Malaysia: Staff Report for the 2018 Article IV Consultation

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Malaysia

Abstract

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Malaysia

Economic Outlook: Continued Favorable Performance with Balanced Risks

1. The Malaysian economy has shown resilience and continues to perform strongly. In recent years, the economy has grown at a sustained pace despite external shocks. Fiscal consolidation has proceeded, with the government pushing through important initiatives (subsidy reform and the Goods and Services Tax (GST)). Progress was made toward achieving high income status and improving inclusion. Median household income has risen further and the already-low national poverty rate has declined. General elections are due by August 2018.

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Malaysia: Contributions to Real GDP Growth

(In percentage points; year-on-year)

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

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

2. Growth surprised on the upside in 2017, driven by domestic demand. Real GDP growth exceeded potential, and is estimated at 5.8 percent for the year (4.2 percent in 2016), implying a small positive output gap. Employment and wage gains, spurred by a broad-based recovery, boosted private consumption, with private investment and public consumption also contributing to growth. On the external side, Malaysia benefitted from a stronger-than-expected global demand uplift for electronics and improved commodity terms of trade. However, growth in both final and intermediate goods imports lowered the contribution of net exports to growth.

3. There are no signs of inflationary pressures at present. Average headline inflation was 3.8 percent in 2017 (2.1 percent in 2016), with the increase mainly reflecting the impact of higher oil prices. Average core inflation (headline excluding food and energy) fell to 1.6 percent (2.6 percent in 2016), driven by lower services and durable goods inflation. Real wage growth over 2017Q1-Q3 in the manufacturing and services sectors, which account for the bulk of employment, did not exceed labor productivity gains. Private sector credit growth has moderated, implying a further decline in the credit gap to an estimated 3.2 percent of GDP (9.4 percent of GDP in 2016) and housing price growth has declined.

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Malaysia: Contributions to CPI Inflation

(Year-on-year, in percentage points; averages for respective periods)

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Sources: Haver Analytics; and IMF staff calculations.1/ Weights, in percent, for the CPI components are shown in the chart legend.

4. Fiscal consolidation continued in 2017, albeit at a slower pace. The 2017 federal budget deficit edged lower to 3 percent of GDP (3.1 percent of GDP in 2016), in line with budget plans. A decline in revenue of 0.5 percent of GDP, mostly due to low GST buoyancy, was more than compensated by cuts in subsidies and transfers totaling 0.7 percent of GDP, while protecting social and development spending. The consolidated public sector deficit is estimated to have fallen by 0.2 percent of GDP in 2017, after a sharp drop of 2.5 percentage points of GDP in 2016.

5. The external position remains stronger than the level consistent with fundamentals and desirable policies, unchanged from the July 2017 External Sector Report (Appendix I).1 The current account (CA) surplus is estimated at 2.8 percent of GDP in 2017, compared to 2.4 percent of GDP in 2016. The current account gap, estimated based on the IMF’s External Balance Assessment (EBA), is 2.4 percent of GDP, implying a real exchange rate undervaluation of about 5 percent. Malaysia recorded a small net financial outflow in the first three quarters of 2017, reflecting lower net FDI inflows relative to a year ago, and large nonresident portfolio debt outflows in 2017Q1. Nonresident portfolio debt inflows have resumed since 2017Q2. Relative to end-2016 levels, the bilateral and real effective exchange rates have appreciated, Treasury yields have stabilized, and the stock market has registered gains. However, the real effective exchange rate remains about 14 percent depreciated from its 2013 level, reflecting in part the impact of negative terms-of-trade shocks.

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Malaysia: Current Account Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

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

6. Policies have been largely in line with past Fund advice (Appendix II). As recommended by staff, the authorities are anchoring fiscal policy to their medium-term consolidation objective, while considering economic conditions in deciding the year-to-year pace of consolidation. Similarly, the current monetary policy stance, including the bias towards reduced accommodation, is consistent with staff advice to carefully calibrate monetary policy in response to economic conditions. In line with staff’s advice of maintaining a flexible exchange rate as a shock absorber, the authorities have notified the Fund of the change in their de jure exchange rate regime effective September 2016, following which the de facto regime is currently classified as floating. In relation to staff’s advice of reviewing the December 2016 FX market measures, the authorities see them as appropriate, helpful, and not entailing undue cost. Structural reforms are largely in line with staff’s advice.

