1997

MALAYSIAN CURRENCY CRISIS

Presented by:

M. Rizwan Qamar

Outline

1. Definition of Currency Crisis2. Theoretical Models of Currency Crises and their

Applicability to Malaysia.3. Asian Economic Outlook before the crisis4. Causes of the Currency Crisis5. Response to the Crisis6. Lessons from Malaysian Currency Crisis7. Malaysian Economic Outlook after the crisis8. Conclusions

Outline

Definition of Financial Crisis

Currency crisis: Defined as a situation in which an attack on the currency

leads to substantial reserves losses, or to a sharp depreciation of the currency – if the speculative attack is ultimately successful – or to both.

Banking crisis:– Performance of bank stocks relative to the overall equity

market– Non-performing loans– Bank runs " closure, merging or takeover by publicsector

Malaysian Currency Crisis 1997/98 “I can‘t imagine that 20 or 25 years ago my predecessors

would have been worried about an economic crisis in Thailand or Indonesia, or even Korea” Robert Rubin, Former Secretary of the Treasury

Much more heterogeneous than first two generations Three main variants:

– Moral-hazard-driven lending– Currency crises as the byproduct of a bank run– Balance-sheet implications of currency depreciation

Short-term debt Other key topics: Maturity mismatch, currency mismatch,

contagion, crony capitalism, etc.

Brief History of Crisis

Economic Outlook before Crisis

Graphs taken from: WORLD ECONOMIC OUTLOOK

Interim AssessmentDecember 1997

A Survey by the Staff of the International Monetary Fund

Malaysia Before Crisis year 75-

82

83-89

90-95 90 91 92 93 94 95 96 97

Growth 7.1 5.4 8.8 9.6 8.6 7.8 8.3 9.2 9.5 8.6 7.8

Inflation 5.3 2.0 3.5 2.8 2.6 4.7 3.5 3.7 3.4 3.5 2.7

UE - 7.3* 3.6 5.1 4.3 3.7 3.0 2.9 2.8 2.5 2.7

CA/GDP -2.0 -0.7 -6.2 -2.1 -8.8 -3.8 -4.8 -7.8 -10.0 -4.9 -4.8

Saving 21.6 29.4 31.3 29.1 28.4 31.3 33.0 32.7 33.5 36.6 38.0

Investment 29.4 28.5 37.7 32.4 36.4 36.0 38.3 40.1 43.0 42.2 42.7

Export 15.0 12.0 19.9 17.4 16.8 18.5 15.7 24.7 26.0 5.1 -

Budget - -4.0 -0.3 -2.2 0.1 -3.5 -2.6 2.5 3.8 4.2 1.6

Money 20.2 9.2 19.3 10.6 16.9 29.2 26.6 12.7 20.0 25.3 17.5

RE(US$) 0.68 0.86 0.96 1 1.01 0.95 0.98 0.92 0.89 0.88 1.34

RE(Yen) 0.53 0.78 1.07 1 1.07 1.00 1.13 1.16 1.06 0.91 1.23

Causes

Broadly, the views about Malaysian financial crisis can be divided into two categories:

Macroeconomic imbalances and structural distortions.

Sudden shifts in market expectations and confidence.

Causes (Continued)

Current account deficits and composition of foreign liabilities.

Fixed exchange rates system and overvalued currencies.

Failure of developmental state model. Unfavorable changes in external environment. Inadequate financial supervision and regulation. Moral hazard. Inherent flaws of global financial structure.

Current Account Deficits and Composition of Foreign Liabilities

It has been widely agreed that a current account deficit should be closely monitored if it is in excess of 5% of GDP and largely financed in a way that could lead to rapid reversals.

Large current account deficits mostly financed by short-term reversible investments.

Current Account Deficit

1990 1991 1992 1993 1994 1995 1996 1997 Korea -1.26 -3.16 -1.70 -0.16 -1.45 -1.91 -4.82 -1.90 Indonesia -4.40 -4.40 -2.46 -0.82 -1.54 -4.27 -3.30 -3.62 Malaysia -2.27 -14.01 -3.39 -10.11 -6.60 -8.85 -3.73 -3.50 Philippines -6.30 -2.46 -3.17 -6.69 -3.74 -5.06 -4.67 -6.07 Thailand -8.74 -8.01 -6.23 -5.68 -6.38 -8.35 -8.51 -2.35 Hong Kong 8.40 6.58 5.26 8.14 1.98 -2.97 -2.43 -3.75 Taiwan 7.42 6.97 4.03 3.52 3.12 3.05 4.67 3.23

