Malaysia
2010 Article IV Consultation-Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Malaysia

Strong fundamentals and countercyclical policies have helped Malaysia during the global financial crisis. Executive Directors welcomed the authorities' challenge to make progress toward economic growth and structural transformation. Directors welcomed the consolidation effort in the 2010 budget, and stressed that a sound and sustained fiscal adjustment is essential. Directors appreciated the monetary policy stance to sustain noninflation growth. They welcomed the new Central Bank Act, which reinforces the underpinnings of the financial system. Directors also commended the authorities’ decision to participate in the Financial Sector Assessment Program.

Abstract

Strong fundamentals and countercyclical policies have helped Malaysia during the global financial crisis. Executive Directors welcomed the authorities' challenge to make progress toward economic growth and structural transformation. Directors welcomed the consolidation effort in the 2010 budget, and stressed that a sound and sustained fiscal adjustment is essential. Directors appreciated the monetary policy stance to sustain noninflation growth. They welcomed the new Central Bank Act, which reinforces the underpinnings of the financial system. Directors also commended the authorities’ decision to participate in the Financial Sector Assessment Program.

I. Introduction

1. Malaysia has come out strongly from the world recession. Forceful counter-cyclical policies, sound balance sheets, and intra-regional trade have primed the recovery. With rebounding domestic and global demand, output losses have by now been largely reversed. Prospects for the near term are good, provided that the external environment does not deteriorate.

2. The cyclical momentum has re-energized the policy debate. The global downturn has led to a rethinking of the development strategy. The emerging view is that Malaysia is at a crossroads. The economic model that produced significant advances over three decades has lost the ability to drive the country forward. Old polices are under review and the political leadership is making the case for a national transformation to free Malaysia from the middle-income trap where it is now stuck.

3. A multi-pillar strategy has taken shape. It spans a vision to increase social cohesion while preserving Malaysia’s cultural diversity (“1Malaysia”), a plan to improve governance and the delivery of public goods (the Government Transformation Program), a framework for far-reaching structural reforms (the Economic Transformation Program built on the New Economic Model, NEM) and a blueprint for economic change over the next five years (the Tenth Malaysia Plan, 10MP). Development policies have been dressed in rhetoric before but the sense of urgency seems higher now than in the past.

4. Against this background, the 2010 Article IV discussions tackled both short-term and longer-term questions. Exchanges of views focused on the policy requirements to support the expansion and the priorities for structural reforms. There was broad agreement on the key issues.

5. Malaysia has requested to participate in the Financial Sector Assessment Program (FSAP). This is an important outcome of the 2010 Article IV discussions.

II. Economic Developments and Outlook

Background

6. A broad-based recovery is underway and the economy has regained lost ground.

  • After three quarters of contraction, GDP began growing in the last quarter of 2009 pulled by exports, private consumption, and public spending. With strong momentum in late 2009 and the first quarter of 2010, seasonally-adjusted GDP is now close to pre-crisis levels, reversing a 6½ percent peak-to-trough loss.

  • As the output gap widened and global energy and food prices collapsed, headline inflation fell to below 1 percent (y/y) last year, after a stretch of monthly deflation. The momentum has shifted with the upswing. On a monthly basis, inflation has been positive since last December, with the latest reading in May at 1.6 percent.

  • Labor markets are also tightening after showing resilience throughout the downturn. The unemployment rate for 2009 peaked at about 3¾ percent, better than anticipated at the time of the 2009 Article IV consultations. Job vacancies in manufacturing are now larger than before the crisis, but slack in other sectors remains.

uA01fig01

Real GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: CEIC Data Co., Ltd.; Haver; and IMF staff estimates.
uA01fig02

Monthly Inflation: Headline and Core

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: CEIC Data Co., Ltd.; and IMF staff calculations.
uA01fig03

Manufacturing Job Vacancies and Wages

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: CEIC Data Co., Ltd.

7. Domestic financial conditions have improved with the turn of the cycle.

  • Supported by policy, credit growth remained positive even as output shrunk. It is now gaining steam on its own benefitting from strong demand for consumer loans and mortgages. The recovery in business lending has also been robust. Base lending rates, which bottomed out at 5½ percent, have been trending up since March 2010.

  • Equity prices have risen about 50 percent since the lows of March 2009, and about 5 percent so far this year. The rally has not been as strong as in other regional markets, reflecting Malaysia’s weaker capital inflows and shallower correction in the sell-off.

