Malaysia: 2019 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Malaysia

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Malaysia

Abstract

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Malaysia

Economic Developments and Outlook: Continued Favorable Performance with Downside Risks

1. Malaysia’s economy continued to show resilience as a smooth political transition took place in May 2018. The opposition coalition led by former PM Mahathir secured a surprise victory in Malaysia’s 14th General Election, resulting in the first ruling party change since independence in 1957. The peaceful political transition was a demonstration of the strength of Malaysia’s institutions, and robust economic activity also endured.

2. Growth is moderating (Figure 1). Growth is estimated at 4.7 percent in 2018 (5.9 percent in 2017), narrowing the output gap. While improved labor market conditions and the zero-rating of the GST boosted private consumption, public investment declined due to the winding down of large projects. Tightening global financial conditions, trade tensions, and a temporary spike in uncertainty regarding the new government’s policy agenda have affected confidence and private investment. That said, exports have risen, driven by electronics, and investment strengthened in the third quarter. On the supply side, disruptions in the oil and gas sector and adverse weather conditions contributed to lower growth.

Figure 1.
Figure 1.

Malaysia: Growth and Exports

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Chart 1.
Chart 1.

Malaysia: Contributions to Real GDP Growth

(In percentage points; year-on-year)

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

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

3. Inflation has come down (Figure 2). Headline inflation dropped from an average of 3.7 percent in 2017 to 1.0 percent in 2018 as domestic fuel price adjustment was suspended in March, the GST was zero-rated in June, and food price inflation declined. The pass-through to prices from the re-introduction of the Sales and Services Tax (SST) in September, with a smaller tax base than the GST, was moderate. In addition, the price-cutting pressures faced by government contractors partly offset the effect of the SST. While credit growth has rebounded recently, driven by lending to corporations, the credit-to-GDP ratio is declining, and the credit gap has almost closed (Figure 3).

Figure 2.
Figure 2.

Malaysia: Inflation and Domestic Resource Constraints

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Figure 3.
Figure 3.

Malaysia: Monetary Developments

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Chart 2.
Chart 2.

Malaysia: Contributions to CPI Inflation

(Year-on-year, in percentage points)

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Sources: Haver Analytics; and IMF staff calculations.

4. The 2018 fiscal deficit exceeded the budgeted level (Figures 4 and 5). The new government took immediate steps to increase transparency over the fiscal accounts, recognizing additional tax refund obligations (about 0.3 percent of GDP in 2018) and bringing on budget identified off-budget spending. The latter, together with additional spending needs (partly on social assistance), has raised net government spending by 0.5 percent of GDP, despite the review of existing infrastructure projects. Moreover, the re-introduction of subsidies for lower-grade petroleum added 0.2 percent of GDP in spending. On the revenue side, replacing the GST by the SST has narrowed the tax base and has created an estimated revenue shortfall of 1.2 percent of GDP in 2018. Higher oil revenues and transfers from Petronas and other government-linked companies (GLCs) raised 1.2 percent of GDP. Consequently, the 2018 deficit is estimated at 3.7 percent of GDP, 0.9 percent of GDP higher than budgeted.

Figure 4.
Figure 4.

Malaysia: Capital Flows

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Figure 5.
Figure 5.

Malaysia: Fiscal Policy Developments

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Chart 3.
Chart 3.

Malaysia: Official Foreign Reserves

(In billions of US dollars and percent of ARA metric)

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

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

5. Although vulnerabilities exist, capital outflows have been manageable. During the second quarter of 2018, Malaysia experienced large capital outflows in face of the general EM risk-off sentiment and post-election policy uncertainty. Nonetheless, the impact on the exchange rate, stock market prices, and government bond yields was contained due to increased domestic investor participation and central bank foreign exchange market intervention to counter disorderly market conditions (Figure 6). The share of resident holding in government paper (MGS, MGII, Treasury Bills, and Islamic Treasury Bills) increased from an average of 71 percent post-GFC to 75 percent in October, amid robust demand for government bonds from domestic institutional investors.

Figure 6.
Figure 6.

Malaysia: Public Sector Fiscal Stance and Prospects

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Chart 4.
Chart 4.

Capital Flows and Exchange Market Pressure Index 1/

(EMPI = percent change in U.S. dollar/local currency exchange rate plus percent change in reserves; since end 2017)

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Source: Institute of International Finance; Haver Analytics; and IMF staff calculations.1/ As of Oct 2018
Chart 5.
Chart 5.

