Malaysia is showing signs of rapid recovery and reduced vulnerability. Since mid-1999, the country’s output growth has been among the strongest of the Asian crisis economies, led by buoyant world demand for electronics and supported by accommodating macroeconomic policies. This recovery has become more broad-based in recent months, with domestic consumption picking up and private investment beginning to recoup. Inflation remains subdued, and international reserves are at a comfortable level. In response to better economic performance and a gradual easing of the capital controls imposed during the crisis, market confidence in Malaysia has begun to strengthen and portfolio inflows have resumed.
This article looks at Malaysia’s evolution into an emerging market economy, its distinctive handling of the Asian crisis (notably the use of selective capital controls and a pegged exchange rate), and the challenges it now faces.
Transition to emerging market economy
Malaysia’s rapid growth from 1970 to the mid-1990s reflected a dramatic shift from agriculture and mining to a growing reliance on manufacturing. By the early 1980s, however, growth was accompanied by substantially increased budget deficits and an unsustainable public debt.
The Malaysian authorities took steps to reduce the federal government deficit and lower the public debt, while more open trade and payments systems helped rapidly expand Malaysia’s export base. Diversification, coupled with deregulation and liberalization of its financial system, helped transform Malaysia into a middle-income emerging market by the end of the decade and allowed it to improve living standards and income distribution.
In the early 1990s, Malaysia’s macroeconomic performance was very strong. Real output growth averaged 8½ percent a year; unemployment dipped below 3 percent; prices and the exchange rate remained stable; and international reserves were robust. But there were also signs of stress, as exports decelerated and large current account deficits developed.
Malaysia: net portfolio investment
Data: Malaysian authorities
With the benefit of hindsight, it is clear that Malaysia’s accelerated economic growth also gave rise to vulnerabilities that exposed it to the crisis.
Excessive investment produced a number of uneconomical capital-intensive projects and created substantial unused capacities. Deteriorating investment quality led to lower productivity and declining corporate earnings. Also, close government involvement in the privatized infrastructure projects created potential public sector liabilities and the perception of reduced transparency and weak corporate governance.
Fast economic growth, a stable exchange rate, and relatively low external indebtedness induced large private capital flows, fueling excessive investment in real estate and equity markets that raised their prices beyond underlying values. Relatively easy access to bank credit encouraged further speculative investment, and the ensuing fast credit growth weakened the quality of bank assets.
A high level of stock market capitalization combined with substantial corporate short-term bank financing left the corporate sector vulnerable to declines in asset prices and increases in interest rates, with adverse repercussions for the financial system.
Malaysia’s dependence on electronic and electrical exports made it more susceptible to boom-bust cycles in the global electronic markets, while the real appreciation of the ringgit reduced the country’s external competitiveness. Rapidly expanded imports resulted in large current account deficits financed in part by portfolio flows, which increased Malaysia’s vulnerability to sudden reversals in market sentiment.
Fiscal tightening and monetary sterilization allowed Malaysia to avoid a substantial nominal appreciation of the exchange rate despite the large capital inflows. But the ringgit’s predictability encouraged further foreign borrowing and discouraged the development of hedging instruments, leaving the banking and corporate sectors exposed to currency risks.
An active off shore ringgit market that faced relatively few restrictions rendered the currency more open to speculative attacks once it became apparent that the currency was overvalued.
Despite Malaysia’s relatively strong banking culture and well-developed accounting and prudential supervision systems, the capacity of financial institutions to manage risks did not keep pace with global technological advances and financial innovation.
Generally speaking, however, Malaysia entered the crisis with a better fiscal position, a stronger financial sector, a lower short-term external exposure, and higher usable international reserves than other Asian crisis countries. These features, indicative of the country’s overall financial discipline and prudential regulations on external borrowing, mitigated weakening market confidence early in the crisis and reinforced stabilization efforts that were key to managing the crisis later on.
Onset of the crisis
From early 1997 through the period following the eruption of the crisis midyear, as these vulnerabilities were recognized, confidence in Malaysia, along with the rest of the region, increasingly diminished. Large portfolio outflows took place (see chart, page 282), and equity and property values declined significantly.
