Malaysia Exchange Controls during the Asian Crisis - Research Paper Example

 A Report to Malaysia Exchange Controls during the Asian Crisis Executive Summary The Malaysia had its significant share in the financial crisis of South East Asia in 1997-98. The devaluation of Ringgit and negative growth rate of infrastructure along with rise in inflation made its situation vulnerable. There were several reasons both in short term and long term contributed for the higher extent of damage during the crisis. Even though the government of Malaysia had implemented some exchange control measures, they could result in partial success only. It is mainly due to the accumulation of several global and domestic factors and lack of contingency planning. Hence it should learn lessons form this experience which would be used in formulation of future financial strategies. The present report discusses all these aspects in detail. Introduction In 1997-98 there was a severe financial crisis experienced by the countries of South East Asia famously known as tiger economies (Stephen Haggard, 2000). Malaysia also faced this crisis severely. The reasons for this crisis were many as felt by the researchers (Wing Thye Woo, 2000). The main causes are uncontrolled foreign investment in the country, allowing capital fight from Malaysia to other countries, magnifying the currency situation in international level and inefficient monitory policy. Reacting to the crisis in the initial weeks the Malaysian government has taken initiatives to regulate foreign exchange as the devaluation of Ringgit has been very fast. However its measures could not bring much equilibrium to the financial condition of Malaysia and hence it needs to be analyzed so that the loop holes can be identified and one can be accurate in formulating any exchange control measures in future. Keeping this in view the present report has been prepared with the objectives of finding out the reasons for the financial crisis, what happened and what was the extent of damage, measures to control the crisis, short comings and future strategies which are described as follows. a. What happened exactly in Malaysia in 1997-98? In early 1997, the Malaysian stock market index began a downward spiral together with stock markets of several ASEAN countries like Thailand and Indonesia. On 14 July 1997, Bank Negara of Malaysia gave up the defence of the Malaysian ringgit after jacking up the short rate to 50% and spending US$10 billions on unsuccessful monetary operations. There were huge amounts of foreign capital has entered Malaysia in previous years (prior to 1997-98) which was uncontrolled in nature by the Malaysian government. This capital was mainly of short term in nature and was also highly conditional. The rate of interest was fixed very high and at the same time the amount can be taken back according to the convenience of the investors with out prior notice of minimum time period. This has left the situation worst in the time of crisis which happened in 1997 July. In July, 1997, within days of the Thai devaluation, the Ringgit was attacked by speculators. This has also shown us the severe effect of currency speculation on financial condition of any nation. In September, 1997, Malaysian Prime Minister Mahathir Mohamad vowed to combat "racist" foreign speculators with a $20 billion public fund (Paul Blustein, 1998) to prop up the nation's sagging stock market 1. However, in many respects, the Asian crisis has had a much greater and more averse impact on Malaysia than the world market crash in October 1987 and the extent of damage is described here. b. What was the extent of damage in Malaysia during financial crisis of 1998? The extent of damage was extremely high which is reflected in terms of higher lending rates, poor credit rating etc. The interest rates of currency or capital lending have reached peak during this crisis. The overnight rate jumped from under 8% to over 40%. This led to rating downgrades and a general sell off on the stock and currency markets. At the same time the international credit rating agencies started giving poor rating to Malaysia. By end 1997, ratings had fallen many notches from investment grade to junk. 1 : http://www.washingtonpost.com/wp-srv/business/longterm/asiaecon/timeline.htm. Similarly, the KLSE (Kaulalampur Stock Exchange) had lost more than 50% from above 1,200 to under 600. This led to poor economic status of several millions of investors and the corporate houses have lost huge money due to poor capitalization value of their firms. This has resulted in devaluation of Ringgit. The ringgit had lost 50% of its value, falling from above 2.50 to under 3.80 to the dollar. One more observation is that the economic crisis was felt to be severe in the next year due to cumulative effects of all these negative factors. As a result, in 1998, the output of the real economy declined plunging the country into its first recession for many years. No sector was left unaffected by the financial crisis in Malaysia. The infrastructure sector was hit severely. The construction sector and other infrastructure sectors were poorly hit recording negative growth rates. The construction sector contracted 23.5%, manufacturing shrunk 9% and the agriculture sector 5.9%. Inflation has cropped up. The negative impact on stock exchange was also highly reflected. During the year, the Ringgit plunged below 4.7 and the KLSE fell below 270. Overall, the country's gross domestic product plunged 6.2% in 1998. c. What are the main reasons or causes for this crisis? The immediate cause of the crisis is Baht devaluation in Thailand following economic crisis. This has made situation worse in Thailand and foreign investors lost confidence in other south east Asian countries like Malaysia leading to unnecessary panic among the investors. Another important factor is the faster flight of foreign investments from Malaysia. As discussed earlier even though the government has taken some steps in foreign exchange and currency regulation there were several areas of improvement left. These areas exposed the weakness of financial reforms of