Malaysian Economic Recovery Measures: A Response to Crisis Management and for Long-term Economic Sustainability

MAHANI Zainal-Abidin
Faculty of Economics and Administration
University of Malaya

 * Paper presented at the ASEAN University Network’s Conference on Economic Crisis in Southeast Asia: Its Social, Political and Cultural Impacts, February 17-19, 2000, Bangkok, Thailand


  1. Introduction

The high economic growth of the East Asian economies since 1970s was interrupted by the devastating crisis that began in July 1997. Most of these economies adopt outward-looking growth strategies, are competitive in exports, encourage foreign participation in economic activities, particularly in manufacturing sector, have educated and diligent workforce, liberalise their financial sector and practice prudent fiscal policy management. However, some of these economies were growing at a pace beyond their economic potential, embarked on a high investment growth strategy that led to persistent current account deficits, received large short-term capital inflows and did not develop sufficient institutional capacity to cope with rapid growth and liberalisation. The affects of the crisis were deeper and more damaging than expected: the economic contraction experienced in 1997 and 1998 was severe, with the Gross Domestic Product contracting sharply. More seriously the impact of the crisis has caused higher employment and lowered the standard of living, which in some cases led to social instability.

Conversely, the recovery of the troubled economies from the crisis was very rapid. In 1999, most of the affected economies had not only stabilised their economic contraction, but had in fact registered reasonable growth rates. For example, the Malaysian economy is expected to grow by 4 – 5% in 1999 while the growth rate for South Korea is anticipated to be higher. Foreign capital has flowed back into the region, some of the affected economies are enjoying strong export performance and their currency exchange rate volatility has stabilised.

Since most of the affected economies received assistance from the IMF, they have embraced similar recovery strategies: implemented tight fiscal and monetary policies, floated the exchange rate and initiated reform and restructuring measures. The initial tight fiscal and monetary policies were later relaxed to boost domestic economic activities. In reviving its economy, Malaysia, on the other hand, has taken a slightly different path from the other affected countries when it introduced the selective capital controls in September 1998. It has institutionalsed its recovery efforts by establishing a central agency, the National Economic Action Council, to formulate, implement and monitor the measures to revive the economy. In addition, during the recovery process Malaysia limits foreign participation to areas that meet with its overall liberalisation targets.

The objective of this paper is to analyse and to draw some lessons from the Malaysian recovery strategies. Section 2 reviews the impact of the crisis on the Malaysian economy. Section 3 analyses Malaysia’s response to the crisis while Section 4 discusses the recovery of the Malaysian economy. The concluding part, Section 5, evaluates the Malaysian recovery strategies.


  1. Impact of the Crisis on the Malaysian Economy

While the Malaysian economy was in a relatively strong position when it entered the East Asian crisis, it could not escape the economic and financial implosion. As a result, the Malaysian economy experienced its deepest recession and the Gross Domestic Product (GDP) contracted by 7.5% in 1998. The economy was still buoyant in 1997 with GDP growth of 7.7% and the impact of the crisis only began to be felt in the first quarter of 1998 when the GDP declined by 3.1% as shown in Table 1. The severest contraction occurred in the third quarter of 1998 when GDP fell by 10.9%.

The severe contraction was due to a combination of several things: the deflationary impact of the regional crisis, massive capital outflow, public sector expenditure reduction and tight monetary policy. Since East Asian countries constitute about 50% of Malaysia’s export market, economic recession in these countries seriously cut the demand for Malaysian exports. Furthermore, the sharp currency depreciation of other East Asian countries affected by the crisis provided stiffer competition to Malaysian exports. The massive outflow of the short-term foreign capital, particularly from the equity market, drastically reduced the funds available to Malaysian companies, thus forcing many to reduce their business activity

The sharp contraction of the Malaysia economy in 1998 was caused by the collapse of aggregate demand by 20.3%. This fall came from three components: public consumption and private consumption and investment. Public consumption fell by 7.2% while private consumption fell by 7.5%. However, the single most important cause for the contraction in aggregate demand was the 50.5% fall in private investment, which was triggered by the lack or higher cost of funds, excess capacity and the expectation of decreasing consumption.

