Why Malaysia fared badly during the 1997/98 economic crisis
Awang Abdillah
A trade-based economy like Malaysia depends on many general, economic, global and financial market fundamentals. In this article, I would like to touch on the international trade and financial market fundamentals.
1) The international trade
In the global trade there are 4 macro economic variables that contribute to the economic well-being of a nation –
i) Exports and imports
A country should have a big trade surplus where possible to ensure it can earn sufficient foreign currencies to service its’ imports and foreign loans, to strengthen the value of the currency and to enable its’ Central Bank to regulate or defend its’ currency. A country that gains consistent accumulative foreign reserve earnings especially from the surplus balance of payments annually may not have to resort to foreign borowings to finance its’ economic growth.
ii) Foreign (international) reserves
Foreign reserves can come from the annual trade surpluses (exports over imports), the surplus balance of payments items such as tourism and incomes from abroad, and the inflow of foreign funds either long term or short term. Among others, a big surplus of foreign reserves will enable the local currency to appreciate in value against other major foreign currencies.
iii ) Foreign capital inflow and outflow
The inflow of foreign funds for long-term investment (FDI) can boast the domestic economic development, while short-term funds (hot money) is temporary in nature that are deposited in local banks to take advantage of higher interest rates offered to attract foreign capital, or to be invested in the stock market.The short term funds have more negative effects than positive ones. Though they may either prop up or cause the value of the local currency to fall, and can raise the value of the shares (bullish market) or pull it down (bearish market), the big risk is that these massive funds can trigger a crash to the stock market, especially if the funds withdrawn within a short notice constitute a major amount as what had happened in the 1997-98 economic crisis that hit Malaysia badly.
iv) Foreign debts
The ratio of foreign debts to the total national debt should not be too high as what Thailand had experienced before the 1997-98 economic crisis. A country with low foreign reserves in its’ banking system will have difficulty in paying off foreign debts, servicing imports, and stabilising or defending the local currency leading to its’ fall or even crash. A fall in the value of the local currency vis-a-vis the foreign currencies will raise the cost of these foreign debts. Any substantial currency fall will likely trigger panic in the equity market and can even cause its’ crash. As a rule, a high foreign debt is associated with poor exports performance and hence low foreign reserves earnings.
2) The financial market
In the financial market, there are 4 fundamentals that determine its’ performance –
i) Exchange rate of local currency vis-a-vis foreign currencies
The exchange rate is determined by the demand and supply of the local currency vis-a-vis the foreign currencies. The currency is the base item that not only facilitates the business activities in the international trade and financial market, but the commodity, like the shares in the stock market is a trade commodity itself. Therefore, it is pertinent that the currency has a strong acceptance value in international trading, and a stable commodity in the trading of shares in the equity market and in the forex market. Any substantial unstable fluctuation especially the steep fall in the currency value will trigger panic in the whole financial market and put the business of the international trade in disarray.
ii) The value of the shares in the stock exchange
The equity market is where a very substantial amount of the nation’s capital resources are being invested. In 2010, total market capitalization (total value ofshares) of Bursa Malaysia stood at more than RM2 trillion. The value of the shares in the stock exchange are very much linked to the value of the currency. Like the currency commodity, the shares commodity is sensitive and volatile to changes to general economic, global and financial market fundamentals.
iii) Bank interest rates
The banking system is another financial entity where a substantial volume of the capital resources of companies, individuals, and the government are deposited for various purposes such as savings, investments, loans, global trade etc. Bank interest is part of the government monetary policy to regulate the currency value, maintain high levels of deposits, control loans to curb inflation or artificial economic boom, stimulate economic growth, to attract foreign capital inflows, etc. Commercial banks work closely with the Central Bank to regulate the currency through the adjustment of interest rates and the trading of the foreign reserves available in the banking industry.
iv) Role of Central Bank
The Central Bank has many functions; among them is to regulate the value of the local currency. If the ringgit depreciates, the bank will intervene and buy it in exchange with a foreign currency, say US dollar, and vice versa. Bank Negara must have sufficent foreign reserves to regulate the ringgit. The central bank should hold a substantial amount of foreign reserves vis-à-vis the commercial banks at any one time to enable it to influence the currency value. After the speculation trading fiasco in 1992/93 by Bank Negara in the London forex market, the bank lost billions of vital foreign currencies, rendering the ringgit vulnerable to speculative attacks in the local forex market ie the bank would not be able to defend the ringgit under such circumstances because its’ foreign reserves had dried up!
Lucky for Malaysia, the speculators were not eyeing the Malaysian forex market at that time.
The nature of the financial market
The global and financial market macro fundamentals will substantially determine a nation’s values of its’ currency and its’ stocks. The financial market is a volatile and sensitive system.
Firstly, the market becomes volatile ie overreacting (negatively) to major general, economic and global changes such as in the demand and supply of goods and services, mounting national debt, excessive bank credit, continuous deficits in annual national budget, and continuous deficits in balance of trade and balance of payments, political instability, international crisis etc.
Secondly, it is sensitive ie reacts fast (negatively) to financial market forces such as erratic currency movements and bank interest rates, depleting foreign reserves, unstable inflows and outflows of short-term foreign capital etc.
