http://www.asiaweek.com/asiaweek/daily/foc/0,8773,108619,00.html

Asiaweek
4th May, 2001

FOC: Half-Measures Won't Save Malaysia

It's time to bite the bullet and abolish capital controls

By ASSIF SHAMEEN

What are we supposed to make of the fact that the Kuala Lumpur Composite Index on Wednesday moved up 26.92 points, or 4.6%, to 611.42? Does it mean the good times are coming back? Should we be popping the bubbly? I don't think so. The move was a knee-jerk reaction to the decision by the Malaysian government to finally dismantle the last barrier to the repatriation of stock market funds - the 10% exit levy on stock profits that are moved out within one year of investment. That brings Malaysia in line with rest of Asia.

In my view, the move is no more than a desperate bid to shore up a key pillar of capital controls that Prime Minister Mahathir Mohamad introduced two and half years ago when he fired his deputy Anwar Ibrahim and closed much of Malaysia for overseas investors. I am talking about the currency peg, which anchors the ringgit at 3.80 to the U.S. dollar. The disappearance of the exit levy, as welcome as it is, does not mean that Mahathir has suddenly grown fond of foreign portfolio investors. He still blames the likes of George Soros for precipitating his country's economic slump. It's not that there has been a sudden change of heart or change of policies in Malaysia. It's just that things are so bad on the economic front that Mahathir has been forced to play his last card.

While its true the 10% levy has kept many foreign portfolio investors away, its removal won't bring them rushing back anytime soon. Capital controls were first imposed in early September 1998. Since February 1999, Malaysia has fine-tuned the levies several times to attract foreign investors. But, instead of coming in, they have using the relaxations to bolt out of the market.

Mark Mobius, the emerging-markets guru for the Templeton group of the U.S., seems to think it's still not time for investors to dip their toes into Malaysia. "They still have a problem with corporate governance, transparency, crony capitalism," says the man who manages nearly $12 billion in funds globally. Moreover, with 74-year-old Mahathir facing angry members of the Malay community around the country, Mobius believes "political risks" for investors in Malaysia are growing not receding. There is more. Mobius outlines a weakening economy, lackluster corporate profit growth, the danger of the ringgit peg collapsing and an ensuing huge devaluation hanging over the country. "Really, if you want to invest in emerging markets and want to make money, there are other more attractive markets around," he says. Having been burnt in Malaysia several times before through his investments in politically connected companies, Mobius says he'll be sitting on the sidelines until he sees changes such as improved corporate governance.

Malaysia has a weighting of about 9% in the Morgan Stanley Capital International (MSCI) Asian benchmark index, which large international institutions use as a guide for their international portfolios. The MSCI will next week re-calibrate its index - the first time since it announced that indices will be weighted according to tradability of shares rather market capitalization - and most analysts say it could bring Malaysia down to no more than 4%. The beneficiaries will be Northeast Asia and India. One more reason for foreigners not to invest in Malaysia.

But, as I said, the reason Mahathir abolished the 10% levy wasn't to get people like Mobius back in as minority shareholders in troubled but politically connected firms such as Renong, UEM, and TRI. The aim is to defend the ringgit peg to the dollar. The softening of the yen and other regional currencies in recent months is making Malaysia increasingly uncompetitive because of the overvalued ringgit rate. Moreover, Malaysia's foreign exchange reserves, which back the peg, have been falling - from $34 billion last July to just over $26 billion currently. Nearly a billion dollars worth of foreign portfolio investments have flowed out of the country in the past four months. Some analysts argue that if the yen remains weak and the U.S. economy struggles for another few months, Malaysian reserves could drop to just $21 billion by year-end. At that level, something would have to give. It could be the ringgit. Asian currency analysts in Singapore believe that a devaluation of between 15% and 20% is likely.

Malaysia doesn't need half-measures such as the abolition of the exit levy. It needs to get rid of capital controls completely and let the ringgit float again. There might be short-term pain, but the long-term benefits would outweigh everything, with the floodgates reopened for foreign direct investments in higher value-added industries and services. Mahathir may lose a few political points, but his country will reap huge gains. When he first came to power, he was known as a pragmatist and a visionary. What he needs to show the world now is that he has not lost that skill.