Short Selling in 1997

Before the1997 financial crisis, Malaysia was a top investment destination. At the start of 1997, the KLSE Composite Index was above 1,200 and the Ringgit was trading above RM 2.50 to US$1. Right after the Thai Baht devaluation in July 1997, the Malaysian Ringgit was “attacked” by speculators. This led to rating downgrades and a sell off on the stock and currency markets. By the end of 1997, the Ringgit had lost 50% of its initial value, falling from Rm 2.50 to under Rm 3.80 against the greenback. In 1998, the Ringgit further plunge below Rm 4.7 and a defensive measure was taken to move the Ringgit from a free float to a fixed exchange rate regime.

The question is how did the speculators short sell the Ringgit Malaysia? Selling short or “shorting” refers to a way to gain profits from the drop in price of a security, such as a stock or a bond. It is opposite from investors who “go long” in hope of a rise in the security’s price. To profit from short selling, the short seller can borrow a security and sell it with the expectation that the security will decrease in value so that the short seller can buy back the security at a lower price and earn the difference in prices.

Selling short in the currency market has a slight difference than selling short in the stock markets. This is because currencies are traded in pairs, with each currency being priced against another currency. The short selling of currency occurs when a trader wants to trade with a certain currency lets say Ringgit. The trader borrows the currency and buys another currency (let us say US dollar) in anticipation that the previous currency (Ringgit) will fall. When the Ringgit falls, the trader then uses his US dollar currency to buy back the Ringgit at a cheaper conversion rat, thereby enabling the trader to gain more of it and pay back the sum he borrowed. Since the trader has now obtained more money than he had initially borrowed, he earns the difference.

Take for example: a trader wants to trade with US dollar and Ringgit Malaysia currencies. For the purpose of this example, let us assume the exchange rate is $1=Rm2.50. The trader than borrows let say Rm 250. With this amount of money, he then buys $ 100 in anticipation that the Ringgit will drop in value. If the conversion rate the following day becomes $1=Rm4.00, then the trader sells his $ 100 and gets Rm 400. He returns the Rm 250 and keeps the Rm 150 as profit. Of course, the opposite can also happen (the Ringgit increase in value) and the trader makes a lost. Take a look at the illustration below.

Day 1 – Exchange rate $1 = Rm 2.50

Trader borrows Rm 250 and converts it into $100

Day 2 – Exchange Rate $1=Rm 4.00

Trader converts $100 into Rm400

Day 3 – Trader returns Rm 250 and keeps Rm 150 as profit

One of the reasons why speculators were able to hit the Ringgit so hard was due to what Frederick Mishkin dubbed as the role of asymmetric information in the financial markets. Asymmetric information according to Frederick, is a situation that arises when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decisions when conducting the transaction. Asymmetric information in turn will lead to a herd behavior among investors that will result in a chain reaction with investors trying to realize their stocks and converting their existing Ringgit currencies into foreign currencies which in turn results a stock market crash and a devaluation of the local currency.

In the same way, the speculators rely on this herd behavior of investors when short selling the currency. By first converting their borrowed Ringgit into another currency, this action would prompt other investors to do the same thereby insuring that the value of the Ringgit will drop (the speculators have already estimated that the Malaysian foreign reserves would not be able to absorb the excess supply of Ringgit in the market). When the value of the Ringgit spirals downward, the speculators then buy back the Ringgit and gain the difference from the conversion. Also noted is the relationship with the currency and the stock markets. When the value of Malaysian currency falls, foreign investors will also face loses due to the conversion rate. Foreign investors will then sell their stocks and convert the proceeds into foreign currencies to minimize their losses. 

 

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