Monday, August 10, 2015

Will our Ringgit and Stock Market goes Terminal Velocity?

It is a known fact that one of the hottest topics of discussion among Malaysians for past few months has been our Ringgit. Thanks to our current economic debacle, it helped raised our awareness of our economic situation. Despite the numerous propaganda engaged by our authorities assuring us of our economy’s resilience, it still failed to alleviate our suspicions. Cliché like high level of international reserves, current account surplus, solid domestic financial system and Ringgit reflecting our economic fundamentals were often used. Is it true that our economy is really that resilient and solid? This article aims to look into the current state of affairs of the Malaysian economy and also how it affects the Ringgit.
To begin with we shall look at the macro side of things. Unfortunately, all is not well with the current state of affairs in the world economy. A combination of falling oil and other commodity prices, strong dollar, stock market rout in China and record level of debts around the world has led the IMF to downgrade this year’s global economic growth to 3.2%. This represents the lowest growth rate since 2009. Slower growth means a smaller economic pie to share among all nations.
According to the CPB Netherlands Bureau of Economic Policy Analysis, the Merchandise World Trade Monitor index which covers the global import and export trade provides a good indication of the global economy. World Trade shrank 1.2% in May from the previous month. The index felled from 139.8 to 135.1 points or a 4.7 points drop. This is the sharpest and longest drop since the Global Financial Crisis in 2008. This can be shown graphically below.


To lower the volatility of the monthly analysis, CPM has a 3 monthly Trade momentum index. According to them the World Trade momentum had dipped to below -1%. This represents the slowest pace since the last Global Financial Crisis in 2009. Here’s the graph.


It also reported that the decline was widespread, import and export volumes declined in most regions and countries and in both advanced and emerging economies.

Another indicator that shows the global economy is in bad shape is the performance of commodity prices. When commodity prices decline sharply, it means that either there is an over-supply or weakening demand. A good indicator is the S& P GSCI or Goldman Sachs Commodity Index. It comprises of 24 major commodities from all sectors and thus provided a good indication of the overall performance of the commodity space. Below is the latest S & P GSCI chart.

It can be seen from the chart above the index has crashed to its lowest point since the last Global Financial Crisis in 2008.
In view of this global economic malaise nations began to increase their competitiveness through competitive currency devaluation (beggar thy neighbor policy) to gain market share. The U.S started the ball rolling when it instituted the QE program in Jan 2009. As a result, the Federal Reserve balance sheet expanded and caused the dollar to decline. This helped to improve the terms of trade with its trading partners.

This led to other countries to join in the fray on competitive currency devaluation. Japan is next by devaluating its Yen to reflate its economy and so does Europe. As of July this year, there are more than 30 countries in one way or another joined the currency war. As a result this put an upward pressure on the Dollar and it has since appreciated more than 30%. The following USD index chart shows the movement of the USD since 2008.

Malaysia can be considered as one of the most vulnerable economy that is susceptible to both internal and external exposure. This means our economy is elastic to sudden capital outflow which can cause detrimental damage to our economy. Below I present the External and Domestic Exposure Heat Map by Morgan Stanley.

As can be seen from above between 2nd Quarter of 2009 and 4th Quarter of 2012 Malaysia recorded the highest surge in Portfolio flows, 24% to be exact. On top of that out of the total FDI inflows between that timeframe 68% are of Portfolio inflows. That means most of them are short term capital inflow while the 32% went into long term investments such as building factories or expanding existing facilities. Short term capital inflows can turned outflow in a heartbeat whereas long term capital inflows are more difficult to reverse as their investments ‘are stuck on the ground’.

The second point to note is that 40% of our external debt is short term in nature meaning they can reverse flow at any moment.

Malaysia External Debt

As of March this year our external debt ballooned to RM 768 billion from RM 744 billion in December 2014. Since our foreign exchange reserves have dropped to USD 96.7 billion in July the ratio of our External Debt/FX Reserve now exceeded 200%.