In terms of sectoral performance, it was not a surprise that the construction sector suffered the worst because of over-investment made during the period of high growth (1987 to 1997) that resulted in massive excess capacity. GDP in this sector shrank by 28% and 29% in the third and fourth quarters of 1998 respectively. The manufacturing sector also recorded a severe decline: the contraction in the second half of 1998 of 18.7%. The agriculture sector experienced a relatively mild contraction (- 4.5%) when compared to the construction and manufacturing sectors. Even the services sector was not spared –in the second half of 1998 the sector’s output dropped by 3.5%.

At the onset of the crisis, when regional currencies were under the pressure to devalue, Malaysia tried to defend the ringgit but it found this strategy unsustainable and costly. On July 14, the ringgit was floated and subsequently the ringgit exchange rate slipped from RM2.50 to US$1 prior to the crisis to its lowest level of RM4.88 on January 7, 1998.

The equity market, not surprisingly, was among the worst affected sectors when the Kuala Lumpur Stock Market when it lost 80% of its market valuation. From a high of RM917 billion in February 1997 the market valuation sank to RM 182 billion in September 1998 when the selective capital controls were imposed. This drop was reflected in the movement of the KLSE composite index, which fell from 1271 points to 262 points during the same period.

The sharp depreciation and the subsequent pegging of the ringgit and the robust US economy have contributed significantly to the commendable performance recorded by Malaysia’s external sector in 1998. In nominal ringgit terms, total exports grew by 29.8%, with palm oil registering the highest increase of 64.4%, followed by manufactured goods (32.2%) and crude petroleum (6.2%). Exports of liquefied natural gas (LNG) decreased by 4.4% due the lower demand as a result of economic downturn in two of its major export markets – South Korea and Japan. The almost doubling of palm oil price has enabled this commodity to enjoy exceptional growth rate while the recovery of demand for electronic goods (partly to meet the Y2K requirement) has allowed manufacturing exports to register a double-digit growth. However, when valued in USD terms, exports declined by 2% in 1998.

Malaysia’s large merchandise balance of RM 69 billion (USD 18.2 billion) in 1998 was achieved not only from high export growth but also from the collapse of imports. Sharply dampened consumer demand and low investment have reduced the demand for imports - total imports only grew by 3%. Due to the strong performance of the merchandise account balance, the balance on goods and services has reversed its deficit trend that was prevalent during the 1990-1997 period into a surplus of RM 46.7 billion in 1998. The merchandise account surplus of RM 69 billion was more than sufficient to offset the RM 22.3 billion deficit from the services account.

In 1998, RM 10.6 billion worth of long-term capital flowed into Malaysia, a reduction of about RM 9 billion over the 1997 inflow. Not unexpectedly, the short-term capital account showed a substantial net outflow of RM 21.7 billion due to the decline in net external liabilities of the commercial banks and the liquidation of portfolio investments by foreign investors. The lower net external liabilities by commercial banks is in response to the stagnation in domestic demand and the unwinding of trade-related hedging activities. The short-term capital outflow stabilized in the fourth quarter following the implementation of the one-year holding period for portfolio investment in Malaysia effective 1 September 1999. Even with this large short-term capital outflows, Malaysia managed recorded a very strong balance of payment position with surplus of RM 40.3 billion, partly due to the substantial surplus in the merchandise account.

The crisis has created strains on the banking system. High interest rate and the collapse of the stock market have raised non-performing loans (NPLs) of financial institutions to a level that was considered threatening. Prior to the crisis, financial institutions’ NPLs was 4% in 1997 but they had jumped to 15.8% in August 1998. Higher cost of financing and tighter liquidity has discouraged private investment. The cost of fund for investment increased substantially when the base lending rate rose from 10.3 % in June 1997 to 12.3% in July 1998: in some cases the effective interest rate had reached a high of 20%.

Fortunately, the crisis did not pushed the inflation rate to a very high level as observed in some other crisis-hit countries. In 1998, the inflation rate rose to 5.3%, doubled that of 1997. The highest price increases were among food items.

