The Malaysian government may change the ringgit's peg to the US dollar

if the value of the greenback continues to slide against the euro and yen, a top official said…. The ringgit has been pegged at 3.80 to the US dollar since September 1998. ……….Some analysts believe the time has come to end - or at least change- the peg.

Source: The Straits times, 23rd March 2004

Evaluate the merits of pegging the exchange rate and consider what should be the appropriate level of the exchange rate [25]

Exchange rate controls have always been controversial as they are seen as governments intervening with market forces of supply and demand of domestic currency. So too has Malaysia's currency peg and capital controls been questioned. In argument, there are various pros and cons to pegging the exchange rate to consider.

[Insert demand/supply diagram here, similar to Fig. 15.2, p432 of Sloman, 5th ed.]

Pegging the exchange rate implies setting a price for domestic currency higher or lower than the equilibrium level as determined by market forces (at Pe and Qe). This means the central bank will have to buy up the surplus domestic currency if the peg is too high or sell more if the peg is too low to maintain the pegged price above or below equilibrium.

There are various advantages to the fixed exchange rate regime.

The most fundamental of all is stability. Foreign investors are more confident in investing in your country, knowing that they can plan their finances without the uncertainty of exchange rate fluctuations when they repatriate profits or sell operations and exit the country.

By fixing the currency's value below the equilibrium level, as is the case with Malaysia, exports become more competitive as they now cost less to foreigners and domestic aggregate demand is boosted as consumers switch from now more expensive imports to locally produced goods. If the Marshall-Lerner condition holds, and supply is price elastic enough, the balance of trade (BOT) (and perhaps the balance of payments (BOP) account) will improve. If the peg is a dirty float or adjusted regularly, then the government can tweak the economy in a way which suits its policy objectives through fixing exchange rates. Inflation due to exchange rate fluctuations is also reduced.

Another major reason for Malaysia to fix its exchange rate was to deter speculation. In the wake of the Asian financial crisis, speculators made huge profits by running on the central banks of many South-East Asian countries, causing economies once booming to collapse overnight. By pegging the currency, there is no speculation which can destabilise the economy.

However, there are many disadvantages to take into consideration. There is the problem of imported inflation where inflation in another country spreads to the domestic economy via the fixed exchange rate. BOP imbalances which were once automatically balanced by the floating exchange rate will become a concern for the government.

There is also a policy control loss over monetary policy, as the Malaysian central bank will no longer be able to control interest rates, although this may not be the case because in Malaysia's case, capital control laws were also implemented.

In fiscal policy, the concern will be over the dampening effect of the change in money supply, which will cause capital flows, thus distorting the original aim of fiscal policy. The central bank, in pegging the currency must also keep foreign reserves, which could have been spent more productively elsewhere.

Having said that, back in 1998, there was some merit in Malaysia's decision to peg its currency. The Asian financial crisis hit it badly and speculation was a big concern to the government. This path to recovery was chosen and the peg was instituted. At that time, it looked like a necessary evil.

However, its relevance today is questionable. Gone are the days of George Soros and Malaysia's economy has largely recovered. Today's exchange rate is much below the equilibrium level and needs to be reconsidered by the central bank. It can be cautious and adopt a dirty float instead of a full fledge flaot, and still maintain a sizable control over the Ringgit's value. But the peg cannot go on forever.