Malaysian Twilight Zone.

Nobody saw the financial crisis coming, but it did. No one thought capital controls would work, but they have. Here's what happens next.

"Malaysia, don't you just hate it?!" "But isn't it delicious?!" Few countries or leaders in Asia can excite such extremes of opinion, as well as such perfidious shifts in the recommendations of the Glenda Slaggs of the analytical community, as Prime Minister Mahathir Mohamed's manor.

For the record, I have always had a soft spot for the place. Despite the dubious use of judicial power, the regular anti-foreigner rants, and the periodic manipulation of official data when it suits the authorities, Malaysia has always been better run than most of its neighbors. Besides, selling sensible policy moves to the recalcitrant Malaysian audience sometimes requires rhetoric heavy with assaults on foreigners -- and the behind-the-scene policy moves are often sensible. Sun Tzu's strategy of creating external diversions when facing internal problems is one that Kuala Lumpur understands well.

Let's be clear, though. Malaysia, along with the rest of the region for that matter, has rarely been an investment that could be made on ethical grounds. Hence, it's difficult to have empathy with holier-than-thou money managers crying into their decaffeinated double lattes, and easy to have sympathy for Mahathir's reply to his accusors: Crony capitalism was never an impediment to investment in the past. After all, capital controls had been employed by Kuala Lumpur in 1994, albeit in a different guise.

Nevertheless, the argument that Malaysia was hunky dory before falling victim to the dark speculative forces unleashed by the Darth Vaders of global capitalism does not add up. In reality, the country had nurtured a huge, easy credit-financed asset bubble in the preceding years, and the bubble was ripe for bursting. The chart below, which I first produced in 1996, shows the extent of the speculation which built up the stock market over the 1990s. Tall tower syndrome was yet another manifestation.

Malaysia's monetary authorities had been trying to calm things down for a long time, to be fair. But political imperatives always seemed to get the upper hand. From 1992 onwards, Bank Negara Malaysia (BNM) attempted on several occasions to use currency revaluations, direct credit controls, interest rates, moral suasion, and limited capital controls to tighten monetary policy. But all to little avail. Most of these measures were subsequently reversed or watered down as a result of well-connected lobbies throwing their rattles out of the pram. And by the time the central bank was allowed to significantly raise rates in 1995 and 1996, the stock market did not care. Although primes rose from 7.4 percent in April 1995 to 9.25 percent by the end of 1996, the Kuala Lumpur Stock Exchange put on 30 percent and the second board surged 150 percent. The logic was: Why worry about a rise in funding costs if your stocks will go up 10 percent next week? Does this sound familiar to our readers by the way?

Injudicious comments by Malaysia's prime minister may have provided the catalyst for its collapse. And no doubt the country's fall was exacerbated by the attempts of foreigners to take their money out of a one-way market. But given Malaysia's relative absence of short-term foreign borrowings and controls that were already in place on offshore ringgit trading, the panic was generally domestic-led. Hence, I have held for some time that capital controls, far from being aimed at foreign investors, were meant to prevent unpatriotic Malaysians from taking their money out of the country. That foreigners got caught in the crossfire was just too bad, though the plight of Singapore may have aroused a certain element of schadenfreude in Malaysia.

So were capital controls a success? Like many at the time, I (wrongly) feared the worst: I thought cranking up the printing presses to bail out the well-connected would come at the expense of the poor and the middle class. To the credit of the authorities, however, the shelter has been successfully used to carry out the most effective and far-reaching financial system clean-up among the crisis countries. Despite the constant criticism against foreigners, the Danaharta/Danamodal program looks a lot like America's Resolution Trust Corporation. And it has been more effective and fair than many of the other more cosmetic efforts in the region -- notably those of Thailand and Indonesia but also that of South Korea. Danaharta's purchase of bad assets at a steep discount to face (on average 57 percent) minimises the taxpayer cost and ensures that the biggest hit is taken by those who caused the problem. Moreover, since the majority of bad loans have been mostly extracted from the banks' balance sheets, and since the authorities are simultaneously pushing through wide-ranging mergers and industry consolidation, the financial system should be well placed to begin lending again when demand reemerges.

