Cynthia Kalasopatan, PhD Market Economist

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1 Chang Wei Liang FX Strategist Cynthia Kalasopatan, PhD Market Economist Mizuho Bank, Ltd. Singapore Treasury Division Mizuho Insights (Ref: MI16311) March 11, 216 MYR: Durability of rebound still in doubt The Malaysian Ringgit has rebounded strongly this year on a number of sentiment-related factors. A rally in oil and rebound in global commodities, stabilization of capital flows amidst reduced Fed rate expectations, and a firm commitment to fiscal consolidation in the February budget have all provided a fillip to MYR. But we remain cautious on prospects for further commodity price gains, while Fed rate expectations also look unsustainably low to us, particularly with market volatility easing off. Malaysia s trade situation still looks challenging despite significant MYR depreciation last year, while the retirement of Governor Zeti in April could raise speculation on the central bank s ability to tackle market pressures. Key to a sustained MYR turnaround would be a stronger filtering down of US demand for Malaysian exports, as well as sustained efforts at structural reforms to bolster growth. Over the next 3 months, we expect USD/MYR to trade higher towards the 4.33 level as sentiment-related factors fade out while structural improvements continue to lag. MYR s surprising bounce The Malaysian Ringgit (MYR) has outperformed our expectations with a strong rally against the US dollar since January, boosting MYR to the second best-performing currency in the Asia ex-japan space this year (after the Indonesian Rupiah). Is there scope for a more sustained MYR rebound, especially since year-to-date gains are still small relative to 2 losses? We analyze the different global and local factors that could be driving recent MYR strength and assess if these could mark a turning point in the MYR s fortunes, or if key structural issues are likely to resurface again. 1

2 Oil-fuelled rally One major driver for the MYR has been a sharp rally in oil prices, with oil prices soaring about 33% from its nadir in early February (See Figure 1). Sentiment towards oil was helped by news that major oil producers, including Saudi Arabia and Russia, have pledged to freeze production at January levels, even though the deal remains uncertain given a lack of commitment from Iran and Iraq. Perhaps the prospects of increased co-operation between OPEC and non-opec producers, on top of large cut backs in exploration and production spending by major oil companies and reduction in US shale production, are underpinning expectations of reduced supply growth, supporting oil prices to an extent. Figure 1. MYR rebounds with crude oil prices in 216 Oil vs USD/MYR Apr 13 Oct 13 Apr 14 Oct 14 Apr Oct Apr 16 Tapis Oil Price (lhs, USD) USD/MYR (rhs, inverted) Sources: Reuters, Mizuho Bank Singapore Treasury Figure 2. Sharp rebound in commodities in Q Jan Commodity Prices (Jan 2=1) Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Sources: Reuters, CEIC, Mizuho Bank Singapore Treasury Jan 16 Feb Mar Commodity CRB Index Copper Crude Palm Oil 62% iron ore Commodity uplift on stabilized RMB A broad uplift in sentiment has also permeated the commodity complex, with prices accelerating upwards after Chinese policymakers affirmed that the RMB will be kept stable, thus anchoring risk appetite. This led to positive spillovers to the MYR given its commodity-currency status and Malaysia s large commodity export base. To us, the sharp selling in global commodities looks exhausted at this juncture, with valuations perhaps compelling enough to encourage financial inflows back into the commodities. The broad-based Thomson Reuters CRB index is up over 8% from its lowest level in early February, while bellwether industrial commodities, including iron ore and copper, have also rallied 4% and 1% respectively (see Figure 2). Palm oil, a key export commodity for Malaysia, has already rebounded 17% since November. Thus, we think MYR could also be benefiting from a belated catch-up to higher palm oil prices now as sentiment normalizes. Flow stabilization on reduced Fed expectations MYR has also been supported by a stabilization of capital outflows from Malaysia. This was partly due to exhaustion as long MYR FX positions were already significantly pared back by Q4 last year, evident by a large decline in non-resident holdings of short-term bills (See Figure 3). 2

