Malaysia
Background Paper

This Background Paper on Malaysia examines developments and trends in the labor market since the mid-1980s. The paper describes the changes in the employment structure and the labor force. It reviews wages and productivity trends and their effects on unit labor cost. The paper highlights that Malaysia’s rapid growth, sustained since 1987, has had a major impact on the labor market. The paper outlines the major policy measures to address the labor constraints. It also analyzes Malaysia’s recent experience with international capital flows.

Abstract

This Background Paper on Malaysia examines developments and trends in the labor market since the mid-1980s. The paper describes the changes in the employment structure and the labor force. It reviews wages and productivity trends and their effects on unit labor cost. The paper highlights that Malaysia’s rapid growth, sustained since 1987, has had a major impact on the labor market. The paper outlines the major policy measures to address the labor constraints. It also analyzes Malaysia’s recent experience with international capital flows.

Malaysia: Basic Data

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Sources: Data provided by the Malaysian authorities; and staff estimates and projections.

Fiscal year ending December 31.

As of June 30, 1995.

I. Labor Market Developments

A. Introduction

Eight consecutive years of rapid economic growth have resulted in a tight labor market throughout the Malaysian economy. Strong employment growth, exceeding the growth in the labor force, has reduced the rate of unemployment to below 3 percent in 1994, a rate which the authorities regard as full employment. At the same time, there was a major shift in employment from agriculture to manufacturing and a sharp rise in the use of foreign labor. Reflecting the tight labor market condition, the annual increase in the average wages accelerated in the 1990s. These wage increases exceeded the growth in labor productivity and contributed to a rise in the unit labor cost and an erosion of international competitiveness.

This chapter examines developments and trends in the labor market since the mid-1980s, beginning with a review of the changes in the employment structure and the labor force. This is followed by a review of wages and productivity trends and their effects on unit labor cost. The last section outlines the major policy measures to address the labor constraints.

B. Developments in the Labor Market

Malaysia’s rapid growth, sustained since 1987, has had a major impact on the labor market. Reflecting employment growth (averaging 3.8 percent annually), which outpaced the labor force growth by about one percentage point per annum, the unemployment rate declined from 7.3 percent in 1987 to a record low of 2.9 percent in 1994, while employment of foreign labor increased sharply to 1.1 million in 1994, about 15 percent of total employment (Table 1 and Chart 1). At the same time, there was a major shift in the employment structure of the economy.

1. Employment structure

The share of employment in agriculture dropped sharply from about 30 percent in 1985 to about 20 percent in 1994. Plantations have shifted their crops from labor-intensive crops to production of more capital-intensive crops by the massive conversion of rubber holdings into palm oil and cocoa growing areas. The decline in agricultural employment was spurred by the migration of the younger population (within the 15-24 year age group) from rural areas to the cities in search of higher paying jobs and better living conditions. Agricultural employment was also adversely affected by the vulnerability of agricultural income, owing to price fluctuations and weather conditions.

The decline in employment in agriculture has been driven by rapid employment growth in the manufacturing and services sectors. In particular, export-oriented industries have led the growth in manufacturing employment. Mirroring the sharp increase in the manufacturing share of GDP from 19 percent in 1985 to 35 percent in 1994, the share of manufacturing employment increased from 15 percent to 24 1/2 percent. The share of employment in the services sector also increased, albeit more moderately, from 45 percent in 1985 to 47 percent in 1994. However, reflecting the objective to downsize the public sector through privatization and rationalization programs, employment in government service increased only modestly during the period 1985-94, and its share in total employment declined from 14 1/2 percent to 11 1/2 percent during the period.

Table 1.

Malaysia: Labor Market Developments, 1980-94

(In percent, unless otherwise indicated)

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Source: Data provided by the Malaysian authorities.

Weighted average of collective wage agreements.

CHART 1
CHART 1

MALAYSIA: LABOR MARKET DEVELOPMENTS, 1988-94

(In percent)

Citation: IMF Staff Country Reports 1995, 127; 10.5089/9781451828221.002.A001

Sources: Data provided by the Malaysian authorities.

2. Sources of labor supply

The strong demand for labor in Malaysia during the past several years was met by the relatively high growth rate of the labor force, a reduction in the unemployment rate, a sharp increase in the imports of foreign labor, and a restructuring of employment in the economy. However, as noted above, the slack in the labor market has disappeared, and the supply constraint will be tighter in the future.

