The interest rate differentials or gap between the Bank of Japan (BOJ)’s overnight call rate (OCR) and the federal funds rate (FFR) had been widening since the first FFR hike post-Great Financial Crisis (2008/09) in 2015.
Jerome Powell’s move to start a series of consecutive FFR hikes in March 2022 followed the outbreak of hostilities between Russia and Ukraine over the Donbass region. Not least also was Ukraine’s avowed aim to join the North Atlantic Treaty Organisation (NATO).
Although Ukraine’s proposed membership has been aborted at present pending official confirmation, nonetheless Western-backed militarisation continues unabated.
This implies that US monetary policy in the form of the FFR – although obscure and apparently unrelated at first sight – is actually intimately connected with US foreign policy.
In short, the former is in the service of the latter.
And it can’t be strongly emphasised enough that US foreign policy has often been speculated to be beholden to foreign powers/entities – which exercise indirect influence and stranglehold via their lobbying representatives and political operatives in Congress (the “first layer”).
Returning to the issue at hand, namely, looking at the monetary policy situation in Japan.
Now, in a relatively unprecedented move, the BOJ has decided to raise its OCR from -0.1% to between 0% and 0.1% for the first time in 17 years as well as marking the end of 8 years in the negative rate “wilderness” (territory). For some, this signals the beginnings of policy normalisation.
The move was in response to the Shunto wage negotiations – an annual spring process/affair between Japanese labour unions and management. This year the unions secured the biggest pay rise since 1992 from the country’s largest companies – with an average increase of 5.28% that outpaces inflation.
The decisive issue is whether the BOJ’s rate hike will continue on a trajectory of policy “normalisation”.
Thus, the question is, will the overnight call rate go up until 2%, for example, given that the inflationary momentum is expected to finally pick up (even if there’re no subsequent second-round effects in terms of further wage hikes)?
This’d mean that there’s ample space for monetary policy to hike the interest rate given that the so-called “natural rate” of interest (which supposedly “equilibrates” investments and savings) in the long-run should now, for all intents and purposes, be at a higher level (given the narrowing of the output gap) than before, inter alia.
The BOJ would need to balance between increased wages and, by extension, increased savings and the present spending effects (viz. inflationary pressures) on the one hand, and the need to maintain ultra-low interest rates that supports future consumption capacity, on the other.
Therefore, the ultra-low interest rate policy which includes the zero-interest rate policy/ZIRP (not necessarily the same as negative interest rates) is critical for the sake of Japan’s monetary and fiscal policy.
Firstly, it’s critical for Japan’s liquidity and debt management.
Liquidity management-wise, it’s pertinent for financial institutions such as banks (compliance to capital adequacy ratio regulations), insurance companies (asset-liability matching) and not least the pensions system (both public and private) to park their funds in low or zero-risk financial assets, i.e., Japanese government bonds/JGBs set against a liquidity trap translating into deflationary impulses that’s interlocked with a “super-ageing” population which in turn correlates with shrinking birth rates and, by extension, falling productivity rates.
Secondly, debt management-wise, this is why the BOJ’s engagement in quantitative easing (QE) of JGBs helps to keep yields low which in turn ensures that government borrowing charges (debt service interest) remained likewise (low).
The national pension system in the form of the Government Pension investment Fund (GPIF) relies not only on premiums (i.e., contributions) but also government borrowings in the form of JGBs.
Altogether, premiums and borrowings constitute 90% of total funding. Approximately 93% of JGBs are domestically owned of which 8% is collectively owned by both public and private pension funds. GPIF allocates around 26% of the pension reserves for domestic bonds as part of the total asset mix (based on the updated 50/50 and 25% allocation strategy).
JGBs also play the role of hedged bonds, i.e., in terms of the forex dynamics of the JPY/USD currency pairing vis-à-vis GPIF holdings in foreign bonds (especially US Treasury bonds). At the same time, JGB holdings enable arbitraging on the yield differentials.
Hence, QE allows pension funds to off-load JGBs at the secondary market and recover the full bond price as they seek to invest in higher returns overseas, especially in the context of the interest rate differentials grounded in the FFR, particularly with the issuance of new Treasury bonds.
The BOJ also implements qualitative easing through large-scale purchases of domestic equities, especially focussing on exchange-traded funds (ETFs) – which are also heavily invested by pension funds – to boost prices and hence returns.
Thus, we can see that the underlying fundamentals of the Japanese financial system and the economy remain strong, stable and robust, notwithstanding any deflationary impulse or pressure.
In looking at the forex correlation between the RM and JPY, the increase in the OCR by the BOJ isn’t expected to negatively impact the former.
In fact, the RM should continue to perform positively at a marginal level vis-à-vis the JPY (yen). In turn, the latter isn’t expected to appreciate significantly against the USD since investors would still be taking a “wait and see” approach, i.e., in anticipation of further interest rate hikes (as is hoped for).
