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IMF 1998?

To anyone looking at time series data on the Malaysian economy, especially since they comprise only of twenty-five or so annual observations, one year stands out distinct: 1986.  ( See, for example, the chart on Real GDP growth.)  It was the year when for the first time in modern Malaysian economic history, Gross Domestic Product (GDP) shrank, as it did by approximately one percent.  As we celebrate the coming new year, one quietly wonders if 1998 will go down the same way, as a blip in what otherwise would have been a rather stable series.  Sadly, however, the way economic events are developing - or should I say not,  developing - the chances thereof are increasing by the day.

Even without any new dramatic developments, that official forecasts predict a real GDP growth of only four to five percent is in itself a break from the past.  However, the persistence of strong growth in credit lending, and hence the monetary expansions it results, threatens to worsen the situation.  That I have been at pains to stress the need to slow credit growth down can be
gleaned from my previous articles.  In my view, virtually ALL of our economic 'problems' - from the shortage of food, to the huge Current Account deficit, to the so-called 'overheating' phenomenon (which since this is not a term one encounters in academic literature I take to mean above-potential GDP growth), a depreciating ringgit and inflationary pressures - can be accounted for by excessively-high and unjustified ( i.e. not backed by a corresponding increase in resources ) credit lending.  Previously, for better or for worse, one could at least 'rationalise' the high credit lending.  As alluded to in the Ringgit Crisis article, attempts to in the early 1990s, to target the exchange rate implied a loss of control over domestic monetary policy. In that manner, one could argue that excessive credit lending was at least consistent with some sort of economic rule.

The decision to float the ringgit should in theory have allowed Bank Negara to lower credit-lending since it was now able to refocus its sights on domestic monetary considerations.  Yet when August's Monthly Statistical Bulletin (MSB) was released, the first in the post-crisis period, there was no tangible evidence of any slowdown.  The excuse given was: Adjustment lags -the
28.6% increase in credit lending was due to previous commitments.  At the time, it seemed plausible and no one remarked about it.  Then came September's MSB - credit lending as it turned out did slow, but only by 0.2 percentage points.  Credit lending was still expanding in excessively rapid fashion, as it did by 28.4%.

But September's MSB also revealed a darker side to the economic picture and one which could prove, if nothing is done to secure a reduction in credit growth, instrumental in making 1998 the year of the IMF.  This was the revelation that the loans-to-deposit ratio rose to 94.5% from 92.7% within a month and, more crucially, that the banking system's net external
liabilities increased by some RM6bn.  It is not difficult to appreciate why this is indeed alarming.  Since the very existence of financial institutions is to bridge the gulf between those who save and those who need to borrow, in principle, the less people save the less are banks able to extend loans.  Yet this was not the case: Banks continued relentlessly in their lending activities regardless of the fall in deposit growth.  Thus we find that whereas a sum of RM1.9bn was placed by way of new deposits with the banking system in the month of September, the system lent out RM9.8bn!

What was more worrying however was that in its attempts to bridge the gap, the banking system was resorting to offshore borrowing; hence, the increase in net external liabilities of RM6bn.  It was pointed out to me at the time that part of the aforementioned figure could simply reflect a fall in offshore deposits and as such it does necessarily imply an increase in 'borrowing' as such.  In my view, the economic consequences of the increase renders the difference immaterial - even if the entire RM6bn was due to offshore withdrawals of deposits, there should have been a corresponding decrease in (future)
lending by that amount, an event which was not borne out by subsequent figures.

The picture which September's MSB painted was thus bleak: A tumbling stock market and currency had already prompted a capital flight as confidence in foreign (portfolio) investors evaporated.  The decline in lending resources was exerting further upward pressures in interest rates: Interest rates were already on an upward trend, having been artificially-low ever since 1993.

 LT and ST interest rates

Under perfect foresight, both long- and short-term interest rates should equal.  Where perfect foresight is not feasible, short-term rates should at least shadow movements in long-term rates.  (Long-term rates are often taken as a proxy, albeit an imperfect one, for the 'natural' rate of interest, that rate which is consistent with optimal growth.)  Yet, they fell without a
corresponding change in long-term rates having been the result of excessively-rapid credit expansions.  By March 1994, short-term rates stood at a mere 2.77% as against a long-term rate of 7.25%.  Given this situation, a restoration to overall equilibrium would have necessitated a period in which short-term rates exceeded the long-term.  However, Bank Negara introduced a series of measures to resist the increases, which, following the ringgit crisis, had been made more acute - a cap was imposed upon the lending rate, the reserve ratio requirement lowered (thereby allowing banks to create more credit out of every ringgit of deposits) and reserve money was pumped into domestic money-markets.  Since these measures rendered inter alia the failure of investment-demand to dampen, banks were forced to borrow offshore to make ends meet.  In other words, the Government's attempts to resist interest-rate rises was forcing the banking system to increasingly depend upon short-term foreign borrowing; a state of affairs which resembles disconcertingly close to the situation Mexico and Thailand found themselves in during the run up to their respective crises.

