Other central bankers spoke out

THEN it was the turn of other speakers to exchange their views. On the pattern of speculative attack, Ms Yeo Lian Sim, director of International Department, Monetary Authority of Singapore, observed that commercial banks did give their own views on why there should be a currency devaluation and why the interest rate should come down.

The views had brought about political pressure to effect something that the public wanted. Singapore's experience in the mid-1980s was that many politicians called for a devaluation. Had this not been the case, the situation would have been better.

At the time, the sharpest hedge funds settled their position in six months. It was the providers of liquidity who came later that got hurt the most.

On the separation of onshore and offshore markets, Yeo commented that Singapore was already very exposed to the external economy. Singapore did not need extra exposure through the foreign exchange market, and the offshore market was not encouraged.

However, this measure was not a matter of separating the onshore and offshore markets but rather to ensure against excess liquidity in the system. There was also some uncertainty as to whether the separation and control were effective.

Although there was no hard evidence, Yeo heard that the hedge funds borrowed in yen and invested in other currencies, including those of the emerging markets. The position of these hedge funds was indeed large in terms of the local market size.

When the yen interest rate increased, the cost of borrowing became higher, and the hedge funds had to liquidate their position. This put additional pressure on the currencies they invested in.

Andrew Sheng, deputy chief executive, of the Hong Kong Monetary Authority, shared Yeo's insight in the foreign exchange market behaviours. He noted that the HKMA's tactic was to intervene quite explicitly in the market but would make no comment on intervention to the media.

Andrew Sheng

The rationale was that the market feared uncertainty so surprise tactics were useful. He also noted that the hedge funds were well prepared and obtained the necessary funding in advance.

Thus, if the interest rate was raised to defend the currency, the hedge funds would benefit from the on-lending borrowed money at a much higher rate. If the authority devalued the currency, they would make profit from the speculation.

In either case, they would win. Moreover, they looked for others to join in the bandwagon, which explained their use of public relations statements.

There were two other issues involved, which put the speculators at an advantage -- information asymmetry and leverage asymmetry. On information asymmetry, Sheng explained that since speculators had a target, they had some information advantage over other players.

Moreover, as they carried out their attack through transactions spread out over a number of local banks, each local banks which provided them with the domestic currency liquidity did not know the full extent of the speculators' actions. This posed implications on supervision.

On leverage asymmetry, hedge funds were able to leverage up to eight times their capital, an extent a much larger than what domestic banks could, while central banks were not able to leverage at all.

Of course, if it were the case that the market had information on the hedge funds' position and perceived great risks associated with it, then market discipline could kick in through the adjustment in the market interest rate and forward rate.

Sheng continued that volatility in the exchange rate between the US dolar and the Japanese yen had significant implications on the regional currencies. As long as the dollar strengthened against the yen, Asian currencies closely linked to the dollar would be in trouble.

Consistency of policy mix

Takashi Anzai, executive director of the Bank of Japan, focused on the issue of consistency of the policy mix, asserting that one could not simultaneously maintain the following three policies -- free capital flows, fixed exchange rate and an independent monetary policy.

About 20 years ago, Japan did not want to float the currency but had no other options. The largest component of demand came from the domestic sector, so priority was given to control over the interest rate. The exchange rate and capital flows were hence freed.

Anzai referred to Sheng's comment on the effect of yen appreciation on other Asian currencies, by saying that Asia had enjoyed the time during which the yen appreciated before. Given the present situation, Japan could not endure much further currency appreciation.

Moreover, the G-7 nations also agreed in April 1997 that the correction of the currency misalignment had already been sufficient.

Referring to the triable of impossibility, Latifah Merican Cheong, manager of Economics Department of Bank Negara Malaysia, said that Malaysia had relied on exchange and capital controls quite a few times in the past. These included the imposition of restrictions on offshore borrowing, especially to finance the purchase of stocks and property.

Nonetheless, the economic fundamentals played a crucial role, and the speculative attack on the ringgit still arose despite the existence of exchange control and restrictions.

While recognising that a prolonged control on capital flows could put friction and pressure on commercial banks, Latifah outlined the rationale behind BNM's adoption of the policy. In 1993-94, BNM managed the monetary aggregate to influence the interest rate, which was effectively hiked up to fight inflation. That led to an increase in capital inflows and prompted the need for capital restrictions.

The movement toward capital account liberalisation thus meant that the central bank would face a constraint in raising the interest rate to fight inflation. On the separation of onshore and offshore markets, Latifah pointed out that one limitation to such instrument in the case of the ringgit was the large volume of offshore transactions in Singapore and the New York Cotton Exchange.

Responding to Chaiyawat's question as to what central banks could do, individually or collectively, to stabilise the international financial markets, Latifah said central banks could get together to match information which would go towards correcting information asymmetry.

Anzai commented that if a country had a current account deficit, there would be a need for foreign capital inflows. So to impose capital controls would pose a contradiction. The country would also need to maintain higher interest rates to reflect the higher risk premium.

Bambang Trianto, director of Bank Indonesia's Foreign Exchange Department, said that the rupiah was not really affected by the speculative attack on the baht. The depreciation of the rupiah owed mostly to the rumour that BI would cancel the swap facility. When the rumour was denied, the market stabilised.

