Official speech: "Preparing for the New International Financial Architecture: Malaysia's Programme"

By Deputy Governor Dato' Dr. Zeti Akhtar Aziz, at the International Conference on "Managing The Asian Financial Crisis: Lessons & Challenges" in Kuala Lumpur on 2-3 November 1998

I. Introduction

First of all, I would like to thank the organisers for inviting me to speak at this international conference on "Managing the Asian Financial Crisis: Lessons and Challenges". It is a great pleasure for me to speak today before such a distinguished gathering of speakers and participants. In the first section of my presentation this afternoon, I will attempt to put into perspective the events prior to 1 September 1998 which culminated in the introduction of selective capital control measures and subsequently discuss some issues of importance related to these controls.

II. The Need for a Comprehensive Solution

Much has been discussed as to the solution to the East Asian Crisis. After more than a year into the crisis, however, no general consensus has emerged on the appropriate policy response and concrete results have yet to emerge. In the mean time, while the debate continues on the initiatives that have been taken, where the weaknesses lie and the relative merits of the more conventional versus the more interventionist approach, the financial crisis has now spread to other regions and the economic crisis in the region has deepened. The lack of progress in yielding the desired results may be on account of several factors. These include the lack of understanding and diagnosis of all the problems and issues involved, the emphasis on partial solutions as opposed to a more comprehensive approach, and the inappropriate sequencing of policies. Finally, there has been tendency to generalise the problems confronting the region, reflecting the failure to recognise the important differences in the East Asian economies, their institutions and economic structure.

What is needed is a viable solution that will produce a sustainable outcome. For such a solution to be developed, there is a need to recognise and to come to terms with the whole spectrum of problems and issues associated with the crisis. The East Asian crisis is the result of an amalgamation of several elements. Any solution would therefore need to be comprehensive in its approach. While such a solution will involve addressing issues within individual national economies, of equal importance is the need to review the international financial architecture, with a view to enhance its ability to cope with the risks and challenges of globalisation. Thus, while such a move would require a concerted effort by the international community, it in no way reduces the importance for commitment and determination by individual countries to do their part in this process. It is only in this context that a more permanent solution can emerge that will allow the global economy to reap the benefits of globalisation.

In the recent weeks following the IMF/World Bank annual meetings in Washington, D.C., there is an emerging consensus on the need to develop a more comprehensive solution to the crisis. In particular, there is a recognition of the need to strengthen the architecture of the international financial system to better cope with the challenges of the international financial markets. Most significant was the acceptance of the fact that the current financial crisis was a global problem, and therefore required a global solution. This is a departure from the situation last year, when the crisis was seen as a regional problem arising from internal factors in the affected countries.

An important development was also the emerging consensus on the need to improve the transparency of financial market players, including additional regulatory and disclosure measures. In this connection, the IMF and relevant international financial agencies have been tasked to review and determine the appropriate disclosure requirements or regulations to ensure better assessment of the risks involved in the operations of institutional investors, including their highly leveraged operations.

Another shift in thinking has also occurred on the issue of capital controls. Such controls on capital movements may be considered under specific circumstances to provide breathing space for macroeconomic and financial measures to take effect. The IMF, in particular, now acknowledges that liberalisation of capital movements need to be carried out in an orderly manner and sequenced in a manner that is in tandem with the pace of strengthening of the domestic financial system and within an effective prudential framework.

And of importance was the consensus on the need to involve the private sector in both preventing and resolving financial crises. Here, the IMF is examining options to use market-based mechanisms to cope with the risk of sudden changes in investor sentiment that could lead to financial crises.

Over the weekend, a move was made by the G-7 in terms of an agreement on a package of proposals to contain the crisis and prevent future crises. These include a combination of improved regulation and transparency and a new financial safety net at the IMF to assist countries in coping with liquidity crises. The measures also included proposals for closer regulation of banks to promote safe and sustainable capital flows and a review of the activities of institutional investors, including that of hedge funds. It is hoped that further concrete steps will be taken following these discussions to strengthen the architecture of the international financial system and to ensure the prospects for the restoration of stability in the global financial markets.