  • Corporate bond issuance, which remained relatively strong in 2008, has also been recovering. Sovereign CDS spreads have risen in recent months, reflecting global market jitters. The widening has been in line with that elsewhere in the region. A landmark issuance of a U.S. dollar government Islamic bond took place in June. Notwithstanding unsettled investor sentiment, the global sukuk was oversubscribed and priced at 180 basis points over U.S. treasuries, a more favorable pricing than for other regional issuers.

uA01fig04

Kuala Lumpur Stock Index and Volatility

(January 1, 2008 = 100)

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: Bloomberg L.P.; and IMF staff calculations.
uA01fig05

Selected Asia: Change in Sovereign CDS Spreads

(In percent of beginning of the period spread level)

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: Thomson Reuters Datastream; and IMF staff calculations.

8. Malaysia’s external position continues to be strong.

  • The current account surplus fell modestly to 16½ percent of GDP in 2009. Imports of intermediate goods shadowed the decline of manufacturing exports and demand for commodities (mainly hydrocarbons, rubber, timber, and palm oil) held up better than expected. Despite a boost to the service account from tourism, the income balance remained in deficit, reflecting profit repatriation by multinationals and continued excess of payments over receipts in the investment account.

  • Malaysia experienced net outflows throughout the year (Box 1). Portfolio inflows picked up in the second half of 2009, but outward FDI and “other investments” swamped the uptick. Both flows have been negative in net terms for years reflecting underlying trends—the expansion abroad of Malaysian businesses, trade financing flows, and the recycling of current account surpluses.

  • The buildup of official reserves during the commodity up-cycle before the crisis helped accommodate large capital movements through 2009 in the global sell-off of emerging market assets. Reserves fell from nearly $126 billion in mid-2008 to just above $88 billion in March 2009, as Bank Negara Malaysia (BNM) intervened to support the ringgit. By the end of the year, the drawdown had been reversed. At end-June 2010, reserves were about $95 billion, roughly unchanged from a year earlier. A light forward book suggests limited intervention.

uA01fig06

Bank Negara Malaysia: Long Forward Positions

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Source: IMF, RTTS database.

Malaysia: Recent Trends in Capital Flows

Malaysia has experienced net capital outflows on the financial account since the late 1990s. These have been the reflection of current account surpluses after the Asia crisis as well as structural factors favoring investment abroad by residents. In particular, over the last few years net FDI outflows have grown, as a result of limited opportunities for domestic investment by foreigners (for example following the IT bubble crash), greater competition from China, Singapore, and Hong Kong SAR, as well as growing investment abroad by Malaysian companies seeking economies of scale, a regional exposure (e.g., in telecom), or supplies of natural resources (oil and gas field or land for plantations).

uA01bx01fig01

Malaysia: Selected Financial Account Items, Net

(In percent of GDP)

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

sources: IMF, BPTS Database; and IMF staff estimates.

Over the last four quarters, capital flows on the financial account have rebounded somewhat but continue to be negative (charts at bottom of the Box).

  • Net capital flows to the general government have bounced from crisis-lows into positive territory, reflecting increased appetite of foreign investors for government securities and related portfolio inflows.

  • Net flows related to sectors other than the general government were negative and more than offset the government-related inflows. The main drivers were sustained current account surpluses, a revival of trade credit from exporters to importers overseas, and an increased willingness of the private sector to place funds abroad. In particular, net outflows related to loans and other non-portfolio investments have picked up for both banks and nonbanks, while net portfolio flows to nongovernment sectors, which spiked in the second quarter of 2009 mostly due to debt inflows, have since trailed off and turned into outflows.

Malaysia: Capital Flows, Net

(Period average, in percent of GDP)

article image
Sources: Department of Statistics, Malaysia; and IMF staff estimates.
uA01bx01fig02

Malaysia: Capital Flows by Recipient, Net

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: IMF, BPTS Database; and IMF staff estimates.
uA01bx01fig03

Malaysia: Capital Flows, by Instrument, Net

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: IMF, BPTS Database; and IMF staff estimates.

Outlook and Risks

9. Malaysia’s near-term prospects are favorable.

  • Near-term outlook: GDP is projected to expand by around 7 percent in 2010, narrowing, but not closing, the output gap. As favorable base effects play out and policy support is reeled in, growth should moderate in 2011. Both external and private domestic demand will propel activity in the near term. Net exports should continue to benefit from the electronics cycle, commodity demand, and the regional upswing, while household consumption should be supported by higher rural incomes and improving labor markets. A pronounced bounce-back of private investment does not seem in the cards, given still unused capacity, but capital expenditure at public enterprises is expected to pick up. CPI inflation should continue to remain low at about 2 percent for the year while slack is being taken up, although it could spike if key administered prices are adjusted.

