This Selected Issues paper analyzes the use of capital controls and evolution of the capital control regime in Malaysia. The paper highlights that following a period of strong downward pressures on the ringgit, the Malaysian authorities introduced on September 1, 1998 a wide range of capital controls along with pegging the exchange rate at RM 3.8 vis-à-vis the U.S. dollar. The paper provides a brief review of Malaysia’s approach to capital account liberalization prior to September 1998. It also reviews the circumstances surrounding the imposition of the controls in September 1998, and their impact.


This Selected Issues paper analyzes the use of capital controls and evolution of the capital control regime in Malaysia. The paper highlights that following a period of strong downward pressures on the ringgit, the Malaysian authorities introduced on September 1, 1998 a wide range of capital controls along with pegging the exchange rate at RM 3.8 vis-à-vis the U.S. dollar. The paper provides a brief review of Malaysia’s approach to capital account liberalization prior to September 1998. It also reviews the circumstances surrounding the imposition of the controls in September 1998, and their impact.

I. Use of Capital Controls and Evolution of the Capital Control Regime1

A. Introduction and Summary

1. Following a period of strong downward pressures on the ringgit, the Malaysian authorities introduced on September 1, 1998 a wide range of capital controls along with pegging the exchange rate at RM 3.8 vis-à-vis the U.S. dollar. The measures effectively eliminated the offshore ringgit market and prohibited nonresidents from repatriating portfolio capital held in Malaysia for a period of 12 months; foreign direct investment (FDI) flows and payments and transfers affecting current international transactions were excluded from the measures. In February 1999, the authorities replaced the 12-month restriction on the repatriation of portfolio capital with a system of exit levies, with the levy decreasing with the duration of investment.

2. This paper reviews Malaysia’s experience with the use of capital controls, reviews the adequacy of Malaysia’s prudential framework to manage the risks involved in cross-border capital movements, discusses issues related to the strategy for exiting from the capital controls, and examines the options for the evolution of the capital control regime. It finds:

  • While the capital controls have provided the authorities with a breathing space in which to implement more fondamental policy reforms, a key objective now should be to promote foreign investor confidence. The elimination of the exit levy on profits would send an important signal that the capital controls have been temporary;

  • In view of its emerging market status, Malaysia would need a robust prudential framework that can handle the risks in cross-border capital flows. Most key elements of this framework are already in place and others will need to be implemented. It will be critically important that Malaysia also adopt a consistent monetary and exchange rate policy framework.

  • Careful consideration would need to be given to the benefits and risks of cross-border transactions in ringgit.

3. The rest of the paper is outlined as follows. Section II provides a brief review of Malaysia’s approach to capital account liberalization prior to September 1998. Section III reviews the circumstances surrounding the imposition of the controls in September 1998, and their impact. A discussion of the modification of the September measures in February 1999 is provided in Section IV. Section V discusses issues in exiting from the capital controls. Section VI provides conclusions.

B. Malaysia’s Approach to Capital Account Liberalization

4. Malaysia is a highly open economy and traditionally followed an approach to economic development that included the liberalization of capital movements. Exports plus imports of goods and services account for more than 150 percent of GDP. After accepting the obligations of Article VIII in November 1968 and the floating of the ringgit in 1973, the authorities implemented a first round of liberalization of the regulations on foreign exchange transactions, and reviewed the exchange control rules periodically. These periodic reviews led to further liberalization of controls in 1986–87 and 1994–96. The process of capital account liberalization was interrupted in early 1994 when the authorities introduced a number of temporary inflow controls on portfolio transactions following a period of heavy inflows.2

5. Malaysia’s capital control regime was comparatively liberal prior to the imposition of the outflow controls in 1998–99. For a number of years, prior to September 1998, Malaysia had adopted a fairly liberal approach to cross-border transactions in ringgit, including the use of ringgit in trade payments and receipts, relatively few restrictions on ringgit financial transactions with nonresidents, and tolerance of offshore over-the-counter trading in equities and bonds listed on the Malaysian exchanges. An active offshore market in ringgit developed, mainly in Singapore, with the majority of cross-currency hedging of ringgit taking place there rather than in Malaysia. Until 1997, Malaysian banks were unrestricted in providing forward cover against ringgit to nonresidents, thus facilitating arbitrage between the domestic and offshore markets.