The ringgit came under significant pressure. Currency traders took short positions off shore in anticipation of a large devaluation. As a result, off shore ringgit interest rates increased significantly relative to domestic rates, which intensified outflows of ringgit funds off shore. These flows exacerbated banks’ liquidity problems and overall financial distress, and heightened pressure on domestic interest rates.
The Malaysian corporate sector experienced significant wealth loss as a result of sharp falls in the value of real estate and stocks used as bank collateral. Corporate incomes and cash flows also declined, leaving corporations unable to service their debt. Cross-shareholding—which permitted companies to build up higher debt than was obvious on individual balance sheets—exacerbated the financial difficulties.
Managing the crisis
Similar to the other crisis countries, Malaysia initially tightened monetary policy to help anchor market sentiment and restore confidence in the financial system. The authorities temporarily hiked interest rates in mid-1997, while the 1998 budget was revised early that year to an expansionary position. This policy stance was expected to sustain the economic adjustment process needed to correct external imbalances. The contagion effects of the crisis and the associated economic contraction, however, were far worse than anticipated. The fiscal policy proved insufficiently expansionary, and growth rates slowed and then turned sharply negative in early 1998.
An abrupt fall in domestic demand shifted the external current account to a significant surplus but also led to a further deterioration of the financial sector. The level of nonperforming loans rose, deposits slowed, and financial institutions saw earnings and capital decline. Market confidence faltered amid adverse regional developments and uncertainties. Capital outflows persisted, leading to a self-fulfilling vicious cycle of financial panic, and anticipation of a further devaluation heightened. By the summer of 1998, the stock market fell to its lowest level in recent history (see chart, this page).
Asian crisis countries: stock market index
Data: Bloomberg and WEFA/INTLINE
In September 1998, the Malaysian government launched a policy package designed to insulate monetary policy from external volatility. The authorities pegged the ringgit to the U.S. dollar and imposed exchange and capital controls. The controls prohibited off shore trading of the ringgit and restricted the repatriation of portfolio investment. The portfolio restrictions were set to be temporary and focused on selected transactions; payments for current account transactions and foreign direct investment flows were not affected. These measures permitted greater monetary independence and facilitated the subsequent lowering of interest rates, and complemented a May 1998 fiscal stimulus package that stepped up capital spending. However, by the time the September policies were introduced, some measure of stability had already returned to the regional financial markets, and currency movements had become less volatile.
Malaysia’s exchange and capital controls reflected a significant departure from the policy mix adopted by the other crisis countries, and international market responses were initially negative. Rating agencies downgraded the country’s credit ratings and removed Malaysia from major benchmark international investment indices. As a consequence, Malaysia’s risk premium in international markets increased markedly (see chart, page 284).
Malaysian policymakers and businesses, however, viewed the exchange rate peg and the controls as a means of gaining some predictability at a time of intense financial volatility. The initial impact on the domestic market was broadly positive, with stock market prices increasing immediately after the controls were imposed, reflecting both inflows of funds unable to leave the country and renewed interest by both domestic and foreign investors as the regional situation began to stabilize.
Impact of crisis measures
Improved market sentiment and economic recovery in Malaysia shortly after the introduction of controls resembled the pattern in other Asian crisis countries, and it is difficult to isolate the impact of Malaysia’s approach to the crisis from regional developments that have also permitted other countries to pursue monetary easing and structural reforms. The controls have been effectively implemented, yet they have had limited identifiable impact on portfolio flows. This could be because by the time the measures were introduced, substantial portfolio capital had left the country and the external environment had already improved. Also, the subsequently undervalued ringgit reduced incentives for capital outflows. The elimination of the off shore ringgit market did, however, help quell speculation against the currency.