As with inflation, the unemployment problem did not reached a critical level; in 1998 the rate of unemployment was 3.2%, compared to 2.5% for 1997. The presence of a large group of immigrant workers has absorbed the severe employment impact of the economic recession and many of them left Malaysia for their home countries and thus mitigated the problem of high unemployment.


  1. Response to the Crisis

3.1 The Early Response

As with other affected countries, Malaysia adopted the orthodox approach to such a crisis, namely tightened fiscal and monetary policies, introduce measures to redress the balance of payment weakness, and floated the exchange rate. The government had announced a 3% surplus for the 1998 budget. Among the budgetary measures introduced were a 20% reduction of government’s expenditure, deferment of mega projects and cutbacks on the government purchase of foreign goods. On the financial aspect, a comprehensive set of measures were implemented such as reclassifying the NPL in arrears from six to three months, greater financial disclosure by financial institutions and increasing general provision to 1.5%. A credit plan was also introduced to limit the overall credit growth to 25% by end-1997 and 15% by end-1998, where priority was given to productive and export-oriented activities. The Bank Negara Malaysia (the central bank) had also raised the three-month intervention rate from 10% to 11%, increase the minimum risk-weighted capital adequacy ratio from 8% to 10% and reduce single customer limit from 30% to 25%. The level of provisions against uncollateralised loans was also increased to 20%.

With respect to measures to strengthen the balance of payment position, a target was set to reduce the current account deficit from 5% to 3% of the Gross National Product in 1998. Stricter criteria were also introduced for new reverse investments while higher import duties were imposed on selected items such as automobiles.

These initial policies did not produce the expected results. The fiscal reduction of 20% and the deferrment of some infrastructure projects severely contracted domestic demand. In addition, the tight monetary policy stance of higher interest rate and credit tightening increased the cost of funding and starved domestic firms of funds at a reasonable cost. As a result, the domestic economy continued to deteriorate and the exchange rate remained volatile.

3.2 National Economic Action Council

The Malaysian government established the National Economic Action Council (NEAC) on 7 January 1998 as a consultative body to the Cabinet to deal with the economic problems inflicted by the crisis. The purpose of the NEAC is to formulate an integrated strategy to overcome the crisis and restore the Malaysian economy back onto its growth path. The Council consists of 26 members of economic Ministers and representatives from various fields of the private sector and selected organisations, and is chaired by the Prime Minister. The Council is assisted by an EXCO chaired by the Prime Minister to evaluate strategies and measures to revive the economy as well as to monitor the progress made. The EXCO is supported by the Executive Director who heads a Working Group and he is responsible for formulating the measures needed to restore the economy. The structure of the NEAC is shown in Figure 1.

In late July 1998 the NEAC launched the National Economic Recovery Plan (NERP) which recommends wide-ranging proposals for economic stabilization, recovery and structural reform. The Plan stipulates six objectives namely,

Objective 1: Stabilizing the Ringgit

Recommends an exchange rate regime that provides flexibility but reduces volatility, reduce over–dependence on the US dollar, and a balanced interest rate policy.

Objective 2: Restoring Market Confidence

Improves the regulatory environment and transparency and consistency of government’s policies. It also recommends improving public relations and dissemination of economic information.

Objective 3: Maintaining Financial Market Stability

Preserves the integrity of the banking system by closer surveillance of banks and the improvement of non-performing loans (NPLs), encouraging bank mergers, and addressing worsening collateral and non-performing assets. For this purpose, the government established the asset management company, Danaharta, to take over the bad debts of bank, and a special purpose vehicle, Danamodal, to recapitalise banks. There are measures to monitor credit expansion in the economy, improve the capital market and develop the private debt securities market.

Objective 4: Strengthening Economic Fundamentals

Proposes that the government embark on a policy of fiscal expansion to boost domestic growth. In addition, suggestions were also made to improve competitiveness.

Objective 5: Continuing the Equity and Socio-Economic Agenda

Continues commitment to the equity and socio-economic agenda of reducing poverty and improving quality of life in order to lessen the pain associated with the financial crisis.

