an insight into macroeconomic policy management … insight into macroeconomic policy management ......

An Insight intoMacroeconomic Policy Management

and Developments in Malaysia

Mohd. Haflah Piei and Tiangchye Tan

Mohd. Haflah Piei is Deputy Director, Malaysian Institute of Economic Research.Tiangchye Tan is Senior Research Officer, Malaysian Institute of Economic Research.

2 A STUDY OF FINANCIAL MARKETS

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IntroductionMaintaining the delicate balance between high growthand macroeconomic stability has become one of themost challenging tasks of the 1990s. Runaway growthsince the end of the 1980s has led to an overheatingof the Malaysian economy, resource constraints, andinfrastructure bottlenecks, especially in the early1990s. Shortages of labor became a serious concernfor investors. On the other hand, the increasing num-ber of immigrant workers gave rise to serious con-cerns. Eventually, limiting their recruitment becamea policy option to sustain growth. Instead, Malaysiabegan to recognize the importance of sustaining fu-ture growth and development through increasing pro-ductivity. This will be imperative in addressing thevarious challenges that have emerged during the pe-riod. Strategically, it will be necessary to tackle theprospective loss of competitiveness vis-à-vis otheremerging economies, inflationary pressures, and lag-ging labor productivity as a result of rising wages.

Growth in the Asia-Pacific region moderatedslightly in 1996, mainly as a result of a sharp slow-down in merchandise exports brought about by thedeclining demand for electronic products, especiallysemiconductors. Compared with robust growth of9.5 percent in 1995, the Malaysian economy’s growthfell to 8.6 percent in 1996. This was mainly due tomuch slower growth in domestic demand especiallyin private investment expenditure. As the secondlargest component of real gross domestic product(GDP), with a share of 32 percent in 1996, privateinvestment declined sharply from a high of 25.4percent in 1995 to only 7.2 percent the next year.In the trade sector, the deficit on net exports fell by18.6 percent following a rise in the deficit of 105.1percent in 1995. Higher growth in exports relativeto import growth contributed to a lower net deficit.

The federal Government budget was in surplusfor the fourth consecutive year in 1996 and the defi-cit in the external payments (current account) wasfully financed by a net inflow of long-term corporate

investment. Business confidence remained strong in1996 as seen in the continued increase in proposedinvestment from the manufacturing sector through-out the year. With the consumer price index (CPI)increasing a mere 3.5 percent, inflation remained low.

On the whole, economic growth in 1996 was stillconsidered rapid and the external position of theeconomy improved significantly due to a much lowergrowth in imports. The merchandise trade balanceregistered a much higher surplus of RM8.6 billion in1996 compared to the 1995 figure of only RM233million. The current account deficit narrowed con-siderably in 1996 to RM13 billion from the previousyear’s figure of RM18.7 billion as a result of a slightlyimproved services balance, which recorded a lowerdeficit that year. As a proportion of nominal grossnational product (GNP), this amounted to -5.5 per-cent in 1996 as compared to the previous year’s fig-ure of -9 percent. In macroeconomic terms, thesedevelopments indicated that the Malaysian economywas still expanding at a healthy rate in 1996.

As such, 1997 was ushered in with much opti-mism, despite indications that the peak was over.Growth was expected to continue to remain strongand was projected at 8 percent for the year. Funda-mentals could still be described as strong. Inflationcontinued to be low. The current account deficit wasexpected to further narrow as a percentage of GNP,while the public sector fiscal position was expectedto be in surplus. This optimism was probably due to astrong feeling that adjustment measures to addressthe existing economic imbalances would achieve asoft landing in terms of a more sustainable growthwith stability (Bank Negara Malaysia [BNM] 1998).

In a situation of full employment and capacity, andinfrastructure constraints, concern began to mounton the adverse impact of too rapid growth. Excessdemand pressures on the balance of payments andthe disproportionate expansion in bank credit, espe-cially loans to finance unproductive sectors, had be-gun to raise questions. Another issue concerned theintense competitive pressures on Malaysian exports

3AN INSIGHT INTO MACROECONOMIC POLICY MANAGEMENT AND DEVELOPMENTS IN MALAYSIA

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from lower-cost producers. Remedial measures in-stituted since 1995 to alleviate the situation seemedto have produced some results, including a signifi-cant improvement in the external balance as well asa moderation in the inflation rate in 1996. Furtherprudential measures announced in the beginning of1997 boosted confidence that measures were in placeto reduce credit and monetary growth as well as topreempt rises in asset inflation (BNM 1998).

Therefore, when the Thai baht was first hit by awave of speculative selling in mid-May 1997, andthe subsequent contagion effect was initially felt,Malaysians maintained a certain calm and optimism.After the free-floating of the baht in July and theensuing effect folded in, reality began to take hold.The Malaysian Government’s first reaction was totry to maintain the status quo by rushing in to defendthe national currency. After July, the regional eco-nomic situation took a radical turn for the worse.

In the half decade before the Asian crisis, the Ma-laysian ringgit exchange rate had been hovering in anarrow band of between RM2.36 and RM2.51 to thedollar. The slide of the Malaysian ringgit against thedollar and most other major currencies began in March1997. From a level of 2.48 against the dollar that month,the ringgit slid to 2.52 in June. In the face of a specu-lative attack in July, it then plunged to an average of2.57. The central bank, BNM, tried to uphold the cur-rency for about a week but was finally forced to floatit on 14 July, by which time the bank had already lostclose to $1.5 billion in its efforts to prop up the ringgit.By the end of 1997, the ringgit depreciated to a low ofRM3.77 against the dollar. Worse followed in 1998 asthe ringgit plunged to an all-time low of RM4.88 to thedollar on 7 January, a depreciation of 48 percent withinhalf a year. It eventually pegged at an average ofRM4.40 to the dollar for the month. By April 1998,the ringgit settled at an average of RM3.73 to thedollar. More wide swings continued. All these trig-gered panic among businesses and policymakers, se-verely undermining confidence in the country (Malay-sian Institute of Economic Research [MIER] 1998).

In tandem, the Malaysian bourse, the Kuala LumpurStock Exchange (KLSE), saw prices diving during theperiod. Thus the Malaysian economy, which had, untilearly 1997, been regarded as one of the star perform-ers of emerging East Asia, began to experience a turn-about in performance. Notwithstanding the acclaimedfundamentals, the economy succumbed.

The economic turmoil and instability following theonslaught of the crisis raised various questions onthe effectiveness of macroeconomic policies andgovernance in the region. The debate over East Asia’s“economic model” that brought years of phenom-enal growth to the region subsided. The cry of the“triumph” of Asian values over Western practicesdissipated into naught. Malaysia’s immediate con-cerns in the aftermath of the crisis were stabilizingfinancial markets, restoring investor confidence, andstrengthening the resilience of the economy to po-tential systemic risks arising from the contagion ef-fects. The initial focus of macroeconomic manage-ment was along these lines.

The first part of this paper will feature a briefoverview of macroeconomic policies in Malaysiabefore the crisis. Following this, it will deal with de-velopments during the crisis period, while comment-ing on and discussing measures taken by Malaysiato alleviate and remedy the situation.

Overview of MacroeconomicPolicy Management in theYears Preceding the CrisisThe main objective of Malaysia’s macroeconomicpolicy is to promote the highest sustainable rate ofgrowth consistent with exchange rate and price sta-bility, while at the same time keeping control on in-flationary trends and improving external balances.

Interest Rates and Credit PolicyInstrumentsIn 1987, guidelines and measures were instituted toimprove and rehabilitate the financial sector. The gap


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between lending and deposit rates narrowed andcompetition began to intensify. The central bank re-viewed the interest rate system and in February 1991,controls on the base lending rate (BLR) were lifted.The behavior of the BLR and interest rates fell morein line with the market, and the spread between av-erage lending rates and the average cost of funds ofcommercial banks further narrowed in the early1990s.

In 1989, the statutory reserve requirement (SRR)was revised to one uniform rate applicable to all com-mercial banks, merchant banks, and other financialinstitutions to level the playing field (Economic andSocial Commission for Asia and the Pacific 1997).The central bank was also able to make use of thisrequirement as an effective tool for monetary controland to contain inflationary expectations. Between 1992and 1994, Malaysia experienced large capital inflows.During this period, the central bank adopted a tightmonetary policy and increased the statutory require-ment to mop up excess liquidity in the system.

Among other monetary tools employed by BNMto reinforce the policy impact were the minimum li-quidity ratio, the management of the Government’sexcess funds, and the Employees’ Provident Fund(EPF). (At the end of 1993, excess funds from theEPF were placed in a money market account at thecentral bank.) The management of these funds al-lowed the Government to mop up liquidity at sourceto ensure consistency between its fund allocation andmonetary policy as well as to enhance flexibility inmonetary management.

Continuous capital inflow into the economy in thefirst half of the 1990s arising mainly out of relativelylow interest rates and liberal exchange control sys-tems in developed economies; Hong Kong, China;and Singapore increased pressure on BNM to con-trol money supply. There were then conflicting ob-jectives between a contractionary monetary stancemeant to control inflation and the need to maintainlow interest rates to discourage more speculativefunds. Similarly, monetary aggregates became in-

creasingly difficult to interpret as a result of theinteraction of externally induced growth of moneysupply with the rapid rise in money demand due tothe wealth effect of rapid economic growth and theneed to finance the buoyant stock market. The cen-tral bank, in its interventions, had to ensure that rais-ing interest rates to reduce consumption would notdampen investments. Thus, as part of its strategy,BNM intervened in the foreign exchange markets.When foreign interest rates were lower, local inter-est rates were reduced while maintaining the gap.

BNM also used direct short-term borrowing fromthe interbank money market on a large scale to ster-ilize the large inflow of funds. To prevent a furtherreduction of interest rates, Malaysian Governmentpapers were issued. In 1993, a series of Bank Negarabills (BNB) and Malaysia Saving Bonds comple-mented these. Nevertheless, short-term inflows per-sisted and such funds normally result in an immedi-ate increase in the monetary base without a corre-sponding increase in fixed investments. The volatil-ity of these funds creates instability in both the do-mestic and external sectors. In 1994, sterilizationmeasures were eased as tight liquidity was pushinginterest rates up, resulting in continuous capital in-flow. Direct controls were then imposed. These in-cluded the introduction of a ceiling on the net exter-nal liability position of commercial banks, prohibitionon the sale of short-term monetary instruments tononresidents, and prohibition on banks from buyingforeign currency forwards. Measures requiringnontrade related foreign funds to be subjected to theSRR were also imposed (nonspeculative funds andthose placed in noninterest bearing external accountswere exempted). Similarly, limits on swap transac-tions with foreign clients were imposed occasionally(e.g. in 1988/89 and 1992).

Malaysia also engaged in moral suasion to dis-courage excessive lending for speculation and toencourage long-term financing on the basis of viabil-ity rather than collateral as well as to increase lend-ing to priority sectors. By the second half of 1994,


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differentials between domestic and international in-terest rates had narrowed and even became nega-tive, resulting in a net outflow of short-term funds.Direct controls were then lifted in response. In 1995,the BLR framework was revised again and wasaimed at enhancing the responsiveness of the BLRto money market conditions and the liquidity situa-tion of the financial system. This was meant to en-hance institutions’ efficiency.

Exchange RatesIn 1989 and similarly in 1992, BNM imposed restric-tions on the liberalized exchange market to reducespeculation by limiting nontrade related currencyswap transactions (Claassen 1992). As the Malay-sian economy began its high growth path and theGovernment implemented deliberate policy measuresto curb capital outflows, the situation began to re-verse when the value of the ringgit appreciated atthe start of the 1990s. These measures included thesale of Government securities and increases in statu-tory reserves. The position was also helped by aweakening of most major currencies during the pe-riod. The ringgit’s rise began to reverse after 1991,mainly due to persistent current account deficits. Thesituation experienced a dramatic turn at the end ofApril 1997, affected by the now historic consolida-tion of the stock market and short-term capital out-flows.

