A. National Accounts

1. Following several years of sustained growth exceeding 7 percent, real GDP contracted sharply by 6.7 percent in 1998, weighed down by a large fall in private domestic demand as a result of a sharp decline in investment and, to a lesser extent, consumption (Appendix Tables 1 and 2 and Chart 1). Factors contributing to the fall in private domestic demand included the adverse wealth effect generated by the collapse in asset prices as well as the effect on consumer and business spending of uncertainty over the direction of the economy. In particular, the fall in private investment demand was very severe (58 percent), as the rapidly deteriorating business environment forced companies to strengthen their cashflow position. The fall in private domestic demand was partially offset by improving net external demand, reflecting largely a sharp compression of imports. Despite stepped-up government spending, mainly in infrastructure projects following the fiscal stimulus packages introduced in March and July 1998 (Section II below), the public sector made a negative contribution to the growth of aggregate demand in 1998.

MALAYSIA REAL SECTOR INDICATORS, 1994–98

Citation: IMF Staff Country Reports 1999, 085; 10.5089/9781451828252.002.A001

Source: Data provided by the Malaysian authorities.1/ In current prices.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

MALAYSIA REAL SECTOR INDICATORS, 1994–98

Citation: IMF Staff Country Reports 1999, 085; 10.5089/9781451828252.002.A001

Source: Data provided by the Malaysian authorities.1/ In current prices.

• Download Figure
• Download figure as PowerPoint slide

MALAYSIA REAL SECTOR INDICATORS, 1994–98

Citation: IMF Staff Country Reports 1999, 085; 10.5089/9781451828252.002.A001

Source: Data provided by the Malaysian authorities.1/ In current prices.

• Download Figure
• Download figure as PowerPoint slide

B. Sectoral Developments

2. Most major sectors recorded lower output in 1998, with the manufacturing and construction sectors among the hardest hit. Manufacturing output contracted by 10.2 percent in 1998, following strong, robust growth averaging 13.5 percent in 1994–97 (Appendix Table 3). Falling domestic demand and, to a lesser extent, weaker overseas orders—especially from the countries in the region—were the major factors behind the decline. The decline, which gathered momentum over the course of the year, was broad based across industries, and was more pronounced in industries producing construction-related materials and transport equipment (Appendix Table 4).

3. Value-added in the construction sector declined by 24.5 percent in 1998, compared with growth of 9.5 percent in 1997, owing mainly to a sharp drop in construction starts of commercial buildings and upscale residential units. The decline was partly offset by robust demand for medium- and low-cost residential units. The civil engineering subsector, in particular, contracted severely, owing mainly to the deferment of new projects.

4. Production in the agriculture, forestry, and fishery sectors declined by 4 percent in 1998, following a modest rise of 1.3 percent in the previous year, affected mainly by adverse weather conditions, lower yields, and labor shortages stemming from the departure of migrant workers. All major commodities registered lower output in 1998. Output of crude palm oil declined by 8.3 percent and rubber production by 8.8 percent; saw log production fell by 27.2 percent, reflecting weaker demand from countries in the region as well as the slump in the domestic construction sector.

5. Mining output rose slightly by 0.8 percent in 1998, compared with a 1 percent gain in 1997. The performance of the sector reflected primarily higher crude oil and gas production, notwithstanding a sharp contraction (24.5 percent) in the quarrying subsector in response to the decline in construction activity.

6. The services sector grew at a slower—albeit positive—rate in 1998, affected by the decline in overall economic activity. Value-added in the services sector grew by 1.5 percent in 1998, compared with 8 percent in 1997. Growth was stronger in the intermediate services subsector (mainly finance, insurance, real estate, and business services), while the final services subsector (mainly wholesale and retail trade, hotels and restaurants, and government services) expanded at a much slower pace. In particular, growth in government services moderated to 2.4 percent in 1998 from 6.1 percent in the previous year, reflecting the freeze in filling nonessential vacant posts and the reduction in allowances for civil servants.

C. Saving and Investment

7. The excess of saving over investment turned positive in 1998, mirroring a modest rise in gross national saving and the sharp contraction in investment demand. Gross national saving rose by 1.5 percentage points to 38.8 percent of GDP in 1998, as rising private saving offset a marked decline in public saving (Appendix Table 5). Mounting uncertainty over the direction of the economy as well as the negative wealth effect from the sharp fall in asset prices contributed to a decline in consumption and a rise in the saving rate of households. Public saving fell markedly, largely reflecting the automatic impact of the economic cycle on the budget. Gross domestic investment fell sharply from 42.5 percent of GDP in 1997 to 25.8 percent of GDP in 1998, capturing a fall in private investment to less than half the level (as a share of GDP) of the previous year. Contributing factors included the completion of large infrastructure projects and the slowdown in implementation of existing projects (Appendix Tables 6 and 7). The latter factor reflected a reluctance to embark on investment spending amidst mounting uncertainty as well as the need to improve cash-flow positions.

D. The Labor Market

8. Labor market conditions deteriorated in 1998 (Appendix Tables 8–10). The unemployment rate rose to 3.9 percent in 1998 from 2.6 percent in the previous year (Chart 2). Two main factors accounted for the relatively small rise in the unemployment rate in view of the severity of the output contraction: substantial labor hoarding by firms, and a large decline in the number of foreign workers, who absorbed the brunt of the adjustment in the labor market. Most firms preferred to institute pay cuts rather than shed labor (so as to avoid the costs associated with firing and hiring), in the belief that the contraction would not last long. At the same time, most job cuts affected migrant workers, who represented a high proportion of agricultural workers. Government policy on foreign labor (as stated in the midterm review of the Seventh Malaysia Plan, 1996–2000) became more restrictive in 1998 by giving increased emphasis on measures to reduce reliance on foreign workers.

