’s meeting but will likely raise the overnight policy rate (OPR) by another 25 basis points to 2.5% in July. Thereafter, the OPR will likely stay at this level for the rest of this year.

◆ In this respect, we expect the ringgit to fluctuate at around RM3.20-3.30/US$ for the rest of 2010 before settling at RM3.20/US$ by end-2011.


More Widespread Normalisation Of Monetary Conditions

Countries across the Asia Pacific have stepped up their efforts to normalise their monetary conditions, as policymakers are feeling more comfortable to do so given that economic recovery is gaining strength and more entrenched. The normalisation of monetary conditions, in our view, aims to prevent asset prices and financial imbalances from building up in some countries and to address rising inflationary pressures in others.

Leading the pact is Australia with the Reserve Bank of Australia raising its key policy rate for the fifth occasion in six months to 4.25% on 6 April and signalling further increases ahead. Indeed, the Reserve Bank of Australia Governor said that “Australian house prices are getting too high and interest rates to most borrowers have been somewhat lower than average,” signalling that he wants to minimise the danger of a housing boom and bust in the aftermath of the US example. On the other hand, though inflation in Australia has begun to pick up to 2.1% yoy in the 4Q, from a low of +1.3% in more than 10 years in the 3Q, it was still within the central bank’s target range of between 2-3%.

To be ahead of the curve, Bank Negara Malaysia also started to normalise the country’s monetary conditions by raising the overnight policy rate by 25 basis points to 2.25% on 4 March (see Chart 1). The move followed the Governor’s remark of the need to bring back interest rates to a more normal level to prevent financial imbalances from building up. Indeed, anecdotal evidences suggest that low returns from deposits are increasingly pushing Malaysians to take higher risks by venturing into various investment schemes without knowing the underlying risks.

Joining the pact was India with the Reserve Bank of India raised its key policy rate for the second time in month and by 25 basis points to 5.25% on 20 April, after unexpectedly raising it on 19 March, a month before the quarterly scheduled monetary policy meeting. India’s move came about as inflation accelerated to a 15-month high of 9.9% yoy in February and it sustained at the same level in March, exceeded the Reserve Bank of India’s estimate of 8.5% by 31 March. The central bank said that elevated level of inflation remains a concern in the immediate term and an interest rate move before the next monetary policy meeting scheduled for 27 July cannot be ruled out, signalling that it may increase interest rates further in the months ahead. Earlier, India’s Finance Minister reversed some of the tax cuts initiated in 2009 in the budget tabled on 26 February. This includes raising the excise tax on almost all consumer products to 10% from 8% and increased customs duty on overseas purchases of crude oil.

In the same vein, Singapore raised its real GDP growth forecast for 2010 to 7-9%, the second time this year and from 4.5-6.5% projected previously, after it recorded an annualised growth of 32.1% in 1Q 2010. As a result, Singapore raised its inflation forecast to between 2.5-3.5% in 2010, from an earlier projection of 2-3%, as stronger economic growth will likely lead to higher price pressure. At the same time, the Monetary Authority of Singapore (MAS) also joined its regional counterparts in tightening the country’s monetary policy. It said on 14 April that it would undertake a onetime revaluation and seek a gradual and modest appreciation of the currency, a shift from a zero-appreciation stance of the Singapore dollar in October last year. Singapore dollar rose by 1.6% against the US dollar on 14 April, the most in 10 months following the MAS’s move. MAS uses the currency instead of interest rates to conduct monetary policy and it opted for a de-facto devaluation of the exchange rate in April 2009. The central bank guides the Singapore dollar against a basket of currencies within an undisclosed band and the stance of its monetary policy is assessed twice a year.

Despite stronger economic growth and rising asset prices, China may delay its move to raise interest rates and allow the currency to appreciate, where it has refrained itself from doing so. Instead, China preferred to use administrative measures to cool down inflation and property prices. Indeed, in a latest move announced on 15 April, China set a 30% minimum down payment for the purchase of first homes larger than 90 square meters and raised the down payment for the second home for the second time this year to 50% from 40% previously. Earlier, China targets to cut banks’ new loans by 22% in 2010 from a record of US$1.4trn in 2009 and it has re-imposed a tax on homes sold within five years of the purchase in January. In the first three months of 2010, new loans extended by banks fell by 43.2% compared to the same period last year (see Chart 2). At the same time, developers are required to pay a higher deposit for land purchases and China banned banks from lending to builders found to be hoarding land or holding back home sales in anticipation of higher prices. In addition, the People’s Bank of China raised banks’ reserve requirement twice to soak up liquidity from the system. The preference for regulatory measures such as outright caps on lending, as opposed to price-based measures such as interest rates to influence the market for loans, reflects the legacy of China’s command-based economy, while almost all banks are government controlled. Furthermore, the authorities are concerned that raising interest rates in the current economic environment could attract capital inflows and complicate its monetary tightening, and they see rising risks from the external global environment and worry about the sustainability of the recovery. Indeed, China’s cabinet signalled caution in ending crisis policies on 14 April, as it said current economic growth was largely driven by stimulus policies and a comparison with low levels in 2009.

