The currency crisis in 1997 sent the stock market reeling and hurt the economy severely.

December 22, 2011

This is an extract from the book A Doctor in the House by former prime minister Tun Dr Mahathir Mohamad on the currency crisis of 1997. The book is published by MPH Publications

I WAS not familiar with the international monetary or financial system when it faltered and soon after threatened to implode on us in 1997. As a boy, I had experienced high inflation rates during the Japanese Occupation, when things were priced in thousands of dollars and people had to carry gunny sacks of the so-called “banana currency” to buy anything. There were no banks then and all transactions were carried out in cash.

Everything was in short supply during the Occupation and prices tended to go up very rapidly. The Japanese Military Administration overcame this problem by merely printing more currency notes in higher denominations, and even resorted to printing over new figures on the smaller denomination notes to meet the ever more inflated cost of paying their local employees and for their supplies.

Somehow, we managed. In my family, I was better off than my brothers because I chose to sell bananas and other items at Pekan Rabu, the weekly Wednesday market. I soon learned to raise my selling price in order to pay the expected higher cost of my supplies. My brothers held salaried jobs with the government and its agencies, but their pay increases always lagged behind rising prices and came too late to meet increased costs.

All of us were involved in the black market, and we sold old clothing, jewellery and some of our few possessions. When we could get Japanese cigarettes from the soldiers, we would sell them, too.

By 1944, the war was not going well for the Japanese and I believed the British would return sooner or later. In anticipation, I paid a huge amount of Japanese banana money for 100 dollars of the old Straits Settlement and Malay States currency notes, as I was sure they would become legal tender again when the British returned.

The way prices went down to pre-war levels as soon as the old currency came back into circulation again was quite miraculous. Government servants were given three months’ pay to compensate them for not having been paid when the British left Malaya and in this way, the old currency was decisively returned into circulation. It flooded back into a battered economy that had been operating for some time without any effective, stable and credible currency.

People then were not very sophisticated. They unquestioningly accepted the currency that the British Military Administration issued and got rid of the Japanese banana currency, which soon became worthless. That’s the thing about paper currency — it’s not worth anything in itself. It has value because, and only for as long as, people believe it does. That’s how money works.

Unfortunately, the restoration of the Malayan economy and the reintroduction of the Malayan dollar to replace the Japanese currency has never been properly studied and documented. Perhaps we could learn something from that experience and about how to handle currencies and currency crises.

I worked as a temporary clerk at the office of the Custodian of Enemy Property early in 1947 and was paid 80 dollars per month. Permanent clerks were paid 60 dollars per month, the same pay for clerks before the invasion. It was as if there had been zero inflation during the Japanese Occupation.

There was also very little inflation during the early years of the British Military Administration, the Malayan Union and then the Federation of Malaya. Supplies improved but unemployment was high, and the Colonial Government quickly introduced price controls. That kind of measure is often taken in wartime, but the colonial government found it a good way to reduce inflation.

Even today, Malaysia still controls the prices of essential goods, as we do not think this contravenes free market rules. The idea that demand and supply must always determine prices is not completely correct as traders can always cause artificial shortages or oversupply and so influence, even manipulate, prices.

The market is not always a pure and impersonal mechanism that can be relied upon to deliver the uncontaminated truth about proper price levels. In fact, we were to learn 50 years later that free market principles permitted the unregulated freedom to manipulate prices, whether of basic domestic commodities or national currencies at the global level.

I learnt a few lessons about dealing with high inflation during my wartime forays into small business, and I learnt bookkeeping in school. But none of this equipped me with the knowledge to handle the currency crisis which hit Malaysia in 1997.

In May of that year, I decided to take two months’ leave, leaving Datuk Seri Anwar Ibrahim in charge as acting prime minister. I saw it as a good opportunity to observe how he performed as I was already thinking of stepping down in 1998. I wanted to be sure that when Anwar took over from me, he would be able to administer the country well.

While I was in Bledisloe in the Cotswolds in England, I received news about the Thai baht coming under attack by currency traders. Thai businessmen had apparently been borrowing a great deal of foreign currency at low interest rates compared with those of baht loans. Quick profits could be made from the differences between these interest rates — but only if the value of the baht remained stable.

International currency traders — people who make a living from noting and exploiting such anomalies and vulnerabilities — thought the situation was suitable for their kind of trading. They spread the word that the baht was overvalued and that the Thai economy would prove unsustainable. The currency traders then sold large qualities of baht, causing it to depreciate against the US dollar, and throwing Thais who had borrowed US dollars into difficulties.