MALAYSIA LABOR AND PROPERTY MARKET DEVELOPMENTS, 1994–98

Citation: IMF Staff Country Reports 1999, 085; 10.5089/9781451828252.002.A001

Source: Data provided by the Malaysian authorities.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

MALAYSIA LABOR AND PROPERTY MARKET DEVELOPMENTS, 1994–98

Citation: IMF Staff Country Reports 1999, 085; 10.5089/9781451828252.002.A001

Source: Data provided by the Malaysian authorities.

• Download Figure
• Download figure as PowerPoint slide

MALAYSIA LABOR AND PROPERTY MARKET DEVELOPMENTS, 1994–98

Citation: IMF Staff Country Reports 1999, 085; 10.5089/9781451828252.002.A001

Source: Data provided by the Malaysian authorities.

• Download Figure
• Download figure as PowerPoint slide

9. Total employment declined by 3 percent in 1998, with retrenchment totaling 83,900 workers during the year. Retrenchment trends gradually eased over the course of the year. Many firms relied on temporary layoffs and voluntary retrenchment to reduce the size of their workforce, including by offering attractive voluntary separation packages.

10. The authorities implemented a number of measures to increase flexibility in the labor market and mitigate the impact of the crisis on the unemployed. The Employment Act of 1955 was amended in August 1998 to promote more flexible work practices and encourage employers to provide incentives for productivity. The amended Act provided for a link between duration of employment and compensation for those retrenched. Other measures included efforts to coordinate the job-matching process, job mobility programs to encourage mobility of labor between sectors, and retraining schemes for retrenched workers (targeting mainly the manufacturing sector).

11. Salary increases moderated in 1998. Average salary increases in the private sector slowed to 6.2 percent in 1998, compared to 8.9 percent in 1997. Among the reasons for the relatively high increase—in view of the economic crisis—was the staggered effect of union contract negotiations. In the unionized sections of the labor market, contracts cover wage increases over three years, with the result that only the contracts that came up for negotiation in 1998 reflected the prevailing labor market conditions. Several employers agreed with their workforce to implement pay cuts (labor laws mandate that pay cuts be made in consultation with workers). Pay cuts ranged from 3 percent to as high as 15 percent for those at the upper end of the pay scales.

E. The Property Market

12. Conditions in the property market deteriorated sharply in 1998. The total number of properties transacted fell 32.3 percent to a seven-year low, compared with a modest rise of 1.6 percent in 1997 (see Chart 2). The industrial, development, and commercial sectors were the worst hit. In the residential sector, the decline in transactions was more pronounced in the high-end segment of the market, especially condominiums, which faced particularly acute excess supply conditions.

13. Housing prices faced a downward adjustment in 1998, as falling demand and oversupply conditions forced the first decline in housing prices since 1988. Nonetheless, the residential sector was the least affected by the crisis, with average prices in 1998 lower than in 1997 but still higher than in 1995. The apparent resilience of property prices in the residential sector reflected to a certain extent the impact of measures taken by the authorities during the year to support the sector. Measures included easing the lending norms for the construction or purchase of low- and medium-cost housing, abolishing the margin limit of loan financing for the purchase of nonowner occupied properties, the removal of the levy on foreign purchases of high-end properties, and a reduction in the property gains tax.

F. Prices

14. Inflationary pressures remained relatively subdued in 1998 (Appendix Tables 11–13). Consumer price inflation rose to 5.3 percent in December 1999 (12-month rate) from 2.7 percent in the previous year. Contributing factors included rising food prices and the pass-through effect of the depreciation of the ringgit since the beginning of the crisis. Against the background of weak domestic demand, the full impact of the depreciation of the ringgit was not passed through to consumers, as firms felt compelled to absorb part of the rising costs stemming from higher import prices. Excluding the volatile food component, consumer price inflation was more benign in 1998 (at 3.1 percent).

15. Producer prices rose faster than consumer prices in 1998. The producer price index (PPI), which has a higher import component, rose fast during the first half of 1998 but subsequently moderated in response to the slump in demand as well as a decline in prices of mineral fuels, lubricants, and related materials. For 1998 as a whole, the PPI rose by 10.7 percent, compared with a rise of only 2.7 percent in 1997.

A. Overview

16. Following a succession of surpluses for the most part of the 1990s, the consolidated public sector registered a deficit in 1998 (Chart 3).¹ The outturn mirrored mainly a turnaround in the fiscal position of the federal government from a sizable surplus to a modest deficit, reflecting the cyclical impact of the recent crisis on budget revenue as well as policy measures designed to deal with the crisis (Appendix Tables 14–24), Since March 1998, the Malaysian authorities have sought to stem the decline in output by aiming for expansionary fiscal policies. To this end, a number of measures were taken over the course of 1998 aiming to achieve the first federal government deficit since 1991. In the event, the resulting deficit reflected mainly a cyclical reduction in the tax-to-GDP ratio and, to a lesser extent, a modest pickup in development spending (Chart 4).

MALAYSIA PUBLIC SECTOR ACCOUNTS, 1994–99 ^1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 085; 10.5089/9781451828252.002.A001

Sources: Data provided by the Malaysian authorities; and Fund staff estimates.^1/ The consolidated public sector comprises the operations of the federal government, state and local governments, statutory bodies, and nonfinancial public enterprises (NFPEs).2/ Staff estimates. They exclude domestic debt of the NFPEs.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

MALAYSIA PUBLIC SECTOR ACCOUNTS, 1994–99 ^1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 085; 10.5089/9781451828252.002.A001

Sources: Data provided by the Malaysian authorities; and Fund staff estimates.^1/ The consolidated public sector comprises the operations of the federal government, state and local governments, statutory bodies, and nonfinancial public enterprises (NFPEs).2/ Staff estimates. They exclude domestic debt of the NFPEs.

• Download Figure
• Download figure as PowerPoint slide

MALAYSIA PUBLIC SECTOR ACCOUNTS, 1994–99 ^1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 085; 10.5089/9781451828252.002.A001

Sources: Data provided by the Malaysian authorities; and Fund staff estimates.^1/ The consolidated public sector comprises the operations of the federal government, state and local governments, statutory bodies, and nonfinancial public enterprises (NFPEs).2/ Staff estimates. They exclude domestic debt of the NFPEs.