6. Concerning other capital movements, portfolio capital inflows by nonresidents were unrestricted into all types of Malaysian financial instruments (bonds, equities, money market, and derivative instruments, as well as bank deposits). FDI inflows were actively encouraged through tax and other incentives, although prior approval was needed for investment in certain sectors. Nonresidents were completely free to repatriate their investments through a system of external accounts. Outward FDI was not restricted. For portfolio outflows, prior to September 1, 1998, there was no restriction for corporate residents with no domestic borrowing to remit money for overseas investment. However, corporate residents with domestic borrowing were required to seek prior approval to remit funds in excess of RM 10 million per corporate group per year for overseas investment, including extension of loans to nonresidents. The primary issue of securities in Malaysia by nonresidents, and of securities abroad by residents, required approval. No controls applied to the extension of suppliers’ credits to nonresidents for periods up to six months. Borrowing abroad by authorized dealers and Tier-1 merchant banks, as well as their lending in foreign exchange to residents and nonresidents, was unrestricted, subject only to meeting prudential net open position limits. Foreign currency borrowing by residents was subject to limits, and amounts above this limit required approval (granted for foreign exchange saving or earning projects).

7. The liberalization of the capital account was accompanied by measures to deregulate the financial system beginning in the late 1980s with key reforms targeting a gradual liberalization of interest rates, reduction of credit controls, and enhancement of competition and efficiency in the system. The authorities took measures to improve the legal and regulatory framework and supervisory practices. A new law on governing the banking and financial institutions, was enacted in 1989 that provided broad regulatory, enforcement and intervention powers to the supervisory authorities, and Bank Negara Malaysia (BNM) followed active policies to update regulations and to address prudential concerns, including loan classification, provisioning and disclosure requirements, limits on large exposures, capital adequacy, and bank liquidity. The authorities have also made significant efforts to deepen the financial markets. The interbank money and foreign exchange markets had developed rapidly; however, the domestic bond market remained relatively underdeveloped because of the limited supply of government securities and captive demand for securities resulting from high minimum liquid asset requirements. The stock market had developed significantly and became a major source of funds for economic development, supported by the establishment of the Securities Commission in 1993, improvement in trading and settlement systems, establishment of credit rating agencies, and strengthening of the regulatory framework of the capital market.

C. The September 1998 Exchange and Capital Control Measures

Economic and financial environment

8. Malaysia entered the 1997 economic crisis with generally stronger fundamentals than the other Asian crisis economies, but potential vulnerabilities also existed from rapid credit expansion and deterioration in the asset quality of banks. Following the onset of the crisis in mid-1997, which revealed structural weaknesses in regional banking systems and resulted in a more general reassessment of regional lending risks, the ringgit came under significant depreciation pressure along with other regional currencies. Much of this pressure occurred through currency trading in the more efficient offshore ringgit market. As agents took short positions in ringgit in the expectation of a depreciation, offshore ringgit interest rates increased relative to domestic interest rates and resulted in capital outflows.3

9. In order to try and break the link between the domestic and offshore interest rates, in early August 1997, the authorities imposed limits on noncommercial-related offer-side swap transactions. As a result, wide spreads emerged between domestic and offshore interest rates.4 However, the breaking of the direct arbitrage link did not prevent capital outflows, which now occurred through various legal channels to take advantage of the large offshore/onshore interest differentials.5 The flow of ringgit funds from the onshore to the offshore market resulted in an increase in domestic interest rates (see Chart I.2), accelerating the contraction in the economy, and exacerbated the difficulties in the corporate and banking sectors. The economy contracted by 4.8 percent in the first half of 1998, and initial estimates indicated that NPLs in the banking system could be as high as 25 percent of total loans.

Chart I.1.
Chart I.1.

Malaysia: Various Indicators of Market Reaction to Exchange Capital Controls

Citation: IMF Staff Country Reports 1999, 086; 10.5089/9781451828306.002.A001

Source: Data provided by the Malaysian authorities; Fund staff estimates; and Bloomberg.1/ Interpolated yield on Malaysian Yankee bonds with maturity date 9/27/2000 minus the yield on U.S. treasury bonds with maturity date 8/15/2000.
Chart I.2.
Chart I.2.

Selected Comparative Financial Indicators in the Asian Countries

Citation: IMF Staff Country Reports 1999, 086; 10.5089/9781451828306.002.A001

Source: APD Database.

September 1998 measures

10. Against this background and breaking political developments in the late summer of 1998, the authorities introduced on September 1, 1998 a wide range of capital controls targeted at eliminating the offshore market for ringgit, protecting the foreign exchange reserves and regaining monetary independence; payments and transfers for current international transactions and FDI were not subject to restriction. The introduction of the controls was accompanied with pegging the ringgit at RM 3.80 per U.S. dollar and an immediate further cut in interest rates. The exchange control measures eliminated practically all legal channels for the transfer of ringgit abroad, required the repatriation of ringgit held offshore to Malaysia by end-September 1998, blocked the repatriation of portfolio capital held by nonresidents in Malaysia for a 12-month period, and imposed tight limits on transfers of capital abroad by residents (Table I.1). Concurrently, changes in the rules for the transfer of shares on the Kuala Lumpur Stock Exchange (KLSE) closed the over-the-counter offshore market in Malaysian equities (the so-called Central Limit Order Book, (CLOB)), which froze the shares of 172,000 investors then worth about RM 10 billion in 112 Malaysian corporations, and it was announced that large denomination ringgit notes would be demonetized. The Companies Act was also subsequently amended to close possible loopholes. The wide-ranging nature of the control measures seem to have been one of the main factors behind the effectiveness of the control measures in preventing outflows (Box I.1).

