Bank Negara said in its 2016 Annual Report that a large part of the rise in exchange rate volatility in recent years can be attributed to cyclical factors.
These factors included the unprecedented introduction of unconventional monetary policies of the major developed countries in the post-crisis years and global developments that have led to shifts in sentiments in the global financial markets, The Star Online reported.
Recent years have also seen emerging market currencies experiencing a significant rise in the volatility of their exchange rates, particularly after the financial crisis in the developed countries, Bank Negara said.
“This volatility has become increasingly persistent, to the extent that it has led to periods of an exchange rate disconnect, a situation that describes prolonged deviations between exchange rate movements and the underlying economic fundamentals,” the report said.
Bank Negara also noted that the structural evolution of the global foreign exchange markets may have exacerbated the degree and persistence of exchange rate volatility. The markets have grown bigger in size and have outpaced the growth of underlying economic activity.
“At the same time, market players and their behaviour have also evolved as the markets became more complex. These structural developments, coupled with structural rigidities such as the continued reliance on the US dollar, may have contributed to the increased volatility of exchange rates,” it said.
On a related matter, Bank Negara said that an important structural change that has enabled the increased foreign exchange trading is the rise of electronic and algorithmic trading, which has reduced transaction costs significantly and increased market liquidity.
“While these changes have enhanced the depth of the foreign exchange market, they have also inadvertently opened up the market to more speculative behaviour and greater volatility. This is especially evident in episodes of high uncertainty, during which traders tend to show herding behaviour, leading to a drying up of liquidity that can cause sharp swings in prices and hence volatility,” it said.
The report also noted that global foreign exchange trading has outpaced real economic flows.
“Over the years, as global financial flows overwhelm trade flows, the foreign exchange turnover of regional currencies has also increased more than the underlying economic activity. This implies that the role of the underlying demand for currency that is driven by global trade has become less prominent in determining the exchange rate,” it said. – The Star