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RM Crisis
Section 2

Why Fix the Exchange Rate?
In the previous section, much has been made of the rigidity that is associated with a fixed exchange rate regime in order to explain the precipitation of the ringgit crisis. Namely, by restricting the ringgit's movements to a predetermined target zone, the necessary adjustments needed to maintain the economy in an equilibrium state vis--vis the rest of the world were hampered. Yet, notwithstanding the inflexibility, some of the more successful economies of the world today, such as Hong Kong, have fixed exchange rate regimes. Moreover, as of 1999, twelve of the current sixteen Member States of the European Union would lock their exchange rates together permanently at a fixed and irrevocable rate when they retire their domestic currencies in favour of the Euro, the new currency of the European Monetary Union. If indeed the inflexibility of fixing or pegging one's currency to another's proves so detrimental to the economy, how might one account for these observations?

There are numerous advantages in a fixed exchange rate regime. The most obvious one is the provision of certainty in the currency markets. Many economists believe that exchange rate uncertainty harms international trade, discourages investment and accentuates the problem of economic agents insuring their human capital where there are incomplete asset markets. Moreover, agents hurt by volatile exchange-rate swings may pressure their governments to delay opening up the economy to foreign competition or otherwise to demand some form of import-protection. However, although this may be true, the magnitude of damage inflicted by exchange-rate uncertainty upon the real economy is hard to quantify and there are economists who believe that they are small. Indeed, the opening quote from Bank Negara's Annual Report of 1994 seems to confirm this view: exchange rate volatility does affect trade, but not significantly.

Then, there is the advantage of 'hitching a ride' from another country's monetary credibility. This argument has been used persuasively in Latin America to peg their currencies either against the US dollar (as per Mexico) or against a basket of currencies (as per Argentina). The argument here is that since domestic monetary discipline is lax, by fixing one's exchange rate to a country with a proven track record of monetary stability, the domestic monetary authority would be forced to shadow that discipline. This policy appears to have indeed worked in Argentina - annual inflation has dropped from a whopping 324% in 1991 to a mere 1% in 1995. Whilst this argument is persuasive on its own merits, personally, I do not find it so for Malaysia insofar as she is not a hyperinflationary economy and therefore does not need a dose of external discipline.

But whilst the benefits are obscure, fixed exchange rates exert huge costs upon an economy, even where its inhabitants are willing to tolerate wild swings in prices and wages; or indeed economic growth. This cost comes from the famous economic dictum that: A monetary authority can control either the domestic interest rate or the exchange rate, but not both. To see why this is so, consider the case where there has been a slowdown in the electronics market. Such an occurrence would have necessitated prices and wages in Malaysia to fall (so that exports become cheaper, thereby encouraging export-demand once again). Even if they do so instantaneously, as they do in many theoretical models, Malaysia would be made worse-off. With a fixed exchange rate regime, and allowing for the fact that prices and wages only adjust with a lag, there is no way for Malaysia to maintain its competitiveness; and as such the problem translates into a fall in output and employment.

But why can Bank Negara not simply pump more liquidity into the money markets by purchasing domestic debt securities from the money markets so that interest rates fall? And so that with such a fall, investment will be stimulated once again and the potential fall in output and employment avoided? The answer lies in the combination of a fixed exchange rate and the fact that capital is mobile. In the presence of both, domestic nominal interest rates must equal foreign nominal interest rates. (For simplicity, we ignore the possibility of a risk premium.) Straightaway, we see that this implies that with fixed exchange rates, domestic interest rates are determined by what happens abroad, events which are outside Bank Negara's control. Any increase in liquidity in the money markets would leave money-market traders with too much ringgit, for a given rate of interest, and in response to this they simply sell their ringgit back to Bank Negara for foreign currency and shift their funds abroad so that their 'optimal' relative holdings of ringgit and debt securities are restored. And under fixed exchange rates, Bank Negara would have to buy back the ringgit inasmuch as to not do so would mean the ringgit depreciates. Hence, we are back to square one, as it were, albeit with a decline in reserves and higher domestic credit. The key lesson here is that controlling the ringgit's exchange rate portends a loss of control of domestic money supply and hence interest rates. The implication of this, especially where prices and wages cannot adjust instantaneously, is crucial: a fixed exchange rate regime would imply inter alia more volatile output growth and employment.