• Download Figure
• Download figure as PowerPoint slide

MALAYSIA FEDERAL GOVERNMENT REVENUE AND EXPENDITURE, 1994–99

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 085; 10.5089/9781451828252.002.A001

Source: Data provided by the Malaysian authorities.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

MALAYSIA FEDERAL GOVERNMENT REVENUE AND EXPENDITURE, 1994–99

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 085; 10.5089/9781451828252.002.A001

Source: Data provided by the Malaysian authorities.

• Download Figure
• Download figure as PowerPoint slide

MALAYSIA FEDERAL GOVERNMENT REVENUE AND EXPENDITURE, 1994–99

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 085; 10.5089/9781451828252.002.A001

Source: Data provided by the Malaysian authorities.

• Download Figure
• Download figure as PowerPoint slide

B. Fiscal Performance in 1998

17. The federal government budget for 1998 (announced in October 1997) aimed at a moderate increase of the fiscal surplus to 3 percent of GDP from an anticipated surplus of about 2 percent of GDP in 1997.² Part of the envisaged increase in the surplus was to be accomplished through cuts in operating expenditures (amounting to 0.5 percent of GDP). The budget aimed to restrain domestic demand—to safeguard Malaysia’s external position in the wake of overheating concerns—and strengthen the banking system amidst the developing financial crisis in the region. In December 1997, when it became clear to the authorities that output growth was going to be lower than earlier forecast, the projected 1998 budget surplus was revised downward to about 1.5 percent of GDP. The revision reflected a substantial downward adjustment of revenue projections, offset by additional cuts in operating as well as development expenditures amounting to 2.5 percent of GDP.³ In addition, several large off-budget infrastructure projects were indefinitely postponed.

18. Against the backdrop of a rapidly deteriorating external environment and the realization that the output effects of the financial crisis were going to be severe, the government gradually shifted to expansionary fiscal policies during 1998. The government announced in March and in July 1998 two policy packages designed to revive economic activity through spending on development projects.⁴ Including the implications of the spending packages for the federal government, the revised federal government budget for 1998 aimed for a fiscal deficit of 2.6 percent of GDP, compared with an actual surplus of 2.6 percent of GDP in the previous year. In addition to the expenditure measures taken during the year, a large part of the envisaged widening of the deficit was to come through a decline in tax revenues, reflecting the cyclical losses from a weak economy.

19. Despite stepped up development expenditures during 1998, the deficit of the federal government was smaller than planned. The federal government budget recorded a deficit of 1.5 percent of GDP, reflecting higher-than-expected tax revenues and delays in project implementation. Tax revenues exceeded the revised budget target by 0.6 percent of GDP as gains from buoyant direct taxes more than offset a small shortfall in indirect taxes. In particular, direct tax revenues rose by about 5 percent over the previous year and exceeded the revised budget target by over 8 percent in 1998, as the impact of the crisis on individuals’ and corporations’ ability to pay taxes was much less severe than what the authorities had projected.⁵ Collections of taxes on goods and services were largely on target, but import duties fell short of the budget target, reflecting a marked fall of imports during the year. Despite lower-than-budgeted dividend payments by Petronas (a major NFPE), strong rent and interest receipts helped contain the shortfall in nontax revenues to 0.1 percent of GDP.

20. Federal government expenditures were 0.5 percent of GDP less than the revised target. The expenditure shortfall reflected primarily savings of 0.5 percent of GDP in current expenditures, mainly related to efforts to contain nonessential and unproductive spending to make room for additional spending in priority areas. Reflecting these efforts, development expenditures exceeded the budget target by 0.3 percent of GDP.⁶ The federal government overfinanced its fiscal deficit in 1998, thus accumulating about RM 8 billion (2.9 percent of GDP) in deposits with the banking system. The excess financing of the deficit reflected efforts to mobilize funding for projects included in the National Economic Recovery Plan covering 1998–2000. Against this background, total federal government debt rose from about 33 percent of GDP in 1997 to 37 percent of GDP in 1998 (Appendix Table 25).

21. The overall financial position of the NFPEs reverted to a deficit of 0.5 percent of GDP in 1998, after recording a small surplus in 1997 (see Appendix Table 23). The operating surplus in 1998 was slightly lower than anticipated, primarily owing to an increase in operating expenditures—including higher debt servicing stemming from the weaker ringgit—of major NFPEs. Revenues of NFPEs performed well in 1998, despite the severity of the crisis. The large NFPEs (such as Petronas) benefited from operations overseas that translated to higher gains in ringgit terms, as they were largely shielded from rising costs stemming from the depreciation of the ringgit Sharp increases in palm oil prices also contributed to the increase in revenues. Development expenditures rose by over 16 percent in 1998, reflecting, among other factors, increased capital spending (in ringgit terms) overseas as well as increased domestic spending on infrastructure and utility projects.

22. Following five consecutive years of surpluses, the fiscal position of the state governments moved to a deficit in 1998 (see Appendix Table 20). State government revenues fell short of budget targets by 0.3 percent of GDP, reflecting the contraction in economic activity and depressed prices of selected commodities (such as saw logs and petroleum products) on which a range of state taxes are based. A tight control over operating expenditures accommodated a small increase in development spending. In the event, state governments recorded a deficit of 0.1 percent of GDP in 1998, compared with a surplus of 0.2 percent in 1997. Against the background of a small deficit (0.1 percent of GDP) in the operations of local governments, and a surplus of 0.5 percent of GDP in the operations of the statutory bodies, the consolidated public sector recorded a deficit of 1.1 percent of GDP, compared with a surplus of 3.5 percent of GDP in 1997.

