At the time of writing, it has been two months since the ringgit has been dislodged from its target zone of RM2.49/55 to the US dollar. All of a sudden, the high years of economic prosperity seemed to have evaporated. The ringgit has since depreciated by some 34%, the stock market by about ten percentage points more, whereas growth threatens to slump to levels unheard of in nearly a decade. The 'Malaysian model' of economic development hailed as an example to developing countries the world over is suddenly allegedly replete with all kinds of weaknesses. In the wake of such an abrupt change of fortunes, many explanations have been proffered, ranging from the irresponsible actions of currency speculators to strong credit growth.
This article argues that whilst each of those explanations has its own merits, they can all be linked to the engagement of a fixed exchange rate regime. Whilst some might argue, quite correctly, that the problems were not so much the result of fixed exchange rates per se but to the ill execution thereof, that it would be practically impossible to know at any one time what the 'correct' exchange rate is and that more often than not we would all prefer to avoid the violent swings in economic growth that might sometimes be necessary to preserve a particular exchange rate, monetary policy is best geared towards containing domestic inflation, rather than to target exchange rates. The rest of this article is organised as follows: Section 1 puts the argument into perspective by giving an account of the events which led to the ringgit crisis. Section 2 explores various issues with respect to fixing a country's exchange rate. We then consider some lessons, as well as some non-lessons, from the experience in Section 3. Before concluding, Section 4 ponders upon some unresolved issues.
The Making of the Crisis
Following the harsh recession of the mid-1980s, many developing countries were forced to institute structural reforms in order to remove market distortions and encourage capital inflows. Impelled by this and the threat of a recession in the early 1990s, capital fled the developed world and into the developing world. Thus, whereas the sum of all developing countries' capital account surpluses stood at US$48.7bn in 1990, by 1993 that figure had more than trebled to US$162.9bn. In this regard, Malaysia was no exception - net capital inflows exploded from an annual average of RM732 million between 1981 and 1990 to RM7,345 in the following three years.
No doubt, much of these inflows were attracted by Malaysia's track record of low-inflationary growth. However, part of the reason for these inflows - and as it so happens would emerge some years later as one of the precipitating factors of the crisis - was to be found in the gyrations of the yen and the US dollar. Whereas the yen-dollar rate stood at ¥165 on March 27th 1992, exactly three years later to the date, the rate stood at ¥89.3. Needless to say, this exerted severe pressures upon Japanese manufacturing, pressures which no reasonable amount of productivity gains could compensate, at least not within such a short space of time. As such, Japanese multinationals were forced to shift production lines to other countries. Their main destination was Southeast Asia, particularly Thailand and Malaysia. Of course, apart from stimulating capital inflows, the high yen also meant that Southeast Asian economies by and large received a major export boost - US imports of Japanese manufactures opted to purchase from Southeast Asian plants, rather than from Japan herself, for example.
These huge inflows created a dilemma for Bank Negara. Had capital inflows been matched by a current account deficit of an equal magnitude, there would have not been a problem: the upward pressure on the ringgit caused by the inflows would have been exactly offset by the downward pressure resulting from higher imports. However, this was not the case in Malaysia: from an overall balance of payments deficit of RM1.1bn in 1988, a surplus of RM29.24bn was posted in 1993.
Herein lay the first mistake: in order to maintain macroeconomic stability, which modern economic orthodoxy takes to be synonymous with price stability, balance of payments surpluses makes necessary a currency appreciation. However, Bank Negara was unable to allow this insofar as it was bound to maintain the ringgit's target zone. The target zone is a band within which the currency would be allowed to float and it is usually considered to be that range within which the currency was at its 'correct' level. Although it undoubtedly allows greater flexibility than, for example, Thailand's single-rated peg, that the zone allows market forces to work only within a limited range, it is often treated as a cousin of fixed exchange rates. Officially, no target zone existed; but it was more than an open secret, at least amongst FOREX dealers, that in the past year or so Bank Negara intervened to keep the ringgit within the RM2.49/55 range.