III. Malaysia's Programme

Malaysia has responded to the crisis with a series of policy packages during the course of the crisis. The policy response has evolved according to the changing conditions operating to achieve the objectives of monetary and financial stability in an environment of sustainable growth. Within a brief period of experiencing the turbulence in the financial markets in mid-1997, Malaysia recognised the fundamental nature of the regional financial crisis. Unlike on previous occasions when the response to bouts of speculative pressure was to sharply increase interest rates supported by intervention operations, it was recognised that this would not be a sustainable response. On July 14, the ringgit was therefore left to adjust downwards and interest rates were brought down to the levels prior to the currency attack. While this resulted in an initial 5% depreciation in the currency, this policy allowed the international reserves to remain intact and reduced the damage on the financial system and real sector arising from sharply higher interest rates. The view taken was that high interest rates was unlikely to contribute to stabilising the currency given the factors causing the shift in flows.

Policy at the early part of the crisis essentially focused on addressing the key areas of vulnerabilities, in particular, to contain inflation, to maintain the standard of living and Malaysia's competitiveness. In this context, interest rates were adjusted with the expected rate of inflation to ensure that savers earn a positive rate of return. Secondly, the focus was to reduce further the current account deficit which was 10% of GNP in 1995 and which had been reduced to 5% in 1996. The deficit was seen as a potential source of instability given the uncertainty with respect to developments in the capital account. Finally, while the financial sector was strong in terms of capitalisation (risk weighted capital ratio of 11.3%) and quality of loan portfolio (non-performing loans of 3.6%) and in terms of performance, initiatives were taken to reduce further the banking sector vulnerabilities to adverse developments following the adjustments that had occurred in the financial markets.

Policies with respect to the financial sector aimed specifically to enhance the efficiency of the banking institutions, to rationalise and consolidate the banking institutions, thereby ensuring the intermediation process to provide adequate financing to support economic growth. Of importance was for the financial sector to remain resilient to further adjustments that might occur. While there were encouraging signs of stability in the financial markets over the period March to early June this year, events in Japan and then Russia triggered a further wave of adjustment during this period. At this stage of the prolonged period uncertainty, the inefficiencies that had emerged in the financial system, had its effect on the real sector.

Several measures followed that aimed to minimise the implications of the financial developments on the real sector. On the fiscal front, expenditure was increased to protect the more vulnerable segments of society. Special funds were set up to enhance access to financing by specific identified sectors. With inflation having peaked in July, interest rates were adjusted downwards in early August. These measures were designed to contain the severity of the adverse implications on overall economic development. In terms of the overall macroeconomic framework, Malaysia had contained inflation, improved its external balance, maintained low external debt exposure, external reserves remained in tact and the banking sector continued to perform its intermediation function. Despite these positive trends, Malaysia continued to remain vulnerable to external developments.

IV. Malaysia Moves to Exchange Controls

By mid-year, exactly one year since the outbreak of the crisis, the external environment continued to deteriorate. The risk of further waves of instability of increasing proportions still very much remained on the horizon. Despite the measures and reforms that had been put in place by the affected countries, there did not appear to be signs of stability returning to the financial markets. On its part, Malaysia had persevered to undertake adjustment policies and implemented financial reforms to reduce the risks and vulnerabilities to external developments. While the measures are ongoing, the prospects for these initiatives to yield the desired results can only be achieved in a stable environment. A source of concern that was emerging during this period was the increase in the rate of the internationalisation of the ringgit. This trend became increasingly apparent since April 1998. This trend reflected an increasing outflow of ringgit as opposed to foreign currency. This ringgit outflow was attracted by higher and higher interest rates in the region of 20 to 40% offered by offshore centres while onshore rates were in the region of 11%. The strong demand for offshore ringgit at high costs increased the vulnerability of the ringgit. The build up of offshore ringgit represented a potential source of instability to the ringgit. In view of the openness of the Malaysian economy, this trend could have fundamental damage to the real economy. This trend would affect the ability for Malaysia to conduct independent monetary policy based on domestic conditions. Following these developments, Malaysia announced the introduction of exchange control measures on September 1, 1998.

