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Monetary Reform in Malaysia

Policy and Implementation
A report by Kreatoc Ltd.
December 2005
Monetary Reform in Malaysia: Policy and Implementation 1
Executive Summary
Key Implementation Processes
1. Reform Objectives
1.1 The Need for Monetary Reform
1.2 Economic Consequences of Fractional Reserve Banking
1.3 Main Stages of the Reform Process
1.4 Key Themes of the Reform Process

2. The Transition Phases
2.1 Phase One: Elimination of Bank Money Issuance
2.2 Phase Two: Elimination of State Issued Reserve Money
2.3 Post-reform Monetary Aggregates
2.4 Monetary Oversight Committee
3. Policy Tools
3.1 Fractional Reserves and Reserve Money
3.2 Money and Bond Market Operations
3.3 Provision of Temporary Assistance by the Public Sector
3.4 Risk, Capital Requirements and Asset-liability Structure
3.5 Central Bank Directives and Recommendations
3.6 Foreign Exchange Market Intervention
3.7 Establishment of Conduits for Temporary Refinancing of the Private Sector
3.8 Financial Trading Strategies
3.9 Restrictions and Disincentives to the Use of Interest-based Financing
3.10 Encouragement of Public and Private Interest-free Finance Facilities
4. Implications for Financial Markets
4.1 Financial Market Activity Post-reform
4.2 Securities Market Regulation
4.3 Capital Controls and Foreign Ownership Issues
4.4 Foreign Exchange Market
4.5 Precious Metals and Commodity Markets
5. Commercial Banking Position
5.1 Forecast Balance Sheet
5.2 Management of Changes in Statutory Reserve Ratio
5.3 Account Types Post-reform
5.4 Liquidity Management for Investment Accounts
5.5 Forecast Impact Upon Profitability
5.6 Costs of Payment Transmission Services
5.7 Dual or Single Track Approach?
6. Federal Position
6.1 Domestic Federal Debt Levels Post-reform
6.2 Impact on Federal Debt Service
6.3 Utilising the Monetisation Dividend
6.4 Government Debt Maturity Profile
6.5 Federal Revenue
Monetary Reform in Malaysia: Policy and Implementation 2
7. Central Bank
7.1 Main Balance Sheet Elements Post-reform
7.2 Central Bank of Malaysia Act 1958
8. Some Relevant Empirical Data
8.1 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 Sterling
8.4 Long-run Growth in US Dollar Money Stock
8.5 Public plus Private Debt as a Percentage of GDP
9. Change Management Issues
9.1 Consensual or Non-consensual Approach?
9.2 Use of Existing Levers Where Possible
9.3 Achieving Public Buy-in
9.4 Transparency Versus Confidentiality
9.5 Achieving Institutional Buy-in
9.6 Opponent Strategies
Appendix One: Secular Themes
1. Introduction
2. Classical Theories of Money
3. The Bullionists
4. The Banking and Currency Schools
5. Leon Walras
6. Ludwig von Mises
7. Tobin and Hicks
8. Irving Fisher
9. The Cambridge Economists
10. Knut Wicksell
Appendix Two: Islamic Themes
1. Paper Money as an IOU (an Evidence of Debt Owed to the Bearer)
2. Paper Money as a Commodity
3. Paper Money to be Treated as Fulus
4. Paper Money as a Substitute for Gold and Silver
Appendix Three: Some Key Episodes in Monetary Reform
1. Guernsey 1815
2. Lincoln’s Greenbacks 1862
3. The Federal Reserve 1913
4. Schwanenkirchen, Bavaria, 1930
5. Worgl, Austria, 1932
Appendix Four: Project Schedule
Appendix Five: Working Party Resources
1. Informational Resources
2. Human Resources
3. Media Resources
4. Financial Resources
Authors and Contact Details
Monetary Reform in Malaysia: Policy and Implementation 3
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 Shari`ah. 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.
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• 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
• 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.
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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
• 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
• 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.
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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 Cycle
Largely 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.
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1.2.2. Endemic inflation
Given 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 patronage
The 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 leverage
The 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
1.2.5. Environmental degradation
The 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 inequality
The 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.
