Malaysia has triumphed in FX reforms – but what comes next?

Malaysia’s Bank Negara has done better than many in tackling currency speculators, but the next chapter – easing back on currency controls – will be harder to write.

From India to Indonesia, Asian central banks have been locked in a war with that bête noire of monetary policy: the offshore currency speculator.

These are emerging market economies where governments still like to exert a certain amount of control over the domestic currency. Such influence, though, does not extend to the offshore non-deliverable forward (NDF) markets, which is where currency speculators like to play.

Four years ago – having suffered periods of intense volatility for years – Malaysia’s central bank warned international banks operating within its jurisdiction to avoid the NDF market.

Not wanting to be shut out of the onshore market, global players swiftly fell into line, and volatility of the ringgit – which hitherto had largely been driven by offshore speculators – largely died away.

But then Covid-19 came onto the scene. In March, the outbreak of the pandemic – coupled with a series of US interest rate cuts – sent the Malaysian currency into another tailspin, moving from 4.08 at the start of the year to 4.41 in mid-March. As a result, daily close-to-close volatility this year is double that seen from 2017–2019. 

Bank Negara has proved its commitment to engaging with market participants and listened to the needs of real-money hedgers that have been wrestling with their currency exposure

This underscores the fact that the success of Malaysia’s currency reforms should not just be judged on the stability of the ringgit alone. Bouts of volatility are bound to happen. The question is, when they do, are the tools currently on the market sufficient for managing this risk?

And here Bank Negara chalks up another success.

Since the death of the overseas NDF market, the central bank has gradually introduced a series of FX liberalisations – as it had promised to – in order to bring currency hedging onshore.

Most smaller companies can now hedge their import and export currency exposure without difficulty, up to about a year, and no longer need Bank Negara’s permission for putting on options trades (which helps make their hedging more cost-effective during periods of volatility).

Bank Negara has proved its commitment to engaging with market participants and listened to the needs of real-money hedgers that have been wrestling with their currency exposure. This constant engagement persuaded it – at the end of March – to drop the requirement for firms to seek formal permission if they want to put on a currency option of longer than a year.

It is true that liquidity is still confined to the shorter end of the tenor curve. Try to use options to hedge currency exposure out beyond two years and liquidity fast disappears.

But there is also some sign that longer-term liquidity might now start to build up – and even the treasurers of larger corporates, which tend to have longer-term US dollar exposures, appear to be pleased with how the market is developing.

Different approaches

Other controlled economies have dealt with the problem of NDF speculation and currency volatility in very different ways. India, for example, has recently removed the restriction that prevents domestic banks from trading in this market, which affords the central bank some measure of reach into the offshore market, while Indonesia has taken steps to set up its own onshore NDF market. It is too early to tell whether these reforms will enjoy the same success as those from Bank Negara.

Malaysia’s central bank can justifiably feel vindicated in waging such an aggressively decisive war against the offshore market. But there is still another chapter that needs to be written.

NDF markets exist precisely because the currencies they serve are not freely convertible. There is a very valid argument to make that, in restricting NDFs, most of Asia’s central banks are treating the symptom rather than the cause of domestic currency volatility.

Relinquishing control over the currency altogether – and making it freely convertible – will be a much harder thing to do.