The world still runs on US dollar

 

THEORY, with the US economy officially entering recession as its GDP contracted by 0.3 per cent QoQ in the 3Q2008, the US dollar (USD) should be weakening against other currencies in particular against those of the US major trading partners.

Surprisingly, a barrage of grim economic news has failed to fret the USD.

Since the breakout of what we would term as the second-round explosion of the global financial crisis in mid-September 2008, the USD has actually raced to multi-year highs against virtually all currencies with the exception of the Japanese yen (JPY) and to a certain extent, the Chinese yuan (CNY).

To be fair, this USD vigour emerged towards mid-July 2008 in tandem with the start of the ongoing downtrend in global commodity prices especially related to food such as agro-based commodities; energy such as oil and gas as well as building materials such as base metals, cement and other raw materials.

As an indication, spot prices of precious metals versus USD such as silver, platinum and palladium took a beating, losing ground by 36.5 per cent, 47.1 per cent and 50.5 per cent respectively between end-December 2007 and November 21 2008.

Only gold has more or less managed to defend itself against the “punishment” as it held its year-to-date value loss vis-à-vis the USD at less than eight per cent, given its status as a traditional safe haven in times of crisis or as a good hedge against inflation.

Indeed, the latest bout of the global financial meltdown has only made matters worse for “commodity currencies” or currencies of countries with sizeable exports of agricultural or mining natural resources such as the Aussie dollar (AUD), New Zealand dollar (NZD) and Canadian dollar (CAD) of the developed world and Chilean peso (CLP), South African rand (ZAR) and Russian ruble (RUB) among emerging markets.

Except for RUB, these currencies of commodity exporters have seen a plunge of between 20 per cent and 35 per cent versus the USD year-to-date.

The explanation behind this commodity currency pounding is quite simple.

In view of the severity of the global financial turmoil and its obvious negative implications for the real economy, increasing risks of a global recession will eventually translate into a pullback in global demand for commodities, taking down with it export earnings for commodity-exporting nations with possible deterioration in their trade balances.

Nevertheless, the newfound strength in USD after weakening against a basket of currencies for more than five years has only confirmed the myth that the USD is indeed the most viable safe haven in times of crisis.

The demand for USD has been overwhelming in large part because of this safe haven perception that the US Federal Reserve had to open swap lines with 14 central banks a few weeks ago to enable them to provide the greenback directly to banks operating in their jurisdiction.

Other motivations for the surge in USD demand include the usual business needs for international trade and investments as well as the repayment or roll-over of foreign currency debt, which could prove to be harder to service for countries with slumping currencies.

Despite doubts over its status as the world’s reserve currency due to the severe weaknesses suffered during much of the first half of 2008, the current forex episode proved that the USD is still far from losing its grip on this status and that it still has a unique role to play in global finance.

After all, about two-thirds of the global official foreign reserves are held in USD although the private sector banks, companies and investors are increasingly diversifying into other currencies in particular the euro (EUR).

2008 has been a rather volatile year for the MYR especially vis-à-vis the USD.

After hitting a peak of RM3.1322 on April 23 2008, the descent continues for MYR, breaching below the RM3.60-mark to around RM3.62, a two-year low on November 20 2008.

It is worth reiterating that these forex gyrations are not specific to Malaysia, rather a region-wide phenomenon.

Truth be told, a weak currency could be a blessing in disguise for many Asian countries to export their way out of the global economic downturn.

With receding inflationary risks (inflation has actually peaked at 8.5 per cent in August 2008), a depreciating MYR should make Malaysian exports more competitive without exerting excessive pressures on price stability in the domestic economy although Malaysian organizations, businesses or individuals with high foreign currency-denominated borrowings in particular in the USD could be hammered.

Although MYR has strengthened considerably versus major currencies such as the EUR, pound sterling GBP, CAD, AUD and NZD since the mid-September 2008 explosion of the global financial and liquidity crisis, its performance against Asian currencies has been mixed.

While it has gained ground a great deal against the Singapore dollar (SGD) and Indonesian rupiah (IDR), the MYR has noticeably weakened vis-à-vis the JPY, the Thai baht (THB), Hong Kong dollar (HKD) and CNY.

However, on a whole, we rule out any concerns that the MYR is out of synch versus its regional peers.

The current MYR levels in particular versus the USD do not reflect Malaysia’s underlying economic fundamentals, driven largely by portfolio outflows due to foreign investor redemptions of Malaysian assets as part of the global de-leveraging process and the conversion to safe havens especially the USD in the flight to safety given the heightened risk aversion.

Despite worries about the punishing impact of a global slowdown on Malaysian exports, ranging from commodities such as oil and gas and palm oil to manufactured goods in particular electrical and electronics products, we anticipate Malaysia’s external position going forward to remain within fairly manageable levels.

For now, the continued slide in our foreign reserves, to below the US$100 billion-threshold as at mid-November 2008 is not a cause for concern since findings of a study revealed that the optimal level of foreign exchange reserves for Malaysia is at around US$30-US$40 billion.

Once the de-leveraging and repatriation-to-home-countries related activities as well as flight to safety (which are short-term in nature) subside, we can in fact expect a reversal of trends for both foreign reserve build-up and MYR.

In all likelihood, the MYR could stay under pressure but remain within the current RM3.55-RM3.70 range in the immediate term, at least until end-2008.

However, the medium-to-long-term trend for the MYR should be a gradual appreciation in an orderly manner, with high probability of recovering to RM3.30-RM3.40 levels by end-2009.

Although a number of currencies may appear to be in an “oversold” territory and hence “undervalued”, the USD could still reign supreme in view of the still high volatility and abundant uncertainties dogging the sentiment.

In the near-to-medium term, exercise extreme caution with commodity currencies and currencies seem to be “overbought” which are still the most vulnerable to selling pressures.

Azrul Azwar Ahmad Tajudin is a senior economist at Bank Islam Malaysia Bhd