Table I.1.

Malaysia: Changes in Capital Account Regulations in 1994–99

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11. There were initially markedly different internal and external reactions to the measures. The initial international response was nearly uniformly negative. Rating agencies (such as Moody’s Investor Service, Thompson Bank Watch, and Fitch IBCA) downgraded Malaysia’s credit and sovereign risk-ratings immediately following the measures, citing concerns that the controls threatened Malaysia’s relative openness to trade and foreign investment, which was one of the cornerstones of its rapid economic development. Malaysia was also removed in September 1998 from key indices that track emerging country stock markets and are used as investment benchmarks for fund managers (the investment and capital indices of International Finance Corporation, Morgan Stanley (MSCI) and FT-S&P) for reasons, inter alia, of lack of liquidity in the local market and, thus, out of the list of options available to many equity investors. Malaysia’s risk premium in international markets also increased raising the costs of foreign currency funding to Malaysian corporations and banks.6 Notwithstanding the announced exclusion of FDI and current international transactions from the controls, there was considerable initial uncertainty about the coverage and impact of the measures. Because of ambiguities in the nature of announced controls, the Fund conducted an immediate on-site review to determine whether the measures were in conformity with Malaysia’s obligations under Article VIII, Sections 2, 3, and 4 of the Articles of Agreement. The measures were found to be in conformity with the Articles, but their implementation would need to be kept under review.

Effectiveness of Controls: The Malaysian Experience

One of the main concerns in applying capital controls is that such measures are not particularly effective in achieving their objectives. In addition, they distort the allocation of resources. It is generally agreed that capital controls can be effective for a period, in terms of reducing the overall quantity of capital flows; but effectiveness of individual controls tends to be eroded as means of circumventing the controls are exploited; and controls therefore may need to be wide-ranging to ensure effectiveness. Controls may also be more effective if they are used for the right reasons (i.e., to buy time to correct macroeconomic imbalances and/or to make rapid progress in structural reforms).

In the case of Malaysia, available evidence suggests that the controls have so far been effective in achieving the objective of eliminating the offshore ringgit market. Among the various measures introduced, the restrictions on the internationalization of the ringgit are believed to be the most instrumental. In particular, the freezing of the external accounts, which prevented ringgit funds from being transferred from one account to the other, and from being used to settle transactions or lend to other nonresidents, effectively eliminated offshore ringgit trading and the desire to hold ringgit overseas. The 12-month holding period rule for repatriation of portfolio capital, on the other hand, was not seen essential in eliminating the offshore ringgit trading; instead, the 12-month rule seemed helpful in containing the potential outflows by requiring capital to remain in the country for a period of 12 months.

The effectiveness of the controls is also evident in the absence of speculative pressures on the ringgit since the controls and the fixed peg were introduced, notwithstanding the significant relaxation of monetary and fiscal policies; in the absence of significant indications of the emergence of a parallel market (initial indications of black market activity developing in the cash market apparently subsided once market participants realized that there were adequate reserves to meet their needs); and in the lack of significant evidence of the emergence of an nondeliverable forward (NDF) market.1 Preliminary information also suggests that there are only a few reports of efforts to evade controls,2 and no indications of circumvention through underinvoicing of exports or overinvoicing of imports.3

The effectiveness of the controls in containing capital outflows in Malaysia’s case may have been contributed by a combination of factors. These include: (i) the adequacy of foreign exchange reserves; (ii) the timing and the circumstances under which the capital controls had been adopted (in particular, relatively strong fundamentals of the Malaysian economy at the time of their introduction) and acceleration of macroeconomic and financial reform efforts; (iii) ex post under-valuation of the ringgit following its fixing at RM 3.8 per U.S. dollar as other regional currencies have started to appreciate around the time the ringgit was pegged, which limited the incentives for circumvention; (iv) the wide-ranging nature of the controls that has covered essentially all the potential loopholes in the system, including the effective closing of the CLOB, amendment of the Companies Act to limit distribution of dividends, and demonetization of large notes of denomination; (v) strict implementation of the measures by BNM; (vi) a disciplined banking system which strictly interpreted the measures and has not sought for potential loopholes; and (vii) dissemination of information on the nature of and changes in exchange control rules to provide greater transparency and understanding of the measures.

