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Promoting Market Stabilisation

National Economic Recovery Plan
Chapter 4

Contents





Objective 1: Stabilising the Ringgit

Since the start of the currency crisis, the ringgit has been volatile, fluctuating by the day, if not by the hour. There are many external and internal forces influencing the exchange rate. This has made business planning and investment decisions difficult, since what may now be a good business decision may turn out to be disastrous later because of unfavourable exchange rate movements. The wider the exchange rate fluctuates, the more would businesses and individuals have to hedge against future ringgit movements in order to reduce risk.

In the midst of this, currency traders thrive on the uncertainties and takes advantage of the volatility as an opportunity for profit making, without regard for the hardship it causes for the economy and people.

It has become a matter of vital importance for the nation to have a stable ringgit. A strong, stable ringgit is interlinked with restoring confidence, maintaining financial and capital markets stability, as well as enabling the real economy to recover and grow.

Three areas of action to strengthen the ringgit are proposed below. In addition, the other measures for restoring market confidence, maintaining financial markets stability, strengthening economic fundamentals, and restoring the sectors adversely affected by the crisis, will also help to boost confidence in the ringgit.

Actions

  1. Appropriate choice of exchange rate regime
  2. Increase external reserves
  3. Reduce an over-dependence on the US dollar
  4. Adopt a balanced interest rate policy

  • Action 1: Appropriate Choice of Exchange Rate Regime

Since 21 June 1973, Malaysia has adopted the flexible exchange rate regime. Bank Negara exercises the option to intervene when deemed necessary in order to even out sharp exchange rate fluctuations. Since mid-July 1997, Bank Negara had allowed the ringgit to be determined by market forces, but started intervening again in early January 1998 in order to stop market panic, following the free fall of the rupiah. In money market interventions, the Central Bank had to exercise great care to ensure that the timing of the interventions is just right, which is not always easy to achieve.

The basic argument in favour of flexible exchange rates is that an economy can adjust easily to external shocks. In addition, monetary policy can be used for domestic ends, such as price stability, rather than having to use interest rates to keep the exchange rate on target. The most important disadvantage is that flexible exchange rates can be volatile and, on occasion, grossly misaligned. This can hinder trade and upset the economy.

On the other hand, a return to fixed rates in todayís world of highly mobile capital is unsuitable. A fixed peg is also a fixed target for speculators. The situation would not improve with the adoption of a currency board in place of a central bank.

Unlike a conventional central bank, which can print money at will, a currency board issues domestic notes and coins only when there are foreign-exchange reserves to back it, one-to-one. Under a strict currency board regime, interest rates carry the burden of adjustment and are not determined by the government. In other words, the government loses the lever of an independent monetary policy. Although a currency board has the advantage of predictability and rule-based nature, the currency is still pegged to another currency and can be attacked, as in the case of the Hong Kong dollar that survived two attacks in 1997.

  • Recommendations

To avert future attacks on the ringgit, the following measures are to be adopted:

  1. Adopt an exchange-rate regime for Malaysia that provides flexibility but reduces volatility. It may be necessary for the ringgit to move within an exchange-rate band against a trade-weighted basket of currencies that is reviewed regularly, at least every three years.

  2. Establish an early warning system to be monitored among key government agencies that identify negative developments within the financial and currency markets well ahead of time.

  3. Continue with the roadshows to encourage investors from countries, such as Japan, Taiwan, Europe and the United States, to invest in Malaysia.

  4. Work towards getting an international agreement for more transparency and greater disclosure in the operations of investment funds, such as pension funds, currency funds, and hedge funds.

  5. Better macroeconomic coordination and exchange of information among countries to detect signs of growing financial instability and currency crises.

  6. Strengthen international surveillance for an orderly international monetary system that is based on sound banking and financial system.
  • Action 2: Reduce an Over-Dependence on the US Dollar

Although 18 per cent of Malaysiaís overall trade is with the United States, about 70 per cent of its trade settlements are conducted in the US dollar, which has appreciated against most currencies. Only about 15 per cent of Malaysiaís total trade settlements are in ringgit and 6.5 per cent in yen. There is a need to reduce an over-dependence on the US dollar in Malaysiaís trade with other countries and build up reserves of different foreign currencies.

  1. Encourage quotations of Malaysiaís exports in the currency of the country concerned.

  2. An expert group should examine the details on the mechanics and operation of bilateral and multilateral payment arrangements for trade among ASEAN countries.

  3. A study should be conducted on the feasibility and prerequisites of adopting an ASEAN currency at a future date. This would have to be examined within the context of intra-ASEAN trade as well as trade between ASEAN and other trading partners.

  • Action 3: Increase External Reserves

Although currency attacks cannot be entirely prevented, large external reserves can help to deter such attacks from occurring. As shown in Figure 6, the international reserves held by Bank Negara as at 15 May 1998 was around RM57.4 billion, sufficient to finance 3.4 months of retained imports. The reserves will need to be increased to enhance the countryís "war chest" for confidence building in the ringgit. The measures to increase external reserves include:

  • Short-Term Measures
  1. Raise Malaysiaís reserves equivalent to at least 5 months of retained imports.

  2. Urge Malaysian individuals and large corporations to sell off part of their assets overseas and bring back the funds to strengthen the ringgit.

  3. Reduce or suspend reverse investment temporarily with the assurance that overseas investment would be allowed when things improve.

  4. Get registered immigrant workers to contribute to SOCSO or EPF and make necessary amendments to relevant Acts to expedite the matter. This measure should be accompanied with better monitoring of foreign workers in order to ensure that they are not driven underground in order to escape this requirement.
  • Medium-Term Measures
  1. Increase exports, reduce imports, improve the services account balance, and increase foreign direct investment.

  2. Consider using loans, issue of bonds or other means to augment the reserves. This includes a financing package to raise funds with short maturity averaging three years.

  3. Continue with prepayments of external debts to reduce their size, and ensure that they are smaller than the external reserves.

  • Action 4: Adopt a Balanced Interest Rate Policy

The Government recognises the problems associated with low interest rates, which are as follows:

  1. Low interest rates will allow banks to delay the balance sheet adjustment, but liquidity will be frozen in non-performing assets.

  2. The lack of value adjustment will prevent market clearing and limit investment opportunities for both local as well as foreign investors.

  3. In the initial stage, low interest rates will lead to credit growth of the poorest quality (distress borrowing), adding to banksí NPL problems. Over time, though, a weak economy and ongoing bad loan problems will make banks reluctant to extend new loans, leading to a credit crunch despite low interest rates.

On the other hand, some arguments have been forwarded against high interest rates. They are as follows:

  1. Many businesses, even well-managed ones, will fail if the interest rates continue to increase, resulting in a recession. The poorly-managed businesses have already been punished by the market, but why kill off the good companies?

  2. High interest rates will not necessarily attract inflows of funds. In the face of currency volatility, investors are more attracted to currency stability and value appreciation than interest yield.

  3. High interest rates may not really encourage domestic savings if the ringgit is weak. The rich could always park their money offshore. High interest rate is often regarded as more risky and a symptom of weakness in the economic system.
  • Recommendation

In view of the above, the Government should adopt a balanced approach to interest rates since a sharp and prolonged increase in interest rate would be untenable. This would fuel inflationary expectations through higher cost of funds.

On the other hand, nominal interest rates should be kept above the inflation rate so that the real interest rate does not become negative. This is to ensure that savers receive a positive rate of return for their deposits, and funds do not go offshore in search higher returns. While interest rates are allowed to rise to underpin currency stability, care should be taken that they are not prohibitive and damaging to the private sector.






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