ECONOMICS: Malaysia's draconian measures
Far Eastern Economic Review
Sept 10, 1998
As Asia's year-old crisis deepens, governments flirt with some dubious
cures; The danger is that they'll be distracted from fixing their
By Faith Keenan in Hong Kong with S. Jayasankaran and Murray Hiebert in
* Kuala Lumpur and Salil Tripathi in Singapore
It was a week that shook the world: One by one, Asian governments
announced their once-robust economies had plunged into their worst
recessions in a generation. Financial and political turmoil in Russia
pummelled New York and other Western stockmarkets, deepening uncertainty
in Asia. But worst of all was the sight of former free-market bastions
resorting to desperate measures: Malaysia invoked currency controls
while Hong Kong threw billions of dollars into a gargantuan market
battle with speculators.
The unchecked pace of the free fall has increased the feeling
that orthodox solutions to the region's slump aren't working. Instead of
IMF-style attempts to prop up currencies with painfully tight monetary
and spending policies, governments are casting around for alternatives.
By doing the once-unthinkable in taking draconian steps to protect its
currency, Malaysia may encourage other governments to consider
quick-fixes that will divert attention from what's really necessary.
It was hardly a surprise that Malaysia's fiesty prime minister,
Mahathir Mohamad, was the first to plunge into uncharted waters. On
September 1, he told his recession-wracked nation that its currency, the
ringgit, was no longer freely tradable and that any ringgit outside the
country after September 30 would be illegal tender. The move yanked the
country off a free-market course that has made it the world's
15th-largest trading nation and brought the ouster of Anwar Ibrahim, the
reform-minded deputy prime minister and finance minister who had been
seen as Mahathir's heir. Kuala Lumpur set a new exchange rate of 3.80
ringgit to the U.S. dollar, up from around 4.20 several days earlier.
Economists argue that the new medicine is certainly no cure-all,
many fear it will ultimately do more harm than good. Even if in place
only temporarily, currency controls could delay the return of foreign
investment, which is already drying up because of the worsening global
What remains of utmost importance, they argue, is for governments
finally become aggressive about fixing banking systems paralyzed by bad
debt. "The sooner, the better," says one central banker. Only then will
capital again course through the veins of Asia Inc.
Speeding the process would likely require some forgiveness of
domestic and international loans, more bank closures and massive capital
injections to get flattened banks back on their feet. Yet while some
progress has been made in cleaning up banks, Asian governments are under
pressure from suffering citizens to provide a quicker economic stimulus.
Many have opted for looser monetary and fiscal policies in hopes of
reviving flows of capital to healthy companies, and hence creating
growth and jobs. The International Monetary Fund's prescription has been
to keep rates high to strengthen currencies; but companies are
clamouring for cheaper capital.
It's essential," says John Hobson, a banking analyst with Morgan
Stanley Dean Witter in Hong Kong. "Every corporation is being crushed by
high rates. You need to have productive capacity at the end of the day.
You need a real economy."
That argument appeals to just about everyone. Thailand and South
Korea have steadily lowered interest rates with the blessing of the IMF,
whose approval is needed if billions of dollars in emergency loans are
to continue flowing to those countries. Malaysia, too, has cut back
interest rates under pressure from Mahathir, who chafed for months under
the tight monetary policies advocated by Anwar and other subordinates.
Malaysia never sought IMF he, but that doesn't mean it isn't
fix. The country is suffering its worst-ever recession (GDP contracted
6.8% in the second quarter). Before the new rate was set, the ringgit
had lost 39% of its value since July last year. Mahathir believes that
erecting a solid fence around the currency and portfolio investment will
allow the central bank to push interest rates down fast while blocking
domestic savings from pouring out in search of higher rates elsewhere.
He seemed to receive important intellectual backing in late August when
renowned American economist Paul Krugman said exchange controls could
give Asian economies a breathing space in which to resume growth.
Yet there has been no such support from the premier's own top
bankers. Sometime in late August, Fong Weng Phak, then deputy governor
of Bank Negara, Malaysia's central bank, tried to persuade Mahathir that
the country didn't need capital controls. When that failed, Fong and his
boss, Bank Negara Governor Ahmad Mohamad Don, resigned.
The new measures are aimed at drying up offshore deposits of
-- estimated at up to 25 billion ringgit ($6.6 billion at the new rate)
and thereby curbing speculation. The controls also seek to thwart flows
of hot money -- short-term portfolio investment that can be withdrawn at
the blink of an eye. Mahathir, speaking in a live television interview
after the announcement, said individual countries have to protect
themselves from external risks.
"Why should anyone get upset if we, who have been so abused
forces, decide to insulate ourselves?" he countered. Other countries
should follow Malaysia's example, he said. "What is obvious is that
people can no longer stay with the so-called free-market system."
The reaction -- both foreign and domestic -- was quick in coming.
Within hours of the announcement, the Kuala Lumpur Stock Exchange fell
more than 13%. An economist with a foreign brokerage in Kuala Lumpur
says his London counterparts told him they won't be interested in doing
business in Malaysia for the next year. "Who wants to buy and sell
shares when you can't take the money out for one year?" the economist
Some indebted, middle-class Malaysians are downright angry about
their curtailed freedom. But some executives sympathize with Mahathir,
saying he had no choice because globalization had changed the nature of
currency trading irrevocably. "I think we should give him a chance,"
says a senior official in a listed corporation. "We tried the IMF route;
we've tried being nice, and it didn't get us anywhere. So let's try it
If trying it Mahathir's way means back-pedalling on financial
and treating currency controls as the cure-all, even economists who like
the new measures turn sceptical. Daniel Lian, an economist at BZW
Investment Bank in Singapore, thinks the new controls could he
"salvage the real economy." But he cautions: "If Mahathir does all these
controls without addressing larger structural issues -- cronyism, the
links of state-backed companies and banks -- in the longer term the new
policies could come back to haunt him."
