Another tsunami on the bourse?

INTRODUCTION:

Desi's Place has been running a series of economics articles, from wire services plus from my Journalist buddy, ex-Business Editor of The Star, PY CHIN, as a sort of community service to blogospheric residents. Another mGf @2020freelunch.blogspot.com -- herself a young but pretty professional pressboy (by this I mean I've come across many 4th Estaters but I rarely compliment them about being 'professional'...) takes much trouble doing financial blog posts with passion. I appreciate her US-Malaysia FTA 'rites. She also notes that financial journalists are paid a "premium" compared with other categories of journalists, and for a good reason. One can offer one's opinions on politics like tehtarik feeflow, BUT NOT IN BUSINESS and FINANCIAL WRITES because readers will always ask you why. And of course, you must know the difference between a line-chart and a pie-chart!Hence, when I read Commenters' views at Raja Petra's more economics-oriented columns, 90% provide Desi with a good laugh. I guess Bloggers say LOL!:)

The following article was published in TheSundayPost yesterday. You are advised to visit www.theborneopost.com to digest another PY's column published a week earlier titled
"A primer on international trade".

DISCLAIMER: I may get a freelunch or sponsoreddinner for this promo, but you are advised not to dabble in the KL Stock Market based any any "feel good" feeling generated, knowingly or unwittingly, by anything you read at Desi's Place. This is a free or flee world by choice or imposition! LOL.




Is BNM prepared to handle another ‘financial firestorm’?

By P Y Chin


THESE days it is understandable that many Malaysians should have a ‘feel-good’ feeling. Thanks to the local media in promoting this ‘feel-good’ factor so that an air of expectation has been generated of an early general elections, possibly by end of this year. The KL stock market has been good to punters, reaching close to pre-1997 financial crisis levels before retreating to present levels of about 1,200, which is still very comfortable with punters. The pace of mergers and acquisitions has picked up; so have some large government-linked corporations reporting better than expected financial results.

The economy is moving along steadily and smoothly, with latest figures showing last year’s growth hitting 5.9 per cent — slightly better than 2005’s 5.2 per cent. This year’s growth is estimated at between 5.5 per cent and six per cent, slightly slower in line with the slowdown in the world economy. Inflation is also seen to be more benign at two per cent to three per cent, though for January 2007, the consumer price index jumped 3.2 per cent year-on-year.

Everyone is getting excited over the $105-billion 20-year Iskandar Regional Development project in southern Johor, hoping that the development will give a much-needed shot in the arm to the economy under the Ninth Malaysia Plan (9MP).

On the monetary front, even Bank Negara Malaysia (BNM), having come through stronger than before the 1997 Asian financial crisis, is looking seriously into clearing the last of the capital control hurdles imposed by the former political leadership to insulate the economy from the Asian ‘financial firestorm’.

From a political perspective, many may read the complete dismantling of the capital control hurdles as a reversal of policies of the former political leadership.

But it is 10 years since the crisis, and Malaysia, specifically BNM, should feel confident, reassured, and prepared to handle any ‘financial firestorms’ even before they arise.

It is a lesson well learnt, fortunately or unfortunately, through the hard way. In many ways it should enrich Bank Negara’s wisdom in viewing financial crises with a wide-angle perspective.

At the end of the day, it is whether BNM has come out with a statistical model of its own that could provide it with early warnings before any ‘financial firestorm’ hits Malaysian shores.

The learning has also reinforced BNM’s nerves of steel in decision-making, which was put to the test when Thailand recently made a blunder by imposing capital controls to curb the sudden rise in the value of the baht, which had surged 16 per cent last year, making Thai goods more expensive overseas and cutting exporters’ competitiveness.

Realising the mistake, Thailand reversed its decision the following day. In the process, the regional foreign exchange and stock markets were rattled, but Bank Negara did not even blink an eye. Neither did any of the other Asian central banks.

Rightly or wrongly, many view this as a likelihood that a contagion effect may not exist should another ‘financial firestorm’ break out in Asia. After all, in the 1997 financial crises, the dominoes started falling when almost every Asia central banker panicked.

