Monetary Reform in Malaysia : Policy and Implementation

Monetary Reform in Malaysia :Policy and Implementation

A report by Kreatoc Ltd.LondonDecember 2005

Monetary Reform in Malaysia: Policy and Implementation 1

CONTENTS

Introduction

Executive Summary

Key Implementation Processes

1. Reform Objectives1.1 The Need for Monetary Reform1.2 Economic Consequences of Fractional Reserve Banking1.3 Main Stages of the Reform Process1.4 Key Themes of the Reform Process

2. The Transition Phases

2.1 Phase One: Elimination of Bank Money Issuance2.2 Phase Two: Elimination of State Issued Reserve Money2.3 Post-reform Monetary Aggregates2.4 Monetary Oversight Committee

3. Policy Tools3.1 Fractional Reserves and Reserve Money3.2 Money and Bond Market Operations3.3 Provision of Temporary Assistance by the Public Sector3.4 Risk, Capital Requirements and Asset-liability Structure3.5 Central Bank Directives and Recommendations3.6 Foreign Exchange Market Intervention3.7 Establishment of Conduits for Temporary Refinancing of the Private Sector3.8 Financial Trading Strategies3.9 Restrictions and Disincentives to the Use of Interest-based Financing3.10 Encouragement of Public and Private Interest-free Finance Facilities

4. Implications for Financial Markets4.1 Financial Market Activity Post-reform4.2 Securities Market Regulation4.3 Capital Controls and Foreign Ownership Issues4.4 Foreign Exchange Market4.5 Precious Metals and Commodity Markets

5. Commercial Banking Position5.1 Forecast Balance Sheet5.2 Management of Changes in Statutory Reserve Ratio5.3 Account Types Post-reform5.4 Liquidity Management for Investment Accounts5.5 Forecast Impact Upon Profitability5.6 Costs of Payment Transmission Services5.7 Dual or Single Track Approach?

6. Federal Position6.1 Domestic Federal Debt Levels Post-reform6.2 Impact on Federal Debt Service6.3 Utilising the Monetisation Dividend6.4 Government Debt Maturity Profile6.5 Federal Revenue


7. Central Bank7.1 Main Balance Sheet Elements Post-reform7.2 Central Bank of Malaysia Act 1958

8. Some Relevant Empirical Data8.1 Long-run Changes in the Purchasing Power of Gold (USA & UK)8.2 Long-run Change in the Purchasing Power of Silver (USA)8.3 Average Annual Change in the Purchasing Power of Sterling8.4 Long-run Growth in US Dollar Money Stock8.5 Public plus Private Debt as a Percentage of GDP

9. Change Management Issues9.1 Consensual or Non-consensual Approach?9.2 Use of Existing Levers Where Possible9.3 Achieving Public Buy-in9.4 Transparency Versus Confidentiality9.5 Achieving Institutional Buy-in9.6 Opponent Strategies

Appendix One: Secular Themes1. Introduction2. Classical Theories of Money3. The Bullionists4. The Banking and Currency Schools5. Leon Walras6. Ludwig von Mises7. Tobin and Hicks8. Irving Fisher9. The Cambridge Economists10. Knut Wicksell

Appendix Two: Islamic ThemesIntroduction1. Paper Money as an IOU (an Evidence of Debt Owed to the Bearer)2. Paper Money as a Commodity3. Paper Money to be Treated as Fulus4. Paper Money as a Substitute for Gold and Silver

Appendix Three: Some Key Episodes in Monetary Reform1. Guernsey 18152. Lincoln’s Greenbacks 18623. The Federal Reserve 19134. Schwanenkirchen, Bavaria, 19305. Worgl, Austria, 1932

Appendix Four: Project Schedule

Appendix Five: Working Party Resources1. Informational Resources2. Human Resources3. Media Resources4. Financial Resources

References

Authors and Contact DetailsMonetary Reform in Malaysia: Policy and Implementation 3

INTRODUCTION

This paper is a development of an earlier discussion entitled Monetary Reform in Malaysia: Strategy and Resourcing. The strategic issues raised in that paper are addressed here in greater detail in order to establish a policy framework for monetary reform. For readers unfamiliar with the contents of the earlier paper, the need for monetary reform is summarised at the outset.

In a small number of cases, simplifying assumptions have been made in this report in order to provide a quantitative summary of the broader thrusts of the proposed reforms. Discussions with key personnel in the monetary and governmental authorities will enable a more detailed analysis and set of policy recommendations to be developed where such assumptions have been made. The resource requirements for the drawing up of such an analysis, which would be the third document to be produced in this series, are given in Appendix Four.

The discussions contained in this paper are divided into nine main sections and five appendices. Section One summarises arguments in favour of monetary reform and outlines the key reform phases and objectives for consideration by policy makers. Section Two provides details on the two reform phases proposed in Section One and includes an assessment of the impact on the main monetary indicators, while Section Three identifies the main policy levers that can be used to carry out the implementation. A forecast of the impact of the reforms upon the main financial markets and institutions is given in Section Four. Section Five provides an overview of the impact of reforms on the commercial banking system, and Section Six does so from the Federal perspective. Section Seven examines the central bank’s role in the reforms, in particular highlighting the relevance of existing statute to the reform process. Section Eight provides a brief analysis of relevant historical data, and Section Nine concludes with a look at change management issues. Academic ideas relevant to monetary theory in the secular world are summarised in Appendix One, while Appendix Two discusses various opinions on the nature of money under Shariàh. Appendix Three briefly describes some key historical events in monetary history that are of relevance to these discussions. A forecast resource requirement for the further development of these proposals and a related project implementation schedule are included in Appendices Four and Five respectively.

The data on which the paper is based are those for September 2004, being the most recent series of statistics available when preparation began.


EXECUTIVE SUMMARY

• The ceding to commercial banks of the right to create money has provided these institutions with a substantial economic advantage over the non-bank sector. This has resulted in a distortion in the allocation of society’s resources towards the provision of banking and financial services, and simultaneously damaged economic welfare in areas as diverse as wealth creation, wealth distribution, price and output volatility, and environmental sustainability.

• Removing the right of commercial banks to create money will lessen distortions in resource allocation, improve the quality of economic performance, and allow large scale net gains in wealth creation within the non-bank and non-financial sectors of the economy.

• Interest is a cornerstone upon which modern money creation is based, and its influence upon economic activity is reinforced because of this interconnection. Breaking the link between interest and money creation will lessen the damaging impact of interest-based finance.

• A Phase One reform is proposed in which the right to create money would be removed entirely from the commercial banks and placed under the control of the Government.

• The Phase One reform will enable a reduction of at least RM18.8 billion in Federal Government debt to be achieved. A total reduction of up to RM64 billion in public sector debt may be achieved during this period, depending upon the implementation methods adopted by the authorities.

• A minimum annual saving of some RM0.7 billion to the Federal Government budget will result from the Phase One reform. This saving in debt service may increase to as much as RM3 billion annually depending on the methods adopted by the authorities to implement the Phase One reform.

• An optional Phase Two reform is proposed in which the creation of money by the state authorities will be abandoned in favour of a market-led commodity based monetary system. The new currency unit will be denominated by weight, not by nominal value.

• Coincident with the Phase Two reform, the use of interest-based finance will be prohibited within Malaysia.

• Most current international and domestic operations presently in use by Malaysian financial institutions will continue unaffected throughout and after the reform process.

• The implementation of the two main reform objectives should be gradual so as to minimise sudden shocks to the domestic economy, and should allow for modifications in policy to be adopted in response to developments on the ground.

• Existing policy levers should be utilised to implement the reform proposals, where possible, so as to reduce the cost, administrative and legislative burdens involved.


KEY IMPLEMENTATION PROCESSES

Phase One

• Establishment of an independent Monetary Oversight Committee to implement, oversee and audit monetary reform processes.

• Creation of a minimum of RM64 billion in new reserve money by the state, as a direct obligation on the Treasury or through the issuance of interest-free Government securities to Bank Negara Malaysia.

• Injection into circulation of the newly created reserve money by means of redemption and repurchase of public sector debt, tax reductions, welfare payments and Federal expenditure over a period of three years from commencement of Phase One of the reform.

• Stepped increases in the required reserve ratios for commercial banks’ sight deposits to 100% over a period of three years, in tandem with the injection into circulation of newly created reserve money, thus restricting the issuance of new money to the state.

• Further issuance of state money to be undertaken under the supervision of the Monetary Oversight Committee in accordance with the performance of various defined price indices or other economic indicators.

• Prohibition of payment of any form of return by commercial banks to holders of sight deposits.

• Restriction of chequing facilities, electronic transfer and other on-demand withdrawal facilities to sight deposit accounts operated by commercial banks.

• Conversion of time deposits at banking institutions into investment accounts over a period of three years, such accounts to be operated on an off-balance sheet basis where withdrawal is dependent upon the liquidity of the underlying assets, subject to a minimum withdrawal notice period to be imposed by statutory instrument.

Phase Two

• Conversion of state issued fiat money into commodity money undertaken at market prices using a selected commodity or set of commodities as the new monetary medium.

• Establishment of commodity markets and bullion conversion facilities enabling commodity producers and purchasers to transact efficiently for the purpose of supplying and converting commodities for conversion into currency units.

• Abolition of interest-based financing techniques to be phased in over an agreed period.

• Promotion of equity based investment products, leasing and instalment purchase schemes within the private sector, through tax and other incentives.

• Provision of Government interest-free financing facilities for lower income groups.


1. REFORM OBJECTIVES

1.1. The Need for Monetary Reform

The modern model of commercial banking developed from the practices of European goldsmith bankers of seventeenth century England. These bankers took deposits of gold coins and in return issued receipts to depositors. The receipts in due course came to be used in payment for goods and services among merchants and others, and thereby came to be used not as receipts for money but rather as money itself. Eventually the bankers saw that they could alter their business model radically, by acting not as safe-keepers of gold but as lenders of money. When borrowers came to the bank to borrow money, what they would be given was not gold but newly printed paper receipts. The bankers had found a mechanism for creating money, and they did so in order to charge interest on the newly created amounts. One consequence of this banking model was that with each new unit of unbacked paper money issued by the bank, there would appear within society a debt corresponding to the loan that the banker had made.

Some commentators argued that if the banker had issued a receipt promising payment of a certain amount of gold, then he should have at least that amount in his vault in order to fulfil the promise if required. The banks however argued that traders would rarely seek to cash their receipts for gold at the banker’s office and the majority of gold on deposit in their vaults would therefore remain untouched for extended periods. It would therefore be safe to make promises to pay a greater amount of gold than existed on deposit in the bank vault.

Today the process of money creation by the commercial banking system is widely known as "fractional reserve banking" or "multiple deposit expansion" and while its techniques have become more sophisticated, the key principle remains the same. Commercial banks create money from nothing and lend it to society at interest. Whereas in the past the state issued gold coins and banks issued paper receipts, today it is the state that issues paper notes and electronic balances through the medium of the central bank, whilst the commercial banks use chequing facilities and accounts in order to pursue their own money creating activities. In the monetary systems of the modern economies, the majority of money supply is created by the commercial banking system.

For the purpose of the following discussions, money produced by the state will be referred to as "state” money, and that produced by the commercial banking system as "bank money". In more contemporary language, the former is referred to as “reserve money”, whilst the latter is normally the largest component of the common measures "M1", "M2" and "M4". Not all reserve money circulates freely, some being held in non-operational accounts at the central bank for example, hence the term “M0” is used to refer to the amount of reserve money in circulation outside the banking system, plus the amount held by the commercial banks in their operational accounts at the central bank, plus till cash.

1.2. Economic Consequences of Fractional Reserve Banking

1.2.1. Business CycleLargely as a consequence of the variation in the rate of money creation by the commercial banking system, a business cycle has developed that is unrelated to real factors such as climate variation or technological progress. When money creation by the commercial banking system increases sufficiently, the wider economy can experience boom conditions that are evidenced in due course by asset or consumer price inflation. At times when the rate of money creation decreases substantially, a contraction in business activity can result, accompanied in some cases by price deflation. The business cycle is not only an unnecessary feature of the modern economy, but one that can be highly damaging to economic development. Business and consumer confidence is undermined by economic volatility, long term planning and investment is discouraged and, once sacrificed to a recession, a firm's resources and business relationships may be irreparably damaged.


1.2.2. Endemic inflationGiven that commercial banks have the power to create new money at zero cost, it is a rational business strategy for them to maximise money creation within the existing regulatory regime. The greater the amount of money created, the greater their interest revenue and the greater their profit. The growth in money supply may not therefore be in accordance with the growth in the demand for money arising within the real economy because of growth in population or trade, for example. It is therefore the case that the volatile business cycle described above plays out against a backdrop of endemic inflation in every major economy over the longer term. Often, the inflation that is experienced is disguised in that asset prices are not included in headline inflation figures (for example, house prices are often excluded from retail price indices despite the fact that houses are the most expensive item that many individuals ever buy). A monetary system that suffers from endemic inflation is widely acknowledged to weaken confidence and distort decision making processes. Yet, where one or more public or private entities have the legal right to arbitrarily create new amounts of money to their own advantage, history testifies to the impossibility of achieving stability in the purchasing power of money over the longer term. It is therefore a common thread among reformers’ arguments that the legal privilege to create money with a face value higher than its factor cost should at the very least be removed from private entities, and ideally from public ones too.

1.2.3. Banking patronageThe ability to create money, and subsequently lend it, grants to the banking establishment a substantial power of patronage over other members of society. At a simple level this power takes the form of choosing which entrepreneurs to finance. At a more sinister level, it takes the form of supporting political ideologies that accord with the ambitions of banking institutions. The major lending nations have enjoyed the benefits of this power of patronage over debtor nations for several decades. It should not go unremarked that they have in part been granted this power by virtue of those many debtor nations who have decided to adopt Western currencies to satisfy their trading and investment needs.

1.2.4. Financial leverageThe fractional reserve banking system is largely responsible for the ascendancy of interest-based financing techniques within the modern economy. At the practical level this is evidenced by the emergence of financial leverage as the dominant business model among modern corporations. In this model, entrepreneurs undertake projects where forecast returns exceed interest costs, maximising the amount borrowed in order to maximise profits. As a result, small scale economic activity is sacrificed to ever larger scale production techniques, and local control over community activities is lost to distant corporate headquarters. This process is often accorded the term "globalisation".

1.2.5. Environmental degradationThe pervasive use of interest in modern finance has in turn sponsored the use of highly questionable tools in financial decision making. For example, discounted cash-flow analysis has been shown in a number of studies to be very short term in its scope, reducing significant long term costs to an insignificant present value component in a financial appraisal. This factor works alongside more direct practical expressions of the pressure than can be exerted upon human activity by a need to service interest-bearing debt. For example, the world’s major deforesting nations are also among its most indebted.

1.2.6. Wealth inequalityThe use of collateral as a criteria when making lending decisions is a key feature of interest-based finance. It often encourages resource allocation that is speculative, and promotes wealth inequality because wealthier members of society usually have the most collateral to offer as a basis for bank borrowing. To the extent that monetary reform reduces the role of interest-based commercial banking in business finance, there will be a commensurate longer term reduction in domestic wealth inequality.


1.2.7. Conflicts in monetary policyThe setting of short-term interest rates is a most common tool of monetary management in the modern economy, operating on the assumption that the level of interest rates determines the degree of borrowing and hence money supply expansion in an economy. In other words, management of the money supply is most commonly undertaken by affecting borrowers' ability to borrow, not lenders' ability to lend. In seeking to reduce new borrowing, increases in interest rates have the undesirable consequence of harming the cash-flows of all existing borrowers and are therefore a "blunt" weapon of economic policy. Meanwhile reductions in interest rates often spark a speculative boom as investors and speculators engage in financial leverage upon assets such as property in the expectation of future capital gains. In some circumstances, the level of interest rates must be chosen so as to satisfy two opposing requirements at the same time. This can be the case, for example, when high interest rates are deemed appropriate to support a weak currency while recession indicates that lower interest rates are necessary. Such circumstances produce impossible dilemmas for monetary authorities operating in an interest-based monetary environment.

1.2.8. Increased systemic riskThe potential for systemic collapse within the commercial banking system arises from a variety of factors including liquidity shortage, volatility of interest rates and alterations in the purchasing power of the currency unit. A sudden change in any of these three components carries with it a major risk to confidence in such spheres as domestic investment, transaction turnover and bank liquidity. These risks manifest themselves in the form of hyperinflation, wild currency fluctuations, volatile interest rates, and the occasional bank run (Indonesia 1997, Argentina 2003). Systemic risks are typically higher in the less developed economies. Here, monetary policy may be lax or politically motivated, debt service ratios (debt repayment as a percentage of export revenue) may be high, regulatory regimes weak, institutional mismanagement more common and personal financial behaviour less predictable. Within the more advanced economies, whilst such risks exist, their appearance is usually more prominently and publicly heralded due to the transparency of the relevant monitoring systems allowing economic agents the opportunity to take pre-emptive action. Nevertheless, in both advanced and lesser developed economies, monetary reform remains one of the lowest cost opportunities for risk reduction.

1.2.9. Resource misallocationBy the removal of the subsidy to commercial banking that is granted by the privilege to engage in fractional reserve banking, resource allocation to the rest of the economy will improve greatly. We believe that the necessary provision of payments and transaction services will remain at levels sufficient to support public sector, commercial and household economic activity, but there will undoubtedly be a reduction in the number of banking institutions competing for such business. The redirection of resources from banking and finance to the health, education and construction sectors for example, cannot be achieved overnight of course. The development of a carefully thought out restructuring policy for such areas as bank mergers, retraining and educational grants will be required, with the objective of minimising transitional unemployment during the reform process.