Subsequent easing of the controls also moderated their negative impact. In early 1999, the one-year holding period on the repatriation of portfolio capital was replaced with a graduated system of exit levies. The levy system was then further eased so that only profit remittances on portfolio capital brought in after mid-February 1999 remained subject to a flat levy. Market participants welcomed these moves. Although net outflows occurred during February—October 1999, the amount was smaller than anticipated. Relatively large inflows followed as sovereign spreads narrowed and investors repositioned themselves in anticipation of Malaysia’s reinclusion in key benchmark investment indices.
The policies could have lingering and indirect effects, however. The ringgit peg and control measures have reduced activity in the onshore foreign exchange market, dampened trading in futures and options, and discouraged hedging activities. Foreign direct investors now face higher administrative costs associated with additional verification and approval procedures and perceive investment policy regimes as unpredictable. All these factors may increase Malaysia’s country risk, but it is too early to assess whether there will be longer-term adverse effects on investors’ outlook or on the development of the domestic financial market, including the advancement of robust risk-management practices.
The Malaysian authorities believed capital controls were needed to avert an imminent financial panic. The pegged exchange rate permitted domestic businesses to make plans with less uncertainty, and low interest rates gave some breathing space, allowing the authorities to focus on structural reforms. Beginning in mid-1998, Malaysia sped up efforts to improve banking sector balance sheets. It created an asset-management agency to acquire and maximize the recovery value of nonperforming loans, a recapitalization agency to bring the capital of financial institutions up to adequate levels, and a committee to help restructure large corporate loans. A comprehensive bank merger program subsequently focused on the development of a core of resilient and dynamic domestic banking institutions able to compete in a more globalized environment.
In parallel, the authorities assigned high priority to strengthening prudential regulation and supervision in line with international best practice, highlighting capital adequacy and asset quality. Notable progress has been made toward the introduction of consolidated and risk-based supervision, complemented by the use of formalized risk-management practices by banking institutions. Malaysia has also taken steps to strengthen corporate governance and disclosure standards.
Asian crisis countries: sovereign bond spreads
Data: Bloomberg and Deutsche Bank, Emerging Market Weekly
Better economic conditions and restructuring efforts have contributed to the improved financial performance of the banking and corporate sectors. Well-coordinated undertakings to remove nonperforming loans and raise capital have contributed to better financial sector performance. Strong external demand, higher asset prices, reduced interest rates, and debt restructuring have helped upgrade corporate balance sheets. Restructuring of operations and management has also accompanied debt restructuring, but the effects of this will take time to be felt.
Malaysia’s economy is recovering rapidly, and it will be important to sustain the recovery while keeping inflation under control. Over the near term, macroeconomic policies will have to maintain a judicious balance between the need to sustain domestic demand and a fast-closing output gap. Restructuring efforts will also have to continue. Over the medium term, Malaysia aims to return to high, sustainable growth through productivity gains. To achieve this, it will have to maintain macroeconomic stability while facilitating efficient resource allocation and encouraging investors to take a long-term view of Malaysia. Internally consistent macroeconomic policies combined with an appropriate regulatory framework are key. Such policies will improve risk management and allow for an orderly exit from the remaining capital controls and development of more resilient and competitive financial and corporate sectors. Accelerated corporate reforms will raise productivity and help contain potential contingent liabilities of the government.
The government is mapping a long-term strategy to transform Malaysia into an economy whose high-skilled sectors are based on information, communications, and technology. A crucial issue will be advancing this transformation through deregulation and encouragement of a competitive environment.
Ian S. McDonald
Senior Editorial Assistant
The IMF Survey (ISSN 0047-083X) is published in English, French, and Spanish by the IMF 23 times a year, plus an annual Supplement on the IMF and an annual index. Opinions and materials in the IMF Survey do not necessarily reflect official views of the IMF. Any maps used are for the convenience of readers, based on National Geographic’s Atlas of the World, Sixth Edition; the denominations used and the boundaries shown do not imply any judgment by the IMF on the legal status of any territory or any endorsement or acceptance of such boundaries. Material from the IMF Survey may be reprinted, with due credit given. Address editorial correspondence to Current Publications Division, Room IS7-1100, IMF, Washington, DC 20431 U.S.A. Tel.: (202) 623-8585; or e-mail any comments to