The December issue of the IMF Research Bulletin, a quarterly guide to research issues at the IMF.


The December issue of the IMF Research Bulletin, a quarterly guide to research issues at the IMF.

By Alex Mourmouras and Niamh Sheridan

Malaysia’s economic performance since its independence in 1957 has been strong. It is now an upper-middle income economy whose income per capita has grown 20-fold over the past 40 years. Economic growth was inclusive, with the share of households living below the national poverty line falling from over 50 percent in the 1960s to less than 1 percent currently. Natural resource wealth has been well-managed and widely shared; inflation has been stable, and a strong financial sector has been developed that is at the center of global Islamic finance. Despite facing significant shocks, the Malaysian economy has shown remarkable resilience, and has recovered quickly from the Asian financial crisis and from the global financial crisis. The reform process is ongoing with the aim to achieve high-income status by 2020.

Successful Structural Transformation

Malaysia’s transformation was achieved through a wide range of structural reforms throughout the last four decades, with continuous reform efforts to support growth, boost productivity, and strengthen resilience. To gain a systematic understanding of the stages of structural reforms in Malaysia we follow the classification of the stages of structural reforms adopted in recent IMF research (IMF Board paper on structural reforms, IMF 2015). The main insight is that the reform agenda evolves as economies develop: each stage of development brings its own reform challenges. The payoff in terms of higher productivity also evolves through time. Governments need to prioritize reform areas depending on the level of development in their country.

The focus of reforms in the 1960s and 1970s was on tackling Malaysia’s extensive rural poverty and upgrading its undiversified agriculture- and natural resource extraction-based economy. Various government programs aimed to increase productivity and eradicate rural poverty, for example, a land settlement scheme provided poor farmers with rights to the land; and sizable resources were channeled to improve agricultural infrastructure (irrigation and drainage systems). Agricultural extension and support services were provided in rural areas, and government supported research and development in high-yielding agricultural products. These reforms paid off: improvements in agriculture productivity contributed to the reduction of poverty and income disparities.

The release of surplus rural labor helped to lay the foundation for industrialization. Malaysia followed a public sector-led development strategy during the 1970s. Public investment and the state-owned enterprise (SOE) sector both grew significantly. Higher public outlays boosted economic growth to around 8 percent and reduced poverty from about 50 percent in 1970 to 37 percent by 1980, but also led to double-digit fiscal deficits and record high public debt in the early 1980s. This coupled with a downturn in external demand and a fall in the prices of Malaysia’s major primary export commodities, resulted in a sharp recession in 1985. In response to the recession, the authorities launched far-reaching structural reforms in the mid-1980s aiming to revitalize the private sector and restore macroeconomic stability.

The next stage of reforms, from the mid-1980s to the mid-1990s, focused on trade, financial liberalization, and infrastructure. Trade liberalization was greatly accelerated when Malaysia adopted an outward-oriented development strategy in the 1980s. Import duties on manufactures that had enjoyed extensive tariff protection were dismantled. Industry was deregulated and industrial licensing and ownership rules were relaxed. The capital account was liberalized and tax incentives and targeted allowances for foreign direct investments led to large FDI inflows into the manufacturing sector. The structural transformation was substantially underway.

The upgrading of infrastructure was an important component of the transformation. Public spending in the transport and power sectors was increased. Other infrastructure sectors were privatized. Private investments in telecommunications, for instance, helped with the infrastructure push. Economic diversification coupled with financial deregulation and liberalization helped spur the banking system and develop capital markets. Collectively, these reforms transformed Malaysia into an upper middle-income country by the mid 1990s. However, the rapid pace of financial liberalization and deregulations, combined with a pegged exchange rate system also brought a surge of speculative capital inflows, increasing vulnerability in the financial sector.

Fiscal reforms played an important role during this reform phase. The government initiated a comprehensive fiscal structural adjustment program, with large-scale expenditure cuts in the public sector and institutional reforms in the budget process. Tax reforms sought to lower the tax burden and incentivize private investment. A sound resource wealth management framework, with natural resource rents being invested in productive capital and saved abroad rather than being consumed, further contributed to productivity growth and macroeconomic stability.