1.2.10. Public and private sector indebtednessAs the bulk of modern money supply is created by means of interest bearing loans, money has effectively become the balance sheet counterpart to interest bearing debt at the macro-economic level. The indebtedness of private individuals, corporations and the public sector has its roots in this relationship between money and debt. Reductions in debt imply reductions in money supply, hence efforts to repay the debts of a nation can be the cause of severe recessions. Sustained long term increases in indebtedness are therefore a feature of developed and developing economies. In Malaysia, total private and public sector indebtedness to the banking system increased from 60% to 139% of GDP between 1970 and 1993. Debt service payments on government debt currently run at RM10,546 million (2003), more than


the entire Malaysian education budget. The monetary reform proposals outlined in this document would enable a gradual reduction in both private and public sector indebtedness, and would in the process reduce public sector interest charges substantially.

1.2.11. A note on the efficiency of the payment and clearing systemThe reduced cost of banking services is often cited as an argument in favour of money creation, since the profits derived from it cross-subsidise the payment and clearing system. Putting aside the wider economic costs of the fractional reserve system, if the price of payment transmission services under the reformed system comes to reflect the true cost of service provision, then this would be the more efficient position to adopt from an orthodox economic perspective.

1.2.12. A note on qualitative consequencesThe consequences of permanent indebtedness for society as a whole, particularly the household sector, are wide-ranging and substantial. Aggressive competition in the market economy is in part a by-product of the unnatural shortage of money that results under present monetary arrangements. Stress caused by heavy indebtedness affects the individual and the corporate executive with further pressures that need not be documented here. The large scale nature of modern business processes produces a physical environment in which the human scale is sacrificed to that obtained by economies of scale. Two very visible consequences include anonymous modern housing developments that predominate over older individualistic construction, and monopolistic supermarket outlets that smother smaller enterprises and market traders. While it is wrong to claim that such symptoms are entirely caused by the fractional reserve system, it is also true that they are greatly encouraged by it. They are some of the features of the system that our reforms target, features that are seldom discussed, difficult to quantify, but widely felt.

1.3. Main Stages of the Reform Process

The reform process contemplated in this document comprises two main phases, the first or both of which may be implemented.

In the first phase of reform (“Phase One”), the right of private profit-seeking institutions to create part of the monetary aggregates would be removed in a gradual process of restriction that could be implemented over a period of some three years. The precise policies adopted within this first transition period would be determined in accordance with the institutional, political and economic circumstances of the time. The target position at the end of the Phase One reform would be a monetary system in which a public sector authority would have vested in it the sole right to create money in the same form as the present monetary base (“reserve money”). Existing commercial banking institutions would continue to operate as providers of financial services and payment transmission services. In effecting this change, commercial banks would be required to maintain 100% reserves of reserve money against customers’ sight deposits. Term deposits would attract no reserve requirements and the nature of a term deposit would be redefined over time such that redemption would be at the deposit-taking institution’s option, subject to its liquidity position, upon a minimum notice period. The link between the creation of money and the creation of interest-bearing debt would thereby be broken. In the second phase of reform (“Phase Two”), the public sector monetary authority would yield its role of money creation to an entirely market-based system in which a chosen commodity, or set of commodities, would be adopted as the domestic monetary medium. Any economic agent wishing to act as a producer of money would then have the right to do so, in effect by mining or otherwise accumulating the specified commodities in refined form, and presenting them to the relevant regulatory authority for assessment and exchange into monetary medium under strict and transparent quality standards. The specified commodities need not circulate as minted coinage only. Instead, warehouse deposits of commodity in bullion form could be established under Government authority, operating as a centralised custodian through which electronic transfers could take place between larger account holders.


The exchange value of the new money would be established by free market processes, not by Government decree, and because the supply of commodity money would depend in general terms upon production costs, a firm anchor would exist to tie the monetary system to the real economy. In such a system, the level of money supply could not easily be destabilised by politically motivated action. Precious metals have traditionally played the role of commodity money, though more modern proposals have been made for the creation of a commodity basket in which warehouse receipts fulfil the role of the monetary medium whilst simultaneously standing in evidence of a claim to physical commodities held at specified warehouses (B. Lietaer, The Future of Money, 2001).

The transitions between the structure of the present monetary system and that obtained following the Phase Two reforms will require delicate management, given the various commercial and political lobbies involved, and the need to protect the domestic economy from external and internal disturbances. Detailed specifications would need to be drawn up if a process of reform is decided upon, addressing in more detail the basic themes highlighted in this document, and mapping the relevant processes for each institution affected by the proposals. This would apply, for example, to central banking and commercial banking operations, financial market regulation, and markets for foreign exchange and other financial assets.

1.4. Key Themes of the Reform Process

1.4.1. Staged process with pilot implementationThe reform process should be implemented in carefully designed stages, some of which could be piloted so as to test the implementation framework and monitor early feedback in the form of quantitative and qualitative information. It will be necessary to develop a common project language, measurement tools and to set benchmarks against which performance can be measured. In a small number of cases, it may be necessary to establish suitable monitoring capabilities where none presently exist.

1.4.2. Low-risk strategyThe implementation strategy emphasises a low-risk approach to reform such that authorisation for each stage in the process would depend upon suitable feedback from prior stages. Sudden major changes to the framework of the monetary system are to be avoided wherever possible, with the utilisation of existing operating and regulatory infrastructure wherever possible.

1.4.3. Identification of “quick wins”A small number of quick wins may be identified and will no doubt assist in gaining political support for the reform process. For example, a substantial tax reduction or series of major public projects could be funded from the savings to the Federal budget that are identified in this paper. Also, the imposition or lowering of maximum interest charges on certain kinds of financing facility will prove popular among a large section of the public. These types of quick win could be promoted and undertaken early in the reform process, if indeed the issue of reform is to be placed within the public domain at all.

1.4.4. Change managementIt would be necessary to design the implementation framework with regard to political confidentiality and sensitivities in the financial markets. Attention should therefore be paid to issues in change management when planning the reforms. These plans would encompass the major issues of objective setting, resourcing, buy-in, scheduling and risk management.


2. THE TRANSITION PHASES

2.1. Phase One: Elimination of Bank Money Issuance

2.1.1. Formal restructuring of time and sight depositsIn order to restrict the issuance of new amounts of money supply to the state sector, it will first be necessary to formally define the nature of money within the banking system. The current variety of monetary aggregates reflects an uncertainty as to what precisely constitutes money in a modern setting. The increased variety of measurement statistics in many countries (M1, M2, M3 or M4 for example) reflects in part a cat and mouse game that has developed over recent decades between regulators and commercial banks, in which each attempt to control the growth of a particular monetary aggregate leads to the innovation of new account types that fall outside the existing definition of the targeted aggregate and are therefore not subject to the formal control of the authorities. By formally restructuring time and sight deposits within the commercial banks along the lines suggested below, the monetary structure can to some extent be simplified, allowing a less complex monetary policy to prevail following the transition to state money.

2.1.2. Withdrawal from sight depositsTo effect the Phase One reforms, a requirement would be imposed that unconditional withdrawal facilities through cheque, card and other transfer facilities should exist only for sight deposit accounts at commercial banks. 100% reserves of reserve money will be required against sight deposits and it will be prohibited for a banking institution to offer depositors a return or profit of any kind on these deposits. Such a law would echo the prohibition upon the payment of interest on sight deposits that existed for much of the twentieth century in the United States of America.

2.1.3. Withdrawal from investment accountsWithdrawal from all other commercial bank accounts, to be defined in due course as “investment accounts”, would be subject to the liquidity position of the financial institution in question. Such a restriction need not in fact be onerous upon the investment account holder, since the deposit-taking institution may in practice be able to meet requests for redemption of investment accounts by allocating the balance in question to another existing customer or to a new customer. A minimum notice period of perhaps one month would be imposed on withdrawals from investment accounts by means of statutory instrument. The principle under which investment accounts operate would be that funds placed with a banking institution cannot be available for withdrawal if they are simultaneously invested elsewhere.

2.1.4. Length of transition periodThe new account system would be introduced during the Phase One transition, a period of perhaps three years. During this transition, time deposits might exist side by side with the new investment account system, although these two types of account would be regulated in different ways. New accounts opened during Phase One would be established as investment accounts, and holders of time deposit accounts would be required to transfer their balances into either sight deposit accounts or into investment accounts that matched their investment preferences by the end of Phase One. For example, investment accounts of different risk and return profiles could be established by commercial banking organisations, into which existing loan assets were pooled according to type and term, with basic historical and forecast performance data provided to aid the term deposit holder’s investment decision.

2.1.5. Measurement of money supply under reformed systemUnder the reformed monetary structure, domestic money supply would unambiguously be identified as the value of notes and coins in circulation outside the banking system, sight deposits within commercial banks, and other deposits of a minor nature (for example at the central bank). Formally speaking, M0, reserve money and M1 would each assume much more similar values than is presently the case.


2.1.6. Potential shift to sight depositsIt is to be expected that given the change in the nature of time deposits following the reform, there could be a fairly sizeable shift in preference for deposit type among depositors from time deposits to sight deposits, since only the latter type of account would allow immediate withdrawal through chequing or similar transfer services. (Acting against this trend will be the fact that sight deposits will not earn any kind of return for the depositor.) The policy mechanisms described in this report are fully able to cope with such a shift in deposit preferences. However, for the time being, our proposals assume that sight deposits will remain at their existing level during the reform period and that all term deposits will be converted into investment accounts.

2.1.7. Provision of new reservesA substantial increase will be required in the reserve holdings of commercial banks as a result of the move to 100% reserves against sight deposits. This change would be achieved in steps during Phase One, in keeping with appropriate changes in reserve requirements. The Government, or more likely Bank Negara Malaysia as its agent, would first create the amounts of new reserve money that are required (see Section 3.1.2) and then inject them into circulation (see Section 3.1.3). Contemporaneous with the creation and injection of each new amount of reserve money, the statutory reserve ratio imposed upon the commercial banks would be increased in respect of sight deposits. The speed of implementation for each change in the reserve ratio and phasing-out of time deposits would be forecast using the central bank’s existing modelling resources, in order to neutralise the impact of the expansion of the monetary base upon M1 and the other wider monetary aggregates as presently defined. In other words, commercial banks would not be able to use the newly issued amounts of reserve money to expand the volumes of their own own money creation at any stage prior to the achievement of 100% reserves against sight deposits. In this way the potential for domestic inflation and currency weakness to result from an expansion of the monetary base would be removed. It would be necessary to set each phased increase in the minimum reserve ratio at a level that did not prejudice the operation of any one commercial bank. Regulators would need to avoid sponsoring a position in which one commercial bank, or one segment of the commercial banking sector, was forced to make substantial adjustments in its lending volumes whilst others went relatively unaffected. For example, any sudden calling in of overdraft facilities from borrowers by commercial banks in an effort to achieve newly increased minimum reserve ratios on sight deposits would need to be avoided. This could be done by adopting a stratified approach to determining reserve ratios, based upon the type of commercial bank involved and the size of each deposit against which the reserve was to be calculated.

2.1.8. Finance companiesFinance companies, being generally prohibited from offering sight deposit accounts, would be largely shielded from the changes described so far. It has been assumed here that the present requirement upon them to hold a statutory reserve will be phased out since the bulk of their deposit taking is on a time deposit basis, and such accounts will be replaced by investment accounts in due course.

2.1.9. Removal of automatic withdrawal rights on time deposits and investment accountsThe right to on-demand redemption of time deposit accounts would be removed gradually, possibly by statutory enforcement during Phase One. The minimum notice period for withdrawal from investment accounts would be a condition of such accounts from commencement, again by statute. Reserve ratios for existing time deposits could be imposed as a temporary disincentive to the deposit-taking sector to maintain such accounts in operation. Subject to commitments under international agreements, the calculation of capital adequacy ratios may also be modified so as to reflect preferential treatment for the new investment accounts. Such a change would seem warranted since the liquidity risk on investment accounts would, by definition, be negligible as far as the deposit-taking institution is concerned.


2.1.10. Inflationary consequences?The target position on the commercial banking sector’s balance sheet would be for reserve money to replace interest-bearing loans and securities, particularly public sector debt. There would be no inflationary impact to this change, since money supply would not alter in total, as presently defined, but rather in composition. In the case that interest-bearing securities held by the non-bank sector were purchased for the purpose of injecting new amounts of reserve money into circulation, private sector holders would subsequently have the option to hold sight deposits or cash, or acquire new financial assets in the form of investment account holdings or other assets. Here, the central bank would monitor changes in the distribution of holdings of sight deposits and financial assets by the various sectors as each injection of reserve money takes place, so as to ensure a smooth transition to 100% reserves whilst minimising instability in the wider monetary aggregates.

2.1.11. Publicly funded safety netFaced with radical attempts to curtail their profitability, some privately controlled banking institutions may be tempted to call in loans whether or not their position was in danger of breaching the newly established minimum reserve requirement, in order to create the public perception that the reform process was damaging to economic performance. Government should be prepared to react quickly to any such developments, for example by making standard loan and overdraft facilities available to the private sector on a fast-track basis through favoured institutions, perhaps through commercial banks presently under its control. Such facilities could be advertised in advance of any potential need.

2.2. Phase Two: Elimination of State Issued Reserve Money

2.2.1. Transition to commodity money systemDuring Phase Two, a transition would be made from a system in which reserve money is issued by the state (in other words, a fiat money system) to a system in which it is constituted as one or more commodities. This stage of reform would therefore remove the right of the state authority to create money with an exchange value above its factor cost. The newly defined commodity money could circulate in specie (bullion minted into coinage) or in the form of receipts (physical or electronic) issued by an appropriate state institution with warehouse stocks held on a 100% reserve basis against the circulating volume of such receipts. The warehouse facility could be established as a trust for all holders of commodity reserve receipts. Commodity money could be spent at point of sale, or deposited into sight deposits or investment accounts at commercial banks, as before. 100% reserve ratios would be held by the commercial banks against sight deposits of commodity reserve money, also as before.

2.2.2. Steps in Phase TwoThe Phase Two transition from state issued reserve money to commodity based reserve money can be achieved in three steps. In step one, the central bank would acquire sufficient amounts of the chosen commodity (or commodities) in exchange for existing financial assets (foreign exchange for example). Such acquisition would be gradual in order to achieve an optimum average price for open market purchases of the commodity (or commodities). In the second step, the acquired commodity reserves would be transferred to a newly established reserve account whose purpose would be to support the outstanding fiat reserve circulation on a one-for-one basis in terms of market value. Thus, for example, if the central bank’s reserve money issuance prior to the establishment of the reserve account was RM80 billion, the reserve account would in due course hold RM80 billion of the chosen commodity. In step three of the transition, fiat reserve money in circulation or held in commercial bank accounts would be made fully convertible into the warehouse stocks by Government decree, and at a rate of exchange determined in accordance with the market value of the bullion prevailing at the time of the decree. Holders of state issued reserve money would from this point onwards be permitted to present their holdings (physically in the form of notes or coins, or by transfer from a commercial bank sight deposit account) to the appointed warehouse office and require redemption in bullion form. Existing pre-


reform base metal coinage would be retired from circulation and replaced by a new coinage minted from the chosen commodity in weights and purities that equate with the prescribed exchange rate between Ringgit and bullion. Thereafter, the exchange value of the new commodity money would be largely determined by the performance of the global market for the underlying commodity bullion.

2.2.3. Commodity selectionAs a result of the commoditisation process, the unit of currency would assume the status of a defined weight of one or more commodities, in contrast to the previously existing abstract nominal value. The new commodity system could be restricted to a single commodity or expanded to include a variety of commodities. One or more of gold, silver, platinum, palladium, copper and other storable homogeneous commodities might be approved for adoption as the unit of currency within the domestic system. Such may occur under a number of different systems of implementation. For example, under a gold commodity reserve money system, fifty Ringgit might be exchangeable for one gramme of gold. Under a commodity basket reserve money system, fifty Ringgit might be exchangeable into half a gramme of gold and thirty grammes of silver. Or under a bimetallic system, a gold Ringgit and a silver Ringgit would circulate side by side, each convertible at fixed exchange rates into their respective bullions, and sellers would be free to choose in which of these two currencies they denominated their prices. The key elements throughout would be the definition of the Ringgit as a commodity weight, and the holding of 100% reserves (both of bullion at the warehouse against reserve money issued, and of reserve money held by commercial banks against customers’ sight deposits).

2.2.4. Naming conventionsThe naming convention adopted for the new commodity based currency might depend upon the nature of the commodity selected. Under the commodity basket approach, the naming convention would be flexible. Here, the term “Ringgit” could be retained though it would thenceforth be defined as a specified set of weights of constituent commodities. Under a bimetallic or multi-metallic system, each commodity would behave as a separate sub-currency. Here one might encounter the Gold Ringgit, the Silver Ringgit or the Platinum Ringgit.

