International Monetary Fund
World Bank Group
|1998 Program of Seminars|
Amidst the continuing debate on the free movement of capital, recent trends in the global financial markets indicate that the international environment has deteriorated further. There is now a growing concern of the risk of a global financial meltdown. The risk of a systemic breakdown in world financial markets has been heightened in recent weeks by the unfolding developments of the Long-term Capital Management (LTCM). This development clearly demonstrates the potential risks posed by the lack of regulation on the activities of hedge funds and their creditors. Even the International Monetary Fund (IMF) has now acknowledged the need to consider carefully the pace and sequencing of capital account liberalisation, to minimise the risk of destabilising short-term capital flows.
2. Notwithstanding the increasing recognition of the risks involved, the prospects of an international consensus for a rapid response to restore stability in the world financial system remains remote. However, Malaysia is not prepared to wait indefinitely for global action which may come too little or too late. At last year's IMF/World Bank Annual meetings in Hong Kong, my Prime Minister had raised many of the issues that are to be the focus of the discussions at this year's meetings. In particular, this relates to the need for an overhaul of the architecture of the international monetary system to deal with the mounting destabilising flows that were having a devastating effect on countries. These cautions after a year are now receiving the urgent attention after a high cost has been inflicted on the global economy. Malaysia, however, is encouraged by the emphasis that will be given to these issues at this year's meetings and hopes for a constructive and concrete outcome to the discussions.
3. As part of an overall strategy of pre-emptive measures to counter the threat of contagion arising from a global financial meltdown, Malaysia introduced selective administrative controls in September 1998. The move has generated much debate and apprehension, or should I say misapprehension. Doubts have been raised about the future direction of public policy in Malaysia: Do the controls represent a step backward for Malaysia? Is Malaysia abandoning the free market mechanism and isolating itself from the global financial system?
Will the controls become a permanent feature of Malaysian policy? Are such controls intended to delay or avoid economic and financial reforms?
4. The answer, of course, is that Malaysia is not withdrawing from the international financial community or abandoning the free market mechanism. In fact, the controls are administrative in nature and imposed mainly on the trading of ringgit in offshore markets. There are no restrictions on most inflows and outflows of foreign exchange.
5. In this connection, I should point out that Malaysia has a long track record of prudent and pragmatic macroeconomic policies. The period of more than 3 decades of high growth with low inflation is testimony to our commitment to sound policies. In the initial stages of the crisis, Malaysia had adopted the conventional macroeconomic prescriptions to address the risks of contagion. Comprehensive measures have also been put in place to restructure and strengthen the domestic economy and financial system, in order to minimise Malaysia's vulnerability to the risks of contagion. However, as the crisis became more prolonged than anticipated, it became increasingly apparent that conventional macroeconomic tightening was not the solution; indeed it aggravated the negative impact of the crisis by further depressing domestic economic conditions. In these circumstances, Malaysia implemented selective administrative controls. These controls will be removed once stability returns to financial markets and an appropriate global regulatory framework is in place.
6. To understand the rationale behind the recently imposed administrative controls, it is important to appreciate the following considerations:
- Malaysia is concerned that the risks of contagion from the Asian crisis have increased and that pre-emptive measures are necessary to protect the domestic economy from the risk of a global financial meltdown;
- In the absence of a global solution to what is essentially a global problem, Malaysia had to undertake selective controls to safeguard the progress made to date in terms of economic and financial restructuring; and
- The need to regain monetary policy independence, to ensure that the conduct of monetary policy is consistent with the need to promote economic recovery.
Permit me to elaborate.
The need to protect the Malaysian economy from the risks of contagion
7. The Asian crisis and its continuing contagion has heightened the financing issues faced by crisis countries because by their very nature, portfolio capital flows are subject to sharp reversals. Markets can only operate efficiently
under ideal conditions, including perfect knowledge and a level playing field. In reality, this has not been the case. Recent trends in the global financial markets indicate that markets have not always behaved rationally, and the international environment has continued to deteriorate.
8. A major concern for Malaysia was the rapid growth of an offshore market for the ringgit, which provided easy access to ringgit funds for speculative activities. At its peak, offshore ringgit deposits were attracting interest rates in excess of 30%. Such high interest rates demonstrated just how profitable ringgit speculation had become. It also revealed the constraints imposed by external developments on the conduct of monetary policy.