1 Some market reports indicated that occasional trades were being done on bilateral basis based on RM 3.80 per U.S. dollar as spot, but the trading volumes were too small to constitute a market. Anecdotal evidence suggests that difficulties in finding an onshore counterparty to execute the operation prevented the development of such a market.2 One such incidence took place through swaps of portfolio investment for FDI among market participants; this transaction was approved by BNM.3 Based on a comparison of the value of Malaysia’s exports to its three largest trading partners against the value of the trading partners’ imports from Malaysia, a Morgan Stanley report found no signs of misinvoicing of external trade to circumvent the controls, due primarily to the ringgit’s undervaluation.

12. The initial domestic reaction was more mixed. There was also confusion domestically about the precise nature of the measures, in part reflecting the very short time (three days) that the Exchange Control Department of BNM had to prepare the implementation regulations and notices. The exercise had been much longer in planning, but also a very well kept secret. To address such concerns, BNM subsequently issued many clarifications and press releases, met with investors, and provided seminars on the new controls.7 These efforts have been effective. The stock market initially fell by 13.3 percent, to its lowest level in 1998, but rose significantly subsequently (Chart I.2), in part reportedly because of purchases by state-controlled institutional funds, investments by nonresident investors that had their funds blocked in Malaysia, and in part due to an improvement in confidence in the region more generally. Domestic businesses generally viewed the package of measures positively, particularly the sharp cut in interest rates and the relative stability provided by pegging the exchange rate at a level that export was believed to be undervalued relative to long-term trends.

Economic performance in the period following the imposition of the controls

13. The pattern of economic performance in Malaysia since the emergence of the crisis has in many respects been similar to that of other countries in the region. This makes it very difficult to disentangle the impact of Malaysia’s capital controls from broader international and regional developments. In the period after the imposition of the controls in Malaysia:

  • The overall balance of payments continued to strengthen reflecting a steeper decline in imports than in exports, reflecting the real depreciation of the ringgit and weak domestic demand. Net portfolio capital outflows were contained following the September measures, and foreign exchange reserves increased (see Chart I.1). However, realized net private FDI and new FDI commitments fell in 1998.

  • The authorities have pressed ahead with bank and corporate sector restructuring. The reduction in interest rates that accompanied the controls helped to contain the increase in NPLs of the banking system.8 Also, the overall process of cleaning up the bad loans and recapitalizing the banking sector through Danaharta and Danamodal appears to compare favorably with efforts elsewhere in the region, with some positive results already achieved. There is a need to speed up corporate restructuring.

  • The corporate sector reported that the pegging of the exchange rates and lowering of the interest rates reduced uncertainty and made it easier for businesses to plan ahead their revenues and costs.9 The lower interest rates also helped prevent a further erosion of their repayment capacity.

  • Despite the significant decline in interest rates and increase in financial sector liquidity, bank lending growth remained subdued, and real GDP contracted by 6.7 percent in 1998, owing to sharp falls in investment and, to a lesser extent, in consumption, compared with the 7.7 percent growth in 1997.

  • Activity in the spot and swap currency markets and the futures markets declined sharply after September.10 The decline in activity reflects both the fixing of the exchange rate and the limitations on forward transactions. Moreover, finding a nonresident counterparty to hedge longer-term currency risks became much more difficult after the imposition of the exchange and capital controls.

  • The exchange controls imposed an administrative burden on the parties involved, including BNM, those conducting commercial transactions who had to supply necessary documentation and proof to execute their transactions, and on the commercial banks which were delegated the responsibility to implement the controls, and had to report to BNM on a frequent basis.

D. February 1999 Modification of Capital Controls: The Exit Levy System

14. Against the background of the continued weakness in foreign investor confidence and concerns about the possibility of a massive capital outflow upon the expiry of the 12-month holding period on portfolio investments in September 1999 (see BNM Annual Report, p. 65), the government replaced the 12-month holding period with a system of exit levies on February 4, 1999, effective from February 15, 1999. The system involved two main elements: (i) for capital brought in before February 15, 1999, the one-year holding period restriction on the repatriation of portfolio investment was replaced with a declining scale of exit levies; and (ii) for capital brought in after February 15, 1999, the repatriation of profits, but not the capital, would be subject to one of two rates of exit levies depending on the length of the investment (see Table I.1).

15. Profits were defined to exclude dividends and interest earned. Moreover, certain exemptions were given with regard to repatriation of funds relating to investment in immovable property (which was already subject to a capital gains tax); repatriation of principal relating to FDI; profit, dividend, interest, and rental income from investments of immovable property and FDI; and transactions in the financial futures exchanges. The exit levy regulations also empower the ministry of finance to exempt any transaction or class of transactions from any or all of the provisions of the exit levy system, and in this regard, the newly established over-the-counter share market, the MESDAQ, is exempted from the exit levy. The levy, therefore, would impact mainly on portfolio equity investments, other than MESDAQ.