  • Risks: The risks to the outlook are balanced. On the downside, withdrawal of policy support in advanced economies or adverse developments in Europe may undermine global demand and commodity trade, sapping domestic activity. Volatility in international markets could also spill onto local ones, although direct contagion from Europe through financial channels seems unlikely.1 On the upside, confidence at home and abroad could improve further, intra-regional trade may get a boost from the ASEAN-China free trade agreement in force since January 2010, and revenues from commodity exports could keep trending up.

10. The outlook for the medium term depends on the scope and speed of the government’s own economic transformation program.

  • Baseline. Focusing on current policies, the baseline does not factor in the potential growth-dividend of a vigorous implementation of the economic transformation program. GDP growth thus converges to a rate short of that needed to double per capita income over the next decade, as the NEM envisages. At an approximately unchanged real exchange rate, the current account surplus remains sizeable—and probably larger relative to GDP than the ratio consistent with Malaysia’s demographic structure, fiscal position, productivity growth, and net foreign asset position in comparative terms. From a savings-investment perspective, the external imbalance reflects, among other things, impediments to investment and high precautionary savings, which current policies address only partially.

  • Reform scenario. With stepped-up reforms on a broad front, GDP growth could reach 7 percent by the end of projection period, meeting the goal under the 10th Malaysia Plan. The growth-dividend materializes in the outer years, contingent on the implementation of a critical mass of initiatives. The pace of activity is set by private domestic demand. Private investment is revived by the end of the horizon, compensating for a roll back of public projects. Successful enhancement in social welfare and new business opportunities at home will curb private saving and offset the drag of fiscal consolidation. The current account ratio is some 3 percentage points lower than in the baseline.

Malaysia: Summary of Medium-Term Macroeconomic Framework, 2007–15

article image
Source: IMF staff estimates.

Malaysia: Summary of Medium-Term Macroeconomic Framework, 2007–15

(Reform scenario)

article image
Source: IMF staff estimates.

11. The authorities broadly concurred with these assessments. The latest official projection is for 2010 growth between 4½ percent and 5½ percent but it predates the first-quarter GDP outturn. The range will likely be revised up in the next forecasting round. There was also agreement at the BNM that inflation probably will remain in check and will not be a policy concern for the period ahead. Regarding the medium term, the authorities shared the view that a meaningful uplift in trend growth requires structural reforms on a broad front. Like the staff, they saw encouraging signs of a renewed political commitment to push the agenda but cautioned that grass-root support was still being harnessed.

III. From the Recession to a High-Growth Path

A. Monetary Policy

Background

12. Policy normalization is underway.2 After aggressive loosening in 2009, the BNM started policy normalization in March 2010. It has since raised the policy rate to 2.75 percent in three quarter-point steps. The firming up of the recovery and the danger of excessive risk taking in an environment of very low interest rates set the stage for the monetary exit. Robust activity in the second quarter motivated the latest rate increase on July 8, notwithstanding mixed signals from abroad. A flattening of the yield curve suggests a likely pause in the tightening cycle for the rest of the year.

Staff’s Views

13. The measured pace of monetary tightening so far has been on the mark. It is in line with Taylor-rule calculations and sends a signal against investors’ complacency in the pricing of risks after a year and a half of loose monetary conditions. With real rates still below their long-term average, the policy stance is nonetheless still supportive. In the staff’s view, this is warranted for two reasons. First, the global recovery remains fragile; and second, fiscal risks suggest giving precedence to budgetary consolidation in sequencing the exits from policy support. In fact, using fiscal policy rather than interest rates to contain demand pressures in the period ahead may discourage speculative inflows.

14. Moving forward, further withdrawal of monetary support should continue to be contingent on the evolving risks to growth and the need for policy insurance. The latest hike (after the Article IV discussions) may have put the BNM slightly “ahead of the curve” and the case for staying the course is now even stronger than a month ago. Factors that need to inform monetary decisions in the period ahead include the vigor of the global recovery, second-round effects of possible subsidy reforms, and the spillovers on asset markets from volatile capital movements across borders.

Authorities’ Views and Plans

15. Bank Negara noted that a gradual monetary exit was consistent with the improved outlook, absence of price pressures, and concerns about side-effects of abnormally low interest rates. In particular, financial imbalances arising from underpricing of risk, excessive leverage, and financial disintermediation in the search for higher yields could not be ruled out in an environment of very low interest rates. The increase in the policy rate has shored up the return on bank deposits and reduced the risk of vulnerabilities on the asset side of households’ balance sheets. From this angle, the latest rate hike has been part of a continued normalization process.