Growth in the labor force has averaged about 3 percent per annum, reflecting the high crude birth rates in the 1960s. However, the growth rate is projected to decline gradually in the near future, reflecting demographic developments. The population growth rate, which averaged about 3 percent per annum in the 1960s, has declined to 2 1/2 percent since the 1970s.

Women constitute a potentially important source of additional labor. Although employment opportunities have increased rapidly, the participation of women in the labor force has remained at around 47 percent since the mid-1980s. This rate is relatively low compared with neighboring countries such as Thailand, where female participation rate exceeds 76 percent. By cohorts, the female participation rate is unusually low for those in the age group from 30s to 40s.

C. Wage and Productivity Trends

1. Wage developments

In line with the tight labor market conditions coupled with the strong economic growth, wage increases have been high in recent years. Although economy-wide wage data are not available, an indication of the overall rising wage cost can be obtained from data on new collective agreements among unionized workers,1 which accelerated from 5-7 percent in the late 1980s to more than 10 percent in the 1990s.

High-wage settlements were observed initially in those sectors which require skilled labor particularly manufacturing and services sectors, but have spilled over to the rest of the economy. During the period 1988-94, wage settlements were highest in manufacturing (9 1/3 percent), followed by the services sector (7 1/2 percent).2 However, although the manufacturing sector wage settlements in 1994 were below 10 percent, wage settlements in the other sectors of the economy rose above 10 percent, reflecting the spillover effects from the previous years. A large pickup in wage settlements in the agriculture (14 percent) and transport (13 1/2 percent) sectors suggest that the labor market conditions have tightened further across the sectors of the economy. Within the manufacturing sector, wage increases have varied widely, depending on the subsector. A wage survey conducted by the authorities shows that wage increases have been highest in the semiconductor and other electronic components industries.

2. Productivity and unit labor cost

Overall labor productivity, defined as real GDP divided by employment,3 grew at an annual average rate of about 4 3/4 percent during the period 1988-94, well below the average annual increase in labor costs. During this period, productivity growth varied among the sectors of the economy. The agriculture sector, which lost about 10 percentage points of employment share, recorded the fastest productivity growth (about 6 percent per annum), followed by the services sector (4 1/2 percent). On the other hand, productivity growth in the manufacturing sector was only about 3 percent reflecting, in part, the unwillingness of firms to shed labor during periods of slower growth.

An international comparison of Malaysia’s unit labor cost in the manufacturing sector suggests that the recent increases in labor costs may have led to an erosion of Malaysia’s international competitiveness. Chart 2 compares the evolution of unit labor cost in the manufacturing sector of Malaysia4 with those of its major trading partners.5 It shows that Malaysia’s unit labor costs have been on an increasing trend: after declining in the early recovery period of 1988-89, the unit labor cost has picked up sharply since 1990 (about 20 percent during the period 1990-94), reflecting the large increases in manufacturing wages. Mirroring this trend, the relative unit labor cost-measured by the weighted average of trade partners’ unit labor cost-declined by 13 percent during the period 1988-91 but has trended upward in recent years.

CHART 2
CHART 2

MALAYSIA WAGE DEVELOPMENTS AND LABOR PRODUCTIVITY, 1988-94

Citation: IMF Staff Country Reports 1995, 127; 10.5089/9781451828221.002.A001

Source: Data provided by the Malaysian authorities.1/ Unit labor cost in Einggit2/ Malaysia’s unit labor cost relative to the weighted unit labor cost of trade partner countries.

D. Policy Framework

The Government recognizes that economic growth is now constrained by the tightness in the labor market and considers that a shift to high-technology and capital-intensive production is critical to sustain growth with price stability. Toward this end, the Government has been pursuing structural policies on a number of fronts to encourage broader participation in employment, upgrade existing labor force, and boost productivity. These measures can be broadly classified under five categories.