9. Malaysia considers that internationally agreed preconditions and safeguards are the preferred solutions to prevent the destabilising effects of large capital movements. The complete absence of prudential rules on currency trades highlights the negative effects of globalisation. The damage that has been inflicted on the emerging market economies has been particularly serious. While the available resources of speculative currency traders may be small relative to the resources of the industrial countries and the volume of global financial transactions, their combined resources overwhelm the markets in the emerging economies as their amount exceeds external reserves and even the GDP of emerging economies. The speculative pressures of such massive capital flows have been intensified by the herd behavior of market players. The irrational behavior of the market players has resulted in an over-reaction to developments, leading to harmful spillover effects. As shown in the Asian crisis, these developments have eroded economic progress that have been achieved over the past three decades. This underscores the risks and challenges of unbridled globalisation and the need for an international framework to ensure that all countries are adequately protected from such risks. Given that prospects for an early international consensus to restore stability have not been forthcoming, it is necessary to protect the domestic economy from further external shocks.
10. Bold new measures are needed to restore the stability in the world financial markets. Incremental and piecemeal efforts are clearly inadequate. The role and functions of the Bretton Woods institutions need to be reviewed to ensure that they are in keeping with the changing times. Unless this is recognised by the international community, there will never be a permanent solution to the crisis. A new wave of instability could well trigger a global financial crisis and the deepest economic slump since the Great Depression.
11. In an effort to ensure prospects for stability, Malaysia has introduced selective administrative controls to allow for orderly capital inflows and insulate the domestic economy from such external risks.. Malaysia has on previous occasions introduced such measures to restore an adjustment in the stabilisation
process. An example of such selective exchange controls occurred in the 1993-94 period when Malaysia experienced a surge of destabilising capital inflows. These controls were lifted after six months. These measures proved effective and allowed stabilisation to be achieved at a lesser cost to the economy and due to their short-term nature.
The importance of safeguarding progress in economic and financial restructuring
12. Malaysia's experience indicates that for a small open economy, capital account liberalisation works best when accompanied by strong prudential regulations. Overall, prudential regulations (both exchange control and investment guidelines) have enabled Malaysia to strike a good balance between foreign direct investment flows and external borrowing to finance investment and growth. Policies to encourage foreign direct investment flows into the export sector have ensured that export growth increased sufficiently to finance the required outflows for profits. The country's policy on active debt management has enabled Malaysia to contain total external debt without impinging on the ability of the private sector to obtain loans from foreign sources at favourable rates. Prudential criteria on managing external loans by both the public and private sectors have helped to contain the foreign exchange risks of these loans. The bulk of external loans are approved only to firms with foreign exchange earnings, providing a natural hedge to these loans. These rules have contributed to stable flows of long-term funds in Malaysia. On the other hand, the absence of prudential rules on short-term capital flows made Malaysia vulnerable to unfounded adverse sentiments of portfolio fund managers.
13. The policy response undertaken by Malaysia following the outbreak of the Asian crisis can be categorised into three phases. During the first phase from September to December 1997, demand management policies were implemented to reduce the current account deficit, address the high leverage of the private sector and the strong credit growth. It was necessary to ensure that excessive domestic demand did not aggravate the inflationary pressures and deterioration in the balance of payments following the depreciation of the ringgit. Prudential regulations of the financial system have, for the most part, been brought to international standards to ensure bank soundness to avoid systemic risks. The objectives of the adjustment measures were, therefore, to curb inflationary pressures, restore external balance and to reduce bank exposure to the higher risk sectors to avoid systemic risks on the financial system.
14. These measures have shown some positive results in terms of dramatically improving the external balance and containing inflation. However, as the regional crisis became more prolonged, additional measures were implemented to stabilise the economy. In the second phase during the period January to April 1998, fiscal policy was relaxed to allow selective increases in fiscal spending to strengthen the social safety net to protect the more vulnerable segments of society. As part of the overall pre-emptive strategy to further increase the resilience of the financial system to withstand risks from a slowdown in economic growth, the merger programme to consolidate the finance company industry was accelerated and additional measures focused on further strengthening of the financial sector.
