In our organization, we have developed a currency scorecard based on a simple statement made in the 1995 classic paper by Maurice Obstfeld and Kenneth Rogoff titled “Mirage of Fixed Exchange Rates”. In that paper, they note that purchasing power parity, current account imbalance and real interest rate differential are probably the three most important fundamentals that matter to exchange rates.
So, we calculate each country’s real effective exchange rate, current account balance and real interest rate differential (relative to the US). For some subjectively chosen neutral ranges, the score is zero. For levels better than neutral (competitive real effective exchange rate, lower current account deficits or even surpluses, large and positive real interest rate differentials), points are assigned and summed up.
This leads to identification of undervalued or attractive currencies and vice-versa. This is not a trading tool since there is enough literature to suggest that economic fundamentals explain exchange rate movements at horizons over three years. This is useless for most foreign exchange traders.
Nonetheless, we constructed a simple trading rule out of our currency scorecard. With no room for discretion, we devised a trading rule whereby we “buy” the five best attractive currencies as per the scorecard and “sell” the five least attractive currencies every month. The results are mildly encouraging and there is an interesting discovery in the results. The “sell” strategy has delivered good returns whereas the “buy” signals from these fundamentals have not worked that well. In recent months, of course, there has been a reversal of fortunes for both.
The reason why the currencies that we “bought” never performed well is that most of them were from Asia. In fact, in our scorecard, the Malaysian ringgit is the second most attractive currency after the Norwegian krone. In 2008, Asian currencies depreciated significantly against the US dollar. In 2009, they did not appreciate much against the US dollar despite the resumption of broad-based dollar weakness. Asian governments have gone back to their familiar behaviour of 2005-2007, intervening to keep their currencies from appreciating and accumulating reserves. Not much has changed.
In fact, that was the cause of disagreement between the International Monetary Fund (IMF) and Malaysia as the former conducted its Article IV consultation with the latter this year. IMF said the Malaysian ringgit was undervalued and needed to appreciate while Malaysian authorities demurred on the timing and perhaps on the magnitude of the suggested undervaluation itself.
There has to be certain sympathy for the Malaysian point of view. In Asia, it is hard to see many countries allowing their currencies to strengthen against the US dollar unless China sends a strong signal that it is about to let market forces dictate the value of the renminbi against the US dollar. That is not on the horizon and is unlikely to materialize any time soon.
Malaysia is a country with a population of 25 million. It has become a middle-income country and has struggled to scale further economic heights since the Asian crisis of 1997-98. It is dependent on export of electronics and crude oil and gas. On the former, it is losing competitiveness. It is no longer attractive in terms of costs and its affirmative action policies do not allow the country to make up for eroding cost competitiveness with productivity and value-enhancement in its exports.
While the government has begun slowly dismantling its Bhumiputra (favouring Malays) policies, education is regulated and witnesses both positive and negative discrimination.
Its non-oil primary fiscal balance is a deficit of nearly 15% of gross domestic product. Of course, unlike India, the government dismantled large portions of its energy subsidy regime last year at the peak of oil prices. Net foreign direct investment has mostly been a case of outflows for the last several years. Private sector savings are high and hence funding the deficit has not been an issue. But the high savings rate is a reflection of absence of social safety nets and retirement benefits.
Now that the catch-up phase of easy growth is well behind it, the country is struggling to find its niche. It has not succeeded, yet. It is not easy. IMF has downgraded the potential growth rate of the country to around 4.5% for the next several years. That might be both polite and optimistic. The country might have found Islamic financing as a niche area for service sector growth, but large swathes of the population would be untouched by the sector and it is unlikely to generate many jobs for the semi-skilled lacking in tertiary or post-tertiary educational qualifications.
Therefore, we face the classic dilemma of the modeller. Do we go by what the model says and repose faith in the Malaysian ringgit for the long term or go for other Asian currencies such as the Indonesian rupiah and the Indian rupee that score less well on our measures?
The answer has to be found in non-economic metrics and analysis. In the final analysis, I am inclined to override the model’s conclusions on this one.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org