1. Limiting the hiring of foreign workers

To alleviate the excess demand for labor, the Government has recognized the need for employment of foreign labor as a temporary measure. However, the large number of foreign workers, estimated to exceed 1.1 million or one seventh of Malaysia’s total employment, has given rise to concerns about its potential social impact.6 Most of the foreign workers are unskilled, and about 50 percent are employed in the construction sector, followed by agriculture (about 30 percent) and services (10 percent). In view of the social concerns, since the beginning of 1994, the authorities have restricted the imports of foreign labor mainly to the skilled and professional categories, and industries are encouraged to shift to labor saving techniques. Nevertheless, in order to minimize distortions, some flexibility is allowed for certain industries, such as plantations owned by state agencies, special construction projects, and certain service industries. However, the Government will ensure that the firms have exhausted the possibility of hiring domestic labor before resorting to foreign labor. In addition, such firms will be required to pay adequate wages and provide facilities, including housing.

2. Encouraging broader participation in employment

A number of measures are being adopted to overcome the tight labor constraint including: extending the overtime limit from 64 to 104 hours a month, facilitating broader participation of labor, establishing an apprenticeship scheme to recruit school leavers and dropouts, and establishing a data center to register job seekers. In particular, significant attention is being paid to encourage greater participation by women in formal employment.7 For this purpose, the Government is encouraging greater flexibility in working hours, including increased use of part-time workers with proportionate payment of benefits, and it has provided tax incentives to employers to deduct expenses incurred in establishing child-care centers for employees at their premises.

3. Shifting to high-technology, capital-intensive industries

In view of the tight labor market, the Government has taken measures to encourage the development of capital- and technology-intensive industries, including an incentive package to promote such industries. For this purpose, the Government has granted full exemption of corporate income tax for a period of five years or investment tax allowance of 60 percent to investments in capital- and technology-intensive industries. Further incentives are provided to those investment projects that are considered as strategic, based on criteria such as the amount of capital investment and the type of technology, and the degree of linkages within the industry and with other industries. In addition, firms that undertake restructuring to enhance productivity are eligible for tax allowances. At the same time, the Government is discouraging investments in low value-added, labor-intensive projects. Malaysian companies engaged in such industries are encouraged to relocate to the less-developed parts of the country or to invest abroad.

4. Enhancing labor productivity

With the shift toward more capital- and technology-intensive industries, the Government is taking measures to enhance and develop the skill level of the workforce to meet the increasing demand. For instance, it is estimated that the annual requirement for skilled workers in the manufacturing sector during the next five years is 95,000, while the current educational system is only able to supply about 45,000 a year and thus, there would be a shortfall of about 50,000 a year. To overcome this shortfall, the Government introduced several measures, including establishing training institutes and skill technology centers and expanding the capacity of existing training institutes by introducing new technology courses and providing training for services sectors. For this purpose, the Human Resources Development Fund (HRDF), launched in 1993, will be an important vehicle.8 The HRDF provides financial assistance to employers who send workers to approved training programs. The coverage of the HRDF has been extended to small- and medium-sized industries and the services sectors. In 1995, it is estimated that 35 percent of employees in the manufacturing sector and about 10 percent of employees in the services sector will participate in training programs (including short-term programs) sponsored by the HRDF. To encourage the private sector to complement the Government’s efforts, tax incentives were announced in the 1995 budget, including an investment tax allowance of 100 percent for ten years, and exemption from import duties, sales tax, and excise duties.

5. Promoting the flexibility of the real wage

The weaknesses in Malaysia’s wage system have included a tendency for wages to ratchet upward, built-in automatic wage increases, a tendency for nonwage benefits to grow more rapidly and for wage increases to be based on seniority rather than performance. As a result, wage increases, in many instances, were not related to the worker’s productivity or to profitability of the firms. These features have hampered the ability of the labor market to respond quickly to the changing economic environment. In order to link wages more closely to productivity, the Government implemented the New Remuneration System for public servants in 1992, which embodied the concept of performance-based wages. Reflecting the growing awareness of linking wages to productivity gains, a number of new collective wage agreements now include flexible components in their remunerations. The official survey reveals that of 647 agreements concluded in 1994, 385 contain performance and/or productivity-related components.

II. Malaysia’s Recent Experience with International Capital Flows

A. Introduction

Surging capital inflows have been a prominent feature of Malaysia’s economic landscape in recent years. From 1990 to 1993, the Malaysian economy recorded capital account surpluses that reached unprecedented levels, led by long-term capital inflows and boosted by short-term capital inflows. In 1994, the capital account surplus declined sharply, reflecting a large reversal in short-term capital flows (Table 2).