With 40% of our debt is short term in nature, thus it can be said that there are about RM 300 billion in short term debt that are vulnerable to reverse flow. The question is, say if only 50% (RM 150 billion) of the short term funds decided to rush for the exit can Bank Negara counter this move? What chance are we able to defend the Ringgit with just USD 96.7 billion left in the Foreign Exchange Reserves? Please do not forget that from the table above, our Short Term Debt/ FX Reserve stands at 80% which is the second highest after Turkey. Turkey is the biggest Emerging Market economy to succumb to the current financial crisis. The Turkish Lira has dropped to the all-time low to 2.81 against the USD amid political crisis in the country. It has dropped 60% against the USD since 2008. See the chart below.

The Turkish Central Bank has tried to direct intervene in the forex market but failed leaving its reserves with just $35 billion. Similar to Malaysia, Turkey also ran budget deficit for years and had to rely on external financing. Further devaluation meant it will be even harder for them to pay off their dollar debt.

The Turkish political crisis also led the government led by Mr Erdogan to implement erratic policies in order to tighten his grip on his opponents. This includes political pressure on the central bank to intervene and purging of prosecutors, judges and whistleblowers.   

The third point to note from the table above is that foreign holding of Malaysian bonds stands at 44%. This is the third largest after Hungary and Mexico. Malaysia also has one of the largest LCY (Local Currency) bonds in Asia after Japan and Korea. It is close to 100% to GDP or about RM 1 trillion. Below is the breakdown.

Who are on the losing side when they invest in local currency bonds especially when the   Ringgit is depreciating? Well foreign bond holders will be on the losing side. This is because when they exit the bond market they will be getting less USD when they convert their Ringgit to the USD. To ensure the bondholders do not exit at the same time, interest rates will have to rise as a form of compensation. The price of bonds is inversely related to the yield. When happens when foreign investors start selling? The price of bond will go down and the yield will go up. The nightmare every country has is a ‘bond run’. This happens when every bond holder starts rushing for the exit and this will cause a selloff in the bond market which in turn caused interest rates to rise substantially.

By now it is a known fact that our Ringgit has been on the downtrend since last year only recuperating some losses beginning of this year. However the slide begins again and it is likely that we have yet to see the worse. The following chart denotes the exchange rate between the USD and our Ringgit. As can be seen it is now fast approaching the 4.00 psychological level that was set back in 1998 during the Asian Financial Crisis.
USD/MYR chart

Malaysian Dollar

Bank Negara Malaysia has also been involved in the intervention of the Malaysian Ringgit through open market operations by selling the Dollar to prevent further slide of the Ringgit. What supposed to be an orderly or controlled devaluation of the Ringgit by Bank Negara became unmanageable especially after May this year. This also coincides with the onset of our political crisis. This can be shown by the sharp decline of our Foreign Exchange Reserves in the following chart.

Malaysia Foreign Exchange Reserves

Our Foreign Exchange Reserves peaked at $155 billion in August 2011 but has since been declining rapidly. In July 2015, our Foreign Reserves declined to $96.7 billion, a drop of $58 billion from the peak. We have been recording Balance of Payment surplus for the past many years and by right the excess Dollars should be added into the Foreign Exchange Reserves. Yet we are seeing dwindling reserves and one explanation is some of the reserves are being used for open market operations to support the Ringgit. This can be further supported by the expansi
on of Bank Negara’s Balance Sheet as shown below.

Malaysia Central Bank Balance Sheet

Wrapping Up

In wrapping up, from above we know that Malaysia is now one of the most vulnerable countries subjected to capital outflows. This is mainly due to our large exposure to short term debts. With Short Term Debt/ FX Reserve at 80% and Short Term Debt/ Total Debt at 40% and dwindling foreign reserves. In short, we are running on wafer thin safety margin. With Turkey, Russia and Brazil already admitted to defeat in the Currency war, Malaysia’s effort to prop up the Ringgit by selling the Dollar will end up a loser game. Brazil has since gone to the next level of protectionism by enlisting embargo and tariffs. If our political crisis is not solved within a shortest period of time, our economy, exchange rate and stock market will risk a rapid decline soon.
In tradespeak, this amounts to terminal velocity. Terminal velocity decline in any asset price is due to the animal spirits (ideas and feelings) among us. As a normal investor we are all prone to the loss aversion which is a psychological reaction to the market behavior. This refers to our tendency to avoid losses rather than acquiring gains. In normal conditions investors tend to buy when stock price increases and sell when stock price decreases. This will have the tendency to cause a price change in one direction. This will cause a feedback loop where selling begets selling which is also known as price-to-price feedback. This can cause a drastic drop in the asset price as it will lead to panic selling. Eventually it will cause a crash in the asset price. This can happen to our Ringgit when foreign investors start dumping our Bonds and Stocks as it is happening now.