7. Looking ahead, inflation should moderate in 2018 and growth should decelerate from its 2017 peak, converging to its potential rate of close to 5 percent in the medium term. While the ongoing cyclical upturn should begin to normalize, momentum in activity is expected to remain strong in the first half of 2018, supported by domestic demand and continued strength in global trade. Projected at 5.3 percent, growth in 2018 should remain above potential. Core inflation should edge up to 1.9 percent in response to a positive output gap. However, this would be more than offset by lower contribution from global oil prices. Thus, headline inflation is expected to moderate to 3.2 percent in 2018. The current account surplus is expected to decline to 2.4 percent of GDP in 2018, as export growth normalizes. Over the medium term, both growth and inflation should converge to their long-term trend. The capital/labor ratio should continue to rise over the medium term, as firms respond to labor’s rising share in income. This capital accumulation, together with improvement in total factor productivity and gains in female labor force participation, should help offset the impact from decelerating working-age population growth on real GDP growth.

8. Risks to the outlook are balanced (Appendix III). In the near term, strong global demand for electronics lasting longer than expected is the main external upside risk. Downside external risks include policy uncertainty and tighter global financial conditions in advanced economies, which could spill over to domestic financial markets and cause financial stress for indebted Malaysian households and corporations. Domestically, the confidence effects related to the cyclical upturn could be stronger than anticipated, but an abrupt adjustment in real estate prices could have macro- financial spillovers through private sector balance sheet effects. Over the medium term, a global retreat from cross-border integration, structurally weak growth in advanced economies, and a significant China slowdown are the main downside risks, while a speedy approval and implementation of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) represents an upside risk.

Authorities’ Views

9. The authorities broadly agreed with staff’s assessment of the economic outlook and risks. They expected growth to remain strong at 5–5.5 percent in 2018, mainly driven by domestic demand. Sustained demand from trading partners would help maintain the resilience of the external sector, despite a projected narrowing of the current account surplus. They expect inflation to moderate to 2.5–3.5 percent in 2018, with core inflation largely stable, helped in part by productivity gains. Over the medium term, they saw growth at 5–6 percent with risks stemming mainly from external sources, both regional and global. On staff’s external sector assessment, the authorities continued to see limitations in the IMF’s analytical framework given the relatively weak explanatory power of the current account regression model in the Malaysian context.

Macroeconomic and Financial Policies: Striking the Right Balance

10. Striking the right balance in policies is key, and there is room for improving forward guidance on economic and financial policies. Macroeconomic policies should support growth while pursuing revenue-based fiscal consolidation. Medium-term fiscal targets should be better communicated. A comprehensive policy framework to develop onshore FX markets should also be appropriately communicated. Structural reforms should boost medium-term growth, while also helping external rebalancing.

A. Fiscal Policy

11. Staff expects the authorities’ federal budget deficit target of 2.8 percent of GDP for 2018 to be met. Revenue is budgeted to fall by 0.2 percent of GDP, largely due to a conservative estimate of GST collection, considering the early stage of implementation. Expenditure is budgeted to fall by 0.4 percent of GDP, driven by both lower development expenditure and a lower wage bill. The consolidated public sector deficit is projected to fall by 1.5 percent of GDP in 2018, reflecting an improved operating surplus of Petronas and lower development spending as some large projects come onstream.

12. Fiscal consolidation should proceed gradually over the medium term. The IMF staff’s baseline projection envisages a fiscal consolidation of 1.3 percent of GDP evenly spread across 2018–22. Under continued expenditure reduction in line with recent years, but unchanged policies otherwise, this baseline path for the federal government budget balance would be feasible. Such a path would deliver debt reduction, as the federal government debt would remain below 55 percent of GDP in the near term and fall below 45 percent of GDP by 2022 (Appendix IV). Fiscal consolidation is also appropriate given Malaysia’s limited fiscal space, due to large external financing needs (about 39 percent of GDP, see Appendix IV, Fig. 5) and high contingent liabilities. Moreover, the importance of fiscal consolidation is borne out by staff analysis showing that, if fiscal policy continues to react to shocks as in the past, the public debt could exceed the authorities’ self-imposed debt ceiling in a shock scenario (Appendix V).

13. However, the composition of fiscal adjustment could be improved by shifting the emphasis towards revenue measures. During 2016–17, fiscal consolidation has been largely driven by expenditure reduction. Going forward, this consolidation should be more revenue based, starting by broadening the tax base, including by eliminating GST exemptions, and subsequently raising the GST rate (text table). Tax expenditure in the form of investment incentives should also be reduced. These tax measures would be consistent with the authorities’ commitment to have a fair and efficient tax system. There is scope for further cuts in subsidies (including for liquefied petroleum gas, and fuel for fisheries and public transportation) and better targeting of social spending, for example in health and education. Also, cost recovery in health and higher education can be increased, and duplications in public programs, for example in transportation and tourism, should be minimized. Improving the quality of fiscal adjustment would also facilitate the adoption of measures that are important for external rebalancing, such as further improvements in social protection, increases in healthcare spending, and higher public investment in physical and human capital.

Malaysia: Illustrative Medium-Term Fiscal Consolidation Measures 1/

article image
Source: IMF staff estimates.