There’s no firm indication, however, that the BOJ is keen on a proper policy normalisation.
A clear signal from the BOJ on the end of QE hasn’t been forthcoming at all.
In the final analysis, the RM’s correlation with the JPY isn’t as strong as compared with the CNY/RMB (Chinese yuan/renminbi), the emergent regional currency anchor.
However, the RM tends to appreciate against the JPY when the latter (i.e., CNY.RMB) strengthens against the greenback. This is due to market sentiments regarding the close trading and investment links between the two countries and, by extension and inclusion, also in relation to China.
A stronger JPY (endaka) could mean stronger capital inflows into Malaysia via increased foreign direct investment (FDI). But this depends on the extent of the yen’s appreciation.
On the other hand, a stronger JPY indicates stronger purchasing power for Japanese consumers and businesses with implications for imports, including goods from Malaysia as a top trading partner.
But any strengthening of the RM would only be ever so indirectly since the terms of trade (i.e., settlement payments) are still mainly in the USD. The USD would only then be converted into the RM – with implications on the market demand for the latter.
However, no more significant impact on the RM or the (Malaysian) economy as a whole is anticipated.
As for policy recommendations, Bank Negara is correct in monitoring the conversion of USD into RM – from the proceeds of our exports.
That said, EMIR Research has never recommended this policy move because the situation now is different from 2015 – then and now.
Back then, the announcement of quantitative tightening (QT) in 2014 was accompanied by only one FFR hike in 2015 which triggered a massive outflow of funds from the emerging markets (EM). Since then, there’s been a one-year gap in FFR hikes.
Now, we’ve had expectations of consecutive FFR hikes.
This is most recently coupled with no clear cut and definitive signal from Jerome Powell as to when to pivot (i.e., peak cycle).
Despite market anticipation of cuts by the second half of this year (2H), incoming data such as the personal consumption expenditures (PCE) by the Bureau of Economic Analysis (BEA) and non-farm payrolls from the Bureau of Labor Statistics (BLS) show that the economy isn’t currently plateauing towards a downturn/doldrum.
Conversion is costly for our exporters and only benefits the banks which earn the commission.
Exporters need to convert back to the USD especially those who heavily rely on imported inputs (except for those who are able to trade in CNY/RMB or using the Local Currency Framework/LCF for the regional arrangements).
This especially impacts exporters who rely on Just-in-Time (JIT) supply chain arrangements which is the norm in much of manufacturing these days. Higher conversion levels like the 75-25 ratio could entail higher costs for our exporters via cashflow dynamics.
Furthermore, expected/anticipated appreciation in the USD implies higher costs and, hence, the need to hold on to more of the proceeds in the same currency.
Increased or pick-up in demand and orders as reflecting the normalisation of the post-pandemic era means tighter production schedules which means higher imports as reflected in the data.
Higher exports also entail higher imports and the gap has been narrowing post-Covid.
And there’s no guarantee that future forex movements (e.g., a few weeks or months down the line) will see the RM on an upward trajectory although it’s expected to be so this year.
Even if (hopefully and rightfully so) the RM trends on an upward pressure, the costs of conversion dampen the appreciation gains.
For the RM to appreciate from e.g., RM4.77 to RM4.50 represents a nearly 6% gain which would simply be “offset” by say a 6% forex transaction commission imposed by the banks.
Furthermore, retaining export proceeds in the USD is a form of hedging for these companies.
Therefore, conversion needs take into account a hedging strategy or tactic which EMIR Research has recommended in “A simulated or guided peg – neither soft nor hard” (August 4, 2024).
We had called for a strategy and plan which envisages opening up Bank Negara’s dynamic forex hedging programmes to corporate entities (i.e., non-institutional residents) – with the initial phase involving fiscal/tax incentives/allowances and eventually making participation mandatory.
As it is, some companies (exporters and importers) take out loans in USD as part of their – forex and interesting rate – hedging strategy also. It’s impracticable to expect these companies to draw down their remaining deposits into the RM. Conversion would, thus, resemble a kind of an interest rate swap in which they’re forced to undertake but without the hedging.
The rest of the strategy involving the main policy moves as mooted by Bank Negara (and others) such as repatriation of profits and earnings from overseas for government-linked companies (GLCs) is very apt.
It’s in sync with the Prime Minister’s earlier call for the Employee Provident Fund (EPF) to rebalance/reprioritise their overseas portfolios in favour of greater investment focus on the domestic market.
Indeed, the role of the EPF and GLCs will continue to be critical in stabilising and counter-balancing the downward pressure on the RM.
Jason Loh Seong Wei is Head of Social, Law & Human Rights at EMIR Research, an independent think tank focussed on strategic policy recommendations based on rigorous research