2.2.5. Establishment of free-market mechanisms for supply of commodity moneyThe central bank would arrange for the conversion of bullion into currency units, and vice versa, by establishing a currency conversion office at one or more physical locations. A feasible location for one or more conversion offices would be in proximity to the warehouse facilities used for the storage of the underlying commodity (or commodities) in bullion form, or near to the industrial processing facility that would be used for processing commodities from bullion form into minted circulating coinage. The conversion facility would allow producers and wholesale traders of commodities to convert their bullion production into legal tender currency, and thereby create a market based process for the supply or withdrawal of commodity money to and from the monetary system. Producers of underlying commodities would supply them for conversion into currency units at times when the costs of commodity production were low (relative to the value of the commodities so produced). Hence, at times of money supply “tightness”, the incentive would be for suppliers to increase the supply of the commodity to the conversion office, thereby relieving the monetary tightness. Conversely, by allowing holders of currency units the opportunity to convert them back into the underlying commodity form (for example, from coin or deposit into gold bullion) a link would also be established in the opposite direction, providing access to bullion should the currency unit be perceived as undervalued relative to the costs of commodity production. Therefore, a self-correcting market based mechanism for the production of money would come into operation, responding to the price signals generated in the capital goods and commodities markets rather than to interest rates and speculative flows.

2.2.6. Link between commodity money and bullionFollowing the introduction of commodity based money, exchanges of countervalues


throughout the economy would be undertaken by agents with at least some reference to the wholesale price for the underlying bullion in terms of foreign currencies. Of course, there would be no domestic “Ringgit price” for the underlying bullion, since the Ringgit would be defined in terms of bullion by law. Hence the availability of two-way dealing prices in foreign currencies for underlying bullion would be an important element in improving the transparency and efficiency of the new system. The provision of such a facility domestically should be considered.

2.2.7. Public sector buffer stockThe potential for state authorities to establish a buffer stock of underlying commodities and foreign currency assets might also be considered as a means of smoothing any violent swings in the underlying commodity markets during the early years of implementation, and to provide a two-way domestic commodity market with liquidity and sufficient stock levels, as required.

2.3. Post-reform Monetary Aggregates

2.3.1. Longer-term trends in narrow measures of money supply

The upward progression over time of both reserve money and demand deposits is a feature of modern economies. (The severe fluctuation in reserve money shown here for Malaysia in the 1990’s coincides with a period that saw a substantial reversal in GDP growth and heavy downward pressure on the Ringgit exchange rate.) In common with other modern economies, the upward trend in the various monetary aggregates is in due course re-established following such downturns. We suggest that this feature is in keeping with the demands of an interest-based financial system. The application of a positive interest rate to debt and money balances within the banking system requires


such a trend in the longer term. Attempts to achieve stability or contraction of debt and money balances generally sponsors stagnancy or contraction in economic performance. Policy makers have therefore tended to shun such attempts in most countries, most of the time. Expansion of the debt and money aggregates is, in effect, the only politically acceptable economic policy to adopt under the current monetary framework.

2.3.2. Proposed narrow money aggregates post-reformThe current and proposed structure of narrow monetary aggregates is shown in the following chart. While there need be no change in conventional measures of M1, currency in circulation, or demand deposits as a result of the Phase One reforms, we should bear in mind our earlier view that holders of time deposits under the present banking arrangements may request to switch their holdings to sight deposits in order to have immediate access to liquidity. It is also possible, though much less likely, that switching will occur in the other direction (i.e. from sight deposits to time deposits).

2.3.3. Change in reserve moneyThe authorities will need to carefully monitor the degree of switching between time deposits and sight deposits during Phase One because if such developments occur to any substantial degree the amount of newly issued reserve money may need to be altered from that envisaged below. The volume of newly issued reserve money may need to be amended further to cater for changes in demand from the commercial banking system arising from economic growth or other factors not related to the reform process. Since the transition period will be implemented over a period of several years, there should be ample opportunity to modify the rate of increase of statutory reserve ratios and reserve money issuance to cater for such developments. Assuming no net switching between time and sight deposits, we propose that a minimum of approximately RM64


billion of new reserve money is issued by the authorities during Phase One in the manner described in Sections 3.1.2 and 3.1.3 (although if net switching does occur, it can be accommodated by the “monetisation” mechanisms proposed there). As a result of these monetisations, commercial banks’ holdings of reserve money in due course become equal to sight deposits allowing them to achieve 100% reserves ratios against those accounts. Given the requirement to hold 100% reserves, the concept of an “excess reserve” loses much of its meaning. Excess reserves presently held by commercial banks are combined into the total for required reserves and the total for this category therefore reduces to RM229 million in the proposed monetary structure. Notice also that currency in circulation is assumed to remain unaltered at RM26.8 billion. However, if holders decide to deposit cash or withdraw it from sight deposits at commercial banks, this may have a material effect on actual reserve ratios and will again need to be monitored by the authorities throughout the transition in order that appropriate adjustments can be made to the monetisation process.

2.4. Monetary Oversight Committee

A Monetary Oversight Committee will be established to implement and monitor monetary policy during the first and second phases of reform. This regulator would be established upon an independent constitution, its system of appointments and source of funding specified under law, and its operations audited by independent external auditors so as to minimise the potential for political interference and conflicts of interest to affect its operations. 2.4.1. First reform phase

During the first phase of reform, the committee’s objective would be to maintain the rate of inflation of a specified price index or GDP deflator within agreed bounds. An example in this regard is the use of the commodity index system proposed by


Professor Irving Fisher (100% Money, 1936) for guiding the expansion or contraction of reserve money issuance, according to the degree of inflationary pressure apparent in the index. It is possible that various forms of index be adopted, an average of regional indices for example, narrow or wide in their constituent components, but in each case chosen so as to avoid sensitivity to speculative activity, sector-specific events, and political manipulation. (If there is a strong intention to proceed to a Phase Two reform in due course, it would be preferable to adopt a commodity-based index that reflected the scope of the commodities to be adopted in the Phase Two transition.) During Phase One, the committee would:

2.4.1.1. Audit the issuance of reserve money by the Government2.4.1.2. Collect the statistics necessary for the performance of its work. 2.4.1.3. Disseminate the guidelines under which the committee works in public, along

with key statistical information on such matters as reserve money issuance and price index data, thereby imposing a degree of transparency upon the issuing authorities.

2.4.1.4. Act to ensure adherence within the deposit taking sector to the requirement for 100% reserves against sight deposits

2.4.1.5. Monitor developments that may undermine the intended operation of the new monetary system, particularly with regard to financial innovation. Of particular concern in this regard would be attempts to create new forms of account that technically fell within the definition of investment accounts but that offered liquidity on the same basis as that of sight deposits in order to avoid the 100% reserve requirement.

2.4.2. Second reform phaseFollowing the abolition of state issued reserve money in favour of commodity reserve money, the monetary oversight committee would perform the following functions:

2.4.2.1. Establish and operate warehouse facilities across Malaysia where refined bullion and commodity coinage can be held on an allocated basis (meaning that separately identifiable storage palettes would be allocated to each customer) on behalf of commercial banks and other large accounts

2.4.2.2. Establish and operate various branch locations where refined bullion can be assayed on behalf of private and public sector counterparties

2.4.2.3. Accept assayed bullion in return for issuing minted commodity coinage or credits at the Government warehouse facility

2.4.2.4. Establish and operate industrial facilities where bullion is converted into minted coinage for circulation as cash

2.4.2.5. Monitor and regulate adherence to agreed standards of fineness and weight for minted coinage in circulation, including monitoring of abuses (for example clipping of coinage)

2.4.2.6. Research new technology for improving the security of commodity coinage in circulation (for example, the embedding of precious metal in clear plastic for circulation)

2.4.2.7. Research new technology for improving the efficiency of the payment system.2.4.2.8. As 2.4.1.4 above.2.4.2.9. As 2.4.1.5 above.


3. POLICY TOOLS

3.1. Fractional Reserves and Reserve Money

3.1.1. Synchronisation of changes in fractional reserves and reserve moneyEach stepped increase in the required reserve ratio for commercial banks would, in the absence of corrective action, produce a contraction of M1 and the wider monetary aggregates which could be highly damaging to domestic economic activity. Hence Bank Negara Malaysia will need to accurately estimate and monitor the amount of newly issued reserve money required in order to avoid a material variation of wider aggregates. Each new increase in the statutory reserve ratio would be announced in advance and implemented simultaneously with the monetisation so as to allow commercial banks the opportunity to readjust their reserve holdings and deposit portfolios to accord with the new ratios. The size of such increases in the reserve ratio could be of the order of 0.5% per step initially, increasing to perhaps 2.5% per step in due course. It is worth repeating that, as a result of the higher statutory reserves, commercial banks will not be able to use newly created amounts of reserve money as a base for expanding their lending. To the extent that finance companies and merchant banks are not involved in the creation of bank money, the reserve ratio requirements will be removed from them in due course. This is on the basis that finance companies and merchant banks are not operating accounts with sight deposit features. However, pending consultation with the relevant authorities, the present reserve requirements upon both finance companies and merchant banks are maintained within the proposed figures.


3.1.2. Creation of new reserve moneyThe required new amounts of reserve money may be created in one of two ways:

3.1.2.1. As a direct liability upon the Treasury in the form of non-interest bearing notes denominated in Ringgit and specified as legal tender. This would probably require an amendment to the Central Bank of Malaysia Act (see Section 7.3) and hence may be less preferable than the alternative measure.

3.1.2.2. Through the issuance of new reserve money by the central bank in return for the issuance of non-interest bearing Government securities or Treasury Bills. In this regard, it is worth considering the issuance of a new class of Government securities, perhaps named Reform Bonds, being callable and having long term tenors, in order to complete such a transaction. This would avoid the need for refinancing of the position at an early stage, and would allow the Government to retire the Reform Bonds at a later stage if deemed necessary for the purpose of monetary management. At any time following the call date, callable Reform Bonds could be repurchased at par from Bank Negara Malaysia (or from the open market if such securities had by then been sold on). The question of interest charges by Bank Negara Malaysia on its financing of Government borrowing is of course immaterial from a commercial point of view, since much of the Bank’s net profit is returned to Government. Nevertheless, since the main theme of the monetary reform proposed in this document is that newly created money need not be the by-product of an interest-bearing loan, it would seem in tune with the thrust of the reform that such securities are issued on a non-interest-bearing basis. This would not prevent the selling on of Reform Bonds to market participants as zero-coupon bonds, and would indeed provide an investment asset for these participants until such time as interest-bearing financial instruments were abolished during Phase Two.

3.1.3. Injecting new reserve money into circulationFour methods of injecting new reserve money into the commercial banking system are considered here. The first two are direct methods and the last two indirect. An indirect injection may or may not filter through to a new sight deposit at a commercial bank, and its impact is therefore less certain than a direct injection. The processes of redemption or repurchase of public sector debt considered here for adoption by the authorities might also be applied to debts issued by the private sector, given the necessary commercial and political approvals. Such purchases could be implemented at market prices using the facilities of institutions (such as Cagamas) that already purchase and aggregate loans from financial institutions as part of their securitisation activities. The five monetisation methods under consideration are:

3.1.3.1. The purchase or redemption of commercial banks’ existing holdings of public sector debt (Treasury bills, Government securities, Central Bank obligations and debts of public sector corporations) will inject new reserves directly into the operational accounts of the commercial banks at Bank Negara and thereby allow them to meet the newly increased reserve ratios with a high degree of certainty. Government debt held by the commercial banking sector may be redeemed as those debts mature, without recourse to refinancing of the maturing amounts through new issues on the part of the Government. This would provide a natural and gradual schedule to the monetisation process.

3.1.3.2. Lending to the commercial banks on a discretionary basis where necessary at a 0% rate of interest, for example through overdraft facilities at the central bank, may be considered as a short term method.

3.1.3.3. Government debt held by the non-bank sector may be redeemed or repurchased. The Employees Provident Fund could be a participant in such an operation due to its existing relationship with the governing authorities.

3.1.3.4. Government expenditure, welfare programmes and tax rebates could be funded with new issues of reserve money. Recipients could hold the payments as cash, deposit them into sight deposits or repay bank and non-bank borrowings. Here, the impact on the commercial banks’ reserve position is at its most uncertain.


3.2. Money and Bond Market Operations

3.2.1. Use of the three month intervention rate as a tool of reform policyThe three month intervention rate is the main policy rate adopted by Bank Negara Malaysia to vary the amount of reserve money circulating within the domestic monetary system. Other rates of interest and discount on shorter term borrowings (for example through repurchase agreements or the discounting of commercial and bank bills) tend to be affected by, but are subsidiary to, the three month intervention rate. By lowering the policy rate, Bank Negara Malaysia can encourage the commercial banking sector to acquire further amounts of reserve money for lending to their own borrowing clients and thereby encourage an increase in the wider monetary aggregates. During Phase One of the reform process, interest rate policy will continue to be used as a means of smoothing the potential volatility in commercial bank balance sheets. However, the intention will be that such policy is in due course abandoned, since its prime function in the pre-reform period is to act as a control upon the rate of money creation by the commercial banks, an activity that will no longer be conducted by them after Phase One is completed.

3.2.2. Open market operationsBank Negara Malaysia may decide to repo, buy or sell fixed income securities such as Government securities and Treasury bills on the open market to increase or reduce the supply of reserve money. By varying the volume of purchases or sales of such securities, the reserve position of the commercial banks is altered although this normally has implications for the official discount rate. Central banks often try to keep the commercial banking system in a position of slight reserve shortage, enabling them to more easily determine the level of market interest rates (since the central bank is the lender of last resort and is therefore the monopoly provider of funds under such circumstances). In the transition away from bank issued money to state issued money, open market operations will be a main tool for injecting new reserves into circulation. Statutory or regulatory compulsion may be used to gradually enforce the sale of Government issued fixed income instruments by the commercial banks, although the increase in statutory reserve ratios will in any case encourage them to do so. However, purchases of securities in the open market will probably achieve much of the objective in this regard. As the statutory reserve ratio rises, Bank Negara Malaysia may enter the market to repurchase sufficient bills and Government securities, so as to ensure that the new minimum reserve position is attainable by the commercial banks. Any commercial bills purchased in open market operations will, however, be held to maturity when their redemption will cause a reduction in narrow money supply on a one for one basis. This latter operation is therefore only a temporary means of increasing reserve money in circulation.

3.3. Provision of Temporary Assistance by the Public SectorA public authority could be established for the purpose of making temporary loans on preferential terms or to purchase equity interests and assume control, if necessary, of financial institutions and other private sector businesses whose operations are severely weakened by the reform process. This will help to avoid a default or other event that may result in damage to public confidence in the payments or banking system specifically, or wider economy more generally.

The authority might operate according to an agreed set of policies to hold equity or maintain loan facilities until such time as restructuring of the institution in question had taken place. The operation of Danaharta in the financial restructuring of the Malaysian banking system following the events of 1997 and the more recent establishment of the Special Relief Guarantee Fund and Rehabilitation Fund for Small Businesses would seem to provide precedents for the adoption of such a policy.


3.4. Risk, Capital Requirements and Asset-liability Structure

3.4.1. Reduction in financial sector riskA substantial reduction in risk mismatches between a commercial bank’s assets and liabilities is implicit in the fact that (i) 100% reserves are held against sight deposits; (ii) the redemption of investment accounts is dependent on the institution’s actual liquidity position’ and (iii) the rate of return available to investment account holders depends on the rate of return achieved by the bank when investing those funds as an investment manager. Under such a banking system, the need for risk assessment and a risk-based capital framework is substantially reduced. This is because the nature of the contract between the client and the bank is to share the various risks symmetrically and according to ex-post performance of the underlying assets.

3.4.2. Continued use of risk assessment and monitoring techniquesNaturally, risk analysis techniques will continue to be employed on the banking side, in investment evaluation and credit rating for example, in order to inform the decision to invest client money with particular users of funds. However, since policy makers will almost certainly allow commercial banks to hold non-cash assets against sight deposits during the transition period, the continued use of risk weighting ratios would be appropriate well into the reform process. The setting of these ratios may continue to be made within the context of a prudent transition to 100% reserve ratios so that, for example, low risk Government securities are made available that enable the commercial banking sector to generate returns from part of their sight deposit liabilities. Liquidity would need to be assured during the transition, through Bank Negara Malaysia’s market operations, as is presently the case.

3.4.3. Preferential weightingsSubject to commitments under existing international agreements, regulators may consider the adoption of risk weighting methodologies that encourage a shift in financing behaviour away from overtly interest-based structures towards murabahah and ijara based products. The risk weightings for assets held against investment accounts and reserves held against sight deposits may be reduced towards zero on the basis that these have the profiles of an off-balance sheet item from a banking institution’s perspective. The risk weightings applied to the various forms of interest-based loan and other financial assets held by commercial banks that had not been allocated to investment accounts would continue as present until phased out, and if permitted under existing international agreements, disincentives might be applied in a tapered fashion to these deposits in whatever form the authorities deem appropriate.

3.5. Central Bank Directives and Recommendations

3.5.1. Commercial banksBank Negara Malaysia may use a variety of informal means to encourage the commercial banks to alter their asset profile (by volume, target sector or geographical distribution) and lending criteria so as to achieve the desired commercial bank asset structure without resort to formal monetary policy instruments. These would have the advantage of allowing commercial banks to achieve the desired objectives at a pace that suited them on an individual basis, rather than through the imposition of blanket policies that affected different institutions in different ways.

3.5.2. Finance companiesThe activities of finance companies would not directly impact money supply under the reformed system, however their activities as financiers of consumption and investment loans does allow the commercial banks a medium through which to expand their assets when funds become available to them. Commercial banks may therefore be encouraged to alter their lending policy to finance companies, and finance companies may in turn be encouraged to direct their financing activities towards target sectors of the economy, for example if required by a shortfall in commercial bank lending during the transition phases.