16. Generally, the replacement of the 12-month rule with the graduated levy on capital repatriation was viewed as a positive development, since it made it possible to withdraw funds before the end of the 12-month holding period, albeit at a price that punished earlier repatriations. Despite the high levy of 30 percent on early repatriations of investments, some fond managers promptly liquidated part or all of their holdings on the KLSE in the days following the announcement.11 As a result of the introduction of the exit levy, IFC announced that it was planning to reinclude Malaysian equities in its capital index (in November 1999), and discussions with Morgan Stanley are in progress on the reinclusion of Malaysian equities in their emerging market index.12 In upgrading Malaysia’s international credit ratings in April 1999, the rating agencies also cited the changes in these controls.

17. Many concerns were expressed about the levy on the repatriation of profits for funds that came after February 15, 1999. The levy is collected by authorized dealers in foreign currencies and permitted merchant banks and deposited into the consolidated federal account as provided by the Exchange Control Act of 1953. The levy is applied at the time of the conversion of ringgit into foreign exchange and is thus not considered a capital gains tax that can be offset through double taxation agreements. The fact that a 10-percent levy would apply to profits even if held for periods in excess of 12 months suggests that the levy is intended to discourage portfolio investors more generally, rather than the stated objective of changing the maturity composition of the flows. The technical procedures for implementing the levy are highly complex, and led to confusion among investors and required subsequent modifications and clarifications by the authorities.

E. Exiting From the Capital Controls

18. While the September measures appear to have been effective in buying the authorities some time, it was acknowledged at the time they were imposed that the controls would be temporary. This section examines the strategy for exiting from the controls and the necessary supporting policies. This strategy will need to balance the benefits and risks of retaining or eliminating specific capital control measures in designing the sequencing of the liberalization.

The exit levy

19. While it is too early to assess the impact of the levy on the repatriation of profits on the level and composition of investment flows into Malaysia, the benefits of eliminating the levy are likely to exceed any protection it may provide. The following are some observations:

  • The exit levy has added an additional degree of administrative complexity to investing in Malaysia. While the controls are focused on portfolio investment, the additional administrative complexities of the exchange control system may have detrimental effects on all types of foreign investment flows in spite of the explicit exclusion of FDI from the controls.

  • The degree of protection provided by the levy against volatile capital flows appears limited. Since the levy applies to profits excluding interest payments, the levy affects primarily capital gains on equity investments; other forms of portfolio capital flows would be less affected (including nonresident investments in short-term instruments, bank deposits, bonds, derivatives, and property investments) since a larger element of the profits on such investments reflect interest payments. In addition, under the implementation procedures agreed with the banks, investors can repatriate funds invested in equity as capital, rather than profit, up to the amount of the initial investment before becoming subject to the levy. In order to restrict capital flows, capital inflow controls would then have to be wide ranging, which may be potentially highly distortionary.

  • The levy will do little to reduce volatility in the stock market, since it does nothing to reduce the buying and selling of shares against the ringgit. Other actions taken by the KLSE on trading shares on margin and on strengthening supervision of brokers are likely to be much more important in reducing stock market volatility;

  • The levy may raise the cost of capital in Malaysia. The levy will reduce the expected rates of return on equity to foreign investors and thus raise the rates of return that are necessary on investments in Malaysia relative to other markets. The levy may be viewed as an additional risk factor in doing business in Malaysia, since investors may be concerned that the levy would be adjusted depending on economic circumstances. Because of the “last in, first out” rule, prudent fund managers and investors that plan to add Malaysia to their portfolio may choose to apply the higher rate of levy to all investments regardless of the expected maturity of the investment.13

20. By contrast, an elimination of the levy on profits is likely to send an important signal that Malaysia is exiting from its capital controls, and will underpin the improvements in domestic and international investor confidence; indeed, since the replacement of the 12-month holding period with the exit levy, the total net inflow of capital amounted to RM 1.44 billion as of mid-May, compared with the net inflow of RM 18.5 million as of March 10 this year, indicating some return of confidence in the stock market (also see Charts I.1 and I.2).

21. Investor confidence would also respond positively to a resolution of the frozen CLOB shares in an equitable and transparent manner. Among the various schemes that were suggested to resolve this problem,14 the proposed replacement of the frozen CLOB shares with a closed-end fund could provide liquidity to the shareholders, while minimizing the impact of unfreezing the shares on the KLSE. The value of shares in the closed-end funds should preferably reflect their present market value.

22. At this juncture, modifying the graduated levy on the repatriation of capital invested before February 15, 1999 may not be warranted. To the extent that investors wish to repatriate their capital, the graduated nature of the levy will provide some scope for phasing this repatriation, although the high rates of the levy will limit the extent to which investors take advantage of this. At the same time, the additional time bought may provide scope for Malaysia to strengthen further international investor confidence and thus help to reduce the size of any eventual outflow.

