Khor on the Malaysian model and Brazil

[Robert Weissman <rob@essential.org>]

WITHIN THE THIRD WORLD, MALAYSIA'S CASE COULD HELP AILING BRAZIL

Brazil's fast-developing crisis shows that global decision-makers 
have failed to learn from the Asian and Russian crises. IMF and 
the US Treasury still insist that ailing developing economies 
stick to discredited policies of free capital flows, high 
interest rates and budget austerity. Results for Brazil can be 
predicted: more depreciation, capital flight, depletion of 
reserves, and debt crisis. New models are called for. 

By Martin Khor
Third World Network Features

As the world watches helplessly whilst Brazil desperately tries 
to extricate itself from a deepening financial crisis, the 
spotlight falls again on this key question: what should a country 
do to prevent a potential currency problem from becoming an 
economic meltdown?

The East Asian crisis that started in mid-1997 and became full 
blown last year, and the Russian crisis that exploded in the 
second half of 1998, should have provided enough lessons to 
prevent or at least reduce the size of yet another crisis in yet 
another country.

And indeed the lessons are there, quite clear for the learning. 
If only those that make the decisions are able or willing to 
analyse the problems with an open mind, instead of being clouded 
by orthodoxy or ideology.

Many serious analysts (and at least one major institution, the UN 
Conference on Trade and Development or UNCTAD) had concluded that 
the crises had been caused by the nature of the modern global 
financial system. 

Because of financial deregulation in most countries, money is 
allowed to flow into and out of countries. Because they adhere to 
the principle of allowing almost total freedom of capital 
mobility to the market, these countries exposed themselves to 
extreme volatility of funds entering and exiting, and thus to 
high economic instability.

Moreover, new financial instruments (such as derivatives, futures 
contracts and short-selling of currencies) and new financial 
institutions (such as highly-leveraged hedge funds) meant that a 
few big players could influence and also manipulate financial 
markets.

This meant that currency and stock market values could be 
determined not only or even primarily by 'free' market forces 
that reflect the fundamental conditions of trade, production and 
financial balances, but could be manipulated and set by big 
financial players.

The East Asian countries adhered to free capital mobility. Due to 
liberalisation, Indonesia, Thailand and Korea also built up high 
short-term private-sector external debts.

The Asian countries had also enjoyed stable currencies, but these 
came under speculative attacks and after futile attempts to 
maintain the rates, they floated the local currencies, which then 
devalued drastically.

The countries lost many billions of dollars of foreign reserves 
firstly through the unsuccessful attempts to defend their 
currencies, and secondly through the massive exit of funds held 
by foreigners (as credits or shares) as well as locals.

The capital flight worsened the currency depreciation and 
depleted the foreign reserves, making it more difficult or 
impossible for the countries to service their external debts.

The International Monetary Fund was called in but it made the 
crisis worse. In exchange for 'rescue packages', comprising huge 
loans, it insisted that the countries keep their financial system 
open and indeed further liberalise and thus allow even more 
freedom for the inflow and outflow of funds.

That meant that the exchange rate would continue to be subjected 
to speculation and further depreciation, since the countries were 
in a condition of financial panic, with the herd instinct 
prevailing and every creditor or investor wanted to take their 
money out.

In order to counter this stampede for the exit door, the 
countries were asked by the IMF to instil foreign investor 
confidence by jacking up interest rates, imposing a credit 
squeeze, closing some ailing banks, and cutting government 
spending.

But these measures induced a much sharper recession than would 
otherwise have taken place. The deterioration of the real economy 
eroded confidence further and led to more depreciation.

Some of the countries (Korea and Indonesia, and later Russia) 
then fell into a situation where they could not service their 
foreign debts. Korea reached an agreement with its foreign 
creditors to roll over some of the maturing debts after the 
government agreed to guarantee the repayment of loans belonging 
to Korean banks.

Many Indonesian companies have defaulted on their foreign loans 
and the government is still struggling to find a comprehensive 
solution. Russia declared a moratorium on payment of foreign (as 
well as domestic) debt, causing losses and a near-panic among 
foreign institutions.

There was some hope that the global power brokers would now bring 
some order from the spreading financial chaos when the US 
President and Treasury Secretary spoke last year of their 
intention to draw up a new financial architecture.

But the only thing 'new' coming out of that effort was that the 
IMF would now give a rescue package to deserving developing 
countries before they fell into a crisis, rather than after, when 
it was too late. Presumably, the promise of a large loan would 
help fend off currency speculators and thus save the country from 
a devaluation.