Section 3
What Lessons?

Some non-lessons
Personally, I find it unfortunate that the debate thus far as to what contributed to the crisis has centred around the more minor issues and with the consequence of incorrect policy-responses being advocated. Here, we will examine three of them.


"If we had more FOREX reserves, currency speculators would not have dared speculate against the ringgit. That's why the Hong Kong and Singapore dollars have been less prone to speculation."

Not true. The ringgit could have been defended if the Government was adamant about doing so no matter what the costs were. At the end of the second quarter of this year, Malaysia's monetary base - the amount of ringgit in circulation - amounted to RM 63.9bn. Bank Negara's net international reserves at that time was well over that figure, being RM70.7bn. This meant that using its net international reserves alone, Bank Negara had more than sufficient resources to repurchase every single ringgit note and coin in circulation, which is more than what would have been needed to restrict money supply and hence prevent the ringgit from depreciating. However, this is not all - Bank Negara has a whole host of other resources from which it could have drawn to support the ringgit. There are its non-monetary reserves, such as its reserves of gold, and its external reserves. On top of this, we have to include the pre-arranged loan agreements with the IMF as well as various regional central banks; and the fact that central banks often help each other out to weather speculative attacks against a particular currency. Indeed, whilst September 16th 1992 was perhaps best known for the day George Soros bankrupted the Bank of England and precipitated sterling's exit from the Exchange Rate Mechanism (ERM), a lesser-known battle was taking place in Sweden over her krona. Whereas the Bank of England raised interest rates to 15% before the Conservative Government raised the white flag, the Sveriges Riksbank persisted in its defence of the krona until interest rates rose to some 500% and remained there for some time. FOREX speculators saw that the Swedish central bank meant business and ceased to speculate. The point here is that more reserves need not necessarily ward off speculators - even with relatively limited reserves, where a central bank shows that it is willing to endure frighteningly high rates of interest in order to save the currency, even if that means subordinating economic growth, speculators would find it prohibitively costly to go short in the currency in question, thus deterring them from speculating any further.


"More co-ordinated interventions by ASEAN central banks and a Regional Stabilisation Fund would have been able to defeat the speculators."

Not true, once again. To a large extent, the same arguments as 'Response 1' hold. However, there is an additional dimension to this. A country with a relatively stable rate of exchange may after a point be unwilling to spend its reserves or contribute to a common fund in order to prop up an ailing currency. We have to bear in mind of course that a decline in reserves has its implications upon interest rates. A stable economy might therefore not be willing to tolerate higher interest rates simply because a neighbour's running of incoherent economic policies was causing speculative attacks against the latter's currency. As such, its enthusiasm for co-ordinated interventions or regional stabilisation funds may be bounded. If speculators understood this, they would merely persist for longer in their attacks. Therefore, such proposals can merely delay, but not avoid, a crisis altogether.
Nowhere is this argument more potent than in the ERM, which arguably has the world's most sophisticated regional stabilisation fund. Under the ERM rules, the German Bundesbank is obliged to support the currency of any Member State that was under attack, and it practice, it often enlists the help of other European central banks. Although it never shied away from its duty, privately it complained profusely that Britain's dogged refusal to devalue the pound was costing it its reserves. It was not long before the Bundesbank's disquiet leaked out to an already-nervous FOREX market and thereby precipitating a run on the pound. Thus, from all this we can see that if at all co-ordinated interventions and stabilisation funds help, they do so by merely delaying an adjustment. They cannot however avoid speculative attacks where a fundamental policy-error in a country's economy exists.


"FOREX speculation should be made illegal."