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1.2.7. Conflicts in monetary policy
The 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 risk
The 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 misallocation
By 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 indebtedness
As 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
Monetary Reform in Malaysia: Policy and Implementation 9
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
1.2.11. A note on the efficiency of the payment and clearing system
The 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 consequences
The 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

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.
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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
1.4. Key Themes of the Reform Process
1.4.1. Staged process with pilot implementation
The 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 strategy
The 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 management
It 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.
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2.1. Phase One: Elimination of Bank Money Issuance
2.1.1. Formal restructuring of time and sight deposits
In 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 deposits
To 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 accounts
Withdrawal 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 period
The 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 system
Under 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.
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2.1.6. Potential shift to sight deposits
It 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 reserves
A 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 companies
Finance 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 accounts
The 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.
Monetary Reform in Malaysia: Policy and Implementation 13
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 net
Faced 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 system
During 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 Two
The 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-
Monetary Reform in Malaysia: Policy and Implementation 14
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 selection
As 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 conventions
The 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 money
The 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 bullion
Following the introduction of commodity based money, exchanges of countervalues
Monetary Reform in Malaysia: Policy and Implementation 15
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 stock
The 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
Monetary Reform in Malaysia: Policy and Implementation 16
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-reform
The 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 money
The 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
Monetary Reform in Malaysia: Policy and Implementation 17
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
Monetary Reform in Malaysia: Policy and Implementation 18
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: Audit the issuance of reserve money by the Government Collect the statistics necessary for the performance of its work. 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. Act to ensure adherence within the deposit taking sector to the requirement
for 100% reserves against sight deposits 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 phase
Following the abolition of state issued reserve money in favour of commodity reserve
money, the monetary oversight committee would perform the following functions: 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 Establish and operate various branch locations where refined bullion can be
assayed on behalf of private and public sector counterparties Accept assayed bullion in return for issuing minted commodity coinage or
credits at the Government warehouse facility Establish and operate industrial facilities where bullion is converted into
minted coinage for circulation as cash 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) Research new technology for improving the security of commodity coinage in
circulation (for example, the embedding of precious metal in clear plastic for
circulation) Research new technology for improving the efficiency of the payment system. As above. As above.
Monetary Reform in Malaysia: Policy and Implementation 19
3.1. Fractional Reserves and Reserve Money
3.1.1. Synchronisation of changes in fractional reserves and reserve money
Each 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.
Monetary Reform in Malaysia: Policy and Implementation 20
3.1.2. Creation of new reserve money
The required new amounts of reserve money may be created in one of two ways: 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. 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 circulation
Four 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: 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. 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. 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. 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.
Monetary Reform in Malaysia: Policy and Implementation 21
3.2. Money and Bond Market Operations
3.2.1. Use of the three month intervention rate as a tool of reform policy
The 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 operations
Bank 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 Sector
A 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.
Monetary Reform in Malaysia: Policy and Implementation 22
3.4. Risk, Capital Requirements and Asset-liability Structure
3.4.1. Reduction in financial sector risk
A 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 techniques
Naturally, 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 weightings
Subject 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 banks
Bank 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 companies
The 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.
Monetary Reform in Malaysia: Policy and Implementation 23
3.6. Foreign Exchange Market Intervention
A 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 Sector
The 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 sector
Foreknowledge 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 sector
The 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.
Monetary Reform in Malaysia: Policy and Implementation 24
3.9. Restrictions and Disincentives to the Use of Interest-based Financing
The 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 ceilings
Maximum 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 incentives
Tax 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 penalties
If 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 measures
Interest-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 Facilities
The 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 mutuality
As 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 loans
An 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).
Monetary Reform in Malaysia: Policy and Implementation 25
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 Avenues
As 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.
Monetary Reform in Malaysia: Policy and Implementation 26
4.1. Financial Market Activity Post-reform
No 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 debt
The 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 market
The 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
Monetary Reform in Malaysia: Policy and Implementation 27
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 Regulation
The 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 limits
Tighter 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 restrictions
Monitoring 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 speculation
The 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 Issues
The 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 ownership
Restrictions 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 funding
Overseas interest-based funding of Malaysian and non-Malaysian controlled
organisations, particularly those in strategic sectors (including banking and finance)
Monetary Reform in Malaysia: Policy and Implementation 28
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
4.3.3. Investment by foreign entities
Investment 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
4.3.4. Withholding taxes
Withholding 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 penalties
Controls 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 controls
Purchase 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 selling
Short 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 allowances
If 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 metals
The 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 counterparties
Purchase 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.