While greater access to global capital markets has clearly brought many advantages for the Malaysian economy, managing the macroeconomic and financial risks associated with greater financial market integration has become a policy challenge. In the 1990s, capital inflows were associated with strong growth, rising investment, and a rapid accumulation of official reserves (Chart 3). However, in late 1993, the inflows became massive and threatened to destabilize the economy. Reluctant to allow the exchange rate to move sharply in response to short-term capital flows and threatened with a loss of monetary control, the Malaysian authorities imposed a number of administrative and monetary measures in early 1994 to stem the inflows.

This paper discusses Malaysia’s recent experience with capital inflows and the policy responses that were adopted to manage the macroeconomic consequences of those flows. In particular, the discussion highlights some of the events leading up to the massive surge in capital inflows in 1993-94 and the subsequent use of capital controls and other policy measures to contain and stem the inflows in order to help manage domestic monetary conditions.

Table 2.

Malaysia: Balance of Payments Summary, 1990-94

(In billions of U.S. dollars)

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Sources: Data provided by the Malaysian authorities; IMF (1995); and staff estimates.

All capital flows reported on a net basis.

Data on short-term capital by type are not available. According to Bank Negara’s Annual Report, 1994, private short-term capital consists predominantly of changes in net foreign asset positions of financial institutions and large corporations, and portfolio investment (page 74).

Including valuation adjustment.

Average net capital flows to Asian developing countries for the period 1983-89 was $16.7 billion, and for 1977-82 was $15.8 billion.

CHART 3
CHART 3

MALAYSIA: BALANCE OF PAYMENTS, 1984-94

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 1995, 127; 10.5089/9781451828221.002.A001

Sources: Data provided by the Malaysian authorities.1/ Including errors and omissions.

B. Recent Experience with Capital Flows

In the 1990s, many developing countries, including Malaysia, witnessed a return and resurgence of international capital flows.9 Particularly in Asian developing countries, where the negative impact of the debt crisis on capital flows was generally less severe (if not marginal), the level of financial inflows increased significantly. Between 1990 and 1994, net capital inflows to Asian developing countries amounted to over $260 billion, nearly twice the cumulative level of the preceding ten years (Table 2). As for the composition of these inflows, FDI and portfolio flows have accounted for about one quarter and one half of the net inflows,10 displacing to a large extent commercial bank borrowing that had been more dominant in earlier periods.11

1. Long-term capital flows

In Malaysia, FDI has also constituted a significant portion of international capital inflows (Table 2). Classified as long-term capital, FDI represents the largest component of net corporate investment in Malaysia.12 In terms of their relative contribution, net private inflows of long-term capital have comprised nearly three quarters of the total net capital inflows. During the 1990s, the level of private long-term capital flows has shown a notable increase (Chart 4). In fact, since 1990, the value of FDI flows to Malaysia has been the second highest among the ASEAN group, behind Singapore.13

It should be noted that there has also been a significant increase in gross private outflows from Malaysia over the 1990s. The rise in overseas investment has mainly been in the form of equity investment and real estate purchases abroad, and long-term loans extended to nonresidents. These private capital outflows have been boosted in recent years by rapid economic growth and rising corporate profits in Malaysia. As for the pattern of overseas investment, the major destinations for funds channeled abroad include Singapore, Hong Kong, the United Kingdom, Australia, and the United States. However, a growing amount of funds are also being allocated to less-established markets as well. Given tight labor market conditions and labor shortages at home, a number of labor-intensive operations have been relocated to developing countries with relatively more abundant labor supply and lower costs.

CHART 4
CHART 4

MALAYSIA: COMPONENTS OF THE CAPITAL ACCOUNT, 1984-94

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 1995, 127; 10.5089/9781451828221.002.A001

Sources: Data provided by the Malaysian authorities.1/ Excludes valuation adjustment.

Compared with private inflows, net inflows of long-term capital of the public sector have been relatively small or negative over the 1990s. In recent years, these long-term inflows have consisted mainly of external borrowing by nonfinancial public enterprises (NFPEs), which have largely been offset by gross official outflows, mainly representing repayment and prepayment of external loans by the Federal Government.14 Prepayments have been part of a concerted effort by the authorities to substitute more expensive external debt obligations with cheaper funds sourced from abroad or domestically. As part of an active debt management policy, the Government has sought such refinancing opportunities with a view to reducing costs and smoothing out the flow of repayments. At the same time, new external borrowing by the Federal Government has been minimal in recent years, given the significant strengthening of its budgetary position.