At the time of the ad hoc meeting, the rupiah was moving on the stronger side of the band. Bambang added that BI had widened the exchange rate band seven times between 1992 and 1996 to help discourage capital inflows. The widening of the band was timed to coincide with the appreciation of the rupiah to prevent problems in the market.

Dr Stephen Grenville, deputy governor of the Reserve Bank of Australia, said a central bank could widen the exchange rate band only in good times. He added that a central bank could make the economy less vulnerable to exchange rate movements by adopting good monetary and prudential policies.

Chen Yuan, executive deputy governor of the People's Bank of China, agreed that prudential policy at the microeconomic level could help prevent adverse effects of foreign exchange fluctuations on the macroeconomic level.

He also commented that most foreign direct investment to China was directed to project investment. Moreover, foreign financial institutions took heed of PBC's comments.

Mr Hoon Shim, assistant governor, Bank of Korea, said that there was no evidence that speculation actually destablised the economy. To avoid becoming vulnerable to speculative attack, however a country must maintain sound fundamentals.

Yeo comented the NY Cotton Exchange that in general a currency contract was not as successful as an interest rate contract because the cash market was far more liquid. One problem for the Asian currencies was the fact that the most active markets had trading hours, which were different from the local trading hours.

It would be preferable to keep the most liquid market in the same time zone, for that would provide convenience to policy announcements and intervention.

“Speculative attack was vicious”

Paiboon Kittisrikangwal, the division chief of the Bank of Thailand's Banking Department, said that the contradictory views expressed by different government officials might have played a part in triggering the currency attack since the market felt the central bank's broad-based political support might have been weakened for the currency defence.

Paiboon also said the speculative attack this year was particularly vicious, for it tried to force a change in policy regime as opposed to just taking some position under the existing regime.

The dilemma in policy execution was that the speculators' position depended on local commercial banks' liquidity, but at the same time it was the central bank, which ultimatedly supplied such liquidity. But, with shaken confidence and a fragile financial sector, the liquidity injection was necessary to shield the domestic market from the consequences of the policy to fight speculation.

Paiboon further said that the speculators spread false news, including the rumours that domestic residents, as opposed to offshore players, were the ones selling the baht. These speculators aimed for a big bang -- a currency devaluation by as much as 20-25 per cent.

Therefore, maintaining the high interest rate policy at what was considered reasonable, namely around 20 per cent, would not be enough to deter them.

For example, there were market reports that some speculators were rolling over their one-month position at the interest rate of more than 40 per cent just the day before. The speculators also had to launch the attack before macroeconomic and other indicators showed any sign of improvement, which could not happen if the interest rates had to remain high to fend off the currency attacks.

Hence, the most important question was how to break this vicious circle. The currency defence would come to nothing unless the economic fundamentals and situation in the financial sector improved.

Sheng interrupted by stressing that there was an adjustment asymmetry in the economy as well. In particular, the real sector was slow to adjust. The central bank had to buy time for the real sector to adjust. In addition, there was an issue of moral hazard. Commercial banks and hedge fund assumed that the central bank would underwrite all transactions, effectively assuming that international reserves could be transferred from the central bank to commercial banks.

The central bank must therefore monitor the off-balance sheet transactions of domestic banks, especially their foreign exchange and swap positions, very carefully.

Chaiyawat pointed out that the offshore speculators would have to settle their baht obligations eventually. So the issue following the identification of these players would be supervision. The BOT asked other central banks to help monitor financial institutions operating within their jurisdictions which might be taking large speculative currency position.

Sheng said that supervision by Hong Kong Monetary Authority would not be possible if the speculators operated through foreign investment banks.

Yeo added that commercial banks tried to economise and cut cost by having just one global book. If the book was handled in New York, for instance, monitoring would be difficult.

Chaiyawat then asked whether there were any measures the central bank community could do to limit the unregulated hedge funds' destabilising forces.

Anzai pointed out that the way to ward off speculation was to change the incentive structure such that the guarantee against risk to speculators would be removed. Greater exchange rate flexibility would be needed.

However, adopting more flexibility meant that those with foreign exchange debt -- such as domestic financial institutions -- would lose, and this would pose a microeconomic policy question. Correcting the real exchange rate was a macroeconomic issue, whereas ensuring stability of the financial institutions was a microeconomic issue.

Latifah informed the meeting that the IMF in Malaysia held a discussion on the role of the hedge funds. There were, however, divided views on the issue of capital account convertibility, with commercial banks supporting the move to liberalise.

Greenville suggested that EMEAP members convey to OECD nations that their banks should act better when coming to EMEAP markets. The View that market players could always beat the central banks should also be reversed.

Sheng said since the speculators had won against the G-3 countries, the EMEAP members must reflect hard on the appropriate solution to the problem.

Anzai commented that the speculators' resources amounted to US$1 trillion. That meant the central banks could not possibly win every time and perhaps should not try to win.

Finally, the meeting agreed to provide a low-key press statement, only mentioning that the informal meeting was convened to strengthen regional cooperation.

The statement was as follows: "As part of the regular meeting of Executives' Meeting of East Asia and Pacific (EMEAP) Central Banks, senior officials from nine central banks and monetary authorities met in Bangkok on May 24, 1997 to exchange views and information on recent market developments. The meeting has contributed to strengthening the cooperation among the central banks and monetary authorities in the region and enhancing the stability of the regional financial markets."

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