Exchange Rate, Equity Price, and Bond Yield 1/

(Percent change; since end 2017)

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Sources: Haver Analytics; Bloomberg LP.; and IMF staff calculations.1/ As of Oct 2018

6. While moving towards equilibrium, the external position remains stronger than warranted by fundamentals and desired policies (Appendix I). In recent years, Malaysia’s growth drivers have shifted towards domestic demand and its current account surplus has narrowed. In 2018, the real effective exchange rate (REER) appreciated by 4.1 percent and the current account surplus declined to an estimated 2.2 percent of GDP. Although this surplus has helped reassure foreign investors during the recent EM sell-off, it represents a current account gap that cannot be explained by fundamentals nor by desired policies identified by the Fund’s external balance modeling. While identified domestic policy gaps have offsetting effects, low public healthcare spending contributes to the excess surplus, and so does saving by private nonfinancial corporations, as suggested by national accounts data (Appendix II). Going forward, creating fiscal space to expand social safety nets and increase health spending would help reduce precautionary household savings. This, together with structural reforms aimed at enhancing investment and productivity, would facilitate external rebalancing.

7. Policies have been largely in line with past Fund advice, with some exceptions (Appendix III). In line with IMF recommendations, the authorities are anchoring fiscal policy to their medium-term consolidation objective, improving efficiency of spending via zero-based budgeting, and are working on a Fiscal Responsibility Act. However, the GST was zero-rated against IMF staff advice, creating a revenue shortfall. The current monetary policy stance is consistent with advice to carefully calibrate monetary policy in response to economic conditions. The authorities continue to indicate a firm commitment to exchange rate flexibility as the main defense against external shocks. Structural reforms are largely in line with IMF advice.

8. Growth is expected to stabilize in 2019 and over the medium term, with inflation picking up and the current account surplus continuing to narrow. Domestic demand will remain the main driver of growth. Given Malaysia’s position in global value chains, the U.S. tariffs on imports from China could reduce Malaysia’s growth rate by 0.2 percentage points in 2019 via traditional trade channels and through financial and confidence effects, despite some trade diversion.1 While public investment will contribute negatively to growth in the near term due to the ongoing review of infrastructure projects, private consumption and investment are expected to be robust, underpinned by an improved business environment and greater confidence. The latter factors are expected to counterbalance the negative drag from the external environment and fiscal consolidation, leaving growth flat at 4.7 percent in 2019. Inflation should rise above 2 percent in 2019, as the effect of the GST removal dissipates, and oil subsidies become targeted. Over the medium term, growth is expected to converge to potential (4.8 percent) and inflation will remain subdued.

9. Risks to the growth outlook are to the downside (Appendix IV). With a highly open economy, Malaysia is vulnerable to rising protectionism and weaker-than-expected growth in trading partners. Output shocks could undermine households’ ability to service their debts. A sharp tightening of global financial conditions could cause financial stress for banks and corporations. Lower-than-projected oil prices could reduce exports and growth, complicating the authorities’ fiscal consolidation efforts. Domestically, contingent liabilities could necessitate additional measures to ensure medium-term fiscal sustainability, while delays or resistance to the governance reform agenda could undermine confidence, leading to lower investment and growth. Sharp adjustment in real estate prices or a deterioration in households’ debt service ability could affect financial stability and growth.

Authorities’ Views

10. The authorities broadly agreed with staff’s assessment of the economic outlook and risks. They expected growth to be 4.9 percent in 2019, driven by domestic demand and underpinned by strong fundamentals, particularly favorable labor market conditions, in addition to an improved business environment and greater confidence. They expected inflation to rebound to between 2.5–3.5 percent in 2019, contingent on the timing of fuel subsidy reform and oil prices. Over the medium term, the authorities saw growth at 4.5–5.5 percent, with risks stemming from external sources and tilted to the downside. The authorities took positive note of the 2018 methodological refinements to staff’s external balance assessment but 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. They agreed with the structural reforms advised to address policy gaps, noting that their reform plans aim to boost investment and productivity and improve infrastructure.

Macroeconomic and Financial Policies: Achieving Fiscal Consolidation while Safeguarding Growth and Financial Stability

11. Policies should aim at achieving fiscal consolidation while protecting growth and financial stability. A credible fiscal consolidation plan is needed to rebuild fiscal buffers, put public debt on a clear downward path, and boost market confidence. Monetary policy should continue to be geared towards domestic stability, and macroprudential policies should help maintain financial stability. External imbalances should be addressed over the medium term by creating fiscal space to expand social safety nets and reduce precautionary household saving and structural reforms aimed at enhancing investment and productivity.