2. Short-term capital flows

Short-term capital flows consist mainly of portfolio investment and changes in the net foreign assets of financial institutions.15 This component of the capital account, like its long-term counterpart, tended to increase on a net basis during the early 1990s (Chart 4). Particularly in 1993, short-term inflows surged to record levels, led by portfolio investment and commercial bank borrowing. However, whereas private long-term inflows were sustained at a high level, short-term flows experienced a sharp reversal in 1994, recording a large net outflow in that year.16

C. Determinants of Capital Inflows

The economic determinants underlying the recent increase in capital flows to developing countries, including Malaysia, can be identified with both internal and external factors. Sound macroeconomic policies and improved economic performance in recipient countries have generally boosted foreign investor confidence and attracted foreign capital. Similarly, structural policies and reforms, including financial market reforms, have likely increased the attractiveness of some emerging markets. On the external side, cyclical weakness in economic activity and the decline in interest rates in industrial countries during the early 1990s were likely to have contributed to some reallocation of funds toward developing countries. Moreover, the recent trend toward greater international diversification of institutional investors’ portfolios has also resulted in a larger share of financial savings being allocated to emerging markets.17

In Malaysia, strong underlying economic fundamentals have no doubt played a central role in attracting foreign capital, particularly FDI. Confidence in the economy has also been manifested in the local stock exchange, which enjoyed a large upswing in equity prices in the early 1990s. From 1991 through 1992, the Kuala Lumpur Stock Exchange (KLSE) index rose by 30 percent, and the KLSE index roughly doubled over the course of 1993, buoyed in part by surging portfolio flows from abroad (Chart 5).

At the same time, strong economic growth at home had led to rising inflation in 1991-92, which led the central bank to tighten monetary policy to contain demand pressures. Consequently, substantial interest rate differentials emerged in favor of Malaysia and persisted over this period (see Chart 5),18 as interest rates abroad tended to fall. Combined with market expectations of an appreciation in the ringgit, higher domestic interest rates were a major factor in further attracting short-terms funds from abroad.

D. Managing Capital Inflows

The Malaysian authorities’ response to the surge in capital inflows from 1991 through 1993 reflected to a large extent their policy on the exchange rate as well as their intention to maintain a tight monetary stance. Although the central bank was willing to allow some flexibility in the exchange rate, they were intent on avoiding excessive volatility in the value of the ringgit, which they felt could have an adverse effect on trade and investment. Instead, Bank Negara’s primary response to large capital inflows was one of sterilized intervention.

The monetary authorities were particularly concerned with short-term funds that were highly reversible and speculative in nature. Although the volume of equity-type portfolio inflows would be constrained somewhat by the size of the local stock market and the movement of asset prices, inflows related to purchases of debt securities and increases in external liabilities of commercial banks were more problematic to the extent that interest rate differentials remained unchanged. On the long-term side, FDI flows were of less concern to Bank Negara as these flows were mainly driven by long-run factors and had less of an impact on monetary aggregates.19

CHART 5
CHART 5

MALAYSIA: EXTERNAL LIABILITIES AND PORTFOLIO INVESTMENT, 1991-95

Citation: IMF Staff Country Reports 1995, 127; 10.5089/9781451828221.002.A001

Sources: Bank Negera Malaysian Monthly Bulletin; IMF, International Financial Statistics, and IFC, Emerging Marksta Database.1/ Cash basis from cash BOP reporting system.2/ Thirty-day intorbank rate minus one-month U.S. LIBOR.3/ Exchange rate adjusted differential vis-aàvis the U.S. Positive differential indieatee bifber ex post return in Malayaia.

To the extent that capital inflows could lead to an increase in bank reserves,20 the inflows created the potential for an expansion in domestic credit at a time when the economy was already operating at a very high rate of resource utilization. Apart from the macroeconomic risks of overheating associated with the rapid expansion of bank reserves, large capital inflows also entailed certain financial sector risks, such as slippage in loan quality.21

1. Monetary instruments

To minimize the monetary impact of capital inflows during this period, the Malaysian authorities relied on various types of liquidity or sterilization operations. The most common monetary measures used to sterilize the effects of capital inflows include:

• Interbank market operations. Operations involved borrowing or lending in the interbank market, thereby influencing the interbank interest rate. Intervention in this market remains the principal sterilization instrument of Bank Negara.

