Ian Henderson

CURRENCY CONTROLS ARE SOMETIMES A NECESSARY EVIL The hedge funds fiasco could repeat itself

BY IAN HENDERSON, ECONOMIC CORRESPONDENT, THE AUSTRALIAN

Remember the outrage when in late 1997 Malaysian Prime Minister Mahathir Mohamad claimed that wicked foreigners were to blame for that country's crash into financial market chaos?

Well on the best evidence now available to the Reserve Bank of Australia, Mahathir was right.

Malaysia's resort to currency controls came when its officials learned that speculators-almost certainly highly leveraged hedge funds-were taking short positions on the ringgit to the tune of US$5 billion funded from Singapore banks.

That information comes from Stephen Grenville, the RBA's eyes and ears on events in the region.

"If you allow that sort of thing to happen, then you make it easy for hedge funds to speculate against you," Grenville last week told a Canberra conference on financial crisis and globalization.

It was a solution that demanded a firm response from Malaysia's authorities, and that was what Mahathir delivered-both in policy terms by effectively removing the rid testing" case the RBA uses to explian its role in financial markets.

But why was the central bank so committed to taking the plunge.? Why not simply leave the exchange rate up to theb market.

Grenville's arguments goes like this:

Had the dollar continued to tumble unrestrained through the US60c, US55c and even lower markets, confidence in the currency-and ultimately in the ceconomy- would have suffered, regardless ogf the soundness of the economy and of policy.
No other player had the capacity to stem the tide-so the RBNA had to intervenel.

Why was it so certain no-one fromthe private sector would do the job.

Simple. Any dealer working for a big institution would have been told to cut a position that was under water for nay length of time, regasrdless of its economic merits and the prospects of a payoff later.

"So, there really aren't a lot of people out there whom are in a position to do what we can do, and that i a more aggressive stance as the exchange rate approached its post-float lows around US60 cents, a time when the market was naturally quite sensitive," RBA says.

The final stage saw the funds -forced to cover their short positions once the collapse of Long Term Capital Management led to cutbacks in funding from banks-quietly begin to buy back the dollar. Using the power of their huge bets on the dollar combined with media reports of their plans to drive the currency down, the hedges were able to defy any argument based on economic logic that the currency was heavily undervalued at US60 cents.

Capital controls are one measure that might have stemmed the damaging destabilization of the dollar. But the RBA choose another route: to spend A$2.5 billion in two bids to halt the dollar's slide, first at US 60 cents, then at US55cents.

It was much more than the "smoothing and testing" case the RBA uses to explain its role in financial markets.

But why was the central bank so committed to taking the plunge.? Why not simply leave the exchange rate up to the market.

Grenville's arguments goes like this:

Had the dollar continued to tumble unrestrained through the US60c, US55c and even lower markets, confidence in the currency-and ultimately in the economy- would have suffered, regardless of the soundness of the economy and of policy.
No other player had the capacity to stem the tide-so the RBA had to intervene.

Why was it so certain no-one from the private sector would do the job.

Simple. Any dealer working for a big institution would have been told to cut a position that was under water for nay length of time, regardless of its economic merits and the prospects of a payoff later.

"So, there really aren't a lot of people out there whom are in a position to do what we can do, and that is go long on the dollar and hold that position for maybe three or four years before it's profitable." Grenville says.

As it happens, the RBA has already turned a tidy profit from its 1998 trading.

Also as it happens, the global worries about hedge funds appear to be receding, now that Wall Street seems to have been saved from their activities last year.

And the RBA is satisfied it has seen off the local threat. But that has not stopped the central bank from warning it could happen again, unless tough new rules are put in place. Hence the RBA's effort to win international support for increased overseeing of the potentially damaging hedge funds.