A. Fiscal Policy

12. The 2019 budget entails a welcome consolidation and transparency over fiscal accounts (Chart 6). The new government continued its efforts to increase fiscal transparency by budgeting for full clearance of tax refund arrears in 2019 and enhancing the analysis of fiscal risks and liabilities. Expenditure rationalization and improvements in targeting social assistance and subsidies are expected to save 2.1 percent of GDP. Higher non-tax revenue (1.3 percent of GDP), mainly due to additional one-off transfers from Petronas (2 percent of GDP) will partly finance one-off tax refunds (2.4 percent of GDP). The full year impact of replacing the GST with the SST and additional provision for 2019 tax refunds will raise the deficit by 0.7 percentage point of GDP. Consequently, the deficit is budgeted at 3.4 percent of GDP in 2019. Additional, albeit small, revenue measures2 could potentially deliver higher revenue relative to the 2019 budget and IMF staff baseline. While expenditure compression could weigh on growth, particularly through a slowdown in public investment, the adverse impact should be mitigated by the improvement in the targeting of transfers and the tax refunds. More importantly, the anticipated fiscal consolidation should help shore up market confidence. Nevertheless, the one-off dividends from Petronas, together with the revenue shortfall from replacing the GST with the SST, has increased the dependence on oil-related revenue, calling for further adjustment over the medium term.

Chart 6.
Chart 6.

Malaysia: 2019 Projected Fiscal Deficit

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Sources: IMF staff estimates.

13. The authorities plan to further reduce the deficit over the medium term. Malaysia’s fiscal policy is anchored by a commitment to keep the federal government debt below 55 percent of GDP. However, the federal government debt is estimated at 51.9 percent of GDP at end-2018, implying that the limit could be breached if downside risks materialize. Besides, federal government guarantees (18 percent of GDP, as of June 2018) and possible future payment obligations related to Public-Private-Partnerships (PPPs) projects (13 percent of GDP, on an undiscounted cash basis over next 30 years, also as of June 2018) could pose an upside risk to public debt. These factors imply that Malaysia’s fiscal space is at risk3 absent fiscal consolidation. Against this backdrop, the 2019 budget announced a medium-term consolidation path—with the deficit reduced to 3 percent of GDP in 2020, 2.8 percent of GDP in 2021, and 2 percent of GDP over the medium term. This gradual consolidation path would put debt on a downward trajectory, allowing it to reach 47 percent of GDP by 2024 (Appendix V). This would provide welcome buffers vis-a-vis the federal government debt limit, thereby enhancing fiscal space.

14. Revenue mobilization is a priority given Malaysia’s low tax revenue (13.1 percent of GDP in 2017, Chart 7). Based on theory and international best practice, the value-added tax (GST) is a preferable form of taxation. At the current juncture, other measures will be needed, such as strengthening the SST, revisiting existing tax incentives for corporate investment, increasing excise taxes, broadening the PIT base, and introducing a capital gains tax (text table). With this objective in mind, the authorities have established a high-level Tax Reform Committee, tasked to carry out a comprehensive review of the Malaysian tax system including tax incentives and possible new sources of sustainable revenues.

Chart 7:
Chart 7:

Tax Revenue: OECD and ASEAN-5, 2014

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Sources: IMF FAD Tax Revenue Indicators database; and IMF staff calculations.

Options for Fiscal Policy Adjustment, 2020–2024

(In percent of GDP)

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15. Revenue measures should be coupled with expenditure rationalization. The authorities’ zero-budgeting process has rightly increased focus on existing spending but could be further strengthened by a targeted and strategic spending review mechanism, on a rolling basis, which would also help to realize expenditure savings (possible measures are illustrated in the text table). Revenue mobilization and expenditure rationalization should create space for additional social and development spending. Such spending should be prioritized in accordance with the main pillars in the Mid-Term Review of the Eleventh Malaysia Plan and include further improvements in social protection and healthcare spending. This would help put the economy on a path of sustainable, inclusive growth towards high-income status.

16. Fiscal adjustment should be embedded in a strengthened fiscal framework. The government plans to table a Fiscal Responsibility Act (FRA) and adopt accrual accounting by 2021. The FRA should clearly stipulate fiscal objectives, the fiscal anchor, and the key components of the medium-term fiscal framework including operational targets and the institutional setup. Over the medium-term, to further strengthen the fiscal framework, introducing an expenditure rule (capping the growth rate of expenditure at an appropriately calibrated level that meets the government’s strategic objectives while ensuring fiscal sustainability) could be considered to help prevent procyclical fiscal policy and meet the government’s strategic spending objectives without undermining fiscal space (Appendix VI).