Major Economies Lagging Behind In Policy Normalisation

Major economies like the US, Euroland and Japan, on the other hand, lagged behind in policy normalisation.

This is to be expected given that they are at the epicentre of the global credit crisis. Facing with high fiscal deficit and public debt as well as unemployment, these economies will likely normalise their monetary conditions at a measured pace, in our view. Indeed, for a start the US and Euroland have gradually unwound their emergency lending programmes to banks and assistances provided to various markets, which we believe are on the right track.

In light of improved functioning of financial markets, the US Federal Reserve has been closing the emergency liquidity facilities that it created to support markets during the crisis. The only remaining such programme, the Term Asset-Backed Securities Loan Facility, is scheduled to close on 30 June for loans backed by new-issue commercial mortgage-backed securities, while for loans backed by all other types of collateral the closing date was on 31 March. Also, the Fed has raised the discount rate on emergency loan by 25 basis points to 0.75% to discourage banks from borrowing it and is expected to increase further going forward. With the conclusion of the quantitative easing by end-March, the Fed’s next move will likely focus on addressing the huge amount of liquidity that has been injected into the system, in our view. The tools use will likely include raising interest rate on banks’ reserves placed with the Fed, the use of term deposits and reverse repos to soak up liquidity in the system. On the other hand, we believe the Fed will likely leave its key policy rate unchanged at 0-0.25% for an extended period. Meanwhile, the US core inflation rate eased to 1.1% yoy in March, from +1.3% in February and a peak of +1.8% in December, indicating that price pressure outside
food and energy is trending lower. Indeed, the minutes of the 16 March Federal Open Market Committee showed that policymakers were surprised by the rate at which inflation was slowing and the moderation in price changes was widespread across many categories of spending.

In the Euroland, the European Central Bank (ECB) had stopped offering 12-month loans to banks in December 2009. In March, the ECB offered its final tender for six-month loans and said that it would tighten the terms of its three-month loans on 28 April by returning to the pre-crisis practice of offering the funds at a variable rate. The ECB, however, said that it would keep offering banks fixed-rate unlimited funds for seven days and one-month loan at its benchmark rate at least until 12 October, signalling that the phasing out of the emergency lending programmes will be at a measured pace. Similarly, the ECB will likely stop its quantitative easing policy soon, which started in July 2009, once it hits its target. Thus far, the ECB has purchased €47.2bn of bonds or 78.7% of the target as at end-March 2010. Although Euroland’s inflation rate picked up to 1.4% yoy in March, the fifth consecutive month of increase and from +0.9% in February, the ECB is not overly concerned about it, as it was driven by rising energy costs and given that unemployment is still rising. As a result, we expect the ECB to keep its key policy rate at a record low of 1.0% in the near term.

In contrast with its counterparts around the globe who are beginning to withdraw liquidity in tandem with a recovery in their economies, the Bank of Japan (BOJ) increased the three-month loan facility to financial institutions from ¥10trn (US$111bn) to ¥20trn (US$222bn) in a move to shore up liquidity and combat deflation, while holding the key policy rate unchanged at 0.1% on 17 March. Japan is concerned that falling prices may delay consumers’ decisions to make purchases now in a hope to buy them later at cheaper prices and investors may delay their investment, complicating Japan’s economic recovery. As a result, the Japanese government, which is burdened by a record debt load, is pushing the BOJ to do more to help the economy. Meanwhile, Japan’s deflation is showing signs of easing with its inflation rate falling by a smaller magnitude of 1.1% yoy in February, the fourth consecutive month of narrowing and compared with -1.3% in January (see Chart 3).

Asian Currencies Strengthening Due To Better Yield And Speculative Inflows

In anticipation of emerging and developing economies to normalise their monetary conditions at a faster pace than that of developed economies and improving currency yields, Asian ex-Japan currencies have been appreciating against the US dollar in recent months.