Today, thanks not because of the lessons learnt but possibly because of the changes in leadership at the helm of central banks over the last decade that reactions to crises have taken on a different stance.

Central bankers are now calmer when viewing any crisis. When they are calmer, they behave more rationally, and thus are more decisive. More importantly, there are now greater and closer consultations among Asian central bankers on decisions affecting exchange rates and currencies.

Last week, the Thai central bank got it right when it cut the benchmark interest rate for the second time this year, from 4.75 per cent to 4.5 per cent. Earlier it was reduced from 4.9 per cent. The aim is to spur economic growth and to restore confidence in exports that have been hurt by a rising baht.

For Malaysia, the ringgit has also performed to great satisfaction, appreciating not too much but a decent eight per cent to nine per cent from its previously fixed level of RM3.80 to the US dollar — compared to the darkest days of the crisis, when the ringgit plunged to its lowest at RM4.88 to the US dollar.

The country’s foreign exchange reserves too have multiplied almost five times to RM299.784 billion (or $85.136 billion) as of Feb 15 this year from RM61.898 billion on July 15, 1997, at the beginning of the crisis.

On July 15, 2005, the ringgit peg to the US dollar was removed, when China changed its exchange rate policy by freeing its yuan from the peg to the US dollar, allowing it to float upwards.

But BNM opted for a managed float of the ringgit within a band, instead of allowing a completely free float. That move turned out to be a blessing in disguise, working to BNM’s advantage, enabling the central bank to steer the ringgit in the direction and at a speed that it wanted.

Under the present situation, with a stronger ringgit (now at RM3.49 to the US dollar against RM4.88 in those crisis days) and a more solid pile of foreign exchange reserves, Malaysia can afford to remain clam.

At the end of the day, it is whether BNM knows what to do should another such crisis occur at its doorstep again. To seek refuge under the capital controls banner when such a crisis occurs may not be the most desirable solution. Many believe it is unlikely that Malaysia will return to the days of capital controls to cope with another ‘financial firestorm’.

The correct move lies not in using a hammer to kill a fly, but to be selective in picking the appropriate measures to implement. In other words, the solutions will be more specific to the problems.

If BNM opts to follow the capital controls route, the end results would be disastrous of Malaysia’s investment scene, which has already been cut down in volume by China’s ‘vacuuming effect’.

Malaysia still has one last capital controls hurdle to remove, that is, to allow the ringgit to be traded offshore. In foreign exchange terms, this is call ‘internationalising’ the ringgit.

Presently, the ringgit is allowed to be traded only within Malaysia. BNM governor Tan Sri Dr Zeti Akhtar Aziz had said last month that Malaysia might allow the ringgit to be traded offshore some time in the future.

However, she qualified her words by adding that it would be done ‘cautiously, and only if it benefits the country’.

If BNM opts to be cautious in removing the last hurdle, it is understandable in the light that it was due in part to the offshore trading of the ringgit that brought the 1997 ‘financial firestorm’ to Malaysian shores.

In those days, with the ringgit allowed to be traded offshore, currency speculators built up huge amounts of ringgit in offshore banking centres. To do that, financial institutions in these centres offered interest rates for ringgit currency deposits as high as twice that of Malaysia’s internal interest rate.

Not surprising, when BNM decided to insulate the economy against the ‘firestorm’, one of the measures was to ban offshore trading of the ringgit.

The question now becomes: Is the external foreign exchange and monetary environments safe for Malaysia to trade its ringgit offshore?

Everyone is saying that now it has been 10 years since the crisis. After such a long period, it would be unlikely that another crisis would recur. Further, after so many years, BNM should have learnt the bitter lesson on how to handle such a crisis properly.

It has always been said that in a world of uncertainty, it would be foolish to ignore the unexpected. BNM is doing the right thing, by taking what many would say, one step at a time. The world out there is still full of uncertainty, full of haziness where many are unable to see the road ahead.

Ten years ago, at the time of the crisis, the environment was not much different: Every one was having a ‘feel-good’ feeling; economic growth was speeding along on the fast-track; prosperity was everywhere; and almost everyone and every country was living beyond its means. Yet no one bothered about the existence of warning signs that kept flashing every now and then.