15. The third phase of policy responses since May 1998 focused on minimising the severity of the economic downturn. The positive effects achieved on the inflation front and the significant improvement in the current account provided the authorities with some room to ease monetary policy. At the same time, mechanisms were put in place to deal with non-performing loans (with the establishment of the Asset Management Company, Danaharta) and to recapitalise the banking institutions (Special Purpose Vehicle, Danamodal). The role of the Corporate Debt Restructuring Committee would be to facilitate debtor-creditor negotiation in debt settlement. It should be emphasised that the operations of the Danaharta and Danamodal and the Corporate Debt Restructuring Committee will be conducted in a transparent manner, with appropriate safeguards to ensure arms-length transactions based on objective criteria. The initial financing requirements of both institutions will be provided by the Government, while the balance will be financed from a combination of domestic and foreign sources, as needed. It is envisaged that some recourse to foreign financing would be useful to promote a more balanced financing structure. In this connection, the Corporate Debt Restructuring Committee will facilitate mutual agreement on corporate debt restructuring among debtors and creditors, thereby ensuring a more coordinated approach to the problem of NPLs and the need for bank recapitalisation.
16. It is emphasised that the new controls are not a substitute for sound macroeconomic and financial policies. The measures will provide some breathing space to ensure that the ongoing structural adjustment measures could continue uninhibited by external developments. The Government is in fact on course in its efforts to restructure the financial sector, in particular, the recapitalisation of the financial institutions.
Regaining Monetary Independence
17. Due to the East Asian crisis, Malaysia has experienced significant amounts of outflows since June 1997. These outflows comprised mainly portfolio investments by nonresidents in the Malaysian stock market. Consequently, stock prices have declined by 65%, reducing the market capitalisation to a quarter of its prevailing levels prior to the crisis. This resulted in a significant loss of wealth. However, the gains in the trade account have offset the short-term capital oufflows, so that the external reserves position has remained stable at RM 20-21 billion, sufficient to finance 3.7 months' imports.
More importantly, the shift towards a current account surplus in the balance of payments position has given Malaysia greater flexibility in its policy response.
18. Nevertheless, the impact of the contagion effects arising from developments in the region in the early part of this year has been more severe than anticipated. The depreciation of the yen and the consequent sharp declines in regional stock markets led to a further contraction of growth rates of countries affected by the crisis. In addition, slower regional and global economic growth will also affect export performance of Asian countries. Therefore, despite the significant adjustment measures undertaken by Malaysia, the economy continued to remain vulnerable to external developments. In addition, the growing offshore ringgit market continued to grow, creating difficulties for monetary management. This trend has become a source of instability. In these circumstances, the cost of continuing with conventional policies is very high. It is likely to cause a more severe contraction in economic growth. The measures to restrict ringgit trades offshore and to manage short-term capital flows would allow greater flexibility to facilitate economic recovery. With the threat of speculation on the ringgit being reduced, interest rates will reflect domestic conditions while the stability of the exchange rate will facilitate economic and business decisions. However, it should be emphasised that interest rate policy will continue to maintain the balance between the need to contain inflation and the need to create an environment that is conducive to growth. Interest rates will continue to meet the objective of containing inflation by ensuring positive real interest rates.
19. While Malaysia has adopted this strategy, it is not suggesting that this is the appropriate approach to be adopted by all countries adversely affected by this crisis. What we wish to highlight is that this is appropriate for Malaysia at this point in time for several reasons based on conditions and circumstances in Malaysia. More specifically:
- Malaysia needs to insulate itself from externally generated instability in view of the openness of its real economy;
- It became increasingly necessary to reduce the rapid pace of internationalisation of the ringgit, which arose from the special circumstances between Malaysia and the financial centres in the region;
- Malaysia has undertaken the adjustments in the external sector, with a reversal of the current account deficit to a large surplus;
- Financial restructuring and mechanisms are already in place;
- Malaysia has established a track record of implementing selective controls to achieve specific purposes, while maintaining sound macroeconomic policies.
- Malaysia has the administrative machinery to manage these controls to avoid inefficiencies in the economy.