They had to find more baht to repay their foreign currency borrowings for if their trading profits were insufficient, they risked defaulting on their loans. If they defaulted, then the currency traders’ allegation that the Thai economy was weak would appear vindicated. The traders then dumped more baht and the currency weakened further, causing more foreign currency loans to default. Yet the traders could appear to be simply responding as innocent bystanders to a crisis that they themselves had triggered.

A vicious cycle quickly developed: the more the baht depreciated, the more loan defaults increased and the more the Thai economy weakened. The Thai government tried to buy baht with its US dollar reserves to sustain the baht’s value, but the currency traders seemed to have limitless supplies of the currency to dump into the markets. Eventually, the Thai government was landed with a lot of badly depreciated baht and greatly reduced foreign reserves. This started another round of selling as the baht weakened from a perceived lack of foreign currency reserve support.

By the time I came home from leave in August 1997, things were looking very bad for Thailand. We decided to lend it some hard currency to strengthen its reserves but it was to no avail — the baht kept falling.

Malaysian finances were in good shape at the time, as neither the government nor our business people had needed to borrow much foreign currency. Our interest rates had always been low and foreign currency borrowings would not have given us any advantage. Bank Negara’s foreign currency reserves were also sufficient; at least we thought it was sufficient enough to support the ringgit if it came under attack. But that seemed hypothetical. We had not made ourselves vulnerable as the Thais had, through their foreign exchange borrowings and dealings with currency traders. What did we have to fear?

Then we began to hear talk about financial “contagion”, and how our neighbour’s troubles might soon infect us. It seemed that despite the soundness of our economy and finances, the ringgit might still come under attack. If the traders caused a loss of confidence in Malaysia as well, then the ringgit, too, would be devalued. I simply could not understand why this should be so, but the economists were certain it would happen.

They were right. Currency traders began selling the ringgit in huge amounts and it soon began depreciating. Before the attack began in mid-1997, the ringgit exchange rate was RM2.50 to the US dollar, but it would lose half its value by the end of the year.

We did not know who was selling the ringgit nor did we know who they were selling it to. I was told about a man named George Soros who had attacked the British pound and the Italian lira — both England and Italy had a tough time fending off his attacks and their currencies were forcibly devalued.

Not knowing who the currency traders were, I assumed that Soros was one of them. Whoever it was, I was furious. How could outsiders impoverish our country and our people? How could they knowingly and intentionally do such a thing? Even if that was not their main purpose, how could they choose to ruin us as a casual by-product of their own currency trading strategies? It made no sense to me, economically or morally.

Malaysians, particularly the business community, soon felt the effect of devaluation. Importers could not earn enough ringgit to buy the dollars needed to pay for the goods they had purchased from foreign suppliers, leaving them cash-strapped and unable to service their debts. Malaysians who were used to enjoying overseas travel suddenly found foreign trips too expensive.

While our exports should have earned us more ringgit since sales were often denominated in US dollars, foreign buyers demanded to pay less. Malaysia’s costs, they insisted, had gone down because the value of the ringgit had fallen. But imported raw materials and components were costing more, as were the capital goods. The fall in the ringgit did not make us more competitive, certainly not against our neighbours whose currencies were also devalued.

We felt helpless as the ringgit continued to sink and the economy moved further towards recession. Only recently we had been growing at eight per cent per annum for almost 10 consecutive years, but now we faced the prospect of negative growth. But I could say nothing about the currency traders — every time I made a public statement, the ringgit would immediately fall further.

On June 17, 1997, just before the attack on regional currencies began, International Monetary Fund (IMF) Managing Director Michel Camdessus praised the governor of Bank Negara for a well-managed economy and financial regime at the Los Angeles World Affairs Council.

“Malaysia is a good example of a country where the authorities are well aware of the challenges of managing the pressures that result from high growth and of maintaining a sound financial system amidst substantial capital flows and a booming property market,” he said.

Inflation, he had noted, was low and the ringgit had remained at RM2.50 to US$1 for a long time; it was truly a strong currency, reflecting the sound finances of the country. But now the same people were saying the economy was overheated and, as a result, the ringgit was reeling under the onslaught of the currency traders. I refused to believe that the depreciation of the ringgit was due to a weak economy or to any loss of market confidence in Malaysia.