• Other open market operations. Auctions of Bank Negara bills (3-, 6-, and 12-month maturities) were conducted on ad hoc basis to absorb excess liquidity. The use of treasury bills for such purposes was limited by the low volumes of securities issued by the Government as a result of fiscal consolidation.

• Transferring government and Employee Provident Fund (EPF) deposits.

Deposits were withdrawn from the banking sector and placed with the central bank.

• Reserve requirements. Statutory reserve requirements (SRR) were increased on several occasions to absorb excess liquidity.

In 1991-92, the specific measures used by Bank Negara included several increases in the SRR, transfers of government and EPF deposits from domestic banks, and short-term borrowing in the interbank market to mop up liquidity. In total, the monetary authorities absorbed approximately RM 24 billion of excess liquidity from the banking system in 1992, equivalent to 90 percent of the outstanding stock of reserve money.

However, as domestic interest rates remained high relative to those abroad on account of the sterilization activities, the inflows of foreign capital accelerated in 1993. Consequently, Bank Negara was compelled to step up its sterilized intervention. The measures adopted by the central bank included: substantial borrowing from the interbank market (RM 27 billion), further transfers of EPF deposits (RM 6 billion), and the introduction of the first series of Bank Negara Bills (RM 6 billion).22 In total, the measures absorbed about RM 40 billion of bank liquidity in 1993—equivalent to 1 1/2 times the stock of reserve money.23

As interest rate differentials persisted, short-term inflows reached unprecedented levels by late 1993, including portfolio investment, which accompanied the run-up in stock market prices (Chart 5). Of particular concern to Bank Negara was the run-up in net external liabilities of domestic banks—mainly on account of large amounts of short-term external borrowing—which led to a rapid expansion in bank reserves when the foreign currency was acquired by Bank Negara. This is reflected in the sharp increase in net official reserves from $11 billion at end-1991 to a record $28 billion at end-1993 (Chart 3).

The sterilization measures notwithstanding, monetary aggregates also accelerated sharply in 1993. Narrow and broad money, as measured by Ml and M2, expanded by 36 percent and 23 percent respectively, in 1993 up from 15 1/2 percent and 19 percent in the previous year. Also, growth in total liquidity (M3), which is an intermediate target of the monetary authorities, increased from 18 percent in 1992 to 23 percent in 1993.

2. Policy response in 1994

Reluctant to allow the exchange rate to move sharply in response to short-term capital flows and threatened with a loss of monetary control, Bank Negara imposed several administrative and monetary measures intended to contain and stem the inflow of short-term funds (Table 3). In January 1994, the measures included placing a ceiling on the net external liability position of domestic banks and prohibiting sales of short-term monetary instruments by residents to nonresidents. In addition, prudential measures were also implemented to address the liquidity situation, including a redefinition of the eligible liabilities base of banks (used to calculate reserve and liquidity requirements) to include all inflows of funds from abroad. Also, the (SRR) was raised by one percentage point in January 1994. Although the two quantitative restrictions were subsequently lifted, the new definition for the eligible liabilities base has remained in effect 24 and the SRR was raised by another one percentage point on two separate occasions to a historic high of 11 1/2 percent.

Table 3.

Malaysia: Administrative and Monetary Measures, 1994

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Sources: Bank Negara Malaysia, Annual Report, 1994; and Ministry of Finance, Economic Report, 1994/1995.

Applied to commercial and merchant banks, and finance companies.

Includes central bank bills, treasury bills, government securities, and Cagamas bonds with remaining maturity of one year or less, bank acceptances, and negotiable instruments of deposit.