C. 1999 Federal Government Budget

23. The 1999 federal government budget aims to revive economic activity by providing a fiscal stimulus. The budget provides for a widening of the federal government deficit from 1.5 percent of GDP in 1998 to 5.5 percent of GDP in 1999. The widening of the federal government deficit primarily reflects the operation of automatic stabilizers on the revenue side. Most of the policy initiatives in the budget were on the revenue side (Box 1)⁷ The main expenditure measures in the budget included increased allocations for infrastructure spending (both off and in the budget) and spending in the social sectors designed to strengthen the social safety net.⁸ Moreover, the budget included measures dealing with the restructuring of the banking sector.⁹ Total expenditures are expected to be about 8.5 percent higher than in 1998 in nominal terms. In addition, the fiscal stimulus was designed to be supplemented by significant increases in off-budget spending in 1999.¹⁰ Consistent with the widening deficit for the federal government deficit, the consolidated public sector deficit is expected to rise to 4.4 percent of GDP in 1999 from a deficit of 1.1 percent of GDP in 1998.

A. Overview

24. Between 1997 and 1999, monetary policy has swung from being contractionary to being expansionary, as policy priorities have switched from resisting inflationary pressures and supporting the exchange rate to countering a severe economic recession and relieving stress in the financial and corporate sectors.

• In order to achieve its policy objectives, Bank Negara Malaysia (BNM) has actively employed a variety of instruments, including interest rate and reserve ratio changes, lending directives or guidelines, capital controls, and prudential measures.

• Monetary and credit growth contracted sharply in 1998, as did private sector funding through capital markets.

• Since the imposition of capital controls and the pegging of the ringgit, and the move toward expansionary monetary policy, the stock market has recovered part of the ground lost earlier, but credit growth and capital market borrowing by the private sector remains weak.

• In order to deal with the severe financial difficulties that have resulted from, and contributed to, the severity of the economic contraction, in 1998 the government established an asset management corporation—Danaharta—and a special purpose vehicle—Danamodal—to carry out financial sector restructuring, and a Corporate Debt Restructuring Committee (CDRC) to assist with resolution of financial distress in the corporate sector.

B. Monetary Policy Formulation and Implementation

25. Over the course of 1997–99, the conduct of monetary policy in Malaysia has been severely challenged by the spillover of the regional financial crisis into a sharp decline in the external value of the ringgit, a severe contraction of economic activity, and an associated deterioration in the health of the financial system. The nature of the crisis has generated or accentuated conflicts among key policy objectives including, notably, promoting economic growth, maintaining low inflation, providing a supportive exchange rate environment for the export sector, and preserving the health of the financial system. Policy responses to the crisis have involved a wide array of measures including the introduction of additional policy instruments in order to be able to achieve different objectives simultaneously or, at least, minimize conflicts between them.

26. Through the first half of 1997, monetary policy was primarily oriented toward restraining domestic inflationary pressures, particularly evident in property and equity markets. Double digit rises in share market and property prices in 1996 both reflected the strength of demand in the Malaysian economy and also threatened to boost spending further through their impact on household wealth perceptions and the cost of capital to firms.¹² BNM, however, was concerned that interest rate increases to restrain inflation pressures might impinge primarily on “productive investment.” It sought, therefore, to contain pressures more directly in the most affected markets by introducing measures in April 1997 to limit lending for property and share purchases (Box 2). Whether such measures would have been adequate to the task, however, was quickly rendered moot by the spread of the regional financial crisis to the Malaysian economy in July.¹³

27. In July, interest rates were raised to support the exchange rate as the regional financial crisis spread to Malaysia. The spread of the regional crisis to Malaysia was reflected in an acceleration of capital outflows, a sharp fall in share prices, and downward pressure on the external value of the ringgit. In response to these pressures, BNM intervened heavily in the exchange market (reserves fell $4.7 billion in the month). As liquidity was withdrawn from the market, and exchange rate uncertainty soared, short-term interest rates rose sharply, with the overnight rate briefly rising to as much as 40 percent. Despite these measures, by early August, the ringgit had fallen by over 5 percent from the level in early July.

28. From early August, monetary policy actions were geared toward restoring domestic financial market stability. In the BNM’s judgment, the pressures on the currency were unlikely to dissipate rapidly, so that a prolonged defense of the currency through high interest rates was likely to be unsuccessful and do considerable damage to economic performance. The negative outlook for the ringgit in currency markets, however, worked in the direction of holding Malaysian interest rates well above comparable U.S. interest rates, and thus were in conflict with the BNM’s desire to bring domestic interest rates back toward pre-crisis levels. As domestic interest rates were lowered, therefore, a differential emerged between on-shore and off-shore ringgit interest rates, creating incentives for continued capital outflows and downward pressure on the ringgit. In response, BNM introduced limits on banking system ringgit offer-side swap transactions with foreign customers. Despite this measure and continued intervention in support of the ringgit (reserves fell $3.9 billion in the August-September period), however, the ringgit continued to weaken. By end-September, the ringgit had fallen to 22 percent below the level at the beginning of July.

29. In the period from late September 1997 through early February 1998, the stance of monetary policy firmed gradually as BNM sought to counter the inflationary consequences of the depreciation of the ringgit, and to discourage capital outflows that continued to put downward pressure on the currency. In the September-November period, BNM endorsed a modest firming of the 3-month interbank rate by around 100 basis points. This was complemented, in October, by the establishment of publicly announced targets for reductions in overall credit growth through the end of 1998. In December, BNM also introduced tough restrictions on lending for property development and for car purchases. Continuing pressures on the currency, reflected in the interest differential between on-shore and off-shore ringgit interest rates, also contributed to the firming of domestic interest rates through early 1998, with the 3-month interbank rate rising a further 250 basis points to 11 percent in early February. The pass-through of higher interbank rates to retail lending rates was partially offset by a reduction in the Statutory Reserve Requirement (SRR) in mid-February. Although BNM acted to neutralize the overall effect of the SRR change on system liquidity, the reduction in SRR nonetheless lowered the cost of funds to financial institutions and thus limited the rise in lending rates.

30. From February through July 1998, monetary policy remained firm, but did not tighten further. Upward pressure on interest rates was relieved by weakening domestic activity and a sharp fall in lending for property development and share purchases, as well as by the weakening of the U.S. dollar against regional currencies.

