This article first appeared in Forum, The Edge Malaysia Weekly on June 6, 2022 - June 12, 2022

The ringgit’s recent performance, particularly against the US dollar and the Singapore dollar, appears to have unsettled many. At RM4.37 per US dollar and RM3.20 per Singapore dollar, the ringgit is at or near historic lows, even lower than where it was post-Asian financial crisis. 

Currencies, like stocks whose valuation reflects market perception of the issuing company’s management, are really a reflection of a nation’s economic fundamentals, its management and particularly its governance. It is indeed worrying that the ringgit is today some 15% lower against the US dollar, worse than where it was during the depths of the currency crisis in September 1998 when it was pegged at 3.80.

Given this dismal performance, there have been, among other proposals, calls for the ringgit to be pegged against the US dollar.

Underlying the call to peg is the assumption that government diktat can be used to overcome what is an intractable problem. Not only does this grossly overate a government’s ability to dictate market forces, it also ignores the inevitable distortions and the huge economic costs involved. In pegging, the government announces an “official” fixed exchange rate against a major trading currency. Announcing the peg is probably the easiest part since the real challenge lies in doing all that is necessary to ensure the peg holds — with your hands tied.

Exchange rate theories are governed by a “trilemma” which postulates that fixed exchange rates cannot be maintained simultaneously with free capital flows and independent monetary policies. All three cannot coexist simultaneously, and only any two of the three is possible at a given point. So, pegged exchange rates would require capital controls if monetary independence is desired.

Proponents would point to the experience of the ringgit having been previously pegged to the US dollar and the seeming stability it brought. What they ignore are the capital controls and the highly toxic moratorium on capital outflows that was needed to make it work.

Pegged exchange rates have the main advantage of providing exchange rate stability for the home currency against the pegged currency. However, it comes with a number of huge disadvantages.

First is the fact that the nation choosing to peg loses all domestic monetary policy flexibility. For a peg to hold over an extended period, the pegging country will have to follow lockstep the monetary policies of the country it chooses to peg to. In the best case of a long holding peg, the Hong Kong dollar to the US dollar, Hong Kong effectively has no independent monetary policy. Its monetary policies closely reflect those of Washington. 

While such subservience has enabled Hong Kong to hold its peg for close to 40 years since 1983, the same was not the case for Argentina. Argentina, which pegged its peso to the US dollar in 1991 at parity, was forced to give up and sharply devalue its currency barely 10 years later, with disastrous consequences for both its economy and politics. 

Argentina, a developing nation with very different needs, had increased its money supply way beyond that of the US. Under a floating exchange rate system, the peso would have simply adjusted through depreciation, but given the fixed peg, the peso became overvalued, and grossly so, over time.

As the peso’s needed correction through a devaluation became apparent, Argentinian banks suffered runs as even ordinary citizens queued up at ATMs to withdraw their peso deposits and convert them to the US dollar at the pegged rate. All these actions amounted to effectively shorting the peso in favour of the US dollar. The net impact was a sharp erosion of the foreign currency reserves held by the central bank. The government’s attempt at limiting withdrawals only hastened the de-peg and crash.

The second big problem with pegs is determining the correct rate to peg at. Since an exchange rate is a relative price which applies across all of a nation’s goods and services, “mispricing” has huge consequences on the terms of trade, capital flows, competitiveness and even evolution of the country’s industrial base. 

For example, a pegged rate that undervalues the home currency reduces imports and provides a protective barrier for domestic producers, even inefficient ones. This discourages innovation and stunts progress towards higher value-added production — the nation’s industrial base can be trapped within a perpetual low-cost, low-value state.

On the other hand, pegging at an overvalued rate, as was the case with Argentina, meant that as the US dollar rose, Argentina ran into serious current account deficits whose funding required massive US dollar-based borrowing. Determining the correct rate to peg is never easy since exchange rates are dynamic. A rate deemed appropriate today would be a misaligned one in the future as economic factors change.

A third key problem is the incentive pegged exchange rates provide for a free ride by way of arbitraging. Absent the risk of the exchange rate changing, even small interest rate differentials would be profitable to arbitrage. For example, if the US continues raising rates but local conditions, being weak, do not allow for rate increases, the interest differential automatically provides for riskless arbitrage. For both domestic savers and exporters, it will be better to move their funds into offshore US dollar accounts where they earn higher returns without any currency risk.

The net effect of such activity is: (i) the shorting of the ringgit against the US dollar; (ii) capital outflow; (iii) the erosion of reserves, and (iv) placing huge strains on a central bank seeking to maintain the peg. It is this opportunity for riskless profitable arbitrage and the resulting capital flows that will render any attempt at domestic monetary independence impossible. The only way to prevent such arbitrage would be by either imposing capital controls or giving up on domestic monetary policy independence. 

Thus, the trilemma. As Milton Friedman had famously said, “In economics, there is no such a thing as a free lunch.” Malaysian politicians and policymakers ought to take heed.

Dr Obiyathulla Ismath Bacha is professor of finance at INCEIF University

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