Dear Datuk Seri Dr. Mahathir,
Further to my letter of 27th June 1998, I believe that I have found the clue that will help us revive the economy and may recover the exchange rate. For me, personally, it is the accumulation of 6 to 7 years painstaking research to determine mathematically the stock market peak value. The elusive 'Holy grail' of my research is the liquidity in the banking system which has not been quoted publicly on a regular basis.
Let me explain how I look at the stock market as an economic indicator and relate this to our current situation before elaborating on how we could recover.
Rate of inflation / deflation
When I need to know the general or 'true' rate of inflation, as opposed to the Consumer Price Index, I search for clear and 'true' market bottoms. This does happen every so many years. For example the market bottomed 1992. The KLSE Composite Index was around 640 for December 1992. (As I have always created my own composite index (never used KLSE CI), I did not collect the KLSE Composite figures over these years. The actual figure is around 600-640 - KLSE Annual Companies Handbook.) True bottoms indicate the non inflated, non speculative, settled price of stocks. Hence are indicative of the general rate of inflation. The appreciated or depreciated value over the number of years will give the rate of inflation or deflation.
For example the CI in December 1992 was 640 and the CI now is 455 (it has moved higher for other reasons to be explained later in this letter). Hence the change is 455/640 = 0.71. This has occurred within a period of six (6) years. Hence, taking 0.71 to the sixth root gives us 0.944 which is a deflation of 5.5% per annum.
Lets take another example, if the CI had been 470 in 1988 (need to check this figure) and 640 in 1992 the increase in the CI would be 640/470 = 1.36. As this occurred over a period of 4 years the rate of inflation would be 4th root of 1.36 which gives 1.08. Hence the rate of inflation would be 8% per annum, unless one wants to consider that the inflationary rate within the Financial Economy is different from the inflationary rate of the Physical Economy.
As our CI has dropped from 640 to about 455 we are in for a deflation, if the Ringgit had not devalued. I believe that the devaluation of the Ringgit has annulled the onset of a severe recession which other Asian countries may face - they can be pulled out of it too.
Furthermore, I believe that some figure either at the market top or between the market bottom and market top is the rate of growth of the economy.
The Ringgit, Deflation and the Composite Index
As explained above, our expected deflation should have been around 5.5%. This deflation rate may not be noticeable as our Ringgit has devalued to 640/455*2.75 = 3.8 to the USD. You see the Ringgit has taken on the shock to the economy thereby buffered the physical economy from disaster, if we make the assumption that the depth of the fall was precipitated by a currency attack and not from a true drop in growth. The high interest rate will slow the physical economy as explained in my previous letters.
Hence in order to boost the economy to levels that reflect a slow down and not a recession the Composite Index has to be brought to about 640. This is the rated value at which, historically, the public had not noticed a slow down in the economy. Further more at this value of CI we are neither in a deflationary nor an inflationary economy.
If you look at the Ringgit devaluation trend the 'bulk' of the devaluation would have occurred around September - December 1997 period when the CI was dropping to or below the zero inflationary rate range of 600 - 700. Hence the first hypothesis we can draw from this phenomena is that a currency devaluation can be triggered 'permanently' when the CI drops to or below the previous CI true low. That is the local currency and the local physical economy has formed a new state of equilibrium. This drop of the CI to below its previous true low is a weak point of any economy. This also explains why previous devaluation on the Ringgit were temporary (my letter dated 5th June 1998), as the then CI true bottom did not breach the previous true bottom.
As economies are systems in various states of equilibrium, the effect should be reversible. That is making the CI approach 640 or higher should trigger the Ringgit to recover to RM2.75 to USD$1.
Recovery of the KLSE Composite Index
Upon examining the amount of money moved out of the country I have proportioned this to the drop in the CI. Our previous high was of the order of 1300 and our low is 455. Hence USD$32,000,000,000/- divided by 1300-455 gives USD$37,869,822/- per CI unit. That is the holding capacity of the financial markets is USD$38 million per CI unit increase.
Formula (1) . USD$ holding capacity per unit change in CI
USD$32,000,000,000 = USD$38 million per Unit of KLSE CI
(1300 - 455) (Approximately USD$40 million)
My guess is that this figure will change with time and will be proportional to the number of companies listed on the stock market. The more companies listed, the large will be the holding capacity. The question I would like to ask is that were there too many companies listed on the stock market for us to handle comfortably? If there was only one company listed on the stock market, it would not affect our physical economy but how many companies are required before it begins to affect the physical economy? Generally, the KLSE takes about a year to fall. Do we have enough reserves to contain another Ringgit devaluation?
