Commentary: Appreciation of Malaysian ringgit may not be sustainable in the long run

SINGAPORE: The Malaysian ringgit has appreciated by close to 11 per cent against the US dollar between mid-June and end-September this year. Political leaders from the country’s ruling coalition were quick to attribute this reversal of the ringgit’s fortunes to “sound government policies”.
These policies include, among others, government initiatives that are aimed at increasing foreign direct investment, encouraging government-linked corporations to repatriate their foreign earnings as well as structural reforms.
A longer-term assessment of the currency’s fundamentals, however, would suggest that appreciation of the currency might not be sustainable.
By and large, the media has also attributed the ringgit’s strengthening to short-term factors, particularly the expectations of interest rate cuts in the US. The expectations of interest rate cuts emerged in mid-2024 with estimates of declining probabilities of a recession in the country.
Another much-cited driver of the ringgit’s appreciation is the robust growth in exports. Exports grew by 12 per cent year-on-year in July and August this year, driven by the palm oil industry and key manufacturing industries such as machinery and equipment as well as electrical and electronics.
The ringgit’s appreciation is a double-edged sword. A stronger ringgit reduces the cost of imports but it also makes the country’s exports more expensive abroad and hence, less competitive.
Malaysian policymakers have argued that the currency was undervalued before the current cycle of the ringgit’s appreciation. This argument is tantamount to saying that the Malaysian economy has undergone a shift in the country’s fundamentals that has subsequently strengthened the country’s currency.
An examination of Malaysia’s exchange rate over a longer period indicates that the ringgit has slowly depreciated against the US dollar for more than a decade.
A more comprehensive measure of the ringgit’s performance is the real effective exchange rate (REER), which is an index constructed by taking a weighted average of the ringgit against a basket of other major currencies. The REER, which measures how expensive other countries are compared to Malaysia, has drifted downwards over time.
This implies that Malaysia’s exports have become cheaper over the years while its imports have become more expensive. The recent appreciation of the ringgit has reversed this long-run trend only slightly.
Undoubtedly, the downward drift in the country’s real exchange rate has helped maintain the country’s export competitiveness. Malaysia’s share of global merchandise exports increased from 0.4 per cent in the early 1970s to peak at 1.5 per cent in 2000.
Though this has declined during the 2000 to 2016 period, a mini revival since 2017 has restored the country’s competitiveness in global merchandise exports. This is despite the emergence and competition from manufacturing powerhouses such as China and Vietnam since the 2000s.
One fundamental long-term change in the Malaysian economy is the growth of the non-tradable sector, which produces goods and services that are entirely consumed domestically. The services sector, which is mostly non-tradable, accounts for 53 per cent of Malaysia’s GDP today.
Though the size of trade in services has gradually risen over the years, its size relative to the GDP has declined since the late 1990s. Trade in services is still dwarfed by merchandise trade, which is five to six times larger. Thus, the services sector is expected to remain mainly non-tradable in the future.
One consequence of the rise of the non-tradable sector in the economy is the relative decline in the role of trade. The share of trade (exports and imports) in the GDP, or trade ratio, has declined from a peak of 220 per cent in 2000 to less than 150 per cent in recent years.
Not surprisingly, the country’s current account balance (comprising trade balance surplus, net outflows from workers’ compensation and net investment income) as a percentage of GDP has also declined from 17 per cent in 2008 to 1.6 per cent in 2023.
Both the trade ratio and current account GDP percentage seem to have stabilised around 140 per cent and 2.4 per cent, respectively, in the five years before the pandemic.
The decline in the current account balance also reflects an important factor underlying these long-term structural changes, which is the decline in the savings-investment gap amid lower savings rates.  This decline essentially means that the economy will need significant increases in foreign investment for robust growth in the future.
In particular, the long-term lethargy in investment (as a share of GDP) since the Asian Financial Crisis in the late 1990s, especially in the tradable sector, would have driven the relative decline of this sector.
One consequence of the rise of the non-tradable sector is higher average inflation over time. Inflation tends to be higher in the non-tradable sector compared to the tradable sector due to lower productivity and less exposure to international competition. This could be a factor underlying the higher inflation in Malaysia compared to its major trading partners in the past decade.
This is another facet of the lower real effective exchange rate as higher domestic inflation (relative to its trading partners) erodes the purchasing power of the ringgit, which is then expected to depreciate in the long run.
Overall, it is plausible that the long-term fundamentals of the Malaysian economy have indeed shifted in the form of an increase in the relative size of the non-tradable sector, lower trade ratio and lower current account GDP percentage. This has resulted in a lower long-term external balance equilibrium that would be associated with a lower real exchange rate.
If this argument is correct, the recent appreciation of the ringgit is likely to be transitory in nature and, as such, not likely to be sustainable in the long run.
Cassey Lee is Senior Fellow and the Coordinator of the Regional Economic Studies Programme at the ISEAS – Yusof Ishak Institute. This commentary first appeared on ISEAS – Yusof Ishak Institute’s blog, Fulcrum.