If indeed the failure of credit growth to slow was the result of adjustment lags, October's MSB should at least have begun to show a tangible slowdown.  Much to the dismay of the markets, however, credit lending grew by yet another 28.4%, and once again notwithstanding further declines in the rate of growth in deposits.  Presentation-wise, October's MSB Press Release did not help either inasmuch as it raised suspicions that Bank Negara was withholding vital information - discussions with respect to the liquidity situation in the money-markets amounted to a mere one sentence; whereas information on the banking system's net external liabilities was conspicuously absent.  Yet, by piecing together information from other parts of the Press Release, it was not difficult to guess that the figure would have shown an increase; that is, that the banking system would have resorted to foreign borrowing yet again in order to meet the domestic demand for credit.

Having recently edged one step closer to mounting the right 'strategy' for recovery, the Government has stopped in its trails once again.  Credit lending is now being directed at productive sectors, we are told, as if to imply that it should therefore not be a problem.  Perhaps credit is indeed being channelled into productive investments - but directed at productive activities or otherwise, an increase in the supply of credit over and above increases in lending resources will ultimately lead to a recession.  Money is still neutral with respect to output, no matter how it is spent.  After all, it must be borne in mind that South Korea's present problems were the result of an expansion in productive capacity ( mainly the factories, both at home and overseas, of the politically well-connected chaebol ); and so clearly insofar as stabilising the situation is concerned, the distinction does not matter.  Indeed, our account in A CHILD'S TALE OF MONETARY NEUTRALITY proceeded without having to distinguish between productive and non-productive investments.

Meanwhile, strong credit lending continues to pile debts up in the economy.  Whilst the Government may justifiably be proud that its prudent management of external debt has resulted in one of the lowest levels of foreign indebtedness amongst the hardest-hit ASEAN economies, what is also equally true is that domestic indebtedness is the highest in the region.  There is no official figure of Malaysia's debt-to-GDP ratio.  The consensus of most estimates however conjures up a figure of about 165%.  In other words, for every RM1 Malaysians earn, they borrow RM1.65.  ( Note that 'Malaysians' does not refer exclusively to the population but also to companies and other non-financial institutions.  In all likelihood, it is the latter group which accounts for the bulk of this frighteningly-high figure.)  Such a high debt-to-GDP ratio makes us particularly vulnerable to interest-rate increases and it is therefore understandable, though that is not necessarily to agree, why the Government is so keen in wanting to forestall interest-rate rises.  Even at present levels, servicing interest charges is said to absorb some 18% of GDP.  Evaluated at 1996 ratios, that amount is larger than the entire output of the manufacturing sector.  Any interest-rate rises would therefore not surprisingly unleash a record wave of bankruptcies.

But then, as the saying goes: "When one has fallen into a pit, the first thing one should do is to stop digging".  To the extent that a 165% debt-to-GDP ratio was the result of a past monetary expansion making it unjustifiably profitable to borrow, there is nothing that can be done to change the fact; at least nothing that would not undermine creditworthiness.  Interest rates will have to rise in order to restore equilibrium in the loanable funds market and, as Say's Law ( pronounced as 'See' ), assures us it is only when this market is in equilibrium will we have sustainable full-employment non-inflationary growth once again.  Since this is so, I would have thought it self-evident the case for bringing growth rates in credit-lending down to more realistic levels.  ( The average real credit growth rate between 1971 and 1995, for example, was only 13.64%; way below the above-twenty percent rates we are now seeing.  Excluding 1980, which appears as a statistical blip, the figure falls further to 12.52%.)  Moreover, so long as credit growth continues to pile on new debts, and therefore heighten the risk of bankruptcies, so shall the stock market continue to tumble, and likewise the ringgit.  And so long as market forces are resisted, falls in stock-market value and in the exchange rate risks imploding upon itself.

So: high indebtedness, unabated credit expansion, increasing dependence on foreign borrowing, a falling stock market and exchange rate, imminent rises in interest rates and a prospect of slower output growth - to be honest, more or less the stuff that precipitates IMF bail-outs.  But of course, that does not necessarily make such bail-outs imminent nor desirable.  After all, it
is still not too late for the Government to act.  It could still proceed in earnest, and notwithstanding the 'pain', to dampen credit growth and to allow interest rates to rise to levels necessary to restore equilibrium in the loanable funds market.  It could that is, if it wanted to.

Not everybody - hardly anybody? - is confident that the Government will act decisively.  Certainly, insofar as the post-crisis track record of government-spontaneity is concerned, there isn't much to be confident about.  Meanwhile, international rating agencies have lowered their assessment of Malaysian securities in anticipation of a disastrous 1998; whilst at least one leading international investment house is proceeding upon the assumption that an IMF bail-out will be sought before June.  Whether or not their pessimism is justified is perhaps more than what objective analyses can attribute.  In truth, 1998 does not have to be the year of the IMF: It's up to the Government make sure that that rings true.

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