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Malaysia: Monetary Dilemma Version 2001

Daniel Lian (Singapore)

Sluggish Monetary Aggregates Render Fiscal Pump-priming and Low Interest Rates Impotent

The option of pump-priming the Malaysian economy to cushion the sharp deceleration in external demand has become less viable. The reason for this is a monetary dilemma characterized by an inability to expand the money supply to accommodate growth in domestic demand.

The FY2001 budget presented last October targeted fairly small fiscal expansion. However, as export deceleration has become more pronounced in recent months, the Malaysian government has shifted its stance, favoring stronger fiscal pump-priming in 2001. The NEAC (National Economic Action Committee) has announced in the past week its recommendation for stronger fiscal expansion. The government has revived several infrastructure projects.

We are concerned that the involuntary restrictive monetary environment that has prevailed since late-1999 cannot accommodate such fiscal expansion. In other words, the impact of government spending on private consumption and investment is likely to be fairly limited as money in circulation remains scarce. This scarcity of money reflects Malaysia's desire to maintain its currency peg. At the same time, Malaysia is experiencing a decline in foreign exchange reserves that might have fueled an increase in the money base and broad money. In short, Malaysia is caught in a monetary dilemma.

Two Ways to Boost Growth in the Money Supply

In our view, given the nature of its exchange rate and capital control regimes, there are two ways in which Malaysia could raise the money base and expand the money supply.

- Abandon the peg and pursue a floating exchange rate. This would enable the central bank, Bank Negara Malaysia (BNM), to target the money base instead of the exchange rate.

- If BNM chooses to keep the peg, it would have to raise the money base to induce more rapid monetary expansion. However, foreign reserves constitute a significant share of the high-powered money base for a small and open economy like Malaysia's. To expand the money supply effectively, Malaysia would need to attract capital inflows or force repatriation of export earnings hoarded overseas (see "Tracking Capital Flows", February 2, 2001, by Anita Chung and Daniel Lian).

We do not believe that floating the ringgit is an appropriate policy response for Malaysia (see "Devaluation: Factors, Fallacies, Risks and Options", February 2, 2001). However, the second option is not an easy one to implement due to the monetary dilemma currently confronted by Malaysia.

Understanding the High Powered Money Base and Changing Broad Money

Supply in an Open Economy

High-powered money is the key determinant of monetary aggregates in a country. As long as the money supply multiplier is positive, expansion in the high-powered money base causes multiple expansion in monetary aggregates.

High-powered money essentially consists of currency in circulation and commercial banks' deposits with the central bank. However, in an open economy, buying and selling of foreign currency reserves by the central bank affect high-powered money. When a central bank intervenes in the foreign exchange market, the stock of high-powered money is directly affected. For example, when the central bank sells its own currency and buys foreign currency from exporters (presumably to ensure that a surplus in the capital account will not cause its pegged currency to appreciate), exporters deposit the central bank check at a commercial bank. The central bank credits that commercial bank with newly created reserves. High-powered money increases, causing multiple expansion in the money supply.

Understanding How Malaysia's Open Economy Affects its Fixed Exchange

Rate and Domestic Monetary Aggregates

A country that operates both capital control and fixed exchange rate regimes should, in theory, have a greater degree of control over its domestic money supply than a country that operates a fixed exchange rate regime but imposes no restriction on cross-border capital movements. A country with effective capital controls is in a better position to avoid a large balance of payments deficit. It is thus able to use its current account surplus to expand the money supply.

At first glance, Malaysia appears to fit the bill - it has both a pegged currency and capital controls. With the capital account balance at zero, BNM faces persistent current account surpluses: it would therefore want to prevent the ringgit from appreciating to below the RM3.8:US$1 peg by selling ringgit and buying US dollars. This would have the effect of increasing the high-powered monetary base and expanding the money supply.

Given that Malaysia generated consecutive current account surpluses in 1998-2000, it should have seen sizeable expansion in its foreign exchange reserves and a domestic monetary boom. However, this was not the case. Current account surpluses totaled US$32.4 billion, or 37.2% of nominal GDP in 2000. Assuming Malaysia's net capital flows balanced over this period, foreign exchange reserves should have grown to US$48.1 billion by the end of 2000. In reality, reserves were only US$29.9 billion.

The close correlation between foreign reserves, base money and broad monetary aggregates demonstrates that while growth in Malaysia's foreign reserves started to taper off from August 1999, growth in its monetary aggregates began to falter with a lag at the end of 1999.

Paying the Price for Policy Errors Since September 1998

We believe growth in Malaysia's monetary aggregates would have been much stronger since September 1998 if:

- the right policy to secure at least a neutral capital account had been implemented, i.e., if foreign investment inflows had matched the liquidation of foreign investment trapped before the installation of the capital control and fixed exchange rate regimes;

- hoarding of export earnings by exporters linked to the government had been prevented; and

- speculation by Malaysians (domestic capital flight) had been prevented.

Had these conditions been met, we think the prospect of domestic demand drivers underpinning growth would have been much brighter in 2001.

Monetary Dilemma is Real in 2001

Malaysia's monetary dilemma is very real - the country needs faster monetary growth but because of its currency peg is finding it increasingly hard to expand the money supply to accommodate its anti-cyclical pump-priming.

We believe the full negative impact will be felt in 2001 as export income begins to falter. If hoarding of export earnings and domestic speculation against the ringgit continue in 2001 at the same level that it occurred in the second half of 2000, Malaysia will face a severe monetary dilemma. If the declining current account surplus, already visible given recent deceleration in export growth, translates into sharp loss of foreign exchange reserves (if hoarding of export earnings and domestic capital flight significantly outweigh the current account surplus), Malaysia may even have to contract its money supply to maintain its peg. This would render any attempt at fiscal pump-priming impotent.

Preventing Capital Flight and Forcing Repatriation of Hoarded Export

Receipts Is the Only Viable Policy Option

Freeing up the fixed exchange rate and capital control regimes, targeting monetary aggregates and allowing the ringgit to find its own value is a credible option but, in our view, one that is unlikely to be pursued by the present political regime. Hence, we believe that bringing a halt to domestic capital flight and forcing the repatriation of export receipts hoarded overseas, or even recalling flight capital from overseas, is the most feasible and immediately available policy option.

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