Today, the situation is equally fluid. Globalisation and liberalisation are everywhere, with many not knowing what the twin pillars of economic development will bring.

The US twin deficits – ‘trade and budget’ are about to burst, with the future of the US dollar hanging in the balance. American consumers are spending beyond their means. Asian countries are piling up foreign exchange reserves like there’s no tomorrow.

Yet, some are saying the warning signs are already flashing, with some more ominous than others. Overall, the picture ahead looks more gloomy than positive.

• Former chairman of the US Federal Reserve Alan Greenspan warned last week that the US economy, which had been expanding since 2001, might slip into a recession by year’s end.

He said: “When you get this far away from a recession, invariably forces build up for the next recession, and indeed we are beginning to see that sign. For example in the US, profit margins … have begun to stabilise, which is an early sign we are in the later stages of a cycle.”

According to latest statistics, the US economy grew at a slower pace of 2.2 per cent in the fourth quarter of last year, up from the mediocre two per cent in the third quarter and less sunny than the 3.5 per cent fourth-quarter estimate the US government made earlier. For this year, the expectation is a slower growth of 2.7 per cent — the slowest since 2002.

Greenspan noted that there had been no immediate economic spillover from the slowdown in the US housing market, which is now well into a contraction.

The future of the US housing industry has of late been the pivotal point in understanding the direction the US economy is heading. It is now believed that a more protracted weakening of the housing market than envisaged could generate a sharper and longer downturn in US economic growth.

Already, problems are surfacing in the US mortgage market that could trigger a recession in the world’s largest economy. According to the Wall Street Journal newspaper, US banks are holding their lowest level of reserves to cover bad loans in housing since 1990.

The risks of loan delinquencies and foreclosures are getting greater, as loan delinquencies have reached a four-year high. The amount being mentioned is in the region of $400 billion (RM1.4 trillion).

Should a collapse in the mortgage market occur, not only banks but also consumers will suffer. And since consumers do not have enough to repay their loans, they will not have enough to make new purchase of houses.

So consumer spending, and thus retail sales, in the months ahead will be affected, which will mean a drastic slowdown in consumer spending, triggering a recession. In this scenario, many are expecting the Federal Reserve to have no choice but to cut interest rates to ease the tensions in the financial markets.

In addition, the US economy has to-date survived solely on an extraordinary boom in consumption, leading to the excessive heavy imports, and thus the high trade deficits. Many are now saying that the negative impact of falling prices on household wealth in the US could become more pronounced, cutting as much as one percentage point from US’ growth in personal consumption this year.

The US economy has always been considered the locomotive engine that pulls the world economy along. So any slowdown in the US economy will certainly have dire consequences on Asian economies, simple because to most Asian countries, the US is a major export market. Already, Malaysia in projecting a slower growth for this year has taken into account the slowdown in the US economy.

Some have argued that a large portion of the global economy has decoupled from the US economy, leading to an assumption that maintaining a rising domestic consumption could help sustain these economies through a possible US recession, and avoid the effects of a fall-out. This argument is said to be quite flimsy.

A more plausible option would be that many of these economies have diversified their exports away from the US, as well as strengthening their private and public sectors and adopting floating exchanges rates. These economies are now on more solid ground to weather a deteriorating external environment.

However, there is an argument that with the rapid development of the economies of China and India, both these Asian economic superpowers could be picking up the slack from US to become the world’s locomotive engines. Despite that consoling buffer, many are keeping their fingers crossed that the recession in the US would not be too severe.

• UN Under-Secretary-General and UN’s Economic and Social Commission for Asia Pacific (ESCAP) executive secretary Kim Hak-Su had recently warned that East and South-east Asian governments should not be lulled into false security by the current economic boom.

Pointing out that some of the risks which preceded the massive financial crisis 10 years ago could be seen today, he said: “A global liquidity bonanza, inflated asset values, and tremendous speculative pressures on regional currencies could destabilise regional economies, as happened in 1997″.