Under a flexible exchange rate system, capitalinflows will lead to the appreciation of the recipientcountry’s currency, a reduction in the relative priceof imports, and a shift in consumption away fromnontradables. All these eventually tend to alleviateinflationary pressures. Under a fixed exchange ratesystem or a managed float, the impact depends onwhether the inflow leads to an expansion of the mon-etary base, heightened inflationary pressures, or adeterioration of the country’s external position. Ma-laysia does not maintain a fully flexible exchange rateregime. Occasional interventions by the Governmenttake place to smoothen fluctuations.

The Financial SectorThe Malaysian financial sector has experienced aradical transformation and deepening in tandem withthe development of its economy since the 1980s.Reflective of these developments, the current finan-cial intermediation regime has become much broader,deeper, better structured, and more purposefully or-ganized compared with the relatively simple struc-ture during the postindependence years.

Malaysia has not initiated full-scale financial lib-eralization. In the past, the main pillars of reformhave been the reinstatement of interest liberaliza-tion, the liberalization of foreign exchange and capi-tal transactions, the easing of restrictions on busi-ness, the improvement and expansion of regulatoryand supervisory structures, and the development ofthe capital market. Full-scale liberalization is inevi-table as the World Trade Organization (WTO) hasmade it mandatory for all member-nations to adopt afreer policy on services by the year 2003 through theGeneral Agreement on Trade in Services (GATS).(Under Malaysia’s offer schedule for services, nonew entrants are allowed into the banking subsector,except through share acquisition of existing firms.)

As the economy continued to improve in the late1980s and early 1990s, more vigorous measures wereinstituted to strengthen and modernize the system.They were also meant to promote greater competi-tion within the banking system. In the early 1990s,Malaysia began paving the way for a more devel-oped securities market infrastructure in line with itsdevelopment. In 1992, the Securities Commission(SC) Act was passed. The SC, set up to oversee theefficient and overall development of the capital mar-ket, began operations in March 1993. Its responsi-bilities include the regulation of the securities indus-try, unit trust schemes, and mergers and acquisitionsof companies. The Futures Industry Act, aimed atfacilitating financial innovations to develop the op-tions and financial futures markets, came into forcethe same year. This established the legal frameworkfor the protection of investors and stability in the


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marketplace by setting up the minimum standardswithin which the markets should operate (MIER1998).

As foreign funds continued to flood the country in1992–1993, the Government prohibited all residentsfrom selling short-term monetary instruments (thosewith remaining maturity of one year or less, namelyBNBs, Treasury bills [T-bills] and Government se-curities) to nonresidents with effect from 24 Janu-ary 1994 under the Exchange Control Act of 1953.This restriction was subsequently extended to coverprivate debt securities (PDS) including commercialpapers but excluded securities convertible into ordi-nary shares, effective 7 February 1994. The movewas meant to discourage substantial holdings of mon-etary instruments by nonresidents to enable the cen-tral bank to better manage liquidity.

When the Asian crisis hit, many claimed that theMalaysian economy would not have been so badlyaffected had the financial system been sound andbetter managed such as those of Singapore andTaipei,China. Such an assessment is not easy to quan-tify or prove. Nevertheless, it must be realized thatdespite the financial reforms and adjustments sincethe 1980s, weaknesses obviously prevailed and thequestion of efficiency still existed.

Fiscal PolicyCountries react differently to external shocks and inmany of those that have been successful in avertingcrises, sound fiscal management and stable exchangerates have been among the elements playing a vitalrole. In Malaysia, fiscal policy has generally beendirected at revenue generation and the provision ofexpenditures to support basic infrastructure as wellas maintaining law and order.

As the economy continued to grow rapidly afterthe crisis of the mid-1980s, there did not seem to beany need for large fiscal stimuli. When BNM cau-tioned that the economy might be overheating in theearly 1990s, prudence and measures to moderategrowth were recommended. This was, in fact, fol-

lowed by a tighter monetary policy. The high-growthclimate of the first half of the 1990s presented theopportunity for the Government to address tax re-forms. Paradoxically, however, fiscal policy did notmove in the direction it should have.

In the preceding years, liberal personal and cor-porate income-tax cuts, and other tax-based incen-tives were used to stimulate recovery. This under-mined the tax system as an essential source of rev-enue. Given the increasingly competitive economicenvironment among regional countries, any move toreverse this would most likely have affectedMalaysia’s competitiveness. However, an indirect taxsystem could have been introduced whereby the po-tential to raise revenue was restored. Although theneed for such a system was recognized earlier in thedecade, nothing came of it (Narayanan, 1998). Infact, from 1992, there was a move towards a fiscalloosening leading to further cuts in corporate andpersonal taxes, the lowering or abolition of importtaxes on a variety of imports (primarily consumptiongoods), and increased federal Government spend-ing. In 1992, expenditures increased with the deci-sion to raise the salaries of civil servants.

Continued high growth in 1993 yielded a surplusin the public sector budget and eventually blinded theGovernment from realizing the urgency and wisdomof a turnaround in fiscal spending. In such periods, arationalized indirect tax structure would have helpedto remove distortions, contributed to moderatinggrowth, and simultaneously curbed inflationary pres-sures. It would also have laid down the infrastruc-ture for an eventual introduction of a broad-basedtax on consumption such as the value-added tax(VAT). Politically it would have been the right mo-ment for such a move as incomes were fast rising. Itwas, however, not to be so.

International Trade, Industrial andInvestment DevelopmentTrade has been one of the essential elements con-tributing to Malaysia’s growth over the past two de-


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cades. The country has a small domestic market andas a trading nation, it has always adopted one of themost open policies in Asia. Essentially, its trade poli-cies are closely related to its industrial developmentpolicies.

INDUSTRIALIZATION AND INVESTMENTDEVELOPMENT POLICIESAfter the crisis of the mid-1980s, policy essentiallyshifted from an inward-looking, domestic-orientedstrategy to one that was outward-looking. The es-tablishment of the Industrial Master Plan (IMP) for1986–1995 provided a long-term indicative plan fordevelopment. It emphasized export-led growththrough industrial diversification, provision of a lib-eral investment climate, and promotion of industry-linkages. The second half of the 1980s thus saw theenhancement of private investment and the develop-ment of a more focused policy orientation. The liber-alization measures under the IMP were consolidatedin the 1990s and are considered to have been crucialin lifting the country out of the crisis.

Official policy has been the main driving force inthe determination of industrial and technological de-velopment in Malaysia. It has been substantiallygeared towards the promotion of foreign investmentin the country. The neoclassical approach often sug-gests an end to government regulation and interven-tion, or if not, only a market-enhancing role for theState. The State’s role should be limited to effectivedevelopment planning. Nonetheless, in most of EastAsia, government intervention in industrial and in-vestment planning has always been a widespreadpractice and in Malaysia, the success of industrialdevelopment has been largely attributed to the gov-ernment-business nexus.

The Plaza Accord1 signed in 1985 was one of the

first catalysts of the relocations of investment andproduction from Japan and the first-tier East Asiannewly industrialized economies (NIEs) to the region.This thrust was further exacerbated by the withdrawalof Generalized System of Preferences (GSP) privi-

leges from these NIEs in 1988 and the economicand financial deregulation undertaken by East Asiancountries in subsequent years. As manufacturing hasbeen pinpointed as the engine of growth since thelate 1980s, emerging and rapidly industrializing econo-mies in East Asia aggressively competed for foreigninvestment. As a consequence of this increased com-petition, the Malaysian Government launched thedomestic investment initiatives (DII) in 1993 to en-courage more domestic investment. Strategies underthe DII include increased domestic content in localoutput, strengthening and deepening of the local capi-tal market to support domestic investment as well asdeveloping domestic anchor companies, and small- andmedium-size industries (SMIs) to provide greater andenhanced industry linkages. In the same year, theamount of approved domestic investment exceededforeign investment approvals by 19 percent.

While pursuing active industrial policies and at thesame time promoting local industries, Malaysia con-tinued to adopt an effectively “open-door” policy inthe majority of sectors, encouraging foreign directinvestment (FDI) inflows. It became one of the larg-est host countries for FDI during the period and in1995 received the biggest share of FDI in the Asso-ciation of Southeast Asian Nations (ASEAN) region.In all, the electrical and electronics industry receiveda substantial chunk of foreign capital and the prod-ucts were mainly directed to the export market. Sincethe early 1980s, this industry has grown tremendously,and has generated massive growth and helped buildup downstream industries. It was also strongly in-strumental in contributing to overall manufacturingemployment. Besides transferring capital technologyto developing economies, foreign capital also con-tributes to locating new market outlets for the hostnations as a substantial proportion of FDI flowinginto Malaysia (as in most other Southeast Asian coun-tries) is export-oriented, and thus elemental in en-hancing international trade.

However, the high growth generated also meantan acute shortage of labor, and hence rapidly rising


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labor costs. Rising costs unmatched by productivityand inadequate skills became a serious concern tothe Government and investors alike. Recognizing theneed to phase out labor-intensive industries, the Ma-laysian Government embarked on a strategy to at-tract investments with high value-added by introduc-ing the Second Industrial Master Plan (IMP2). Thenew Master Plan promotes the “Manufacturing PlusPlus” concept and the cluster approach to enableMalaysia to reach industrialized status. It concen-trates on the qualitative trend of FDI and stressesglobal competitiveness and productivity as the primemotivators for the future (Institute of DevelopingEconomies [IDE] 1998). The cluster approach willprovide the basis for a more integrated and cohesiveframework for industrial development. The Govern-ment has also set a target for the share of domesticinvestment to make up 60 percent of total invest-ment in the long term. In 1996, the ratio of domesticinvestment to foreign investment stood at 50.1 per-cent (56.2 percent in 1995). The decline was due toa relatively high flow of foreign capital that year.

Overall, the new scenario is meant to develop andenable Malaysian manufacturing to rapidly adapt tothe globalized business and industrial environment.New incentives will be proposed to enable manufac-turing to remain competitive within the liberalizingtrade regime through the realization of the ASEANFree Trade Area (AFTA). In all, industrial policies inthe 1990s have been forward-looking and compre-hensive.

INTERNATIONAL TRADE POLICIES ANDLIBERALIZATIONThe post-Soviet era has witnessed dramatic changesin the international economy. As the process of glo-balization and internationalization of the worldeconomy intensifies, an increasing number of coun-tries are liberalizing their economies and adoptingexport-oriented growth strategies. During the 1990sand especially after 1995, export incentives and tar-iffs began to decline as a result of domestic policy

reforms as well as changes necessitated by WTO,and regional trading arrangements such as AFTAand Asia-Pacific Economic Cooperation (APEC).As a result, the real sector began experiencing ac-celerated trade liberalization (Rasiah 1998).

In order to benefit from better products and enjoyaccess to better inputs, components, and technology,it will be important for a country to accept the re-sponsibilities and obligations that come with its levelof development. Malaysia is thus committed toworldwide liberalization efforts. Nevertheless, it ad-heres to the doctrine that any liberalization will de-pend on each country’s capacity and ability to copewith competition (IDE 1998). Malaysia has madethe following commitments:

• continue to reduce tariffs on imports in line withtrade liberalization efforts and multilateral com-mitments under WTO and AFTA;

• review nontariff measures with a view to relax-ing them when appropriate;

• gradually liberalize the services sector underGATS;

• eventually allow greater foreign participation inthe stockbroking and leasing sectors under theinterim financial agreement;

• provide market access for various businessessuch as telecommunications and hospitality ser-vices; and

• undertake various facilitation measures in areassuch as standards and conformance, customs,and protection of intellectual property rights.