In a similar vein, the treatment of certain well-connected businessmen who got into trouble by over extending themselves could be compared to the Federal Reserve's bailout of Long Term Credit Management (LTCM). In many such cases, equity has been written down to near zero, but company control (and an out-of-the-money equity kicker) has remained with the original owner in the belief that the owner best knows how to manage a recovery. Of course, the better-connected parties have been treated even more generously. But the bill for the taxpayer has still been capped.

Some commentators point to Malaysia's poor foreign direct investment (FDI) numbers relative to Thailand and South Korea as evidence of the damage of capital controls. But this is neither a correct nor a fair comparison. Despite the severity of the downturn, distress in Malaysia's better run corporate sector was far less widespread than elsewhere, and indebtedness was concentrated far more in government-sponsored entities. As a result, there were simply less bargain assets on the block. Moreover, Malaysia's FDI classifications (correctly) categorize purchases of existing plant and equipment as "changes of ownership" and not as "new investments." In other countries, everything is lumped into FDI in order to flatter the headline number.

Nevertheless, to argue the economy's recovery is due to the imposition of capital controls ignores other external developments which have changed the global landscape and led to recovery across the whole region. Had these measures not been introduced around the time that Russia and LTCM both went belly up, forcing the U.S. to belatedly move into international rescue mode, it is uncertain whether the flow would have been stopped given Malaysia's openness and given a balance of payments with more leaks than an eisteddfod. As an aside, I would pass similar judgement on the Hong Kong Monetary Authority's serendipitous intervention in the stock market.

But now that the economy is firmly on the recovery path and the stock market is on the rise, indignant overseas investors who vowed only a few months ago never to touch the place again appear to have forsaken their scruples. Greed has won out over morality, and the old guard has returned to business as usual.

Well, not quite. For a start, the ruling coalition now relies on a non-Malay constituency for its power, which may imply affirmative action programs could be watered down in the future. At the very least, the climate of protest against the system's most unsavory excesses should prevent some of the more blatant abuses known in the past. In addition, changes elsewhere in the region should cause a spillover effect on corporate behavior, while BNM seems to have finally been given the go ahead to consolidate the country's financial system. Although political jockeying continues to delay the process, it will happen this time.

However, other developments generate a strong sense of deja vu, not least those in the currency markets. The debate about whether Malaysia requires a stronger ringgit to force its exporters to move up the value-added chain has been simmering since the early 1990s. On one side stand the technocrats who argue the maintenance of a "cheap" currency policy undermines monetary management, makes imports more expensive than they should be, and acts as a disincentive for exporters to boost their productivity. On the other side are the export lobbies addicted to their implicit subsidies and other industries seeking to hide their deficiencies behind protectionist barriers. In the past few decades, others in the region -- be it Japan

in the 1970s or Singapore, South Korea, or Taiwan in the 1980s -- have learned the costs of a cheap currency policy eventually outweigh the benefits, and a revaluation is the end result that allows the re-establishment of domestic monetary sovereignty. The choice then is whether to take revaluation of the real exchange rate through a pre-emptive move in the nominal value of the currency, or passively and more painfully via a rise in prices.

In early 1992, Malaysia appeared to have reached this stage, and for a while it seemed as though the authorities were countenancing a move toward a more Singapore-style currency policy. From around 2.75 to the U.S. dollar at the end of 1991, the ringgit rose to 2.50 by June 1992 and seemed set to rise further -- most fair value estimates at the time were around 2.20 -- when BNM decided (or perhaps was persuaded) to step in and cap its rise. The result was an explosion in foreign assets from MYR36 billion in June 1992 to MYR90 billion by March 1994, while the central bank's balance sheet surged from MYR49 billion to MYR119 billion over the same period.