Malaysia during crisis period. Had the government stressed for the long term foreign capital investment in the form of foreign direct investment, the damage would have been less. But the main reason for the economic crisis was due to improper foreign investment structure. There were deposits in the form short term capital with out any locking period. Hence the foreign capital was taken away with in a short span of time leading to severe crisis. Similarly, the loss of investor confidence on banking sector led to uncontrolled with drawl of savings. The deposition of savings in commercial banks was on increasing note till mid 1997. However, due to foreign investment reduction and sudden panic, the depositors wanted to take their money away. This made banks difficult to repay all the customers and hence they had to borrow huge capital at higher interest rates. The poor accounting procedures also made the situation worse. The auditing procedures followed have not met quality parameters and they could not give the accurate information to the investors from time to time putting them in dark. The relationship lending to few functionaries is also an important cause for this crisis. The banks used to give huge amount of loans to some special customers with whom they had good relationship. This has led to poor security of the deposits of middle class people. As the investors got the source of information relating to the threat to their deposits, their confidence on the performance of banking sector and government control over banks has taken severe beating. It resulted in pessimism of the investors and hence they started withdrawing their savings at a huge number making banks difficult to maintain their solvency condition. One more reason is that the necessary financial prudence measures following capital account convertibility were not taken resulting in exposure of the economy directly at international level. General slow down of the global economy in early 1997 might have also contributed for higher extent of damage during this crisis. There was a reduction in economic growth of all south east Asian countries since January 1997 (Hooley and Yoo, 2002). The liberalization of economy with out proper supporting measures has also led to this crisis (Philip Arestis and Murray Glickman, 2002). Similarly, lack of long term foreign direct investments in good amount is also one factor under this context. Malaysia could not generate sufficient foreign reserves that can be utilized for tackling the financial crisis. In addition, the absence of contingency planning and necessary financial research studies led to a condition where the country had to suddenly face the crisis with out sufficient warning signals. Similarly, the current account deficit of Malaysia was also one of the main reasons for its severe economic crisis. As we have noted earlier, while the economic malaise broke out in Thailand, it quickly engulfed Indonesia, Malaysia and the Philippines with a vengeance. The biggest reason for this unfortunate turn of events is that those countries share with Thailand the problem of sizable current account deficits financed by inflows of foreign capital. This is of particular concern in Malaysia, where the deficit approached 5.5 per cent of gross domestic product in 1996 (Donghyun Park, 1998). Foreign investors' confidence in the ability of those economies to service their debts has not been helped by the presence of a number of investment projects which do not noticeably improve their debt-servicing capability. Easy global liquidity conditions existed during 1997 also led to vulnerable condition in Malaysia (Morris Goldstein, 1998). In spite of several undesirable developments the authorities could not become dynamic in their ability to supervise and regulate the financial enterprises leading to the pathetic situation in the country. This also resulted in higher corruption in financial sector. Similarly, lack of foreign investor confidence regarding government bail out on banking sector and inflation also led to this crisis. The foreign investors spent heavy amounts in the form short term capital deposits in Malaysia (Steven Pearlstein, 1998). They used to charge heavy interest. However once they realized that there were some discrepancies from government side that led to unregulated financial and banking sector, they started taking money away from Malaysia with in a shorter period. This made the tough situation for the government which was using foreign capital for international transactions. Now it had to borrow capital from out side at very high interest rates leading to severe economic crisis in Thailand. Some desirable financial techniques such as diversification across time, stripping dividends and hedging, have not been implemented in the Malaysian context. d. What measures were taken by the Malaysian government? The Malaysian government took immediate decision to regulate the flight of capital from the country to out side. It identified that the successful regulation of foreign capital is the need of the hour. Hence it restricted the inflow of short term foreign capital which is completely speculative in nature. At the same time it also realized the importance of long term foreign direct investments. Accordingly it had put the condition that capital flows should not be made reversible for 1 year. It was also observed that the currency flight was also contributed by some non residents who participate in currency transactions. Hence the government approval was made compulsory for Ringgit transactions by non-residents. Similarly, the government has also cut down the maximum expenditure to be spent by the travellers out side the country. Travellers’ cash restricted to RM1,000 per trip out of Malaysia. As the inflation was found to be on higher side due to the negative effect of all the above mentioned factors, the anti inflationary measures like reduction in currency supply in side the country, increase in supply of consumer goods etc. were taken. In addition, the role of banking sector in the financial crisis was found to be highly significant and hence the