Structural reforms, coupled with prudent macroeconomic policies help restore fiscal sustainability and put the economy back to a rapid growth trajectory led by the private sector. As a result, the overall budget deficit dropped from 10.5 percent of GDP in 1986 to a near balanced budget in the 1990s. Private investment surged from 14 percent in 1986 to 32 percent of GDP in 1997, and growth averaged around 8 percent over the same period.

The strong economic performance continued until the 1997–98 Asian financial crisis, which left Malaysia reeling from a severe currency and banking crisis, large depreciation, and massive capital flight. Austerity measures, including a significant interest rate increase and public expenditure cuts, were adopted at the beginning of the crisis with views to stem capital outflows and depreciation. As the economic downturn became more pronounced, policies shifted during the second half of 1998 with a view to supporting aggregate demand through monetary easing and fiscal stimulus.

Around the same time, a new round of structural reforms was also adopted as a package of the National Economic Recovery Plan to address the crisis legacy of slow growth and a weak financial system. These reform measures were implemented in stages throughout the late 1990s and the 2000s, including temporary controls on capital flows and fundamental reforms in the financial sector. Capital and currency controls on short-term portfolio flows were adopted during the crisis to reduce volatility, while these controls gradually eased as recovery took place. From 2005 onward, the exchange rate and capital flow policies became almost fully liberalized. More fundamental reforms were undertaken in financial and corporate sectors, including upgrading regulation and supervision in line with international best practices. Banking groups were strengthened and consolidated, and foreign entry was allowed to enhance competition. Equally important were reforms to develop and diversify the capital markets, including liberalization to allow foreign corporations to raise funding. These measures together helped to create a deep and liquid financial system that is more resilient, relying more on the market rather than credit financing. Reforms were also taken to improve the business regulatory environment, firmly placing Malaysia in the top 25 countries for the ease of doing business.

With the aim of reaching high income status by 2020, Malaysia launched in 2010 a new generation of reforms targeting private sector led growth by moving into higher value-added activities in both industries and services. These reforms include transforming industrial policies into innovation and technology policies, improving the quality of infrastructure and addressing labor skills shortages and mismatches. Substantial progress has been made in raising school enrollment, though challenges remain in further improving the quality of education. Social protection was also improved by introducing the minimum wage in early 2013.

Avoiding the Resource Curse

Malaysia’s economic success was underpinned by successful management of its natural resource revenues. Resource rents were channelled into increases in productive capital, infrastructure, and human capital, which in turn supported economic diversification and encouraged innovation. Agricultural and other sectoral policies helped deliver inclusive growth ensuring the benefits were widely shared. The Malaysian experience with successful management of natural resource wealth offers lessons for other economies in avoiding the so-called natural resource curse.

Hartwick (1978) suggested a “rule of thumb” that serves as a guideline for managing finite natural resource wealth so as to ensure sustainability of income and consumption growth. Hartwick’s rule states that the optimal level of consumption can be sustained if the value of net investment equals the value of rents extracted at each point in time. Research by the World Bank (2011) showed that between 1970 and 2005 very few resource rich countries followed this rule, including no countries with resource rents in excess of 15 percent of GDP. Malaysia, however, was one of a just a few countries (along with Indonesia and China) with resource rents above 10 percent of GDP that followed the Hartwick rule and invested rather than consumed their natural resource rents.

The Malaysian economy is well-diversified and Malaysia’s exports include high value-added commodity products along with high-tech manufactured goods as part of the Asian supply chain. This contrasts with the largely agricultural and commodity-based economy at independence. The government actively sought to diversify its manufacturing sector, beginning in the early 1980s with policies to attract foreign direct investment and encourage private-sector led growth. In addition, industrial policies including significant tax incentives and in some cases tariff protection help boost both domestic and foreign investments in manufacturing industries. To a great extent, these efforts have been successful: the economy has diversified both horizontally and vertically and the diversity and sophistication of manufacturing and exports has increased. Malaysia’s diversification is helping to shield the economy from the impact of the decline in oil prices at the end of 2014.