Summary of Main Changes to the Exchange Control Rules
20. Essentially, the exchange control measures comprise 3 elements: measures to eliminate access to ringgit by speculators by reducing the offshore market in ringgit, prudential controls on short-term capital flows and limitations on the carriage of ringgit and foreign exchange by travellers. Existing liberal rules on other foreign exchange transactions remain unchanged. These 3 elements are reflected in the changes to the administrative controls. Towards this end, the main thrust of the measures are directed towards:
- Reducing the ability of nonresidents to engage in ringgit transactions among themselves. This was effected via limits on use of ringgit external accounts held by non-residents, especially by corporate customers;
- Requiring imports and exports of goods and services to be settled in foreign currencies;
- Discouraging short-term capital inflows, by requiring inflows of capital to remain in the country for a period of 12 months. However, the funds in the country can be invested in different categories of ringgit assets in Malaysia and the 12-month period will be aggregated across all categories of ringgit assets; and
- Tightening the rules on investment abroad by Malaysians.
21. As the changes in the exchange control rules are directed at containing speculation on the ringgit and at minimising the impact of short-term capital flows on the domestic economy, they will not affect the normal conduct of economic activity. More importantly, the measures continue to guarantee:
- The general convertibility of current account transactions;
- The free flows of foreign direct investment: and
- The free repatriation of interest, profits and dividends and commissions.
22. As the new rules were aimed at containing speculation on the ringgit, they will have no impact on non-residents who are Malaysian individuals with permanent resident status residing abroad, foreigners studying and working in Malaysia, embassies, high commissions, consulates, central banks international organisations and missions of foreign countries in Malaysia.
23. To reiterate, Malaysia is not closing its doors to the foreign investor community, much less to the international economy. Malaysia still maintains general current account convertibility and is not resorting to any rationing of foreign exchange. Beyond that, Malaysia has not changed its policy on foreign direct investment and repatriation of profits and dividends from foreign
investment. We also wish to emphasise that we remain fully committed to making all external debt payments, in full and on time, and that foreign exchange is freely available for such payments. The Malaysian economy is a significantly open economy. Trade as a percent of GNP will remain high, exceeding 170%, foreign direct investment of more than 20% of total private investment and foreign market share in total assets of the banking system of more than 30%.
24. The initial response to our new exchange control policy has so far been encouraging. Interest rates have adjusted downwards based on the assessment of the expected inflationary trend. In addition, Malaysia's reserves have also risen by US$1 billion since the controls were introduced.
Implementation of Administrative Controls
25. The Government has adopted a flexible and pragmatic approach in the implementation of the new exchange control rules. The situation has been closely monitored. Efforts have been directed to ensure that the administrative machinery is in place for prompt approvals so that disruptions and inefficiencies are minimised. Emphasis has been placed on the efficiency of the implementation process as well as the dissemination of information on the changes to the exchange control rules to allay the fears of long-term investors. In the short term, there may be some concerns, especially among portfolio fund managers, on the need to retain funds in Malaysia for twelve months. Assurance is given for flexibility in the management of these funds during the twelve month period and for the convertibility at the end of the twelve month period.
26. It must be emphasised that Malaysia's competitive position will not be undermined by the introduction of recent capital control measures or the fixing of the ringgit exchange rate against the US dollar. The ringgit was already trading at US$1=RM3.80 in the foreign exchange market prior to the fixing of the exchange rate. Thus at this level, the exchange rate level is appropriate. For the first seven months of 1998, the cumulative trade surplus amounted to RM26.2 billion. For the year as a whole, the current account is expected to record a large surplus of RM20 billion or 7.7% GNP. The fixing of the exchange rate together with the imposition of administrative controls to contain short-term speculative activities will contribute to the build-up of Malaysia's external reserve position. Despite the currency crisis and significant outflow of short-term funds, Malaysia's external reserve position has remained high in the region of US$20 billion. As at mid-September 1998, international reserves stood at US$21.3 billion, sufficient to finance 3.7 months of retained imports.
27. The recent measures are aimed at creating stable domestic conditions to promote economic recovery with price stability. In the interim period, the measures will strengthen Malaysia's economic fundamentals in order that we can better manage the challenges of the globalised financial markets. Towards this end, Malaysia remains committed to pursuing structural adjustments in the economy in general, and the financial sector in particular. These adjustments are necessary and important to protect long-term investments in Malaysia. Reflective of the commitment to direct foreign investments, existing measures will continue to guarantee free flows of long-term capital.
4 October 1998