3 On a broader basis, EM outflows have also seen some relief from the push out of Fed rate hikes since the start of 216, with markets now expecting just one rate hike in 2H 216. With recent US PMIs flagging a potential slowdown in momentum (see Figure 4), some Fed officials have also turned cautious in rhetoric. We think these dovish developments have supported sentiment towards EM FX, including the MYR as well. Figure 3. Foreign long MYR positioning cleared in 2 Malaysia - Non-resident holdings of Govt debt USD bn Jan 14 Apr 14 Jul 14 Oct 14 Jan Apr Jul Oct Jan 16 Non-resident holdings - Govt Bonds Non-resident holdings - Short-term Bills USD/MYR (rhs, inv) Sources: Reuters, CEIC, Mizuho Bank Singapore Treasury Figure 4. US soft data has softened somewhat this year ISM PMIs Feb 13 Aug 13 Feb 14 Aug 14 Feb Aug Feb 16 ISM manufacturing ISM non-manufacturing Sources: Reuters, CEIC, Mizuho Bank Singapore Treasury Firm fiscal commitment despite revenue headwinds Finally, the firm commitment of Malaysia s government to pursue fiscal discipline was encouraging for bond investors, supporting MYR sentiment. In the recent budget revision (Jan 216), the fiscal deficit for 216 was maintained at 3.1% of GDP despite sharp downward revisions to oil price assumptions (from $48 to $3-35) compared to the initial budget in Oct 2. Oil revenues, which account for a significant portion of total revenues, are facing strong headwinds. While Petronas dividend should be maintained at MYR 16bn, petroleum tax and royalties could see a proportionate drop of around MYR 4bn, if oil trades at the midpoint of the $3-35 range. Corporate income taxes will also shrink (by around MYR 5bn) owing to the expected drop in Petronas earnings this year, constituting a second sizeable hit given its large share in tax revenues. Figure 5. Malaysia s fiscal deficit (% of GDP) Malaysia's Budget consolidation efforts Budget deficit (% of GDP) (e) 216 (Budg) Sources: IMF, Bloomberg, Mizuho Bank, Singapore Treasury 216 (rev) Figure 6. Malaysia s oil revenue projections Malaysia's Oil revenues: Headwinds Ahead Petroleum tax Royalties Dividends Total (e) 216 (Bud) 216 rev Source: CEIC,Mizuho Bank, Singapore Treasury. For 216 revised Budget, Petronas Dividends at MYR 16bn, royalties at 2. bn, petroleum tax at 6.5bn. 3

4 The government has proposed an adjustment to the expected revenue contraction via a cut in operational expenditures (of a similar amount) to avoid further fiscal slippage. Additional GST revenues from the cut in employee pension contributions should also help at the margin (around MYR 5mn). The broad commitment to fiscal consolidation efforts were viewed favorably by rating agencies, and reassures investors that credit risks are averted in the near term. MYR Outlook: Near-term global risks abound We think risks of renewed setbacks in the MYR cannot yet be discounted at this juncture despite recent outperformance. For oil, while marginal supply shifts appear to be supportive as US shale production falls, the overhang of record high OECD oil inventories (see Figure 7) should blunt further gains. Furthermore, the structural shift in shale technology and efficiency looks to have lowered the marginal cost of US shale oil to as low as $5-$6 per barrel for North Dakota and Texas oil fields. Much higher oil prices from current levels of about $4 could risk traditional producers ramping up supply to defend market share. Without meaningful upside in oil, we see limited impetus for further MYR gains. Meanwhile, recent commodity strength on RMB stabilization and hopes of a commodity demand uplift supported by Chinese fiscal stimulus look quite overdone. Both hard and soft Chinese data are still pointing to subdued activity. China s manufacturing PMI, a proxy of Chinese commodity demand, has retreated to Global Financial Crisis lows. Imports are still contracting at a double digit pace on a YoY basis for Jan-Feb. Furthermore, China s fiscal stimulus is really aimed at supporting growth while structural industrial overcapacity issues are addressed, and we would hardly consider it to be substantially additive to demand. Restructuring of such sectors, with its resultant factory closures and re-allocation of labor towards the still growing services sector, imply that future Chinese commodity demand growth would be a step down from prior levels. Furthermore, the mix of stimulus this time could also be materially different from the 29 cycle. Chinese policymakers recent emphasis on supply-side reforms also implies that big-bang Keynesian-style infrastructure style projects could fall out of favor relative to more efficient tax cuts and re-organization of underperforming state-owned enterprises. Thus, prospects for outsized commodity gains look highly limited without any acceleration in Emerging Markets growth, as EM countries struggle to find a new growth model to replace their export-driven growth model of the past. 4