Authorities’ Views

17. The authorities reaffirmed their commitment to medium-term fiscal consolidation. They stressed that the higher deficit in 2018–2019 is temporary and reflects efforts to improve fiscal transparency and governance. They noted that the revenue shortfall from replacing the GST with the SST will be addressed through revenue mobilization measures to be identified by the Tax Reform Committee and further expenditure rationalization. The authorities noted their commitment to reducing the deficit to 2 percent of GDP over the medium term. While the authorities agreed on the importance of revenue mobilization, they indicated that additional spending needs can also be accommodated by improving expenditure efficiency. They agreed with the need for a strengthened medium-term fiscal framework, including better fiscal risk management, and highlighted their plan to propose a Fiscal Responsibility Act and adopt accrual accounting by 2021.

B. Monetary, Exchange Rate, and Financial Markets Policies

18. The monetary policy stance should remain broadly neutral. 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. After raising the policy rate by 25 bps to 3.25 percent in January 2018, the Monetary Policy Committee has kept the rate unchanged in its five subsequent meetings, thus maintaining the real policy rate within the natural rate band (Chart 8). Looking forward, at unchanged policy rates, the monetary policy stance will remain broadly neutral. Given gradual growth deceleration toward sustainable levels, no evident underlying inflation pressures, and gradually tightening financial conditions (Chart 9 and Appendix VII), monetary policy should remain on hold.

Chart 8
Chart 8

Real Policy Rate versus Natural Rate, 2013:Q2–2019:Q4

(Percent)

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Sources: IMF staff calculations.Note: Natural rate band derived using TV VAR with inflation expectations proxies by backward looking inflation moving average and forward looking Consensus Forecasts. Projected real policy rate assuming no change in the nominal monetary policy rate through end 2019.
Chart 9
Chart 9

Financial Conditions Index For Malaysia

(1991:Q1–2018:Q2)

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Note: Based on the model outlined in 2017 April GFSR, estimated using 10 financial indicators covering credit, foreign exchange, debt, and equity markets for 43 advanced and emerging market economies for 1990–2016. An increase in the index means tightening financial conditions.

19. Exchange rate flexibility is essential. BNM intervention in the foreign exchange market following the surprise election results helped ensure orderly market conditions. Looking forward, and in the context of protracted uncertainty in global financial conditions, foreign exchange market intervention should continue to be limited to preventing disorderly market conditions and the exchange rate should continue to play the role of shock absorber. This would safeguard reserves and help to further develop and deepen financial markets. Gross foreign reserves are adequate (US$101.4 billion as of end 2018—about 108 percent of the Assessing Reserve Adequacy (ARA) metric for a floating exchange rate regime). When adjusted for net forward positions, which is also relevant given the forward-looking nature of the ARA metric, reserves are below 100 percent of the metric. In case of an inflow surge, some reserve accumulation would be appropriate to increase the reserve coverage. Although banks and corporates could resort to their own external liquid assets to service their maturing external debt, foreign currency debt still represents a potential claim on BNM’s foreign exchange reserves.

20. Malaysia’s external debt remains manageable, although external financing vulnerabilities are higher than in the median peer country (Appendix VIII). Malaysia’s external debt-to-GDP ratio has risen by about 11 percentage points of GDP between 2009 and 2018Q3, to 65.4 percent of GDP, measured in U.S. dollars (2009: 54¼ percent of GDP). About one-half of this increase in the debt ratio was due to the rise in other investment liabilities, including intercompany loans and interbank borrowing. Portfolio debt inflows accounted for about 3 percentage points of GDP of the increase, despite large portfolio outflows in 2018Q2. 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. However, close to one-third of external debt is denominated in ringgit, which provides some cushion against exchange rate risks.

21. The measures introduced by the authorities in December 20164 have reduced volatility in the onshore FX market, but at the likely cost of creating distortions. The attestation requirement for banks’ noninvolvement in offshore ringgit derivatives trading is motivated by the authorities’ goal of closely monitoring activity in the FX market and dissuading speculative activities. A removal of this ban would have to proceed with caution as conditions for further liberalization allow. While domestic FX markets appear to be functioning well (Appendix IX), the export proceed conversion requirement and limit on foreign currency investments by residents with domestic ringgit borrowing (including the limit by resident non-exporters) can be distortive, potentially leading to resource misallocation, and therefore may not support market development. In August 2018, the BNM eased the conversion requirement by allowing exporters to keep FX earnings in excess of 25 percent of export proceeds when these are needed to meet import or debt service obligations in the next six months without going through a process of conversion/reconversion as previously required. These measures should be gradually phased out with due regard to market conditions.