Vulnerability andUnderlying WeaknessesNobody would have expected at the onset of the cri-sis that its repercussions could have been so severe.The beginning of summer 1997 still saw companiesenthusiastic about investing in emerging Asia. Severaleconomists in the West had cautioned East Asia aboutthe possibility of the bubble bursting in the mid-1990s.Lau and Kim (1992) and Young (1994) commented


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that East Asia’s growth had been more “a matter ofperspiration than one of inspiration.” Nevertheless,when the going was still good, would most have takenheed of “academic” theories? Warning signs hademerged by the middle of the decade. Overheatingeconomies, severe infrastructure bottlenecks, and bigdeficits should have been the first signs for caution.

The regional macroeconomic environment hasmostly been considered favorable. Malaysia’s mac-roeconomic management was seen as sound by anystandards with considerable fiscal discipline andmonetary policy prudence. The economy posted bud-get surpluses for five years consecutively after 1993.At the same time, BNM was able to maintain finan-cial stability by successfully sterilizing short-termcapital flows. The Malaysian savings rate remainedat a high of nearly 40 percent of GNP. External debtswere low (about 42 percent of GNP) and externalreserves were at a comfortable level. Capital inflowscontinued, but over a very short period, a reversal offortune and confidence occurred.

Essentially, contagion was only part of the story.At the same time, it must not be denied that cur-rency speculators played a predatory role in the event.Unfortunately, investors tended to perceive that alleconomies in the region are identical. Herd behaviordriven by panic and hysteria led to a wholesale pull-out of funds from the region. Thus, the speculative

attack on the Thai baht amid concerns of a slow-down in exports, high short-term external debt posi-tion, overvaluation of the currency, and the decline inasset prices led to the belief that similar risks werepresent in other regional economies.

Looking at the situation, one must perhaps con-cede that currency speculators, after all, aremessengers with a message that all may not be wellat home (Ariff 1999). Were there reasons forMalaysia’s economy to be vulnerable then? To beginwith, macroeconomic figures can conceal underly-ing weaknesses. The economy was already over-heating due to the rapid high growth since the late1980s. This may be evidenced by the persistentlylarge balance of payments and current account defi-cits since 1990. In fact, it could be clearly inferredfrom an analysis of the situation before the crisisthat internal and external factors played a part inending Malaysia’s “miracle.”

During the initial phase of the crisis, Malaysiaadopted a set of stabilization measures and financialsector reforms that were similar to the InternationalMonetary Fund’s (IMF) prescription for the othercrisis-affected regional economies, though Malaysiawas not under the IMF program. The policy pack-age was essentially a combination of tight fiscal andmonetary policies accompanied by financial sectorreforms (Table 1).

Table 1: Wrong Turns Taken During the Initial Stage of the Crisis

Particulars

Measures were introduced to drastically reduce credit growth. Among them were the impositionsof stringent limits on lending to the property sector and for purchase of shares and the introductionof credit plan to limit loan growth.In January 1998, Bank Negara Malaysia (BNM) announced a merger program for finance compa-nies. This program, while intended to rationalize finance companies to increase their resilience,was untimely.BNM’s policy to increase interest rates by raising its three-month intervention rate from 8.7 percentat the end of 1997 to 11 percent in early February 1998, while intended to address inflationaryexpectations, raised the cost of loanable funds and debt service commitments.The reclassification of NPLs to strengthen prudential supervision was untimely. It increased lossesto financial institutions and weakened their lending capacity at a time when liquidity was tight.

In order to address the problem of tight liquidity in the financial system, BNM opted to lend its ownfunds to the banking system at prevailing market rates causing unnecessary losses to banks.Federal Government expenditure was reduced by 18 percent, resulting in the deferment of severalpublic sector projects and exacerbating the slowdown in economic activities.

Source: Malaysian Government 1999.

Measures

Curb of credit growth

Untimely merger programfor financial companies

Increase in interest rates

Revision of nonperformingloan (NPL) classificationfrom six to three monthsApproach used toincrease liquidityCut in Governmentexpenditure


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Erosion in CompetitivenessMalaysia’s exports began to experience an erosion incompetitiveness partly due to rising costs and partlybecause of the overvaluation of the ringgit. The de-valuation of the People’s Republic of China’s (PRC’s)yuan in 1994 and the depreciation of the Japanese yeneroded Malaysia’s export competitiveness. At the sametime, the dollar appreciated in the couple of years pre-ceding the crisis. With the ringgit and most East Asiancurrencies “quasi-pegged” to the dollar, this trend be-gan to undermine the region’s competitiveness.

Resource Misallocationand Loss of EfficiencyThe high GDP growth was essentially input-drivenand not productivity-driven. Total factor productivity(TFP) was beginning to plunge into negative terri-tory. Productivity could not keep up with rising wages.It averaged 0.9 percent per year between 1991 and1996 and 2.9 percent between 1987 and 1990. Itscontribution to GDP growth declined from 28.7 per-cent between 1991 and 1995 to 19.5 percent during1996-1997 (Malaysian Government 1999) .

As can be seen in the rising incremental capital-output ratio, there has been inefficiency in capitalallocation. There has also been a diversion of re-sources from the real sector into speculative activi-ties; while within the real sector itself, there was di-version into nontraded activities such as the propertysector and the construction of various mega-projects.Such an exaggerated expansion of investment led toa worsening of the current account deficit.

Excessive Credit Expansionand Diversion of Resourcesto Nonproductive SectorsOver the period, excessive credit disbursement by thebanking sector to nonproductive sectors (defined toinclude the broad property sector, consumption credit,and loans for the purchase of stocks and shares), be-came a major cause for concern. Between 1992 and1994, loans were growing at an average rate of 12.2

percent but by 1995, the rate had risen to 28.6 per-cent. In 1996, it eased slightly to 26.7 percent but inearly 1997, it increased again to reach a worrisomelevel of close to 30 percent. As a percentage of nomi-nal GDP, the loan-GDP ratio rose strongly from 103percent between 1992 and 1994 to an excessively highlevel of 135 percent in June 1997.

2 Loans disbursed

to the property sector accounted for the largest share,constituting 31.8 percent of total loans in June 1997and were growing at a high rate of above 30 percentfor most of 1997.

3 Substantial lending to the property

sector was attributed to the construction boom. Thesurge in property prices was reflected by the Malay-sian house price index (MHPI), which grew by 25.5percent and 12.2 percent in 1991 and 1992, respec-tively. This encouraged involvement in the propertymarket in view of profit expectations. “Moral hazard”also played a large part in the rise in unproductiveinvestment and loan disbursement, often leading banksto perform only a cursory review of projects and toprovide loans for unprofitable or unproductive sectorssuch as property development, stock market specula-tion, and consumption credit.

Escalating Savings-Investment Gapand Current-Account DeficitMalaysia may boast of one of the highest savingsrates in the world, hovering at about 38 to 40 per-cent; nevertheless, the rate of investments was con-sistently higher at above 45 percent during the 1995–1997 period. By the middle of the 1990s, the sav-ings-investment gap was behind the current accountdeficit. In the past, this gap was bridged by Malaysia’sheavy reliance on FDI. However, high inflows offoreign investment and foreign debt actually resultedin hefty investment income outflows overseas. (Whileexternal debts remained comparably low, domesticdebts were excessively high. They represented about160 percent of GDP by the end of 1997, which wasthe highest level of domestic indebtedness in South-east Asia [Athukorala and Warr 1999].) Arguably,the current account deficit per se may not be a prob-


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liberalization, the long-term costs seem to have out-weighed the benefits.

Lack of Institutional Infrastructureand Deficient GovernanceThere have been accusations of nepotism, cronyism,and bad governance prevailing in East Asian busi-ness and malpractices within governments in the wakeof the crisis. There may be a half truth in these alle-gations as many of these elements are not necessar-ily unknown in developed nations either. It must, nev-ertheless, be admitted that, in terms of governanceand institutions, Malaysia (and most of East Asia)still has a certain way to catch up. The country lacksthe necessary institutional infrastructure that shouldgo hand in hand with industrial deepening. Similarly,institutions necessary to generate the required hu-man resources for these industries remain underde-veloped. Even though Malaysia has launched sev-eral commendable initiatives to upgrade human re-sources through a strengthening of institutions andthe development of infrastructure and support sys-tems, real progress has often been limited or ham-pered by problems of coordination. The transition froma labor-intensive economy to a technology-based onenecessitates institutional support. Similarly, a higherdegree of transparency will provide more fertileground for good governance to breed.

High Debt-Equity RatiosAt the micro level, debt-equity ratios of many corpo-rate entities have been abnormally high. In addition,there have been chronic mismatches, with short-termborrowings being employed to finance long-term in-vestments (Ariff 1999). As a whole, nonperformingloans (NPLs) of the financial sector hovered at a not-too-alarming figure of 10 percent but certain bankshad NPL ratios exceeding 40 percent (based on theinternational definition of bad loans as those not ser-viced during the preceding three months). In spite ofthe sweeping reform measures carried out followingthe 1985–1986 crisis, unsound practices within the

lem but the financing of the deficit does matter. In1994 and 1995, the current-account deficit was onlypartially financed by net long-term capital inflows.Reliance on short-term capital to cover the current-account deficit is not tenable in the long term be-cause of the volatile nature of this form of capital.At the same time, sharp increases in the outflow of“reverse investments” between 1995 and 1997 byMalaysian companies to finance long-term projects(with no prospects of early returns) have inadvert-ently exacerbated the country’s balance of paymentproblems. In addition, many of these outward invest-ment projects in new emerging regions failed miser-ably because of the lack of proper analysis or de-tailed studies prior to investment.

LiberalizationSince 1996, there has been a sharp decline in FDIflowing into Malaysia. This has had significant reper-cussions on the economy. The downturn was causedby factors such as the reduction in Japanese invest-ments overseas following the fall in value of the yen,and perhaps more important, the tight labor supply inMalaysia. In the past, the country’s abundant laborsupply had been one of the main attractions for labor-intensive industries. To some extent, the decrease inFDI was offset by an increase in portfolio investment,which gained importance beginning in 1993 followingmeasures to liberalize the capital account. Short-termportfolio investments can be a source of instability asthey are notorious for being extremely “footloose” anddependent on investor sentiment. Any slight hint ofeconomic, political, or social instability in the countryor region may well result in capital flight.

Capital account liberalization may have its ben-efits, the most important of which would be accessto international savings, but it could also prove to bea precarious step if an economy is not ready for it.Malaysia has tended to walk the thin line betweenliberalization and the continued protection of certainkey industries at the same time, one of which is thefinancial sector. However, in terms of capital account


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financial system and poor corporate governance con-tinued. These, admittedly, also contributed to the fi-nancial crisis. Rising M2 relative to international re-serves, the ratio of which increased from 3 percent inthe early 1990s to 4.7 percent at the onset of the cri-sis, was another indication of the growing vulnerabil-ity of the Malaysian economy. This rise eroded theability of the economy to defend the currency(Athukorala and Warr 1999). Thus, not all was well.

Further CommentsGlobalization has become an inevitable phenomenonbut free and uncontrolled capital movements will poserisks to the international financial system in the fu-ture. Investors may have been blamed for their herdbehavior but are they not just behaving in a humanlyfashion when confronted with possible or impendinglosses? Malaysia and a few other countries havecalled for a revamp of the international financial sys-tem. While this may not be easy or readily accept-able to all, guidelines and prudential regulations couldand should be established gradually, in conformitywith international norms and practices, to reduce risksresulting from speculation and uncontrolled globalcapital flows. Politically, more transparency and lib-erty will also serve to enhance the situation and cre-ate a more fertile ground for better practices to breed.Internal as well as external elements had a hand inending Malaysia’s (and the region’s) “miracle.” Un-derstandably, as the country’s fundamentals havealways been considered to be good, the Government’sinitial response was to look for causes externally.But there is still much work in store internally.

