On the evening of July 21, within an hour of the Chinese announcement that the renminbi would be unpegged from the US dollar, Bank Negara, Malaysia's central bank, followed suit. For seven years since the Asian financial crisis, when it lost 44% of its value in just six months, the ringgit had been a currency in recovery, insulated from financial flows by the Bank Negara's vast dollar reserves. But the move back to managed flotation was a cautious one, the revaluation minimal and any market moves closely controlled. So how significant a development will it prove? What does it tell us about economic conditions in east Asia? And how far will emerging markets now risk their currencies following the experience of the 1990s?
Malaysian central bank governor, Zeti Akhtar Aziz, is keen to stress that lessons have been learned since the Asian crisis. "We have strengthened our ability to manage any potential inflows or outflows," she explains. "Our reserve position has been strengthened to $80 billion. In addition, our ability to monitor financial flows and market conditions has greatly improved. But we have an important rule: the non-internationalization of the ringgit." The latter amounts to a ban on offshore trading of the ringgit, further helping the Malaysians to maintain control of the currency's value.
Despite the positive macro indicators, the bank's sights remain trained on cautious flexibility and managed recovery. Integration into the global economy had exposed the country to speculative risks largely divorced from real domestic economic conditions. Malaysia remains one of the most open economies in the world ("three times more open than the United States," Zeti claims), with exports accounting for 80% of GNP. As such, it remains especially vulnerable to the peaks and troughs of the economic cycle.
Safety zone
Renewed confidence there may be, but emerging markets have been recovering in an exceptionally kind global environment: commodity prices have been buoyant (Malaysia is Asia's largest oil exporter), inflation and interest rates low, and demand from the United States, Europe and China consistently strong. Nevertheless, should there be a turn of the tide, Malaysia's healthier current account, prudent fiscal policy and more tightly managed currency mean that it shouldn't be as vulnerable as it once was.
Zeti is thus understandably bullish about the attractive environment the country now presents to international investors and plays down the risk of speculative outflows: "We've had solid growth for some years now, combined with low external debt, low inflation and a strong external balance. Moreover, our capital and bond markets are significantly more developed. We see no basis for such destabilizing capital flows."
The ringgit revaluation should be seen as both a tactical and a strategic move, according to Homi Kharas, the World Bank's chief Asia economist. On the one hand, speculators now have no certainty over the currency's value, which helps the Bank Negara's attempts to discourage volatile, short-term flows.
"The new phenomenon since 2004 has been a growing amount of speculative inflows into east Asia, particularly into economies with currencies pegged to the dollar. With the ringgit pegged to the dollar at 3.8, traders were in effect making a one-way bet. Now they don't know whether the rate will go up or down. The Malaysians are keeping the market guessing."
On the other hand, the move to a managed float also reflects longer-term developments in the regional economic environment and renewed confidence in Malaysia's ability to remain stable without the use of stringent controls. While the dollar peg lent much needed stability, and facilitated a crucial bout of corporate restructuring, economic recovery in the past couple of years has reduced the immediate need for a rigid exchange rate mechanism. While there has been an influx of portfolio investment (or "hot money") into the country, it has been accompanied by positive, long-term flows into the equity market.
Claudio Piron, a JP Morgan analyst in Singapore, also sees the managed float as at least partly a reflection of Prime Minister Abdullah Badawi's success. "He's surprised a few people by pursuing transparency and reform. For example, trying to shake up Proton motors. Moving to a managed float is certainly the spirit of the times there."
Though the size of the revaluation would suggest little has changed (analysts expect the Bank Negara to permit an appreciation of no more than 3% or 4 % this year), the importance of the managed float derives in reality from the flexibility it provides to adjust to the currency fluctuations of major trading partners. Indeed, so managed is this float that the Bank Negara is getting the best of both worlds. While the ringgit can float enough to ensure that speculators are given the toughest time possible, the value of the currency will nevertheless remain stable and credible because of the bank's commitment to intervene on the markets. Since July, this has certainly been the case: a small revaluation, but any larger appreciation has been carefully held in check by Bank Negara. More of a flexible peg than a managed float, in fact.
Indeed, such a revaluation is eminently sensible for the Malaysians in the current climate, Homi Khoras argues. "At a time when monetary policy is tightening and where the dollar is going through significant volatility against other major currencies, for countries like Malaysia, with such diversified export markets, it's simply prudent to have your exchange rate set against a basket of currencies." Moreover, the Chinese move allowed the Malaysians to act without hurting their own exporters.
But what of the renewed risk of capital flight? A more flexible regime enables the economy to pursue an autonomous monetary policy by insulating the money supply and the banking system from balance-of-payments inflows. Yet the flexibility entails risk. Since the financial crisis of 1997/8, governments have been understandably fearful of large speculative swings in exchange rates that exact costs on the real economy.
Caution
The difficulty facing Malaysia, as with other emerging economies in east Asia, is how to navigate between exchange-rate volatility and the currency peg. China, Malaysia, Singapore and Hong Kong are all operating subtly varying systems, reflecting the different structural conditions pertaining in each country. Yet the common east Asian experience since 1997/8 has been that of caution. The region has sought to insulate itself from any future financial crisis, most notably by accumulating vast dollar reserves. Now, in a climate of tentative optimism, policy is shifting.
The "new" situation is in fact a return to the system that operated before the financial collapse, with the ringgit being managed carefully against a basket of currencies. Moreover, the ringgit revaluation has been preceded in the past year by gradual liberalization of capital markets. "Re-liberalization" would be more accurate, since it was the imposition of those capital controls by Mahathir Mohamed's government in 1998 which signalled the beginning of seven years of extreme caution in Malaysia.
The risks of speculative flows will never be eradicated by a country like Malaysia, but they are being minimized through structural reform and sustainable growth. The dollar peg was one insurance policy. The managed float will operate in a similar fashion. As Zeti admits, "It will always be a managed float. It's a question of degree. It is very important for us to have our exchange rate reflect underlying economic and financial developments and to prevent extreme volatility that is highly destabilizing for our open economy."
The conditions for a genuine float are a long way off, says Kharas: "It requires, among many other things, deep liquidity in financial markets, diversified pools of assets, and well-founded bond markets." In short, all the things emerging markets are striving to build. In the meantime, Asian countries will continue to strike an uneasy balance between the demands of integration and protective autonomy.