Illegal, no; eliminated, yes. But how is FOREX speculation to be eliminated if it were not declared illegal? It will I hope already have been clear that speculation cannot exist unless there is an opportunity to do so. Indeed, it is for this reason some economists (and doubtless the speculators themselves!) think that speculation occupies a healthy role in the world economy - it 'helps' to expose governments of their poorly-executed economic policies. If economic policies were sound and mutually coherent, there cannot exist loopholes in the economy with which speculators might exploit to their own advantage. Whatever the merits of this argument, it does point to an important conclusion: the way to combat speculation is to have robust economic policies, and not to outlaw it.

The Real Lesson?
Since this article has portrayed the causes of the ringgit crisis to be largely the result of fixed exchange rates, or at least the improper execution thereof, a natural lesson would be for the ringgit to freely float. The advocates of freely-floating exchange rates make four principal claims:
a) real exchange rates would be stabilised and that any variance in exchange rates would merely reflect changing terms of trade. The real exchange rate is the relative prices between two countries. Thus, for example, the real ringgit-US dollar exchange rate is given by the Consumer Price Index (CPI) in Malaysia divided by the CPI in the US. Since freely-floating exchange rates would render domestic stabilisation policies workable, prices should in theory be more stable (because the monetary authority has more room to target inflation by raising interest rates). The more stable are prices, the more stable is the real exchange rate. Indeed, it is the real exchange rate that ultimately matters inasmuch as the nominal rate itself converges onto the real rate.

b) individual economies would be relatively insulated against macroeconomic shocks from abroad. The case of Hong Kong illustrates the obverse of this point succinctly. Since Hong Kong pegs its currency to the US dollar, worries about inflation in the US are transmitted to Hong Kong through the exchange rate. This is so because in order to target US inflation, the Federal Reserve Board has to raise interest rates; thus forcing the Hong Kong Monetary Authority (HKMA) to do the same in order to maintain parity between the Hong Kong and US dollars, although there is no reason for the Hong Kong domestic economy to require higher interest rates. With a freely floating Hong Kong dollar, the HKMA would not need to raise interest rates insofar as the currency would be allowed to depreciate.

c) it would be unnecessary to impose trade restrictions and capital controls. It is widely agreed that trade restrictions and capital controls do more damage in the long-term than the good they bring in the short-term. Restrictions to trade and capital controls result in an inefficient allocation of resources. Capital controls have, in recent years, been a favourite policy tool of Bank Negara to manage the flows of capital in and out of the country. Budget '98 on the other hand unleashed a wave of tariff hikes. Since the imposition of both measures are for macroeconomic reasons, they would have proven unnecessary under freely-floating exchange rates because now the task for maintaining macroeconomic equilibrium fell to the exchange rate - current account deficits not met by an equal inflow of capital would have implied a depreciating currency. A cheaper currency would boost exports and reduce imports, thereby correcting the deficit itself. In other words, there would have not been a need to impose distortive capital controls and tariff measures to control the deficit.

d) the economy's current account would be kept consistent with net capital flows which, in turn, would appropriately reflect differences in wealth accumulation and investment potential in different countries. Under freely-floating rates, it would be inconceivable that a country could run into problems with its current account deficit insofar as the exchange rate would fluctuate in the manner described in (c) lest macroeconomic equilibrium is maintained.

Would exchange rate volatility not harm foreign direct investment (FDI)? I would not have thought so. Exchange rate volatility only pertains to the short-run. Over a span of a few years, the nominal exchange rate itself fluctuates about the real exchange rate. Given that a recent paper by Manzur and Ariff (1995) indicates that the real exchange rate of ASEAN economies are predictable over a span of several years and that I presume genuine FDI would adopt the view to staying in the country for at least that long, foreign investors would have no problem in quantifying at least the trend, if not the level, of the real ringgit exchange rate vis--vis their respective home currencies.

SECTION 4: A Puzzle Remains; & CONCLUSION


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