Exchange rate volatility driven by structural factors

PETALING JAYA: The high volatility of the emerging markets currencies in 2016 was largely attributable to cyclical factors, but the main drivers of this condition were underlying structural factors in play, Bank Negara Malaysia said.
These structural factors include the growth of the global market size by four times in the last 15 years, outpacing the growth of real economic activity –whereby exchange rate movements have become more prone to financial flows driven by portfolio investors and currency traders instead of by global trade.
Market size growth also drove the increase in foreign exchange trading, triggered by electronic and algorithm trading, which in turn has also opened the market up to speculative behaviour and greater volatility.
This condition was also fuelled by the behaviour projected by market players, for example the herding behaviour of fund managers of asset management companies, losing sight of the underlying fundamentals of assets.
These factors coupled with structural rigidities such as continued reliance on the US dollar and the interest rates of major central banks remaining low for a long time, as well as divergence in the monetary policy between the United States and other advanced economies, is expected to continue to cause volatility, the central bank said in its report.
The cyclical factor which is the ‘risk-on’ and ‘risk-off’ factors stemming from investors sentiments concerning growth prospects, policy directions and geopolitical developments is also expected to be a large contributor to this condition.
The report also to an extent counters the textbook notion that weaker currencies will boost exports competitiveness, saying that the impact is only limited.
Asian exporters despite seeing a 13% average depreciation with the US dollar between September 2014 and October 2016, experienced a 13.2% fall in exports, and only benefited from a favourable conversion rather than a stronger demand.
Bank Negara said that given the prolonged and pronounced volatility, policymakers have to manage the trade-off between the benefits of allowing exchange rate flexibility to act as a shock absorber to the economy and the potential costs of allowing sharp adjustments in the exchange rate, especially in uncertain periods.