Apart from domestic factors, currency traders were betting on a repeat of five years ago of what had happened to the regional currencies when China depegged its currency. Then the Thai baht, Korean won, Singapore dollar (S$), Indonesia rupiah, Philippines peso and the ringgit rose by 9.6%, 9.2%, 5.8%, 5.8%, 5.0% and 3.4% against the US dollar in the 12 months after officials in Beijing relaxed the foreign-exchange regime in July 2005. The euro also appreciated by 4.7%, while the renminbi by 3.5% against the US dollar during the same period. The Japanese yen, Indian rupee and Taiwan dollar, on the other hand, fell by 2.0%, 5.5% and 1.3% respectively against the US dollar during the same period.

As a result, the ringgit, rupee, rupiah, won, baht and peso appreciated by 6.7%, 3.9%, 3.6%, 4.4%, 2.5% and 4.0% respectively against the US dollar year-to-date (see Chart 4). Similarly, the S$ and Taiwan dollar strengthened by 2.1% and 2.3% respectively against the US dollar during the same period (see Chart 5). The appreciation of the S$ will likely catch up with other regional currencies, after the MAS shifted its policy stance to favour a gradual appreciation.

The renminbi, on the other hand, remained stable as it has been pegged to the US dollar since July 2008. As a result, pressure is mounting on China to let its renminbi to appreciate, particularly from the US. China’s President said on 15 April that the country would not be pushed by external pressure on the exchange rate and it would follow its own path in reforming the currency policy, and any changes will be based on the country’s own economic and social development needs. The US, by delaying a report to label China as currency manipulator, is hoping that international diplomacy will work better than US pressure to get China to strengthen its currency. As a result, we expect a compromise situation to happen and China may allow the renminbi to appreciate by 3-5% in 2H 2010.

The Ringgit Is Running Ahead

Among the regional currencies, the ringgit is running ahead, as Bank Negara Malaysia was the first country in this region that has started to normalise its monetary conditions and investors are expecting more to come. Expectation of improving currency yield coupled with positive news flow from the announcement of the New Economic Model by the Prime Minister during Invest Malaysia on 30 March have attracted short-term speculative capital inflows, in our view. As it stands, the foreign portfolio investment in fixed income papers rose by RM4.1bn in January, the seventh consecutive month of increase before falling by RM1.0bn in February. As a result, total holdings in fixed income instruments by foreign portfolio investors rose to a 17-month high of RM73.3bn at end-January, before easing to RM72.3bn at end-February. We believe the February’s decline is likely to be temporary and the holding of fixed income papers by foreign investors is likely to have bounced back in March and April.

Also, we believe the Central Bank has not been in the currency market to intervene to smoothen the appreciation of the ringgit given that the country’s foreign exchange reserves have remained relatively stable at around US$95-96bn since September 2009. This has contributed to a rapid appreciation of the ringgit in a short span of time. Indeed, Bank Negara Malaysia issued a statement to state that the ringgit’s strength reflects its economic fundamentals and the country has never relied on the exchange rate for trade competitiveness.

Bank Negara Will Normalise Its Monetary Conditions At A Measured Pace And The Ringgit Will Fluctuate At RM3.20-3.30/US$ For The Rest Of The Year

Given that Malaysia is already ahead of the curve and faster compared to regional economies in terms of normalising its monetary conditions, we believe Bank Negara Malaysia will not be in a hurry to increase its interest rates further. Future rate hike will likely occur at a measured pace. Furthermore, the recovery in the global economy will likely be uneven and neighbouring countries have delayed their moves in raising interest rates, as inflation, though trending up, remains not a major threat to regional economies. As a result, we expect the Central Bank to pause in May’s meeting but will likely raise the overnight policy rate (OPR) by another 25 basis points to 2.5% in July. Thereafter, the OPR will likely stay at this level for the rest of this year. We expect the Central Bank to raise its key policy rate again in early part of 2011 and by a total of 50 basis points during the year, pushing the OPR to a more normal level of 3.0% by end-2011.

In this respect, we believe the surge in ringgit vis-à-vis the US dollar might have over done. This, coupled with possible disappointments over an OPR rate hike by Malaysia in May and an appreciation of the renminbi in the near term, suggests that the ringgit will likely weaken back. We expect the ringgit to fluctuate at around RM3.20-3.30/US$ for the rest of 2010 before settling at RM3.20/US$ by end-2011. Based on the real effective exchange rate (REER) model, the fair value of the ringgit is at around RM3.38/US$.