TigerTalk  |  JANUARY 15, 2016 4:30AM

Why Bank Negara should not increase interest rates

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tiger-talk-2zThe interest rate is usually used to mop up excess liquidity in the market or cool down an overheated economy. With GDP growth expected to contract this year, Bank Negara Malaysia cannot afford to raise interest rates.

The old line that goes “when the United States sneezes, the whole world catches a cold” is still applicable today.

So when the US Federal Bank announced it would start tapering its massive quantitative easing (QE) programme, the “taper tantrum” erupted in many markets across as the world got used to the idea that the days of easy money flowing into their economies were coming to an end.

Then came the reality that the Fed’s next step would be to increase its interest rates which had been near zero since the height of the Global Financial Crisis (GFC) and markets around the world, especially emerging economies like Malaysia, felt the impact as investors started to withdraw funds to move back into the US.

The Fed kept the world guessing on when it would raise rates up until December 2015, when it inched it up 0.25 percentage point to 0.5%. The question now is on what the impact of that decision on the interest rates of economies will be. Many countries will have to ask itself whether raising its interest rates is the best course of action for its economy.

Bank Negara Malaysia’s (BNM) Monetary Policy Committee (MPC) will meet for the first time this year over Jan 21 and Jan 22 to debate and decide this matter. Should the interest rate be increased or should it stay put at 3.25%?

The argument for raising interest rates will be to stem the outflow of funds which investors are pulling out to pump back into the US economy now that investing in the latter has become more attractive.

As Malaysia was one of the emerging markets which benefitted from the quantitative easing or “easy money” policy of the Fed, which sent significant inflows into economies like Malaysia’s, it also felt the blow when these flows started reversing.

Perhaps the biggest loser of these outflows has been the ringgit, as investors sell the local note for foreign currency, in particular for the US dollar. So shoring up the ringgit is likely to be a significant consideration of the committee when they meet. But will raising interest rates really do that much for the ringgit?

In economic terms, there are two main reasons for raising interest rates. The first is to provide a real rate of return to savers so as to ensure liquidity within the country. The second is to dampen economic activity if it is being fuelled by rampant demand.

Let us consider the first reason in Malaysia’s context.

Interest-rates-and-inflation-by-country-150116-01Yes, savers have a negative rate of return now, but these are difficult circumstances with the world still adjusting to economic volatility brought on by the fall in commodities prices and slowing growth in China among others. Even if our savers took the money out, no one else pays better rates for the same amount of risk.

The second issue is even more important in this instance. A broad-based interest rate increase is something that has a tendency to slow the entire economy down and should only be used when there are signs of economic overheating stoked by rampant demand caused by excessive money in the system.

That is surely not the scenarios now. Malaysia’s economy is already slowing and gross domestic product (GDP) growth is expected to slow this year. The impact of falling oil prices on the economy continues to be significant and the government has already announced a Budget revision scheduled for later in January.

The government will probably try and avoid cutting programmes which affect economic growth, but any reduction in public sector expenditure will likely dampen growth prospects. It is clearly not the time to be taking measures which might contract the economy.

The MPC might see a rate hike as being necessary in order to keep foreign funds in the country. But as it stands, Malaysia’s rate of 3.25% is still a significant 2.75 percentage points more than US interest rates. Economists have also said that much of the foreign fund outflows seems to be in the short-term notes rather than long-term ones, strongly suggesting that it is mostly “hot” or “fast” money which is being pulled out.

It is also worth noting that the ringgit did not benefit from the last rate hike. It still bore the full brunt of the weak oil prices and the uncertainty over the Fed’s economic policy. Furthermore it was affected as much by domestic issues, such as the 1Malaysia Development Bhd controversy, the threat of a ratings downgrade from Fitch and political uncertainty. The oil price drop added fuel to the fire.

The year 2016 already looks set to be a tough year for the Malaysian economy. The Finance Ministry has already cut its GDP projections to 4.0%-5.0% in 2016, compared with 4.5%-5.5% projected for 2015.

Given that it is arguable how much an interest rate hike will actually help the ringgit, it is simply not worth risking the impact it will have on an already slowing economy. It is not time for an interest rate hike.


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