Capital control a right move, says Dr. Mahathir

Capital control a right move, says Dr. Mahathir

This is the first of two part series, based on Prime Minister Mahathir Mohamad's monthly column Dr. Mahathir's World Analysis which was first published in Mainichi Shimbun.

MALAYSIA: It is now almost a year since Malaysia introduced selective capital control. Initially we were worried over whether or not the control would work.

The criticisms leveled at us by the international media and foreign financial experts did not help to strengthen our confidence in the measures that we took to revive our economy.

But our doubts soon disappeared as almost immediately we saw signs of economic recovery.

Currency control as imposed by Malaysia is not generally understood by the international financial community. Their criticisms are therefore based more on their text-book models than on proper examination of what Malaysia has done.

To understand the measures we took it is necessary to look at the root cause of the financial turmoil that undermined the economy of the country.

The Malaysian economy and finances were very sound prior to the July 1997 attack on the ringgit. We had good reserves and very little foreign debt either by the government or the private sector.

There really was no reason why the currency should have become weak. But the currency traders, in their quest for big profits, borrowed the ringgit and sold it down repeatedly, thus devaluing it greatly.

This meant our wealth was halved in terms of purchasing imported goods. Inflation set in, and people found difficulty in making ends meet.

To make matters worse, the foreign investors in the stock market began to dump their shares and to short-sell.

They did this through the Singapore-operated Central Limit Order Book (CLOB), which traded in Malaysian shares without the approval of the Kuala Lumpur Stock Exchange (KLSE) or the Malaysian government.

By registering all shares held by thousands of investors under the name of a few nominee companies, trading through CLOB did not require registration with the KLSE.

The nominee companies were able to lend the shares to speculators who short-sell them and caused the prices to plunge. Through CLOB the composite index of the KLSE went down from 1200 to 260 points.

Between the depreciation of the ringgit and the severe fall in share prices, the companies and the banks rapidly deteriorated and were bankrupted or became nearly so.

The government, too, faced revenue shortfalls as businesses were unable to make any profit and could pay no tax.

Clearly the country's economy would have collapsed completely if the currency had continued to depreciate and the share prices remained very low.

To prevent this it was imperative for the government to regain control of the exchange rate of the ringgit and to stop CLOB from destroying the Malaysian share market any further.

To devalue the ringgit the traders had to borrow and sell it. Singapore offered high interest rates so as to lure the ringgit to Singapore where it was lent to the currency traders.

The Malaysian banks found themselves without money to lend.

To stop this outflow of the currency, the government decreed that if within one month the offshore ringgit in whatever form was not repatriated to Malaysia it would not be allowed to be brought back at all.

Effectively this rendered offshore ringgit worthless after one month.

This forced all offshore ringgits to be repatriated within one month, leaving nothing for the traders to borrow and manipulate.

Trading in ringgit ceased and the government was able to fix and stabilize the exchange rate at RM3.80 to US$1.

As for CLOB and the short-selling activities, this was stopped by abolishing the right of nominee companies to hold the shares of their clients.

Since all sales of shares must be registered with the KLSE in the name of the shareholders and sales outside the KLSE are not recognized the business of CLOB stopped.

Short-selling of borrowed shares held by the nominee companies could no longer be done and manipulation of share prices ceased.

The net result was stability of exchange rates and a rise in share prices on the KLSE. The forced repatriation of funds from Singapore resulted in more money being available for loans.

It was therefore possible to lower the interest rates to stimulate consumption and business activities.

Many other measures were taken such as setting up an asset management company to deal with non-performing loans and the recapitalization of banks through a recapitalisation fund.

Every aspect of the economy was studied by a National Economic Action Council (NEAC) set up to take counter measures if the economy were faced with any problems.

For example, imports of nonessentials were reduced while exports were encouraged.

The balance or payment which had been in deficit for many years was reversed and huge surpluses achieved in the trade balance. This enabled the reserves to increase from $20 billion (RM76 billion) to $30 billion (RM114 billion) in the space of six months.

All other indicators show that the economy is now improving rapidly and it is expected that the target of 1 percent growth in the gross domestic product for 1999 will be achieved easily.

It is expected that the growth in year 2000 will be around 5 percent.

The controls have apparently succeeded in bringing about the recovery of the Malaysian economy. Although many still condemn capital controls, others now say that controls can resolve the problems brought about by the rapid devaluation of the currency by currency traders.

Some even recommend that other countries open to attacks by currency speculators should adopt currency controls.

It is now easy to think that countries should at least try currency controls in order to solve the problem created by currency devaluation by unscrupulous traders. But deciding on such controls is not easy.

In the case of Malaysia, more than six months of intense debate preceded the decision by the executive committee of the NEAC to impose controls.

