Lessons Never Learned

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I've been cautioning my friends in Kuala Lumpur against breaking open the champagne. I understand why they are in a mood to celebrate: Malaysia's stock market has rebounded this year--at the end of last week, it was up 20% from January. And it will keep climbing if the government has its way. But this is a false boom, in no way underpinned by the factors that make sustainable economic growth possible--namely balanced budgets, transparent financial institutions and an efficient allocation of resources. Mahathir's Miracle is just another financial-credit bubble, doomed to burst in a couple of years at most.But investors are greedy and their memories short. They will forget about the capital controls Prime Minister Mahathir Mohamad imposed in September 1998. They will ignore the jailing of his former deputy, Anwar Ibrahim, and others. And they will be deaf to the echoes of Mahathir's attacks on foreign speculators. Instead, they will try to buy into the boom and then get out--nimbly--before the bust.

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How will this bubble be inflated? Like many other crisis-hit Asian countries, Malaysia has generated a rising trade surplus, producing an increased inflow of foreign exchange. Unlike the others, however, the government has barred its citizens from holding foreign investments and currency, which means the extra capital has been trapped at home. So foreign-exchange reserves are inflated by returning capital. Korea, Thailand and Indonesia have maintained tight monetary policies--their currencies rose along with their equity markets. Under the cloak of capital controls, however, Malaysia's central bank, Bank Negara, has kept the ringgit fixed and turned its increased foreign-exchange inflows into domestic currency to boost bank coffers.

Malaysia's economy took longer to rebound than Korea's or Thailand's. But now economic activity is rising, boosted by huge government spending on infrastructure to the tune of 8% of GDP this year, with more to come in 2000. Exports are soaring, underpinned by a cheap ringgit and strong global demand for semiconductors, of which Malaysia is a major producer. Some capital controls have also been relaxed, and a few foreign investment advisers have restored Malaysian shares to their emerging-market indexes.

Now, to curry popularity, the government will probably remove the remaining capital controls. But it will keep the currency pegged at 3.8 ringgit to the U.S. dollar. Continued foreign-exchange inflows will exert upward pressure on the currency. But Bank Negara will just convert those dollars into ringgit, flooding the economy with excess liquidity and cutting interest rates instead.

Finance Minister Daim Zainuddin is a businessman. He wants cheap credit for corporations. He's not thinking of sustainable economic growth. So while some of the newly created liquidity will flow into investment--raising industrial production and export capacity along the way--the allocation of capital will be distorted by the undervalued ringgit. A cheap currency will keep out imports. Too much investment will be sucked into producing goods (like Proton cars) to substitute for the loss of more efficiently produced imports. And, just as before, a lot of the credit will end up in the stock market or in property speculation. So Malaysian assets will soar--only to fall again.

But there are some important factors and events that may stem the market's rise sooner. Elections are approaching. The ruling coalition led by Mahathir's United Malays National Organization will almost certainly win again, but not without a substantial loss of votes. UMNO's hold on power is weakening. There are signs of broad-based dissent, ranging from public demonstrations of support for Anwar to the visible displeasure of the ethnic Chinese business community over the government's bank restructuring plans and its carve-up of real estate, which they feel favor ethnic Malays. It's possible Mahathir may retire soon after the election or opt for rule by emergency decree. Either way, political uncertainty will hit the market.

Also, world interest rates are likely to rise as global growth accelerates and the U.S. dollar slides. American stocks will plummet and markets everywhere will suffer in their wake. The global supply of capital will shrink. Those countries that depend heavily on foreign investment for growth will suffer the most. Malaysia may have a current-account surplus, but its industry is more dependent on foreign input than any other in Asia, absorbing on average 6% of GDP in foreign direct investment every year. Even so, Malaysia's credit boom could go on through 2000 before Mahathir's Miracle is exposed as another conjuring trick. Then Malaysia will pay for the deception with low economic growth, diving financial markets and political confusion.

David Roche heads Independent Strategy, a London investment firm