This table provides examples of alternative combinations of revenue and spending measures that would yield the same overall balance as in Fund staff’s baseline scenario.

A positive sign indicates an improvement in the overall balance.

The changes in the baseline between 2018 and 2022 are taken as a reference.

Reduction in spending on the wage bill and supplies.

Assumes a 1.5 percentage point increase in the rate from 6.0 percent to 7.5 percent.

Streamlining investment incentives.

14. Fiscal transparency and fiscal risks management could be further enhanced. Following the formulation of key projections under the Medium-Term Fiscal Framework, started in 2015, the yearly communication of a more detailed set of accounts, underpinning the authorities’ medium-term objectives, and of annual fiscal risks statements, should be fully integrated in the budget preparation process. An explicit medium-term framework would help in identifying risks and developing risk mitigation strategies, and would contribute to anchoring market expectations regarding the course of fiscal policy. A medium-term framework would also facilitate the work of the recently established Fiscal and Financial Committee on Risks and Liabilities, which aims at monitoring and mitigating fiscal risks. This is especially important given the high level of contingent liabilities. Loan guarantees by the federal government, which stand at 16 percent of GDP, are issued mostly to support infrastructure investment, frequently under public-private partnerships.2 While the authorities have taken some helpful mitigating actions,3 contingent liabilities exceed loan guarantees, however, as other fiscal risks could materialize (e.g. unfunded pensions for public employees).

15. Progress in other areas of the fiscal structural agenda could be accelerated. The authorities are encouraged to complete the implementation of accrual fiscal accounting, which is at an advanced stage. Undertaking targeted spending reviews would help eliminate duplication and raise efficiency in social programs, which would help fiscal consolidation. While Malaysia’s public investment management institutions are already quite strong, there is scope to further improve project appraisal processes and strengthen the gatekeeping role of central agencies in project selection.

Authorities’ Views

16. The authorities noted that fiscal policy must be countercyclical, business friendly and inclusive. They reiterated their commitment to fiscal sustainability and fiscal consolidation, indicating that the balanced budget objective would be delayed by 2–3 years beyond 2020 to support growth. Regarding the composition of fiscal adjustment, they prioritize improving revenue collections first, then broadening the tax base, including by reviewing tax expenditures. They also stressed their plans of maintaining expenditure restraint by increasing expenditure efficiency. They agreed on the need to strengthen fiscal risks monitoring, but stressed that, although contingent liabilities are sizable, the steps taken to mitigate associated risks are appropriate. Government loan guarantees have a low probability of being called in their view, as they are granted to entities with healthy balance sheets.

B. Monetary, Exchange Rate, and Financial Market Policies

17. Monetary policy remains supportive with a bias towards reduced accommodation. Domestic economic and financial considerations continue to guide monetary policy decisions, within a policy framework that has been delivering broad price and output stability despite economic shocks. Bank Negara Malaysia (BNM) has maintained an accommodative stance with its policy rate kept unchanged at 3 percent since July 2016. However, in its November 2017 policy meeting, the BNM signaled a bias toward reduced accommodation, justified by above-potential growth but stable core inflation and no signs of financial sector stress. Should leading indicators suggest the emergence of inflationary pressures, the policy rate should be increased.

18. Monetary policy and exchange rate flexibility should be the first line of defense against shocks. Domestic private sector balance sheet strength will help mitigate the impact of exchange rate fluctuations under the current floating regime. At about US$102 billion as of end-2017, BNM’s gross official reserves are adequate as per the IMF’s Adequacy of Reserves metric (still adequate, but closer to the lower bound, if adjusted for BNM’s forward book), and could be deployed at times of disorderly market conditions. In the face of a capital inflow surge, a combination of further reserve accumulation and some exchange rate appreciation would be appropriate.

19. Malaysia’s external debt remains manageable, although external financing vulnerabilities are higher than in the median peer country. Since end-2016, Malaysia’s external debt-to-GDP ratio has stabilized after rising by about 13½ percentage points in the previous seven years. About one-half of the increase in external debt was driven by a rise in nonresident investment in Malaysia’s local-currency debt market. External borrowing by nonfinancial corporations has also increased in recent years. Standard stress tests under the IMF’s External Debt Sustainability Analysis indicate that the external debt-to-GDP ratio would remain close to the baseline level under a variety of shocks over the medium term, except under an exchange rate depreciation shock (Appendix VI). However, about one-third of external debt is denominated in ringgit, which provides some cushion against exchange rate risks. Nonetheless, relative to the median peer country, Malaysia’s external financing vulnerabilities are higher, due to, for example, high amortization-to-GDP ratio, lower share of FDI liabilities in gross external liabilities, and slightly above-average potential claims on FX reserves from non-FDI liabilities.