16. There was agreement that the return to a neutral stance needs to be informed by external as well as internal considerations. Policy will need to adapt flexibly over the next few quarters. A pragmatic approach had already been reflected in the decision not to reverse the November 2008 cut in reserve requirements which had lost relevance as a policy tool and undercut intermediation. Flexibility had also been shown earlier with the adoption of schemes to maintain the flow of credit to consumers and SMEs. Similar facilities could be re-activated if the conjuncture deteriorated. Finally, the BNM thought that the depth and sophistication of Malaysia’s financial sector could spread the impact of sudden capital movements across a wider set of markets and thus curb the risks posed by volatile flows. However, judicious exchange rate policies are still required to lessen their impact on the real economy.3

B. Fiscal Policy

Background

17. The 2010 budget marks a return to consolidation. The policy response to the global recession led to rising deficits in 2008 and 2009. While the stimulus was timely, diversified, and appropriate, it has exacerbated fiscal risks. The 2010 budget addresses this situation by targeting a reduction in the deficit for the central government to about 5½ percent of GDP (from 7 percent of GDP last year). The adjustment is skewed to the expenditure side, with economies expected from improved procurement as well as cuts in discretionary spending and transfers. Stimulus in the pipeline from the 2009 packages (which have not been fully deployed yet) offsets in part the policy withdrawal.

uA01fig07

Central Government Overall and Non-Oil Primary Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: CEIC Data Co., Ltd.; and IMF staff calculations.

18. Other fiscal initiatives are being considered. The roll out of the long-delayed goods and service tax (GST) has been announced but legislative details are still in the works. The GST is intended to broaden—and stabilize—the tax base by replacing two existing taxes in a revenue-neutral fashion. Tax incentives to foreign and domestic companies are also under review as the mandate of the Malaysia Investment Development Agency is being revamped. According to a 2006 World Bank study, tax holidays represent a very large drain on the budget, estimated at about half of total tax revenues. On the expenditure side, the authorities are considering overhauling Malaysia’s fragmented and ill-targeted social safety nets—a task which will gain prominence if a big push for reforms gets underway and programs to mitigate their transitional costs are developed. Finally, subsidy reform has taken center stage in the public discussions—and has become the poster-child of the costs and benefits of structural adjustment. Excluding those for education and health, subsidies account for some 20 percent of government spending or about 5 percent of GDP, with the bulk going to reducing the cost of fuel to consumers and industry.

Staff’s Views

19. Fiscal risks in Malaysia have grown over the years. Policy has been procyclical in good times, setting the stage for unprecedented deficits when budget support was necessary during the crisis. Increased dependence on oil revenue further undermines the public finances.4 Against this backdrop, the authorities are right in their commitment to strengthen the fiscal position.

20. Consolidation is needed to reconstitute room for maneuver and forestall market concerns. The 2010 budget marks a welcome step in this direction. The deficit target, which seemed ambitious when the budget was unveiled, now looks within reach thanks to stronger-than-anticipated growth and oil revenues. Budgetary gains will prove transitory, however, if the broader agenda of fiscal reforms remains unfinished.

21. Savings can be achieved by rationalizing subsidies and tax structures. Political realities suggest that subsidy reform needs to be gradual but sustained. The sooner it starts the better. The broad approach under consideration—centered on periodic reductions of key subsidies with compensatory cash transfers to the most vulnerable groups—seems broadly appropriate, provided that reform fatigue does not set in. Fuel subsidies are particularly ill-targeted and should be prime candidates for reform, unlocking efficiency gains across the economy. The roll out of the GST should also not be held back, although some delays on technical grounds may be unavoidable even after the relevant legislation is enacted. More focused outreach and clearer communication may be necessary to galvanize the public debate and mold a consensus. An overhaul of tax incentives could also mobilize savings and should be considered in the context of a future reform of corporate taxation.

22. Malaysia should also strengthen its budget framework along three dimensions. First, an indicative consolidation path along which the deficit is brought back to more manageable levels should inform fiscal plans. This approach could cast budget decisions in a starker multi-year perspective and provide discipline. Second, budget documents could include a statement of fiscal risks to assess vulnerabilities surrounding budget outcomes. Publication of the statement could improve transparency (as recommended in the NEM report) and market perceptions. Third, budget decisions could emphasize the evolution of the non-oil balance and be benchmarked against a framework that links spending to an equitable drawdown of oil wealth.5 This approach would lessen the impact of oil price volatility on fiscal planning.

Authorities’ Views and Plans

23. Officials at the Ministry of Finance shared the staff’s views on the desirable direction of fiscal policy. They noted that, over the last decade, government demand had to compensate for sluggish private investment, giving the appearance of policy pro-cyclicality. This would likely change going forward, under the reform plans of the NEM and the macroeconomic objectives of the 10MP. The transition to sustainable public finances has started. The policy shift has not been forced by markets since Malaysia’s government securities remain an attractive asset for domestic and foreign investors as shown by the successful launching of the global U.S. dollar sukuk.

uA01fig08

Foreign Holdings of Malaysian Debt

(In millions of Malaysian ringgit)

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: CEIC Data Co., Ltd.