31. Subsequently, monetary policy began to ease in response to increasing signs of a sharp contraction of economic activity and the consequent prospect of declining inflation, as well as in response to some easing of exchange market pressures on the ringgit. In July, BNM reduced the SRR further to facilitate a reduction in retail lending rates. The shift toward policy easing was briefly interrupted by the Russian financial crisis in July. As exchange market pressures dissipated, the easing of monetary policy accelerated in August with three cuts in the BNM intervention rate. By the end of August, the 3-month interbank rate had been reduced 150 basis points from the level at the beginning of July.

32. In September, monetary policy was eased sharply following the introduction of exchange controls and the pegging of the exchange rate. Despite the adjustment in the stance of monetary policy over the previous month, the scope for easing had been substantially constrained by concerns for the potential exchange rate consequences. The imposition of exchange controls and the pegging of the ringgit immediately lifted this constraint, permitting a rapid adjustment in the stance of policy. Measures taken included further cuts in SRR, reductions in the BNM intervention rate, and modification of the Base Lending Rate (BLR) formula to make it more responsive to changes in the intervention rate. As a consequence, the 3-month interbank rate and average lending rates of banks fell by about 250 basis points between August and October. In addition, BNM introduced administrative measures to encourage a resumption of lending, including loosening of restrictions on lending for property, car and share purchases, and setting of an 8 percent loan growth for banking institutions on a bank-by-bank basis.¹⁴

33. Since late 1998, monetary policy has eased further, but more gradually. The pace of easing has reflected a number of considerations:

• A substantial easing has already occurred, and BNM has been wary of the dangers of easing too far, particularly as a recovery of activity appears already to be under way in response to past monetary easing, improved external demand, and fiscal stimulus measures.

• BNM has also been aware that lowering interest rates too far would tend to create incentives for disintermediation and renewed capital outflows despite the existence of controls.

• A BNM view that, at this stage, the scope for stimulating credit expansion is less limited by the level of interest rates than by a very cautious approach to lending on the part of financial institutions, reflecting both their own impaired financial health and uncertainties regarding the financial health of potential borrowers.

• A long-standing BNM policy of keeping retail deposit interest rates positive in real terms. Malaysia’s traditionally high saving rate has been regarded as one of the key strengths of the economy and, consequently, BNM has been reluctant to take measures which would discourage saving.

• BNM’s desire to tailor the speed of adjustment of retail lending rates to changes in banks’ average costs of funds. Because bank lending mostly occurs at floating rates while a significant proportion of funding is from term deposits at fixed rates, rapid reductions in lending rates tend to squeeze banking system cash-flow positions until fixed rate deposits are rolled over at new, lower rates.

34. Taking these considerations into account, BNM has absorbed large amounts of liquidity from the interbank market in order to resist downward pressure on the 3-month rate. As a result, the 3-month interbank rate remained around 6.5 percent from mid-November through mid-March 1999. Subsequently, as inflation prospects were revised downward, BNM permitted a decline in the 3-month rate to the 3 percent to 3.5 percent range by early May 1999, where the rate has remained.

35. Adjustments in the BNM intervention rate, which essentially determines financial institutions’ lending rates, have significantly lagged the decline in interbank rates. This has reflected BNM’s concern to keep reductions in retail lending rates closely linked to reductions in banks’ average funding costs and has led to a pronounced widening of the spread between the BLR and the 3-month interbank rate, especially in the last few months.¹⁵

36. The 8 percent loan growth target set for banking institutions in 1998 has been renewed for 1999. In 1998 the target was implemented flexibly, making exceptions for banking institutions facing financial distress or where increased lending would have compromised prudent behavior. As a result, the bank lending target was substantially undershot: total loans (including nonperforming loans (NPLs) sold to Danaharta) increased only 1.3 percent in 1998. Within this total, however, commercial banks achieved loan growth of 7.1 percent, but this was offset by sharp falls in lending by distressed finance companies. For 1999, BNM has again indicated that achievement of the target should not compromise prudent lending practices.

C. Money and Credit Developments

37. The evolution of monetary and credit aggregates since 1997 has reflected three inter-related developments: the slowing and then sharp contraction of domestic economic activity; the collapse of equity and housing market values; and efforts to restore the strength of the financial system. On the demand side, falls in property and equity prices in 1997–98, together with weak export prices and increases in interest rates, all contributed to a sharp contraction of demand for credit. On the supply side, financial institutions became less willing to lend as uncertainties about borrower quality increased and as their own balance sheets were adversely affected by NPLs. The contraction in lending was accentuated, at least until mid-1998, by BNM restrictions on lending. Finally, the measured growth of lending by the banking system has also been affected by operations to relieve the banking system of NPLs.

38. Broad money and credit growth began to moderate in 1997. M3 growth eased slightly, to 20 percent in 1997 from 24 percent in 1996, while Ml growth slowed more sharply, to 10 percent from 24 percent, as depositors shifted funds to take advantage of higher rates. M2 growth, however, remained high (22 percent compared with 23 percent in 1996), as deposits shifted toward commercial banks from finance companies. (See also Appendix Tables 27–33)

39. Money and credit growth fell sharply in 1998 in response to the contraction of economic activity, and financial consolidation efforts of banking institutions, but has begun to recover more recently. Between December 1997 and September 1998, annualized growth rates of Ml, M2, and M3 plummeted to -40 percent, -9 percent, and -6 percent, respectively (Appendix Tables 29 and 31). Subsequently, however, growth in the monetary aggregates has begun to pick up in response to stabilization of economic activity, declines in interest rates, and easing of restrictions on lending to the property sector. In the six months to March 1999, annualized growth rates of M1, M2, and M3 picked up to 1.4 percent, 11 percent, and 9 percent, respectively.