How was Bank Negara going to maintain the target zone in the wake of capital inflows? Answer: it supplied more ringgit to the FOREX markets. Since the increase in the supply of ringgit more or less matched that in demand, the exchange rate remained stable. The extent of these increases in supply was reflected in the net change in Bank Negara's FOREX reserves: whereas in 1988 the reserves declined by RM1.222bn, by 1993, it increased by RM 29,217bn. Since a country's money-supply is the sum of its domestic credit and foreign-exchange reserves, this was in turn reflected in soaring rates of money-supply expansions: thus we find the broad measure of money-supply while expanding by only 6.7% year-on-year in 1988, in 1993 it did so at a rate of 26.6%!
But why should such money-supply expansions be a problem? In a forthcoming article, we will put forward the case why stable money-growth is essential for economic stability. Suffice to say for now that such rapid expansions would lead to high inflation, if not of the consumer-price variant, of wage- and asset-price inflation. Even with an inflation at a mere 4-5%, the implied loss of purchasing power is equivalent to having a stock market crash every few years!
Indeed, conscious of the potential dangers, Bank Negara sought to 'neutralise' the expansions by resorting to sterilisation. Sterilisation involves issuing debt securities to the banking sector in exchange for cash. The effect of this would be to deprive the banks of liquidity and hence curtail their ability to create new credit. Thus, in this manner money-supply growth might yet be contained. However, the effectiveness of sterilisation has long been a moot point. Indeed, even those who are generally congenial to the procedure admit that it cannot be effective in the long-run and at least insofar as Malaysia's experiences between 1991 and 1993 are concerned, this by and large appears to be the case - whereas Bank Negara's stock of sterilisation debt was negligible in 1991, by 1993 it had landed itself borrowings amounting to RM60.3bn! That this represented some 39% of GDP, and bearing in mind the costs of servicing the debt, it is not difficult to see why Bank Negara decided to reverse its policy on sterilisation.
In 1994, Bank Negara's stock of sterilisation debt was gradually liquidated. Liquidating sterilisation debt however creates high-powered money and artificially lowers interest rates. Thus, whereas Bank Negara's discount rate stood at 7.23% on average in 1990, increasing to 7.7% the following year, by 1994, it fell to 4.51%. Naturally, artificially-low interest rates fuel credit expansions. That this is so comes forth as somewhat ironic - the sterilisation debt that was supposed to prevent credit creation in the first instance was now the cause of it!
By mid-1995, however, seemingly-distant economic developments were threatening to alter the economic fortunes of Southeast Asia. The previous trend in the yen-dollar spot rate was reversing. On March 27th 1995, the rate stood at ¥89.3. A year later, however, it had declined to ¥107 and subsequently to ¥124 on March the 25th this year. This threatened to diminish the amount of capital inflows from Japan and reverse the gain in competitiveness which Southeast Asian economies had acquired during the yen's ascendancy. But this was not all. Bank Negara's convention of targeting the US dollar, rather than a trade-weighted basket of currencies (which would have been more reflective of the ringgit's movements vis-à-vis her trading partners), meant that the ringgit was also appreciating against other currencies. That is, although the ringgit-US dollar rate was stable, that the US dollar itself was appreciating against other major currencies, so too was the ringgit. In 1996, an oversupply in the electronics market, particularly of computer chips where prices reputedly fell from US$50 to below US$10 on some variants, compounded these problems. The combination of a slowdown in the electronics markets and an appreciating US dollar meant that in real terms, the ringgit was over-valued and there was downward pressure on the exchange rate.
Ideally, under these circumstances, the ringgit should have been allowed to depreciate (and it would have done so gradually). This would have restored Malaysia's export competitiveness and mitigate the volume of imports caused by an artificially-high ringgit. Once again, however, Bank Negara's commitment to the target zone meant that it was now obliged to support the ringgit. This would be done by purchasing ringgit in the FOREX markets and supplying foreign currency from the Bank's reserves. Indeed, in 1994 and 1995, Bank Negara's FOREX reserves declined by RM8.47bn and RM5.15bn respectively. All this should have led to a money-supply contraction and a rise in interest rates; credit creation would have ceased, economic growth slowed down, imports reduced and the current-account deficit moderated. Had this happened, it would all have been in conformity with the adjustment process of a fixed exchange rate regime.
