What happened last time Asia rocked world markets

In late July, I visited Kuala Lumpur, the capital of Malaysia, known to locals and travellers alike as “KL.”

The Iconic Petronas Twin Towers In Kuala Lumpur, Malaysia

In late July, I visited Kuala Lumpur, the capital of Malaysia, known to locals and travellers alike as “KL.” I was there as the guest of Tun Dato’ Sri Dr Mahathir bin Mohamad, the fourth Prime Minister of Malaysia, and longest serving.

Dr Mahathir was Prime Minister for 22 years, from 1981 to 2003. The title “Tun Dato’ Sri” is a title similar to “Lord” or “Sir” in the English system of nobility and titles.

Despite the titles, Dr Mahathir was a democratically elected leader. He is a doctor by training – his bestselling memoir is titled A Doctor in the House. His political career lasted 40 years from his earliest days in parliament through his time as prime minister.

I was invited to Malaysia to meet with Dr Mahathir and a select group of current and former ministers, central bankers, academics, and businesspeople in a closed-door dialogue.

Our main agenda item was the structure and future of the international monetary system, but there was ample time to discuss Malaysian economic development among other subjects.

Dr Mahathir is counted alongside other leaders such as Lee Kwan Yew of Singapore as among the fathers of the Asian economic miracle of the 1960s to 1990s. Mahathir gained the most attention during the 1997-1998 Asian economic crisis when he confronted George Soros and others on the subjects of capital flight and exchange rate volatility.


Standing up to “hot money”

That crisis began in June 1997 when Thailand devalued the Thai baht against the US dollar. Prior to that devaluation, global capital had been flowing into Asian markets in Thailand, Malaysia, Indonesia, Singapore, Korea and elsewhere.

Suddenly, in June 1997 those capital inflows went into reverse and money began to leave South Asia. This caused a drain on reserves. Thailand responded by devaluing its currency. Malaysia was also faced with a rapidly depreciating currency as bankers dumped their Malaysian ringgits to buy US dollars.

Mahathir noticed that the collapse of the ringgit was due entirely to bank trading transactions, and that the outflow of reserves from Malaysia was actually not that severe. The banks were not that heavily invested in Malaysia, they were merely speculating in the currency. Mahathir quickly imposed capital controls to stabilize the reserve position and restore calm.

At the time, capital controls were taboo as far as the International Monetary Fund was concerned. Matters came to a head at the IMF annual meeting in Hong Kong in late September 1997. I was there along with Treasury Secretary Robert Rubin, George Soros and Dr Mahathir.

The name calling began quickly with Soros referring to Mahathir as a “menace” to Malaysia and a “loose cannon” because of Mahathir’s suggestion that currency speculation should be banned.

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The Thai devaluation set off a global liquidity panic that quickly spread to Malaysia and the rest of Asia before hitting Russia and Brazil. In the midst of the crisis, the Greenwich, Connecticut hedge fund Long-Term Capital Management was caught in the liquidity crunch and had to be rescued with $4 billion of new money put together by a consortium of Wall Street banks. I was General Counsel of LTCM in 1998 and negotiated that bailout. Dr Mahathir and I were able to reminisce about that global panic and our respective roles in solving the problems that arose and preventing a complete breakdown of global capital markets.

Ironically, all these years later, Dr Mahathir’s views have received vindication. The IMF recently admitted that capital controls can be useful in certain circumstances to stabilize hot money inflows and outflows from emerging markets’ economies.

Today Malaysia is on a much sounder footing with ample reserves and solid if unspectacular growth. It has robust exports in electronics, energy, palm oil, tin, rubber and textiles. Malaysia’s transportation infrastructure and educational system are excellent.

Beneath the surface, however, Malaysia is facing powerful headwinds from two sources that will stand in the way of its growth and development for the time being.

The middle income trap

The first headwind is called the “middle-income trap.” This is a common problem in emerging markets that have moved from poverty levels (say, annual income below $2,000 per capita) to middle-income (say, annual income of $10,000 per capita). The move from poverty to middle-income is not easy, but the process is straightforward. It mainly consists of bringing a rural population into cities where they can be combined with capital investment in the form of factories to produce assembled products in electronics, and automobiles or garments.

The move from middle-income to high income (say, annual income of $20,000 per capita) is much more difficult. This involves not just more of the same, but something more high-value added such as new technology that can be the basis of spin-offs and networks of related enterprises.

Taiwan did this with semiconductors and South Korea did this with automobiles and electronics. But, so far, no other countries in Asia, including China, have managed to break out of the middle-income trap.

Even if Malaysia explores new high-value added technology, it may take a decade or more before results appear on a sufficient scale to move the needle on GDP growth. In the meantime, growth in the 2% to 3% range can be expected – not awful, but not that strong for a developing country.

The second headwind is far more disturbing. Some corruption exists everywhere, but it is generally kept within bounds except for extreme cases such as Robert Mugabe in Zimbabwe and his ilk.

Recently credible reports have emerged in the Wall Street Journal and Bloomberg that the current Prime Minister of Malaysia, Najib Razak, and his cronies have looted over $1 billion from Malaysia’s sovereign wealth fund called “1MDB” using unauthorized loans, sweetheart asset purchases, front companies and hidden bank accounts.

The current prime minister has responded by closing newspapers, dismissing his deputy and the chief prosecutor, and threatening others with arrests for treason. In the weeks ahead, observers expect street demonstrations and more turmoil inside the ruling UMNO party.

In an extreme case, where the integrity of Malaysian democracy and rule of law is at stake, the military might step in with a coup d’état to assume temporary rule until a new civilian government can take over.

Regardless of the substance of the allegations and the ultimate outcome one thing is certain. Investors are highly averse to political uncertainty and will keep away from Malaysia until the situation is resolved.

Malaysia is also under threat from Janet Yellen’s insistence that she is about to raise interest rates in the US. As readers know, we are highly sceptical that Yellen will in fact raise rates given the weak US economic data.

Yet, the mere threat of a rate hike has been enough to strengthen the US dollar and weaken emerging markets currencies such as the Malaysian ringgit. Capital outflows from Malaysia have been reminiscent of the early stages of the 1997 crisis that Dr Mahathir and I experienced first-hand.

Until next time,

Jim Rickards

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