MacroeconomicDevelopmentsDuring the CrisisPolicy InitiativesAs turbulence struck, a series of policy packageswas introduced (see Appendix). The measures, how-

ever, evolved with the changing circumstances dur-ing the course of the crisis. Although Malaysia re-jected the IMF aid package, the initial approach was,in fact, IMF-inspired. This section will discuss theevolution of Malaysian Government macroeconomicpolicies since the onset of the crisis to the present.

THE INITIAL MONTHS: INTERNATIONALMONETARY FUND-INSPIRED TIGHTMONETARY AND FISCAL POLICIESIn the initial phase of the crisis, macroeconomic policygenerally focused on addressing areas of vulnerabil-ity and priority, notably:

• restoring confidence and stability in the financialmarket,

• containing inflationary expectations associatedwith ringgit depreciation,

• controlling excess domestic demand resultingfrom rapid credit growth,

• managing the current-account deficit in the bal-ance of payments,

• strengthening the resilience of the financial sec-tor in order to avoid systemic risks, and

• maintaining export competitiveness and the stan-dard of living.

The tight monetary policy already in place beforethe crisis was further tightened. The policy pack-ages announced during the final quarter of 1997 andduring the presentation of the 1998 Budget weremainly directed at maintaining tight monetary and fis-cal policies while sustaining investor confidence inthe financial market. Further policy measures wereannounced as 1998 unfolded. The National EconomicAction Council (NEAC) was established to act as aconsultative body to the Cabinet to deal with the cri-sis in early January.

Interest rates were raised in line with the expectedhigher rate of inflation. This would then ensure apositive return rate to savers. The central bank fur-ther curbed loans and a credit plan was introducedto limit the growth of loans to 25 percent by the endof 1997, 20 percent by the end of the first quarter of


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1998, and 15 percent by the end of 1998. Stringentguidelines on hire purchase and property lending (ex-cluding low- and medium-cost residential properties,factories, and industrial buildings) were issued.

Fiscal spending was scaled down. Governmentexpenditure was reduced and the implementation ofvarious infrastructure projects was either cancelledor deferred. The objectives were to reduce importsand to address the problem of excessive credit growthas well as the high leverage of some corporations.

Simultaneously, prudential regulations of the finan-cial system were adjusted to bring them in line withinternational norms. NPLs were reclassified as loansin arrears for three months instead of six months asMalaysia had previously stipulated. The rate for gen-eral provisioning was increased and the central bankpursued a merger program for finance companies.

Nevertheless, maintaining this delicate balance ofpursuing tight monetary and fiscal policies withoutexcessively affecting the already slowing economicgrowth was made difficult by a volatile external fi-nancial environment.

The “virtual IMF policy” eventually brought morepain because it was contractionary. Given the strengthof the Government financial position, there was noneed for such a drastic slash on expenditure. Thecombination of a tight monetary policy, fiscal restraint,and financial sector restructuring measures managedto contain price increases and succeeded in bringingthe balance of payments from a deficit to a surplusposition, but they severely dampened private sectorbusiness activity. The measures only served to worsenthe cash flow problem of businesses already badlyaffected by the ringgit’s depreciation. The effects ofthe initial response could perhaps have been less se-vere if a more moderate policy had been imple-mented. Rapid increases in interest rates might haveseemed a short-term measure but eventually such amove would only further choke an already strugglingeconomy. The interest rate rises could have beenmore restrained while allowing other measures to bephased in.

THE EXPANSIONARY STAGEAny easing of interest rates to boost spending wouldhave sent the ringgit and investor confidence on afurther downward spiral while high interest rateswould have continued to choke the business com-munity. As the economy continued to plunge into adeep recession in the first half of 1998, declining4.8 percent, policymakers began doubting the fea-sibility of the combined tight monetary and fiscalpolicy regime. The second quarter contraction of6.8 percent in the GDP (MIER 1998) prompted arethink. After the brief experiment with IMF-stylemacroeconomic measures, the Malaysian Govern-ment moved in the opposite direction, initiating mon-etary and fiscal expansion as the middle of 1998unfolded. In July 1998, it launched the NationalEconomic Recovery Plan (NERP), providing a com-prehensive framework for an economic turnaround.Its objectives are to:

• strengthen macroeconomic fundamentals,• stabilize the national currency,• restore market confidence,• restore severely affected sectors,• continue with the socioeconomic agenda, and• maintain financial stability.NERP recommends the easing of monetary and

fiscal policies and lowering the cost of capital to re-vitalize the economy. Its recommendations include awide-ranging proposal for economic stabilization andstructural reforms while at the same time, address-ing socioeconomic priorities, the implementation ofwhich will be scrutinized by NEAC.

Interest rates peaked in June 1998. The three-month interbank rate, which rose to an average of11.05 percent in June 1998, declined to 10.22 per-cent in August. In the same month, there were threedownward revisions in the three-month interventionrate of the central bank, bringing the rate down by150 basis points (bp). By November 1998, it had fallento 7 percent. The lowering of the SRR had, in fact,begun in mid-February as it fell from a high of13.5 to 10 percent. It continued to be subsequently


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lowered in stages in the following months. The BLRfor commercial banks declined from 11.96 percentin March 1998 to 8.05 percent in March 1999. How-ever, BNM’s attempt to step up bank lending to8 percent as announced late in 1998 failed, mainlydue to depressed credit demand. Loans for the lowerend of the housing market were stepped up while amoratorium was imposed on loans for office andshopping malls, which faced an acute glut.

The lowering of interest rates, nonetheless,sparked accusations that investment flows would bediscouraged. Such accusations are unfounded as lowinterest rates are a boon for the bond market and ahigh interest rate is not the sole criteria to attractforeign capital during “abnormal circumstances.”These investment flows include portfolio funds de-spite the fact that interest rate considerations tend tobe one of the factors that they are sensitive to. (FDIis generally not influenced by the interest rate-ex-change rate factor. Foreign investors tend to look atthe regional market as a whole rather than focusingon an individual market.) High interest rates in Ma-

laysia in the months following the onslaught of thecrisis did not result in an inflow of capital. Rather,high interest rates during the period served to deter aflight of domestic funds in search of better returnsoffered by offshore facilities.

Simultaneously, the Government introduced a fis-cal stimulus package of RM7 billion (Table 2), ex-panded existing funds, and set up new specializedfunds targeted at specific priority sectors. The stimu-lus package would see the overall public sector ac-count registering a manageable deficit of 1.8 per-cent of GNP in 1998 and 5.5 percent in 1999 (Ma-laysian Government 1999). The Government also lib-eralized the equity policy for the manufacturing sec-tor to further promote FDI. Certain sectors includingtelecommunications, shipping and forwarding, insur-ance, tourism, and Multimedia Super Corridor (MSC)-approved activities saw a relaxation of the 30 per-cent limit imposed on foreign ownership. (The relax-ation in equity policy applies to applications receivedbetween 31 July 1998 and 31 December 2000, aswell as those already received but pending approval.)

Table 2: Fiscal Measures to Restore Economic Growth


• Restoration of the previous cut in the federal Government expenditure for 1998.• Provision of an additional allocation of RM7 billion for development expenditure for projects meeting the following criteria:

– enable import substitutions and increased exports of goods and services,– generate demand for domestic goods and services,– increase efficiency and national competitiveness,– short gestation period,– will not cause a decline in reserves nor outflow of liquidity, and– provide assistance to the poor and lower income group.

• Based on these criteria, the above allocation was channeled towards infrastructure and public facilities, industrialdevelopment, rural development, housing, education, and health.

• Provision by the National Housing Company Berhad of bridging finance to developers for the construction of housescosting RM150,000 and below.

• Establishment of an Infrastructure Development Fund, with initial allocation of RM5 billion, to assist in the financing ofinfrastructure projects.

• Tax exemptions on 70 percent of statutory income from the increased value of export sales for companies grantedinternational trading company status and that are at least 70 percent Malaysian-owned or using local facilities.

• Stamp duty exemption for the refinancing of loans for business purposes and for purchase of property under the HomeOwnership Campaign.

• Imposition of income tax on actuarial surpluses actually transferred to the Shareholders’ Fund as compared with thepresent practice, which is based on accrual principle.

• Abolition of excise duty on refrigerators, television sets, and air-conditioners to enable local manufacturers to competewith manufacturers from other Association of Southeast Asian Nations (ASEAN) countries when the ASEAN Free TradeArea (AFTA) is implemented.

• Change in the tax assessment system from one based on the income derived in the preceding year to the current yearbeginning from 2000.

• Introduction of tax incentives to promote domestic tourism.


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In recessions, expansionary fiscal policy makesconsiderable sense although the question of financ-ing large deficits may be of concern, especially sinceaccess to foreign funds is limited while there are otherdemands on domestic funds (Ariff 1999). Keynesianpolicies, too often derided in the recent past, couldhave gone down as a better remedy, and perhaps,helped avoid such a severe slide if they had beenprescribed much earlier. For the present, financingsuch budget deficits may not be a serious problem.The Government should, nevertheless, proceed withcaution as severe financial constraints may surfacein the future because budget deficits are more thanlikely to persist over the next few years.

SELECTIVE EXCHANGE CONTROLS—A MOVEINTO CONTROVERSYAfter the change in policy orientation, Malaysia be-gan to see some progress in containing inflation, im-proving its external balance, and maintaining lowexternal debt exposure, as well as keeping externalreserves intact. However, the economy continued toremain vulnerable to external developments, espe-cially the instability in regional financial markets. Simi-larly, this also affected the progress of the reforms inthe country. The increasing outflow of the ringgit,attracted by higher interest rates elsewhere withinthe region (international offshore centers were of-fering between 20 and 40 percent while the onshorerate was only 11 percent), was becoming a seriousthreat to the economy. With little room for maneu-ver, selective capital controls (Table 3) and the peg-ging of the national currency to the dollar were im-

posed on 1 September 1998 to insulate the economy.The dilemma was obviated. The controversial move,nonetheless, was both lauded and attacked by vari-ous quarters all over the world. The objectives werebasically to:

• eliminate speculation by declaring offshore ringgitnonlegal tender,

• contain speculative capital,• stabilize short-term capital flows, and• maintain the stability of the financial market in

order to proceed with reforms unhindered.Many countries have, in fact, begun to see the

urgency and the necessity for some form of mecha-nism or regulation on short-term volatile funds in or-der to avoid another crisis of this magnitude. Thiswas especially so after the effects of the Asian cri-sis spilled over to Latin America and Russia. Selec-tive controls may not necessarily be a bad thing pro-vided that they are implemented only to provide atemporary respite for the affected country to under-take reforms. It can then rejoin the world economyonce it is ready. However, distinction will have to bemade between measures to discourage inflows andthose to restrict outflows. As controls on outflowsare often imposed during times of crisis where thereis increased volatility in financial variables and ex-change rates, there is a possibility that they will dis-courage potential investors because they are some-times thought to indicate “worse times on the hori-zon.” Following the imposition of capital controls, thecentral bank’s three-month intervention rate droppedfurther to 7 percent. The controversial move enabledthe system to accommodate an expansionary policy.

Table 3: Selective Capital Controls


Controls On• Ringgit-denominated transactions among nonresidents via

nonresident external accounts.• Outflows of short-term capital by requiring such inflows to

remain in the country for a minimum period of a year.• Import and export of ringgit by travelers, residents, and

nonresidents.• Malaysian investment abroad by requiring approval as there

are insufficient funds to be taken out. Capital may, however,be raised abroad, collateralized by foreign assets.