On February 2, 1994, commercial banks were also required to place with Bank Negara the ringgit funds of foreign banking institutions maintained in noninterest-bearing accounts (vostro accounts). Furthermore, from February 16 to March 16, 1994, these ringgit funds were also included in the eligible liabilities base of commercial banks and, thus, were subject to statutory reserve and liquidity requirements. This regulation resulted effectively in a negative interest rate being imposed on these deposits, thereby further discouraging the excessive inflow of such funds.25 Although the reserve and liquidity requirements on vostro balances were subsequently lifted, the requirement that these accounts be maintained at the central bank remains in place. 26

Also, from February 1994, commercial banks were not allowed to engage in swap or forward transactions (on the bid side) for nontrade-related purposes. This measure was intended to curtail the speculative activities of offshore agents seeking long positions in the ringgit, based on perceptions that the currency was undervalued and would appreciate. The measure was lifted in August 1994.

In addition to the administrative and monetary measures, the central bank also eased its interest rate policy, in part as domestic inflation had declined in 1993. Specifically, Bank Negara curtailed its sterilization activities and allowed domestic interest rates to drift downward in 1994. As a result, interest rate differentials narrowed quickly and reversed sign, as foreign interest rates rose throughout the year (Chart 5).

Reflecting the swing in interest rate differentials, a correction in the stock market, and the administrative measures themselves, short-term capital inflows abated in early 1994 and reversed in the second half of the year, leading to a sharp decline in the net external liabilities of commercial banks and net international reserves (see Chart 1). By contrast, long-term capital inflows were relatively unaffected and remained at a high level. With the outflow of short-term funds, monetary aggregates decelerated markedly in 1994, and many of the control measures were lifted (Table 3).

E. Concluding Remarks

Malaysia’s recent experience with capital flows illustrates the increasing complexity of monetary management in an era of integrated financial markets. In particular, monetary authorities must now be more conscious of the possible effects of their policy actions on international capital markets. In an environment of rapid market reaction and large capital movements, the costs of inappropriate policies can be very high.

Among the lessons that can be drawn from Malaysia’s experience, the use of sterilized intervention, while limiting the monetary impact of the inflows in the near term, seems to have only prolonged the episode by maintaining wide differentials between domestic and foreign interest rates. Allowing interest rate differentials to narrow appears to have contributed significantly to halting and reversing the capital inflows.

The use of capital controls as a policy response to surging capital inflows is somewhat controversial. To the extent that some of the administrative measures in Malaysia were intended to safeguard the soundness of the banking system, they could be justified on prudential grounds. Control measures that constitute capital restrictions, on the other hand, are likely to be distortionary. In recognition of this, the authorities implemented such measures on a temporary basis. Furthermore, the controls were placed on capital inflows rather than outflows in order to minimize any adverse effects on credibility.

APPENDIX

Table 4.

Malaysia: Economic Trends, 1977-94

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Sources: Data provided by the Malaysian authorities; and staff estimates.

Period average.

1979-80.

In percent of exports of goods and services.

In months of imports of goods and services.

Table 5.

Malaysia: Summary of Federal Government Budgetary Developments, 1986-95

(In percent of GNP)

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Sources: Data provided by the Malaysian authorities; and staff estimates and projections.
Table 6.

Malaysia: Federal Government Functional Expenditure Shares, 1986-95

(In percent of GNP)

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Sources: Data provided by the Malaysian authorities; and staff estimates and projections.
Table 7.

Malaysia: Components of Revenue, 1986-95

(In percent of GNP)

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Sources: Data provided by the Malaysian authorities; and staff estimates and projections.
Table 8.

Malaysia: Banking Survey, 1991-95 1/

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Source: Data provided by the Malaysian authorities.

Consolidation of the accounts of the monetary authorities, commercial banks, finance companies, merchant banks, and discount houses.

Table 9.

Malaysia: Balance of Payments, 1990-94

(In billions of U.S. dollars)

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Source: Data provided by the Malaysian authorities.

Excludes operations of the central bank.

Includes valuation adjustments.

Table 10.

Malaysia. Expenditure on Gross Domestic Product in 1978 Prices, 1990-94

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Source: Data provided by the Malaysian authorities.

Contribution to GDP growth.

Table 11.

Malaysia: Expenditure on Gross Domestic Product in Current Prices, 1990-94

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Source: Data provided by the Malaysian authorities.

Contribution to GDP growth.

Table 12.

Malaysia: Gross Domestic Product by Sector of Origin in 1978 Prices, 1990-94

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Source: Data provided by the Malaysian authorities.

Includes utilities, domestic services to households, and import duties less imputed bank charges.