40. In 1998 there were also large shifts in the sources of growth in M3. In 1997, the increase in net claims on the private sector had accounted for more than all of the increase in M3, mainly offset by reductions in net external claims (reflecting declines in BNM reserves and increased net liabilities of the banking system in ringgit terms). By contrast, in 1998, net external claims made a large positive contribution to M3 growth, reflecting the accumulation of foreign reserves by BNM and the reduction of short-term foreign debt of the banking system. Offsets were provided by a large negative contribution from net other influences and by a fall in net claims on government. The negative contribution from net other influences partly reflected the effects of capital losses as banks sold NPLs at a loss to Danaharta, as well as the effect of the revaluation of BNM foreign exchange reserves in September.¹⁶ The fall in net claims on government primarily resulted from increased government deposits with BNM, including the deposit of a drawdown of a $300 million World Bank loan in June and the proceeds of a (RM 6 billion) bond sale to the Employees Provident Fund in October.

41. Total lending by the banking system (excluding NPLs sold to Danaharta) fell 1.8 percent in 1998 after expanding 26.5 percent in 1997. Although lending growth was weak in virtually all sectors, loans for the purchase of shares, personal consumption (predominantly car loans), and real estate loans were particularly hard hit by the lending restrictions imposed by BNM in 1997. Excluding lending to these sectors, total loans to other sectors increased 2.9 percent in 1998 after increasing 23.3 percent in 1997. In addition, lending growth by different parts of the banking system also varied significantly in 1998. Finance companies, in particular, saw lending fall by 14.4 percent while lending by commercial banks increased by 4.4 percent, as banks gained business being lost by finance companies.

42. Sales of NPLs to Danaharta lowered banking system loan growth in late 1998 and 1999, but have had a more neutral impact on overall M3 growth. Sales of NPLs to Danaharta (amounting to RM 21 billion by end-1998) lowered lending growth in 1998 by a little over 3 percentage points. If such loans are included in total loans, then total lending growth in 1998 was 1.3 percent. The effect of Danaharta operations on overall M3, however, are neutral, since sales of NPLs are offset by increased banking system holdings of Danaharta securities and reductions in banking sector capital liabilities. Injections of capital into the banking system by Danamodal also tend to have offsetting effects on M3, as capital injections have a negative impact on the net other items, while the funding of such operations through sales of bonds to the banking system raise claims on the private sector.¹⁷

D. Capital Market Developments

43. Long-term fund-raising in the Malaysian capital market in 1997 and 1998 largely paralleled the slowing and then contraction of borrowing through the banking system, with the notable exception of government financing. Total funds raised in the capital market in 1997 increased by 11.5 percent to RM 38.4 billion, a marked slowing from the 54 percent increase registered in 1996 (Appendix Table 35). In 1998, however, total funds raised fell by 52 percent to RM 18.4 billion. The contraction of private sector funding was even more pronounced, falling nearly 75 percent to RM 8.9 billion. And of this, RM 7.7 billion was accounted for by the issue of Danamodal bonds in October.

44. The public sector significantly increased its funding through the long-term capital market in 1998, in contrast with the decline in net financing of the public sector through the banking system. Funds raised, largely by Khazanah Berhad, the government’s investment agency, amounted to a net RM 9.8 billion versus a net redemption of RM 1.4 billion in 1997. The long-term government bond issues in 1998 also continued the government’s program of providing yield curve benchmarks for the development of the domestic bond market.

45. After several years of spectacular gains, the Kuala Lumpur Composite Index (KLCI) fell sharply in 1997 and 1998. In the first two months of 1997, the KLCI rose about 3 percent and then declined gradually through the beginning of July to about 12.4 percent below the end-1996 level. From the onset of the Asian financial crisis at the beginning of July, the KLCI fell sharply, losing 27 percent of its value by the end of August. Thereafter, stock prices continued to slide, so that by year’s end the KLCI stood nearly 52 percent below its value a year earlier. In 1998, the slide in the stock market continued, so that by the beginning of September, the KLCI was down 79 percent from the end of 1996.

46. In late 1998, the KLCI began to recover along with equity prices elsewhere in the region as economic prospects stabilized. In Malaysia, the easing of monetary policy following the imposition of exchange controls, together with the program for restructuring the financial sector, have also undoubtedly played an important role in boosting share prices. By the end of May 1999, the KLCI had risen by 145 percent from the level at the end of August 1998, though still 40 percent below the end-1996 level.

E. Financial and Corporate Sector Restructuring

47. A full discussion of financial sector restructuring efforts in Malaysia is contained in Chapter III of the Selected Issues paper, while details of corporate sector restructuring efforts are contained in Chapter IV. This section, therefore, provides only a brief overview of developments.

48. The contraction of economic activity in 1998, together with high interest rates, quickly showed up in Malaysia’s banking system in the form of rising NPLs, strained earnings, and declining capital. Malaysia has avoided the effects of full-scale financial sector crisis because of fundamental strengths that were present in advance of the distress, as well as a prompt and concerted effort on the part of the authorities to arrest deterioration once it had begun.

49. The authorities moved in January 1998 to consolidate the finance company sector as it was viewed to be the most vulnerable segment within the banking system. By midyear, this effort was augmented by a comprehensive strategy to restructure and revitalize the banking system, creating Danaharta to acquire NPLs, Danamodal to provide fresh capital, and the CDRC to help negotiate the restructuring of large corporate loans. The authorities (Ministry of Finance and BNM) provided the initial capitalization to Danaharta and Danamodal and stand behind the issuance of approximately RM 30 billion in debt financing. The authorities expect to be repaid when the assets are sold.

50. In 1998, BNM sharpened its supervision over the banking sector by tightening loan classification requirements and, later, requiring that banks reach agreements to sell NPLs to Danaharta in order to improve asset quality. These actions were accompanied by more frequent on-site examinations to scrutinize individual banks and bank managers. To the extent that NPL sales to Danaharta depleted capital, banks were forced to seek new equity either from shareholders, new investors, or through Danamodal.