Objective 6: Revitalising Affected Sectors

Recommends measures to assist the twelve sectors that were adversely affected by the crisis.

There are six thrusts to the Malaysian recovery measures:

3.3 Fiscal Policy

Since the private sector was unable to spur growth during the crisis period, the public sector has to take the initiatives to generate economic activities by increasing its consumption and investment. For this purpose, the budget stance was reversed from a surplus of 3.2% of the GNP in 1998 to a deficit of 6% in 1999. Additional development expenditure of US$1.8 billion was allocated for agriculture, low and medium-cost housing, education, health, infrastructure, rural development and technology upgrading. The fiscal stimulus programmes concentrated on infrastructure projects and an Infrastructure Development Fund (US$ 1.6 billion) was formed to finance essential projects.

3.4 Easing the Monetary Stance

The earlier tight monetary policy has resulted in a liquidity crunch, with high interest rate and reduced availability of credit. For the economy to stabilise and grow, there must be sufficient liquidity and a reasonable level of interest rate, which will allow companies to borrow again and resume their activities. The measures introduced include:

3.5 Reform and Structure the Financial and Corporate Sectors

The depreciation of ringgit has had an adverse effect on the banking sector. Many companies, including large corporations that have borrowed from the banks were unable to repay loans. As a consequence, banks are unable to provide sufficient funds to finance business activities. Thus, Asset Management Company (Danaharta) was set up to manage the non-performing loans (NPLs) of financial institutions. Its main objective is to remove the NPLs from the balance sheets of financial institutions at fair market value and to maximise their recovery value. This will free the banks from the burden of debts that had prevented them from providing loans to their customers.

As the capital base of banks has been affected by the decline in share prices and NPLs, these banks need to be recapitalised. For this purpose the Special Purpose Vehicle (Danamodal) was set up to capitalise and consolidate the banking sector, i.e., to inject capital into banks facing difficulties. The injection of capital will enhance the resilience of banks, increase their capacity to grant new loans and consequently speed up the economic recovery process.

To complement the restructuring of the financial system by Danaharta and Danamodal, the Corporate Debt Restructuring Committee (CDRC) was set up in August 1998 to facilitate debt restructuring of viable companies. The aim is to minimise losses to creditors, shareholders and other stockholders; avoid placing viable companies into liquidation or receivership and; to enable banking institutions to play a greater role in rehabilitating the corporate sector. The CDRC devises constructive and market-approach based to enable creditors and debtors to devise and implement workout plan without resorting to legal procedures. It also brings together all interested parties to assist the progress of all corporate debt restructuring.

3.6 Stabilisation of the Ringgit

Malaysia’s response to the East Asian crisis created some controversy when it implemented the selective capital controls measures on 1 September 1998. The selective capital controls have two inter-related parts: first the stabilization of the ringgit and second the restriction on the outflow of short-term capital. Stability of the currency is guaranteed by pegging the ringgit to the US dollar at a rate of RM 3.80 to US$ 1.00. For the fixed exchange rate system to work, the outflow of short-term capital flows had to be controlled. Specifically the measures are:

Thus, the capital control measures affect the transfer of funds among non-residents via non-resident external accounts, import and export of ringgit by travellers (both residents and non-residents) and investment abroad by Malaysian residents. Similarly, non-residents are restricted from raising credit domestically for purchase of shares. Non-resident portfolio investors are required to hold their investment for at least twelve months in Malaysia.

Another measure that significantly affects portfolio investors requires all dealings in securities listed on the KLSE were to be affected only through the KLSE or through a stock exchange recognized by the Malaysian authority. Consequently, trading of the 112 Malaysian companies on the Central Limit Order Book (CLOB), an over-the-counter market in Singapore was discontinued by the Singapore Stock Exchange.