There had been a sharp rise in hedge fund activities and capital inflows into the Asian region last year. Heavy foreign inflows into Asian equity and financial products had raised fears of inflated asset values again. Asian-Pacific equity markets rose 29 per cent in 2006. Speculative inflows and a weak US dollar pushed most regional currencies higher last year.

Kim commented: “That trend is expected to continue in 2007 despite the best efforts of central banks in the region to tame their currencies’ rise”.

• For Malaysia, as with all other Asian economies, the more important issue is the handling of the rising value of the local currency — a situation that is directly opposite that in the 1997 financial crisis.

The Malaysian ringgit has risen eight per cent to nine per cent, and had it not been for Bank Negara’s micro managing the currency float, the ringgit would have appreciated higher and faster, as in the case of the Thai baht last year.

The main cause of the local currency appreciating that fast is the high inflows of capital, as ESCAP Kim had pointed out. According to the Institute of International Finance, total private capital flows to 30 emerging countries, including Asia-Pacific, had reached $502 billion (RM1.76 trillion) last year, slightly below the $509 billion (RM1.78 trillion) in 2005. For this year, the estimated inflows are $469 billion (RM1.65 trillion).

To counter that, some Asian countries tried to encourage greater outflows by implementing certain measures. But this strategy has not worked well, as investors made no rush to get their money out given the high returns from the country’s stocks and bonds.

At the same time, a rising local currency is hurting exporters, as it is making exports more expensive.

The Philippine central bank recently relaxed currency rules to try to take the heat off the peso — by raising the ceiling on residents’ foreign exchange investments to $12 million from $6 million.

The Filipino peso has gone up almost two per cent against the US dollar this year alone due to record remittances from Filipino workers abroad as well as strong foreign investments flowing into the country.

As part of the move to spur greater outflows of capital, the Thai Government Pension Fund was reported to have said that it would invest about $1.04 billion in foreign shares, raising its holding to 11 per cent from five per cent.

Similarly, South Korea was also reported to have encouraged its companies and residents to invest heavily overseas.

This strategy, if anything, by these Asian countries is expected to receive lukewarm response — for the moment at least. Simply because the stock markets in most of these countries are giving exceptional returns, and fund managers are in no mood to move their money offshore.

The Morgan Stanley Composite Index of shares in Asia (excluding Japan) registered a four per cent jump to-date this year, after leaping 30 per cent last year, as compared to Dow Jones which moved up only 1.5 per cent this year, and 16 per cent last year.

• A survey of some of the world’s central banks recently revealed that many are becoming more active managers of their growing pile of foreign exchange reserves. The central banks, seeking to raise the yield on their portfolio, are going for ‘riskier’ assets.

The reason for this is simple: In many of the Asian countries, the reserves that they have accumulated this past decade have exceeded the required level for which they could be used as an insurance against any financial crisis.

Traditionally, central banks have invested their reserves in low-risk and low-yield instruments such as US Treasury bills. But the sharp build-up of reserves in these Asian countries has sparked calls for them to invest their surplus reserves in instruments with higher returns, or to put their reserves to more efficient uses.

This means the volume of capital available for all forms of investments could have increased substantially. Hence, the ‘global liquidity bonanza’ that ESCAP Kim was talking about.

The world is certainly awash with cash. According to a rough estimate, the value of the world’s money and asset markets totalled some $200 trillion (RM700 trillion) at present.

As Fred Joseph, managing partner of Morgan Joseph & Co in New York and former chief executive of Drexel Burnham Lambert, said of the KKR-Texas Pacific Group-Goldman Sachs Group’s joint $45 billion (RM158 billion) bid to buy Dallas-based power producer TXU Corp in the biggest takeover in corporate history: “I’ve never seen so much money being thrown at deals.”

According to statistics, central banks worldwide controlled a total of more than $4.7 trillion (RM16.5 trillion) at present. Of this, about $3 trillion (RM105 trillion) is found in Asia.

China, with its $1 trillion (RM3.5 trillion) foreign exchange reserves, has set up an investment vehicle to manage at least $200 billion (RM700 billion) of the reserves, which will be invested overseas. Another is Singapore, which has already started investing some of its reserves in higher yielding assets.