Thirdly, due to human greed, or overzealous policies such as excessive or massive borrowings with little collateral to finance mega projects and property investments or for purchasing stocks etc, causing the market economy to react positively leading to artificial short term bullish stock market, appreciation of the local currency, and economic boom in certain sectors. However, this artificial economic prosperity is only short-lived and will later lead to an economic bubble burst.
Both the government and the Central Bank can intervene from time to time to stabilise the general economy and regulate the financial market, provided the nation has strong major economic and financial market variables such as high employment and economic growth, strong banking systems, accumulated surpluses in the balance of trade and the balance of payments and sufficient foreign reserves in the banking industry, stable currency, high market capitalisation of the equity market, and good governance. A sound economy very much depends on good national leadership and a clean and responsible government too.
Thailand economic crisis of 1997-98
Britain in 1991/1992 went through a major economic downturn due to its’ sluggish economy but the general economic and financial market fundamentals were still strong, hence the devaluation of the pound did not create aftershocks.
In fact the official devaluation and the consequent floating of the sterling in 1992 enabled the economy to recover in 1993. Unlike Thailand, when it was hit by the economic crisis in 1997, the country was defenceless against the onslaught due to weak general economic and financial market macro components. Substantial amount of funds for development went to real estate investments which did not give good returns due to graft and other forms of abuses of political power resulting in high non-performing loans.
Thailand suffered from depleting foreign reserves and mounting foreign debt due to continuous annual trade deficits (exports–imports). The external debt stood at US112 billion. In other words, Thailand had scarce foreign reserves, so had to resort to heavy foreign borrowings to finance development projects. This led to strong pressure on the value of the baht vis-à-vis foreign currencies, thereby pushing down the value of the baht.
With low reserves, Thailand had to service imports and foreign loans and the central bank of Thailand could not regulate or stabilise the baht. At the time, the baht was pegged at 1US dollar to 25 baht. Mahathir, the mega speculator and Bank Negara were unaware that global speculators including his nemesis George Soros were focusing on the Thailand forex market at that time, ready to make a big kill! Speculators were taking their positions in the Thailand forex market in May 1997. To stimulate the economic recovery, Thailand though aware of the speculative vultures hovering above, had no choice but to float the baht on 2nd July 1997. As expected, the currency tumbled and the stock market was hard hit!
Under such circumstances, Thailand should have taken the following steps –
Thailand should have carried out economic adjustments first ie devalue its currency officially to stimulate its general economic fundamentals towards recovery as what Britain did in 1992, ie to stimulate exports and tourism (attract foreign reserves) and make imports more expensive thereby saving on spending scarce foreign reserves.
Secondly, it should peg back the baht to the US dollar to give time for the main general economic fundamentals to recover say 6 months – 1 year. Only then it can float the baht to regulate the financial market macro variables (market adjustments). Direct floating may only adjust to the financial market macro variables, not the economic recovery aspect. Hence, the unfavourable economic circumstances coupled with poor economic strategies provided a perfect storm for a financial tsunami to strike Thailand’s economy.
The speculators keen to make money only waited for the right time to take place not only in Thailand but other Asian countries.
Malaysia economic crisis of 1997-98
Mahathir is an ambitious man who believes in the theory of mega economics. He believes through massive projects Malaysia can get into the fast lane to become a fully industrialised country by 2020. He may be right if Malaysians are like the Western or Japanese people. Both Japan and Germany were able to rise again to become industrialised economies after the 2nd World War. But not Malaysia. The Malays and other Bumiputras are not as enterpreneurial as other races.
Furthermore, instead of getting the best people to carry out his plan, Mahathir carefully chose his own cronies to implement his mega economic model. During that time, Malaysia growth was due partly to the artificial boom where there were massive and excessive loans with little collateral given to crony-linked companies and the big players especially Mahathir cronies were gambling in the stock market, heavily financed by bank loans. Hence, the money market was overstretched where banks’ resources were seriously drained.
Since 1992-93, Malaysia lost billions of foreign reserves due to Bank Negara’s speculative activities in Britain’s forex market. By 1994, Bank Negara was technically insolvent. From 1980 to 1997 trade surpluses (exports over imports) were not more than RM10 billion a year, meaning Malaysia had low foreign reserves when the crisis struck.
In 1996, Malaysia foriegn debts stood at RM 97.8 billion and shot to RM170.8 in 1997 (partly due to ringgit depreciation). Foreign reserves are required to finance imports, service foreign debts and to stabilize the ringgit. With a limited pool of foreign reserves in the banking industry, and low foreign reserves in Bank Negara hands, the ringgit was defenceless against an external attack. The speculators knew about this phenomenon in Malaysia and in other SEA countries. The badly needed strong macro economic and market fundamentals were not there when the financial crisis in Thailand reached Malaysia’s shores. Speculators began attacking the ringgit. Both Mahathir and Bank Negara did not know what hit them!
There was a panic selling spree of the ringgit forcing the currency to tumble. The foreign fund managers who were the major players in the KL stock exchange sold their stocks and took their billions of US dollars hot money out of the country leading to a crash!
On the other hand the local big players, especially Mahathir cronies, who were heavily backed by bank credit, could not prop up the crashing share prices. Both the ringgit and the stocks were ‘slaughtered’!
Mahathir cronies lost billions of ringgit in the crash. Mahathir, being a mega speculator himself, instead blamed speculators for the debacle! They were not the prime cause of the market instability; rather they profited from the economic boom or downturn, genuine or otherwise.
