At the World Economic Forum in Davos last week, the Prime Minister highlighted the need for a global system to regulate currency speculation, and the protective measures taken by Malaysia in the absence of such a reform. With a report on the dangers of hedge funds being released last week, the continuing turmoil in Brazil and the debt repayment problems of many countries and companies, the PM's message should be better received than when he first criticised the speculators and the financial system in September 1997.

By Martin Khor

Currency speculators and capital controls were part of the talks at the Davos meeting of world corporate and political leaders last week amidst continuing uncertainties arising from the Brazil crisis and the increasing number of debt defaults in the world.

Although so much has been said about the global crisis, ranging from the corruption and poor governance in Asia to the wrong policies of the International Monetary Fund, the role of currency speculators has not been sufficiently highlighted.

It was no surprise that Prime Minister Datuk Seri Dr Mahathir Mohamad chose to focus again on currency trade and the greed of a few speculators when he gave a luncheon address at the World Economic Forum.

What he said may not be new to Malaysians, as the PM has made similar criticisms several times at home.

But it was worth mentioning again at the high-level international gathering in Davos, because when he first broached the subject in September 1997 at the World Bank-IMF annual meeting in Hongkong he had been derided for not understanding the modern financial system and for trying to divert blame for the crisis away from domestic policies.

As the only world leader who from the start had focused on speculators, Dr Mahathir could have said (but didn't say) "I told you so."

This is because currency attacks and other forms of financial speculation via hedge funds and other institutions have since 1997 continued in many countries and have now been recognised as a major (or even the major) source of "contagion" and destabilisation.

Countries like Thailand, Malaysia, Taiwan, Hongkong, South Africa and Brazil have known the damaging role of speculators since they have come under their attack in 1997 and 1998. But it took the losses and rescue of the American hedge fund Long Term Capital Management (LTCM) in September 1998 to show up in the great scale and potentially huge effects of such speculation.

The Western world could no longer ignore the power and destabilising effects of speculative institutions, some of which derived their massive clout through unbelievably high leverage.

With a capital base of some four to five billion US dollars, LTCM was able to obtain loans of US$200 billion at one stage and used these to place positions in financial markets worth $1,300 billion.

Not all hedge funds have such leverage or market outreach. But considering that the capital of hedge funds as a whole come to some US$300 billion, one can only imagine the tremendous funds they can leverage as loans, and the many trillions of dollars in bets or positions they have placed in the markets for currencies, bonds, stocks and other instruments.

Moreover hedge funds are only one category of institutions; other highly-leveraged funds also speculate. Together this small number of institutions are able to exert great influence over prices of currencies and other financial assets.

In the wake of the LTCM debacle, the central bankers of industrial countries commissioned a study on the speculative institutions.

Last Friday the Basle Committee for Banking Supervision released the "Report on Highly Leveraged Institutions" which warned about how hedge funds and other high-borrowing institutions could put the world economy at risk.

Committee chairman William McDonough said: "Given the very turbulent markets that existed within 24 hours of the LTCM collapse, the danger to the world economy of these very large market positions being thrown on already turbulent markets would have resulted in danger to the economic growth of this and other countries."

McDonough is also president of the Federal Reserve Bank of New York and had arranged the LTCM rescue in which banks poured US$3.6 billion to recapitalise the sinking hedge fund.

Judging from the initial news, the Basle Committee report only called for sound risk management practices among banks and lenders to highly leveraged institutions. It did not recommend regulations for the hedge funds themselves.

Thus, any regulatory actions that may arise are unlikely to impact directly on hedge funds. If the banks that lend to these funds lower their credit, the hedge funds may however get less leverage and thus less market power.

But unless regulations are strict and keep up with new financial instruments and devices, it can be predicted that the speculative institutions will find new ways and means to make profits from speculation and manipulation.

It looks as if any new "global financial architecture" that curbs currency instability and reins in the freedom of capital flows will take a long time in coming, if at all, since the Western countries consider it to the benefit of their financial institutions to keep the system of floating exchange rates and free capital mobility.

This is where the Malaysian experiment with selective capital controls and a fixed exchange rate comes in useful as an example of what developing countries can do to protect themselves against predatory speculators and against financial volatility.

At Davos, Dr Mahathir took the opportunity to explain the rationale of the Malaysian measures from the Malaysian point of view, which is important since there has been so much bias and negative slant in the comments from some international institutions and media.

He said the moves had stopped speculation in the ringgit and the KLSE, and gave some evidence of improvement in the economy (growth of foreign reserves, rise in stock market values, revival of sales) which he attributed at least partly to the exchange rate and capital control measures.

The extent to which his audience was impressed would be difficult to gauge since the dominant Western establishment view is still against a developing country acting on its own to protect its own interests.

But the IMF and developed countries' continuing pressurising of developing countries to keep their national financial system open whilst the global system remains unreformed is going to be more and more discredited as more countries and companies face a situation of unrepayable debt.

Last week, Brazil's now free-floating currency continued to fall, even past the psychological level of 2.00 real to the dollar and with the devaluation being so fast, doubts are rising whether it can meet its debt obligations this year.

Russia has given notice it will not be able to service its foreign debt in full in 1999. Companies in Thailand, Indonesia and China are defaulting on their foreign loans and seeking debt rescheduling or write-downs. Pakistan is also seeking to reschedule US$7.7 billion in foreign debt, according to a news report last week.

Clearly the developing countries have need for a new world financial system where their currencies are much more stable, and where flows of capital can be checked and channelled in orderly fashion.

Until the developed countries also feel the need, such a system may not emerge. Until then the developing economies need to have their own safeguards. - (January 1999)

(Martin Khor is the Director of Third World Network.)