Authorities’ Views

20. The authorities agreed with staff’s assessment of the current monetary policy stance. They noted that, since growth has become more entrenched, future monetary policy decisions may entail reduction of the degree of monetary policy accommodation, while also ensuring sustained growth. The exchange rate will continue to play an important role in responding to external shocks. Reserves are adequate and external debt is manageable. The authorities highlighted several factors which provide resilience against external shocks and exchange rate movements: the international assets position is diversified and mitigates financing vulnerabilities, as BNM’s reserves account for only about a quarter of total foreign assets, with the remaining three quarters held by resident banks and corporates, which can be drawn upon to meet external debt obligations without creating a claim on official reserves; the domestic financial sector is strong; about two-fifths of external debt is ringgit-denominated; foreign currency debt is subject to prudent management practices; and medium/long-term debt exceeds 50 percent of total external debt.

21. Financial markets development remained at the forefront of the authorities’ agenda with the Financial Markets Committee (FMC) taking measures to improve the functioning of foreign exchange (FX) markets. The methodology for calculating the reference USD/MYR exchange rate was revised in July 2016 and the credibility of the rate fixing mechanism was enhanced by using transacted rates over longer intra-day trading hours. Trading hours on the onshore market were extended. A revision of the Code of Conduct for market participants was initiated in the fall of 2016, with the final policy document issued in April 2017.

22. As other emerging market economies, Malaysia experienced a bout of capital outflows after the November 2016 US presidential election. Malaysia has experienced higher capital flow volatility than its median peer since the Global Financial Crisis, amid a global capital flow surge in the wake of quantitative monetary easing in advanced countries. A significant share of portfolio inflows to Malaysia target the conventional Malaysian Government Securities (MGS) market, which is the most liquid of local government debt markets and which functions well (Appendix VII). By October 2016, the share of nonresident holdings in conventional MGS was at an all-time high (52 percent of the outstanding stock; 17 percent of GDP). However, a significant portion of the inflows into MGS reversed after the US presidential election.4

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Malaysia: Net Capital Flows

(In percent of GDP; positive = inflow)

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Sources: Haver Analytics; and IMF staff calculations.
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Selected Asia: Nonresident Holdings of Local-Currency Government Securities

(In percent of outstanding amounts; end of period)

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Sources: Asian Bonds Online; CEIC Data Co. Ltd.; Haver Analytics; and IMF staff calculations.1/ 2017 data for Korea and Thailand are as of November.

23. In December 2016, the FMC announced additional FX market measures that have entailed both costs and benefits.

  • Some of the measures helped enhance onshore FX risk management by liberalizing hedging (Appendix VIII). Two measures, classified as capital flow management measures under the IMF’s Institutional View on Capital Flows (IV), aimed at (i) increasing FX liquidity onshore by requiring the conversion into ringgits of export proceeds; and (ii) extending prudential limits on foreign currency investments by residents with domestic ringgit borrowing to exporters, who were previously exempted. The BNM also strengthened in late 2016 the enforcement of regulations, in place since 1998, on banks’ non-involvement in offshore ringgit transactions. This measure is considered an enhanced enforcement of an existing capital flow management measure under the IV.

  • Following the introduction of these measures, hedging opportunities and the supply of foreign exchange onshore both increased; turnover in the onshore spot, forward, and swap FX markets improved, bid-ask spreads narrowed and ringgit volatility declined. Some of these developments could be also linked to the rebound of capital inflows to emerging markets in early 2017. Meanwhile, most banks stopped quoting non-deliverable ringgit forwards (NDF) offshore and liquidity in the NDF market fell sharply. In the bond market, foreign positioning has become less concentrated in very short maturities. However, some of the measures have imposed compliance costs on market participants.

  • While causality is difficult to establish and foreign investor sentiment could have been also weakened by other factors, some of the measures may have temporarily protracted the portfolio capital outflow episode. During 2017Q1, nonresidents’ share in MGS holdings kept falling, reaching 38.5 percent by March 2017, while portfolio flows returned to other major emerging markets. Asset managers accounted for most of the reduction in nonresident holdings in 2017Q1. Malaysia’s weight in the JP Morgan GBI EM global diversified index, one of the main benchmarks for local-currency emerging market fixed-income investors, was reduced from 9 percent at end 2016 to 7½ percent at end March 2017 (and further to 5.6 percent as of December 2017), whereas the weight of neighboring Thailand and Indonesia changed only marginally. This likely reflects, in part, reduced interest by international investors in exposure to Malaysia government bonds. Domestic institutional investors and banks helped cushion the impact on yields.

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Malaysia: Monthly Onshore FX Market Turnover

(In billions of US dollars)

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Source: Bank Negara Malaysia.
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Malaysia: FX Forward Volumes

(Monthly, in billions of US dollars)

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Sources: Bank Negara Malaysia; Bloomberg L.P.; and IMF staff calculations.
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Selected Emerging Markets: Net Portfolio Flows during 2016:Q4 and 2017:Q1

(In percent of GDP)

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Sources: Haver Analytics; IMF, Balance of Payments Statistics and staff calculations.