24. There was also agreement about possible enhancements to Malaysia’s fiscal frameworks. For example, the authorities noted that the 10MP includes an indicative consolidation path for the deficit over the next five years, as recommended in earlier consultations. Fiscal risks are also routinely assessed in the context of the budget process. Nonetheless, the suggestion to flesh out a more formal statement for possible inclusion in the budget documentation is worth considering.

25. Reforming subsidies, social programs, and tax structures remains a top priority but the timing for action needs to be chosen carefully. These reforms require spending political capital and need to be sequenced with care. Welfare schemes are under review and the general thrust of past recommendations from the IMF will be reflected in the policy design. Technical assistance from the IMF on tax incentives to corporates is also being sought ahead of the next budget cycle. Subsidy reform holds out the promise of significant budgetary savings in the short term. However, it must be gradual (to give households and firms time to adjust) and it must be complemented by targeted relief measures (to avoid a backlash). Savings from greater efficiency in public service delivery under the Government Transformation Program will also contribute to consolidation. Finally, the authorities agreed that, while the roll out of the GST is on track, a better outreach to the general public and SMEs will increase the buy-in. In the same vein, an anti-profiteering bill has been tabled in parliament to allay concerns that the introduction of the GST may provide a pretext for price gouging.

C. Financial Sector Issues

Background

26. Malaysia’s financial sector has withstood the global recession well. Thanks to the BNM’s proactive supervision, measures to ensure uninterrupted access to financing, and prudent lending practices, loan books did not deteriorate as much as feared and started improving in the second half of 2009. Banks remain well capitalized and liquid, as are insurance companies. There are no obvious vulnerabilities in corporate balance sheets as well.6 SMEs have benefitted from government guarantee and credit-enhancing schemes as well as developmental programs run by SME Corp, a dedicated government agency. Household debt has been rising, though, partly as a result of official initiatives to promote home ownership. Nonetheless, there are no signs of strains in servicing debt. There are also no signs of systemic froth in property markets.

Key Financial Soundness Indicators for Commercial Banks

article image
Sources: Bank Negara Malaysia; and CEIC Data Co., Ltd.

27. Islamic finance has performed as well as conventional finance in the downturn. Although sukuk issuance was lower than in previous years, Malaysia strengthened its position as an Islamic finance hub by introducing last year the world’s first Shariah-compliant commodity trading platform using palm oil as the underlying commodity.

28. An international working group is coordinating the modalities of exit from blanket deposit guarantees. The decisions of the group, which brings together officials from the BNM, the Monetary Authority of Singapore, and the Hong Kong Monetary Authority, will also pave the way for the adoption of enhanced deposit insurance schemes in 2011. In the case of Malaysia, deposit insurance will provide coverage for virtually all depositors including businesses and around 40 percent of deposits. The insurance premium will continue to be risk-based.7

29. A new Central Bank of Malaysia Act was passed in 2009. The act provides more clarity on the mandate of the BNM and vests with it the necessary powers. Overall, it strengthens the ability of the BNM to undertake surveillance and to avert risks to financial stability. The act also lays out a more robust and transparent governance framework.8

Staff’s Views

30. The authorities’ sustained efforts to develop capital markets, broaden intermediation, and strengthen risk management have paid off in the global downturn. Built-in cushions softened the blows from market turbulence and collapsing activity. The Central Bank of Malaysia Act further reinforces the underpinnings of the financial system, among other things by expanding the BNM’s ability to resolve financial institutions.

31. Notwithstanding strong balance sheets, stricter regulations on capital, liquidity and leverage under discussion in international fora could be burdensome for local institutions. For example, the proposed treatment of subsidiaries may put pressure on the capital adequacy of bank holding companies and the proposed treatment of wholesale deposits could erode liquidity buffers at banks. The impact of other reforms in the works (e.g., levies, surcharges on systemically important institutions, “through-the-cycle” provisioning) remains more speculative, given lack of specificity so far on the design of the reform package. As the prudential framework adapts, the BNM’s commitment to a hands-on proactive approach will continue to serve Malaysia well. From this angle, there may be a case for a formal broadening of the regulatory perimeter to encompass financial holding companies—a step that would institutionalize current practices.