Authorities’ Views

22. The authorities agreed with staff’s assessment, albeit with caveats. They viewed monetary policy as still accommodative and noted that growth and inflation remain the key determinants of monetary policy. The authorities stressed that, in the post-election months, FX interventions were needed to prevent disorderly market conditions. However, they also noted that exchange rate flexibility will continue to be the first line of defense against external shocks. They viewed BNM reserves to be adequate and external debt to be manageable, highlighting several buffers against external shocks: (i) BNM’s reserves account for a quarter of total foreign assets, with the remainder held by resident banks and corporates, which can be drawn upon to meet external obligations without creating a claim on international reserves; (ii) about one-third of external debt is ringgit-denominated; (iii) three-quarters of FX-denominated external debt is subject to prudential requirements; (iv) over half of external debt has medium/long-term maturity; and (v) three-quarters of short-term interbank borrowing is intragroup, which must comply with local liquidity regulations and is deemed more stable. Regarding the 2016 FX market measures, the authorities disagreed that these created distortions, noting that they helped reinforce Malaysia’s long-standing policy on the non-internationalization of the ringgit, limit speculation that causes excessive exchange rate volatility, and deepen onshore markets.

C. Financial Sector

23. The financial system seems well positioned to cope with most shocks (Figures 7, 8). Banks are well-capitalized and liquid, with capital and liquidity buffers exceeding regulatory levels. Loan quality is strong, with aggregate NPLs at 1.5 percent of gross loans as of 2018 Q3, and provisions are sizable. The impaired loans in the oil and gas sector are adequately provisioned for, have been written off, or restructured. The real estate sector (especially its commercial segment) represents a vulnerability, but risks are mitigated by large developers’ sizable cash buffers. While some small property developers have faced cash flow problems recently, the risks appear to be contained.

Figure 7.
Figure 7.

Malaysia: Financial Sector Developments

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

Figure 8.
Figure 8.

Financial Soundness Indicators 1/

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

1/ Financial Soundness Indicators for Malaysia are as indicated, while for the other countries those indicators range between 2017Q2 and 2018Q3 depending on availability.

24. The potential for spillovers from the non-bank financial institutions (NBFIs) to the banking sector appears limited. NBFIs include retirement funds, investment funds, credit cooperatives, Development Financial Institutions (DFIs), and the National Higher Education Fund, among others. NBFIs’ investments in equities and bonds continue to be the main transmission channel of contagion risk to the financial sector. Also, some segments of the sector are government-owned, posing potential fiscal risk in case a large adverse shock materializes. To help manage these risks, the BNM has taken steps to improve the flow of NBFIs’ financial reporting.

25. Household debt is elevated compared to regional peers, but declining (Figure 9). Total household debt stood at 83.2 percent of GDP as of 2018Q3. High household financial assets (twice the size of total household debt) help mitigate the vulnerability for all but the lowest income group (with income below RM 3,000 per month). Households in the second income group (earning between RM3,000 and RM5,000 per month) would face the largest cash flow shortages under income, interest rate, or cost-of-living shocks, according to BNM stress tests. Macroprudential norms and credit underwriting standards have been effective in containing household NPLs at 1.4 percent. Mortgages, which represent 60 percent of total household debt, have mostly a variable rate structure and are subject to interest rate risk. Despite high loan quality and the positive outcome of the BNM’s latest stress testing, household debt continues to require close monitoring.

Figure 9.
Figure 9.

Malaysia: Household Debt

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

26. The authorities continue to closely monitor risks emanating from the housing market, although the risks are deemed manageable (Figure 10). House price growth has declined from 6.5 percent in 2017 to 3 percent in 2018H1, and the volume of transactions has also declined. The number of unsold housing units that have been completed or are currently under construction is increasing and is mostly concentrated in high-rise buildings. Banks’ direct exposure to developers remain small and is closely monitored by the BNM.5 According to BNM stress tests, potential bank losses originating from a possible sharp real estate price adjustment and shocks to income and interest rates are small relative to the banks’ capital buffers. The BNM, MOF, and Ministry of Housing and Local Government have introduced new measures that help reduce the cost of property or of contracting a mortgage loan, with the objective to strengthen the demand for housing and facilitate leasing, and therefore gradually reduce the supply overhang. The impact of these measures should be evaluated on an ongoing basis to ensure effectiveness and correct potential distortions.

Figure 10.
Figure 10.