The state-owned oil company PETRONAS has played an important role in managing resource wealth. Although not a sovereign wealth fund, PETRONAS has played a similar role by facilitating cross generational sharing of resource wealth, buffering the federal budget from shocks and helping to stabilize capital flows. PETRONAS made significant investments in upstream and downstream activities that facilitated vertical integration of the economy. Furthermore, recognizing the limited domestic hydrocarbon reserves, overseas investments by PERTRONAS have ended the lifespan on Malaysia’s resource wealth. Not all revenue was repatriated back to Malaysia helping to insulate the economy from excessive capital inflows and exchange rate appreciations during resource booms.

The New Economic Policy (NEP) in 1970 aimed to eradicate poverty and achieve a more equitable distribution of wealth and remove the association between race and economic activity that was undermining stability in the fledgling nation. Efforts were focussed on supporting education and creating employment opportunities for poorer households and were successful in reducing poverty, in addition to facilitating political stability, which enhanced the business climate.

Securing Macroeconomic Stability after the Asian Financial Crisis

Malaysia’s macroeconomic policies have also contributed to its resilience.

Malaysia has experienced four decades of low and stable inflation—an enviable record among emerging market and advanced economies alike. During this period, the Malaysian economy has been buffeted by significant domestic and external shocks; nevertheless inflation has remained in single digits (with the exception of one episode). Since Bank Negara Malaysia’s founding in 1959, a key feature has been the continual redesign and reformulation of the monetary policy framework, although at times abrupt, in general, change was more gradualist. The “guided evolution” of the monetary framework reflected a deliberate response to the changing domestic and global macroeconomic environment and the development of the financial sector. A stable real effective exchange rate was supportive of growth and investment through the 1990s as the infant manufacturing sector developed. Since 2005, the exchange rate has become increasingly flexible as post-Asian financial crisis capital controls were gradually unwound, and domestic financial markets and manufacturers became increasingly able to withstand exchange rate fluctuations.

Far-reaching structural and fiscal reforms at the end of the 1980s put the Malaysian economy on a rapid growth trajectory leading up to the Asian financial crisis. Key fiscal initiatives included expenditure-based fiscal consolidation, increased emphasis on infrastructure expenditure to support private sector development, provision of tax incentives for investors, and tariff reduction. These reforms were complemented by comprehensive structural reforms such as industrial deregulation and enhancing the business climate. Altogether, these reforms sought to reduce the role of the state in the economy and lower government’s share in GDP and facilitate private sector driven growth. Empirical estimates suggest that these reforms boosted Malaysia’s growth substantially (by as much as 2.3 percent per annum on average) compared with a synthetic control group.

Growth, Resilience, and Inclusion: The Role of Finance

Malaysia’s financial sector has grown to be sizable (over 400 percent of GDP), is diversified and profitable, and is making an important contribution to growth, resilience, and inclusion. This is underscored by a new financial sector index developed by the IMF that was designed to track three dimensions of a country’s financial sector—depth, diversification, and inclusion. (See Sahay and others 2015.) In a cross section of countries, to some extent, financial sector development as measured by this new IMF financial sector index is associated with higher economic growth. Importantly, beyond a critical level, additional financialization of the economy does not pay off. Malaysia happens to be at the sweet spot in development—it is at a level of financial development associated with the highest attainable growth rate.

The first channel through which finance helps in economic development is by lowering the cost of funds in Malaysia and making possible the scaling up of public and private investment. Malaysia’s growth in recent years has been driven in large part by a scaling up of private and public investment, and the investment ratio has risen by several percentage points of GDP. Large-scale projects under the Economic Transformation Program (ETP)—a multiyear plan to strengthen Malaysia’s economy—are helping to expand and rejuvenate strategic sectors and boost infrastructure for Malaysia’s industry and urbanizing society. These programs have helped catalyze private investment which had declined significantly after 1997–98. The country now boasts a modern infrastructure and its business climate has benefitted, as evidenced by high and improving rankings in international indicators of competitiveness.