No Controls On• Current account transactions. Amendments to rules

require only that trade transactions for goods andservices are to be settled only in foreign currencies andno longer in domestic currency.

• Repatriation of interest, dividends, fees, commissions,and the rental income from portfolio investments and otherforms of ringgit assets.

• Foreign direct investment inflows and outflows, includingincome and capital gains.


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INTRODUCTION OF THE GRADUATED EXIT LEVYAfter five and a half months of controversy, Malay-sia, on 4 February 1999, modified the rule on the one-year holding of portfolio capital. Foreign funds stuckin the country would be allowed to be repatriated sub-ject to a new graduated levy depending on the dura-tion of each investment and when the funds werebrought into the country, with effect from 15 February1999. The slow trickle of foreign funds seen over theprevious months while neighboring countries experi-enced renewed investor interest could have been oneof the reasons that propelled the Malaysian Govern-ment to initiate this move. The measures are also aimedat addressing the possible outflow of funds upon theexpiry of the 12-month moratorium on fund repatria-tion. This new levy is considered more “market-friendly” than the moratorium (Table 4).

The argument is that the top rate of 30 percent isonerous and as the levies are high, would investorsremain in the country up to 1 September 1999? Ifthey were low, then investors might decide to leavethe country. Similarly, would reinvesting in Malay-sian markets defer payment of the levy? The Gov-ernment feels that the exit tax would, in fact, en-courage a larger inflow of new capital rather thansee large outflows as the economy is stabilizing andrecovery is anticipated. Would this be a little too op-timistic despite the current positive economic vari-

ables? Also, the new measures would inevitably addto the already cumbersome administrative problemsin investing in Malaysia and, therefore, discourageinvestors. In any case, it is still too early to tell andshort-term outflows cannot be discounted. However,it would be unfair to dismiss the new measures out-right. The Malaysian economy has been recoveringsince the second quarter of 1999 and these mea-sures could be a start to reinstate Malaysia on theworld investment map.

FINANCIAL AND CORPORATE SECTORRESTRUCTURINGWhat began as a currency crisis evolved into a finan-cial crisis before transforming itself into a full-blowneconomic crisis, with banks and other financial institu-tions taking the center stage as the drama unfolded.The currency crisis fueled concerns about the healthof the banking system in the crisis-hit economies. Ex-cessive lending without adequate safeguards has beenthe main drawback of financial institutions, resultingin soaring NPLs and gross capital inadequacy. In sev-eral crisis-hit economies, the banking system took asevere beating with many institutions folding altogether,while the real sector in these economies suffered badlyas a consequence. Malaysia was, however, more for-tunate in the sense that none of the banks caved in.The toll on the corporate and financial sectors, never-theless, has been extensive.

While Malaysia may be credited for maintainingsound financial policies and good supervision, it mustnot be denied that inherent weaknesses do exist withinthe system. Thus, there are concerns about the healthof the banking system in the aftermath of the crisis.Rising NPLs in the banking sector prompted fearsof systemic bank failures. Nevertheless, the NPLproblem in Malaysia pales in comparison with that ofother crisis-hit countries in the region. It also pales incomparison with Malaysia’s own previous experi-ence in the mid-1980s crisis when NPLs rose as highas 33 percent of total loans. This time around, theNPL ratio was at most, about half of what it was in

Table 4: Exit Levy on Investments

Investments Before 15 February 1999• A levy of between 10 and 30 percent on the principal to

be repatriated within 12 months.• Repatriation after the 12-month period will not be

charged any levy.• Profits repatriated within the 12-month period will not be

levied but those repatriated after this period will becharged a 10 percent levy.

Investments After 15 February 1999• The repatriation of the principal will not be levied.• Profits repatriated within 12 months will be charged a

30 percent levy.• Thereafter, profits will be charged a 10 percent levy.

Source: Malaysian Treasury press release, Repatriation of Portfolio Capital,4 February 1999.


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the previous crisis (14.9 percent in November 1998if measured by the “three-months” classification).

The Government has, therefore, taken measuresto restructure and consolidate the financial and cor-porate sectors with the primary aim of:

• relieving institutions of their NPLs,• strengthening and recapitalizing banking institu-

tions,• facilitating corporate debt restructuring, and• enhancing efficiency within the system.The thrust of Malaysia’s banking and financial

sector reforms introduced during the crisis was two-fold. They aimed at stabilizing the banking system inthe immediate period, and building a strengthened,more resilient banking sector over the medium to longterm. Short-term measures were initiated to ensurethe smooth functioning of the intermediation process,while rationalization, consolidation, and reform of thefinancial and banking sectors were initiated throughthe setting up of an asset management company, abank recapitalization agency, a corporate debt re-structuring committee, and mergers. These repre-sented part of the long-term strategy to strengthenand consolidate the sectors.

Two agencies, dubbed “special purpose vehicles,”namely, Danaharta and Danamodal, were establishedto deal with NPLs. While Danaharta (Table 5) wascreated to buy up bad loans and take over the sup-porting assets, Danamodal (Table 6) was establishedto inject capital into banks that had to bear lossesresulting from the sale of NPLs. By the end of July1999, Danaharta had acquired and managed loansamounting to RM39 billion from the financial sys-tem, representing 1,999 loan accounts. From the bank-ing system alone, it acquired and managed NPLsamounting to RM28.5 billion or 35 percent of totalNPLs in the banking system. With this, the net NPLratio moderated to 7.9 percent based on a six-monthclassification as at the end of June 1999 after peak-ing at 9 percent as at the end of November 1998. Ifbased on the international three-month classificationof bad loans, the NPL ratio would be about 13 per-

cent. At the same time, Danamodal pumped RM6.2billion into the banking system. The risk-weightedcapital ratio (RWCR) was also at fairly comfortablelevels, partly due to new capital injections and partlydue to the tendency for banks to avert high-risklendings. Thus Danaharta and Danamodal have per-formed fairly well so far and the overhaul of the fi-nancial sector has received cautious praise from someanalysts. Nevertheless, more needs to be done.

The arduous task of buying up bad loans at rea-sonably discounted prices and financing them withzero-coupon bonds may seem easy compared withthe more daunting task of managing the assets thathave been acquired in the process. In many cases,the restructuring of underlying businesses and as-sets are necessary. Thus, besides debt restructuring,operational restructuring is vital for the long term.As evidenced in the Mexican experience, restruc-turing and recapitalization are lengthy and compli-cated processes. Danaharta will be working alongthe lines of the successful Swedish Securum Asset

Table 5: Danaharta Nasional Berhad: Objectivesand Plans

Asset Management Company• Established 20 June 1998, Companies Act of 1965• Authorized share capital: RM10 billion• Paid-up capital: RM250 million

Main Objectives• Remove nonperforming loan (NPL) distractions from

financial institutions• Maximize recovery value of acquired assets

Stages of Acquisitions PlansStage 1 involves:

• secured loans,• strategic sectors.

Stage 2 involves:• unsecured loans.

Stage 3 involves:• foreign currency loans,• financial guarantees,• private debt securities.

Prioritization of Financial InstitutionsPhase 1: Weaker financial institutionsPhase 2: Local financial institutionsPhase 3: Financial institutions of moderate strengthPhase 4: Stronger banks



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Management Company and has projected to startselling NPLs as soon as the acquisition phase is overbut only after having first gone through an activerestructuring role.

4 Apparently, Danaharta has now

emerged as the biggest owner of real estates in thecountry in the process. Disposing of these propertiesin an orderly fashion without upsetting the market isnot going to be easy, given the supply glut. Also, forhow long will or can Danaharta continue to buy upbad loans?

The successful operation of these asset manage-ment outfits requires a private sector approach fo-cused on the following:

• complete autonomy,• full transparency in their workings,• commerciality,• best practice,• equal opportunity for investors, and• professionalism. .At the same time, the Corporate Debt Restruc-

turing Committee (CDRC) was established tocomplement the two agencies by providing a chan-nel for banks and debtors in distress to sort out anagreeable and workable loan restructuring exercise.As at 20 August 1999, 62 applications had been re-ceived, of which 10 restructuring schemes involvingdebts of RM10.2 billion had been completed and werein the process of being implemented. Three casesinvolving debts of RM1.1 billion have actually beensold to Danaharta, while 12 other cases involvingdebts of RM2.9 billion have been rejected. Never-

theless, without any empowerment, and being just afacilitator bringing creditors and debtors to the nego-tiating table, there is little that the CDRC can actu-ally do. The overhang of corporate debts is certainlya cause for concern. Banks and finance companiesare still saddled with about two thirds of the NPLsas Danaharta has managed to absorb only one third.Even though Malaysia’s external debts are not largerelative to GDP by developing country standards, itstotal domestic debt is large. Bank loans, which rep-resent the largest chunk of domestic debt, amount to145 percent of GDP (the precrisis peak was 135percent), which is, by far, the largest in SoutheastAsia. This does not go very well with the centralbank’s call for higher loan growth in order to stimu-late the economy. Higher loan growth will raise theloan-GDP ratio, which is already too high, therebyweakening the country’s macroeconomic fundamen-tals. One redeeming feature is that the central bank’sreserves have increased significantly within the lastyear.

For a small population of 22 million, Malaysia isconsidered overbanked with 21 commercial banks,12 merchant banks, and 25 finance companies, notto mention foreign-owned institutions. In order tofurther consolidate and rationalize the banking sys-tem to meet the challenges of an increasingly global-ized market, the central bank has encouraged banksand finance institutions to merge. In the initial phaseof the crisis, the number of finance companies wasreduced from 39 to 25 following central bank inter-

Table 6: Danamodal: Objectives and Tasks

Source: Danamodal Fact Sheet, 1998.

Restore and Revitalize theBanking Sector• Restore and improve solvency• Provide liquidity• Enhance profitability• Restore confidence• Refocus intermediation• Reenergize lending activities

Catalyze Improvements in theBanking Sector• Restructure the balance sheet• Restructure operations by

introducing better practices• Improve corporate governance• Improve technology• Influence and encourage bank

restructuring and consolidations• Institutionalize ownership

Operate on a CommerciallyViable Basis• Earn positive return commensurate

with risk• Meet Bank Negara Malaysia’s and

international banking standards• Achieve more independence and

transparency• Ensure effective corporate

governance


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vention. The central bank then announced plans toreduce the number of 58 domestic financial institu-tions to only six anchor institutions through mergers.This exercise will, nevertheless, not involve locallyincorporated foreign banks. The two main objectivesof this consolidation process are to enlarge the capi-tal bases thereby ensuring a better management ofrisks and enhancing the resilience of the system, andto cut costs and improve the competitiveness of lo-cal institutions. On 20 October 1999, the Malaysiancentral bank announced that all banking institutionswill, henceforth, be allowed the flexibility to form theirown merger groups, a reversal from the previousruling, which saw the Government’s hand in the pro-cess. Frequent changes and reversal of policies couldprompt perceptions of inconsistency and should beavoided.

It is true that a merger exercise of this size willenhance prudential supervision and reduce systemicrisks besides producing larger and stronger institu-tions capable of meeting future global competition.However, questions arise as to how the operationswill be funded and where the thousands of retrenchedemployees will go. More worrisome still will be theimplications of this exercise on the day-to-day man-agement of the institutions if attention is divertedaway from such pressing problems as bad loans, notto mention significant interbank cultural differencesthat would challenge postmerger harmonization. Fur-thermore, mergers alone cannot transform the bank-ing system into a formidable force overnight. Somesmall banks have performed better during the crisisthan some bigger ones. Size may still matter but it isnot synonymous with professionalism, competence,and the level of sophistication and efficiency. All thesehave much to do with the competitive environmentwithin which banks operate and underscore the im-portance of deregulation and liberalization in the bank-ing reform exercise. The merger exercise wouldbecome more meaningful if banking reforms includedan agenda to expose the sector to increased compe-tition, paving the way for a greater opening of the

sector to foreign competition. It is understandablethat Malaysia will not liberalize the banking sectorimmediately, but over the medium term, gradual lib-eralization will be necessary.