32. Plans to unwind by year-end the blanket deposit guarantee and move to an insurance system with higher deposit coverage are welcome. They ensure international consistency among economies with strong financial linkages and, in all likelihood, make the removal of support a non-event. More broadly, as the regulatory landscape evolves, efforts to upgrade contingency planning and coordinate with supervisors in other jurisdictions will continue to be helpful.

Authorities’ Views and Plans

33. The BNM broadly shared the staff’s views on financial sector issues. Officials noted, however, that the buildup of household debt largely reflected fundamentals and should be seen in the context of Malaysia’s quickening pace of household formation. In their view, there are no imminent dangers from the liability side of households’ balance sheets.9

uA01fig09

Household Debt Versus GDP Per Capita

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: Bank Negara Malaysia; CEIC Data Co., Ltd. ; IMF, World Economic Outlook; and IMF staff estimates.

34. There was also agreement that, despite ample Tier I capital at local institutions, the adoption of some Basel III norms could create pressures in the financial system. Tighter requirements on liquidity and funding may place onerous demands on some banks, if the sizeable (and stable) deposits of the Employee Provident Fund are treated as wholesale funding for which liquid assets need to be set aside.10 More broadly, the BNM noted that the international consultative process needs to become more inclusive and some discretion in implementation should be left to the national authorities who can best assess local conditions without compromising the outcome of the regulations.

35. In the BNM’s view, the global crisis has cast a sharp light on Islamic finance. In the Islamic finance business model, financing can only be extended to real sector activities that have economic value. This principle establishes a close link between financial transactions and productive flows. Exposure to excessive leverage and risk taking is thus curtailed, giving the system added resilience when shocks originate in the financial sector. Accordingly, the appeal of Islamic banking as “ethical banking” has grown—and Malaysia, a hub of Islamic financial services, is well placed to capitalize on the trend. As recognized by the Task Force on Islamic Finance and Global Stability (chaired by Governor Zeti), additional development of Shariah-compliant liquidity management and hedging instruments would further underpin the soundness of the system.

36. The Malaysian authorities have requested to participate in the Financial Sector Assessment Program. Malaysia has undertaken more than a decade of capacity building and financial reforms under an ambitious Financial Sector Master Plan now in its final phase of implementation. As a result, the efficiency and stability of the financial system have been fundamentally strengthened. There was agreement that participation in the FSAP would reinforce the strong fundamentals already in place and facilitate the identification of areas for further enhancements. The BNM suggests that the FSAP take place next year at the earliest.

D. Priorities for Structural Reforms and Exchange Rate Assessment

Background

37. Malaysia is stuck in a middle-income trap. A low-income country at birth in 1957, Malaysia climbed the ladder to attain upper middle-income status in the early 1990.11 Sectoral shifts (from the primary sector to advanced manufacturing) fuelled growth. Strong foreign investment, a proactive government, and high saving rates facilitated the transition. However, the momentum stalled in the run up to the Asia crisis and has never been recovered. Unlike some countries with comparable initial trajectories, Malaysia has so far been unable to breach the high-income threshold.12

38. Growth underperformance in a small open economy suggests supply-side problems. These are what the NEM tries to address by rolling back affirmative action, improving human capital, and spurring productivity growth—steps necessary to revive the business climate and double Malaysia’s per capita income by 2020 (Box 2).

The New Economic Model and the Tenth Malaysia Plan1/

The New Economic Model (NEM), prepared by the National Economic Advisory Council and unveiled by the government in March, is a program to transform Malaysia into an innovative, knowledge-intensive, and high-income economy by 2020. The overall framework of the NEM identifies strategic reform areas that include enhancing private sector participation in the economy, improving workforce skills, supporting innovation, developing new sources of growth, and strengthening public sector management.

The Tenth Malaysia Plan (2011–2015), released in June, provides the policy framework for implementing many of the NEM’s strategic suggestions. Its main macroeconomic objectives are to sustain annual GDP growth at 6 percent on average and to bring gradually down the budget deficit to less than 3 percent of GDP by 2015. Microeconomic objectives include a competition law, further liberalization of services, divestment of some public enterprises, market prices for subsidized commodities, an innovation-friendly environment, and reduced dependence of on foreign labor.

1/ Details can be found at www.neac.gov.my/node/235 and www.epu.gov.my/html/themes/epu/html/RMKE10/rmke10_english.html

39. The Tenth Malaysia Plan (10MP) makes operational the economic strategy through 2015. The 10MP provides a broad framework for budgetary allocations. It is to be revised after about two years, in light of progress toward its macroeconomic and social goal-posts. These include raising the shares in GDP of private consumption and investment, promoting high value-added services over low-value added manufacturing, and improving the well-being of the most disadvantaged. The National Economic Advisory Council will refine implementation details later this year.