Short Term Debt as a Percentage of Total Debt

1996 Korea 67 Indonesia 61 Malaysia 50 Philippines 58 Thailand 65 Hong Kong 82 Taiwan 84

Short Term Debt as Percentage of Foreign Reserves

1990 1991 1992 1993 1994 1995 1996 Korea 72.13 81.75 69.62 60.31 54.06 171.45 203.23 Indonesia 149.28 154.62 172.81 159.70 160.36 189.42 176.59 Malaysia 19.54 19.05 21.12 25.51 24.34 30.60 40.98 Philippines 479.11 152.31 119.37 107.68 95.00 82.85 79.45 Thailand 62.55 71.31 72.34 92.49 99.48 114.21 99.69 Hong Kong 23.52 21.78 18.38 17.09 16.49 14.16 22.35 Taiwan 21.56 20.21 21.00 23.64 21.76 21.64 21.31

Debt-Service Plus Short-Term Debt as Percentage of Foreign Reserves

1990 1991 1992 1993 1994 1995 1996 Korea 127.43 125.90 110.35 105.66 84.90 204.93 243.31 Indonesia 282.92 278.75 292.03 284.79 277.95 309.18 294.17 Malaysia 63.96 45.87 45.55 42.37 48.73 55.92 69.33 Philippines 867.64 256.99 217.08 212.60 171.98 166.60 137.06 Thailand 102.35 99.34 101.34 120.28 126.54 138.13 122.62 Hong Kong 30.51 26.87 22.82 20.64 22.02 16.82 Taiwan 23.92 22.29 23.08 25.21 23.69 24.20

Fixed Exchange Rates System and Overvalued Currencies

Almost all these economies pursued export led growth by keeping the currency fixed with USD.

When USD appreciated in 1995, the real exchange rates appreciated and deteriorated the cost competitiveness.

Problems arose when the central banks were unable to support the currency against currency speculation in view of their small international reserves.

Failure of Developmental State Model

Most of these Asian countries followed Japanese growth model with all its inefficiencies like speculative investment, crony capitalism and unsound business and economic decisions.

These decisions led to bad loans, unsustainable growth and overvalued assets.

Unfavorable Changes in External Environment

Changes in international financial system like capital account liberalization and financial market deregulation played a critical role.

Some aspects like intense competition from China, Japan’s economic slow down and a worldwide fall in demand of semi conductors also significantly affected the exports from Malaysia.

Inadequate Financial Supervision and Regulation

Market liberalization was not accompanied by sophisticated control systems and the supervisory capacity was limited.

As a result of negligent supervision there were low capital adequacy ratios, lack of deposit insurance schemes and risky lending.

Moral Hazard

Krugman pointed out two dimensions of Moral Hazard:

Domestic banks were seldom concerned about their investment and were anticipating a bail out by Government.

International investors also anticipated a bail out either by governments or IMF.

Inherent Flaws of Global Financial Structure

According to this view roots of capital flows lie in the Global Financial structure in which there are repeated patterns of “Booms” and “Busts”

Increasing confidence leads to massive capital inflows followed by busts created by panic by investors.

IMF Conditionality

Tighten Macroeconomic Policies: ↓ Government deficit: ↑ T , ↓G ↓ Current account deficit: 2% Tight monetary policy ↑interest rate

Financial Sector Reform: Enhance regulations and supervisions ↑Transparency/Disclosure Closure of troubled financial institutions

Real Sector Reform:

Measures Taken By Government

Only Three Measures Taken by Govt.

1- Freezing the External Ringgit Account2- Fixing the Exchange Rate @3.80RM/$3- Introduction of Twelve Month Rule

Source: The Malaysian Currency Crisis Mahatire Bin Muhammad (1997)

Important Lessons

Lessons: Malaysian Currency Crisis

Key Lessons: Financial market reform Manage investor confidence Curb unproductive & speculative capital Accumulate huge international reserve Avoid excessive reliance on external fund

& short-term capital Reform international financial architecture Embrace flexible exchange mechanism Temporary currency & capital control

Lessons: Financial Market Reform

Develop robust & resilient financial system. Strong institutions with capabilities & expertise

Disclosure & accounting reform (i.e. International Accounting Standards)

Adopt proven & stricter regulations- International organizations (i.e. IMF, World Bank, Asian

Development Bank)

- Developed financial centers (i.e. New York, London)

Lessons: Manage Investor Confidence

Continuously improvement in investment climate by enhancing regulations, intensifying supervision, tackling corruption etc

Caprio (1998)

Ranking Country Ranking Country 1 Singapore 7 Malaysia 2 Argentina 8 Colombia 3 Hong Kong 9 South Korea 4 Chile 10 The Philippines 5 Brazil 11 Thailand 6 Peru 12 Indonesia

Source: “Asian Crisis: Distilling Critical Lessons”, Dilip K. Das

Lessons: Curb Unproductive & Speculative Capital

Avoid or cut speculative activities in real properties & securities

In Thailand 70% of foreign capital is invested in securities

Lessons: Accumulate Huge International Reserve

Feldstein (1999) supports this notion in view of increasing integration of world capital market.