One member of the executive committee brought up 32 reasons why currency controls would be bad for the country. But the arguments were demolished one by one.

Other members of the NEAC also found difficulty in supporting the proposal.

The deputy governor of the Central Bank was invited to give his opinion and he too was not supported. He gave all the standard reasons why it would harm the country, its economy and its relations with the rest of the world.

The former deputy prime minister was still a member of the NEAC executive all the time the controls were being discussed. Although he had favored and implemented all the International Monetary Fund (IMF) solutions for dealing with the country's deteriorating economy and finances during the turmoil, he did not argue against the controls.

When the decision was finally made to impose the controls, he agreed with the decision.

It was decided that Sept. 1 was the date for the controls to be implemented.

There is no particular reason for choosing this date except that we reached agreement in August 1998 and wanted to implement control as soon as possible.

But when the date was almost due, the governor of the Central Bank and his deputy tried to scuttle it by resigning.

This was a heavy blow as the Central Bank was the principal implementing authority under the law.

Immediately, the most senior officer of the Central Bank was given the responsibility for carrying out the various actions to make the Malaysian ringgit invalid outside the country and to require all shareholders of Malaysian companies to register their ownership directly with the Malaysian Stock Exchange, thus eliminating the nominee companies.

Currency controls mean different things to different people.

To the text-book economists currency control means cutting the country off from every kind of financial links with the rest of the world.

The Malaysian control is not a simple turning your back to the world. Malaysia is a trading nation. Its economic growth and well-being depends largely on its commercial and financial links, including direct foreign investment with the rest of the world.

It is not like the United States, which can actually cut itself off from the rest of the world and still survive and even prosper.

With only 22 million people and a relatively low per capita income there is no way for Malaysia to be totally independent economically and certainly no way for Malaysia to grow and prosper.

Malaysia must maintain strong economic links with the rest of the world.

And so Malaysian currency control had to be so crafted that it would prevent the currency from being manipulated by foreign currency traders while allowing normal business transactions to be carried out without hindrance.

And that is precisely what was formulated and carried out.

Trade has therefore not been in any way affected and it has not only grown much bigger but the surplus has increased considerably.

The foreign currency to pay for imports is thus readily available from the surplus.

Foreign long-term direct investments have not been affected either.

The investment are flowing in because conversion to ringgit at a fixed rate within the country facilitates business budgeting.

At the same time the exchange rate is more favorable than when the ringgit was stronger.

The money invested can be taken out without any difficulty if there is a need to liquidate and take the money in foreign cur rency elsewhere. Profits from such long-term investments can be repatriated.

Clearly the movement of foreign funds in and out of the country is not affected by our selective currency control.

However, short-term investment in the stock-market are subject to some tolerable conditions.

The capital must stay in the country for at least a year and earlier repatriation would be subjected to an exit tax.

Apparently these conditions have not stopped foreign short- term investors from coming in.

Today, Malaysia's economy is growing again. We believe it is due to the controls we have imposed.

But our detractors disagree and point out that the economies of other East Asian countries are also recovering. They say that even without controls Malaysia would recover.

We believe that the recovery of other East Asian economies is due to the currency traders stopping their manipulation of the currencies.

The are several reasons why they stopped.

When Malaysia imposed controls, there was a fear that the other countries might do the same if the attacks continued.

Secondly, at about this time the Long Term Capital Management Fund collapsed threatening to destabilize the financial system of the rich countries.

As a result, the banks stopped lending to the hedge funds, thus stopping them from attacking and devaluing the currencies of East Asia.

Freed of the threat posed by the currency traders the countries were able to ignore the IMF prescription for countering currency devaluation.

They lowered their interest rates and expanded their budgets.

The big conglomerates which had been ordered to dismantle did not really do so.

And so the economies of South Korea and Thailand recovered.

Even the Indonesian rupiah strengthened. But Malaysia's recovery is earlier and stronger.

The business community, both local and foreign, is convinced that controls have benefited them.

The investing public returned to the stock exchange and helped push up the Composite Index by almost 200 percent.

With this the companies were freed from the need to meet margin calls by their banks and were able to do business again.

The Reserve of the Central Bank shot up by 50 percent as the trade surpluses increased. All other indices indicate a positive recovery for the Malaysian economy.

Malaysia's currency control is made possible by its strong economic fundamentals. The reserves stood at $20 billion (RM76 billion) when controls were imposed. There was hardly any foreign debt.

The financial system and the bankruptcy laws were already in place. The political climate was stable and the government was backed by a big majority.

Inflation was low even when the currency was devalued. Reduction in imports and expanding exports had resulted in huge surpluses.

The initial attempt to raise funds through bond issues was frustrated by Moody's and Standard and Poor's downrating Malaysia's credit rating to almost junk-bond level.