3.6. Foreign Exchange Market InterventionA policy should be adopted for managing the foreign exchange market during the transition phase. Targets could be set for the attainment of mean mid-market values during each given period, a desired trend in the mean over time, or price volatility across periods. Against these targets Bank Negara Malaysia would use its reserves of foreign exchange and alter official interest rates as required to achieve the desired exchange rate. (The use of reserves would of course be conditioned by the transition to commodity money in Phase Two). However, attempts to defend the Ringgit’s foreign exchange value by means of substantial increases in official interest rates should be avoided so as to protect the domestic economy. Increases in interest rates affect the cash-flow of all existing floating rate borrowers within the economy, as well as the decisions of potential borrowers. Therefore, raising of the short term interest rate is to be seen as a blunt tool and used sparingly during the transition phase.

3.7. Establishment of Conduits for Temporary Refinancing of the Private SectorThe authorities should seek to have at their disposal the intermediating capabilities of one or more commercial banking institutions and finance companies, either existing or established especially for the purpose, operating under the direction of the relevant Government department. Such institutions would allow the Government to speedily inject or withdraw money into or from the private sector should this be necessary during the reform period, due for example to changes in the availability of liquidity from other sources. The institutions in question would most likely be an existing commercial bank in which the Malaysian Government has a controlling stake. Contingency policies and outline lending criteria for these institutions would be drawn up in advance of the commencement of the reform process for both personal and corporate lending. Such preparations could be extended to all Government controlled commercial banks and finance companies. The institutions would focus mainly but not exclusively on preparing refinancing facilities and policies for those cases where refinancing might be refused following commencement of the transition. For example, an appropriately labelled fast-track refinancing package could be publicised in advance of the commencement of the reforms, allowing distressed borrowers the opportunity to refinance themselves quickly in the event that private sector lenders were to restrain their lending in any large measure.

3.8. Financial Trading Strategies

3.8.1. Public sectorForeknowledge of reform implementation should provide the Malaysian authorities with substantial opportunities for implementing successful financial market trading strategies. Success here does not necessarily mean the achievement of trading profit so much as a defence of financial and monetary stability such that the reform process can be completed successfully. Trading strategies effected by Government could include the purchase and sale of Ringgit on the foreign exchange market, Ringgit or foreign denominated Government bills and bonds, commodities and precious metals. It should be expected that international markets will view with uncertainty any formal announcement of reform and it may therefore be best that no such announcement is made at any stage. Information management would clearly be a major part of the financial market trading strategy, however it would have to be undertaken in a way that did not severely prejudice foreign parties against Malaysian interests.

3.8.2. Private sectorThe ability of private investment funds, banks and traders to take out large positions on currency and Government securities presents the authorities with a need to develop protective strategies. In particular, these should include appropriate restrictions on the advancement of Ringgit loans to foreign banks and counterparties which might subsequently be used to short-sell the Ringgit on the foreign exchange markets. Tighter restrictions should be considered for daily limit moves and margin requirements on the various Malaysia financial market exchanges so as to reduce the potential for price volatility and systemic market failure during the transition.


3.9. Restrictions and Disincentives to the Use of Interest-based FinancingThe long term success of the monetary reform process will depend upon the abolition of interest-based financing techniques within both the private and public sector. It is therefore necessary to develop a longer term plan for the removal of interest-based finance domestically, as well to regulate the provision of such finance from international sources. The commencement of this process may provide easier “wins” than the latter stages. Early wins might include:

3.9.1. Interest rate ceilingsMaximum lending rates may be introduced, or lowered where they already exist (for example in credit card lending), so as to reduce the burden of interest-based lending upon vulnerable sectors and to reduce the profitability incentive that presently attracts lending institutions. Rates above the quoted maximum interest rate would not be enforceable under Malaysian law. The maximum rate could be reduced over time on interest rates for personal customers (for example on credit cards, personal loans, mortgages), yields for corporate customers (for example, on internal rates of return at the issue date for corporate bonds) and for Government (on Government securities and bills, where these remain in use).

3.9.2. Removal of tax incentivesTax incentives in favour of interest-based financing could be gradually removed to further reduce the incentive for interest-based financing and encourage equity type financing in its place.

3.9.3. Non-interest-based late payment penaltiesIf interest penalties on late payment are to be removed, repossession and other rights of recourse for trade creditors would be simultaneously strengthened.

3.9.4. Regulation of loan-to-value ratios and other measuresInterest-based personal finance would be discouraged, possibly through the imposition of maximum loan-to-value and loan-to-income ratios on residential property financing for example, and encouragement of capital risk sharing and interest-free Government sponsored alternatives for the financing of lower income groups

3.10. Encouragement of Public and Private Interest-free Finance FacilitiesThe provision of genuine non-interest-bearing financial alternatives could be greatly augmented if Government were to support the entrance of private sector operators into the sector or to step into the sector as a service provider itself:

3.10.1. Interest-free mutualityAs an example of private sector involvement, interest-free mutuality could be promoted as a concept in specific areas such as home finance, door-to-door cash lending and small business loans. In each of these cases, communities could be supported to fund themselves by recycling surplus funds to borrowers, perhaps through the medium of a regional or national organisation that would administer the systems and processes, and thereby reduce unit overhead costs through economies of scale.

3.10.2. Government interest-free loansAn example of Government involvement in the provision of interest-free financing is that of Saudi Arabia, where until recently, the state provided interest-free loans to Saudi nationals to enable them to purchase residential property. This scheme used academic qualifications as a determinant of loan size (PhD’s received more funding than holders of Bachelor degrees), saving Saudis very large sums in financing costs over its life. Another possible entrance point for the state would be as a refinancier of interest-based loans under conditions of subsequent abstinence from interest-based credit by the refinanced party. Such a service could perhaps be used as part of a financial restructuring package for severely indebted individuals who might otherwise find themselves in bankruptcy (for reasons other than persistent loan delinquency).


The provision of export financing in critical sectors might also be expanded, but conditionality would need to be put in place to prevent artificial cross-border transactions being undertaken for the purpose of arbitrage.

3.10.3. Other AvenuesAs a further plank of policy, private sector financial organisations could be encouraged to expand the funding of commercial clients on a purely profit-sharing basis. Perhaps most important in terms of funding volume, the promotion of asset based financing in the form of operating leases of capital equipment, or inventory financing, for example, could be supported. Likewise, venture capital organisations could be encouraged to expand their start-up and business development financing operations. In all of these sectors, the Government could reduce the bureaucratic and tax burden on the organisations involved by reducing formal reporting requirements during the early years, and by granting tax privileges and other financial incentives as appropriate.


4. IMPLICATIONS FOR FINANCIAL MARKETS

4.1. Financial Market Activity Post-reformNo material alteration in the structure of the equity or foreign exchange markets need arise as a result of the proposed reforms. As for the turnover on these markets, it is to be expected that trading volumes on the Malaysian equity market will increase substantially if the abolition of interest is implemented under a Phase Two reform, because profit-sharing instruments will at that stage be the only income-yielding financial assets permitted domestically. Similarly, the turnover on foreign exchange markets may decline by this stage of the reform, since the Ringgit will by then be a proxy for an underlying commodity or set of commodities. However, the operation of the Federal Government debt market and the domestic money market will alter substantially both in structure and in turnover.

4.1.1. Market for Federal Government debtThe size of the Federal Government debt market will shrink during Phase One as the monetisation process is enacted. However, Government may wish to continue financing itself by raising reserve money from the domestic non-bank sector. (Since such financings will be satisfied from existing money, and not from money newly created by the commercial banking system, there is no reason to legislate against this form of fund raising.) However, there will need to be a debate as to whether such financing will be raised on an interest-bearing or non-interest bearing basis and this will constitute part of the decision to proceed with Phase Two. The use of asset backed bonds (for example, lease-backed bonds as recently popularised in the Islamic finance sector) may emerge as one solution that brings together the various interest groups in such a debate. These would provide low risk low returns to institutional investors who seek them, although it may also be possible to design new forms of Government finance where the return is linked to a specified performance measure or underlying investment in a particular sector. Where Government finances infrastructure development for example, it may be possible to issue bonds whose coupons are determined by revenues received by the underlying infrastructure project (tolls on tolls roads, perhaps). Alternatively, general securities may be issued in which returns are linked to the growth of GDP during the most recent period.

4.1.2. Domestic money marketThe extent to which the domestic money market undergoes change during the first and second phases of reform depends largely upon the limits that are placed upon the use of interest-based financing. If the authorities determine that interest-based techniques shall remain more or less in place, then the role played by Bank Negara Malaysia, discount houses and commercial banks will remain largely unchanged. Otherwise, major and fundamental changes in the money market will occur. However, of itself, the conversion to 100% reserves need not affect the structure or operation of the money market.

During Phase One of the reform, Government will retain the right to issue reserve money and will therefore be able to provide liquidity to the money market should this be required. Indeed it is envisaged that the provision of liquidity by or through the medium of Bank Negara Malaysia to the commercial banks will be a vital part of the reform. This is in order that confidence in the monetary system is maintained during the transition. The provision of shorter-term liquidity could be undertaken through the current technique of discounting bank bills or commercial bills, agreeing repos, allowing overdrafts on commercial banks’ operational accounts at the central bank, or temporarily reducing statutory reserve requirements in more extreme cases. These various liquidity operations will no longer be needed following the achievement of 100% reserves since liquidity risk will at that stage, by definition, be eradicated for commercial banks. (However, emergency loans may still be required from Bank Negara Malaysia in cases of mismanagement within private sector financial institutions, and such facilities will continue to be made available in the post-reform system).


During Phase Two, the introduction of commodity money will remove the right of money creation from the state and therefore remove from the money market the facility of a “lender of last resort”. This function will be transferred in a loose sense to commodity producers and refiners who will be the providers of new money to the economy, either by investing it, lending it or spending it into circulation. The cash requirements of the commercial banks, no longer being affected by unexpected developments within the fractional reserve system, will now be the result of developments in the real sector (export slumps, Government deficits, and so on). If a money market exists, it will be one in which commodity money holders and commodity money producers offer funds to bidders (on a commercial basis) and the possibility arises that from time to time suppliers of money will not be willing or able to meet the demand for money on such a market. None of this will create a confidence crisis in the commercial banking system of course, since 100% reserves will be held against sight deposits throughout. However, it is indeed possible that public sector and private sector spending will be rationed in a way that has not been experienced for many decades. The economic implications of this change at the core of monetary management are indeed complex, although our philosophical position is that a system built upon economic justice is unlikely, in the long term, to be the source of economic injustice.

4.2. Securities Market RegulationThe following policy initiatives in fixed income, derivatives and equity securities markets may be considered for implementation during the transition phase of reform:

4.2.1. Trading limitsTighter regulations on margin requirements, maximum limit moves and alterations in the length of account settlement periods should be considered in order to encourage lower volatility in financial market prices throughout both transition phases.

4.2.2. Listing restrictionsMonitoring and restrictions would be considered upon new market listings of vehicles that might be used for undertaking interest-based lending on terms that broke any of the reform regulations in an indirect manner. For example, vehicles whose main activity was the selling of consumer goods on an instalment basis at high internal rates of return might be prevented from subsequently selling securities backed by those assets.

4.2.3. Leveraged speculationThe restrictions outlined in Section 4.2.1 would largely curtail speculative activity if implemented thoroughly, however the regulation of broker loans and other methods of financing security positions provides a further target for restrictive measures. The use of repos for example is a particularly powerful means of leveraging exposure to fixed income securities and is widely used by financial market operators. If means could be found of effectively restricting the use of such instruments (without merely sending them offshore, for example) then volatility and speculative activity in the domestic market would be further reduced.

4.3. Capital Controls and Foreign Ownership IssuesThe following policy initiatives in respect of international capital movements and foreign ownership may be considered for implementation during the transition phase of reform:

4.3.1. Restrictions on strategic ownershipRestrictions on the purchase of controlling stakes in financial organisations critical to the reform process could be reviewed and tightened as a long term strategy to prevent undermining of the reform objectives.

4.3.2. Overseas fundingOverseas interest-based funding of Malaysian and non-Malaysian controlled organisations, particularly those in strategic sectors (including banking and finance)


should be monitored and regulated to guard against actions that may destabilise the reforms, particularly those that seek to produce instability in the loan and equity markets.

4.3.3. Investment by foreign entitiesInvestment by foreign entities in critical financial organisations (e.g. payment system and banking sector) should be monitored and regulated at short notice if it appears that the reform strategy is being undermined at the executive level, for example by tardiness or deliberate failures to implement guidance from the relevant Malaysian authorities.

4.3.4. Withholding taxesWithholding taxes may be used to discourage foreign interest-based or quasi-interest-based investment into Malaysia, whether securitised or non-securitised, lending or asset based.

4.3.5. Repatriation penaltiesControls on the repatriation of funds from Malaysia by corporations and individuals should be prepared so as to dampen (not prevent) capital flight during transition.

4.4. Foreign Exchange Market

4.4.1. Currency controlsPurchase and sale of Malaysian currency by foreign counterparties should be regulated during Phase One in order to prevent short selling or ramping by foreign counterparties. A currency peg may be considered as a temporary measure.

4.4.2. Short sellingShort selling might occur through the borrowing of Ringgit by offshore parties from the Malaysian banking system, for subsequent sale on the foreign exchange market. The creation of Ringgit by Malaysian commercial banks presently allows foreign counterparties to fund their short-selling of the currency to a greater extent than would be possible following the transition to 100% reserve banking.

4.4.3. Personal foreign exchange allowancesIf any foreign exchange restrictions are imposed, purchase and sale of Malaysian currency by private Malaysian residents could be allowed with generous per person limits so as to support public confidence and maintain political support for reform.

4.5. Precious Metals and Commodity Markets

4.5.1. Domestic trading in precious metalsThe purchase of precious metals and commodities within Malaysia by domestic residents and organisations would be lightly regulated initially with the objective of achieving “fair price discovery” through free market transactions for precious metals prior to the commencement of Phase Two. As part of this process, Bank Negara Malaysia or another public sector institution (such as the Monetary Oversight Committee) might stand in the domestic market as a two way market maker with a tight bid-offer spread in order to better measure market flows and sentiment.

4.5.2. Trading by foreign counterpartiesPurchase of precious metals and commodities within Malaysia by foreign residents and organisations would be heavily regulated in the event that a decision to proceed to Phase Two was taken. The aim would be to minimise the opportunities for hoarding or deliberate disruption of the markets relevant to the Phase Two implementation. In due course, a free commodity market might be allowed to develop for overseas counterparties, so long as Malaysia’s trading position with the countries of origin of such counterparties was also maintained on a free basis.


4.5.3. Delaying final conversion to commodity moneyAn efficient bullion market with representation of overseas brokers, dealers and state sector market makers would help to forestall attempts to manipulate domestic bullion prices by allowing arbitrageurs to maintain a reasonably tight price equilibrium with foreign commodity markets. An attempt to manipulate Malaysian commodity prices would then become, in effect, an attempt to manipulate the global price of the commodity or commodities in question. Under the Phase Two monetary arrangements, foreign holders of commodities would be able to flood the Malaysian market with their commodity only if sufficient Malaysian sellers of goods and services were willing to part with their produce in return for the commodity in question. Basic market forces will therefore make it very difficult for foreign parties to achieve such a result. However, if the authorities are concerned by the possibility that foreign actions may disrupt the Phase Two transition, then the final step of converting fiat money to commodity money that is described in Section 2.2.2 may be delayed.

4.5.4. Incentives to commodity tradingIncentives to retail operators in the bullion market would be provided from an early stage of the Phase One reform in order to familiarise the public with the purchase and sale of bullion, to encourage public awareness of its pricing, and to de-emphasise the role of the jewellery market as a means of holding precious metals (since the implied cost of doing so is very high compared to holdings in bullion form). Low bid-offer spreads and competitive commission rates would emerge as competition spread among commodity dealers for public custom.


5. COMMERCIAL BANKING POSITION

5.1. Forecast Balance Sheet

5.1.1. Factors affecting asset structureThe asset position of the commercial banking system will vary widely depending upon the method deployed by the authorities for injecting new reserve money into circulation. Where the authorities purchase government debt from a commercial bank, the commercial bank will experience a substitution of one asset (an amount of debt receivable) for another asset (reserve money). The same will result where the private sector receives new reserve money (as a welfare payment for example) and uses such funds to repay debt owed to the commercial banks. Where the authorities purchase government debt from the non-bank sector, the commercial banks will experience an increase in assets (the reserve money received following the sale of the non-bank holder’s government debt) and an increase in liabilities (sight deposits). In short, monetisation may lead either to a substitution of assets, or to an increase in both assets and liabilities.

5.1.2. Comparison of current and proposed structureThe asset structure proposed here assumes that the purchases from the commercial banks of public sector debt produce the substitution in asset structure detailed in Section 5.1.1. As a result there is no net increase in commercial banking assets, ceteris paribus, since an increase of some RM67.2 billion in holdings of reserves is offset by a decline of RM3.4 billion in cash holdings, RM18.8 billion in total government debt holdings, and of RM45 billion in debts owed by the central bank and other issuers.


It is assumed that present holdings of commercial bank assets classified in the Bank Negara Malaysia statistical returns as “Amounts due from Central Bank of Malaysia” and of securities classified as “Other Securities” comprise sufficient public and quasi-public sector obligations to allow for a monetisation of approximately RM45 billion between the two asset classes. This will obviate the need for any indirect injections of reserve money into circulation during Phase One (by, for example, the purchase of government debt from non-bank institutions or an increase in welfare payments). Pending a detailed investigation, the proposed structure shows that obligations of the central bank will be reduced by the full RM45 billion.