Supporting reforms for a more liberalized capital account

23. Cross-border capital flows typically involve different dimensions of risk (credit, liquidity, interest rate, and foreign exchange risk) from those found in purely domestic transactions. In opening its capital account, Malaysia will need a robust system that can handle these risks. Such a system would involve three main elements: (i) strengthening the corporate and banking systems; (ii) promoting prudent risk management through best practice prudential regulations, in order to increase the ability of the financial institutions and markets to cope with the risks involved in capital flows; and (iii) following consistency in monetary and exchange rate polices to reduce the incentives for more volatile capital flows. The main elements of the system are outlined in Box I.2.

24. Malaysia already has made considerable progress in strengthening the regulatory and supervisory framework for the financial and corporate sectors, and toward adopting and implementing best practice prudential regulations. Box I.3 provides a summary of the measures already taken and some suggestions for further refinements; more detailed descriptions are provided in Table I.2.

Table I.2.

Malaysia: Stock Position With Respect to the Main Elements of a Prudential Risk-Based Framework and Recommendations

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25. Malaysia will need to adopt a consistent monetary and exchange rate policy framework, under which either the exchange rate is managed and interest rates are allowed to adjust, or monetary policy is targeted toward managing the domestic interest rate, in which case the exchange rate would have to be permitted to adjust (see Chapter IV for details). Countries with liberal capital accounts should either have very strong commitments to a pegged exchange rate or a flexible exchange rate. Experience has shown that implicit or explicit exchange rate guarantees in the form of currency pegs that were unsustainable have resulted in large and volatile capital flows as investors and borrowers have tended to underestimate the currency risks and have taken large unhedged currency positions. As few countries have been able to make the policy commitment required for a credible exchange rate peg, many emerging market countries that have opened their capital accounts have adopted more flexible exchange rates.

26. Concerning the sequencing of the supporting reforms and capital account liberalization, such liberalizations are not “all or nothing” affairs, and in an orderly liberalization certain components of the capital account can be liberalized before all the supporting reforms are in place and indeed can help support the reform and economic objectives of the authorities. In this regard, the elimination of the levy on the repatriation of profits would not pose significant risks in the present regulatory environment. Broader liberalization of portfolio capital flows (e.g., approval requirements for resident investments abroad and derivative transactions) should be phased consistent with the implementation of the above supporting reforms.

Main Elements of a Modernized Approach to Capital Account Regime

An internally consistent monetary and exchange rate policy framework

A crucial component of a more liberal capital regime is an internally consistent exchange rate and monetary policy mix, which would help minimize incentives for such short-term capital flows. A consistent mix would entail either a flexible interest rate policy if the exchange rate is pegged or tightly managed, or greater exchange rate flexibility if monetary independence is to be preserved.

As capital account transactions become more liberalized, the desirability of greater exchange rate flexibility tends to increase. Greater exchange rate uncertainty under a more flexible exchange rate regime would stimulate foreign exchange market development and better risk management; in addition, it may provide a “natural control” over volatile capital flows, as it would limit incentives for speculative, short-term capital inflows.

Existence of a healthy and sound financial system

If the banking system is weak and restructuring efforts are ongoing, broad liberalization of capital transactions that affect weak bank balance sheets must proceed cautiously; such balance sheet growth should be subject to adequate controls and administration and bank reform measures must be accelerated.

Financial sector development and the regulatory and supervisory framework

Liberalization of capital controls, particularly those on short-term capital transactions, has been problematic when such liberalization has not been accompanied by adequate financial sector reforms. Main elements of the financial system reform include:

  • Establishing appropriate limits to manage risks involved in cross-border transactions (e.g., net open foreign exchange position limits to manage foreign exchange risk; limits against maturity mismatches (involved in different types of currencies), maturity ladder, and liquid asset requirements incorporating foreign currency liabilities and off-balance sheet operations in order to manage interest rate and liquidity risk; and tighter exposure limits for foreign currency loans to manage credit risks involved in capital transactions).

  • Incorporating cross-border risks into loan classification and provisioning, capital adequacy, and disclosure requirements: this may involve, for example, applying risk weights to capital requirements that specifically reflect elements of cross-border risk and higher capital adequacy requirements for banks with large international business; requiring greater provisioning against NPLs to incorporate risks involved in off-balance sheets, offshore, and derivative activities, and foreign currency loans; and imposing additional information disclosure requirements on banks’ cross-border transactions, such as offshore or derivative activities.