5 Figure 7. OECD oil inventories still near record high OECD commercial oil inventories OECD Oil Inventories (days of supply, sa, 3mma) Brent Price (rhs, inv) Sources: Reuters, EIA, Mizuho Bank Singapore Treasury Figure 8. Estimated US inflation expectations are rising US - Inflation Expectations (%) vs Fed Funds Rate Y ahead inflation expectations (%) Fed Funds Rate (rhs, avg) Sources: Reuters, CEIC, Mizuho Bank Singapore Treasury On the other hand, markets currently dovish pricing of US rate hikes look unsustainable to us. While we agree there is room to delay a rate hike in March amidst market volatility, rate normalization should remain on track, especially if the US slowdown proves transitory. We premise our view on US underlying inflation that is already trending towards the 2% target, while labor market buffers are also increasingly exhausted, given a solid pace of hiring in recent months. While 2 inflation is very low at.1%, we see this as largely due to one-off drags and thus not reflective of any material softening in the state of the US economy or a marked decline in inflation expectations. To us, the fact that US inflation was actually positive in a year where oil prices fell 48% and the US dollar rose 13% speak to quite firm underlying price pressures. Housing prices were up a healthy 5.1% in 2 as well. Our modelling suggests that US underlying inflation expectations have likely risen in 2, which corroborates with the robust labor market outturn seen thus far (see Figure 8). Thus, we see risks lying towards the Fed guiding rate expectations higher again, especially with subsiding financial market volatility. This in turn could see EM currencies, including the MYR, coming under pressure again in Q2. Uncertainty over trade and BNM transition looms large In addition to global-related risks, recent signs of weakness in Malaysia s trade numbers are pointing to ongoing challenges in the external sector. YoY export growth has returned to negative territory while imports stayed firm (see Figure 9). As a result, Malaysia s trade surplus has weakened by a fairly large margin in February compared to previous months. While part of February s exports slowdown is due to the Chinese New Year activity slowdown, the big picture of commodity export headwinds will probably persist in the near term. Tellingly, lower energy prices have severely pressured export earnings for energy-related products and exerted a significant drag on exports (see Figure 1). 5

6 Meanwhile, the electronics sector which has shown resilience over the past months appears to be struggling as well, suggesting only a limited boost to export competitiveness despite sharp MYR depreciation last year. Attractive export prices are not sufficient to beget demand from Malaysia s main trading partners. Near term growth prospects for Europe, Japan and China still look subdued, suggesting that external demand may remain lackluster. Overall, trade surplus may be dented in 216 as exports underperformance is not necessarily accompanied by import compression as in other Asian countries. Tourism receipts could buffer, but is unlikely to be sufficient to prevent further narrowing of the current account surplus this year, posing downside risks for MYR. Figure 9. Exports still facing headwinds despite FX depreciation Figure 1. Exports weighed by lacklustre external demand (5) Malaysia: Headwinds in the exports sector Trade Balance (RH Scale) Exports YoY Imports YoY MYR, bn (1) Jan 1 Jan 11 Jan 12 Jan 13 Jan 14 Jan Jan 16 Source: CEIC, Mizuho Bank, Singapore Treasury (1) Contribution to exports growth (%, YoY, ppt) Palm Oil EE Natural gas Exports Rubber Petroleum and products Other (2) Jan 13 Jan 14 Jan Jan 16 Source: CEIC, Mizuho bank, Singapore Treasury Finally, investors may adopt a cautious stance and keep investment plans on hold as focus turns on the succession of the highly regarded Governor Zeti, who has been a steady hand at the central bank for the last 16 years. With her mandate ending in April and the appointment of a new Governor not yet finalized, there is scope for MYR to be pressured to the downside during the transition period given potential speculation on the credibility, policy continuity and independence of the central bank under a new Governor. With Asian markets facing growth challenges and incipient Fed rate hikes, the ability of the new Governor to respond to pressures could be tested by markets. While there are no official candidates, potential BNM Governor names floating in the press include three Deputy Governors, Muhammad Ibrahim, Nor Shamsiah Mohd Yunus and Sukhdave Singh. Amongst top government officials, recurring names are Awang Adek Hussin, Ambassador to the US (also former BNM official), Abdul Wahid Omar, Minister in charge of Economic planning and Mohd Irwan Serigar Abdullah, Secretary General of Treasury. 6

7 With our bias for restrained upside in the oil/commodity space, potentially earlier Fed rate hikes, a sluggish export profile and uncertainty surrounding the transition towards a new BNM Governor in April, we think that the MYR still faces significant downside risks at this juncture. To truly mark a turning point in the MYR s prospects, we would need to see significant structural shifts and not the sentiment-related drivers that have propelled MYR in the last month. In particular, we would watch for a stronger filtering down of stronger US demand to Asian economies (including Malaysia) via exports and renewed efforts to promote structural reforms and domestic demand within Malaysia. Given the balance of risks, we are wary of USD/MYR retesting the 4.33 level in the short term, with current levels around 4.1 looking quite stretched on the downside to us. 7

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Mizuho Insights. Fig 1. USD/IDR traded below 13,300. USD/IDR - Monthly Trading Range Mar 16 Jun 16 Sep 16 Dec 16 Mar 17 Jun 17 Sep 17

Mizuho Insights. Fig 1. USD/IDR traded below 13,300. USD/IDR - Monthly Trading Range Mar 16 Jun 16 Sep 16 Dec 16 Mar 17 Jun 17 Sep 17 Chang Wei Liang FX Strategist weiliang.chang@mizuho-cb.com Mizuho Bank, Ltd. Asia & Oceania Treasury Department Mizuho Insights (Ref: MI170914) September 14, 2017 IDR: Unshackled Bank Indonesia (BI) has