Monetary Reform in Malaysia: Policy and Implementation 29
4.5.3. Delaying final conversion to commodity money
An 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 trading
Incentives 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.
Monetary Reform in Malaysia: Policy and Implementation 30
5.1. Forecast Balance Sheet
5.1.1. Factors affecting asset structure
The 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 structure
The 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.
Monetary Reform in Malaysia: Policy and Implementation 31
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 lending
Loan 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 reserves
Although 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 deposits
New 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 deposits
If 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 deposits
The 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 accounts
Commercial banks will need to prepare for the abolition of time deposits and the
Monetary Reform in Malaysia: Policy and Implementation 32
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
5.4. Liquidity Management for Investment Accounts
The 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 Profitability
In 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 Services
Bernard 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.
Monetary Reform in Malaysia: Policy and Implementation 33
6.1. Domestic Federal Debt Levels Post-reform
6.1.1. Total outstanding debt
The 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.
Monetary Reform in Malaysia: Policy and Implementation 34
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 holdings
Holdings 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 securities
The 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
Monetary Reform in Malaysia: Policy and Implementation 35
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
Monetary Reform in Malaysia: Policy and Implementation 36
6.3. Utilising the Monetisation Dividend
The 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”):
5,870 Pensions and Gratuities
2003 (RM millions) Annual Operational Expenditure
6.4. Government Debt Maturity Profile
The 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.
Monetary Reform in Malaysia: Policy and Implementation 37
6.5. Federal Revenue
Federal 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.
Monetary Reform in Malaysia: Policy and Implementation 38
7.1. Main Balance Sheet Elements Post-reform
7.1.1. Reform bonds
Should 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 bank
The 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 liabilities
Open 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 reform
Meanwhile, 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 reform
Bank 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
Monetary Reform in Malaysia: Policy and Implementation 39
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 reform
In 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 matters
These 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 Shari`ah 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. Currency
Clause 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.
Monetary Reform in Malaysia: Policy and Implementation 40
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. Operations
Clause 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.
Monetary Reform in Malaysia: Policy and Implementation 41
8.1. Long-run Changes in the Purchasing Power of Gold (USA & UK)
Average Annual Change
Purchasing power index for
Gold against UK CPI
Purchasing power index for
Gold against US CPI
1996 1930
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
195 100
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 2.4 100
1900 1990 Average Annual Change
Source: Economist intelligence Unit 1995
8.4. Long-run Growth in US Dollar Money Stock (M2)
7.23% 5392.9 150.81 17.59
Average annual change 1997 1950 1915
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
169 250 187 149 1993
144 198 151 85 1983
60 113 136 81 1970
Malaysia Japan USA UK Year
source: IMF FInancial Statistics Yearbook 2000
Monetary Reform in Malaysia: Policy and Implementation 42
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 Possible
Most 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 dividend
Substantial 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 wins
In 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 exercise
A 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
Monetary Reform in Malaysia: Policy and Implementation 43
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 implementation
Informal 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 representation
The 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 technicians
Eventually 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 campaigners
The 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 bank
It 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
Monetary Reform in Malaysia: Policy and Implementation 44
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 banks
Investment 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 Strategies
Policy 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 strategies
At 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 strategies
The 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 strategies
Political 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.
Monetary Reform in Malaysia: Policy and Implementation 45
(Summarised by T. El Diwany, from Fonseca, G. & Ussher, L., John Hopkins and New School, USA)
1. Introduction
Money'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 Money
William 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 Bullionists
In 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
Monetary Reform in Malaysia: Policy and Implementation 46
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 Schools
The 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 Walras
Leon 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 Mises
Ludwig 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 Hicks
If 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 Fisher
Irving 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).
Monetary Reform in Malaysia: Policy and Implementation 47
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
9. The Cambridge Economists
Irving 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 Wicksell
At 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.
