Bursting Malaysia's Bubble
[This article ran in the The Asian Wall Street Journal, January 28, 2000. Copyright (c) 2000, Dow Jones & Company, Inc.]
The performance of the Malaysian stock market this past year would appear to have vindicated Prime Minister Mahathir Mohamad's economic policies -- including his controversial decision to impose limited capital controls in September 1998. Less than one month into the New Year, the Kuala Lumpur Stock Exchange Composite share price index has risen by 15.7%, and analysts expect the rally to continue. Yet for anyone concerned with the long-term health of the economy, there is more to the story than rising share prices.
While the surge in foreign investment and the concomitant boost given to the KLSE are very real, to equate these two indicators with a fully recovered economy--much less a reformed one--would be a mistake. Both are being driven by the false perceptions arising from an expansionary monetary policy, rather than by sound economic fundamentals. Eventually, the distortions created by this policy will be forced to the surface, as they were during the Asian financial crisis, and perceptions will have to adjust to the more sobering reality.
Nevertheless, there is a growing feeling that the Malaysian economy is heading for better times. The consumer sentiment index, compiled by the Malaysian Institute of Economic Research, rose 6.4 points in the fourth quarter of 1999 to 117.7 from 111.3 in the previous quarter. Manufacturing sales jumped 30.8% year-on-year in November after growing by 27.5% in the prior month. Also, on a yearly basis of comparison, industrial production increased by 23.1% in November after rising by 13.9% in October. Gross domestic product, which shrank by 7.5% in 1998, grew by 5% in 1999 and is forecast to grow by 5.7% this year. Moreover, despite booming economic activity, price inflation appears to be subdued. In 1999 the consumer price index increased by 2.8% versus a 5.3% rise in 1998.
Foreign investors, meanwhile, are now attracted by the very capital controls derided by the international community when they were implemented over a year ago. They now relish the opportunity to take advantage of a destination largely sheltered from the volatility of the global marketplace. By imposing exchange controls and rigidly fixing the external value of the ringgit, the Malaysian government has managed to have its cake and eat it too. For the time being this type of policy permits the pursuit of loose monetary policy without any ill side effects.
After reaching 11.05% in April 1998 the three-month Kuala Lumpur inter-bank rate fell to 3.2% at the end of December 1999. Furthermore, year-on-year the M1 money supply increased by 25.1% in November 1999 after growing by 21.3% in October. It is this expansionist monetary policy that is behind the current KLSE boom.
Whenever a central bank engages in loose monetary policies, it does more than simply spur inflation--in fact, as in Malaysia's case, there may be no immediate price inflation. It also sends inaccurate price signals to producers, in the form of artificially low interest rates. Rather than being determined by the supply and demand for savings and thus giving producers an indication of consumers' spending preferences, interest rates are now determined outside of the marketplace. What this means is that the costs of production become distorted -- in the case of loose monetary policy, production costs become artificially low.
As long as the monetary pumping and the consequent artificial lowering of interest rates remains in force, there is no way for businessmen to know that the costs of production do not accurately reflect consumer preferences. On the contrary, as the loose monetary policy continues, it generates apparent profits and a sense of prosperity. The longer the loose monetary policy, the more widespread will be the errors committed on the part of producers deprived of accurate market signals.
All this leads to a situation where entrepreneurs are committing themselves to unprofitable businesses that ultimately must be liquidated. It is this liquidation that is called an economic bust or recession. As a rule the central bank, which initiates the economic boom by means of loose monetary policies, sets in motion the economic bust by tightening money in response to rising inflationary expectations. In short, the central bank's tighter monetary policy bursts the bubble. This is precisely what happened prior to the 1997-98 economic crisis.
There is a growing likelihood that a similar end awaits the current boom. Using lagged yearly percentage changes in the M1 money supply, it is very likely that yearly percentage change in the CPI will accelerate strongly in the months ahead. In fact, already year-on-year in December 1999 the CPI increased by 2.5% from a rise of 1.6% in November. Furthermore, the strong monetary growth is likely to put more pressure on the external value of the ringgit. Consequently, in a few months' time the central bank might be forced to reverse its current loose monetary policy stance, thereby bursting the stock market bubble. Statistical analysis indicates that the yearly rate of growth in money M1 leads the KLSE share price index on average by 2 months. This suggests that once the money growth momentum weakens, the stock market will follow suit rather quickly.
It seems that Malaysia's authorities are repeating the same mistakes that plunged the country into a severe recession in 1997-98. The idea that capital controls and fixing the external value of a currency can strengthen economic fundamentals is flawed. While capital controls may help boost economic activity in terms of GDP, they cannot lift the real net worth of the economy. On the contrary, capital controls will only add to distortions caused by the monetary pumping and the artificial lowering of interest rates, thereby making the inevitable economic bust much more severe.