  • Strengthening of accounting and auditing standards and consolidated supervision as part of a more general strengthening of the regulatory and supervisory framework; existence of such systems would facilitate adequate measuring of the overall financial condition of banks and proper enforcement of compliance with regulatory requirements for managing and limiting risk.

  • Accelerating development of financial instruments and markets, including (spot and forward) foreign exchange, interbank money, and securities markets. Deep and liquid money and foreign exchange markets and adequate instruments would facilitate efficient allocation of financial resources; risk management and hedging by market participants against interest rate, liquidity, credit, and foreign exchange risks, and implementation of monetary policy under greater capital mobility. Presence of deep and developed securities markets would reduce the burden on banking institutions in intermediation of capital flows.

Prudential Risk-Based Framework for Cross-Border Transactions

Cross-border capital flows typically involve different dimensions of risk (credit, liquidity, interest rate, and foreign exchange risks) from those found in purely domestic transactions.

In opening its capital account, Malaysia would need a robust system that can handle these risks, including the existence of a healthy and sound financial system and the promotion of prudent risk management through best practice prudential regulations, in order to increase the ability of the financial institutions and markets to cope with the risks involved in capital flows.

BNM’s initiatives that would facilitate such a system

  • Bank restructuring efforts started in early 1998 and have continued to date to strengthen the financial system under a four-pronged approach.

  • Use of internal techniques to assess and manage risks involved in cross-border transactions: BNM has started to move toward a system where banks manage their own risk through internal control mechanisms, and, since March 1998, have required financial institutions to conduct monthly stress tests under a variety of scenarios and report to BNM on a quarterly basis. Existence of an appropriate infrastructure for risk management and internal controls has been a requirement for banks to use derivative products since 1995.

  • Existence of limits against various sources of cross-border risks: Appropriate limits to manage credit risk, including those to limit banks’ exposure to foreign currency loans, are in place; a prudentially based liquidity framework based on maturity ladder approach was introduced in August 1998 to replace the liquid asset requirement by January 2000.

  • Incorporating cross-border risks in loan classification and provisioning, capital adequacy, and disclosure requirements: Since March 25, 1998, off-balance sheet items are incorporated in loan classification and provisioning requirements, and sensitivity to potential losses from adverse movements in interest rate and exchange rates are assessed. Market risks were also incorporated in capital adequacy requirements, to be fully implemented sometime in 2000. BNM will impose different minimum risk-weighted capital adequacy requirement on individual banking institutions according to their overall risk profile and internal controls. Disclosure requirements were tightened in early 1998, but somewhat relaxed in September 1998.

Recommendations and further refinements

  • BNM should proceed speedily with bank and corporate restructuring programs to restore balance sheet strength of the financial institutions and increase their resiliency to potentially large and volatile capital flows following liberalization.

  • The existing open foreign exchange position limit (though not binding at present) is large and should be reduced to no more than, for example, 25 percent of regulatory capital, from the existing 50 percent.

  • Regulation of liquidity should separate management of liquidity risk for each currency component on a regular basis within the new liquidity framework.

  • Loan classification, provisioning and disclosure requirements and supervision activities should pay due attention to banks’ offshore activities in Labuan, and ensure that off-balance sheet items cover derivative activities in view of a likely increase in such activities under greater capital mobility; banks should disclose more frequent data on such activities, and BNM should return to quarterly frequency for disclosure requirements as soon as feasible to enhance market confidence and discipline; and extension of capital adequacy requirements to incorporate market risks should be implemented as soon as possible.

  • Conditions conducive to financial market development should be created, including the removal of the restrictions that may interfere with the efficient functioning of the markets and that limit risk management capability of market participants.

Cross-border transactions in ringgit and the offshore ringgit market

27. Among the controls introduced on cross-border transactions in ringgit, it would generally seem desirable that as economic and financial stability is restored, some of the more onerous restrictions that Malaysia has imposed on cross-border transactions in ringgit be relaxed. These would include replacing the restrictions on the exports and import of ringgit currency notes with higher limits; raising the RM 10,000 limit above which residents need exchange control approval to remit funds for investment abroad; and removing the restriction on banks’ use of ringgit in trade transactions. Whether some liberalization in ringgit transactions would lead to the reemergence of an offshore market in ringgit, will largely depend on the institutional and market incentives. However, the following observations can be made:

  • Offshore markets can provide benefits to the economy. Access to more developed and diversified financial hedging products and instruments in the offshore market may have served to reduce the costs of conducting trade and investment in Malaysia and therefore helped to promote FDI inflows and trade transactions.

  • The existence of an offshore market can result in a somewhat more rapid transmission of changes in international interest rates to domestic interest rates or swap currency premiums. However, the risks that this will disrupt policy would depend on the consistency of the monetary and exchange rate policy mix.