5.1.3. Post-reform lendingLoan disbursements by the banking system represented 89.7% of total gross financing in Malaysia during 2003, amounting to RM441.7 billion. This total remains unaffected by the Phase One reform and the commercial banks will continue to be the most important source of finance for domestic borrowers well into Phase Two.

5.1.4. Post-reform cash and statutory reservesAlthough the reserve requirement of 100% against sight deposits will be a legal one upon the commercial banks, statutory reserves under the reformed arrangements will be held either in an operational account with the central bank or as till cash at the commercial bank, whereas presently all statutory reserves must be held at Bank Negara Malaysia. Hence, in this forecast, the proposed cash holdings of commercial banks post-reform decline to zero. In practice, they may still hold some petty cash.

5.2. Management of Changes in Statutory Reserve Ratio

5.2.1. Potential switches to sight depositsNew reserve money issued on behalf of the Government and injected into circulation through the non-bank sector will be deposited into the operational account of the seller’s commercial bank at Bank Negara Malaysia. If the seller decides to continue holding the newly received reserve money in his sight deposit account, then the commercial bank will have a higher sight deposit liability which is exactly compensated by a higher reserve money asset on its balance sheet. Prior to the achieving of a 100% reserve ratio, an equal increase in both sight deposit and reserve money will produce, ceteris paribus, a higher ratio of reserve money to sight deposits at a commercial bank, and will therefore enable the commercial banks to meet the higher reserve ratio requirement set by authorities.

5.2.2. Unexpected withdrawals of cash from sight depositsIf non-bank sector sight deposit holders decide to withdraw cash from commercial banks at a time when the authorities are monetising securities previously held by them, then it might not be possible for the reserve ratios at commercial banks to increase as much as required by the authorities. In these circumstances the newly increased reserve ratio target would need to be scaled back to account for the behaviour of sight deposit holders.

5.3. Account Types Post-reform

5.3.1. Sight depositsThe modification in the nature of reserves will allow commercial banks to satisfy withdrawals of any size at immediate notice from sight deposits, although in practice commercial banks may ask for one or two days’ notice for very large withdrawals. In all cases, non-cash transfers out of sight deposit accounts will continue to be satisfied through existing clearing arrangements, for example by cheque or electronic transfer, and will result in a movement of reserve money between the operational accounts of the paying and receiving commercial banks at Bank Negara Malaysia.

5.3.2. Investment accountsCommercial banks will need to prepare for the abolition of time deposits and the


establishment of a replacement in the form of investment accounts. Investment accounts could take many forms, but during Phase One the two main principles would be their establishment as off-balance sheet items and that withdrawal would be subject to the liquidity of the underlying investments. Hence, if a commercial bank were to sell units in a venture capital fund through an investment account, account holders would purchase units on the understanding that liquidation of their holdings into reserve money might not be achievable at short notice. At this stage, commercial banks could compete for investment account funds by offering various risk return profiles, or by forming partnerships with specialist fund managers. During Phase Two, the restriction and abolition of interest-based financing techniques would introduce a third principle, that of profit and loss sharing, into the operation of investment accounts.

5.4. Liquidity Management for Investment AccountsThe central bank may wish to intervene in the investment account market as a provider of liquidity, for example by purchasing investment account units through the commercial banks at times when net redemptions are being requested by existing holders. This activity could form the basis of a liquidity management facility analogous to the present discounting and repo operations provided by the Bank. Such liquidity operations would require the creation of new reserve money and would therefore apply to Phase One only. They would be carried out with regard to the rules laid down by the proposed Monetary Oversight Committee.

5.5. Forecast Impact Upon ProfitabilityIn theory if a depositor places 100 units of reserve money into a commercial bank account that operates with a 10% reserve ratio, then a maximum expansion of 1000 units of bank money can result. If the lending counterpart of this bank money attracts an interest margin of 3%, then the commercial bank will earn an extra 27 units of income (900 * 0.03) because of the initial deposit of 100. In 2003, the Malaysian banking system’s gross interest margin was 3.69% and the average ratio of commercial bank statutory reserves held against sight deposits was 16.53%. With statutory commercial bank reserves totalling RM13.315 billion in September 2004, an approximate minimum estimate of the annual loss of revenue to the commercial banking system of moving to 100% reserves is in excess of RM2.1 billion. The estimate is derived by measuring the gross interest margin lost as a result of the reduction of commercial bank loan assets (in this case a reduction of some RM64 billion) that accompanies an increase in reserve ratios to 100%. This loss in revenue is of the same order as the saving in public sector debt service estimated using the alternative approach set out in Section 6.2. Any net switching from time deposits to sight deposits during Phase One would increase the size of the revenue loss to the commercial banks. The extent and speed of implementation of reform is therefore to be judged partly against the ability of the commercial banking system to withstand the decline in its profitability.

5.6. Costs of Payment Transmission ServicesBernard Lietaer reports in The Future of Money (2001) that banks in the United States of America earn some 40% of their revenue from the provision of payment services to their customers. Despite this fact, it remains true that commercial banks tend to cross-subsidise the cost of payment transmission with profits earned from interest-revenues gained by means of money creation. Hence, a substantial sight deposit will often earn the depositor the right to free banking services. It is therefore to be expected that there will be an increase in charges for basic banking services as a result of the move to 100% reserves on sight deposits. Furthermore, because a recipient of banking services does not pay tax on those services, the ending of free banking services will represent the loss of a tax free benefit.

5.7. Dual or Single Track Approach?The implementation of a dual system of both fractional and 100% reserve banks operating side by side, would give a substantial commercial advantage to the former group for the reason outlined in 5.5 above. The adoption of such an approach to the introduction of reform is therefore unlikely to succeed if left to market forces alone. A single track approach would in any case be easier to legislate for and to administer, and we therefore recommend that strategy be formulated within a “single track” framework wherever possible.


6. FEDERAL POSITION

6.1. Domestic Federal Debt Levels Post-reform

6.1.1. Total outstanding debtThe eradication of a substantial portion of Federal Government debt and the subsequent maintenance of debt at the reduced level is achievable so long as Government maintains a balanced budget following the monetisation.

Here, an initial reduction of some RM18.8 billion in Government debt is proposed (comprising some RM18.1 billion in Government securities and RM0.7 billion in Treasury Bills held by the commercial banks). The proposed reduction in domestic Federal debt from approximately RM169.5 billion to RM150.7 billion will allow debt as a percentage of GDP to be reduced by some 6% assuming no change in other variables (Federal debt was 48.2% of GDP as of end 2003).

The initial reduction would be achieved early in Phase One. It is assumed that some proportion (possibly all) of the “Investment issues” and “Other loans” will also be identified for monetisation as discussed in Section 3.1.3, especially if these debts are held by the commercial banks. Given the 2004 figures detailed above, it is possible that a further RM16.8 billion of Government debt will be monetised in this way.

Annual budget deficits will improve because of the reduction in debt service charges following the monetisation, and as GDP continues to grow, comparisons between total Federal debt and GDP will improve over time.


External Federal debt (debt to non-Malaysians) need not be affected by the monetisation (the external Federal debt was RM37.3 billion during 2003). However, where the terms of the external borrowings allow, redemption or early repayment of external debts may be concluded using external reserves that are surplus to the requirements of Phase Two.

6.1.2. Treasury bill holdingsHoldings of treasury bills by the commercial banking sector will be reduced to zero during Phase One of the reform. These instruments are usually held by the commercial banks as a means of generating interest income on short term liquidity at zero credit or capital risk. With the imposition of 100% reserves on sight deposits, commercial banks will only be able to hold treasury bills through funds held on behalf of investment account holders or as part of their equity reserves.

Banks will hold cash instead of Treasury Bills by the end of Phase One, and will therefore see an income generating asset replaced by a non-income generating asset on the balance sheets. Of course, this will not provide a material problem for the commercial banks as they will be required to hold the newly acquired reserve money against sight deposits, which will in turn be offered on a non-income bearing basis to depositors.

6.1.3. Government securitiesThe initial reduction in outstanding Government securities depicted below impacts entirely upon the commercial banking system. The other major holders indicated in the following chart include the Employees Provident Fund. Since it has close ties to the authorities, the Fund may be approached if it is required that injection of new


reserves is achieved through the monetisation of non-bank sector holdings of Government securities. If this is the case, or indeed if any of the other indirect methods of injecting new reserve money are adopted as described in Section 3.1.3, then the amount of monetisation required will depend upon the manner and degree to which this reserve money filters back to the commercial banking system. Much of the new reserves may do so, but it also possible that some of the newly created amounts will be held as cash in the hands of the private sector, or exchanged for foreign exchange and thereby returned to an exchange equalisation account or other reserve at Bank Negara Malaysia. In all cases, the amount of Government debt monetisation proposed in this Section is a minimum, and therefore the impact on Federal debt service shown in Section 6.2 is a conservative estimate.

6.2. Impact on Federal Debt Service

The following chart shows the extent of the reduction in Federal debt service that would be produced by a monetisation of approximately RM18.8 billion of Government debt, assuming that Federal debt attracts an average interest yield of 3.8% per annum across Treasury bills and Government securities. (During 2003, Malaysian Government securities with maturities of between 5 and 10 years had coupons of between 3.702% and 3.917%. For maturities of between 10 and 15 years the range was 4.24% to 4.41%.) The estimated recurrent annual saving in debt service of some RM0.7 billion would increase to approximately RM1.5 billion should the further monetisation of RM16.8 billion in other forms of Government debt contemplated in Section 6.1 be implemented. Further annual public sector debt service savings of approximately RM1.5 billion could arise if the monetisation of debt issued by the central bank or by public sector corporations was undertaken in preference to the other forms of injecting reserve money discussed in Section 3.1.3


6.3. Utilising the Monetisation DividendThe annual debt service saving of between RM0.7 billion and RM3 billion highlighted in Section 6.2 compares with the following levels of annual Federal operating expenditure in various sectors of the economy. An opportunity clearly exists to substantially improve service provision in each of these sectors on a continuing basis using the amounts of debt service saved through the monetisation process (what might be termed the “monetisation dividend”):

10,194

2,684

5,870Pensions and Gratuities

Healthcare

Education

2003 (RM millions)Annual Operational Expenditure

6.4. Government Debt Maturity ProfileThe following chart shows the maturity profile of Government securities and indicates that the up to RM19.4 billion of Government debt can be earmarked for monetisation within the 0 to 1 year maturity bracket and a further RM43.9 billion within the 1 to 3 year maturity bracket. These amounts will be more than sufficient to allow the commercial banks to achieve the 100% reserve ratio during the period, even if the non-bank sector demands a substantially increased volume of sight deposits post-reform.


6.5. Federal RevenueFederal revenues are likely to be affected by the reforms in ways that are hard to quantify at this stage. The main factors to be balanced in this regard are the likely reduction in taxes levied from the commercial banking sector resulting from the expected decline in total profits there, and the likely increase in tax revenues resulting from increases in production in the non-bank sector as well as among non-interest-based financial organisations and service providers. Qualitative improvements in economic performance following the move to 100% reserves (for example, greater economic stability and a less stressed workforce) are likely to provide quantitative revenue benefits in the longer term. Allocation of the monetisation dividend towards healthcare, education, housing and infrastructure is also likely to bear such fruit in the longer term.


7. CENTRAL BANK

7.1. Main Balance Sheet Elements Post-reform

7.1.1. Reform bondsShould Bank Negara Malaysia issue new reserve money in return for the Reform Bonds or other securities contemplated in Section 3.1.2, as opposed to such money being issued as a direct obligation on the Treasury department of Government, then these would become assets on the Bank’s books balanced by the liability resulting from the issues of Ringgit reserve money.

7.1.2. Reserve money outside the central bankThe present status of reserve money held outside Bank Negara Malaysia as a liability of the Bank will continue following the Phase One reform. During Phase Two, however, the note issue will be substituted with the central bank’s commodity reserves, and both the note issue and Bank Negara Malaysia’s reserves will disappear from the Bank’s balance sheet. Commodity money will thenceforth be an asset in the hand of the holder but will not be any other party’s liability. At present of course, the domestic note issue of most (all?) countries is a liability of the respective central bank, albeit a liability which is discharged by redemption with a further note issue. Following Phase Two, the holder of Malaysian commodity currency in circulation will have no recourse to any issuer for “redemption” of his holding since the unit of currency would be defined as the commodity (or commodity basket) itself. (Holders of sight accounts at commercial banks would of course continue to have the legal right to redemption of account balances in the form of commodity money, and of course commercial banks would have the right of redemption of operational accounts at Bank Negara Malaysia in the form of commodity money).

7.1.3. Short term liabilitiesOpen market operations are used by Bank Negara Malaysia to absorb excess liquidity from the banking system, especially where a current account surplus produces such liquidity via the foreign exchange market. These operations typically produce a substantial amount of obligations outstanding from Bank Negara Malaysia to the commercial banks. In these proposals, a large proportion of these obligations will be repaid in order to provide the commercial banks with some of the reserve money that is required for the attainment of 100% reserves. The amount of this reduction could be as much as RM45 billion, as described in Section 5.1.2.

7.1.4. Domestic reserves during the Phase One reformMeanwhile, reserves of domestic currency at the central bank may increase as a result of the imposition of 100% reserve requirements on commercial banks’ sight deposit accounts. This is not certain however, for it may be the case that commercial banks decide to hold substantial amounts of reserve money as till cash rather than in a reserve account at Bank Negara Malaysia. During Phase One, this reserve account will become an operational account, as opposed to a non-operational account, in the sense that reserves deposited there will be free for withdrawal by the commercial banks. Of course, commercial banks will continue to provide regular returns to the central bank detailing their sight deposit liabilities and reserve holdings.

7.1.5. External reserve position under the Phase One reformBank Negara Malaysia’s external reserves need show no immediate change as a result of the first phase of the proposed reform process. However, it is to be expected that external factors that are indirectly related to the reform process may cause some pressure on external reserves. For example, if institutions in the foreign exchange market sell Ringgit in any substantial quantity, then the central bank may be required to support the currency by selling part of its reserves. These reserves currently total RM169 billion, greater than the current total of sight deposits within the Malaysian monetary system and therefore sufficient to convert the entire Ringgit sight deposit money stock into foreign exchange or other assets at current market prices, which is


unlikely in the extreme of course. However, given the expectation that sight deposits will rise moderately following the reform due to conversion of part of the existing time deposit stock into sight deposits, the scale of central bank external reserves vis-à-vis sight deposits will be less excessive. The regulations proposed in Section 4.4.2 regarding the borrowing of Ringgit by foreign institutions for use in short sales of the Ringgit on the foreign exchange market are designed to limit speculative attacks on the currency. Therefore, we estimate that Bank Negara Malaysia's reserves are sufficient to cope with the scale of any likely foreign exchange operations against the Ringgit during Phase One of the reform.

7.1.6. External reserve position under the Phase Two reformIn order to convert the stock of fiat reserve money into commodity based reserve money, part or all of Bank Negara Malaysia’s present external reserve assets will in effect be converted into the selected form of underlying commodity and released into the ownership of the holders of sight deposits and cash in circulation. The conversion of foreign exchange reserves and other external assets into the chosen commodity or commodities will therefore need to be managed carefully so as not to unsettle the various commodity markets at the centre of the conversion. It may be necessary to phase in the required purchases quickly or gradually, depending upon the market and the political factors in play. It is probably not fruitful to debate the nature of the decision-making process so far in advance of implementation. Once completed however, the required portions of the central bank’s reserves will be transferred to allocated or unallocated palettes (at Bank Negara Malaysia or the Monetary Oversight Committee, as determined in due course) as the property of the holders of operational accounts at the central bank (these being public sector and commercial bank entities for the most part) or released to the custody of private holders outside the central bank as requested.

7.2. Central Bank of Malaysia Act 1958

7.2.1. General mattersThese paragraphs briefly review the concordance of the strategic plans outlined in previous Sections in the context of the Central Bank of Malaysia Act 1958. The three main parts of the Act that impact upon the reform proposals are those governing the issuance of currency, the setting of reserve ratios and other guidance to deposit taking institutions, the adjustment of liquidity within the monetary system, and issues of management control over Bank policy. In all of these areas we see no general barriers to the adoption of the reform proposals. In particular we note that the principle objectives of the Bank are to safeguard the value of the currency, to promote monetary stability and to influence the credit situation to the advantage of Malaysia (Clause 4). We submit that the reforms proposed here would help the Bank achieve these objectives with the same or greater efficiency than under the present framework. As the net profit of Bank Negara is returned partly to Government (Clause 7) a precedent of sorts exists for the appropriation by Government of profits arising as a result of money creation in the private sector. Secondments to the Bank are contemplated (Clause 15.4), hence an opportunity exists to place selected external consultants and advisers within the central bank for the purpose of assisting with the reform process. The Shariàh Council within the Bank may provide rulings for the operation of the Islamic banking sector as necessary (Clause 16B) to accord with the reform process, although the nature of the changes within Islamic commercial banking are likely to be little different from those proposed for the interest-based banks, given that both presently operate on fractional reserve principles.

7.2.2. CurrencyClause 18.1 of the Act will not need to be amended under either the Phase One or Phase Two reforms. The Clause states that the unit of currency shall be the Ringgit and that all transactions shall be carried out in Ringgit. This will of course continue to be the case following the reforms, except that following Phase Two implementation, the Ringgit shall be defined as a specified amount of one or more commodities.