Already, the Asian Development Bank was quick to suggest that Asian central bankers wishing to invest in riskier assets should invest in infrastructure projects within the Asian region, which is in great need of funding.

A joint study by the Asian Development Bank (ADB), Japan Bank for International Cooperation and the World Bank revealed that 21 developing countries in the Asian region will need to spend $200 billion (RM700 billion) a year to improve basic services to achieve their income potentials. This means more than $1 trillion (RM3.5 trillion) by 2010 for transport, electricity, piped gas, information and communications technology, and water and sanitation systems.

The ADB estimated that Asia alone will need $106 billion (RM371 billion) in new infrastructures between 2006 and 2010.

• The growing concern about the future direction of the US dollar and the worst possibility of the currency depreciating substantially is hanging like a Damocles sword over global financial markets.

The situation the US dollar is in today has been largely attributed to the sky-high trade and budget deficits that the US has accumulated on one side on the Pacific, and the huge trade and current account surpluses of Asian countries on the other side of the Pacific.

Today the US trade deficit alone accounts for six per cent to seven per cent of US’ gross domestic product — way beyond the level when alarm bells are ringing under International Monetary Fund rules — and is still growing.

Many believe that a disorderly depreciation of the US dollar could take place even in the absence of a sharper-than-expected US slowdown. This is because there has been evidence in the last few months, including from the December report from the Basle-based Bank of International Settlement, showing that many official central banking institutions have been diversifying their reserve assets away from the US dollar.

The oil exporting countries, including Russia and Venezuela, as well as some of the Gulf States, have hinted of taking such a strategy, and is opting for the euro. The danger arises when everyone makes for the exit, dumping US dollar in the process.

Though the effects remain uncertain at present, many are now saying that the potential for disorderly adjustments of large global current account imbalances continued to raises the level of uncertainty.

• An even more precarious blowout could happen if not monitored properly. It concerns what is now popularly known as a ‘carry trade’ in currency trading.

According to the online dictionary Investopedia, ‘carry trade’ is defined as where an investor sells a certain currency with a relatively low interest rate and uses the money to buy a different currency with a higher interest rate.

What the investor does is to capture the difference between the two interest rates, and make the profit. The gains could be substantial as most investors would be leveraging on the deal.

For example, a yen carry trade, which is common these days. An investor borrows 1,000 yen from a Japanese bank, converts this into US dollars, and buys a bond equal to that amount.

The bond may pay, say, a 4.5 per cent interest, while the Japanese interest rate is 0.5 per cent. The investor makes a profit of four per cent (4.5 minus 0.5 per cent), so long as the exchange rate between yen and US dollar does not change.

The gains become substantial when the deal is leveraged, say 10 to one, in which case, the investor makes 40 per cent profit.

The risk in these trades is the uncertainty in the exchange rates. Thus, in the above example if the US dollar were to fall substantially in value against the yen, then the investor will lose his pants.

It is common to find these transactions being done with high leverage. For that the risks are enormous should there be even a small movement in the exchange rates. Presently, volatilities in exchange rates and interest rates are at historical lows and are providing an excellent environment for carry trades to function. But this trend cannot continue forever, and risks of the large number of carry trades unwinding this year have risen. Interest rate spreads are changing. Central banks are getting more vocal as to diversifying their foreign exchange reserves to higher yields.

Carry trades are a new phenomenon, just like the existence of hedge funds during the 1997 financial crisis. However, despite the danger of a massive unwinding of carry trades, said to be mainly in Japanese yen, there are certain factors that prevent against a collapse.

Interest rates are only partially influenced by exchange rates and international trade. They are more influenced by domestic economic conditions. As one commentator said: “It would take a lot for Japan to close its interest rate gap with the US, the UK and even Europe.”

Further, interest rate changes are infrequent, usually in small amounts, such as 25 basis points increments, which is equal to a quarter of one percent, and they come after a pre-determined meeting. These factors allow market traders time to unwind their trades. It is only in the sudden changes that may catch market traders by surprise that cause the greatest damage.