Malaysia: House Prices

Citation: IMF Staff Country Reports 2019, 071; 10.5089/9781498302418.002.A001

27. As systemic risks from the housing market dissipate, the residency-based differentiation in the real estate measures introduced in 20146 should be gradually phased out. Given banks’ sizable exposure to mortgage lending and to the construction industry, a real estate market price correction, through a reduction in household and corporate wealth, and these agents’ debt servicing capacity, could have a significant impact on growth and financial stability as NPLs rise. During 2012–13, the Malaysian House Price Index (MHPI) grew by a cumulative 24 percent, well-above its long-run annual average of 6 percent and, in 2014, amid further significant price increases, the number of transactions by non-citizens surged by 30 percent (Appendix X). The measures introduced in 2014 helped cool down the market (cutting growth in property purchases by non-citizens by over 50 percent in 2015 and by another 38.9 percent in 2016, and slowing the growth rate of MHPI to 9.4 and 7.4 percent in 2014 and 2015, respectively), avoid significant price adjustments, and reduce the rate of future debt build-up, thus reducing the probability of systemic distress. In the absence of a capital inflow surge for the time-being, but still high household leverage, gradually removing the residency-based differentiation in both measures is recommended as systemic risk dissipates. Carefully calibrated changes to the measures could have the additional benefits of helping to reduce the excess supply of high-end housing where nonresident buyers are concentrated and thereby the probability of a sharp downward price correction.7 Should the activity in certain segments again threaten financial stability, the authorities may consider macroprudential measures that target the specific segments, without a differentiated treatment of non-residents.

28. The corporate sector is moderately leveraged. Intercompany loans in 2018 have increased as a share of GDP, driven largely by multinational companies’ lending to local subsidiaries, which is considered relatively stable (compared to other market-based funding). Corporations remain resilient to interest rate shocks: the interest cover ratio is above 8 sector-wide, against a prudent threshold of 2. The overall corporate sector NPLs are at 2.5 percent, suggesting strong debt service capacity. However, some corporations are presently experiencing declining margins due to ongoing renegotiations of public sector projects and delays in infrastructure projects, which represents a risk to their profitability.

29. Although the financial sector is deemed resilient at present, the authorities continue to closely monitor risks and consider measures to mitigate them. The authorities are making ongoing efforts to enhance operational resilience and crisis preparedness. These actions could be further strengthened by a comprehensive internal review of crisis preparedness, resolution framework, and related facilities (ELA or Deposit Insurance payout framework) and legislation. This would help ensure, inter alia, seamless inter- and intra-agency functioning at a time of distress. Over the medium term, to strengthen the macroprudential framework, consideration could be given to introducing sector-wide LTVs (on the second and first properties) and debt-service-to-income limits for all income groups to replace the ones that are presently self-imposed by the banks.

30. The framework governing BNM’s financial oversight functions appears robust. The 2012 FSAP found that the BNM’s role is clearly defined in the law; it is well funded; and its staff has credibility based on their professionalism and integrity. It also found that the overall supervision of the banking sector and some non-bank financial institutions, as mandated, is sound and delivers effective oversight. The main gaps identified by the 2012 FSAP—specifically, improving the administration of licensing standards, extending information-sharing arrangements with foreign supervisors, and strengthening the supervisory powers in the insurance sector—have been addressed.

31. The authorities should continue strengthening the implementation of AML/CFT measures, which would also assist in mitigating risks from corruption. Ensuring that financial institutions effectively apply enhanced customer due diligence measures on high risk politically exposed persons can help detect and deter the laundering of corruption proceeds. In this regard, efforts to strengthen the asset declaration system should be stepped up, in particular expanding the coverage of high-level public officials and improving mechanisms for verification, sanctions and public access. The proposed study by the Companies Commission of Malaysia on the implementation of beneficial ownership requirements should identify measures to enable competent authorities to have access to accurate and up-to-date ownership information of legal persons and legal arrangements established in Malaysia.

Authorities’ Views

32. The authorities viewed financial sector risks as appropriately monitored and contained. They noted that the financial sector has the necessary buffers to cope with sizable shocks. While agreeing that household balance sheet risks require close monitoring, the authorities noted that the associated problems do not pose systemic financial stability risks at this juncture. They were of the view that, with real estate price increases moderating, and given the strength of the macroprudential framework, the likelihood of a sizable adjustment with systemic implications is low. The authorities viewed sector-wide LTVs on first and second mortgages as unwarranted given existing supervisory measures and prudent risk management practices at banks. They noted staff’s recommendation to phase out the residency-based differentiation in the RPGT and property floor price but consider these measures necessary to limit speculative demand and minimize financial sector risks, given the rebound in growth of property purchases by non-citizens in 2017–2018H1. Regarding crisis preparedness, they indicated that, in addition to periodic reviews of such preparedness, resolution frameworks, and related liquidity facilities, they were increasingly focused on testing the banking system’s operational resilience, including to cyber risks.