The scaling up of investment has boosted economic growth in the context of a sluggish post global financial crisis environment. The scaling up of investment has also helped to raise potential growth and to support Malaysia’s drive to reach high-income status by 2020. Many of these investments, however, have been debt-financed, raising the question of debt sustainability. Malaysia’s deep financial markets have helped to lower its borrowing costs and make them more stable. The nominal ten-year sovereign borrowing rate fluctuates around 4–4.5 percent even in turbulent periods. At close to 2–3 percent, inflation is low and well anchored. Real growth is about 5 percent. With these parameter values, the difference between the real interest rate and the real growth rate (r-g) is substantially negative, between -3.5 and -4, implying favorable dynamics for debt-financed infrastructure. A drive to further improve infrastructure and institutions, including tackling barriers to competition, will prove decisive in Malaysia’s quest to escape the middle-income trap and reach high-income status by 2020.

Malaysia has made remarkable progress in increasing access to finance. Further improvements in using financial services require adoption of innovative distribution channels and products that cater to the underserved in a cost-effective way. The regulatory environment is enabling and the market is at a stage of development that permits banks to harness the retail payments infrastructure to invest safely in innovative delivery channels. The development of Islamic finance has also contributed to financial inclusion. The main challenge for Bank Negara Malaysia (BNM) will be to strike a balance between targeted market interventions to advance its developmental agenda and creating market-based incentives for sustainable innovation and healthy competition in retail payments and banking.

Malaysia’s highly developed financial sector reflects a concerted, multiyear policy reform effort. The Asian crisis exposed weaknesses in Malaysia’s financial system, including over-reliance on bank credit and a fragmented banking system dominated by small, weak institutions. In response, BNM focused its efforts on strengthening and consolidating domestic banking groups. It allowed foreign entry into the domestic banking system to enhance competition. In recent years, Malaysian banks have been expanding in ASEAN, helping to promote the region’s integration. A second hallmark of the reform effort was to develop and diversify Malaysia’s capital markets. Deep and liquid domestic currency equity and bond markets were nurtured with high levels of domestic and foreign institutional investor participation. The bond market has doubled over the past 10 years to over 100 percent of GDP. Financial supervision and regulation are coordinated and proactive, striking a balance between tighter regulation, including system-wide surveillance to ensure financial stability, and liberalizing remaining financial restrictions. Market discipline was enhanced by strengthening mechanisms for resolving distressed financial institutions and strengthening corporate governance to enhance risk management, self-regulation, and market-discipline.

These efforts have delivered important macroeconomic results in terms of growth, resilience, and inclusion. Malaysia’s banks were resilient during the global financial crisis; and deep financial markets and the role of deep-pocketed domestic institutional investors helped insulate the domestic real economy from foreign financial market volatility.

More importantly, Malaysia’s deep financial markets have enabled Malaysia to borrow on its own currency for infrastructure investment–avoiding original sin–which has also helped to boost productivity growth.

Escaping the Middle-Income Trap

Malaysia’s reform agenda remains ambitious with many and is aimed at reaching high income status by 2020 (defined as GDP per capita above US$15,000). This ambitious target serves as a focus for the structural reform agenda. Few countries have succeeded in moving from middle-income to high-income status and while Malaysia is on track to meet its goal by 2020, more reforms will be needed to achieve this objective. The 11th Malaysia Plan appropriately focuses on boosting innovation to drive higher productivity growth. Empirical analysis on the sources of growth shows that total factor productivity growth has lagged behind other countries and had even declined over the last decade.

Surmounting this challenge was the rationale behind the establishment of the Performance Management and Delivery Unit (PEMANDU) in 2009. PEMANDU oversees the implementation of the Government Transformation Program (GTP) and the Economic Transformation Program (ETP). PEMANDU also provides an independent view on performance.