24. Nonresident inflows into the MGS market resumed in the second quarter of 2017, driven by both global and domestic factors, including new FMC policy measures. Malaysia’s rapid economic growth and the recovery in global sentiment toward emerging market securities likely helped. In May 2017, partly in response to feedback from market participants, new measures were implemented that increased flexibility and ease of FX hedging facilities onshore. These measures likely also reassured international investors. By December 2017, nonresidents’ share in the MGS market had risen to about 45 percent of the outstanding stock. Meanwhile, the equity market has received net capital inflows, although much smaller than the debt markets, in most months of 2017. The FMC continues to monitor financial market developments and, in consultation with market participants, propose adjustments, such as the most recent measures in November 2017 to deepen the onshore financial market (Appendix VIII).

25. Building on the recent steps, a comprehensive approach towards onshore market development would have potential benefits. The FMC is a welcome and appropriate forum because it allows the BNM to consult with market participants and the private sector on steps to develop onshore markets. In accordance with its mandate, the FMC should help articulate a high-level strategy based on broad market consultation and communicate it to the public to enhance predictability and build confidence. It would be important for the strategy to ensure that continued reliance on exchange rate flexibility and macroeconomic policy adjustments remain the first line of defense against capital flow shocks. The strategy to develop financial markets needs to address existing gaps in market development and phase out the recent capital flow management measures while preserving financial stability. Market participants pointed to the following gaps: transaction costs associated with extensive documentation requirements; and lack of liquidity in the forward market beyond very short-term (3–6 months) instruments. Meanwhile, to contain financial stability risks associated with exporters’ possible unhedged ringgit borrowing, the authorities could consider alternative measures that directly address the risk such as higher risk-weighting for loans to unhedged borrowers by banks.

Authorities’ Views

26. The authorities viewed their current approach towards development of onshore FX markets as appropriate and effective. They argued that the measures introduced by the FMC have been successful in achieving their objective to ensure an orderly and efficient functioning of the onshore FX markets by addressing foreign currency imbalances arising from speculative activities. The authorities did not see the recent measures as imposing excessive costs. They highlighted that continued healthy and improving onshore transactions volume throughout 2017 indicates that the FMC measures represented a balanced approach in terms of fostering the above objectives and addressing the impact from external spillovers. The authorities do not believe the late 2016 measures should have been seen as capital flow management measures because they were not targeted to limit capital flows, or that they had a sustained negative impact on market sentiment and attributed the decline in the MGS weight in JP Morgan ‘s GBI EM Global Diversified Index mainly to a broadening of the index’s country coverage. They disagreed with staff’s recommendation to phase out these measures and stressed the importance of preserving policy flexibility and indicated that they will remain vigilant in implementing necessary policies to ensure an efficient functioning of FX markets.

C. Financial Sector

27. The financial sector is robust, and overall risks appear contained. Bank profitability and liquidity are sound, and nonperforming loans (NPLs) are low. Corporate access to credit remains healthy and the sector is moderately leveraged. Overall corporate sector NPLs are at a manageable 2.7 percent. While the sector’s FX borrowing has been on the rise (currently at 26 percent of total debt), a large share of this increase consists of intercompany loans and trade credits, which are subject to lower rollover risk and more favorable terms. Household debt declined slightly but remains high at 84.6 percent of GDP in 2017Q3; internal bank credit underwriting standards have been effective in curbing household NPLs, which declined slightly to reach 1.4 percent of gross loans to households.

28. Despite low impairment ratios, households’ mortgage exposures require close monitoring. These exposures represent nearly half of households’ total indebtedness, one of the largest in the region. Direct risks to the mortgage portfolio are mitigated by: (i) a very large share (about 85 percent) of primary homeowners; (ii) a small share (3 percent of total) of investment property mortgages; (iii) with the latter subject to conservative LTV ratios (70 percent for individual owners of 3 properties or more and 60 percent for all legal entities); (iv) households’ sizable total asset and liquid asset buffers (two times and 1.5 times total liabilities, respectively); and (v) very low levels of foreign ownership (1–2 percent of transactions only, in the 1 million ringgit and up segment where foreigners are allowed to buy). However, at end 2017Q3, the overhang of unsold houses was at a 10-year high and growing, exposing the housing market to a potential price adjustment. In addition, most mortgages in Malaysia carry variable interest rates (that can adjust monthly), exposing their holders to interest rate risk.