To prevent this balance sheet expansion from feeding into a generalised credit boom -- after all, BNM worded about an overheating economy even at that stage -- the central bank began conducting massive sterilization operations, issuing large amounts of BNM paper and borrowing funds directly from the interbank markets. However, with Malaysian interest rates at around a 300 to 400 basis point premium to equivalent verylow U.S. rates, such interventions became increasingly expensive, and unorthodox measures had to be used by the central bank to plug the growing hole in its balance sheet. BNM, which already had a reputation as a major speculator in the international currency markets, took a huge bet on the high yielding British pound in 1992, only to see it forcibly ejected from the European Union's exchange rate mechanism in October of that year, courtesy at least in part to one George Soros. (By the way, this is one of the reasons why the Hungarian financier remains a huge bogeyman in Kuala Lumpur.)

Another trick was to devalue the ringgit at the end of both 1992 and 1993 in order to boost the ringgit value of foreign exchange reserves and thereby dress up the central bank balance sheet for the December 31 reporting date. The move from 2.52 to 2.60 in December 1992 did catch the markets unaware, though it was quickly unwound. But when BNM tried the same maneuver in December 1993, spiking the dollar/ringgit from 2.55 to 2.70, the markets simply saw a "gimme" ringgit buying-opportunity. Foreign reserve accumulation exploded by MYR30 billion between November 1993 and March 1994, culminating in the imposition of inward capital controls on the ringgit.

These controls succeeded in reversing foreign exchange inflows. But instead of allowing monetary conditions to tighten and thereby slow a booming economy and asset markets, BNM simply unwound its sterilization operations, which fuelled a domestic credit boom and a current-account deficit blow-out. Domestic credit growth surged 30 percent both in 1995 and 1996, while the current-account deficit deteriorated from MYR15 billion in 1994 to MYR22 billion in 1995. The deficit did narrow during 1996 as controls on certain types of imports were imposed, but the lending and asset booms continued unchecked. Even though headline inflation remained under control -- largely thanks to threats to arrest chicken hoarders and other such enemies of the people -- many costs, most notably those of labor, did rise sharply. By 1996, I estimated that the ringgit and a number of other regional currencies were around 30 percent overvalued against the dollar. And the rest is history.

Several years on, a number of familiar trends are starting to reemerge. Along with the Korean won, I now calculate the ringgit to be the most undervalued currency in the region -- perhaps by around 20 percent. To date, BNM's balance sheet has not expanded that rapidly because foreign capital has still flowed out of the country, despite huge current account surpluses. In recent months, however, the outflows appear to be turning to inflows and sterilization operations have again commenced. It should be noted that with Malaysian rates below their U.S. equivalents, there is no implicit fiscal cost being imposed by these actions this time around. In fact, the central bank is making a profit! Nevertheless, as the year progresses pressures will probably build for the currency to appreciate. The question will be whether this occurs via a rise in the nominal exchange rate or whether another asset bubble is going to be set in motion. My own betting would be that with so many of the elite still underwater on their investments from the previous cycle, the politically expedient policy will be to keep the currency where it is and let things rip at home. Besides, what reason do they have not to?

Turning The Tables

Malaysia, along with the rest of the region for that matter, has rarely been an investment that could be made on ethical grounds. Hence, it's difficult to have empathy with holier-than-thou money managers crying into their decaffeinated double lattes, and easy to have sympathy for Prime Minister Mahathir Mohamed's reply to his accusors: Crony capitalism was never an impediment to investment in the past.

--S. Ogus

Now that Kuala Lumpur and the Malaysian economy are firmly on the recovery path and the stock market is on the rise, indignant overseas investors who vowed only a few months ago never to touch the place again appear to have forsaken their scruples. Greed has won out over morality, and the old guard has returned to business as usual.

--S. Ogus

Simon Ogus, formerly Managing Director and Chief Economist for Asia at Warburg Dillon Read, is Founder and Chairman of The Dismal Science Group Limited, Hong Kong.