Issues and PolicyRecommendationsIt would not be accurate to simply say that contagionor a self-fulfilling prophecy prompted the Asian cri-sis. Though there may be some parallels and simi-larities in regional economies, they should not belumped together and considered as identical. Certaincountries were severely afflicted while others suf-fered ripple effects much later. It would, thus, beunfair to propound one theory to suit all cases. Ex-ternal and internal factors were responsible. But whywere some countries more vulnerable than others?

It is more appropriate to identify the elements thatcould have rendered an economy more vulnerableon a country-by-country basis. The magnitude of thecrisis itself posits that favorable macroeconomic gov-ernance is necessary to sustaining economic stabil-ity. Vulnerability itself would not have led any coun-try into a severe crisis. Vulnerability of an economyresulting from cracks within the system such as policyinefficiencies or policy errors may, nevertheless,when combined with some external factors, makean economy succumb.

Before the crisis, macroeconomic managementin Malaysia was considered sound by any standards.Fundamentals were strong. The country enjoyed rea-sonable price stability, fiscal surplus, high foreignexchange reserves, and high rates of savings andinvestment. The suddenness and the severity of thefinancial reversal have sparked a debate on past mac-roeconomic management as well as the appropriate-ness of policy responses to the crisis. Policy man-agement in Malaysia has, since, been focused onreducing risks in the economy to ensure macroeco-nomic stability and to promote a stronger financialsystem. It is targeted at maintaining price stability


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while preventing a further contraction of the economy.However, circumstances changed and the situationevolved along the way, so policies and measuresimplemented had to be modified.

Considering the various stages that the recoveryprocess has been through, it is clearly still too earlyto assess the success of the measures applied. Thecrisis has revealed serious shortcomings in theeconomy. Simultaneously, to a large extent, the crisisin Malaysia has become one of confidence. As aresult, like other afflicted economies in the region,the country now faces domestic policy reform chal-lenges in order to restore confidence and rekindlethe economy. There are various areas in which im-portant reforms and changes need to be targeted.Briefly, these may be identified as follows:

• macroeconomic policies,• financial sector reform,• improving risk management and maintaining fi-

nancial stability,• corporate governance and institutional restruc-

turing, and• improving long-term competitiveness.

Macroeconomic ReformsCAPITAL CONTROLS AND MAINTAININGEXCHANGE RATE STABILITYThe imposition of selective controls and the peggingof the national currency at RM3.80 to the dollar weremeant to provide the economy with a temporary re-spite from external volatility. The move also madethe Malaysian ringgit nonlegal tender outside of Ma-laysia and therefore encouraged ringgit parked abroadto be remitted back to the country. All receipts origi-nating from capital account transactions (but not in-cluding FDI) must be held in Malaysia for a yearfrom the date of purchase of ringgit-denominatedassets or securities before they are eligible for repa-triation.

In the meantime, the Malaysian economy has be-come anemic following the massive outflow of capi-tal between the onset of the crisis and the imposition

of selective controls in September 1998. There is,thus, an urgent need for capital infusion from exter-nal sources. This calls for policies to attract new for-eign capital. However, exchange controls are notconducive to a massive injection of capital fromabroad. Exchange controls and open economies areinherently incompatible. Therefore, when the intendedreforms have ultimately been completed, these con-trols should be phased out.

Fears and concerns of a large capital pullout on1 September 1999, exactly a year from the datecontrols were imposed, prompted the Governmentto ease its policy and implement a graduated exitlevy in February 1999. Nevertheless, the fears wereunfounded as there was no substantial outflow offunds on the designated date. The selective con-trols and the fixed exchange rate have been suc-cessful in bringing stability back to the economyand improved Malaysia’s external accounts. Busi-nesses involved in international trading no longerneeded to factor in an exorbitant exchange rate riskpremium into their business plans. Capital costs havereduced sharply and planning, into the medium termat least, has become easier. Business sentiments inthe manufacturing sector improved in the first halfof 1999 and are continuing to progress gradually,perked up by improved sales performance. Whilegeneral business conditions remain subdued follow-ing a sharp recession in 1998, manufacturers ap-pear to be cautiously optimistic. Business conditionsbegan to show an upward trend in the third quarterof 1999 but there was a slight moderation in thefourth quarter (according to the MIER QuarterlyBusiness Conditions Index). In all, the controver-sial capital control move has been largely lauded bythe local business community. Similarly, an upturnin consumer sentiments has been registered in theMIER Consumer Sentiments Index.

However, there is an argument that controls maybe a short-term dream that will be detrimental to theeconomy in the long run. The peg may have been aboon to businesses but they must not be led to be-


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lieve that the current euphoric situation will be per-manent, and be lulled into a false sense of security.In the long term, should the controls continue orrather, be refined? Should the ringgit peg be reviewedand if so, when?

If foreign exchange controls remain in place fortoo long, the ambition of turning KLSE into a re-gional bourse of significance will remain a pipe dream.Investor confidence will be dampened since othermarkets in the region do not impose controls. Notonly will speculative activity be curbed, long-termoverall investment activity will probably be affectedas well. Standard & Poor’s upgraded Malaysia on1 April 1999 and Moody’s upgrading followed threeweeks later. This may be good news, but the me-dium-term effects of controls and the ringgit peg stillremain uncertain. Currently, the large current accountsurplus and external borrowing have helped to alle-viate short-term concerns on capital needs but thelonger controls and the peg remain in place, thegreater the distortion in competitiveness and capitalflows into the country. Once imports begin to growagain, external liquidity would most likely be affected.At the same time, it is questionable if the positiveevents (stock market rally, balance of payments[BOP] current account surplus, increased foreignexchange reserves, interest rate reduction, etc.) sup-posedly due to the imposition of controls are actuallyattributable to these. Similar trends are present inother countries where there are no controls.

With the ringgit peg, it is difficult to determinereal exchange rates. Analysts believe that the ringgitis undervalued. At the same time, there has beenmuch speculation as to whether or when the ringgitpeg will be adjusted. The Malaysian Governmenthas said that the same rate would be maintained(unless some serious structural imbalances occurin the economy). In real terms, the exchange rateparity at RM3.80 to the dollar makes the ringgit thesecond cheapest currency in the region after theIndonesian rupiah. This undervaluation allows Ma-laysia to capitalize on competitiveness gains. While

this has greatly favored exporters, a low ringgitmakes imports more expensive.

Any decision to float the ringgit will depend onwhether it will subject the system to more volatility.The idea of the Government holding on to controlsand the peg until changes occur in the internationalfinancial architecture to address speculation and vola-tility may be unrealistic. As long as the BOP currentaccount remains in surplus, the capital controls andthe ringgit peg will remain sustainable. Nonetheless,such a policy flexibility will evaporate with a deterio-ration in the BOP position as the economy recovers,in which event, the capital account will have to beliberalized.

It is thus imperative that the Government moni-tors the situation closely in order to avoid severeshocks to the exchange rate system should and whenthese take place. The choice to peg or float the ex-change rate in the long run will have to be carefullyconsidered. Lessons can be learned from a fewcases. Pegs in Latin America have, in the recentpast, helped to bring inflation down. However, infla-tion is not a serious issue in Malaysia (and in mostEast Asian economies). Pegging brings out a risk inthat any sharp devaluation can prove fatal if the fi-nancial fundamentals are weak. On the other hand,under a pure floating regime, small daily adjustmentsexpose risks and encourage hedging but such flex-ible exchange rates allow a country to undertake in-dependent macroeconomic policies. A managed floatis not viable because it normally degenerates into asingle-currency peg. Malaysia has suggested peg-ging to a basket of currencies instead of just one,having been through the recent experience of de-pendence on the dollar. Eventually, floating exchangerates could be advisable though such a measure mayput the country through some initial turbulence suchas interest rate problems and bankruptcies. NewZealand experienced these when it freed capital flowsand floated exchange rates in the 1980s. However,as the economy was further opened and prudentialregulations, transparency, and good institutional


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infrastructure were put in place, the problems wereeventually smoothed out and the exchange rate sta-bilized.

FISCAL STIMULUSMalaysia’s main concern during the crisis was theunprecedented contraction of the real economy inthe first three quarters of 1998. A top priority in suchcircumstances would be to ensure that the economyis not trapped in a prolonged recession. Some impe-tus to rekindle the economy is necessary. The strat-egy of maintaining fiscal surpluses should be reversedin favor of a deficit budget. In pursuit of a deficitbudget, the Government project selection criteriashould be geared towards performance-based ac-tivities. As such, viable small-scale projects shouldbe encouraged as they entail greater risk diversifica-tion. (In this sense, some of the existing mega-projectsneed to be scaled down or even abandoned in orderto achieve a more moderate deficit budget.)

Financing a deficit from external sources at areasonable cost would have been difficult. Therewas also a need to avoid the crowding out of theprivate sectors’ sources of financing. Therefore,the overall deficit should be kept at a sustainablelevel. This would ensure that Malaysia’s externaldebt servicing ratio remained at a reasonable andprudential level.

MONETARY POLICYTo foster an economic recovery, domestic spendingneeds to be stimulated. To this end, a low interestrate regime is essential as it will lead to a reductionin the cost of financing economic activities. None-theless, a low interest rate regime may encouragethe problem of moral hazard. Such a problem ariseswhen lenders are unable to observe the actions ofborrowers after the granting of loans. To minimizethis problem, a more thorough and prudent assess-ment of lending practices should be implemented.This includes a stricter definition of risks and greatertransparency in disclosure of information.

Banking and Financial SectorReformsReforms and liberalization are not limited to the fi-nancial sector. Rather, they cut across the boardthough the financial sector would probably need toundergo extensive restructuring.

The crisis has revealed cracks in the financial sys-tem in Malaysia. In spite of the various reforms un-dertaken in the late 1980s and early 1990s, risky lend-ing practices persisted in the banking system. Struc-tural reforms and prudential measures to strengthenthe financial system are, therefore, imperative and needto be accelerated as the country rebuilds its economyin the postcrisis period. It is surprising that it has takenthe crisis to highlight the need for financial sector re-forms. The decade of high growth has led Malaysia(and other countries in the region) to gloss over seri-ous problems and practices in the financial sector.

Reforms must not be thought of only in termsof recapitalization or liberalization. In the shortterm, adequate measures for recapitalization havebeen undertaken (see Section on Danaharta andDanamodal). In the long term, reforms should be seenas an overhaul with new regulations put in place, andunhealthy and high-risk practices of the past weededout. The restructuring must facilitate a competitive,transparent, open, and stable structure in order tobetter withstand future shocks to the financial sys-tem. Similarly, market players must continue to en-hance their skills and knowledge. The infrastructureof the financial market must be constantly upgradedand complemented by dynamic, highly skilled, tech-nology savvy market players.

RESOLVING THE PROBLEM OFNONPERFORMING LOANSMuch effort has been poured into the managementand restructuring of NPLs and the recapitalizationof banks, which will be important in consolidatingand rationalizing the banking industry. Stringent poli-cies and checks to prevent future buildup of NPLsto unhealthy levels need to be implemented. While


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the move to revert to the precrisis definition of NPLsas those in arrears for six months may downsize themon paper for now, it would probably be prudent to letthe appraisal of NPLs be defined according to inter-national norms of classification once reforms havebeen completed and the situation has returned tonormal. A correct and consistent appraisal policy ofNPLs including an appraisal of lending to the corpo-rate sector and the State will be necessary.