Staff’s Views

40. The NEM report suggests a sea-change in the attitude toward comprehensive structural reforms. It sets up a stark choice for Malaysians and their political leadership, a choice between muddling through in a business-as-usual mode and going for a historical transformation of the economy. The report takes on many of the recommendations raised in previous Article IV discussions—reform of government-linked companies, further product and labor market liberalization (including a review of employment protection), improved education and vocational training, and better targeted social safety nets and tax incentives. The agenda is daunting and will require difficult trade-offs, given the tight fiscal envelope.

41. Implementation needs to be pragmatic but steady. Acting at a measured pace on a broad front is probably the best way to exploit policy complementarities and harness the benefits of reform. Future elaborations of the roadmap could usefully develop “What if?” scenario analysis to take into account that unforeseen contingencies may force detours from the envisaged transformation plan.

42. A stronger ringgit over the medium term will help achieve the objectives of the NEM and the 10MP. An appreciated ringgit in real effective terms will over time facilitate the implementation of the authorities’ economic transformation program and contribute to higher real incomes for households, greater capital deepening, faster productivity gains, and demand shifts in favor of services. Subject to the usual wide margin of uncertainty, model-based estimates suggest that the real effective exchange rate (REER) of the ringgit is currently weaker than the level implied by its estimated medium-term determinants (Appendix I). This assessment needs, however, to be seen in a context of structural rigidities that have generated a persistent excess of national savings over investment and significant share of commodities in exports. Moreover, there is no feasible reorientation of the policy mix in the near term (toward a more expansionary fiscal stance and a more restrictive monetary policy) that could speed up the external adjustment without compromising domestic stability—or potentially triggering speculative inflows. In fact, under established exchange rate policies (captured by the appreciation of the ringgit in effective terms since the beginning of the year) the undervaluation could be eliminated over the medium term, thus limiting concerns about Malaysia’s external stability (Figure 2).

Figure 1.
Figure 1.

Malaysia: Real Sector Developments and Outlook

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: IMF, World Economic Outlook; and APD databases.
Figure 2.
Figure 2.

Malaysia: Exchange Rate and Monetary Developments

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: IMF, World Economic Outlook; and APD databases.

Authorities’ Views and Plans

43. There was agreement that the reform program needs to be calibrated to political realities. The authorities’ stressed that consensus is still being forged and there are limits to what may realistically be expected in the short run. Nonetheless, the leadership’s commitment to reform is strong and implementation questions are more a matter of “when” or “how” than “if.” In their view, it is encouraging that measurable progress had already been made on a variety of fronts, for example in liberalizing services and rolling back social policies that had proved ineffective in addressing income inequality and lack of opportunity.

44. The authorities share the staff’s view that the ringgit will strengthen with the economy over the medium term but disagree strongly with the assessment of the current level of the exchange rate. They stressed again that Malaysia’s exchange rate policies: (i) do not target a particular exchange rate; (ii) have been informed by the need to prevent overshooting in both directions, as evidenced by the massive draw-down of reserves last year; and (iii) are consistent with a gradual appreciation of the currency, as shown by the recent gains of the ringgit REER. The BNM further argues that it is naïve to think that monetary policy can control the real exchange rate and that pre-committing to an appreciation path could at present invite disorderly capital inflows. Moreover, in the BNM’s view, the machinery for the assessment is opaque as to the policy implications or the appropriate pace for balance of payments adjustment.13

IV. Staff Appraisal

45. Malaysia has emerged from the global recession with strong forward momentum. Countercyclical policies and sound fundamentals have paved the way for the broad-based recovery underway. Smooth exits from extraordinary interventions are in train and policy is returning to more normal settings. The authorities should be commended for skillful macroeconomic management.

46. The cyclical upswing has galvanized the policy debate. The realization that strategies used to achieve the current state of development are now inadequate to move further up the income ladder has motivated an ambitious agenda for social change. The reform program at the heart of Malaysia’s New Economic Model could bring about a far-reaching transformation of the economy and achieve the authorities’ goal of doubling per capita income by the next decade.

47. The authorities have already taken first steps to bolster the public finances. The 2010 budget marks a commendable return to consolidation. Sustained fiscal adjustment will be necessary to reconstitute policy space and put the debt ratio on a firmly declining path. The indicative consolidation path in the Tenth Malaysia Plan provides a useful benchmark for future budget decisions.

48. Budgetary gains will prove transitory, however, if a broader agenda of fiscal reforms remains unfinished. In particular, poorly targeted and distortionary fuel subsidies should be phased out sooner rather than later, and the introduction of a goods and service tax should not be unduly delayed. Malaysia should also enhance its budget framework by articulating as part of the budget documents a statement of fiscal risks and by benchmarking budget decisions against a framework that links spending to an equitable drawdown of oil wealth.

