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The Doctor's Prescription... - Views on News from Equitymaster
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  • Sep 1, 1997

    The Doctor's Prescription...

    So it is finally out in the open. Malaysian Prime Minister, Dr Mahatir, has said what few people had the guts to say in front of an august gathering of global bankers and policy makers: Gentlemen, currency trading is an unnecessary evil - lets stop it.

    As the audience of policy makers, each out to prove their capitalist credentials to the army of World Bankers and IMF types, shrunk in their seats Dr Mahatir went on to use his international platform to speak about the jealousy and envy of the white skinned race against the success of the yellow and brown skinned population of the world. What happened in South East Asia (especially in Malaysia), he implied, was part of a global conspiracy.

    I will leave this race conspiracy theory out for the moment and focus on this clarion call to ban this unproductive, unnecessary thing called currency trading. First, a refresher on some numbers. The total daily trading volume in the currency markets is estimated to be over US$ 400 billion. The total daily global trade in goods and services is estimated to be about US$ 2 billion. This suggests that the trading of currency is supposed to be 200 times the need for the currency by actual users: the multinationals who sell dollars to buy Rupees when they have to pay for building factories in India; the exporters from Indonesia who convert their dollars into Rupiah; the importers from USA who convert their dollars into Ringitt to pay for palm oil or tin; the Philippine maids in the Middle East who sell their dollars to send Pesos back to their families. Each of these transactions needs a foreign exchange market. Dr Mahatir was not asking for banning this market - he was asking for banning the excessive trading and the speculation in the market. Not an unusual request, actually, considering that regulators have trading restrictions on some markets - even the share market.

    Take the case of ITC, an active stock on the Indian share bazaar. On a normal, high-strung speculative day, the ITC counter could clock in a trading volume of US$ 150 million - less than 3% of its total market capitalisation. The actual daily delivery of ITC shares is probably in the region of US$ 10 million. In this case, our excessively speculative stock markets (a common view of most regulators) is seeing activity in ITC at 15 times its physical demand. If ITC was a currency with a factor of 200 times trading volume versus physical demand, it would have a trading volume of US$ 2 billion every day - 13 times its present volumes! If you factor in the amount of money stock brokers make on share commissions on ITC's present volume, you will understand why there is an extremely rich and strong lobby of foreign exchange dealers around the world, who will not be too keen to dismantle this freewheeling currency market that throws economic planning to the wolves but gives fx traders a shot at a fortune for fairly unproductive work.

    Which takes me to the next argument of why currency trading in its present laissez-faire form is an unnecessary evil. Lets move again to the stock market. Remember the euphoria surrounding HDFC a few months ago? The stock zoomed from Rs 3,400 to Rs 4,600 within a few days in July on news that foreign investors were in queue to buy the share after the raising of the 24% limit. Well, two months later that stock is down to Rs 3,000 and HDFC has seen a US$ 800 million erosion in its market value. Has the fundamentals of the company worsened? Not that anyone seems to know of - not yet, anyway. But, yes, you batter the stock some more and every shareholder will start to get frightened and, at some point in the fear cycle, there will be a queue of sellers and no buyers. The stock price will plummet, HDFC's standing in the market will decline and it will be hard pressed for loans and it will be in bad financial shape. All this up and down movement caused by some people took a speculative position in HDFC which they got wrong. Replace HDFC for Malaysia which has a loss of US$ 150 billion in market cap and you will understand why Dr. Mahatir has thrown away his scalpel for an axe.

    Here was an economy which most economists were pretty comfortable with. Yes, there are allegations of crony capitalism, excessive spending on symbolic projects (the tallest buildings in the world), and concern over this ambition. But there was no doubting the strategy: educate the people, move up the value chain, be a base for multinationals, and give them the best infrastructure including a high technology super corridor. Sounds good to me. But now a lot of projects may have to be abandoned or will take longer than before to accomplish because the currency guys saw a Thailand blowout in every new construction and a current account deficit each time a multinational opened an office in Kuala Lampur. Malaysia will suffer slower growth suggesting that its people will grow richer but in a lot more time.

    The currency markets in their present form bear little resemblance to economic reality and, by the very might of their actions, the outcome of events are influenced to occur just as currency traders predicted. Remove the trading and delivery restrictions on the NSE and BSE and see how ITC gets to a price of Rs 1,000 this week and possibly Rs 10,000 next week. Once in a while, central bankers step in and make some noise (they don't have the firepower to match the markets, you see) about what their views of currency levels are, but the market pauses only to catch it breath before it runs in its own direction again. Since Bretton Woods, when the gold standard and the fixed currency regime was given up as failures, the world has moved to a managed currency system where central banks influenced exchange rates. But the last seven years has seen the growth of market forces that are now ready to take on - and pulverise - any central bank, be it the Bank of England or the Bank of Malaysia. And by their actions these fx traders influence economies and lives of people. Exchange rates are supposed to be a reflection of economic fundamentals, not determinants of it. May the Doctor's prescription not lie discarded on your table.



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