Clause 19 allows for Ministerial direction to alter the parity of the Ringgit with other currencies or other denominators. This facility may be used to effect the transition from state issued reserve money to commodity based reserve money during Phase Two. So long as such a direction effects a transition at market value, then private sector agents should not bear any substantial or immediate direct loss as a result of the reform. Clause 20 prohibits issuance of notes by the Government. This clause would therefore need to be amended if the Government is to issue Treasury notes into circulation during Phase One, but it will not prohibit the issuance of reserve money by the Bank to the Government in return for the newly issued Reform Bonds contemplated in Section 3.1.2. Hence, no change in the clause is required to implement the Phase One reform. Clause 23 allows for the Minister to determine the standard weight of coins on the recommendation of the Bank. The power of the mInister to overrule the Bank should be verified, and the clause amended if necessary, such that the Minister may direct the issuance of commodity money during Phase Two. Clause 29 seems to give power to the Minister to set the level of the Bank’s foreign reserves as a percentage of notes and coins in circulation. This facility will be relied upon to achieve a 100% backing for state issued money immediately prior to the implementation of Phase Two when the conversion to commodity money commences.

7.2.3. OperationsClause 30 permits the Bank to establish funds and borrowing facilities to finance specific projects for the purpose of promoting economic development. The applicability of such funds to supporting the reform process should be clarified, in particular for the purpose of establishing financial safety-nets for the private sector during conversion to 100% reserve banking. However it should be noted that Clause 31 limits the right of the Bank to take shares and interests in third parties to short periods of time and extreme circumstances. It should also be noted that Clause 42 allows loans to financial institutions in order to preserve financial stability, and that interest-free advances to finance companies are permitted in Clause 31B. Clause 33 limits the financing that Bank Negara Malaysia may provide to Government, and this limitation may need to be relaxed in order for the monetisation process to proceed during Phase One of the reform. Most importantly, the Minister has the right to instruct the Bank on any matter of policy under Clause 34, and the Bank has the right to instruct all commercial banks on matters pertaining to the critical issues of reserve ratio and lending policy. Finally, Clause 54 gives the Bank the powers that it requires to make regulations for the purposes of attaining the Act’s objectives.


8. SOME RELEVANT HISTORICAL DATA

8.1. Long-run Changes in the Purchasing Power of Gold (USA & UK)

+1.202%

+1.056%

220

Average Annual Change

200

Purchasing power index for Gold against UK CPI

Purchasing power index for Gold against US CPI

100

100

19961930

Source: Gold as a store of value, World Gold Council, Research Study No. 22, 1998

8.2. Long-run Change in the Purchasing Power of Silver (USA)

+1.017%Purchasing power index for Silver against US CPI

195100

1930 1996 Average Annual Change

Source: Gold as a store of value, World Gold Council, Research Study No. 22, 1998

8.3. Average Annual Change in the Purchasing Power of Sterling

Purchasing power of Sterling 2.4100

1900 1990 Average Annual Change

-4.06%

Source: Economist intelligence Unit 1995

8.4. Long-run Growth in US Dollar Money Stock (M2)

7.23%5392.9150.8117.59

Average annual change199719501915

US Money Stock M2 billions

source: US Commerce Department 1970; IMF Financial Statistics Yearbook 1997

8.5. Public Plus Private Debt as a Percentage of GDP

1692501871491993

144198151851983

60113136811970

MalaysiaJapanUSAUKYear

source: IMF FInancial Statistics Yearbook 2000


9. CHANGE MANAGEMENT ISSUES

9.1. Consensual or Non-consensual Approach?A largely political judgement will need to be made as to the extent of consensus building or compulsion in achieving the reforms. Government control of several key commercial banking institutions will reduce the need for consensus building but any moves that allow a strengthening of foreign controlled banking institutions in Malaysia will complicate matters considerably. Foreign entities are more likely than Malaysian nationals to place the long term interests of commercial banking above the long term interests of Malaysia itself. They are therefore more likely to oppose reforms that undermine the basic principles upon which commercial banking is built. Perhaps the greatest danger for commercial banking internationally is a successful example of 100% reserve banking in practice.

9.2. Use of Existing Levers Where PossibleMost of the necessary levers for effecting the policy changes in this document already exist. For example, maximum lending rates on credit cards and statutory reserve requirements are currently implemented and merely need to be extended or widened in scope. Precedents exist for the restructuring of financial sector institutions and assets in the case of the Danamodal and Danaharta entities, and similar exercises could therefore be undertaken to alleviate financial stress within particular banking organisations. The right of the Finance Minister to direct central bank policy also exists in the case of resistance from within the central bank itself. Some levers relating to the issuance of precious metal reserve money in the second stage of the reform will need to be created, but even here the basic framework for implementation already exists. For example, the current use of base metal coinage within Malaysia means that the systems necessary for production, delivery and administration of precious metal coinage can be adapted from the existing base metal coinage infrastructure.

9.3. Achieving Public Buy-in

9.3.1. Quick wins using the monetisation dividendSubstantial tax reductions and or increases in public expenditure can be achieved using the funds released through interest savings on Federal Government debt (the monetisation dividend), as this is reduced during Phase One.

9.3.2. Longer term winsIn the longer term, the indebtedness of Malaysian corporations and individuals will reduce as the ability of the commercial banking system to create debts is reduced. The reduction in the total pool of profits available to the commercial banking system will sponsor a shift of resources away from the sector and into productive industries that are able to satisfy infrastructure needs and provide services that will improve standards of living for all Malaysian residents. These various changes will affect the quality of economic and social life in Malaysia in a subtle way, but a way that may not be sufficiently noticeable to make political capital from in the short term. It is therefore questionable from a political perspective whether the longer term benefits should be emphasised as justifications for the reform package, at least in public.

9.4. Transparency Versus Confidentiality

9.4.1. Merits of a consultation exerciseA consultation exercise has the benefit that new insights and experience can be brought to bear upon the proposals in this report. This will be particularly useful at the technical level, where feedback will be required from those who have long term experience of working within key institutions, such as Bank Negara Malaysia. Against this must be balanced the need to keep what are essentially radical and commercially threatening proposals away from the attention of those individuals and institutions whose objective will be to undermine or discredit them at an early stage. However, an attempt to design detailed recommendations and implement them without undertaking a consultation exercise of some kind may have extremely negative


consequences for buy-in. The preparation of Bank Negara Malaysia’s forward looking Monetary Policy statement should be considered carefully for similar reasons.

9.4.2. Preparation of interest groups ahead of implementationInformal contacts with key opinion formers and representatives of the major institutions should be undertaken in order to gauge their disposition toward the proposals. This could be carried out in a variety of ways, some direct (for example, discussion over lunch), some less direct (for example, requests for comments on a conference document in which the proposals are outlined). If the proposals are outlined by an individual or organisation that is seen to be independent of Government (in other words, through a non-Governmental channel), then the process of obtaining feedback is likely to be easier and more reliable.

9.4.3. International representationThe public relations exercise at the international level will be crucial in this matter. The attentions of potentially hostile parties should be kept distant from the reform proposals for as long as possible. This international dimension may determine the domestic public relations exercise, so that reform is not announced at any level, and key policy implementations are commenced gradually using existing policy levers.

9.5. Achieving Institutional Buy-in

9.5.1. Key techniciansEventually it will be necessary to rely upon a number of key individuals in the major institutions who will drive through the reform package so far as it affects them. Clearly, the commitment of these individuals to the reforms should be substantial. Where commitment is lacking, policy makers will need to consider replacing individuals with those whose loyalty to the reform package is known. If it is to take place, the selection and positioning of reformers within the key institutions should take place prior to commencement of the reforms.

9.5.2. Key campaignersThe support of key politicians, academics, journalists and businessmen both inside and outside Malaysia should be solicited informally through non-Governmental channels with the objective of identifying those who are willing to comment positively on the principle of 100% reserve banking, in public if necessary, but preferably not with specific reference to reform in Malaysia. Industrial leaders in particular may be willing to support such a move and promote it within the non-bank sector, given the commercial tensions that sometimes exist between bankers and industrialists.

9.5.3. Government and central bankIt is assumed here that key ministers and officers of Government will support the reform in the event that a decision is taken to proceed. However, there may be some variation of support among Government departments. Departments other than the Treasury should in general be well disposed towards the changes if budget increases are forthcoming due to the monetisation dividend. The Treasury department and central bank may however harbour orthodox opinions on matters of monetary management. Given that two cornerstones of current orthodox thought are that Governments should not “print money”, and that the “gold standard failed”, such individuals may strongly resist the proposed changes. Building consensus may be extremely difficult here, in which case non-intellectual strategies may be worth considering. For example, “problem” individuals may be promoted to departments that are not essential to the reforms, or in extreme circumstances, removed from office.

9.5.4. Privately controlled commercial banks.Privately controlled commercial banks will be the most difficult group from which to achieve buy-in and compulsion may be the only option here. Existing Government control over several commercial banks in Malaysia reduces the scale of potential resistance here. However, the granting of tax allowances, the establishment of


privileges for operators of investment accounts, and the gradual phasing-in of reforms should be seen as a lever with which reform can be introduced more easily.

9.5.5. Investment banksInvestment banking business may benefit from the proposed changes. The use of securities, funds and equity type financing instruments is likely to increase substantially during the later stages of the Phase One reforms and particularly during Phase Two. The opportunities for investment banks to earn fees from structuring, issuing and trading such instruments may provide higher fee and commission earnings in the longer term.

9.5.6. Pension funds, insurance companies, investment and other funds.Pension and fund management institutions will continue unaffected by reform at the operational level, but would benefit from domestic stability at the macro-economic level. It is also possible that these institutions will enter into service agreements with commercial banks in order to administer or manage the funds held within investment accounts. These opportunities will again prove attractive in terms of commissions and fees and may therefore give rise to substantial support for the reform proposals.

9.5.7. International institutions, including multilateral agencies.A review of existing commitments under international agreements and memberships of the key global organisations will be necessary prior to commencement of the reforms to ensure that no aspect of the reform package directly contravenes those commitments. However, the authors believe that the reform proposals have been designed so that existing arrangements, with the International Monetary Fund for example, do not need to be structurally altered in order for reforms to succeed.

9.6. Opponent StrategiesPolicy makers should be prepared for a variety of opponent strategies. These can be categorised very approximately as intellectual, economic and political in nature.

9.6.1. Intellectual strategiesAt the intellectual level, supporters of the status quo often engage in the introduction of immediate complexity into discussions, thereby obscuring the fundamental principles upon which reform is based before they can be digested by those new to the topic. Another frequent intellectual strategy is the acceptance of certain aspects of the reform critique (for example, “commercial banks do create money”) but the subsequent denial of the importance of such facts (“so what if commercial banks create money?”). A third strategy is intellectual belittlement of opponents experience (for many, being critics, would not work within the system they are criticising), and the exploitation of minor weakness in reform arguments in an attempt to throw doubt upon the integrity of the main arguments without needing to address them directly.

9.6.2. Economic strategiesThe two key opponent strategies at the economic level can be viewed as domestic and external in nature. The creation of domestic recession by a banking system under threat of political reform is not unknown (such a strategy was adopted by the Bank of the United States during the 1830’s) however it is more likely that international economic pressure emerges against reform. Policy makers will need to review the likely levers available to international opponents of reform, for example in the renewal of international credits, or by the use of existing international trade agreements to undermine any restrictions on banking business within Malaysia.

9.6.3. Political strategiesPolitical pressures of unknown dimensions may be brought to bear upon the leading reform groups. This matter is beyond the scope of the authors’ knowledge and, no doubt, serious users of this report will be in a better position to assess it.


APPENDIX ONE: SECULAR THEMES(Summarised by T. El Diwany, from Fonseca, G. & Ussher, L., John Hopkins and New School, USA)

1. IntroductionMoney's functions are frequently held to include that of a "medium of exchange" (when used as a countervalue in a commercial transaction), a unit of account (when used to measure quantities, in company accounts for example) as a store of value (when held by persons to meet a future requirement, known or unknown) and as a standard of deferred payment (a record of a credit transaction that will be settled at a future point in time). As for the nature of money itself, the "narrowest" definition is that money (M0 or high-powered money) is only that issued by the state in the form of coins, paper notes and reserves of such (in physical or electronic form) held at a central bank. M1 includes coins, notes and reserves, plus sight deposits held at commercial banks. Wider measures still, such as M2 and M3 include savings accounts and, as one progresses outwards along the scale of liquidity, less liquid forms of financial asset such as holdings in mutual funds. Economists distinguish two concepts that are key to the role of money in the economy. One is the idea that a change in the supply of money will not change output in the long-run, namely that money is “neutral”. The second is that there is such a thing as the "real economy" and "monetary economy" and that the two do not impact upon one another's performance. This is the idea of dichotomy.

2. Classical Theories of MoneyWilliam Petty (1623 - 1687) wrote of the inflationary effect of debasement and promoted the Mercantilist idea of running a trade surplus in order to 'bring home money'. He argued that the state may experience an over or undersupply of money. In his view, excess money should be melted down and exported or lent at high interest rates. In the case of a shortage, there should be established 'a bank which, well computed, doth almost double the effect of our coined money'. The latter statement indicates Petty's understanding that banks are able to create money. Towards the end of the seventeenth century, John Locke proposed a direct relationship between the supply of money and the prices of goods and services within the economy. Locke argued for example, that if money supply fell then the prices of goods would fall. This would make foreign produce more expensive than domestic produce, and according to him this would reduce the wealth of the nation. Hence he too argued for a balance of trade surplus, in order to ensure an inflow of money to the economy and thereby maintain domestic prices above foreign prices. The period of Tudor Inflation in 16th Century England was seen by some as evidence for Locke's theory, coinciding as it did with an influx of gold and silver from the new colonies of imperial Europe. Later, David Hume added his name to the growing list of quantity theorists. Yet the idea that new amounts of money would merely increase the price level in an economy without affecting production, in other words that money is simply a veil between the two stages of a real world transaction, was widely rejected. Furthermore, the mechanism by which increases in money supply caused increases in price were not well outlined. The antithesis of the various quantity theories was Adam Smith’s “real bills” doctrine in which increases in money supply were accompanied by an increased production of goods and services. Increases in money supply did not therefore result in inflation. David Ricardo (1817), Karl Marx and John Stuart Mill (1848) in due course disagreed with the positions of both Hume and Smith, proposing instead a "commodity theory" in which money was a precious metal of some kind, and the price of money was determined by its cost of production in the long run. Similar ideas were promoted by the German Historical School and by the French Physiocrats during the nineteenth century.

3. The BullionistsIn England during the early 1800's a debate emerged between the Bullionists and non-Bullionists focussing on the question of whether banking institutions should be required to make their paper notes redeemable in gold on demand. The Bullionists included such thinkers as David Ricardo. This group believed that redeemability should be required of banks in respect of their note issue on the basis that without such a restraint inflation would emerge through increased note issuance by the banks. The non-Bullionists argued that banknotes would only be issued to merchants and industrialist to finance real word projects, the so-called real bills doctrine. The implication of this argument was that money supply could not exceed the productivity of the economy and that inflation could not therefore result. In the 1810 Bullion Report, a British parliamentary enquiry into the subject found strongly against the non-Bullionists (including their supporter, the Bank of England). The enquiry found that the needs of merchants and industrialists were potentially unlimited and that therefore note issuance might not be restrained in any way if their demands were to be used as a


limiting factor in the process of money creation. Thus, the resumption of payments of notes in the form of gold was recommended by the Bullion Committee and this was achieved in stages beginning in 1816.

4. The Banking and Currency SchoolsThe issues debated among the Bullionists and non-Bullionists reappeared in the 1840's with regard to redeemability of Bank of England paper notes. The Currency School argued that backing of the note issue in gold was required in order to prevent inflation through excess note issuance. The Banking School (which included John Stuart Mill) argued against the requirement for gold parity, and while accepting the risks of inflation, argued that inflation would encourage holders of notes to redeem them at the bank of issue in the form of gold, and thereby destroy the excess money supply. Once again the arguments in favour of the maintenance of backing won the day laying the basis for the continued gold standard that prevailed until the First World War. We should perhaps note that the proposed mechanism for the removal of excess money supply could only operate properly through the medium of bankruptcy, for how else could a bank's excess note issuance be removed from circulation, and in this respect the Banking School seemed willing to pay the price of increased volatility with no obvious economic gain to society.

5. Leon WalrasLeon Walras proposed that agents within the economy had a "desired cash balance", that they did not simply hold money for the sake of what it could buy, but rather because they desired money itself. Money was a good like any other good, and the demand for it could be modelled in what became known to modern economists as a “choice-theoretic” framework. In such a framework, a model can be constructed in which economic agents decide how to allocate their asset holdings among different asset classes in order to satisfy their wants. Walras identified the want that money satisfies as being the function of storing value, of it being a temporary abode of value in the stage between selling a good or service (one's labour for example) and spending that value at a later time (by purchasing goods for example). Money will be accumulated by an agent until the marginal cost of doing so equals the marginal benefit.

6. Ludwig Von MisesLudwig von Mises concluded that money has no utility, and that its exchange value must therefore arise for some other reason. The reason von Mises proposes in his "Regression Theorem of Money" is that money's value in exchange arises by some kind of imputation from a time when money was linked to a precious metal. Thus, by the mid-1930’s when von Mises was developing his ideas, money was valued due to a psychological link between it and gold or silver, despite the fact that such backing had by then been abandoned in most cases.