Based upon my observations, when the stock market falls as in 1997 or bottoming out, as it is doing now, new listings would perform very poorly. The best time to have new listing is when the market has climbed at least 30% of the way to the top and has begun the bull run, as far as the layman is concerned (this includes the bankers!). 30% to the top? Historically, the CI increases by a factor of x1.5 to x2 (may be
Looking back at the events of a few days ago, dropping of the SRR brought back RM8 billion into the banking system, that is liquidity was increased by USD$2 billion. And the stock market responded to this by an increase of about 25 CI units to 478 (just below 480). That is an USD$80 million change in liquidity caused a change in CI by one unit.
change in KLSE CI = change in Liquidity/holding capacity * X ... Formula (2)
a state of equilibrium equation, where X = approx. 0.5
Does X reflect a drop in purchasing power to 50% (0.5) (my letter dated 27th June 1998) or does it reflect the ratio between the physical economy and the financial markets? I suspect the ratio can be calculated from the ratio of Market Capitalisation / Gross Domestic Product. For 1997 this would have been RM897 billion / RM280 billion = 3.2 .. For an estimate of 1998, based upon the CI drop, this ratio would be (897*455/1300)/280 = 0.69. The closeness of both figures may suggest that the ratio of the Market Capitalisation to Gross Domestic Product reflects the purchasing power of the consumer, i.e. his willingness to spend money. Also if these relations (MC/GDP & Formulae 1 & 2) holds water, it will provide the guideline as to how many companies can be listed on the KLSE based upon banking liquidity.
Lets do some reverse analysis and attempt to 'predict' what had occurred in order to check the validity of the above formula. In 1997 was the change in liquidity in the banking system of the order of :-
Between 1992 and 1997: 1992 CI low to CI 1997 high = 1300 - 640 = 660. Assuming that the holding capacity was about USD$38 million per CI unit, taking X to be between 0.5 to 3.2, the change in liquidity would have been in the region of 660*USD$38,000,000/0.5 = USD50.16 billion and 660*USD$38,000,000/3.2 = USD7.84 billion?
Between 1997 and 1998: 1997 CI high to CI 1998 low = 455 - 1300 = -845. Assuming that the holding capacity was about USD$38 million per CI unit, taking X to be between 0.5 to 3.2, the change in liquidity would have been in the region of 845*USD$38,000,000/3.2 = USD$10.03 billion and 845*USD$38,000,000/0.5 = USD$64.22 billion.
Do these figures sound about right?
If the X factor reflects the consumer purchasing power it can be brought to unity (1) or higher, by reducing prices of consumer products (remember the analysis of the car market and a drop in car prices of 15% to 20%) and lowering interest rates. Hence the CI can be made to climb faster with the increase in liquidity in the banking system.
How much liquidity is enough?
Our target KLSE CI should be 640 as mentioned above. This would be an increase in the CI of about 185 units. Using the equilibrium formula (2) the change in liquidity should be around 185*USD$38,000,000/0.5 = USD$14 billion. As the SRR drop has introduced USD$2 billion in liquidity a further USD$12 billion would be required which can be carried out in stages. That is change in liquidity requirement is based upon the X factor not approaching one (1) as liquidity is increased. If X factor does improve then we may only need a further USD$6 billion or less instead of USD$14 billion. I would like to have the exchange rate data from March to today to have a better understanding.
If we borrow this amount in USD$ we would need to pay back less Ringgit if and when the RM recovers. I do not know whether a specific rate of climb of the CI is required to pull up the Ringgit. Can our local fund managers inject some extra liquidity into the banking system?
My intention in showing simple mathematical relationships is to provide a good direction for the government to govern and not to indicate that economic systems are simplistic and not for calculation of exact values of final results, as economic systems are systems in transient, modelling of transient systems can be complex and pretty difficult.
I have used USD figures as the relation appears linear (or proportional) but I could have used the price of gold or any other unaffected unit of measure. If I had used RM the linear relationships and results would not have been observable. This lends me to believe that the financial markets are a distinct and separate system from the physical economy and like the meeting of two rivers, the financial markets and the physical economy interface at listed companies. Hence the movement of funds affect the physical economy. Remember, change in liquidity in the banking system and interest rates must move favourably for both the financial markets and the physical economy for us to recover as they are tied by a single currency - RM. If our stocks were listed in USD and / or Yen it would have been the US and Japanese governments problem to defend the USD and Yen. Is there any published record of the liquidity in the banking system over the last few years, how about from, as early as 1987?
High interest rates divert funds, consumer spending, from physical goods to servicing of higher interest rate loans. Thereby taking money out of the physical economy. This prevents business from growing. The only beneficiaries (Yes, I use that term as the rest of us will die) will be the banks.
Dear Sir, with respect, I would like to point out what was quoted in NST 6 July 1998, front page, about Tun Daim's speech about citizens in another country who had "taken flight" implying that they had abdicated their responsibility and were not patriotic to their country. Could you please ask him what they should have done when their youngest daughters and wives were systematically being raped? With a "Prosper Thy Neighbour" policy we should at least show more compassion to the innocent, the defenceless, the underprivileged, the hungry and those that are suffering, who ever they are. I do not remember anyone in Malaysia who spoke out for the Kuwaitis during the Gulf War and I assure you that I did have a lot of friends from both sides, Kuwait and Iraq - Christians and Muslims.
This article on the 4th letter to PM was reproduced here by Dr. Peter Achutha - 24 December 2017.