51. Through March 1999, Danaharta has acquired approximately one-fourth of the banking system’s NPLs, while Danamodal has injected fresh capital into banking institutions that in the aggregate represent approximately one-fifth of system assets. Danaharta’s purchases of NPLs have amounted to RM 23 billion, from 37 financial institutions, while Danamodal’s capital injections into 11 banking institutions have amounted to RM 6.2 billion. NPLs have begun to moderate and are expected to peak in coming quarters.

52. The Malaysian economic crisis has also been reflected in severe financial distress among segments of the corporate sector—primarily companies in the construction and finance sectors as well as diversified holding companies—mainly through the impact on cash flows and debt-servicing capacity arising from the sharp exchange rate depreciation, the significant decline in stock prices, the increase in interest rates, and the sharp decline in demand, both domestically and of Malaysia’s main regional trading partners. The peak increase in interest rates and the peak exchange rate depreciation are estimated to have reduced corporate cash flows by some 10 percent of GDP since the start of the crisis, while the total wealth shock is estimated to have been equivalent to some 170 percent of GDP. The distress in the corporate sector is evidenced by indicators such as the sharp decline in earnings before interest and taxes and by the number of corporations filing for court protection.

53. To facilitate restructuring in the corporate sector, the government established the CDRC, modeled after the London Approach, as a complement to the establishment of Danaharta and Danamodal. In addition, the authorities have implemented several reforms to improve corporate governance and to strengthen regulations over banking and other financial institutions.

A. Overview

54. Malaysia’s balance of payments position strengthened significantly in 1998, reflecting mainly a current account surplus generated by a sharp decline in private investment and an improvement in private sector saving in response to the negative wealth shock caused by the stock market collapse in 1997 (Appendix Tables 36—42). The large current account surplus—the first since 1989—was in sharp contrast to the current account deficit and substantial loss of reserves observed in 1997. The current account surplus was somewhat offset by short-term capital outflows and a decline in foreign direct investment flows into Malaysia. Nevertheless, for the year as a whole, there was a significant buildup of reserves, especially in the last quarter of the year when exports picked up and capital outflows ceased as a result of the imposition of capital controls in September 1998.

B. Current Account Developments

55. The current account recorded an unprecedented surplus of $9.2 billion during 1998, mainly on account of a sharp positive turnaround in the trade balance. The rise in the trade surplus to $18 billion in 1998 from $4 billion in 1997, resulted entirely from strong import compression, as exports declined notwithstanding the rebound in manufactured exports by 8.8 percent in the fourth quarter of 1998. The service account also improved due, in large part, to a narrowing of the deficit on net payments of freight and insurance, in line with the improvement in the trade balance. Malaysia also recorded a significant net outflow of transfers, mainly one-time lump-sum repatriation of remittances made by a sizable foreign workforce who took their savings with them as they left the country because of the recession.

56. The value of imports fell sharply in 1998, by 26 percent in U.S. dollar terms. The drop in imports was due to a reduction in volumes of all categories of imports. The biggest drop was recorded in the import of capital goods (39 percent), as a result of the contraction in domestic demand, large excess capacity, the exchange rate depreciation, as well as measures introduced earlier in the year to defer noncritical infrastructure projects and rationalize the purchase of imported goods by public agencies. Imports of intermediate goods also declined by 21 percent, in line with a decline in manufacturing production in response to weak domestic and export demand.

57. The dollar value of exports declined by 8 percent in 1998. For the year as a whole, this resulted mainly from a fall in the prices of key export goods (such as semi-conductors and electronics, as well as commodity exports) and, to a lesser extent, from the slowdown in regional export demand. In the final months of 1998, however, exports picked up as the recovery in regional and world demand led to a rise in export volumes, and the declining trend in key export prices moderated. The improved fourth quarter performance was mainly due to the growth in exports of electronic components, transport equipment, nonmetallic mineral products, and rubber products.¹⁸ In addition, the downward adjustment in semiconductor prices moderated following the decision of some major world producers to halt or cut production levels to restrain falling prices. For the year as a whole, Malaysia was able to maintain its share of the U.S. and Japanese markets at the 1997 levels, reflecting the competitiveness of the ringgit against other regional currencies (which appreciated against the ringgit in 1998 as the yen rose against the dollar).¹⁹

58. Malaysian exports and imports continued to be channeled to and from mainly the ASEAN countries (particularly Singapore), Japan, the United States, and the European Union. However, as their economies contracted, the relative share of ASEAN countries in Malaysian exports declined (by 13 percent), to be replaced by the United States and the European Union, which absorbed larger shares (16 percent and 12 percent more than in 1997, respectively).

C. Exchange Rate Developments and Capital Controls

59. For most of 1998, the ringgit was determined on the basis of a managed float vis-à-vis an undisclosed basket of major trading partners’ currencies. The nominal exchange rate stabilized somewhat after January 1998, following a steep depreciation of the ringgit against the U.S. dollar since the onset of the crisis in July 1997. In June 1998, the currency again came under pressure as the Russian financial crisis unfolded. Through the first eight months of 1998, the real effective exchange rate recovered some ground and, by September 1998, stabilized at about 23 percent below its June 1997 level.

60. At the beginning of September 1998, the Malaysian authorities introduced a wide range of capital controls and pegged the exchange rate at RM 3.8 per U.S. dollar. These measures were aimed at stemming speculation against the ringgit and regaining monetary policy independence.²⁰ The controls effectively eliminated the offshore ringgit market, by removing all legal channels for the transfer of ringgit abroad and requiring transfer of offshore ringgit to Malaysia, and prohibited nonresidents from repatriating portfolio capital held in Malaysia for a period of 12 months. Payments and transfers related to current international transactions and foreign direct investment were exempt from the controls.

61. In February 1999, the 12-month rule was replaced with a declining scale of exit levies that apply to the principal or the profits from investments in Malaysian securities, depending on whether the funds were brought into Malaysia before or after February 15, 1999, respectively, with the size of the levy decreasing with the length of the investment. Some exemptions from the exit levy have also been granted for property investments and transactions related to the new over-the-counter stock exchange and financial futures exchanges. In introducing the exchange and capital controls in September 1998, the authorities stated that these would be temporary, and that Malaysia would in time modify the capital controls and return to more flexible management of the exchange rate. Official statements (as recently as mid-May) indicated that capital controls would remain in place until stricter curbs were imposed on currency trading in international markets.