7. Tobin and HicksIf money has utility, how can it also be a veil? In the 1930's, Hicks noted that under the assumption of perfect foresight made by Walras, if money's only service is to perform a future transaction then why should it be held instead of being lent out at interest until that future date? Hick's argument was that the individual's demand for money should be considered in the same way as any other utility-yielding good, in other words using a "marginal utility theory of money". According to him, the choice of how much money to hold is merely a choice between the amount of income that is consumed today and the amount that is saved (in the form of money, bonds or equity shares) for use in consumption tomorrow. Hence, the savings-consumption decision and inter-temporal asset allocation decision are the key processes to be modelled in the Tobin Hicks analysis.

8. Irving FisherIrving Fisher in the early twentieth century, produced the most famous statement of the Quantity Theory of Money in the equation of exchange: MV = PT where M is money, V is velocity, P the price level and T the level of transactions. Here, V and T are assumed to be fixed, money supply is determined independently, and causation runs from left to right. (The assumption of causation was the opposite of that adopted by David Ricardo who argued that money supply is determined by the needs of trade, in other words that it is endogenous to the system. Hence, if the price of goods fall, or in other words if the price of gold rises in terms of goods, then the mining and production of gold will increase.) The supply and demand for commodities is in equality due to the assumption of Say's law, which expressed simply states that supply creates its own demand (in other words the wages received by workers must be sufficient to purchase the products that have been produced by them).


Money is introduced as a requirement for exchange, a kind of institutional arrangement within society, and agents therefore demand some amount of it in order to transact with one another. By assuming that V and T are both fixed, the only variables that are free to vary are M and P. If the equation above holds at all times, then if M rises, P must necessarily rise by the same amount. If M increases, agents use their excess supplies of it to demand more goods, thus causing the prices of all goods to rise. The real value of money supply (M/P) falls back into line with with real money demand (T/V). A stable demand function for money is required for the theory to hold of course, something that Friedman and Schwartz tried to identify in the 1960's through an examination of the data from American monetary history. Fisher suspended his belief in dichotomy (money does not have real effects) in order to accommodate the transition phase between one equilibrium state and the next. Growth in money supply could indeed affect a real factor (output of goods and services) during transitions. The question then became one of whether equilibrium was ever achieved, or whether the long run was composed entirely of short run transitions between equilibria that were, in fact, never reached.

9. The Cambridge EconomistsIrving Fisher's Quantity Theory assumes a stable transactions demand for money. This requires that money is desired only for its medium of exchange function and this is institutionally imposed. A group of Cambridge economists modified this assumption during the early twentieth century, among them Pigou, Marshall and Keynes. They argued that money is desired as both a medium of exchange and as a store of value. In the latter mode, it increases utility by allowing inter-temporal decisions to be made, in other words it acts as a temporary abode of purchasing power and overcomes the need for a double coincidence of wants in a barter economy. For Fisher, money is medium of exchange only, hence it is demanded only to satisfy the transactionary motive. In the Cambridge approach, the supposition that money is also a store of value produces a real demand function for money that depends upon income, the agent's wealth, and interest rates. Much of this is intuitive. The higher aggregate income (Y), the higher spending and hence the higher the demand for money balances to satisfy that spending. Formally, it can be said that M/P = kY (where k is the so-called "Cambridge constant", although far from being constant k is in fact free to vary under this approach in line with such factors as the level of interest rates). The Cambridge economists saw money as being neutral, but demanded for its own sake because it yields utility. Keynes later developed further ideas on the nature of this utility by proposing the idea of liquidity preference, in which agents decide to hold money for precautionary and speculative reasons in addition to the transactionary motive.

10. Knut WicksellAt the turn of the nineteenth century, Knut Wicksell developed a version of the Quantity Theory that does not rely upon Say's Law or the idea of money as a veil. As for Say's Law, Wicksell saw that if demand and supply were to be equivalent, then the general rise in prices proposed by Fisher in the short run transitions between equilibrium states could not occur since such a rise in prices requires that at some stage demand exceeds supply. In Wicksell's theory, it is the mechanism of credit creation that allows the Quantity Theory to remain valid by allowing investment to exceed saving (I > S) or, using an alternative terminology to say the same thing, it allows aggregate demand to exceed aggregate supply (Yd > Ys). The cause of the expansion of credit in Wicksell's theory is a divergence between the rate of return on capital (his "natural" rate) and the rate of interest. The loan rate is determined by the banking sector and applies to the newly created money that entrepreneurs borrow in order to finance projects that return the natural rate. Thus, Wicksell does not think investment is constrained by savings. The extra investment demand causes capital goods prices to rise, and wage demands from workers to rise. This cycle continues until it meets a limit where the banking system cannot create further money due to the restriction imposed by the minimum reserve ratio, or where the interest rate comes to exceed the natural rate. If the interest rate were to change simultaneously with the natural rate, then the credit creation would not occur. For Wicksell, it is the lag between changes in the two rates that ultimately causes the business cycle. The mechanism postulated by Wicksell here for money supply growth is therefore endogenous, whereas in Fisher the growth is assumed to be exogenous, although both economists accepted that the cause could at times follow either an endogenous or exogenous path.


APPENDIX TWO: ISLAMIC THEMES

IntroductionIn recent times, a small number of Muslim economists have noted the deficiencies of the fractional reserve system in their work. For example, in their work Currencies Banks and Financial Markets, Al-Zamel, ‘Abd al-Khayr and al-Sudani cite Monzer Kahf and Ma’abid al-Jarhi as being against the practice for reasons similar to those cited in this document. Umer Chapra’s opinion that seignorage derived by the state should belong to society is in effect achieved where the central bank repatriates its profits to the government. What the scholars of earlier eras in Islamic jurisprudence do seem to recognise, is that maintaining the integrity of the monetary system requires strict supervision of both the state and the private sector. Al Zamel reports the insistence of the well-known Shafi’i scholar, Imam Nawawi, that only the ruler can mint coins. He also relates Ahmad ibn Hanbal’s position that the Sultan should take responsibility for the minting of dirhams in order that manipulations do not occur at the hands of the private sector. Ibn Khaldun similarly stated that the “ruler should mint the coinage and preserve its standard”.

Among most scholars, traditional and contemporary, it seems that certain key themes remain in place. An Islamically acceptable monetary system adheres to Shariàh at the contractual level, and in so doing maximises stability and justice at the macro-economic level. Some key themes noted by al-Zamel are that the government should not as a rule interfere in economic activity except perhaps in times of war or panic, that the Islamic economy is an inherently stable one and therefore the management of instability should not absorb a large part of the state’s resources, and that monetary policy should not be politically motivated.

Certain major themes seem to be agreed among scholars of Shariàh on the topic of money. As it is a type of wealth, its maintenance as an efficient and justly functioning economic institution is an objective of the Shariàh. Second, the Prophet s.a.w used gold and silver as money, therefore it cannot be wrong to do so, and it is likewise wrong to prohibit their use as money. Third, the state should audit and regulate the monetary standard so as to ensure fair play among the various monetary agents in the economy and to safeguard economic vitality. Finally, Al Manì summarises Ibn Taymiyyah, Ibn al-Qayyim, Ibn Hajar, Ghazzali that the illah of riba in gold and silver is thamaniyyah (moneyness), and the hikma (wisdom behind the rule) is to allow money to fulfil its purpose as a medium of exchange, measure of value and store of wealth.

There is division among scholars as to whether the monetary medium should be confined to gold and silver, or whether other commodities, or indeed other token forms of money, should be allowed within society. Those supporting the view that only gold and silver should constitute money include Abu Hanifah and his student Abu Yusuf, the majority of the Shafi'i scholars, some of Imam ibn Hanbal's followers and contemporary thinkers following the Hizb ut-Tahrir founder Sheikh al-Nabhani, and the Shia author of Iqtisadina, Baqir al-Sadr. Evidence for restriction is weak, and includes the following:

• the illah of thamaniyya is gold and silver according to Shafi'i• Ibn Khaldun says God created gold and silver to be used as money• rational arguments of stability of value over time

Those following the idea that money can include other commodities include the majority of Maliki scholars, Ibn Taymiyyah, and many, perhaps most, contemporary scholars. Evidence against restriction includes the following:

• the ibahah principle (because there is no clear prohibition in the texts)• the sunnah of using gold and silver cannot be seen to prohibit use of other items• the fact that Caliph Umar proposed using camel skins as money but that the idea was

rejected due to fears of a camel shortage, not on other grounds. Also, Imam Malik stated that “If the people were to use skins as money, I would not prohibit them from doing so”.

• the facilitation of ease, in fulfilling ibada of zakat for example, in environment where other materials are used as money.

Various Shari’ah opinions appear on the acceptability of modern forms of money. Although paper money was not known to the early jurists of Islam, their discussions do focus upon the use of other forms of money (for example, animal skins and copper “fulus”) that have provided later jurists with principles with which to analyse money in its modern paper and electronic incarnation. The well


known Saudi Arabian scholar Sheikh Àbdullah bin Sulayman bin Mani`’s discussion is an early contemporary analysis in the Arabic language of the opinions of each major school on the validity of paper money. The following paragraphs summarise the key points of Sheikh al-Mani`’s analysis of the Shari’ah on paper money relevant to our discussions, and have been translated into English by Dr. Usama Hassan in London for use in this document. Sheikh Al-Manì does not directly address the issue of fractional reserve banking in his study, perhaps because the scholars whose ideas he cites have been unaware of its practice, or lived before its practice became commonplace.

1. Paper Money as an IOU (an Evidence of Debt Owed to the Bearer)

1.1. ArgumentsScholars adhering to this view regard token money as a receipt in evidence of a debt owed, held by the creditor or his assignee (as a result perhaps of a subsequent exchange transaction where the IOU was used as payment). In supporting this point of view we can cite the promissory nature of early bank depository receipts, often payable in gold or less commonly silver, to pay the amount specified on the face of the token value to the bearer on demand. Early token money itself had little value in the absence of this promise, since the value of the paper upon which the promise was printed was virtually nothing.

1.2. ProponentsProponents of this view included various 'ulama of al-Azhar in the early years. Ahmad al-Husaini gave the fullest justification for this position, making several points including that there is no meaning to the promise to pay if paper money is the actual currency, and that paper currency is only used as gold and silver coins upon the assumption that it can be exchanged for such coins at the issuer’s office. Al Mani` quotes other scholars who argue that paper money is not the same as an IOU. Sheikh Ahmad al-Khatib says: "If it is said that paper money is not intrinsically currency, for its issuer would otherwise not be obliged to redeem its value, we answer as follows. Transactions are intrinsically carried out using paper money: it is the paper money that is held, handled, exchanged and used in buying and selling like all other currencies. The issuer guarantees its value: this is no reason not to use it, since without this guarantee, it would never circulate to begin with. The cause of its circulation cannot be a reason to forbid its circulation! It is not a debt, but a guarantee of value to ensure circulation ... Value is destroyed if the banknote is destroyed, unlike an IOU which is only a reminder, is not used in transactions, and has no monetary value except the value of the paper ... The debt is not tied to the IOU, it is the responsibility of the debtor. The amount written on an IOU is not the value of the IOU, but a debt for which the debtor is responsible. The debt does not disappear if the IOU is destroyed. Anyone who destroys an IOU (or certificate of ownership of a house, etc.) only pays for its price in terms of the paper, ink, etc. as our jurists have explicitly stated."

1.3. Consequences of following this positionIbn Mani` argues that this viewpoint would prohibit the use of token money for bay` salam (advance payment) since one condition of bay` salam agreed upon by the 'ulama is that one of the parties must take possession of its side of the transaction (goods, commodities, money, etc.) at the majlis al-'aqd (place of transaction). Paper money would not satisfy this requirement, since by its use one would in effect conduct a hawalah (referral of a debt) rather than a cash payment. Furthermore, paper money cannot be exchanged for gold and silver even if this is done on the spot, since paper money is an IOU for a debt unrelated to the contract of exchange; One condition of sarf (currency exchange) is that mutual exchange be completed on the spot. Dealing in paper money is equivalent to the referring of debt in transactions (al-hawalah bil-mu'atah) to a third party, the issuer of the paper money. There is disagreement about the soundness of such third-party transactions, with the majority of the Shafi'i school making it unconditionally invalid since the condition of verbal offer and acceptance is not met. Others accept third-party transactions on condition that the debt referral should be to the one who will fulfil the debt, following the hadith of Abu Hurayrah, "The delay in payment by a rich person is injustice. If a debt is referred to someone who will fulfil it, the referral should be accepted." The fulfiller should have the wealth to pay, should give his word so that he cannot delay payment, and must be present when the debt is settled. There is no doubt that the power and authority of the ruler make him untrustworthy with respect to his word and presence, for he is able to delay payment and refuse to attend


the settlement meeting. Therefore the debt-referral is invalid. The disagreement regarding zakat on debt also applies here, in other words is zakat on a debt obligatory before or after settlement? According to the latter view, zakat is not obligatory on paper money since the IOU has not been settled. It is invalid to sell goods or precious minerals held in trust for paper money since the latter is a receipt for an absent debt, and this is a type of kali' for kali' (receivable for receivable) which the Prophet s.a.w. forbade.

2. Paper Money as a Commodity

2.1. ArgumentsThe proponents of this view commonly argue that paper money is a commodity in itself, in other words that the actual paper and printed inscriptions on it are desirable, valuable wealth. They are treasured and used for buying and selling, though not similar to gold and silver in substance and source. Paper money is not measured by volume or weight, and therefore does not fall under any of the six categories of items on which the ruling of riba applies in exchange according to this view.

2.2. Proponents2.2.1. Sheikh 'Abd al-Rahman b. Nasir al-Sa'di, in his treatise The Ruling on Paper Money

(publ. 1378 AH), argues that banknotes are not the same as gold and silver in substance and source, so the ruling on riba in exchange does not apply to them. The basic principle in trade is that transactions are halal, and decisive proof is required if something is to be pronounced haram. The view that paper money is a debt leads to harm and difficulty, especially in the modern world where most of the world uses paper money. Another reason that paper money is not like gold and silver is that the former's value is based on governmental authority, and this value can vanish if the government is replaced or if it changes its policy. Sheikh 'Abd al-Rahman concludes that paper money is equivalent to gold and silver in trade and in matters of worship that involve the payment of money such as zakat and nisab, but not the same as gold and silver in the ruling on riba in exchange since the majority view in his madhhab is that the 'illah for the riba ruling on exchanging gold and silver is that they are weighed, and a banknote denoting 1,000 units may weigh the same as one denoting 100 units.

2.2.2. Sheikh Yahya Aman, said in treatises published in 1378 AH that paper money is valuable wealth that people store for their needs. The meaning of wealth (mal) is that human nature inclines towards it, and it can be stored for occasions of need. Paper money is wealth in itself, in other words it is a commodity.

2.2.3. Sheikh Ali Hindi quotes a fatwa from Sheikh Sulayman b. Hamdan, publ. 1378, arguing that paper money is equivalent to trade goods, for the definition of trade goods is that these are neither measured by volume or weight, nor are they animals or property.

2.3. Consequences of following this view2.3.1. Under this viewpoint, bay` salam will not be allowed since one counter-value in bay`

salam must be gold or silver.2.3.2. Riba of both types does not apply to paper money since one is allowed to exchange

different quantities of paper with gold and silver, on-the-spot or with deferred payment2.3.3. Zakat is not payable on tokens such as paper unless it is set aside for sale.

3. Paper Money to be Treated as Fulus

3.1. OverviewThis viewpoint falls between the IOU and commodity viewpoints. Fulus was originally a coin made from copper and used for small value transactions. The jurists have considered fulus and generally fallen into two camps, based on their view of fulus as either (i) the original substance from which it is made, or (ii) its role as money and a measure of value. Based on these viewpoints, the jurists differentiated fulus from gold and silver, or equated it with them, respectively. Further, and again respectively, they did not or did give fulus the same legal ruling as gold and silver in such matters as riba, sarf, salam and zakat.


3.2. Arguments on the equivalence between paper money and fulus3.2.1. Proponents

3.2.1.1. Sheikh Ahmad al-Khatib argued that no zakat is to be paid on paper money unless it is set aside for sale, since paper money is the same as fulus. No riba applies on paper money, one can exchange it in equal or unequal quantities, on-the-spot or with deferred payment.

3.2.1.2. Sheikh Abdurrahman al-Sa'di argues that paper money is equivalent to gold and silver in deferred transactions (so that one cannot exchange 10 units for 12 units later), but equivalent to fulus in spot-transactions (so that one can exchange whatever quantities one likes on the spot).

3.2.1.3. Sheikh 'Abdullah b. Bassam proposes that paper money resembles gold and silver in some respects and resembles IOUs or debt-receipts in other respects. However, its strongest resemblance is with fulus coinage such as nickel. Paper money is not intrinsically like gold and silver. Its value fluctuates, just like fulus, due to supply, demand, circulation and governmental decree. Gold and silver are intrinsically desirable. Paper money and fulus are only desirable due to government decree. Therefore, paper money is to be treated like fulus. The correct position in the madhhab of Imam Ahmad is that riba al-nasi'ah applies to fulus (i.e. exchange cannot take place with deferred payment) but riba al-fadl does not (i.e. unequal exchange can take place, but only on-the-spot).