government kept close eye on this sector. Accordingly the banking and other financial sectors were kept under stringent supervision. e. Analysis of the exchange measures It must be admitted at this point of time that the measures taken by the government could result in partial success only. However, taking the gravity of the situation, the measures to control the flight of capital from Malaysia met with considerable success as it blocked the ways in efficient manner. As mentioned earlier, the non residents played pivotal role in capital flight and hence the government started regulating their investments by keeping ceiling limits where ever necessary. This has resulted in satisfactory improvement in the financial condition of Malaysia. Similarly, anti inflationary measures could not succeed completely as they were severely affected by other economic factors which were uncontrollable. Even though the government took necessary steps to control money flow in the market, there were several other factors like huge money with drawl of depositors which could not be controlled. One more important finding is that what ever the stringent measures taken by the government in banking sector have paid off in medium term only. Initially the with drawl of money by depositors made them to borrow money at very high interest rates making the situation horrible in short term. Similarly, the reduction of relationship lending also took enough time and hence the results of the banking reforms were felt in medium and long term only. Even though the measures taken for attracting long term capital flows were encouraging it took considerably longer period. At the same time, the role of foreign speculators was also highly criticised. In july, 1997, Malaysian Prime Minister Mahathir Mohamad accused American trader George Soros of causing the Malaysian ringgit's fall. Similarly, in December, 1997, Malaysia imposed tough reforms, including public spending cuts to reduce its balance of payments deficit which also resulted in some notable economic recovery. f. What went wrong with some measures? The government efforts could not result in complete success due to following factors. The anti inflationary measures were mainly affected by lack of investor confidence on government bail out and banking sector recovery. At the same time, the foreign investors preferred redirecting their investments from Malaysia to other stable Asian economies. Similarly, the proportionate financial requirements for full convertibility of currency were not sufficient to give a positive exchange control measures. In addition, the price control in short term was not successful due to panic among the general public. Moreover, Malaysia could not get required assistance from IMF and World Bank as other south east Asian countries also were passing through crisis. g. Lessons learnt from this experience With this experience of financial crisis in 1997, Malaysia should learn following lessons so that it will implement successful management strategy. The internal and external control measures of exposure of foreign exchange and currency have to be strictly followed (Adrian Buckley, 2003). The short term foreign capital should not be encouraged. The long term foreign direct investment has to be preferred. Transparency in financial auditing and monetary policy. Strong regulation and supervision of financial intermediaries and banks. The capital account convertibility is to be gradual and in proportion with the financial policies of the governments. h. Future strategies for avoiding any financial strategy. Strong banking regulations should be followed in long term which act like insurance against these type of crises. Similarly, the relationship lending must not be encouraged. All the lending measures must be transparent and democratic in nature. At the same time, it should also encourage lending to small and medium enterprises based on their repayment capacity which will also result in diversified money distribution. Moreover, high level of transparency in total financial system of the country is the urgent need of the hour. One more important strategy is in the form of accurate supervision and regulation of foreign capital investment which will control the short term flight of the capital from the country. Similarly, gradual conversion of currency to capital account convertibility and supporting financial policy measures in long term are highly needed for efficient management strategies in future. Moreover, Contingency plan for any such financial crisis is mandatory requirement for efficient crisis management. Lastly, the government of Malaysia should concentrate on anti inflationary measures to control inflation by regulating the money supply in to the market. i. Conclusion There was very little reason to expect the Southeast Asian economies in general and Malaysia in particular to recover quickly from their economic crisis. Ultimately, their crisis does not reflect the failure of any single factor like particular economic policies or particular political leaders or particular business practices. It instead reflects the failure of their political-economic system, a system built on a mutually beneficial partnership between the powerful and the rich (Keith B Richburg, 1998). It is unfortunate to find the mistakes committed by International monetary fund in this financial crisis (Paul Blustein, 1999) Hence it took longer period to recover. However, The Malaysian government has taken several exchange control measures for reducing the effect of devaluation of Ringgit. It has regulated the flow of foreign funds and banking sector reforms and anti inflationary measures. However, it could not control the crisis immediately as it lacked complete regulation package. At present it has learnt several lessons from such experience and is implementing all preventive steps for avoiding any future financial crisis. References: Adrian Buckley. 2003. Multinational Finance, 5th Edition, Prentice-Hall, P:776. ISBN-10: 0273682091. Donghyun Park. 1998. South East Asia’s economic crisis. 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