  • Since banking business will tend to relocate to the least cost centers, to avoid disintermediation to offshore markets, monetary authorities have to avoid the use of instruments that impose large costs on their banking systems. Malaysia has reduced the level of noninterest bearing reserve requirements, and thus reduced the incentives for conducting business offshore.

  • There have been active nondeliverable forward markets in many currencies that were not fully convertible, such as in Korea, Hungary, and Poland, and such a market could emerge in the case of the ringgit if there are incentives to do so even if the present controls are retained, particularly if expectations about the future direction of the ringgit change. Most of the emerging market economies—many with lesser developed financial and regulatory systems than those of Malaysia—have not found that these markets impose insurmountable constraints on their economic policies, and many are accelerating their external liberalizations in view of the perceived benefits of such liberalizations.

F. Conclusions

28. The pattern of economic performance in Malaysia since the emergence of the crisis has, in many respects, been similar to that of other countries in the region. This makes it very difficult to disentangle the impact of Malaysia’s capital controls from broader international and regional developments.

29. The controls appear to have been effective in limiting outflows. Initially, the main reasons were that the capital controls were wide ranging, effectively implemented, and generally supported by the business community. Later, the undervaluation of the ringgit relative to other regional currencies, and the return of international investor confidence to the region reduced the pressures for capital outflows. The use of controls has also been accompanied with an acceleration in the implementation of structural reforms, including bank and corporate restructuring programs, and further strengthening of the prudential framework for the banking system. The replacement of the 12-month rule with an exit levy was broadly well received, and has helped the return of investor confidence in Malaysia.

Concerning the next steps:

  • The elimination of the exit levy on profits would send an important signal that the capital controls have been temporary. The elimination of this exit levy would not appear to pose significant risks in the present regulatory environment.

  • It will be critically important that Malaysia adopt a consistent monetary and exchange rate policy framework, and complete the implementation of its risk-based prudential regulatory framework as it implements broader capital account liberalizations of all remaining controls in the system.


This paper was prepared by R. Barry Johnston (ext. 38980) and Inci Otker (ext. 7810).


See Table I.1 for summary of changes in Malaysia’s capital account regulations in 1994–99.


In the second and third quarters of 1997, net outflows of portfolio capital amounted to RM 24.6 billion.


As of August 1998, the offshore ringgit market was offering deposit interest rates exceeding 20-40 percent compared with 11 percent in Malaysian banks; by that time, the ringgit had depreciated to around RM 4.20 per U.S. dollar from around RM 3.75 in April 1998.


These channels included transfers of nonresident deposits in Malaysia to offshore banks, and portfolio outflows by residents. The net outflow of portfolio capital was RM 5.5 billion in the last quarter of 1997.


While the spreads on all emerging markets debts increased in August 1998 following the Russian default, those on Malaysian obligations rose further in September following the implementation of capital controls (Chart I.2).


Recently (April 15, 1999), BNM published A Guide to the Exchange Control Rules, with illustrative examples on how the rules apply.


In its most recent upgrading of Malaysia’s credit outlook, Standard and Poor’s indicated that if the interest rates had not been cut sharply in the last six months, the NPLs could have risen to above 30 percent of total loans, computed on a three-month basis, including Danaharta sales.


The most recent Federation of Malaysian Manufacturer’s Quarterly Survey on Manufacturing shows that September measures had little impact on most respondents’ investment plans, export orders, import costs, and overall business operations in the last quarter of 1998. About one-third said that the controls had a positive impact on their import costs and overall business operations.


The monthly volume of total transactions in the foreign currency spot and swap markets declined from an average of RM 73.8 billion in January–August 1998 to RM 28.4 billion in the last four months of 1998 (RM 115.8 billion in the same period in 1997).


Such liquidations may have been driven by regulatory conditions in home countries, which established the parameters of eligible markets where unit trusts could invest their funds. The total amount of outflows since then, however, has been limited to RM 154 million as of April 21, 1999 ($40 million at the fixed exchange rate, compared with the estimated amount of $10–15 billion that had been blocked by the 12-month rule).


Morgan Stanley has announced, however, that Malaysia has been taken out permanently from its developed country stock index, where its previous inclusion was seen as an aberration. This may have a permanent affect on volume of foreign equity investment in Malaysia, even if Malaysia is reinstated in the emerging markets index.


Under this rule, in calculating the rate of levy, the exchange control authorities assume that the last investments to be made are the first to be repatriated.


These proposals include: (i) selling CLOB shares at a steep discount (for those investors who would want immediate cash); (ii) exchanging CLOB shares for units in a closed-end mutual fund (for those investors who would want to have the option for liquidity); and (iii) setting up an irrevocable request and authority scheme, under which CLOB shareholders would be able to register their shares into individual central depository accounts with the shares then suspended from trade in Malaysia for a three- to five-year period (for those investors who would want to take a long-term view of the market).