29. Financial risks associated with residential and commercial property developers should also be monitored closely. In addition to the oversupply of residential properties, the supply of commercial retail space is expected to reach historic highs in the coming years. Despite relatively low leverage and healthy margins, the economic footprint of the property development sector (measured by links to other sectors and share of employment) could expose other sectors—including banks and nonbank creditors—to indirect risks. To reduce the flow of housing supply, the authorities recently announced that high-rise luxury property projects with units with sale value above 1 million ringgits in selected locations will require special permission. Banks’ direct exposure to developers remains low and is closely monitored by the BNM.

30. Measures could be considered to mitigate risks to financial stability. For the housing development market, possible measures could include risk weights and lending limits targeting the construction sector, and measures encouraging developers to lease the housing stock that remains unsold for an extended period. To encourage the rental market, the authorities could look into reforming the regulations pertaining to rents and tenant-landlord relationships or granting developers tax exemptions for rental income on leasing units, within the context of the approved government budget envelope. On mortgage lending, sector-wide LTVs (on the second and first properties) and debt service to income limits could supplement the ones that are presently self-imposed by the banks, complementing the existing limit for borrowers with income under 3,000 ringgits per month. Strong economic conditions offer a good window of opportunity for the above policy adjustments.

31. The authorities should also continue to implement AML/CFT and anti-corruption measures, consistent with past policies and commitments. Eradication of corruption and improving the perception of integrity in the public service were identified as goals in the 11th Malaysia Plan. Strengthening anti-corruption institutions, publication and robust verification of asset declarations (especially of high-level public officials) in line with international best practices would contribute to these goals. Effective use of AML tools could further support the authorities’ anti-corruption efforts.

Authorities’ Views

32. The authorities largely agreed with staff’s view on prevailing financial sector conditions. They stated that risks are being monitored closely via stress-testing, and other analyses which indicate that domestic financial stability remains preserved even under extreme scenarios, supported by well-capitalized financial institutions. They indicated that the housing market exhibited signs of recovery, while the oversupply in the commercial property segment is being closely monitored. The authorities assess that banks can manage the potential risks to the property market, given the small size and sound quality of direct exposures to the segments with acute oversupply. The authorities are developing a holistic solution to promote a sustainable property market, including a legislation for the residential rental market and the second National Housing Policy to drive a medium-term strategy for the housing market development. Given that risks to domestic financial stability are well-contained amid a favorable economic outlook, the authorities view that no further macroprudential or other policy measures are needed at this point. Regarding AML/CFT issues, the Malaysia Anti-Corruption Commission is constantly and periodically reviewing the efficacy of the Malaysian Anti-Corruption Commission Act 2009 to remain in line with Malaysia’s obligations to the UN Convention against Corruption, and taking steps to strengthen its measures following the recommendations coming out of these reviews.

Medium-Term Challenges: Raising Living Standards While Helping External Rebalancing

33. Labor market improvements have helped raise living standards (Appendix IX and Selected Issues Paper). Malaysia has recorded employment gains in every year for the past three decades and the overall unemployment rate has remained largely stable. More recently, despite a slowdown in working-age population growth, higher female labor force participation and foreign worker inflows since 2010 have expanded the labor force, contributing to economic growth. The share of lower-skilled or less-educated workers in total unemployed workers has continued to decline. Moreover, the wage gap between lower and higher skilled/educated workers has declined, helped in part by the minimum wage legislation that came into effect in 2013. Meanwhile, the process of capital deepening has continued, with the capital/labor ratio growing at a faster average pace over 2010–16 compared to 2001–08, although the manufacturing sector has seen a slowdown in such growth. However, unlike in most OECD member countries, the unemployment rate for tertiary-educated workers has been consistently higher than the national unemployment rate for over a decade, suggesting potential skill mismatches at the higher end of the labor market.

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Malaysia: Unemployment Rate by Educational Attainment

(In percent)

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Sources: Department of Statistics, Malaysia; and IMF staff calculations.

34. There is scope to further improve labor market outcomes and raise productivity and investment within the context of the authorities’ comprehensive structural reform agenda. Raising productivity growth within the framework outlined in the 11th Malaysia Plan (11MP, 2016–20) and in the recently-launched Malaysia Productivity Blueprint (MPB) would support longer-term economic potential and strengthen resilience to shocks (Box 1). However, achieving some of the labor market targets by 2020 will require additional efforts. Priority should be given to policies to: encourage female labor force participation, particularly for married or less educated women; improve the quality of education and skills; expand vocational and technical training to reduce skill mismatches; raise enrollment in higher education, which is low relative to the OECD average; and encourage R&D. Some of the 2018 Budget measures aim to support higher female labor participation. Any reform to foreign labor policies, to induce firms to switch to more capital intensive technology, should be market-based, clearly communicated, and gradually phased-in to allow sectors that rely on foreign workers to adjust. Improved labor market outcomes, along with updates of public infrastructure and the regulatory framework, would help further improve the business environment and support higher private investment, which would help with rebalancing. The recently passed Employment Insurance System Act, applicable to all industries and aiming to support eligible employees in the event of loss of employment, including with re-employment training opportunities, could help lower private precautionary saving.

uA01fig10

Selected ASEAN Countries and OECD: Female Labor Force, 2016

(In percent)

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Sources: Department of Statistics, Malaysia; OECD.Stat; World Economic Forum, the Global Gender Gap Report, 2016; CEIC Data Co. Ltd.; and IM F staff calculations.