Deep and liquid financial markets are helping Malaysia’s economy to become more resilient to external shocks. Malaysia has a relatively high level of federal debt and large foreign holdings of government securities. In recent years, bouts of capital flow volatility have been triggered by asynchronous unwinding of unconventional monetary policies in advanced economies, oil price fluctuations, and other factors. Interest rates have remained low and stable, and financial market conditions have been orderly in the face of sudden and significant portfolio outflows. A flexible policy framework, with exchange rate intervention limited to smoothing volatility and avoiding overshooting, and a strong external position and comfortable foreign exchange reserves, have also contributed to resilience.

Deep pocketed domestic investors like Malaysian banks, the Employee Provident Fund (EPF) and other saving funds, tend to buy significant amounts of domestic equities and government securities during turbulent periods. This helps to stabilize financial markets and shield the real economy from external volatility, facilitating “financial” (as opposed to “real”) adjustment (see World Economic Outlook, October 2013, Chapter 3). Domestic investors enter these markets when foreign investors are selling because of profit opportunities: the prices of Malaysian securities tend to fall and the ringgit depreciates when foreign investors exit and these assets become attractive to domestic investors who have institutional needs for these securities. Nevertheless, caution is warranted: international exposure of domestic institutional investors, estimated at about 20 percent of GDP, is well below that of total foreign ownership of domestic equities and bonds; and, overseas holdings of domestic institutional investors may not be very liquid.

After several years of rapid credit growth, low or negative real interest rates on deposits, and significant increase in leverage, financial risk is rising. Household debt has grown rapidly. Corporate sector debt has also increased and is now close to average for Asia. Banks continue to expand overseas, but their overseas operations are largely funded by local currency deposits, limiting potential funding and exchange rate risks. Malaysian banks do not rely on offshore wholesale funding to fund domestic operations. Balance sheets in Malaysia are strong, providing additional resilience.


  • Cherif, Reda, and Fuad Hasanov, 2015, “The Leap of the Tiger: How Malaysia Can Escape the Middle-Income Trap,IMF Working Paper 15/131 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Gil Sander, Frederic, and others, “Managing Resource Wealth for Growth Malaysia,” (unpublished manuscript Malaysia: Achieving High-Income Status through Resilience and Inclusive Growth, December 9, 2015), (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Hamilton, Kirk, and others, 2005, “Capital Accumulation and Resource Depletion: A Hartwick Rule Counterfactual,World Bank Policy Research Working Paper No. 3480 (Washington: World Bank).

    • Search Google Scholar
    • Export Citation
  • Hartwick, John, 1977, “Intergenerational Equity and the Investing of Rents from Exhaustible Resources,The American Economic Review, Vol. 67(5): 972974.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2013, World Economic Outlook, October 2013, (Washington, DC).

  • International Monetary Fund, 2015, “Fiscal Policy and Long-Term Growth,IMF Policy Paper (Washington).

  • International Monetary Fund, 2015, “Structural Reform and Macroeconomic Performance: Country Cases,IMF Policy Paper (Washington).

  • Lim, Cheryl, Kelvin Tan, and others, “The ‘Big Fast Results’ Model—Malaysia as the Backdrop,” (unpublished manuscript Malaysia: Achieving High-Income Status through Resilience and Inclusive Growth, December 9, 2015), (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Sahay, Ratna, and others, 2015, “Rethinking Financial Deepening: Stability and Growth in Emerging Markets,IMF Staff Discussion Note 15/08 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • World Bank, 2011, “The Changing Wealth of Nations: Measuring Sustainable Development in the New Millennium,” (Washington: World Bank).

    • Search Google Scholar
    • Export Citation
  • World Bank, 2013, “Malaysia Economic Monitor: Harnessing Natural Resources,” (Washington: World Bank).


This article summarizes the main conclusions from a forthcoming book, “Malaysia: Achieving High Income Status through Resilience and Inclusive Growth,” edited by Alex Mourmouras and Niamh Sheridan, with contributing authors from various departments within the IMF, the World Bank, American University, and Malaysian government agencies.