Weak dollar boosts Malaysia inflation.

There could be trouble ahead for Malaysia's consumers if the government doesn't handle its foreign reserves in a skillful way, according to an April 13, 2005 paper published by the chief economist of Chicago's Northern Trust Company.

The problem began in 1997 when Malaysia - like other of the smaller Asian economies - decided that pegging the ringgit to the dollar would help the country out of the economic crisis that was sweeping Asia at the time. It did help.

But since that time, the dollar has weakened substantially, and the Malaysian government has had to buy dollars to maintain the peg.

Northern Trust explains that as the government has had to buy dollars to continue to support a weakening dollar, it must, in effect, print more money, more ringgits, to execute the transactions. These purchases, in turn, put more ringgits in circulation and Malaysia's money supply expands.

The mid-April Northern Trust paper contains a reminder that in classical economics, inflation is defined by an expansion of the money supply. The consequences of a country's inflating its money supply are higher prices for goods, services and assets.

The bank offered statistics to show that Malaysia's M2 money supply has expanded, particularly in recent years. In 2004, Malaysia's M2 money supply expanded 25 percent.

And inflation has begun to creep up.

According to International Monetary Fund (IMF) statistics, Malaysia's inflation started the decade with its inflation index growing at a rate of 3.5 percent over the base year of 1995. It spiked a year after the 1997 crisis growing 5.3 percent. But beginning in 2000 inflation didn't exceed 2 percent until 2004 when the index grew 2.2 percent. The IMF predicts inflation will be 2.5 percent in 2005.

Most countries that have pegs to the dollar know that it is costing their economies substantially to maintain the peg and that they have to get out. Timing is everything. China, for example, holds US$614.5-billion in dollars compared with Malaysia's US$71.5-billion. If China divests ahead of Malaysia, the value of the dollar will decline further and Malaysia's consumers will be faced with soaring inflation. Malaysia's dilemma will be the astute execution of its move.

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