But why did credit creation continue unabated and economic growth bulldozed on? The answer lies perhaps in the creation of high-powered money that ensued the unwinding of sterilisation debt. That unanticipated money expansions can have non-neutral effects in the short-run, investment continued strongly, albeit in lop-sided fashion now. With the economy already running at full capacity and the presence of a relatively weak demand for manufactured exports (which accounts for more than a third of GDP), much of the credit went into construction and equity-purchases. For example, in 1995, 53.6% of total new loans went into the purchase of shares and to finance consumption, whereas another 16.8% was directed at the property market. By contrast, loans to the services sector totalled only 8.4% and manufacturing 8.2%.
Under these circumstances - an overvalued exchange rate, weakening exports and strong credit growth which was directed primarily at non-tradable production - FOREX dealers became circumspect of Malaysia's short-term economic prospects. They knew that such a cocktail of occurrences were not mutually compatible; that either interest rates would have to rise or that the exchange rate would have to be allowed to depreciate. As a result, the risk premium - what a FOREX dealer 'demands' in compensation for the uncertainty in holding a particular currency - on the ringgit, increased and this led to further downward pressures on the currency. (This was also true of the other three of the ASEAN-Four: Thailand, Indonesia and the Philippines.)
The crisis began in Thailand and, like most currency crises, did
so with a political statement. Mr Amnuay Viravan, the then Thai Finance
Minister, announced that the Bank of Thailand was instructed to review
potential alternatives to a fixed exchange rate regime. Since the baht
was then over-valued, this could foretell an imminent devaluation. Keen to
hedge their companies from potentially untoward movements in the baht,
investors began to undertake various steps and measures, including, for example,
opting not to covert US dollar earnings into baht.
In Thailand, extremes did not have to be reached. Declining reserves would imply higher interest rates and to the extent that the latter are negatively correlated with output, maintaining the baht at its original peg would have meant a sharp fall in economic growth. Moreover, that many of Thailand's financial institutions were weakly capitalised, higher interest rates would have meant closure of a large number of them. FOREX dealers knew that given the choice between the two, the Thai authorities would rather opt for a devaluation, rather than higher interest rates. Since that led them to relinquish their holdings of the baht, the self-fulfilling crisis model kicked into action.
But why should the baht devaluation have spread beyond? We have to
bear in mind, firstly, that the trio were already having problems of their own.
More importantly, however, the baht devaluation served as a sharp jolt to
their competitiveness. Thus, they too were faced with the same two options:
i) match the devaluation of the baht; or
ii) allow economic growth to fall drastically.
In retrospect, the 34% depreciation of the ringgit was not inevitable. If we had 'cared' enough to maintain the target zone of RM2.49/55, we could have done so but at the cost of sharply lower growth. However, knowing that the Government would rather sacrifice the ringgit rather than economic growth, speculators began to off-load their holdings of the ringgit and once again this led to a self-fulfilling crisis.
Thus, from the above, we can see how explanations based on speculation, strong credit growth and loss of investor-confidence can be married together. In a fixed-exchange rate regime, capital inflows lead to credit expansions, which in Malaysia was forestalled because Bank Negara had initially been willing to absorb the excess liquidity. When the US dollar began to appreciate during the latter half of 1995, and insofar as the ringgit was pegged to it, a loss of competitiveness resulted. This was further compounded by an oversupply in the global electronics market in 1996, which meant that a significant proportion of export earnings declined. In a fixed-exchange rate regime, this should have led to a credit contraction and ultimately a fall in growth and employment, assuming that prices and wages adjust more slowly than prices in financial markets. However, this did not materialise because Bank Negara began to liquidate its sterilisation debt, thereby creating additional liquidity which helped sustain the economy. Thus, by the end of 1996 there was an inherent inconsistency in the economic situation in Malaysia - an overvalued currency plus strong credit expansion. That this was also coupled with credit lending directed primarily at non-tradable production, worries with regards to the solvency of the Malaysian private sector emerged; thereby increasing the risk premium on the ringgit. Taken together, that meant only one thing: a ringgit crisis was about to emerge. Speculators caught whiff of this and, perhaps meaning to hedge themselves against potential losses, began to off-load their holdings of ringgit. Consequently, a self-fulfilling crisis materialised and the ringgit was finally forced to depreciate substantially in order to avoid a much larger decline in economic growth.
SECTION 2: Why Fix the Exchange Rate; & SECTION 3: What lessons?