IMPROVING REGULATION AND SUPERVISIONGreater transparency and accountability in the finan-cial system will be imperative for best practices togerminate. Before policies can be implemented, stan-dardized principles and regulations for supervisionneed to be defined. These could be undertakenthrough the adoption of the Basle core principles foreffective bank supervision and after effective com-parison with international norms, as well as finding asuitable balance between traditional prudential andmarket-based regulatory systems. It is necessary forBNM to ensure proper implementation of better su-pervision with a focus on the new global businessenvironment. Simultaneously, supervision and regu-lation must not be impaired by political interference.The issue on central bank independence is thus ofthe utmost importance. In the wake of the recentcrisis, emphasis on risk management will be impera-tive. With the implementation of AFTA, and the pros-pect of greater regional integration and economic con-vergence, new policies should be targeted towardsregional harmonization.

DEREGULATION AND LIBERALIZATIONWhile international financial interests have oftencalled for outright liberalization, this must not be swal-lowed whole without taking into consideration thelevel of development of the individual financial sys-tem. Too rapid a liberalization process when the sys-tem is still unable to cope may ultimately result in aweak domestic banking sector unable to withstandcompetition from abroad. Of late, many analysts have

said that early deregulation and liberalization of thefinancial sector have acted as a catalyst for crises.In Asia, particularly, this has meant a departure fromthe traditional norm of having the government’s guid-ing hand and intervention in external borrowing andcredit allocation before the national economy wasready. This may be true but in the long run, greaterliberalization will be inevitable. Nevertheless, it isimportant to ensure that the regulatory capacity ofthe system is developed and fully in place before anyeffort to liberalize is undertaken.

Malaysian policymakers are still reluctant to openup the services sector, in particular, the financial sec-tor. The argument is that the financial services sec-tor is not ready to face unfettered international com-petition. This argument is not without basis. The cri-sis has highlighted the need and importance of liber-alizing the banking industry in order for it to benefitfrom new capital injections. Arguably, liberalizationand deregulation in the financial sector should begradual. Gradual exposure to foreign competitionwould compel domestic institutions to be more com-petitive and innovative in the long term.

Foreign ownership of Malaysian banks is still lim-ited to 30 percent. But the insurance industry hasrecently been subjected to further liberalization withforeigners now permitted to own up to 51 percent ofequity (up from 49 percent in 1995 and 30 percent in1993). New entrants to the financial sector should,nevertheless, be allowed in on a gradual or a case-by-case basis as they are potential candidates forthe merging and recapitalizing of ailing institutions.The Government could offer two options: first, thenew entrant could be allowed in on condition that itmerges with an ailing domestic institution; or second,a limited number of new permits could be auctionedto the highest bidder, with the proceeds utilized in therehabilitation of the domestic banking system.

A main focus of new policies should now be onthe strengthening of the regulatory and supervisoryframework to ensure a sound financial and bankingsystem in order to avoid another crisis.


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Improving Risk Management andCapital Market DevelopmentShort-term speculative flows have played a role inundermining the stability of world capital and finan-cial markets. Widespread currency speculation wouldhave been impossible under the Bretton Woods sys-tem as almost all countries adopted strict capital con-trols. The abandonment of these controls during the1970s after the breakup of the system, and in the1980s, resulted in an explosion of speculation in worldmarkets. In its wake, currency trading has balloonedout of proportion; by 1995, foreign exchange trans-actions were estimated to be about 60 times greaterthan would have been necessary to fund internationaltrade in the same year. The volume of short-termtransactions has been increasing by about 50 per-cent every three years. In the 1980s, this was comple-mented by the gradual abolition of exchange con-trols, giving birth to a cornucopia of new financialinstruments and derivatives, all of which were de-signed to take advantage of a new liberal financialarchitecture conducive to short-term speculation.This was compounded by the appearance of hedgefunds, which have a particularly destabilizing effectdue to their highly leveraged positions.

As the frequency and magnitude of financial cri-ses intensify, they should no longer be accepted asmere aberrations in the world capital market. Inter-national financial markets are increasingly inherentlyunstable especially for those borrowing heavily fromexternal sources in foreign currencies and in the short-term. Such financing is suitable to finance trade flowsbut should not be used for long-term investments.The risk is even higher if such short-term flows areused to finance long-term on-lending by highly lever-aged financial institutions. Many of the East Asianeconomies overborrowed and as the short-term loanscould not be rolled over, the liquidity crunch rapidlydegenerated into a full-blown insolvency crisis. Thesharp nominal devaluations of domestic currencies thatfollowed led to a consequent increase in the local val-ues of the mainly dollar-denominated liabilities.

Problems in Malaysia’s financial sector could betraced to an overdependence on the sector to meetthe nation’s funding requirements, a phenomenonoften found in emerging economies. Deposits withthe financial institutions tended to be short-term. Onlya small percentage of deposits were those beyond12 months. However, projects with long gestationperiods (such as those in the property sector) werefinanced by syndication of loans among financial in-stitutions in Malaysia. There is thus a liquidity mis-match, where short-term deposits have been used tofinance long-term projects, exposed by the crisis. Atthe same time, cheap foreign borrowing meant thatthe economy was flushed with funds, most short-term. Easy credit led to a rallying of the stock mar-ket and also allowed the diversion of resources fromthe real productive sector into speculation. Thus, whenspeculators began pulling out at the onset of the cri-sis, the system fell apart.

More stringent supervision may serve as a goodcheck but will not, by itself, prevent future crises.Further policies to attract and encourage long-termcapital flows such as FDI and equity portfolio flowsshould be implemented. Speculative flows should bediscouraged and short-term flows should be limitedto financing short-term trade transactions. The Ma-laysian capital market needs to be further developed.The bond market should facilitate more efficient long-term funding. In the financial reforms of the late 1980sand the measures undertaken in the early 1990s, therewere efforts to develop the local bond market.Progress has, nonetheless, been slow. Also, the re-pressive regulatory processes and the lack of ad-equate bond market infrastructure in the country dis-courage the use of such fixed-income securities. TheBanking and Financial Institutions Act of 1989(BAFIA), defines the issuance of bonds as deposit-taking and forbids it without approval of BNM. Allnew issues of debt instruments require BNM ap-proval before applying for the approval of SC, whichregulates the capital market. This dual approval andthe delay involved discourages local companies from


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seeking capital market financing. Thus, while a moveto more secure financing in order to improve riskmanagement is imperative, new policies need to beimplemented to encourage the changeover. Substan-tial improvements in the infrastructure for the bondmarket with a special focus on secondary markettrading systems, a competitive auction system, thereinforcement of the role of credit rating agencies,and hedging instruments for short- and long-term in-terest rate risks, will be necessary.

While much effort has been made through poli-cies and prudential regulation to enhance and im-prove the soundness of financial systems in order tobetter manage risks, the magnitude of the Asian cri-sis has led some countries to call for reforms in theinternational financial architecture. Various recom-mendations have been made including levies on capi-tal flows. Reforms at international level are certainlynecessary, but the political will to arrive at an inter-national consensus remains far off. The process ofglobalization is supposed to bring about better oppor-tunities for the world economy through a more effi-cient allocation of funds across borders. Recent ex-perience has, however, shown that it has brought withit risks that can be destabilizing.

The international financial community is thusfaced with the challenge of ensuring an efficientfinancial system that is not vulnerable to marketfailures and volatile flows of capital. At the level ofindividual economies, the question is now how toparticipate in and be an integral part of this newinternational economy without being vulnerable todestabilizing developments. The push for a moreliberal international financial environment has notbeen matched by parallel development to establishrules to ensure the efficient functioning of marketsand improve safeguards to individual economiesfrom the adverse effects of volatile capital flows.It will not be an easy task to create a new interna-tional architecture to regulate capital flows andhedge funds. Any such attempt will most likely have

to involve not only governments, but also lendersand borrowers. World financial centers will prob-ably need to be brought under an international um-brella regulatory body where there is enforcementof transparent disclosures, and consistent interna-tional standards of cooperation and assessment.These will all be difficult to achieve.

Corporate Governance andInstitutional RestructuringThere has been much debate since the onset of thecrisis about the factors and the structural weaknessesin the afflicted economies that helped to trigger thecrisis. Although it may not have been the prime fac-tor, there is some truth in the claim that poor gover-nance was partly to blame. In mature economies,this issue is addressed through the existence of ad-equate institutions and the enforcement of a combi-nation of corporate laws and regulations. Economicdevelopment in many countries in Southeast Asiawas not always accompanied by the parallel devel-opment of necessary mechanisms of governance andadequate institutional infrastructure. These shortcom-ings have, to a certain extent, contributed to the vulner-ability of the Malaysian economy to external shocks.

Unlike in the crisis of the 1980s where blame wasprimarily on bad public sector governance, poor gov-ernance in the private sector has been a contributoryfactor to recent problems. The use of short-termborrowings to finance long-term lending, and thestrong preference for debt financing to equity-financ-ing have all been commonplace practices in Malay-sia. Borrowing and investment decisions based onnoncommercial considerations prevailed. Crony alli-ances enjoying relatively easy access to credit orother facilities have resulted in unproductive andunviable investments and ventures. It must, never-theless, be added that such practices know no bound-aries and are not restricted to or inherent only in Asianbusiness culture but are found in the developed worldas well.


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There is little that a government can do to actuallyensure good corporate governance other than put-ting regulations in place and enforcing them. Goodgovernance evolves through time and experience.However, it is important that such a regulatory frame-work, checks, and penalties are in place in order toeducate and instill the desired practice and conduct.Steps taken to improve standards of corporate gov-ernance and institutional infrastructure will not onlylead to healthier business practices, but more impor-tant, they will boost investor confidence, especiallyduring times when confidence has eroded.

It is imperative for Malaysia to complement mac-roeconomic policies by making greater efforts toimplement new rules and set up infrastructures thatwill function more efficiently in the provision of gov-ernance, supervision, and regulation. This should gohand in hand with increasing transparency. Thesemeasures may not be an antidote to future crises butthey will be a check on malpractices and irregulari-ties within the economy, which may otherwise ren-der it vulnerable to shocks. Recognizing the role ofenhanced corporate governance, a high-level FinanceCommittee on Corporate Governance was estab-lished by the Government in March 1998. It has comeup with some 70 recommendations aimed at improv-ing market practices, including principles for goodgovernance targeted at listed companies. SC re-viewed and strengthened the rules. These measuresmay be a relevant start but stringency and consis-tency over the long-term with periodic checks andreviews will be of great importance. Otherwise, itwould be pointless to continue.

Improving Long-TermCompetitivenessCompetitiveness will be a key issue in the post-crisisscenario for East Asia. Growing competition fromemerging economies in other regions of the world hasthreatened Malaysia’s export competitiveness. Withthe devaluation of East Asian currencies as a result ofthe crisis, competition has become even keener.

The World Competitiveness Report of 1997, pub-lished by the International Institute for ManagementDevelopment, ranked Malaysia 17th (up from 23rdplace in 1996) out of 46 developed and developingnations. Among the nonmembers of the Organisationfor Economic Co-operation and Development(OECD), Malaysia was third after Singapore andHong Kong, China in 1997. It was also favorablyplaced in several other studies. Nevertheless, its com-petitiveness is likely to be eroded over time.