Singapore’s Experience ($194 billion or > 8 months import as at end of February 2006).

Foreign Reserves (in months of imports) 1993 1994 1995 1996 1997 Korea 2.53 2.63 2.52 2.32 1.42 Indonesia 3.60 3.24 2.94 3.64 3.26 Malaysia 5.64 4.53 3.29 3.59 2.73 Philippines 2.59 2.81 2.33 2.95 1.79 Thailand 5.64 5.65 5.35 5.53 4.40 Hong Kong 3.33 3.27 3.10 3.47 4.80 Taiwan 10.64 10.90 8.90 8.68 7.56

Lessons: Avoid Excessive Reliance on External Fund & Short-term Capital

Large capital inflows can potentially have a destabilizing impact over the recipient economy, particularly when the currency is convertible.

Short-term capital inflows are known to cause volatility in financial markets, which leads to macroeconomic instability.

Monetary authorities should keep strict watch over short-term borrowings denominated in foreign currencies.

Lessons: Reform International Financial Architecture Gordon Brown, former British Chancellor

“… focuses on the stability and integrity of the world financial system should be directed on code of conduct; monetary policy, fiscal policy ...” BBC February 21, 1998

Total assets of top international financial/hedge funds are higher than reserves of some countries

Top International Financial/Hedge Funds 2004 Key Economic Indicators

Company 2004

Assets

External Debts

Reserves of Foreign Exch.

& Gold Soros Fund Management $13.0 b Indonesia $141.5 b $35.8 b Bridgewater Associates $12.4 b Malaysia $53.4 b $55.3 b D.E. Shaw $11.4 b Philippines $55.6 b $16.1 b Golden Sachs Assets Management $11.2 b Singapore $19.4 b $112.8 b Farallon Capital Management $12.5 b S. Korea $160.0 b $199.1 b Caxton Associate $11.9 b

Thailand $50.6 b $48.3 b Source: Absolute Return Magazine (Top International Financial/Hedge Funds)

Lessons: Embrace Flexible Exchange Mechanism Prior to crisis, monetary framework in most Asian

countries was anchored to the fixed exchange regime.

Pegging is infeasible as international reserves and financing were insufficient for developing countries.

Fixed exchange rate vulnerable to speculators’ attack.

Lessons: Temporary Currency & Capital Control

• Malaysia experience:- Imposed currency & capital controls September 1,1998- Reverting to floating exchange a day after China on July

22, 2005- Supported by Prof. Bhagwati- Refuted claims by many economists that Malaysian

economy not sustainable

GDP Growth (%)1997: 7.3%1998: -0.1%1999: 5.8%2000: 8.5%Source: “Capital & Control: Lesson from Malaysia”, Rawi Abdelal & Laura Alfaro (2003)

Lessons: Temporary Currency & Capital Control

2004 Key Economic Indicators GDP Purchasing power parity Real Growth Rate Per capital Indonesia (Aid from IMF) $827 b 4.9% $ 3,500 Malaysia $229 b 7.1% $ 9,700 Philippines $431 b 5.9% $ 5,000 Singapore $121 b 8.1% $ 27,800 S. Korea (Aid from IMF) $925 b 4.6% $ 19,200 Thailand (Aid from IMF) $525 b 6.1% $ 8,000

Reserves of Foreign

Exchange & Gold Indonesia $ 35.8 b Malaysia $ 55.3 b Philippines $ 16.1 b Singapore $ 112.8 b S. Korea $ 199.1 b Thailand $ 48.3 b China $ 610 b India $ 120 b

Source: “World Factbook” extracted from http://education.yahoo.com (2004 estimated data)

Conclusions The Asian financial crisis represents a

new generation of crisis. It involved not only currency exchange problems but also banking problems.

Macroeconomic experts were unable to predict it, since economic conditions remained generally good and private foreign capital was flowing in at a record pace and on very attractive terms.

Conclusions (Continued)

Some key elements: failure to reduce overheating pressures, current account deficits funded with speculative short term debt, lack of soundness, transparency, and supervision of financial system, overvalued properties and stock markets (bubbles), excessive exposure to foreign exchange risk in both the financial and corporate sectors and lax prudential rules.

Conclusions (Continued)

The failure of the IMF rescue package reinforced the importance of the soundness in macroeconomic and financial sector fundamentals.

The causes of the financial crisis in Asia are complex and will need to be thoroughly analyzed both to reduce the risk of similar occurrences in the future and to identify appropriate lessons for economic policies.

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Happy Eid Mubarak