In February 2021, Malaysians began to see the light at the end of the tunnel that is the pandemic. Malaysia announced that it targets to vaccinate 82.8 per cent of its population. There is a growing concern among policymakers regarding how the vaccination programme links to Malaysia's terms of trade, that is, the ratio of export prices to that of imports. In this article, we look at the Mundell-Fleming (M-F) model, a framework commonly used in evaluating exchange rates changes in international macroeconomics.
The government procurement of the Covid-19 vaccine mirrors that of expansionary fiscal policy. In other words, Perikatan Nasional's (which has been recently dissolved) decision of purchasing the vaccines increases government expenditure, influencing market behaviour. Their estimated spending for the vaccines amounts to RM2.06 billion.
With a large spending, the M-F model predicts that Malaysia would have higher interest rates and experience a rise in income. Sure, but how will it affect exchange rates? To determine how exchange rates are impacted, we look at the balance of payments (BoP), which comprise of a balance between two accounts: capital and current. The BoP can either improve or worsen, depending on the changes of interest rates and the nation's income. In this case, a fiscal injection translates to a worse current account balance, however contrasted by a strong surplus of the capital account. When the BoP is in surplus, exchange rates are forced to appreciate, resulting in less competitive exports. Malaysia's terms of trade, therefore, looks bleak.
Malaysia has experienced a relatively long period of current account balance surplus tracing back to 1998 according to the World Bank. Malaysia has seen a steady decline where it has plateaued since 2013 in between 2.3 per cent and 3.4 per cent of GDP. Regarding the fiscal expansion in the form of vaccine purchase, the Malaysian current account showed positive movement in 2020Q3 and 2020Q4 as compared to the previous quarters before dipping slightly in 2021Q1 to seemingly rest at RM12.9Bn. This suggests signs of the impact of the vaccine purchase on the nation's current account balance.
When the pandemic hit, the Malaysian capital flows dipped to its biggest deficit since 2009. However, since then capital flows have been on an upward trend from the extreme low of the 2020Q3 to a large surplus in 2021Q1. The overall relationship between the Malaysian current account and its capital account is accurately captured by the Mundell-Fleming model. The polarity of each of the real current and capital account contradicted the predictions of the Mundell-Fleming model as of 2020Q4. Malaysia's current accounts registered surpluses while Malaysia's capital accounts registered deficits. It appears that was the work of the lagged effect of the fiscal injection as the predictions of the Mundell-Fleming model ring true in the data we see today in 2021Q1.
Meanwhile, the Ringgit in 2021 has slowly depreciated despite showing signs of recovery towards the end of 2020 finishing at its strongest since pre-pandemic January 2020. By 27th of August 2021, it stood at a weakened but seemingly stable RM 4.19 per USD.
There is one caveat that concerns the validity of the Mundell-Fleming model-Bank NegaraMalaysia employs a managed float exchange rate regime. The model meanwhile is built on assumptions of a floating exchange rate regime. This is important because a central bank in a managed float regime will purchase foreign currency or sell domestic currency to manage the national exchange rate which will affect the capital account while a central bank in a floating regime will not.
Although it is not apparent how the central bank predicts the behaviour of the exchange rates, it seems that Bank Negara is holding back on the fiscal policy method and rather focusing on monetary policy.
Bank Negara is maintaining the OPR (Overnight Policy Rate) despite pressure from groups to decrease it. Under the Mundell-Fleming model, an expansionary monetary policy (by lowering the OPR) in a floating exchange rate, can cause the nation's income to rise and a surplus in the current account. In summary, influencing the economy by lowering the OPR can lead to a good outcome.
Despite a sudden large spending package, it is crucial to address that the procurement of vaccines' benefits outweigh its disadvantages. All points discussed, vaccine procurement appears to lead to an income rise and higher interest rates (unfortunately here, loans will become more expensive). Malaysia should experience an appreciated exchange rate which, contrary to popular belief, is not always good news. The country's exports, like palm oil, will become more expensive in the international market, lowering Malaysia's chances of being competitive in its exports.
However, the government can tolerate these because a fiscal injection here seems almost like a saving grace for Malaysia. It is a necessary evil; the pandemic above all, must end first. An upside would be the supposed rise in Malaysia's income given that the injection goes to its intended destination in fulfilling its purpose.
The economy thrives on sentiment of the people that leads them to spend in the economy - and the main purpose for vaccines is exactly that. The government hopes that the vaccines can boost confidence, driving economic confidence in business continuity. As of September 2, 2021, 65.1 per cent of the adult population have received two doses of vaccination, and there is talk in moving major cities into the next phase of the nation's recovery plan.
Even so, the government must note that simply relying on vaccines without effective policy support that encourages spending can quickly make efforts obsolete. If Malaysia experiences the effects that the M-F model predicts, expensive loans make projects difficult to finance. This affects especially SMEs, having to survive a halt in business resulting from the pandemic. As we go into the re-opening phase, the government can structure a programme for small business owners that incentivises digital growth while supporting their losses, including providing tax reliefs or moratoriums.
What is more, since the government has used a fraction of the KWAN (National Trust Fund) to finance the vaccination programme, it has become more urgent for sound policies to surround the rollout in ensuring efforts are not to waste. Economic stimulus package of the most recent, PEMULIH amounting to RM10 billion in direct fiscal injection, provides temporary relief for its citizens.
That said, both the central bank and the government need to work together in ensuring that Malaysians are continued to be well-looked after as the whole nation struggles to get back on its feet.
The writers are graduate students at the University of Nottingham Malaysia