Being an open economy, Malaysia’s macroeco-nomic performance will essentially and largely beinfluenced by external developments. This is provingto be increasingly the case for any economy as theprocess of globalization gathers pace. The globaliza-tion of markets and production centers, and the ad-vent of new technologies have intensified the com-petition. In view of this, the economy has to be pro-pelled towards a higher level of competitiveness inits role as an international player. The intense paceof growth during the boom years has exerted muchpressure on the economy. The increase in labor costsand staff shortages (both skilled and unskilled) haveposed serious threats to growth. Though current cri-sis conditions have alleviated this burden, it shouldbe a major lesson for the future once the situationhas stabilized if Malaysia intends to increase its mar-ket share. The country will eventually have to changefrom a labor-intensive and low-value input economyto a technology-intensive and knowledge-basedeconomy. The future trading environment calls notonly for an urgent improvement of competitivenessbut also greater resilience from industry. This meanssweeping changes, improvements, and facing up toinadequacies. New growth strategies will have to beengineered and adjustments made. The alternativeis losing out to regional competitors.

In the long run, Malaysia will have to face thechallenge of more efficient and optimal utilization ofits resources in order to increase productivity, andsustain and improve national competitiveness in thechanging global environment. Unlike some Asian


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newly industrialized economies, institutional inad-equacy is still lacking in various areas to sufficientlyand efficiently govern the pace of growth. New poli-cies and measures will be required to deal with this.In order to improve competitiveness, there are cer-tain long-term physical considerations to be takeninto account. These include, among others, the ur-gent need to improve human resource assets in termsof education, training, and skill upgrading. Skilledhuman resources are a crucial element in attractinginvestments into a country. Malaysia has a weak basein research and development. This has to be seri-ously dealt with. Simultaneously, a gradual openingto allow greater foreign equity participation couldeventually help bring in badly needed capital and ex-pertise. This will improve professionalism in thecountry’s corporations. Government measures needto be implemented to complement macroeconomicpolicies in order to spearhead Malaysia into the nextdecade of growth. This time around it should be pro-ductivity-led growth and not input-led growth.

Final WordsThe “virtual IMF policy” adopted by Malaysia dur-ing the initial period of the crisis produced negativeresults. It aggravated the situation and worsened thecrisis as it caused a rapid contraction of the economy.This failure of the combination of tight monetary andfiscal policies prompted the Government to changeits course and adopt an expansionary policy by themiddle of 1998. The Government continued to fine-tune macroeconomic policy instruments with the aimof strengthening economic and financial sector fun-damentals and restoring domestic and external sta-bility. Nevertheless, in spite of some positive devel-opments, namely, contained inflationary pressures andan improved external balance, the national currencyand the economy continued to remain vulnerable toexternal developments. Such a situation could gravelyaggravate the crisis and cause fundamental damageto the real economy. In response to this, selectivecapital controls and the pegging of the national cur-

rency to the dollar were imposed in September 1998.Both acrimoniously criticized as well as lauded by

many all over the world, the controversial measureshave given Malaysia a “breathing space” to concen-trate on addressing domestic economic problemswhile eliminating speculation and keeping externalinfluences at bay. Interest rates have significantlyfallen and the improvement in the country’s externalaccounts has boosted investor confidence.

The developments have so far been positive, withlow inflation, a favorable trade performance, in-creasing external reserves, improved labor marketconditions, and a low external debt position, espe-cially short-term debt. Reflecting this, market sen-timents have further improved as indicated byhigher capital market activities, continued loangrowth, higher private consumption, and an increasein property transactions.

The expansionary policies, therefore, went someway towards improving growth prospects for theeconomy. However, there may be some time lag be-fore the effectiveness of those policies fully filters intothe system. After a decline over five consecutive quar-ters, the economy recorded a positive growth of 4.1percent in real GDP in the second quarter of 1999. Infact, the uptrend has been evident since February 1999.GDP growth emanated both from a strong externaldemand as well as a recovery in domestic demand.Since the fourth quarter of 1998, the expansion in theexternal sector has further strengthened. This hasgenerated increases in income, which provided thebasis for a significant revival in private consumption.

Similarly, the domestic labor market situation im-proved in the second quarter of 1999 with a reportedincrease in job vacancies, mainly in the manufactur-ing sector, and fewer retrenchments. At the sametime, loan growth (including NPLs sold to Danaharta)has picked up again from a low of 0.4 percent inJanuary 1999 to reach about 1.8 percent in May(-4.3 percent if NPLs acquired by Danaharta wereexcluded). The gradual acceleration in loan growthin 1999 reflects a moderate increase in demand for


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loans as economic activities pick up. In fact, for com-mercial banks, loan growth has already reached alevel of 8 percent. Loan approvals were also main-tained at a higher quantum of RM7.6 billion in May1999, much higher than the RM4 billion–RM5 billionaverage in 1998.

Simultaneously, manufacturers have also reactedfavorably to the positive economic developments.After six quarters of lackluster performance, manu-facturers are ready to kick start operations in viewof the improving demand conditions. The MIER Busi-ness Confidence Index surged past the 50-pointbenchmark in the second quarter of 1999 to a levelof 60.3 points from 48.2 points registered in the pre-vious quarter. On a scale measuring up to 100 points,levels beyond 50 points are viewed as a plus factorin business activities. Against this backdrop, grossfixed capital formation is expected to expand at amoderate rate of 3.9 percent in 1999, rebounding froma steep 42.9 percent fall in 1998. On the supply side,recovery was broad-based with positive growth indomestic and export-oriented industries. In tandemwith increasing sales, manufacturing production rosesharply in the second quarter of 1999.

The stock market has also recovered strongly torecord new highs in trading. However, this might notnecessarily reflect the performance of the real sector.In this context, it is likely that the recovery in regionalmarkets has, in some way, contributed to the rebound.The Malaysian economy is now expected to post agrowth of about 3 percent in 1999, following a severe7.5 percent contraction in 1998. This growth is ex-pected to be mainly driven by public sector spendingrather than private sector expenditure.

However, one cannot rule out the possibility ofdownside risks. If the external environment does notturn out as expected and if Japan continues to re-main in deep recession, Malaysia’s exports will beaffected. The trade surplus would decline and for-eign reserves will be reduced. Under these condi-tions, it would be difficult to maintain the exchangerate peg and exchange controls. At the same time,

firms may not expand as much as hoped for despitethe low interest rates. They may be burdened bylarge debts and may not be willing to expand duringa recessionary period, while banks may be overcau-tious in lending and reduce funds needed for invest-ment and consumption. Moreover, funding require-ments for strengthening the banking sector and theadditional fiscal expenditure may not be enough.

Serious attention must continue to be paid to long-term reform measures. This is imperative in order torebuild and achieve the long-term goals of the coun-try. Various pertinent issues can be identified andthese range from the persistent issue of how Malay-sia can maximize management of its financial sys-tem and minimize risks to remaining competitive in arapidly changing global environment.

An important concern facing the Malaysianeconomy remains the issue of capital controls andthe fixing of the ringgit exchange rate. Even thoughthese measures have produced a certain calm withinthe storm and even with all due reforms in the finan-cial and the various other sectors achieved, what willhappen when the controls are lifted? When will orshould they be lifted? There has been little such pre-cedent and it is not possible to predict the outcomeof such a move in the medium to long term. A closescrutiny of the situation is warranted and the earliestphasing out of these measures would probably bethe best solution.

The present crisis, unlike the one in the previousdecade, has exposed deep crevices in private-sectorpractices. This provides the opportunity to overhauland restructure the wrongs of the recent past andconcentrate on building a competitive and resilientsystem to face the challenges of future shocks.Rather than adopting the single choice of monetaryor fiscal policy, a fiscal-monetary mix in combinationwith other measures would probably be a more ef-fective tool, judging from experiences of the recentpast. All said, the adversity that Malaysia is currentlyfacing will, no doubt, be an opportunity for improve-ment for the future.


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Appendix

Financial Measures to PromoteEconomic Recovery

1998February. Statutory reserve requirement (SRR)

reduced from 13.5 to 10 percent (16 February).April. Margin of financing for hire-purchase loans

on passenger cars costing RM40,000 or less raisedto 85 percent and repayment period lengthened toseven years (23 April).

June. Pengurusan Danaharta Nasional Berhad,the national asset management company, set up toacquire and manage nonperforming loans (NPLs) ofbanking institutions.

July. SRR further reduced from 10 to 8 percent(1 July). The 85 percent financing margin for hire-purchase loans for lower-cost passenger cars ex-tended to all passenger cars and the limit on the maxi-mum repayment period for cars completely removed(28 July). Introduction of a framework for liquiditymanagement to enable banking institutions to man-age their liquidity positions more flexibly without com-promising prudential standards (31 July).

August. Danamodal Nasional Berhad, a specialpurpose vehicle, established to recapitalize bankinginstitutions. Corporate Debt Restructuring Commit-tee, a joint public and private sector steering com-mittee, set up to facilitate and expedite corporate debtrestructuring. Bank Negara Malaysia’s (BNM’s) in-tervention rate reduced from 11 to 10.5 percent on 3August; 10 percent on 10 August; and 9.5 percenton 27 August.

September. Base lending rate framework re-vised to allow a faster transmission of changes inmonetary policy to lending rates (1 September). SRRreduced from 8 to 6 percent on 1 September withfurther reduction to 4 percent on 16 September.BNM’s intervention rate reduced again to 8 percent(3 September). Lending for the construction or pur-chase of residential properties costing RM250,000and below exempted from 20 percent limit on lend-

ing to the broad property sector (7 September). Bank-ing institutions with the capacity to lend required toachieve a minimum annual loan growth rate of 8 per-cent by the end of 1998 to ensure that viable projectsreceive financing (9 September). Liquid asset re-quirement of commercial banks reduced from 17 to15 percent of total eligible liabilities (16 September).Default period for classifying a loan as nonperformingby banking institutions increased from three to sixmonths (23 September).

October. Sixty percent maximum margin for fi-nancing the purchase of nonowner occupied resi-dential properties costing RM300,000 and above, andthe purchase of land lots abolished (5 October).BNM’s intervention rate further reduced to 7.5 per-cent (5 October).

November. Banking institutions required to es-tablish loan rehabilitation units to enable more in-tensive management of problem loans (20 Novem-ber). The minimum monthly repayment on creditcards reduced from 15 to 5 percent of the outstand-ing credit card balances (20 November). The hirepurchase guidelines for passenger cars abolished,allowing banking institutions to determine their ownterms and conditions for hire-purchase loans(21 November).

December. The maximum finance charges pay-able by cardholders reduced to not more than1.5 percent per month or 18 percent per annum from2 percent per month or 24 percent per annum (30December).

1999January. Banking institutions no longer allowed

to provide bridging finance for development of prop-erties costing above RM250,000, except for ongoingprojects (4 January). Banking institutions required toachieve a minimum loan growth of 8 percent by theend of 1999 (4 January). The tier system of bankinginstitutions discontinued. As part of efforts tostrengthen BNM’s banking supervisory function,additional staff recruited. Finance companies


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encouraged again to merge or be absorbed by banks,given that the liquidity situation had improved andother financial sector restructuring measures werealready in place. The process of absorption/mergerto be market-driven and intended to reduce their

number to a smaller group of large and strong insti-tutions. This process to be expedited to enable thefinancial system to function quickly.



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Notes1Agreement reached by France, Germany, Japan, UnitedKingdom, and United States to drive down the price of thedollar. Their coordinated efforts led to a 30 percent declineof the dollar in the subsequent two years.

2It further increased to 149 percent in December 1997 (BNM1998).

3The rate reached 33 percent in December 1997 (BNM 1998).

4Danaharta’s acquisition strategies and objectives involvevaluation methodology which was used as an asset valu-ation method in various countries. Among the more promi-nent ones are the Swedish Securum Asset ManagementCompany and the US Resolution Trust Corporation.

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