Malaysia's peg to stay, for now
By Chee Yoke Heong

KUALA LUMPUR - As Prime Minister Mahathir Mohamad prepares to leave office in October after 22 years in power, the question of dropping the Malaysian ringgit's peg to the US dollar has taken on added urgency. But don't count on it. With export demand starting to pick up and exports enjoying brisk overseas sales, the peg is likely to remain for some time.

Each time the question is raised, government officials have publicly said they have no plans to change the peg, instituted in 1998 after the Asian financial crisis, as it has been an anchor of stability. The government has repeatedly said it will only review the peg if there is a sustainable swing of 20 percent in the movement of the regional currencies.

However, that has not stopped the speculation. Lately the talk has grown louder, fueled by Mahathir's recent suggestion that Malaysia should consider invoicing in euros and that the gold dinar should be used in bilateral trade. Such ideas are an indication of the government's desire to reduce its reliance on the US dollar. This has given further ammunition to speculators that the US dollar peg might soon be removed or changed.

Other reasons center on the possibility that that China, one of Malaysia's main export competitors, is moving to a more flexible exchange rate. The US has gingerly been pressing China, with US$310 billion worth of dollar reserves and a trade surplus that topped $103 billion in 2002, to revalue its currency upward. So far China has turned a deaf ear to American entreaties.

Kostas Panagiotou, senior economist with Kim Eng Securities, is optimistic about the removal of the peg. He says that the chances are much higher now given the recent weakening of the US dollar against other major currencies. Furthermore, he says, as Mahathir was the one who put the measures in place in 1998 to rescue the battered economy, despite the risk of being ostracized by the international financial community, it would be "politically acceptable" for him to lift the controls before he resigns.

Nonetheless, it is unlikely that Mahathir would take any steps to add to the potential volatility of his currency. He famously hates currency speculators. He has railed against them in the past, particularly international financier George Soros. He called hedge fund speculators the "highwaymen of the global economy" during the 1997-98 Asian financial crisis for their raids on Asian currencies.

Further relaxation of exchange controls will be necessary with the introduction the Asian Bond Fund, launched on June 2 by 11 East Asian and Pacific central banks and monetary authorities, Kostas added. All Executives' Meeting of East Asia and Pacific Central Banks (EMEAP) members have agreed in principle to invest in the fund. The fund, with an initial of $1 billion, is to invest in a basket of US dollar-denominated bonds issued by Asian sovereign and quasi-sovereign issuers in the EMEAP economies other than Japan, Australia and New Zealand. Except for the US dollar peg, nearly all of the foreign exchange measures have been liberalized that were put in place in 1999 to control the wild fluctuations of the Malaysian currency and to stop the outflow of money.

The original measures had three key components: the restriction on transfers between external accounts, which was aimed at curbing speculation in the ringgit; its peg of 3.80 to the US dollar; and a one-year rule whereby portfolio investors were allowed to repatriate their proceeds only after 12 months to stem the outflow of hot money that was driving the local stock and ringgit currency markets to a frenzy.

In line with its policy of gradual liberalization of the financial sector, pushed in no small part by the World Trade Organization, further changes were made between last year and early this year. These include allowing non-residents to obtain ringgit loans to finance projects and properties in Malaysia, and allowing the settlement of ringgit assets by residents and non-residents to be made in either ringgit or foreign currency (previously was only in ringgit). Following the abolishment of the exit levy in 2001, non-resident portfolio investors are now allowed to freely repatriate their principal and profits out of Malaysia. Therefore, the full liberalization of exchange controls would involve the removal of the peg and only minimal reporting procedures for capital outflow and inflow.

Nonetheless, many analysts believe that Malaysia is unlikely to touch the peg in the foreseeable future and should there be changes, it would have been stirred by political reasons as little has changed economically to warrant a change in the currency regime. They agree that the ringgit is currently undervalued but with expectations that demand is going to pick up and the fact that Malaysian exports are currently enjoying brisk sales abroad, the peg is likely to remain for some time.

For now, the signs are positive for the peg. Persistent current account surpluses in the last few years have clocked up the nation's foreign reserves from $15 billion in 1998 to today's historical high of $36.5 billion - sufficient to finance 5.5 months of retained imports. There is therefore no pressure to change the peg.

"It's a political decision but you don't change something that is working," says Malaysian Institute of Economic Research (MIER) executive director Dr Mohamed Ariff.

There are also other reasons why the peg should stay. Given the uncertainty of the global economic environment and the US economy, on which Malaysia still depends heavily, removing a tried and proven peg now could be damaging to domestic stability, both in economic and political terms, write Steve Brice and Joseph Tan, economists at Standard Chartered in The Edge, a Malaysian business weekly.

"The last thing the incoming prime minister would want to do is undo the peg now and have the Malaysian economy slip into recession," they say, adding that regardless of whether unpegging induces a slowdown, negative sentiment could rise against the new prime minister as Mahathir and his controversial policies are hugely popular and have since garnered the reluctant acceptance of the International Monetary Fund and kudos from many emerging markets, such as Argentina.

If Malaysia were to unpeg its currency now, the value of the ringgit would most certainly rise versus the US dollar, given the strength of GDP growth, the positive differential between the ringgit and US dollar deposit rates and strong external reserves. But this would affect the competitiveness of Malaysia's exports. This would mean that Malaysia has done the very thing it wanted to prevent - lose price competitiveness to countries such as China.

But if Malaysia were to liberalize its exchange controls fully, it would be doing so from a position of strength, as the climate is different from what it was during the Asian financial crisis. Fundamental indicators are looking good - the country's banking system has been restructured, its current account surpluses and foreign reserves are healthy and GDP growth averaging 4 percent from a negative growth just a few years ago.

Externally, contagion risks on the scale of the regional financial crisis in 1998 are unlikely to recur, according to Brice and Tan. The proportion of short-term to long-term debt in many Asian countries has decreased since 1998, while there has been an increased focus on local currency financing. The low interest rate environment that ensued allowed many Asian countries to lock in long-term debt at lower interest rates.

Thus the probability of the outflow of hot money recurring in most Asian countries is low. Asia is no longer regarded as the corporate bad boy of the world as positive restructuring efforts have regained investor confidence.

As it is already considered undervalued given the fundamentals, some analysts think the ringgit peg is not sustainable in the longer term. The undervaluation against the US dollar poses a risk of "serious exchange rate misalignment" and the two currencies moving in opposite directions could limit Malaysia's monetary policy options, says MIER's Ariff. But for the time being it looks like it is a case of not rocking the boat while it is sailing smoothly.

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