The selective capital controls was modified effective February 15, 1999 where the quantitative control (the requirement that proceeds from the sales of ringgit asset be kept in the country for one year) was replaced by a price based regulation. The aim is to enable foreign short-term investors to estimate the cost of investment in Malaysia. This easing of capital control contains two parts:

(a) For capital that was brought in before February 15, 1999, a levy is imposed on the principal at the following rates:

  1. For capital that was brought in after February 15, 1999, a levy is imposed on the profits made at the following rates:

Further relaxation was introduced on 21 September 1999 on the exit levy - the two-tier system was reduced to a flat rate of 10% on profits repatriated.

However, capital controls do not impede current account transaction (trade transaction for goods and services), repatriation of interest, dividend, fees, commissions and rental income from portfolio investments and other forms of ringgit assets and FDI inflows and outflows (including income and capital gains).

3.7 Liberalisation

Realising the contribution that foreign capital could make to the recovery of the economy, the Malaysian government had liberalised selected sectors where it is comfortable with foreign presence and it can maximise the gains from foreign capital injection:

Prior to the crisis, there was a 30% limit on foreign ownership in telecommunications, stock-broking and insurance industries.

3.8 Corporate Governance

The crisis highlighted the need to strengthen corporate governance. It is a much more difficult and lengthy process than the other measures introduced. More importantly, it requires the political will and commitment to guarantee that the corporate governance framework that was developed is fully and effectively implemented. Malaysia has adequate laws and regulations to govern its public and private sectors. However, additional measures were introduced to further strengthen the governance environment as well as to strive for a more effective execution. The additional measures are:


  1. Recovery of the Malaysian Economy

The Malaysian economy started to grow strongly in the second quarter 1999, when it expanded by 4.1% and the third quarter growth of 8.1% marked the end of the recession. The recovery, in fact, started in the first quarter of 1999 when the economy contracted by only 1.3%. Growth actually began in February and March 1999, averaging 1.4%, but this was obscured by a sharp contraction in January 1999, so that the overall growth in the first quarter was negative. Other indicators of recovery include:

Three institutions were established to restructure and reform the financial and corporate sectors. Danaharta was established to purchase the non-performing loans (NPLs), Danamodal to recapitalize financial institutions while the Corporate Debt Restructuring Committee is to assist corporate sector restructuring.

a) Danaharta

Danaharta, an asset management company was established in June 1998. Danaharta has successfully completed the first phase of its mandate — to deal with NPLs - and had acquired a total of RM 23.1 billion NPLs, amounting to 31.8% of the total NPLs in the banking system. The level of NPLs in the banking sector has been significantly reduced to 12.4%. The NPLs purchase was completed in 6 months, much faster than the original time target of one year. Financial institutions have had to take losses from the sales. The average discount rate for NPLs was 57%. The second stage of Danaharta operation is asset management. This is a very critical phase because Danaharta has to balance a number of objectives – not to warehouse the NPLs, maximise recovery value, not to depress market prices when it sells the assets, and provide a return to Danaharta’s capital.

b) Danamodal

Danamodal has injected RM6.4 billion into 10 financial institutions, pre-empting any potential systemic risks to the financial sector. As a result, the capital adequacy ratio of the banking system was increased to 12.7%.

The capital injection was accompanied by absorption of losses by shareholders through reduced shareholding in the institutions, change in the composition of the boards of directors and/or change in the management. Danamodal has also appointed their representatives in the recapitalized institutions to ensure that these institutions are managed prudently and efficiently as well as to institute changes that will strengthen these institutions.

c) Corporate Debt Restructuring Committee (CDRC)

The CDRC has shown some progress, but restructuring of the corporate sector remains slow. The CDRC seeks to assist the companies to restructure without government support. Progress has been slow because the process needs agreement of all creditors. Banks, in particular, have been reluctant to settle without full repayment. Negotiations have therefore been long because even disagreement from one creditor will jeopardize the whole process.

Malaysia has moved to another stage of the restructuring process – it is now undertaking a merger exercise of financial institutions. As at 31 January 2000, the 54 financial institutions have submitted plans to the Central Bank for approval to merge into 10 banking groups. Each of the banking groups may offer a complete range of financial services in addition to its not commercial banking services such as merchant banking, fund management and stock-broking services. Plans are also underway to consolidate the stock-broking industry to create strong, efficient and competitive stock-broking companies. These initiatives are consistent with the earlier plan of financial sector restructuring, which was announced at the beginning of the crisis and the financial sector master plan is being formulated for this purpose.