V. Features of the Exchange Control Measures

The exchange control measures adopted by Malaysia have therefore been designed and implemented to achieve specific objectives. The policies are selective and not comprehensive and restrictive as has been suggested by the critics of controls. The controls are aimed specifically at eliminating access to ringgit by speculators by reducing the offshore market in ringgit, limiting the supply of ringgit to speculators. The controls also aimed at stabilising short-term capital inflows, by requiring inflows of capital to remain in the country for a period of 12 months. While in Malaysia, however, these funds can be actively managed in the form of ringgit assets. These funds can be converted upon maturity of the twelve month holding period.

Specifically, it is only the following items that are controlled:

There are no controls on: 

Malaysia's controls are therefore selective, designed to achieve the specific objective of containing speculative capital. The measures do not apply to foreign direct investment. The controls are not intended to disrupt or dislocate genuine trade-related activities or direct foreign investment flows.

As part of the measures, the ringgit has been fixed against the United States dollar to provide a greater degree of certainty to the market for the conduct of trade and investment activities. Following the introduction of selected exchange control measures, the ringgit strengthened against the United States dollar by 10.5% from the end-August level of RM4.22 to an intra-day high of US$1.00=RM3.82 on 1 September 1998. The ringgit appreciated further to US$1.00=RM3.80 after which the ringgit's rate was fixed at that rate, effective 11 a.m on 2 September 1998.

Overall, the Government has adopted a flexible approach in the implementation of the new exchange control rules. The situation has been closely monitored. 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 provide a greater understanding of the measures. Efforts have been directed to ensure that the administrative machinery is in place to ensure prompt response to requests so that disruptions and inefficiencies will be minimised.

VI. Preconditions for Controls

The capital control measures introduced by Malaysia are not unique. Many countries including the industrial countries have resorted to capital controls. Countries such as Germany, Switzerland and the United States imposed capital controls when they faced difficulties in achieving domestic and external balance in post-war years. Capital controls played an important role in the defense of a number of European currencies arising from the aftermath of market disturbances within the exchange rate mechanism (ERM) of the European Union. Among the developing countries, the use of capital controls has been much more prevalent. The Latin American countries (Argentina, Chile, Mexico, and Venezuela), the South Asian countries (India, Pakistan and Sri Lanka), the former centrally planned economies and, closer home, China and Taiwan, have all used capital controls. 

The experience of countries in achieving the objectives of capital controls has varied. The use of controls has been widely criticised by proponents of the free market systems on grounds that it leads to distortions and inefficiencies. Capital controls have been identified as a major cause for creating distortions in some of these economies, undermining their prospects for growth and development. A more constructive approach towards control would be to consider when and under what circumstances such capital controls can be applied, in what form they should take, the preconditions that would ensure it would yield the desired results and how it might be efficiently implemented. There are several preconditions for success and the existing conditions and circumstances in Malaysia gives us confidence that the capital control measures would achieve the desired objectives. Let me compare and contrast some of the unique characteristics of Malaysia which we believe would contribute to achieving our desired objectives. Firstly, capital controls have historically been imposed by countries facing balance of payments constraints. In view of the weak external reserves level, many of these countries imposed restrictions on almost all transactions with non-residents, including current account transactions. On the contrary, the corrective measures taken by Malaysia have strengthened our external payments position significantly. A significant improvement in the current account has already taken place. The official forecasts for current account balance of RM20.1 billion for 1998 (7.7% of GNP) and RM11 billion for 1999 (4.2% of GNP) were based on conservative assumptions.