In an open letter to Mahathir, economist Krugman issues a similar
warning. "Controls must serve as an aid to reform, not an alternative,"
Krugman writes in the letter, which he posted on his Web site. "The
breathing room given by controls should be used to accelerate, not slow,
the pace of financial clean-up." He suggests three years as the maximum
duration of the controls, because the side effects grow worse over time.
Many of those side effects are readily predictable. A currency
black market is likely to develop because demand for foreign exchange
will exceed the supply permitted by the central bank. Corruption also is
likely, largely in the form of falsifying trade transactions. New
foreign direct investment could fall off sharply, although the impact on
existing investment is less clear. Foreign diplomats say the rising
uncertainty increases Malaysian risk. "Thailand is going one direction,
Malaysia another, so where are you going to put your money?" says one.
"You'll have to get new approvals that will take time . . . The
uncertainty isn't good; it's a killer for foreign investment." A Hong
Kong-based derivatives dealer cringes at the amount of paperwork that
regular bank transfers within Malaysia will now require. "Our back
offices are not set up for this, and neither is the central bank," he
complains. Yet another problem: Some businessmen anticipate lawsuits
over contracts denominated in ringgit.
Elsewhere, capital controls show a mixed track record. Thailand
without success to prevent speculation against the baht by creating a
two-tier currency market; dissolving the system in January actually
stabilized the currency. On the other hand, Japan maintained high-speed
growth during the period 1949-64 even though it maintained strict
currency controls. They were gradually relaxed and most were ended by
1980. Moreover, many Asians have noted that China and Taiwan, two
economies with controls on capital, have fared much better than the rest
of the region during the crisis.
"The Krugman thesis has some validity for countries with good
regulatory procedures, legal infrastructure, enforcement and good data
transparency," says Miranda Gultom, a director at Bank Indonesia, the
Indonesian central bank. "In Asean, it is questionable whether controls
can benefit when there are so many factors we have to struggle with."
Rather than trying exotic and risky measures such as exchange
controls, countries would do better simply to fix their banks and
strengthen their regulatory and supervisory mechanisms, many economists
Lower interest rates may ease corporate debt burdens and stop
bad-loan pile-up at banks, but they won't necessarily loosen credit.
Witness South Korea, where the assumption that small companies are more
likely to be allowed to collapse has skewed bank loans in favour of the
largest chaebols even more than usual.
Although many observers agree that bombed-out banking systems
at the heart of Asia's woes, fixing them has been a dangerously slow
process. Malaysia has set up two agencies to clean up banks' balance
sheets and recapitalize them, but still must raise funds for the task.
"There's been a reluctance in Malaysia to recognize the problem" of bad
loans, says a Hong Kong banking analyst. Bad loans are estimated at
about 20% of Malaysia's total loans.
In South Korea, there has been no outright liquidation of insolvent
banks and the practice of making loans to unviable companies continues.
The five banks that Seoul has merged with larger banks represented just
7% of total loans. It has yet to say how it will he recapitalize the
Indonesia still expects its banks to recover bad debts. Fat
say analysts. "There's a risk foreign debtors will have to take pain,"
says Morgan Stanley's Hobson. "There will probably be some sort of debt
forgiveness." But banks -- especially Japanese institutions that are
heavily exposed to Indonesia -- will typically try to delay debt
write-offs as long as possible to avoid weakening their balance sheets.
The longer bank reform and recapitalizations are delayed, the
expensive they will become, say analysts. And it's up to governments to
do it: There has never been a systemic banking crisis that has not ended
with taxpayers footing the bill.
Most governments have stepped gingerly to avoid offending any
potential losers in the process -- especially shareholders. Thailand's
recently announced bank -- restructuring plan is technically stringent,
but is voluntary for most banks -- who will be reluctant to reduce their
own shareholders' equity.
In such a quickly changing environment, where things go from
worse to disastrous within weeks, any fix-it plan must be implemented
quickly or become outdated. Japan is a case in point. In early July, the
government announced its "Total Plan," under which so-called bridge
banks would be created to take over the business of failed institutions.
Officials were vague about whether the scheme would apply to big banks,
apparently imagining they could try it out first on smaller ones. Now
that assumption has collapsed. With Tokyo stocks plunging to a 12-year
low, many big banks are in imminent danger because part of their capital
base consists of stocks that have plummeted in value.
In addition, the rapid deterioration in the economy has increased
Japanese banks' bad loans. Most can't meet the capital standards set by
the Bank for International Settlements. Some officials say the
bridge-bank scheme could be used for the top 19 banks; others, such as
Bank of Japan Governor Masaru Hayami, say those institutions are too big
The moral: The only way out, for Japan or any of the other
emergency-ward economies in Asia, is to follow through with plans to fix
up banks and to deal squarely with the worst-case contingencies.
Otherwise, precious months will be wasted on pointless debates. "You
can't do capital controls and forget about restructuring the banks,"
says Don Hanna, an economist at Goldman Sachs. "The two aren't