One of the dire predictions of the selective capital controls was that there would be a massive foreign capital outflow at the end of the 12-month locking-in period, namely on 1 September 1999. However, the 1 September 1999 deadline was a non-event with only an outflow of USD 800 million, which was well below the estimated outflow of USD 5-7 billion. Nevertheless, the stock market performance has been lacklustre – the KLSE index moved downwards from a high of 870 points in July 1999 to about 700 points at the end of September 1999. The KLSE, however, made strong gains in the first few weeks of the year 2000 because foreign institutional fund came in to take a position before the reinstatement of Malaysia in the MSCI index in May 2000.

5. Evaluation of the Malaysian Response to the East Asian crisis

In 1999, Malaysia as well as all the other crisis-hit East Asian economies have rebounded sharply. The South Korea’s economy is expected to grow by 6.8% in 1999 while Taiwan, Singapore and Thailand’s growth rate will range between 4-5%. Indonesia, which experienced the worst economic recession, is estimated to grow by 3% in 1999. In addition, the exchange rates of the IMF-assisted countries have strengthened, their interest rates have been lowered and current account positions have improved. The equity markets in these countries have also rebounded and in some countries – South Korea and Singapore – the markets have now exceeded their pre-crisis level.

As other crisis-hit economies have also recovered, some with very dramatic recovery such as South Korea, it is important to evaluate the Malaysian policies as some of the measures differ from those taken by the other countries. In particular, the selective capital controls measures were regarded as controversial and many still question their benefits. For example, the IMF concludes that it is unclear whether the selective capital controls measures did make a significant contribution to the Malaysian recovery process. Would any other developing countries confronted with a similar situation impose the same set of measures? Can the Malaysian experience provide some valuable lessons for a small open economy to mitigate the adverse impact of a financial crisis?

Perhaps, the evaluation of the Malaysian recovery policies can best be answered by asking a series of questions:

The IMF-type measures were supposed to restore market confidence, which would stabilise the economy and the exchange rate. When this expectation failed to materialise, Malaysia was forced to re-examine these policies and to find alternative solutions. The search for new measures started with the examination of the underlying conditions of the Malaysian economy. The fiscal position is strong because of the surpluses generated when the government reduced its expenditure and investment after the implementation of the privatisation policy. The private sector has become the engine of growth but this resulted in a high level of private sector domestic debt. Under such a situation, it was not appropriate for the public sector to reduce its expenditure as prescribed by the IMF-type policy but instead it should assume from the private sector the role of the engine of growth and increase its consumption and investment to expand the domestic economy. Furthermore, the high interest rate level was choking businesses and the tightening of credit had caused a liquidity crunch. In order for businesses to continue their activities and for the domestic economy to expand, liquidity must also be restored.

Malaysia could afford expansionary fiscal and monetary policies. The savings from the balanced and surplus fiscal policy during the five years before the prior has substantially augment the public sector financial resources, which was needed for fiscal stimulus programmes. There are also adequate domestic private savings through a scheme of compulsory savings (the Employees Provident Fund) as well as voluntary ones (such as insurance). These funds could be mobilised to for investment that will spur economic activities. Moreover, because of its low level of official borrowings the Malaysia government could seek international official financial assistance to finance its programmes of domestic expansion. Savings by the banking sector that was placed with the central bank in the form of a statutory reserves requirement can be used to inject liquidity into the banking system.