D. Capital Account Developments

62. The capital account swung from a small surplus in 1997 to a deficit of $5 billion in 1998. The deterioration in the capital account can be attributed to an increase in short-term private sector capital outflows (by 32 percent), as well as a slowdown in portfolio capital inflows due to investors’ risk aversion to emerging markets. This was exacerbated by a drop in foreign direct investment inflows (by almost half the amount that came in during 1997), as well as smaller net inflows of official medium- and long-term capital (Appendix Table 43).

63. Foreign direct investment flows moderated because of the tightening of lending conditions in international markets, domestic financial problems in the major investing countries (such as Japan), global excess capacity, and continued regional uncertainties. Reinvestment by foreign investors in Malaysia also declined as a result of higher repatriation of profits and dividends, mainly by Japanese firms, to meet liquidity needs in their parent companies. In addition, the imposition of selective capital controls in September 1998 and the confusion surrounding the initial phase of implementation appears to have been detrimental to foreign direct investment, even though such transactions fell outside the purview of the controls. Matters improved somewhat in the last quarter of 1998 following the liberalization of foreign equity participation in the telecommunications and manufacturing sectors, when funds were brought in by foreign investors for the acquisition of stakes in Malaysian companies. In addition, the number of applications for new investment projects increased significantly during this period, once the operation and scope of the capital controls became increasingly clear to long-term foreign investors.

64. The net outflow of short-term capital increased further in 1998 from the historically high level already witnessed in 1997. This was due to a decline in the external liabilities of the commercial banks and the liquidation of portfolio investments by foreign investors. The former reflected a decline in the short-term external debt of commercial banks in response to the stagnation of domestic demand and reduction in external trade. Heightened uncertainty, including increased concerns about the risks in the financial system and the economic outlook, led to a large portfolio capital outflow, especially in the second and third quarters of 1998. However, such capital outflows stabilized in the last quarter after the imposition of the 12-month withholding period for portfolio capital under the selective capital controls imposed in September 1998.

E. International Reserves, External Debt, and Debt Service

65. BNM’s external reserves rose by $4.5 billion to $26.2 billion at end-1998, equivalent to approximately four months of retained imports of goods and services (Appendix Table 44). This reflects the strong balance of payments position generated by a large current account surplus. This was bolstered in the last quarter of the year by the effectiveness of the capital controls in preventing large private capital outflows. As a result, reserve accumulation accelerated in the final quarter of the year (reserves rose by $6 billion in this period), allowing the reserve loss during the early part of the year to be recouped. In 1999, reserves have continued to build up, reaching $29.8 billion by the end of May.

66. Malaysia’s total external debt stood at $42 billion in 1998, equivalent to 59 percent of GDP, up from 45 percent of GDP in 1997 (Appendix Tables 45–49). Within this total, there has been a noticeable shift in the maturity profile, toward medium- and long-term debt away from short-term debt. The latter has declined significantly as a proportion to total external debt from 25 percent to 18 percent during this period. Medium- and long-term debt rose slightly in 1998 on account of increased borrowing by the federal government from official creditors, while the nonfinancial public and private sectors maintained virtually the same levels of external indebtedness as in the previous year. At the same time, short-term debt declined, owing to a reduction in external liabilities of commercial banks, which in turn reflects lower short-term borrowing by banks as a result of lower trade financing needs following the stagnation in domestic demand and external trade. The currency composition continued to be dominated by U.S. dollar-denominated debt (74 percent of total debt outstanding at the end of 1998), while yen-denominated debt registered a small increase (to 17 percent of total outstanding debt in 1998).

67. Malaysia’s debt-service payments have remained low, at about $6 billion in 1998. However, its debt-service ratio, while still modest, has increased somewhat to 7 percent of exports of goods and services, reflecting the fall in the value of exports.

F. Trade Policy

68. Malaysia’s trade regime is characterized by a relatively moderate average tariff rate of 9.3 percent. All nontariff barriers on agricultural goods (including licensing requirements and quotas) have been converted to tariffs, and several other items such as diamonds, polyethylene, polypropylene, etc., have been removed from import licensing in recent years. However, despite continued progress toward the reduction of tariff and nontariff barriers, Malaysia’s trade system remains somewhat more restrictive than some other countries in the region because of the continued existence of nontariff barriers. These take the form of discretionary import licensing requirements for the import of automobiles, iron and steel products, and other industrial goods, aimed at protecting domestic infant industries, as well as promoting forward and backward industrial linkages.

69. During 1998, Malaysia made further progress toward meeting its commitments to the WTO, mainly through continued tariff reduction, enhanced GATS commitments in the financial services sector, further relaxation in foreign equity participation in the telecommunications sector, and amendment to Malaysian anti-dumping legislation and regulations. During 1998, duties on 65 tariff lines were reduced and those on 12 items, abolished (increasing the number of tariff lines with zero duty to 57 percent from 13 percent in 1993). Some import duties were raised in the 1998 and 1999 budgets, but these increases were consistent with Malaysia’s tariff bindings under WTO.²¹

70. The December 1998 ASEAN Summit agreed to advance the time frame of the ASEAN Free Trade Area (AFTA) by one year from 2003 to 2002. Under this agreement, Malaysia agreed to accelerate the implementation of AFTA to ensure that 85, 90, and 100 percent of the total tariff lines in the Inclusion List would have tariffs of 0–5 percent by January 1, 2000, 2001, and 2002, respectively; to deepen tariff reduction to zero percent as soon as possible; and to accelerate the transfer of products from the General Exception List to the Inclusion List. Moreover, in March 1999 it was agreed that as an initial step, at least 60 percent of total tariff lines of each member country would be at zero percent by 2003. Thus far, Malaysia has been in compliance with the Summit mandate, and is in the process of identifying products for which tariff reduction could be accelerated.