Authorities’ Views

35. The authorities reiterated their commitment to achieving high-income status, while acknowledging that the timing of realization of this goal depends on prevailing macroeconomic conditions and economic performance. They remain committed to structural reforms and aspire to place Malaysia among the top twenty nations in economic development, social advancement, and innovation by 2050 (as laid out in a new National Transformation Plan 2050). To achieve these goals and guided by the 11MP, the authorities agreed on the need to address skill mismatches, further improve the female labor force participation rate, and improve education quality, with an emphasis on technical and vocational training. The authorities stressed that, while foreign workers have contributed to economic growth, there is also a need to reassess the costs of the high presence of low-skilled foreign workers and the overreliance of certain economic sectors on these workers. The authorities emphasized the need to invest in and attract higher-skilled workers. Public investment projects will continue to improve soft and hard infrastructure. Malaysia remains committed to trade openness.

Staff Appraisal

36. The Malaysian economy is performing strongly. Real GDP growth is likely to grow above potential in 2018 before reverting to the potential rate in the medium term. Despite a small positive output gap, there are no signs of inflationary pressures at present. Risks to the growth outlook are balanced. Developments in 2017 suggest that Malaysia’s external position remains stronger than warranted by fundamentals and desired policies. Going forward, macroeconomic policies should strike the right balance between stability and growth, and forward guidance on fiscal and financial policies would need to be enhanced.

37. Fiscal policy should follow a gradual consolidation path, and the composition of fiscal adjustment could be improved. The planned pace of consolidation for 2018 is appropriate, and will help build buffers and maintain financial market confidence. A gradual consolidation path as envisaged under staff’s baseline would be consistent with the authorities’ fiscal anchor and would help build additional fiscal space. However, fiscal consolidation should prioritize revenue measures: The tax base should be broadened, and the GST rate could be raised (for example, in line with staff’s illustrative consolidation measures). A predominantly revenue-based fiscal adjustment would also facilitate the adoption of measures that are important for external rebalancing, such as higher social and health spending, and higher public investment. Finally, there is scope for improvements in fiscal transparency and fiscal risk management, and for making further progress on other areas of the fiscal structural agenda.

38. The current bias towards reduced monetary policy accommodation is appropriate. Malaysia’s monetary policy framework has performed well, delivering both price and output stability in a context of domestic transformation and external shocks. Given above-potential growth combined with stable core inflation, the bias toward reduced accommodation signaled by the BNM at the November 2017 policy meeting is appropriate. Should leading indicators suggest the emergence of inflationary pressures, the policy rate should be increased. Monetary policy and exchange rate flexibility should be the first line of defense against temporary shocks, given limited fiscal space.

39. A more holistic approach towards onshore market development would have potential benefits. The authorities should formulate and communicate to the public a high-level strategy to enhance predictability, build confidence, and help markets understand how the measures taken by the BNM since late 2016 support the overarching objective of developing onshore markets. The strategy needs to address existing gaps in market development and phase out recent capital flow management measures. The IMF stands ready to help with the preparation of both the strategy and a roadmap to implement it.

40. Financial sector risks appear contained, but exposures in household mortgages and the property development sector need to be kept under review. Bank profitability and liquidity are sound, and NPLs low. Corporate access to credit remains healthy and the sector is moderately leveraged. Household mortgages represent a large share in household total indebtedness, and there is a large supply of both residential and commercial properties. To contain risks from a possible real estate price correction, the authorities should consider measures that would further strengthen the prudential framework and encourage the development of a rental market.

41. The authorities’ emphasis on raising productivity and investment is appropriate, and should prioritize further improving labor market outcomes. Malaysia should step up efforts to achieve the productivity targets and related labor market reforms outlined in the 11MP and in the MPB. In this context, priority should be given to measures to encourage female labor force participation, improve the quality of education, reduce skill mismatches, encourage R&D, and update public infrastructure and the regulatory framework (including continued implementation of AML/CFT and anti-corruption measures) to make the business environment more conducive to private investment.

42. The staff recommends that the Article IV consultation with Malaysia be held on the standard 12-month cycle.

The Malaysia Productivity Blueprint

Malaysia aspires to become a high-income nation. To pursue this aspiration, the 11th Malaysia Plan (11MP, 2016–20) focuses on inclusive and sustainable development, with productivity and innovation as the main pillars. Launched in May 2017, the Malaysia Productivity Blueprint (MPB) describes the strategy to reach productivity targets under the 11MP.

