‘Out of the box’ approach needed

by **Cals** Sun 23 Aug 2015, 22:30

‘Out of the box’ approach needed

Saturday, 22 August 2015
By: SURESH RAMANATHAN - CURRENCY INSIGHTS.

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New ways: Ringgit banknotes of various denominations are arranged for a photograph in Tokyo, Japan recently. Interest rate defence has had both success and failure, some quite spectacular.

In light of the recent ringgit weakness, a commonly used defence that is being proposed is to raise short-term interest rates sharply to deter speculation and weakness in the currency. Interest rate defence has had both success and failure, some quite spectacular.
Hong Kong raised its overnight interest rates to several hundred percent and successfully defended its currency in October 1997 against speculative attack.
On the other hand, Sweden similarly raised its interest rate by several hundred percent in its currency defence in September 1992, but the success was short-lived.
In December 2014, Russia raised interest rates to almost 17% to defend its currency, but currently, the currency is still languishing. In many countries, raising short-term interest rates to very high levels to defend the exchange rate appears to have little effect in deterring speculation or arresting its decline, whereas in others, moderate increases in the interest rate seems to dampen speculative pressures.
It leaves the question of the effectiveness of an interest rate defence very much open, which tells us that taking the route of raising interest rates to defend a currency could be a gamble.
Why is it a gamble?
It boils down to the information it gives, that very action of raising interest rates to market participants. Specifically, high interest rates may signal the commitment of policy makers to defend the currency. Raising interest rates instead of letting reserves decline in order to defend the currency may signal weak fundamentals.
It may also be read as a sign of central banks’ panic by speculators. Such information would only encourage further speculation.
Taking an alternative approach to raising interest rates to stem currency weakness, other viable options can be explored, to at least provide and restore stability to the foreign exchange market. These include:
> Establishing a facility with interest rates that are between 200 basis points (bps) and 300bps above policy rates for institutions needing liquidity.
The move should be also seen as providing an avenue to remove any form of shift in deposits by large corporates into foreign currency accounts.
This limits the outflow of funds from normal ringgit accounts to foreign currency accounts and curbs the exchange of ringgit into foreign currencies.
Currently, corporates are lured by the fact that the ringgit is weakening and directionless and the lure of a safe-haven window in the form of a foreign currency account is driving this conversion.
> The central bank provides direct dollar liquidity to strategic public-sector companies that are in need of the currency.
Instead of going through the inter-bank market to secure dollars, this window will remove the pressure on the currency in the short term.
> Tightening onshore liquidity to reduce the availability of the ringgit in the banking system in order to reduce currency volatility.
Although this may induce an increase in short-term interest rates, the move should be seen as temporary, with market-driven interest rates making the adjustment.
The policy rate should be kept steady, signalling the central bank still remains committed in keeping an interest rate policy that is conducive for growth.
> In a bid to attract non-resident Malaysians’ deposits, the central bank could liberalise bank deposit schemes and offshore Malaysian financial institutions raising interest rates for non-resident Malaysians.
To spur banks to attract more dollar deposits from non-residents, the central bank could exempt these deposits from the cash reserve ratio and statutory liquidity ratio requirements for a specific period.
> Using a quarterly exchange rate target or even a monthly exchange rate target provided by the central bank in valuing risk-weighted assets and imposing a moratorium on mark-to-market accounting.
This provides some form of certainty to corporates that have non-ringgit loans and debt payments, and using the exchange rate levels provided by the central bank as the conversion rate.
> Fixing the spread at which Bureau de Exchange operators can sell and buy US dollars to individuals, literally having a narrow corridor on the dollar-ringgit exchange rate at Main Street.
This measure eliminates the wanton marking-up of spreads on certain currency pairs.
These measures are ‘out of the box’ alternatives instead of using the textbook approach of raising interest rates to defend a currency.
Raising interest rates to stem currency depreciation is a gamble, a gamble Malaysia need not take.
Dr Suresh Ramanathan is an independent interest rate and foreign exchange strategist who has spent 20 years in several onshore and offshore financial institutions. He can be contacted at skrasta70@hotmail.com