Monday, May 4, 2015

With GST another Financial Crisis looms in Malaysia - A Sectoral Balances approach

No thanks to the usual rhetoric by our authorities in assuring us that our economy is resilient thus able to shield ourselves from the ongoing global economic crisis. Unfortunately most Malaysians tend to believe this and hence “things are in safe hands”. When our government started to rationalize the subsidy of fuel and other essential goods, things started to fall apart. Since then our economy’s health started to deteriorate and people realizing that our economy is not performing as expected. The worst thing is they could no longer able to maintain their current lifestyle as salaries are not keeping up with the ever increasing inflation rate.

Realising the mistakes in their policy implementation our Government started to appeased the people by ditching out cash to the less fortunate. Hence, a social aid scheme known as BR1M was born. However, such Band-Aid measure will not get us anywhere because it is only a short term solution and will not be sustainable in the long run. What needed are policies that will create jobs and increase productivity which eventually leads to sustainable higher salary for the people.

At the meantime our economy is bleeding red ink. Our GDP growth stalled at around 5% since 2010 when it reached its peak of 10.3%. Moreover since 2010, our other economic fundamentals have also started to deteriorate. Our Current Account balance is declining due to our declining exports. To pump-prime our economy out of the recession during the Great Recession in 2008, both the private and public sector are encouraged to spend. This has resulted in the swelling of our external debt from about RM 400 billion in 2009 to RM 744 billion in 2014. Spending more than the revenue it received from taxes, our Government resorted to running budget deficits. The series of event can be summarized in the following charts.  

Historical Data Chart

Historical Data Chart

Historical Data Chart

Historical Data Chart

Faced with economic uncertainty and lavish spending habits, Fitch Ratings Agency started to caution our government to find a cure for our imbalances or risk a sovereign downgrade. When a nation is downgraded its cost of borrowing will increase as the perceive risk of lending has increased and lenders wants a higher compensation.

This is last thing our government wants as an increase in interest rate means more resources will be committed to interest payment on its debt. The following chart shows the interest payment as a percentage of revenue collected by our government. It has been on the uptrend since 2007.

Hence, on order to address this imbalance our Government started its austerity drive. Then in 2010, Minister Idris Jala, announced that without addressing our debt problem, Malaysia will then be bankrupt by 2019. Everybody was taken by surprise. As a result measures were taken which includes rationalizing of subsidies for certain essential goods such as sugar and fuel. When we are still in a state of shock our government swiftly implemented those austerity measures. Thus with this ‘shock and awe’ tactic, ordinary Malaysians which does not even have the time to react succumbed to it.

The ‘shock and awe’ tactic also known as the shock doctrine was first developed by an economist by the name of Milton Friedman from the University of Chicago. Milton Friedman believes in using bitter medicine and painful shocks inflicted upon the masses so that they can be controlled psychologically. The basis of their techniques can be found in Friedman’s book Capitalism and Freedom and it has since been adopted by the IMF’s bitter medicine for their austerity measures. The very same template of policy is applied to all recipient countries of IMF bailout.

Unfortunately these measures did not produce the results as anticipated. Our Debts seems to be increasing because our Government’s lavish spending habits. To finance further expenditure our Government will either need to borrow more, grow our economy out of its problems or increase taxes. Given that it is unable to borrow more due to the constraint in capping the debt to GDP at 55% and knowing there is no way to grow the economy without spending more, it is left with one choice, increasing taxes. But our income tax has reached its limits due to narrow tax base so the only solution left is to increase the tax base where more people will be ‘inflicted the pain’. Thus GST has to be introduced because of the following reasons.