Medium–Term Challenges: Improving Governance and Achieving Sustainable Growth

33. Weaknesses have been identified in fiscal governance and anti-corruption frameworks. Vulnerabilities on the fiscal side include off budget spending, weaknesses in managing large infrastructure projects and in procurement systems, and a budget process that could be more transparent. Significant reliance on off budget initiatives, including government guarantees and PPPs, have made it difficult to form a comprehensive assessment of the government fiscal position. The governance of large infrastructure projects in terms of project appraisal, approval, costing, and extension of government guarantees presents further challenges and exposes the country to corruption vulnerabilities. Malaysia ranks low compared to the OECD average on the strength of procurement systems and on a range of indicators of corruption and anti-corruption institutions (Appendix XI).

34. The new government has launched multiple initiatives to address governance weaknesses and corruption. The Mid-Term Review of the Eleventh Malaysia Plan reoriented government priorities towards improving transparency and public services efficiency. The National Centre for Governance, Integrity and Anti-Corruption (GIACC) was established to develop a national anti-corruption plan8 and to coordinate governance and anti-corruption reforms. The intention is to move forward with important legislation to secure these reforms, as well as take firm steps towards ensuring public participation and key institutional reforms. Special committees were established to tackle specific governance weaknesses, such as procurement, and existing institutions are being strengthened, including the Malaysian Anti-Corruption Commission (MACC), the Economic Planning Unit, the PPP framework, and the SOE legal framework.

35. The governance reform agenda will take time to implement and will require legislative changes. Several important reforms require constitutional changes (Annex XI). Legislative reforms will be needed covering freedom of information, political financing, and declaration of assets. Improvements in the public investment management framework will require a number of additional legislative and procedural changes. Measures will also be needed to avoid future tax refund arrears, improve financial oversight of SOEs, and publish a more detailed set of accounts and a fiscal risks statement. Tax administration could be improved by merging the multiple tax collection roles under the umbrella of the Inland Revenue Authority.

36. The authorities’ structural reform agenda, laid out in the Mid-Term Review of the Eleventh Malaysia Plan, aims to help Malaysia reach high-income status and inclusive economic development. In addition to governance reforms, the government is prioritizing inclusive and balanced regional development, investing in human capital, enhancing environmental sustainability, and strengthening economic growth. In this vein, accelerating the ratification of the CPTPP9 (currently under review) and increasing female labor force participation and productivity would be essential. Despite robust growth and substantial improvement in export sophistication, Malaysia’s total factor productivity growth slowed recently. Policies to help lift productivity growth should focus on improving education and encouraging innovation, technology adoption, and a move up the value chain.

37. Improvements in education would help raise productivity. Priority should be given to policies that raise the quality of human capital, by improving the quality of teachers and design of curricula and by expanding vocational and technical training to address skills mismatches. This would also help ease labor shortages and prepare Malaysia to better face automation challenges.

38. Productivity gains can also be achieved by accelerating innovation and technology adoption, another objective of the Mid-Term Review of the Eleventh Malaysia Plan. In this respect, aligning research and innovation to business needs and fostering firm dynamism would help. Given the positive but limited technology spillovers from FDI, the authorities place an equal emphasis on the creation of own technologies. In this respect, the authorities are rightly preparing measures to address the lack of coordination in research, development, commercialization and innovation activities and the low commercialization of R&D output.

39. Encouraging a move up the value chain through market-based measures would also help. Digital technology and automation provide an opportunity for Malaysia to upgrade its industries. While the government intends to provide targeted incentives and funding under its Industry 4.0 initiative, concerted efforts by the private sector to invest in digitalization are needed. The authorities view the easy access to low-skilled foreign workers as a drag to the upgrade effort and are working on an updated foreign worker policy to increase the cost of hiring foreign labor and clamp down on illegal foreign workers employment. Any reform to foreign labor policies should be market-based, clearly communicated, and gradually phased-in to allow sectors that rely on foreign workers to adjust.

Authorities’ Views

40. On governance, the authorities agreed with the identified weaknesses and the steps needed to close the gaps. They are firmly committed to enhancing governance and combatting corruption at all levels. In this regard, the implementation of principles of good governance, strong institutions, and integrity and accountability in the public sector will be the pillars of the strategy. The authorities emphasized that they are looking at numerous reforms in the areas of administration, legislation, and judicial system, as well as public financial management and relevant institutions.

