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Section: Daily Dispatches

Malaysia May Use Gold
To Secure Arms Purchases

By Leslie Lopez
The Wall Street Journal
Monday, May 9, 2005

KUALA LUMPUR -- The Malaysian government is considering an arms deal
that calls for it to commit part of the country's gold reserves to
help finance the purchase of warships and other defense equipment
valued at roughly 1 billion, or about $1.8 billion, from BAE
Systems PLC.

The proposed use of Malaysia's gold holdings as collateral for the
deal is highly unusual, according to bankers and economists here. It
could spark controversy in Malaysia, where the country's central bank
incurred losses of about $4 billion during the early 1990s using its
reserves to trade in international currency markets, a strategy that
drew heavy criticism at the time.

Under the BAE-initiated proposal, the British defense contractor
would arrange financing for the arms purchases with a loan secured by
gold certificates issued by the Malaysian government, according to
people familiar with the matter. Other aspects of the plan, such as
the tenure of the proposed loan and the specific details of the
equipment Malaysia intends to purchase, haven't been finalized. But
people familiar with the proposal say the annual interest rate on a
gold-secured borrowing could be as low as 0.5 percent.

A senior aide to Malaysian Deputy Prime Minister Najib Abdul Razak,
who also serves as defense minister, described the BAE plan as "an
unsolicited proposal that is being looked at" by the government. "No
decision has been taken and whatever purchase of defense equipment"
Malaysia enters into "will take into consideration our financial
position," the aide said.

A spokesman for BAE Systems in London acknowledged that the company
was in discussions with the Malaysian government over its defense
requirements, but declined to elaborate or to discuss the arms-
financing proposal.

According to Bank Negara, Malaysia's central bank and custodian of
the nation's financial reserves, the country's gold and foreign-
exchange holdings at the end of 2004 exceeded 250 billion ringgit, or
about $66 billion, enough to finance eight months of retained
imports. The central bank doesn't provide a breakdown of its reserve
holdings by category, but should Kuala Lumpur approve the BAE
proposal, the country would be committing about 2.8 percent of its
total reserves to fund the arms purchases from BAE.

Financial executives familiar with the financing proposal say the BAE
plan is notable for its innovation. Malaysian Prime Minister Abdullah
Ahmad Badawi's government has been pushing to cut the country's
budget deficit and has generally avoided fresh commitments to big-
ticket contracts and state-funded projects. But BAE's suggested use
of gold reserves as security for the arms purchase represents a novel
way to secure funding at low rates. By comparison, the Malaysian
government could expect to pay about 0.75 percentage point over the
interest rate on U.S. Treasury notes -- or slightly less than 5
percent -- for a 10-year U.S. dollar sovereign-risk borrowing, the
financial executives say.

Still, because it is unconventional, BAE's financing proposal could
prompt public debate over management of Malaysia's reserves. Kuala
Lumpur-based bankers and economists say they can't recall any
instance where a government has committed its gold reserves as
security for borrowings to fund a commercial deal. They say that the
pledging of a country's gold holdings as security against borrowings
usually happens when governments are faced with a debilitating
financial crisis.

In 1991, for example, the Indian government -- which then held
foreign-exchange reserves enough to cover just two weeks of imports --
shipped 25 metric tons of gold from its official reserves to the
Bank of England as collateral for fresh credits to avoid defaulting
on earlier borrowings.

Malaysia has had one bitter experience using its foreign reserves for
unorthodox purposes. During the late 1980s, the Malaysian government
under former Prime Minister Mahathir Mohamad approved a plan
permitting Bank Negara to use the country's then-rapidly mounting
gold and foreign-currency reserves to trade aggressively in currency
markets in Asia, Europe, and the U.S.

While central banks routinely trade in currency markets for hedging
purposes, it is extremely unusual for banks to use such trading with
the goal of maximizing profits.

Bank Negara initially racked up substantial profits from its currency
bets. Then in 1992, it misread the market badly, losing heavily on
the plunge in the British pound and the mark. Two years later, the
central bank declared that it had incurred losses of more than 15
billion ringgit from currency trading. After the debacle, the then-
central bank governor, the late Jaffar Hussein, and his chief adviser
for foreign exchange, Nor Mohamed Yakcop, resigned from Bank Negara.
Mr. Nor Mohamed has since returned to government and currently serves
as Malaysia's second finance minister.

Some analysts suggest that Malaysia could blunt potential criticism
of the BAE plan if Kuala Lumpur adopted a more transparent approach
to its arms purchases, perhaps by calling for competitive bidding on
defense contracts. But that appears unlikely, because the government
has long insisted that its defense procurements must be conducted
through private negotiations on the grounds of national security.

Malaysia's defense ministry has lobbied for more offshore patrol
vessels to police its territorial waters. It particularly wants more
vessels for the Straits of Malacca, where piracy has increased in
recent years, and the waters off the coast of the Sabah state in
Borneo, where tourists have been kidnapped in the past by terrorist
groups operating out of the southern Philippines.

The issue has become more urgent after recent problems surrounding a
project by the Malaysian government to build its own offshore patrol
vessels through a joint venture between a local company, PSC
Industries Bhd., and ThyssenKrupp AG of Germany.

Under a 10-year contract awarded in 1998 and valued at 24.3 billion
ringgit, PSC Industries and its partner won the right to build 27
offshore patrol vessels for the Malaysian navy. But PSC, which
already has received 2.5 billion ringgit in advances from Kuala
Lumpur, has yet to deliver the ships.

Government officials say the first two ships built by the company
have failed to pass predelivery trials and are dogged, among other
things, by computer-system glitches. PSC hasn't commented on the
situation.

Problems with the first ships have forced the Malaysian navy to
temporarily shelve plans to purchase the next four patrol vessels
scheduled for delivery from PSC.

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