  1. It helps to widen the tax base that will include virtually every Malaysian instead of relying on the traditional income and corporate taxes.
  2. Government Deficits has to be finance from a source that will not contribute to the existing debt level.     

By introducing GST, our Government hope it will help reduce the debt and also its budget deficit. At the same time it can avoid another Sovereign rating downgrade. Voila !! killing three birds with one stone it seems. All problems solved with a stroke of the pen? But wait a minute, I wonder whether have they evaluated the side effects of this policy?

In implementing any economic policy there is always a cause and an effect. So when our Government implements a policy that improves the finances of the public sector then obviously other sectors of the economy will be affected. If our public sector’s (Government) finance improves then there will be repercussions on the other two sectors of the economy namely the private and external sector. They think that by improving one sector then the rest of the economy will follow suit. In actual fact this is not going to happen and I will be explaining it in the following.    

To bring this analysis into another level let me introduce you an economic model known as ‘Sectoral Balances’ analysis. With this model I hope demonstrate to you why our Government’s attempt to slashed budget deficit will work against its wish to cure our economy.  

Sectoral Balances Approach

Sectoral Balances is a framework for macroeconomic analysis of the economy developed by British economist, Wynne Godley. The basis of the Sectoral Balance model lie in the analysis of fund flows between the three sectors of the economy namely the public, private and foreign sector. The relationship between them can be derived from the balance of payment and national income accounting.

National Income or GDP or Y = C + I + G + (X – M)


C = Consumption
I = Investment
G = Government Spending
X = Exports
M = Imports

Savings can be described as the amount left after income minus consumption and tax. Thus,
Savings or S = Y – C – T
Substituting Y from above,

S = C + I + G + (X - M) – C – T

Netting off the C and rearrange we get,

(S - I) = (G – T) + (X – M) or,

Private Sector = Public Sector (Budget Deficit) + Foreign Sector

Thus, by definition from the Sectoral Balances analysis our economy consists of three sectors which are the Private Sector, Public Sector (Budget Deficit) and the Foreign Sector. The sum of all three sectors whether they are in deficits or surpluses will theoretically equal to zero. But normally it doesn’t due to leakages. So, when our Government runs a Budget Deficit it is obvious the other two sectors cannot be running deficits also. One or both of them should be running surpluses.

Currently, our Government is running a Budget Deficit while both the Private and Foreign Sectors are running surpluses. Since our Government has rationalizing subsidies and implementing GST the net effect will be a reduction in its Budget Deficit? What are the net effects of such policy?

Effects of Reducing Budget Deficit

From above we know that when a Government is running Budget Deficit either one or both of the other two sectors will be in surplus. Malaysia is committed to reducing its budget deficit as per recommended by Fitch. What is going to happen soon will be an increase in government revenue through GST and hence will improve the public sector (G – T). As the public sector improves we know that either the private or foreign sector or both will worsen. This following table is a compilation of data that I gather from several sources.   

(G - T)/GDP %
(X - M)/GDP %
(S-I)/GDP %

Source : BNM, Department of Statistics and World Bank

The above table shows the performance of the three sectors from 2004 to 2014. With this data and for easier visualization, I plotted the three sectors into different charts as shown below.

Source : BNM, Department of Statistics and World Bank

From above we know that our Budget deficit currently runs at -3.5% to GDP while both the private and foreign sector are at a surplus of about 4% to GDP. As can be seen from above when our Government increased its budget deficit from 4.1% in 2004 to 6.7% in 2009, both the private sector (S - I) and foreign sector (X - M) improves. When happens when our Government starts reducing its budget deficit in 2010? Both the private and foreign sector started to deteriorate from about 15% to 4% to GDP currently. So what is going to happen when our government starts Balancing its Budget or (G – T = 0)?

