The cautionary tale of Malaysia's inflation

THE relevance of oil in our daily lives is often understated. Many consumer products are derived from oil and these form a major component in consumer spending worldwide.

However, with the low oil prices, which we are currently experiencing, inflation around the world is directly affected. This prompts economies like Malaysia to take this opportunity to implement inflation-driven policies, in an attempt to reduce current account deficits. For example, the 6 per cent goods and services tax (GST) which begun last month, although it was unpopular with the Malaysian consumers.

The implementation of this GST policy seems extremely timely as Malaysian inflation figures are currently at a low of 0.9 per cent in March. This GST policy would most likely push inflation up which would work well for Malaysia provided inflation is contained at 3-4 per cent.

However, oil prices have been creeping up in recent months. With this increase expected to continue, inflation could spin out of control when coupled with the GST policy.

The extent of Malaysia's deflation coming from the fall in oil prices has amounted to about 3 per cent (July '14-Feb '15). However, this is inclusive of the reduction of fuel subsidies. This implies that when oil prices move up, a 3 per cent return of inflation could even be an understatement. Therefore, Malaysia's April 2015 inflation would be crucial as this will tell us the extent of the GST implementation on inflation. If Malaysia's inflation is already at 3 per cent, this would most likely spell trouble for the economy.

We believe Malaysia may potentially have more issues with higher inflation. In the long run, we would likely see Bank Negara Malaysia cut interest rates, rather than further hikes. By doing so, it gives the Malaysian ringgit more opportunities to weaken. As the ringgit is restricted from being traded on foreign exchanges, one of the ways that investors could take positions would be through non-deliverable forwards (NDFs) on the ringgit against the US dollar. NDFs are essentially outright forward contracts which are settled in US dollars based on the prevailing spot price.

As a result of not needing to deal in the emerging market currencies, which are not exchange traded, this lowers the counterparty risks. This makes NDFs favoured by investors when investing in such markets.