49. Monetary policy has been appropriately recalibrated to sustain non-inflationary growth. Bank Negara Malaysia’s measured pace of monetary tightening so far has been on the mark. With real rates below their long-term average, the policy stance is still supportive. This is warranted both because the global recovery remains fragile and because fiscal risks suggest giving precedence to budgetary consolidation in sequencing the exits from policy support. With subdued inflation in the forecast and the pace of activity likely to moderate going forward, a wait-and-see approach is appropriate for the period ahead.

50. Malaysia’s financial sector has shown resilience in the global downturn. The authorities’ sustained efforts to develop capital markets, broaden intermediation, and strengthen risk management have paid dividend during challenging times. The Central Bank of Malaysia Act of 2009 further reinforces the underpinnings of the financial system. As the regulatory framework adapts, Bank Negara’s commitment to a hands-on proactive approach will continue to serve Malaysia well. Plans to unwind by year-end the blanket deposit guarantee and move to an insurance system with higher deposit coverage are welcome.

51. The authorities have laid out a comprehensive vision for a national transformation over the longer term. The structural reform agenda is daunting and will require difficult trade-offs, given the tight fiscal envelope. Yet, hard choices seem unavoidable to lift productivity growth and living standards. Accordingly, implementation will need to be calibrated to political realities. Acting at a measured pace on a broad front is probably the best way to exploit policy complementarities and harness the benefits of reform. However, careful communication will be needed to sustain the adjustment and pre-empt reform fatigue.

52. A strengthening over time of the ringgit in real effective terms will facilitate the implementation of the authorities’ economic transformation program. Model-based estimates suggest that the real effective ringgit is below its equilibrium level. The currency is likely to continue to strengthen as structural reforms advance. This appreciation should facilitate the achievement of the authorities’ goal of rebalancing the sources of growth toward domestic demand.

53. Malaysia’s request to participate in the Financial Sector Assessment Program (FSAP) is welcome. A decade of capacity building and financial reforms has greatly strengthened the efficiency and stability of the financial system. Participation in the FSAP should reinforce the strong foundations already in place and facilitate the identification of areas for further enhancements.

54. It is recommended that the next Article IV consultation take place on the standard 12-month cycle.

Figure 3.
Figure 3.

Malaysia: External Developments

Citation: IMF Staff Country Reports 2010, 265; 10.5089/9781455206889.002.A001

Sources: IMF, World Economic Outlook; and APD databases.
Table 1.

Malaysia: Selected Economic and Financial Indicators, 2005–11

Nominal GDP (2009): US$206 billion

Main export (percent of total): electrical & electronic products (39%), commodities (23%)

GDP per capita (2009): US$7,141

Population (2009): 28.3 million

Unemployment rate (2009): 3.7 percent

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Sources: Data provided by the authorities and Fund staff estimates.

Capital expenditure in the budget includes foreign fixed assets and other items, such as purchase of shares and land, which are excluded from public investment in the national accounts.

Excludes financial public enterprises and nongovernment-guaranteed domestic debt of the nonfinancial public enterprises.

By remaining maturity.

Table 2.

Malaysia: Indicators of External Vulnerability, 2005–10

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Sources: Data provided by the authorities and Fund staff estimates.

Excludes unguaranteed domestic debt of the non-financial public enterprises.

Discount rate on three-month treasury bills.

Includes net external position of banking system, portfolio investment, and errors and omissions.

Table 3.

Malaysia: Balance of Payments, 2005–11

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Sources: Data provided by the authorities and Fund staff estimates.

By remaining maturity.

Table 4.

Malaysia: Illustrative Medium-Term Macroeconomic Framework, 2008–2015 1/

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Sources: Data provided by the authorities and Fund staff estimates.

Period ending December 31.

Capital expenditure in the budget includes foreign fixed assets and other items, such as purchase of shares and land, which are excluded from public investment in the national accounts.

Staff projections; excludes non-government guaranteed domestic debt of the non-financial public enterprises (NFPEs). The projections assume no off-budget operations. Surplus NFPEs are assumed to roll over external debt.

By remaining maturity.

Table 5.

Malaysia: Federal Government Fiscal Operations, 2005–10

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Sources: Data provided by the authorities and Fund staff estimates.

Includes taxes on property.

Includes other tax revenue.

Overall balance plus interest payments.

Excludes oil and gas related revenues (corporate taxes, dividends and royalty payments).

Table 6.

Malaysia: Monetary Survey, 2007–09

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Sources: IMF, International Financial Statistics; and Bank Negara Malaysia.