Monetary Reform in Malaysia: Policy and Implementation 48
In 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 Shari`ah 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 Shari`ah 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 Shari`ah. 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 Man`i 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
Monetary Reform in Malaysia: Policy and Implementation 49
known Saudi Arabian scholar Sheikh `Abdullah 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-Man`i 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. Arguments
Scholars 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. Proponents
Proponents 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 position
Ibn 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
Monetary Reform in Malaysia: Policy and Implementation 50
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. Arguments
The 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. Proponents
2.2.1. 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 view
2.3.1. 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 payment
2.3.3. 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. Overview
This 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.
Monetary Reform in Malaysia: Policy and Implementation 51
3.2. Arguments on the equivalence between paper money and fulus
3.2.1. Proponents 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. 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). 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-
3.2.2. Consequences of regarding paper money as equivalent to fulus
With 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 silver
Among 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 silver
Among 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."
Monetary Reform in Malaysia: Policy and Implementation 52
(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. Arguments
According 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
4.2. Consequence of following this position
4.2.1. 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
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.
Monetary Reform in Malaysia: Policy and Implementation 53
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
3. The Federal Reserve 1913
The 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
Monetary Reform in Malaysia: Policy and Implementation 54
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
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.”
Monetary Reform in Malaysia: Policy and Implementation 55
• March 2006
Provide a verbal presentation of the key points of this report to a private invited audience of
key Malaysian policy-makers.
• June 2006
Assemble 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 2006
Complete operational proposal for delivery to agreed mutually agreed parties.
• December 2006
Convene for private conference with mutually agreed parties to discuss and agree main
reform policies for implementation.
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 Resources
A 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 Resources
2.1. 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 Shari`ah 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 Resources
3.1. 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 Resources
4.1. 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.
Monetary Reform in Malaysia: Policy and Implementation 56
1. Gold as a Store of Value, Research Study no. 22, World Gold Council, 1998
2. Monetary Problems, Monetary Solutions and the Role of Gold, Research Study No. 25, World Gold
Council, 2001
3. Money and the Price Level under the Gold Standard, Robert Barro, The Economic Journal, UK,
March 1979
4. A History of Money, J. F. Chown, The Institute of Economic Affairs, UK, 1993
5. A History of Economic Thought, Eric Roll, 5th edition, UK, 1992
6. The Distinguished Jurists Primer, Ibn Rushd, tr. Nyazee, Garnet, UK, 1996
7. Financial Transactions in Islamic Jurisprudence, Dr. Wahba al-Zuhayli, Dar al-Fikr, 2003
8. Currencies Banks and Financial Markets, Yusuf Al-Zamel, Yusuf ‘Abd al-Khayr & ‘Abd al-’Aziz al-
Sudani, Saudi Arabia, 2001
9. Paper Money, Its Reality, History, Value and Legal Ruling, `Abdullah bin Sulayman bin Mani`, Saudi
Arabia, 1971/1984
10. The Future of Payment Systems, Bernard Lietaer, Unisys Corporation, 2002
11. The Future of Money, Bernard Lietaer, Century, 2001
12. Monthly Statistical Bulletin, Bank Negara Malaysia, September 2004
13. Bank Negara Malaysia Annual Report (2003), Bank Negara Malaysia, 2004
14. International Financial Statistics Yearbook, IMF, 1997 - 2005
15. Central Bank of Malaysia Act 1958 (revised 1994), Laws of Malaysia
16. Banking and Financial Institutions Act 1989, Laws of Malaysia
17. Exchange Control Act 1953 (revised 1969), Laws of Malaysia
18. Islamic Banking Act 1983, Laws of Malaysia
19. The Money Bomb, J. G. Stuart, UK, 1983
20. Fonseca, G. at John Hopkins University, & Ussher, L. at New School University, USA, on-line material
21. Fisher, I. 100% Money, USA, 1936
About the Authors
Tarek 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 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 Details
Tarek El Diwany
Zest Advisory LLP, 72 New Bond Street, London, W1S 1RR
office telephone: + 44 207 518 0369
mobile telephone: + 44 7771 600 550
Monetary Reform in Malaysia: Policy and Implementation 57