The 11MP and the MPB recognize that long-term growth should rely primarily on higher labor productivity. Since the 1980s, Malaysia’s growth was largely driven by investments in industries and infrastructure. More recently, contributions from productivity declined, a pattern also observed globally. Against this backdrop, the 11MP targets a 3.7 percent annual growth in national labor productivity and an increase in labor’s income share, supported by higher female labor participation; higher skilled labor employment; improvements in education quality; and better alignment of labor skills to industry needs.

uA01fig11

Malaysia: Growth Accounting

(Contributions in percentage points; five-year simple averages)

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Source: IMF staff estimates.

The Blueprint identifies five thrust areas in which national, sectoral, and enterprise level initiatives would be implemented to improve labor productivity:

  • Building workforce of the future— through national strategic workforce planning, with reduced reliance on low-skill workers.

  • Driving digitalization and innovation—through technology improvements and digitalization of the economy, including the small and medium enterprises.

  • Making industry accountable for productivity—reducing reliance on subsidies and linking liberalization efforts and funding mechanisms (including grants and soft loans) to productivity outcomes.

  • Forging a robust ecosystem—addressing regulatory constraints; building a robust accountability system for effective implementation of regulatory reviews. Immediate priorities include removing non-tariff barriers and improving efficiency in the logistics sector.

  • Securing a strong implementation mechanism—create a culture that values productivity; strong coordination and an effective governance mechanism.

Nine subsectors have been identified for productivity improvement given their economic importance and readiness. These include retail and food & beverages; agro-food; and chemicals and chemical products.

Figure 1.
Figure 1.

Malaysia: Growth and Exports

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Figure 2.
Figure 2.

Malaysia: Inflation and Domestic Resource Constraints

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Figure 3.
Figure 3.

Malaysia: Monetary Developments

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Figure 4.
Figure 4.

Malaysia: Fiscal Policy Developments

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Figure 5.
Figure 5.

Malaysia: Public Sector Fiscal Stance and Prospects

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Figure 6.
Figure 6.

Malaysia: Capital Flows

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Figure 7.
Figure 7.

Malaysia: Financial Sector Developments

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Figure 8.
Figure 8.

Malaysia: Household Debt

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Figure 9.
Figure 9.

Malaysia: House Prices

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

Figure 10.
Figure 10.

Malaysia: Financial Soundness Indicators 1/

Citation: IMF Staff Country Reports 2018, 061; 10.5089/9781484345047.002.A001

1/ Data for Malaysia are as of 2017:Q3, while data for the other economies range between 2016:Q2 and 2017:Q3 depending on availability.
Table 1.

Malaysia: Selected Economic and Financial Indicators, 2013–19

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Sources: Data provided by the authorities; CEIC Data Co. Ltd.; World Bank; UNESCO; and IMF, Integrated Monetary Database and staff estimates.

Based on staff’s estimate of the federal government fiscal balance using GFSM 2001, which differs from the authorities’ cash-based measure of the fiscal deficit.

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.

General government includes the federal government, state and local governments, and the statutory bodies.

IMF staff estimates. U.S. dollar values are estimated using official data published in national currency.

Based on data provided by the authorities, but follows compilation methodology used in IMF’s Integrated Monetary Database.

Based on a broader measure of liquidity. Credit gap is estimated on quarterly data from 2000, using one-sided Hodrick-Prescott filter with a large parameter.

Includes receipts under the primary income account.

Table 2.

Malaysia: Indicators of External Vulnerability, 2013–17

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Sources: Haver Analytics; CEIC Data Co. Ltd.; data provided by the authorities; and IMF, Integrated Monetary Database and staff estimates.

Gross debt. General government includes the federal government, state and local governments, and the statutory bodies.

Latest available data.

Based on data provided by the authorities, but follows compilation methodology used in IMF’s Integrated Monetary Database.

Kuala Lumpur interbank offer rate.

Based on balance of payments.

IMF staff estimates. U.S. dollar values are estimated using official data published in national currency.

Includes offshore borrowing, nonresident holdings of ringgit-denominated securities, nonresident deposits, and other short-term debt.

Includes receipts under the primary income account.

Table 3.

Malaysia: Balance of Payments, 2013–22 1/

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

Information presented in this table is based on staff estimates using official data published in national currency.

Based on IMF staff estimates of short-term external debt by remaining maturity.

Table 4.

Malaysia: Illustrative Medium-Term Macroeconomic Framework, 2013–22 1/

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

Period ending December 31.

IMF staff estimates. U.S. dollar values are estimated using the official data published in national currency.

For 2013 and 2014, based on data published by Department of Statistics, Malaysia. IMF staff estimates are used 2015 onward.

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

General government includes the federal government, state and local governments, and the statutory bodies.