But the high savings rates of almost 40 percent and the repatriation of the ringgit from abroad enabled Malaysia to ignore the failure to raise funds from abroad. There were sufficient funds within the system.

At this stage Japan came to the rescue by making available substantial soft loans amounting to several billion U.S. dollars.

Japan was also prepared to guarantee any bond issued by the Malaysian government. And so despite Moody's and Standard and Poor's low ratings, when the government tested the U.S. bond market in 1999, the issue was oversubscribed by three times.

The country is now in a sound financial position. The economy is growing and many predict that it will exceed the 1 percent GDP growth estimated by the government.

The ringgit is still pegged at RM3.80 to $1 even though the currencies of the neighboring countries have strengthen further against the dollar and therefore against the ringgit.

We do not want to change the exchange rate because this will upset the business transaction and profit forecasts.

Besides, a weak ringgit makes us more competitive even if the cost of imports is higher.

This high cost of imports can result in inflation of course. But Malaysia has always had low inflation rates.

We counter imported inflation by producing more for domestic consumption.

Since food imports are the biggest item contributing to our high cost, we have encouraged local food production.

This has been so successful that we can now export more food products, thus increasing our trade surplus.

With the government in full control of the exchange rate we can easily enrich ourselves by strengthening the ringgit, even up to the pre-turmoil level of RM2.50 to the U.S. dollar.

But the downside to this is lesser competitiveness of our exports and therefore less foreign and domestic investment for export industries.

The power to change exchange rates must be used judiciously or the economy may be damaged. The recovery of the Asian economies also owe a lot to the Chinese government's decision not to devalue the yuan.

Had the yuan been made freely convertible there is no doubt that the currency traders would have attacked it and plunged China and East Asia in even worse turmoil and recession.

As it is, they tried to attack Hong Kong instead in an effort to destabilize China.

The Hong Kong government departed from its laissez-faire policy and defended the stock market strongly. The attack failed but Hong Kong's economy and its reputation have been damaged.

It is really not fair to expect China not to devalue the yuan forever.

The devaluation of the currencies of East Asia has effectively revalued the yuan upwards, rendering China less competitive.

The yuan can actually be devalued a little without affecting the economies of East Asian countries.

But I must thank the Chinese government for holding steadfastly to its promise not to devalue the yuan. China is a friend indeed, much more so than some other so-called friends.

As I mentioned the former deputy prime minister was still in the government when the decision was made to control exchange rate and short-term capital flows. He did not object to the decision in any way. So economic reasons are not involved in his removal from office.

He was removed purely for behavior that is not acceptable for a member of the government. It was certainly not a good time to remove him. We were about to defy the world with a strategy that we could not be certain would work. We were in a state of recession and severe economic turmoil.

No one in his right mind would want to add political instability to the already difficult economic situation.

If the removal of the deputy prime minister was planned more propitious time would have been found.

But his misbehavior was such that his immediate removal was necessary. And so a political problem was added to the economic problem for the government to tackle.

Upon dismissal the former deputy prime minister was allowed to move around the country freely to hold rallies to whip up anti- government feelings.

The government did not stop him. This apparently did not suit his purpose. He wanted to convince his followers and foreign observers that the Malaysian government, and in particular the prime minister, is dictatorial and violently oppressive.

And so he organized demonstration and rioting by his followers in Kuala Lumpur. The government was forced to arrest and detain him. With that his followers became truly incensed and violent. They started to demonstrate and to riot in Kuala Lumpur.

The foreign media seized on this to depict Malaysia as an undemocratic, unstable, potentially violent country.

Day in and day out, pictures of rioting were shown by CNN, CNBC, BBC and others. This compounded the difficulties in reviving the economy.

Investors and tourists avoided the country, and the hotels and other service industries suffered very badly.

But the demonstration and riots petered out and try as the detractors could not keep up with the picture that Malaysia is a bad country.

When the former deputy prime minister was found guilty after a much prolonged trial witnessed by foreign and local journalists, diplomats and sundry NGOs, there was another bout of rioting, but it did not last.

Today the Anwar affair is no longer relevant as far as the economic recovery is concerned.

In the meantime the economy is growing again. More and more experts are supporting currency control, condemning the IMF and even indirectly the powerful and influential hedge funds and currency traders.

Even the Group of Eight is discussing regulating the activities of the hedge funds. It will be a long time before they will actually do something but at least they recognize the role of the currency traders in causing worldwide economic turmoil.

If they do it again, the funds will certainly be dealt with appropriately.

The question that has been asked repeatedly is when will the controls be lifted. Many say that the objectives have been achieved and Malaysia should go back to the freely convertible currency. The ringgit should be allowed to cross the border freely.