The shift towards expansionary fiscal and monetary policies was initiated in the first quarter of 1998 but it could only be effectively implemented after the acceptance and launching of the National Economic Recovery Plan in the middle of 1998. The frequently asked questions about the Malaysian recovery measures include:

For the fiscal stimulus programmes to work and for interest rates to be lower without jeopardising the ringgit exchange rate, it is imperative that Malaysia regains its monetary policy independence. In some ways, Malaysia was in a unique position in terms of effectiveness of its monetary policy because of the existence of active securities and ringgit offshore markets. Without the restrictions on the repatriation of short-term capital and the banning of securities trading outside the KLSE, the liquidity injected in the domestic economy by fiscal stimulus programmes and lowering of the statutory reserves requirement would have flowed out of the country and made the recovery policy ineffective. In addition, interest rates could only be lowered without depreciating the currency if the link between interest and exchange rates is severed because the floating of the exchange rate has reinforced the association between the two variables.

The selective capital controls also had an important implicit objective, namely to renew domestic confidence that has been battered by the crisis. Revival of domestic confidence is vital for the resumption of domestic economic and business activities and foster social stability. With the pegging of the ringgit, domestic producers were able to restart production because exchange rate uncertainties have been removed. After making necessary adjustments, most businesses could operate at any exchange rate levels as long as there is some degree of stability. Multinational companies, which import most of their inputs and export all their products, faced no foreign exchange risks when the ringgit exchange rate is fixed. As a result, the business community welcomed the fixing of the ringgit exchange rate. In an ethnically diverse society such as Malaysia, social and economic stability is critical to growth and development and thus the threat of a conflict among the various ethnic groups arising from an economic slowdown must be avoided. By insulating the economic from further deterioration and stabilising the ringgit, the government has managed to revive domestic confidence, thus averting any serious social dislocation.

The selective capital controls is regarded as a temporary measure and Malaysia still has to deal with the issue of its future exchange rate regime. Economic recovery and a fixed exchange rate have encouraged short-term capital inflow into the equity market. The prevailing excess liquidity and the low interest rate have attracted investment in the equity market and large gains were recorded in the KLSE over the last few months. A large foreign capital inflow will exert an upward pressure on the pegged ringgit as foreign investors are expecting to make a double gain from a raising stock market and an appreciated ringgit. This raises the question of an exit strategy from the selective capital controls without adversely impacting the economy.

The general argument against capital controls is that it is more difficult and costly to introduce such measures in an economy where there is extensive trade and investment links. The fixing of the exchange rte will lead to a misallocation of resources. Trade will normally suffer, causing the country to experience balance of payment difficulties. However, the dire consequences anticipated by the critics of the selective capital controls did not materialise and this can be attributed to three reasons: first, the ringgit was pegged at a level where it was "undervalued"; second, the measures made a clear distinction between short- and long-term capital; and third, they were skilfully implemented. Presently, there is no signs that the pegging of the ringgit has caused misallocation of resources.

The inflow of international capital into Asia from the end of 1998 has allowed the pegged ringgit to remain competitive as other regional currencies appreciated. The "undervalued" ringgit gives Malaysian export a price edge, resulting in a double-digit export growth in 1999. Consequently, Malaysia recorded large trade surpluses and as the selective capital controls require export proceeds to be brought back into the country, this has increased liquidity in the economy and revived domestic consumption. Strong export performance has attracted resources to this sector because it has the best growth prospect. In addition, Malaysia has very few protected industries that can benefit from a fixed exchange rate. As such there is no evidence as yet of resources misallocation. The "undervalued" ringgit has acted as a deterrent to a high import growth during the recovery period, thus further strengthening the balance of payment and international reserves position. As a result, the improvement in the current account position and the accumulation of the reserves are considered among the biggest achievement of the capital controls.

The Malaysian capital control measures restrict only short-term capital, which is normally invested in the equity market, but it continues to encourage the inflow of FDI. Investment in equity market can easily leave the country if current sentiment changes but FDI are investments in the manufacturing sector, with longer gestation period and closer linkages to the domestic economy. The separation between short- and long-term capital was essential for the recovery of the Malaysian economy because the selective capital controls did not deter the inflow of long-term foreign capital.