3.2.2. Consequences of regarding paper money as equivalent to fulusWith the exception of Ahmad al-Khatib, for whom neither riba al-fadl nor riba al-nasi'ah apply to paper money, proponents of the view that paper money is equivalent to fulus argue that riba al-nasi'ah applies to paper money but not riba al-fadl. The view of the majority can however be criticised on the grounds that the differentiation in the ruling between riba al-fadl and riba al-nasi'ah needs logical or textual evidence. Al-Mani` argues that in matters where there is a mixture of two situations, the most cautious approach is to be taken. He believes that allowing riba al-fadl in the case of fulus will open the door to riba al-nasi'ah, and that there are important differences between paper money and fulus which indicate that "... the former should be given the same ruling as gold and silver. For example, paper money is used for no other purpose than as a measure of value, unlike fulus that can be traded as a commodity in view of its substance".

3.3. Arguments against treating fulus as gold and silverAmong the scholars documented by Al-Mani` in support of the view that fulus is different from gold and silver, and therefore does not share the same rulings regarding riba, sarf, salam and zakat, are those of the Hanbali school: "It is allowed to sell one fils for two in number, even if they are used for spending (nafiqah) because they are not measured by volume or weight." (Kashshaf al-Qana' 'ala Matn al-Iqna', chapter on Riba and Sarf, vol. 3 p. 206). In the Shafi'i school: "Riba only applies to the types of cash, in other words gold and silver even if they are unminted (such as jewellery and bullion), as opposed to trade goods and fulus even if these are in circulation." (Sharh al-Manhaj by Sheikh Zakariyya al-Shafi'i). In the Maliki school: Sheikh 'Iliyyish al-Maliki says in Fath al-'Ali al-Malik 'ala Madhhab al-Imam Malik, in a fatwa about zakat on paper money "There is no zakat on copper fulus, minted by the ruler and in circulation. In the Mudawwanah, it is narrated that Malik was asked about a man who possessed fulus worth 200 dirhams upon which a year passed. He said that no zakat was due upon it." Imam Abu Hanifah said that if a person bought fulus for dirhams and one of the parties paid whilst the other deferred payment, this was permissible. However, if both parties deferred payment, this was not permissible because it was a debt for a debt.

3.4. Arguments in favour of treating fulus as gold and silverAmong the scholars documented by Al-Mani` in support of the view that fulus is similar to gold and silver, and therefore shares the same rulings regarding riba, sarf, salam and zakat, are the Hanbali opinions: "Fulus in circulation is money (athman). This view is amongst those on the authority of Imam Ahmad. Ahmad said, 'One fils must not be sold for two'. There are two opposing narrations from Ahmad on this matter. In al-Talkhis, the matter was left undecided. One of the narrations is that unequal exchange is not allowed, and this is transmitted by a group of Ahmad's students. It is the view preferred in al-Mustaw'ib and al-Hawi al-Kabir."


(Abul-Khattab, Tashih al-Furu'). Ibn al-Qayyim has a valuable discussion on the matter of the 'illah of riba in gold and silver in his I'lam al-Muwaqqi'in, in which he criticises those who treated fulus as trade goods. For example, he says, "I saw the corruption of their dealings and the harm caused by them when fulus were treated as a commodity to be sold for profit. There was widespread harm and much injustice. If fulus were to be treated as a single currency (thaman) of stable value, by which other things' value was measured and not vice-versa, public affairs would be set aright." (vol. 2, p. 137, Hanbali law). In the Maliki school, Ibn al-Qasim said “I asked Malik about fulus that was sold for dinars and dirhams with deferred payment, and about the sale of one fils for two. He replied, "I dislike that, as I dislike it for gold and silver." (Al-Mudawwanah al-Kubra, Kitab al-Zakat, Maliki law).

4. Paper Money as a Substitute for Gold and Silver

4.1. ArgumentsAccording to this view, paper money is a substitute for gold and silver, and the substitute has the same ruling as the substituted. It has the same moneyness as the gold and silver on which it is based and by which it is backed. This viewpoint is the closest to the truth, except that paper money has passed through several stages until it gained the confidence of the public, who no longer asked about its backing. In due course, the issuing authorities saw that they did not need 100% backing and thenceforth only an acceptable percentage of the paper money was backed. The remainder could be regarded as promissory notes in the sense that the issuing authority must guarantee their value. Further, backing did not need to be with gold and silver as the same could be achieved using property or treasury bills for example.

4.2. Consequence of following this position4.2.1. Both types of riba (fadl and nasi'ah) apply to paper money.4.2.2. Zakat is obligatory when paper money reaches the nisab amount of gold or silver,

depending on its basis.4.2.3. Paper money may be used in bay` salam.4.2.4. Paper money has the same legal rulings as gold or silver, depending on the precious

metal upon which it is based.4.2.5. Unequal exchange of two paper currencies based on the same precious metal is not

allowed.4.2.6. Unequal exchange of two paper currencies based on different precious metals is

allowed, as long as this is done on the spot.


APPENDIX THREE: SOME KEY EPISODES IN MONETARY REFORM

1. Guernsey 1815(Based upon a report in The Money Bomb, J. G. Stuart, Embryo, 1983, UK).In the aftermath of the Napoleonic wars, the British Channel island of Guernsey found itself in need of much rebuilding and improvement to local infrastructure and housing. Yet Guernsey faced a severe money shortage both within the public and private sectors. The state authority was £19,137 in debt and paid £2,390 of its £3,000 annual revenue in interest payments to its creditors. Repairs to the sea walls had been estimated at £10,000. A committee of the island’s laymen was formed to propose solutions to the financial deficit and the solution that this committee proposed was that notes should be issued by the States of Guernsey in the amount of £6,000, with the intention that this amount should be withdrawn from public circulation by means of taxes during subsequent years. In 1816, the first issue of £4,000 in States notes was made, to be spent on various public works. By 1822, the States notes issue had been expanded to £10,000 and it was recorded by the finance committee that such an issue was the “most advantageous method of meeting debts from the point of view both of the public and the States finances”. Further issues were authorised in 1824, 1826 and 1829 by which time a total issuance of £48,000 had been made. No record exists of inflation within Guernsey coincident with the note issuance described here, nor of the Guernsey pound suffering a discount in exchange against Bank of England notes. The Guernsey issuance continued until at least the 1950’s, when total issuance was in excess of £500,000.

2. Lincoln's Greenbacks 1862(Based upon the research of J. F. Chown in A History of Money, Routledge, 1994, UK).The United States Civil War provided President Abraham Lincoln and his Treasury secretary Salmon Chase with the basic dilemma of how to raise the necessary finance. The traditional route of issuing bonds or other forms of debt instrument to raise money, from the banks or direct from the public, was partially rejected as a result of their deliberations, in favour of the issuance of legal tender paper money by the United States Treasury itself. This policy had the obvious advantage over the borrowing of newly created bank money in that United States Notes, having been created by the Treasury itself, did not need to be borrowed from any institution external to government. The issuance of United States Notes thereby helped the Lincoln administration save a large sum in interest charges, at the expense of the banking community. However, the right was given to holders of the Notes that they could exchange them at any time for 6% bonds of between 5 and 20 years term or deposit them for at least 30 days with the Treasury at 5% interest. In practice the Notes circulated as currency and were therefore probably not exchanged or deposited in large numbers. (Of course, had they been so exchanged or deposited, they would have acted as a loan of money to the Treasury and could have been on-lent at interest in the loan market in order to offset the interest expense incurred by the Treasury.) The Bill signed into law by Lincoln in February 1862 made the Notes “legal tender in payment of all debts public and private within the United States” and thereby assured their value in exchange domestically. The use of green ink by the Treasury printers gave rise to the Notes’ common name, “greenbacks”, and some US$ 644 million were issued in order to finance the war. However, public trust was not always high in the survival of the North and its greenbacks. In June 1864, the greenback was exchanged for as little as 35.09% of a commodity gold dollar. United States Notes continued to circulate as legal tender currency until they were retired under the Clinton administration.

3. The Federal Reserve 1913The Federal Reserve System was established in the United States of America by an Act passed during December 1913. The passing of the legislation was achieved against a background of substantial procedural controversy and conflict of interest, recorded in the Congressional Record at the insistence of Senator Bristow of Kansas, the Republican leader. The use of the word “Federal” does not reflect the constitutional nature of the Federal Reserve for it is a private organisation whose main concession to public supervision is that its Chairman is appointed by the President of the United States. Under the Federal Reserve Act, the Board of the Federal Reserve has the right to issue Federal Reserve Notes (“FRN’s”), for example by lending them to the United States government or to the twelve regional Federal Reserve Banks. These notes are legal tender in the United States of America and are now used as reserves for the wider monetary aggregates. Although the wider economic definitions of money supply include bank deposits, legally speaking these are debts owed


by banks to depositors and not money. Title 12 of the United States Code describes Federal Reserve Notes as "obligations of the United States" which "shall be redeemed in lawful money on demand at the Treasury Department of the United States or at any Federal Reserve bank”. The word “money” is conspicuous by its absence when referring to Federal Reserve Notes in these and other definitions. Indeed it might be asked how a Federal Reserve Note could be "redeemable in lawful money" were it itself "lawful money". Article 1, Section 8, Clause 5 of the Constitution, states that it is Congress that shall have the power "to coin Money, regulate the value thereof, and of foreign coin". Article 1, Section 10, Clause 1 requires that no State shall coin Money, emit Bills of Credit or make “any thing but gold and silver coin a tender in payment of debts". Those who drafted the American Constitution clearly went to some lengths, in what is otherwise a very short document, in order to protect the American monetary system from the perils of usurious banking. Of these perils they were no doubt well informed, given the example of contemporary European society. Thomas Jefferson’s warning (The Writings of Jefferson, vol. 7, p.685, Committee of Congress, Washington DC, 1861) appears remarkable in the light of subsequent developments:”If the American people ever allows the banks to control the issuance of their currency, first by inflation then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers occupied. The issuing power of money should be taken from the banks and restored to Congress and the people to whom it belongs”.

4. Schwanenkirchen, Bavaria, 1930(an extract from Lietaer, B. , The Future of Money, 2001)“In 1930, Herr Hebecker, owner of a small bankrupt coal mine in Schwanenkirchen, Bavaria, decided in a desperate effort to pay his workers in coal instead of Reichsmark. He issued a local scrip - which he called ‘Wara’ - redeemable in coal. On the back were small squares where stamps could be applied. A bill would remain valid only if the stamp for the current month had been applied. This negative interest charge was justified as a "storage cost." The workers paid for their food and local services with these Wara. For example, the baker had no real choice but to accept them, and convinced his wheat suppliers to accept them in turn. The process was so successful that by 1931 this Freiwirtschaff (free economy) movement had spread through all of Germany, involving more than 2,000 corporations and a variety of commodities as backing for the Wara. But in November 1931, the German central bank, on the basis of its monopoly on currency creation, prohibited the entire experiment.”

5. Worgl, Austria 1932(an extract from Lietaer, B. , The Future of Money, 2001)”In 1932, Herr Unterguggenberger, mayor of the Austrian town of Worgl, decided to do something about the 35 percent unemployment of his constituency (typical for most of Europe at the time). He convinced the town hall to issue 14,000 Austrian shillings' worth of "stamp scrip," which were covered by exactly the same amount of ordinary shillings deposited in a local bank. After two years, Worgl became the first Austrian city to achieve full employment. Water distribution was generalized throughout, all of the town was repaved, most houses were repaired and repainted, taxes were being paid early, and forests around the city were replanted. It is important to recognize that the major impact of this approach did not derive from the initial project launched by the city, but instead had its origin in the numerous individual initiatives taken in the process of recirculating the local currency instead of hoarding it. On the average, the velocity of circulation of the Worgl money was about fourteen times higher than the normal Austrian shillings. In other words, on the average, the same amount of money created fourteen times more jobs. More than 200 other Austrian communities decided to copy this example, but here again the central bank blocked the process. A legal appeal was made all the way to the Supreme Court, where it was lost.”


APPENDIX FOUR : PROJECT SCHEDULE

• March 2006Provide a verbal presentation of the key points of this report to a private invited audience of key Malaysian policy-makers.

• June 2006Assemble working party to develop a detailed operational proposal for reform of the Malaysian monetary system based upon the contents of this report, and incorporating improvements and recommendations gained from consultation with mutually agreed parties.

• September 2006Complete operational proposal for delivery to agreed mutually agreed parties.

• December 2006Convene for private conference with mutually agreed parties to discuss and agree main reform policies for implementation.

APPENDIX FIVE : WORKING PARTY RESOURCES

For the purpose of preparing a final quantitatively detailed document in this series, the following resources should be made available to a specially constituted working group.

1. Informational ResourcesA database of research articles, statistical releases and other publications relevant to the field of monetary systems and monetary reform should be prepared and made available to the group either as a shared resource or privately where necessary.

2. Human Resources2.1. Access to those with professional services experience in the fields of central banking,

financial law, financial market regulation, both domestically and internationally, should be obtained formally or informally for consultation purposes, if necessary on a confidential basis.

2.2. Secondment of key working party members for placements at key institutions in the Malaysian monetary system will be necessary so that a detailed assessment can be made of the extent and timing of the proposed reforms.

2.3. Advice will be sought from within the Malaysian political domain in order to inform the working party of the constraints that operate at the political level and to delineate practical limits upon the scope and scheduling of the reform agenda.

2.4. Key academics and Shari'ah scholars with an existing preference for the reforms being contemplated will be contacted in order to develop a lobby of support that can in due course be used in public discourse. Contacts with specialists from mixed national backgrounds, schools of Shariàh and economic persuasions is to be preferred.

2.5. Administrative resources will be required to cater for the logistical requirements of the working party, for example co-ordinating travel and meeting schedules.

3. Media Resources3.1. Suitable public relations networks and media channels should be identified for use by

selected individuals within the working group in order to disseminate information to the public when it is deemed necessary to do so.

4. Financial Resources4.1. The working party should have sufficient financial resources to fund its operations for up to

three man-years of work, in addition to the payment of travel, accommodation, research and media expenses.


REFERENCES

1. Gold as a Store of Value, Research Study no. 22, World Gold Council, 19982. Monetary Problems, Monetary Solutions and the Role of Gold, Research Study No. 25, World Gold

Council, 20013. Money and the Price Level under the Gold Standard, Robert Barro, The Economic Journal, UK,

March 19794. A History of Money, J. F. Chown, The Institute of Economic Affairs, UK, 19935. A History of Economic Thought, Eric Roll, 5th edition, UK, 19926. The Distinguished Jurists Primer, Ibn Rushd, tr. Nyazee, Garnet, UK, 19967. Financial Transactions in Islamic Jurisprudence, Dr. Wahba al-Zuhayli, Dar al-Fikr, 20038. Currencies Banks and Financial Markets, Yusuf Al-Zamel, Yusuf ‘Abd al-Khayr & ‘Abd al-’Aziz al-

Sudani, Saudi Arabia, 20019. Paper Money, Its Reality, History, Value and Legal Ruling, Àbdullah bin Sulayman bin Mani`, Saudi

Arabia, 1971/198410. The Future of Payment Systems, Bernard Lietaer, Unisys Corporation, 200211. The Future of Money, Bernard Lietaer, Century, 200112. Monthly Statistical Bulletin, Bank Negara Malaysia, September 200413. Bank Negara Malaysia Annual Report (2003), Bank Negara Malaysia, 200414. International Financial Statistics Yearbook, IMF, 1997 - 200515. Central Bank of Malaysia Act 1958 (revised 1994), Laws of Malaysia16. Banking and Financial Institutions Act 1989, Laws of Malaysia17. Exchange Control Act 1953 (revised 1969), Laws of Malaysia18. Islamic Banking Act 1983, Laws of Malaysia19. The Money Bomb, J. G. Stuart, UK, 198320. Fonseca, G. at John Hopkins University, & Ussher, L. at New School University, USA, on-line material21. Fisher, I. 100% Money, USA, 1936

AUTHORS AND CONTACT DETAILS

About the AuthorsTarek El Diwany graduated in Accounting & Finance at the University of Lancaster in the United Kingdom in 1985. In 1990, he established the over-the-counter bond derivatives desk at Prebon Yamane in London, a major international financial broking house. In 1995 he established the company's Islamic Finance department, advising upon wholesale investments in accordance with Islamic principles in the Middle East and South-east Asia. Since 1998, Tarek has worked as a private consultant in Islamic banking and finance, mainly consulting with professional services firms in the London market. He is the author of "The Problem With Interest", edits the on-line resources at www.islamic-finance.com and is an occasional speaker at international events in the field of monetary reform and Islamic banking.

Dr. Usama Hasan graduated from Cambridge University in 1992 and went on to gain a PhD in Artificial Intelligence from Imperial College in London. He is hafiz in Qur’an and multi-lingual in English, Arabic and Urdu. Usama has translated a number of works from Arabic to English and undertaken a variety of research in Islamic history and Islamic jurisprudence at a professional level. He presently lectures at the University of Middlesex in London.

Shaharuddin Zainuddin is a Chartered Certified Accountant and holds a BSc in Accounting from the University of East Anglia in the UK (1992). He has extensive experience of both practical and regulatory issues in Islamic banking and finance, having worked in the Islamic private equity field and as Director of Banking at a leading regulatory organisation in the Middle East. He is presently the compliance officer for Islamic banking for an international bank in the Middle East. Contact DetailsTarek El DiwanyZest Advisory LLP, 72 New Bond Street, London, W1S 1RRoffice telephone: + 44 207 518 0369e-mail: [email protected] telephone: + 44 7771 600 550


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Monetary Reform in Malaysia : Policy and Implementation