Many of the countries that imposed capital controls faced capital flight. In this regard, it must be noted that Malaysia has generally not experienced significant capital outflows of the type and magnitude experienced by other countries facing balance of payments and reserves constraints. Our capital outflows have been in the form of prepayments of external loans by both the public and private sectors, Malaysians investments in productive ventures abroad with potential to yield spin-off benefits for the domestic economy and, finally liquidation of investments by portfolio investors. Most of the outflows of portfolio investments have already occurred, while the aggressive programme of prepayment of external loans and overseas investment have been put on hold to ease strains on the reserves position.

Meanwhile, our external reserves are intact, unencumbered and increasing. The build-up in external reserves to date has been significant. As at 15 October 1998, international reserves stood at US$22.6 billion, an increase of US$2.4 billion from end-August level, adequate to finance 4.3 months of imports. This growth in reserves would provide greater overall confidence. In addition, the short-term debt is half the size of foreign exchange reserves, which means that Malaysia is not highly vulnerable to credit outflows over the short term, and more than 56% of Malaysia's external debt have remaining maturity that exceeds four years. Experience of countries has shown that countries with strong balance of payments position such as China and Taiwan have achieved a greater degree of success with capital controls.

An important feature of countries which had failed to achieve the desired objectives via capital controls is the inflationary bias in these countries caused by an inappropriate mix of macroeconomic policies, including exchange rate and monetary policies. Most of these countries have either had trade and payments regimes which were protectionist in nature or where public expenditure had been diverted to less productive sectors such as military expenditure. This in turn resulted in supply constraints and a general rise in prices of goods and services. In comparison, such risks for Malaysia are low:

The selective exchange controls imposed by Malaysia have a greater chance of success because the circumstances and conditions are in our favour. As highlighted earlier, Malaysia is not substituting controls for appropriate macroeconomic policies. The controls are to provide some breathing space to allow us to take comprehensive adjustment policies in an environment of stability in the financial markets. Structural adjustments are ongoing to ensure that macroeconomic fundamentals remain strong in the medium term. Overall, the introduction of the recent capital control measures will protect our economy from the instabilities of short-term capital flows and foreign currency speculation and create an environment that is conducive for a revival in investor and consumer confidence.

VII. Conclusion

In this century, the world has experimented with several international monetary systems. The role of the international monetary system is to provide a framework to facilitate cross-border trade and investment through a stable exchange rate system. Such a well functioning and efficient international monetary system is essential to the functioning of the global economy. It is only in this context that the benefits of globalisation can be realised. This is even more important for small open economies such as Malaysia where trade accounts for almost 200% of GNP. An unstable international financial system will leave such countries highly vulnerable to developments in global financial markets. The urgent attention given by the international community towards this has already contributed positively to the financial markets.

The strategy for Malaysia in moving forward is to operate within this framework and become an integral part of the global system. In this context, the strategy is to place emphasise on economic recovery and the transformation of the economy to become more efficient and competitive. Importance is also given to restructuring and strengthening the banking system. As can be observed in most financial crisis, stability and recovery in financial markets generally followed the recovery of the real sector.

Therefore, while efforts are being directed to ensure a stable macroeconomic framework of low inflation and a positive external balance and a financial system that is resilient to external shocks, important consideration is also given to minimise the damage of the financial turmoil on the domestic economy, in particular, to the more vulnerable segments of society. Malaysia's favourable initial macroeconomic conditions, relatively strong financial system and low external debt exposure has allowed for greater flexibility in its policy strategy. To further facilitate the continued restructuring and transformation exercise, the controls represent a means to an end. It represents a means of creating the stable environment that will allow Malaysia to prepare itself to be an integral part of the global financial system within the new international financial architecture from a position of strength and resilience.

 

Bank Negara Malaysia
2 November 1998 

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