Yes, from the sectoral balances approach we know either one or both of the private and foreign sectors will be affected. Our current model that is relying on the private sector (S – I) to boost the economy has stopped working. This is because although investment may be increasing savings rate is not catching up either due to the following

  1. Depletion of their savings in financing the consumption either local or imported products
  2. Increase in quit rent, assessment, taxes esp. GST
  3. Inflation or rising price level due to subsidy rationalization

As a result in order to maintain their current standard of living, households will have to deplete their savings or borrow more which lead to further indebtedness. This is the reason why our private sector’s debt has ballooned to about RM 980 billion in 2012 as shown by the following chart.

Source : BNM, Department of Statistics and World Bank

In short our past policy depending on the private sector for growth has come to an end and it is time for the public sector to take over the job. In order to achieve a more stable and sustainable model of economic growth instead of trying to balance the budget we should expand the public sector in the form of higher fiscal spending. Policies implemented to expand the public sector must ensure that there will be spill over effects into the private and foreign sector so that they will continue to be in surpluses. Graphically our current state of the economy can best be illustrated with the following graph.

When Government Balances Budget (G – T = 0)

The above chart best describes our economy in the next few years if our Government continues its current policy on reducing the budget deficit. The red colour bar represents the public sector, green for foreign sector and blue for the private sector. As can be seen when our government balances its budget from this year onwards the red bar moves from negative to positive zone and will soon become the dominant sector. The foreign sector will remain in positive territory because our exports have become competitive due to the sluggish Ringgit. Thus it can be seen that the private sector (S – I) will be the worst hit due to the depletion in savings and the increase in investment to cater for the export industry. Therefor I expect the private sector to feel more desperate, pain and frustrated due to increasing debts and stagnating salaries.    

What if our Government increases the budget deficit?

It will be another story, when our government increases the budget deficit then the other two sectors will benefit. To increase the budget deficit or (G – T) our Government either have to increase its fiscal spending G or reduce its taxes which will boost the income of the people. Thus it will help increase savings and spending which will eventually boost the economy. The scenario is best described by the chart below.

When Government increase Budget Deficits (G – T > 0)

But some people argued that high budget deficit is not sustainable to our economy. This is not necessary so as I shall demonstrate in the following table.

Government Budget with GDP Growth and Debt/GDP %
Govt. Budget %
GDP Growth %
Debt/GDP %
South A.

The chart above shows the 15 countries that are running the highest budget deficit in the world. As can be seen out of the 15 biggest spenders 13 countries still manage to record positive GDP growth. Look at India it is running a deficit of 4.5% and yet its economy grew by 7.5%. And so does Pakistan, 8% budget deficit but 4.14% economic growth? How about their Debt/GDP? Only three out of the 15 countries record triple digit Debt/GDP figures. So what say those folks who have preaching running huge deficits is bad for the country.


In summary, I like to congratulate our Government on their implementation of austerity measures in order to strengthen the public sector. But I also wish to caution that such measure will eventually backfire as our private sector is most indebted in recent time and thus most vulnerable. This is because when our Government engage in fiscal contraction it will further reduce demand which will reduce output and eventually employment. This tends to weaken the private sector and that leaves the foreign sector to inspire demand. The problem is we cannot rely on our exports to pull us out of the slump in demand. The reasons are as follows.

At the moment everybody is trying to export the way out of trouble by weakening their currencies. At the moment there is a fierce currency war going on out there. Every exporting nation is trying to devalue their currency to cheapen their exports. Since one country’s export is another country’s imports, how are we going to export our way out of trouble.

So our current approach to grow our economy through fiscal austerity will not work because it will weaken the private sector further as there will be further built up of private debts. As mentioned above our household debts is already reaching close to 90% of GDP and any further accumulation of debts will make debt servicing almost impossible. This will end up in a massive repayment defaults What follows are further credit crunch as banks will be more selective in their lending and will lead to stock market, real estate and mortgage crashes.

The right policy is to find a cure for this sector and not weaken it. Our Government will have to continue its deficit expenditure so as to create demand which will add to income and hence savings. When revenue increases so will income and corporate taxes and this process will feed on itself and in time will help turn around the economy. In short, I will confidently say that if Malaysia going to be hit by another Financial Crisis it will erupt from the private sector.

The author is the Economic Advisor to the National Union of Bank Employees