The "soft management" of the capital controls has prevented the creation of a black market for the ringgit. At the early stage of the introduction of the selective capital controls, the Bank Negara Malaysia had ensured that there was adequate supply of foreign currencies to meet any increase in demand and this move has calmed the market and has created confidence among the general public. The procedures for approval for remittance of funds are transparent and Malaysia has the institutional capability and capacity to implement the measures effectively. Another aspect of the skilled management of the measures was the flexibility showed in responding to feedback from the market. for example, the replacement of the rule on the twelve-month holding period for proceeds from sales of Malaysian securities with the exit levy was made after consultation with market players.

The selective capital control measures implemented by Malaysia are not without costs. When the international capital returned to the region from the fourth quarter of 1998, Malaysia missed most of the capital inflow as reflected by the steep recovery of the equity markets of other crisis-hit countries. The administrative costs of the capital controls can deter many investors. Thus in the period of recovery, Malaysia may face some difficulties in attracting short-term capital because it costs more to invest in Malaysia as compared to other countries that do not impose a tax on capital flows (or profit). Another aspect of the costs concerns the issue of policy consistency – there are concerns that a similar policy can be reintroduced without prior warning. This can contribute to a higher international risk premium for Malaysia, which translate to higher funding costs. However, up to the present the benefit of the selective capital controls have out-weighted the costs.

Malaysia is an ethically diverse country, with delicate social and political balance. The stability of the country is very much dependent on its ability to expand the economy to meet its restructuring and distribution objectives as set out in the New Economic Policy. Thus, the Malaysian society may not be able to absorb severe economic contraction. Furthermore, to be beneficial, any restructuring efforts must also take into account the national socio-political economic dimension. For example, if Malaysia were to close any financial institutions, it would create a massive loss of confidence, which could lead to social instability. Similarly, selling the assets of troubled companies at low prices to foreigners is also unacceptable because it involves the issue of the distribution of equity ownership among the various ethic groups. Hence, the Malaysian economy has managed to recover with its social cohesion intact. Furthermore, the majority of financing needs for the recovery process was obtained from domestic resources, thus avoiding the problem of a high external debt.

Like other affected economies, Malaysia has taken serious efforts to restructure its financial and corporate sectors. NPLs were taken out from the banking system and troubled financial institutions were recapitalised. To complete the restructuring process, there is a plan to expedite banks merger to transform them into efficient, institutionalised and well-capitalised banking groups. Likewise, there are plans to consolidate stock-broking companies. The progress in the corporate restructuring is slow but measures are being formulated to expedite this process. However, the insulation from external pressures has allowed Malaysia to postponed some of the needed corporate sector restructuring, where excess capacity is still not clear and the problem is expected to be solved by the economic recovery. Similarly, Malaysia’s strong export performance is just based on price advantage, unlike some other affected countries that have undergone restructuring too increase productivity and competitiveness.

Analysts often associate successful economic reforms and restructuring with the existent of pain and foreign participation. In Malaysia, the restructuring process has involved pain at various levels - losses by shareholders of troubled financial institutions when they were recapitalised by Danamodal; sharing of losses by owners of loans when they were purchased by Danaharta at a steep discount; companies facing bankruptcies; and loss of income when workers are retrenched. The recovery measures of expanding the domestic economy and easing of monetary policy have, to some extent, lessened the pain. In fact, the revival of the equity market has enabled many companies to raise fund and solve their problems.

The crisis has shown that short-term capital flows, which is expected to grow even larger, can determine a country’s economic performance. Short-term capital flow is determined both by a county’s economic fundamentals as well as market confidence. In a situation of uncertainties, market perception over-rides economic fundamentals and as a results, a country with strong fundamentals can also suffer from a flight of capital. In such a situation, it is perhaps imperative to minimise the liquidity to exit until such a time that market confidence has returned. Thus, selective capital controls should be viewed as a measure to calm the market and allow the country to put a brake on the path of economic destruction. However, countries must strengthen their fundamentals because capital controls can only give a temporary relief and the medium- and long-term growth prospects will only be determined on the basis on fundamentals.

In conclusion, Malaysian recovery measures were formulated after evaluating its domestic circumstances, with the aim of reviving the economy without weakening its fundamentals. However, the recovery process must be used to further restructure and improve the economy to ensure that it can move to a higher level of development.


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