Besides this change in timing, the rescue package would remain 
the same, even though the content of the package had already 
proven to be poisonous in the recent Asian and Russian cases.

Brazil became the first beneficiary of this 'new scheme'. The 
same old policies of strictly maintaining a regime of free 
capital flows, attempts at defending the currency, high interest 
rates, credit squeeze and austerity budget, combined to induce a 
recession without being able to save the country from massive 
capital flight and now a sharp devaluation.

The new scheme turned out almost exactly like the old scheme, and 
has now produced the same disastrous results in Brazil.

The 'new financial architecture' lies in ruins, as does the 
reputation of the IMF as well as the US Treasury that in truth 
designed the IMF packages and the new architecture.

The public at least (if not the policy-makers) in Brazil and its 
neighbouring countries are now searching for options for tackling 
the crises of currency instability and capital flight and the 
looming debt repayment problem.

So far Brazil has chosen the path of maintaining capital 
mobility, and having a free float for the real (with some 
attempts to intervene when it falls below a certain level).

This will entail high (and higher) interest rates for some time, 
which might choke off the lives of companies, banks and the real 
economy, without any guarantee that capital flight will stop or 
that the currency will stabilise. In a worst-case scenario, 
Brazil could end up looking like Indonesia.

Brazil could opt for a Currency Board arrangement to fix its 
exchange rate and thus prevent the nightmare of continuous 
depreciation.

But this has its problems. Firstly, the IMF would probably object 
(as it objected when Indonesia's President Suharto had seriously 
entertained the idea). Secondly, it would require very high 
interest rates at this time of crisis to prevent loss of foreign 
reserves, and this would induce intolerable levels of recession.

Thirdly, as the model adheres to free capital mobility, there 
could still be high volatility in the flow of funds. Fourthly, 
the country would give up its ability to set monetary policy as 
the supply of money would be determined by the volume of dollars 
or foreign currencies in its reserves. Finally the Central Bank 
will no longer be able to be 'lender of last resort'.

With such disadvantages in a Currency Board system, what else can 
a country do to stabilise its currency and stem capital flight?

An obvious alternative model is the set of measures recently 
taken by Malaysia. In turn, Malaysia had taken several elements 
of its new system from the existing system in China.

The main feature is simply for the country's Central Bank to fix 
the local currency at a certain rate with a chosen reference 
currency (in the case of Malaysia and China, the US dollar was 
chosen).

The Central Bank will exchange the local currency with the US 
dollar at that rate with commercial banks, and it also requires 
banks and foreign exchange shops to stick to this rate.

In order to limit volatility of capital flows, Malaysia continues 
to allow its currency to be freely converted to foreign 
currencies for purposes of trade and foreign direct investment 
(or for 'current account' uses) but imposes restrictions for some 
other purposes where capital seeks to enter or exit.

For example, foreign portfolio investors have to maintain their 
funds for a year, and residents are restricted on the amounts 
they can take out and for only certain purposes.

To prevent manipulation by currency speculators, the ringgit is 
de-internationalised, as the trade in ringgit outside Malaysia is 
not recognised. Measures were also taken to stop the trade abroad 
of stocks in the Malaysian stock exchange.

These measures are not that radical and the content cannot pose 
such a threat. After all, no one is condemning the Chinese 
authorities for maintaining their system, and indeed China is 
lobbied constantly not to give up its peg to the dollar.

Malaysia's adoption of Chinese-style measures was criticised by 
the global financial establishment because it provides an example 
to countries that have already liberalised that they can choose 
to re-regulate their financial system to prevent or at least 
offset the vicious cycle of depreciation, capital flight, high 
interest rates and deflation.

It is worthwhile for Brazil and other countries facing financial 
crisis to look closely at the Chinese and Malaysian models.

And even more importantly, it is time that the IMF and the rich 
countries that are the IMF's major share-holders show some 
goodwill to the China and Malaysia systems, and allow developing 
countries under the IMF's influence to try these systems.

After all, the IMF-US solutions don't work and have led one 
country after another into the abyss of financial chaos and 
economic deflation. With the old model so discredited by events, 
the global power brokers should allow the poorer countries the 
possibility to try other models. - Third World Network Features

                                 -ends-

About the writer: Martin Khor is Director of the Third World 
Network. 

When reproducing this feature, please credit Third World Network 
Features and give the byline. Please send us cuttings.

Reproduction rights are offered to subscribers of TWN 
Features. If you are not a subscriber and would like to reproduce 
this feature, you can get permission or subscription details from 
our India office via email twnfeatures@vsnl.com