I bought books on currency trading to better understand its mechanisms because I believed it was currency trading, not the basic condition of our economy itself or our currency which was affecting the ringgit. I had met Camdessus earlier and he seemed like a nice man. As finance minister and deputy prime minister, Anwar met the IMF head quite often. I asked Anwar to appeal to Camdessus to stop currency trading and argued that it was unnecessary and damaging to the economy of developing countries. I do not know whether Anwar stated my case to Camdessus, but no attempt was made to stop currency trading.

To me, trading in currencies as if they were commodities was absurd. Coffee, sugar, rubber and the like are real commodities and they have all kinds of substantive human uses. But currency is different. It has no value in itself, only in exchange as a way of procuring real commodities. It cannot be used in any other way and cannot be directly consumed.

We are no longer in the Middle Ages, when the European economy did not have any credible currency and traders in the French markets used Southeast Asian pepper as their money and medium of exchange. Now we use pepper and spices to make our food tasty and we have money to buy the commodities we need.

I remember reading that once, when there was a glut in the coffee market and coffee prices were very low, the Brazilians dumped their coffee beans into the sea to create a shortage and raise the price. But can you dump or burn money in the same way to raise its value? In the case of currency, the situation is actually worse, for there is more money in circulation than there is issued by central banks and currency boards. It is no longer just real money that changes hands during transactions as there are also cheques, credit cards and electronic transfers. The total amount they represent must exceed the total value of currency notes issued and in circulation. Money has, in effect, become virtual.

Looking back now, I suppose I literally took to heart the economists’ cliche that money is the lifeblood of the financial and economic system. As a doctor I understood that there is a finite amount of blood circulating in a person’s body at any time (although you sometimes have to increase it with a transfusion). But I have learned not to take that medical idea or metaphor literally when it is applied to the economy.

Money is different from debt, as there can be far more debt around than the money in circulation to support and denominate it. Economists think differently from doctors. For them, two plus two can sometimes be more than four.

After the United States emerged from World War 2 as the dominant military and economic power, the world accepted the US dollar as the standard currency in international trade and as its reserve currency. The Bretton Woods Agreement had fixed the US dollar at 35 to one ounce of gold. All other countries then fixed their currencies against the US dollar, which, in effect, meant the value of gold.

The post-war world economy recovered while this regime was in place, but when the US went off the gold standard in 1971, largely to pay for the accumulating costs of the Vietnam War, the world’s currencies were destabilised. Market forces would now determine the rates and most currencies would “float” in relation to one another.

I felt that this destroyed the sovereignty of countries and left them at the mercy of the market and human greed. Greedy people will not take the welfare of others into account; they will certainly not be sensitive to the needs of developing countries. For profit, they will destroy whole countries and impoverish their people.

However, we had to accept the situation despite knowing that market mechanisms and forces could be manipulated. It did not take long for speculators to begin abusing the system. They had invented the short selling of commodities and shares; now, they invented the short selling of currencies.

They made fortunes by bankrupting countries, especially those in the developing world; these were quite literally financial killings. Enterprising people set up hedge funds and invited the rich to subscribe to them. The returns on investments would be far greater than through other channels, but the operations of these funds produced nothing that could be used in the market or for people.

The least that could have been done was to regulate them, but while their promoters kept insisting on transparency in every deal or transaction and in everyone else’s plans — for how could serious investors possibly risk their money on anything that was shrouded in secrecy? — the operations of the funds themselves were allowed to remain mysterious. Who the traders were, where they got their money, how much they borrowed, to whom they sold and who bought the currencies that they sold: we did not know the answers to any of these questions. The funds could leverage their capital by as much as 20 times. With them, more than anywhere else in the economy, credit expansion outstripped the supply of money and ceased to have any coherent relation to it. The effect of their operations was devastating.

Camdessus was French and, I heard, a friend of president (Jacques) Chirac. Since I knew Chirac well, I wrote to him about the depredations of the currency traders and asked him to intercede with Camdessus to stop the trading. Again, during the Commonwealth Heads of Government Meeting in Edinburgh, Scotland, in 1997, I met Tony Blair, who had only just become prime minister of Britain. I explained the effect of currency trading to him at length and asked him to take it up with the IMF, but my efforts came to nothing.

Malaysia had some prior experience in currency trading, in which we had become involved because we needed to ensure that our reserves would not be depleted because of the fluctuations in the currencies we kept. But we only dealt in the currencies of developed countries. We speculated as all in the market did, but we did not manipulate. It was a matter of taking calculated risks, and when one of our speculative ventures failed, we lost a lot of money. After that lesson, we got out of the business.

Part 2 of the book extract continues tomorrow

News Link