41. The authorities reaffirmed their goals of achieving high-income status and inclusive development. Guided by the Mid-Term Review of the Eleventh Malaysia Plan, the authorities are prioritizing reforms to improve governance, accelerate innovation, boost productivity, move up the value chain, enhance the wellbeing of the people, and achieve inclusive growth. The new government is reviewing the CPTPP to ensure it will be beneficial to Malaysia, a necessary condition for ratification in the authorities’ view. They are focusing on improving the quality of teachers and design of the curricula and are prioritizing quality over quantity of vocational and technical training. The authorities intend to provide targeted incentives to promote adoption of improved standards under their Industry 4.0 initiative and better integration of R&D. They stressed that, while foreign workers contribute 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.

Staff Appraisal

42. The Malaysian economy has shown resilience in recent years. Real GDP growth is moderating towards potential, and there are no evident signs of inflationary pressures presently. The risks to the growth outlook are to the downside. Developments in 2018 suggest that Malaysia’s external position remains stronger than warranted by fundamentals and desired policies. Policy priorities are anchoring governance reforms in appropriate legislation and achieving fiscal consolidation while safeguarding growth and financial stability.

43. Fiscal policy should follow a gradual consolidation path, prioritizing revenue mobilization to create space for social and development spending. The announced medium- term consolidation path is appropriate and should help build fiscal buffers and bolster market confidence without disrupting growth. The adjustment should be embedded in a strengthened fiscal framework and rely on credible revenue and expenditure measures. Given Malaysia’s low tax revenues, revenue mobilization is a priority. It will help finance needed expenditure to achieve government priorities identified under the Mid-Term review of the Eleventh Malaysia Plan and help with external rebalancing.

44. The broadly neutral monetary policy stance is appropriate. Malaysia’s monetary policy framework has performed well, delivering price stability and robust growth in recent years. The broadly neutral stance is appropriate given close-to-potential growth, no underlying inflationary pressures, and still-supportive albeit gradually tightening financial conditions. Domestic economic and financial considerations should continue to guide monetary policy decisions. Given constraints on fiscal policy and limited reserve buffers, exchange rate flexibility remains the recommended first line of defense against shocks and should help further financial market deepening. The December 2016 FX market measures should be gradually phased out with due regard to market conditions.

45. The financial sector appears resilient, but household debt and the real estate market require close monitoring. Bank profitability and liquidity are sound, and NPLs low. The corporate sector is moderately leveraged and appears resilient. While potential spillovers from NBFIs appear limited, BNM’s steps to improve NBFI financial reporting are welcome. Household debt is high compared to peers, with a high share of mortgages and with pockets of vulnerability in lower-income groups. The real estate sector (especially its commercial segment) represents a vulnerability, which requires close monitoring. The residency-based differentiation in the property market measures should be gradually phased out as systemic risks dissipate. The authorities’ ongoing efforts to enhance operational resilience and crisis preparedness are welcome and could be strengthened by a comprehensive review of the overall framework, covering associated facilities and legislation.

46. Fiscal governance reforms and strengthening of anti-corruption institutions are fundamental. It will be important to see through the intended governance reforms and anchor them in legislation. This is particularly needed to secure the independence of anti-corruption institutions and appropriate separation of powers. Legislative reforms are needed on freedom of information, political financing law, and declaration of assets. The authorities should avoid future tax refund arrears, improve financial oversight of SOEs, enhance the effectiveness of the AML/CFT framework, and consider adopting all staff’s past recommendations regarding public investment management.

47. The emphasis on raising productivity and inclusive development is welcome. The government is rightly prioritizing inclusive and balanced regional development, improving human capital, boosting environmental sustainability, and putting economic growth on a strong, sustainable footing. Priority should be given to increasing female labor force participation and productivity by, among others: (i) improving education; (ii) accelerating innovation and technology adoption; and (iii) encouraging a move up the value chain.

48. It is recommended that the Article IV consultation with Malaysia be held on the standard 12-month cycle.

Table 1.

Malaysia: Selected Economic and Financial Indicators, 2014–20

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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.

Cash basis. The authorities plan to adopt accrual basis by 2021. For 2019, overall and primary balance includes the payment of outstanding tax refund (arrears) amounting to RM37 billion.

Tax refunds in 2019 are allocated for payment of outstanding tax refunds.

Consolidated public sector includes general government and nonfinancial public enterprises (NFPEs). General government includes federal government, state and local governments, and 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, 2014–18

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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 or IMF staff estimates.

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, 2014–23 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, 2014–23 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.