Public Information Notice: IMF Concludes Article IV Consultation with Malaysia
September 8, 1999
|Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.|
On July 7, 1999, the Executive Board concluded the Article IV consultation with Malaysia.1
Since early 1997 the Malaysian economy has been caught up in the regional financial crisis. The spread of the crisis to Malaysia was reflected, initially, in sharp falls in Malaysian share prices and the external value of the ringgit. Through the second half of 1997, fiscal and monetary policy were tightened with the aim of restoring stability and confidence in financial markets, as well as containing the impact on inflation of the depreciation of the ringgit. Despite these measures, however, equity prices and the exchange rate continued to weaken. By the end of 1997, the ringgit had depreciated 35 percent from its year-earlier level, while the Kuala Lumpur Stock Exchange composite index was down 52 percent.
In Malaysia, as elsewhere in the region, the financial crisis has had a much more severe impact on economic activity than expected. Sharp declines in business and consumer confidence, both reflecting and contributing to falls in asset prices (including property prices), led to a pronounced contraction of consumer and investment spending by early 1998. The slump in spending and asset values also led to severe difficulties in the financial sector as financial institutions were simultaneously faced with rising nonperforming loans and capital losses. These problems, in turn, contributed to increasingly cautious lending practices, amplifying the contraction of domestic spending. As a result, domestic absorption fell by 26 percent in real terms in 1998. The decline in domestic demand was also reflected in a fall in imports, leading to a dramatic turnaround in Malaysia's external current account balance from a deficit of around 5 percent of GDP in 1997 to a surplus of 13 percent of GDP in 1998. Overall, real GDP declined by 6.7 percent in 1998. The weakness in domestic demand also limited the rise in inflation arising from the depreciation of the ringgit. As a result, the 12-month CPI inflation rate rose from a little over 2 percent prior to the crisis to a peak of 6.2 percent in mid-1998, before declining to 5.3 percent by the end of the year.
As the evidence began to emerge in 1998 of the sharpness of the economic contraction and the deterioration in the health of the financial system, the Malaysian authorities began to refocus policy toward supporting activity and strengthening the financial system. In the period from March through August, measures taken included the partial reversal of earlier cuts in government expenditure, interest rate reductions, and the establishment of entities to restore financial system health through recapitalization and the purchase of nonperforming loans.
In September 1998, the government introduced capital controls and pegged the exchange rate of the ringgit to the dollar, in order to insulate domestic interest rates from continuing pressures and volatility in the foreign exchange market. These measures were followed by interest rate reductions as well as more direct measures aimed at stimulating credit growth, an expansionary government budget, and accelerated implementation of the financial and corporate sector restructuring program. In February 1999, the capital controls were modified with the replacement of the one-year holding period restriction on portfolio capital flows with a system of exit levies.In 1999, as elsewhere in the region, there have been increasing signs in Malaysia of a pickup in economic activity. Improved economic prospects appear to have been reflected in stabilizing property prices and a significant recovery in equity market prices. Inflation has also fallen, to a little under 3 percent, as the effects of the earlier depreciation of the ringgit have worn off. Progress in restructuring the financial sector has been significant. Malaysia's external current account position remains in substantial surplus, and foreign exchange reserves have strengthened to over $30 billion, equivalent to approximately seven months of imports of goods and services.
Executive Board Assessment
Executive Directors noted that, although the Malaysian economy had been severely affected by the regional crisis, its traditional strengths, including limited external debt, a strong fiscal position, a well-developed financial regulatory framework, and a history of low inflation, had helped Malaysia to avoid more extreme financial difficulties. Moreover, these same strengths should facilitate a sustainable economic recovery.
Directors recalled that the policy measures introduced in September 1998 to promote economic recovery had initially been viewed with considerable skepticism internationally. In particular, there had been concerns that the breathing space offered by the adoption of capital controls and the pegging of the exchange rate might lead to a delay in addressing problems in the financial and corporate sectors.
Directors therefore commended the authorities for using the breathing space well, to push ahead with a well-designed and effectively implemented strategy for financial sector restructuring. They recommended that the authorities move to the next stage of the restructuring process in the banking system and corporate sector, which would help to sustain market confidence. With regard to macroeconomic policies, Directors supported the authorities' adoption of an expansionary stance, which they considered appropriate to reverse the sharp contraction of economic activity, particularly in view of the absence of inflation pressures.
As regards fiscal policy in the short term, Directors recommended that, if the pace of output recovery appeared to falter, the authorities should be prepared to implement additional budgetary measures. If tax revenues turned out to be stronger than anticipated, a number of Directors indicated that the authorities could consider some temporary tax relief or higher operating expenditure to ensure that their deficit target is achieved. While welcoming the various measures taken by the authorities to speed up the use of budgetary allocations and expedite project implementation, a few Directors also cautioned against overreliance on large projects with long gestation periods. Directors encouraged the authorities to continue to give high priority to enhancing social expenditures in order to mitigate the impact of adjustment on the most vulnerable groups of society.
For the medium term, most Directors emphasized the desirability of introducing greater flexibility in fiscal policy in order to be able to respond more rapidly to changes in economic conditions. More specifically, while commending the authorities for their emphasis on maintaining fiscal discipline, Directors saw a case for pursuing operating surpluses over the course of the business cycle rather than on an annual basis. Directors' other recommendations for the medium term included the introduction of a value-added tax to improve the efficiency of the tax system. Directors stressed the importance for fiscal transparency of incorporating all off-budget and quasi-fiscal activities in the overall assessment of the fiscal stance, including public sector assistance for financial restructuring.
With a view to helping monetary policy achieve its aim more effectively, most Directors recommended modification of the structure of administered interest rates to make them more responsive to developments in market-determined rates and to financial institutions' risk assessment. They also recommended avoidance of bank-by-bank credit targets, and the use of more responsive and market-based monetary policy instruments. A few Directors considered, however, that it is too early to judge whether the interest rate structure has constrained the growth of private sector activity.
Directors noted that the pegging of the exchange rate to the U.S. dollar had been positive for the economy, so far, while observing that the undervaluation of the exchange rate had implications for the inflation outlook over the medium term. Some Directors considered that the current monetary framework, based on a currency peg, was more appropriate for Malaysia than one based on a more flexible exchange rate, as it provided a clearer nominal anchor for inflation expectations. Many other Directors, however, recommended that serious consideration be given to developing a monetary policy conducive to a sustained low inflation environment, combined with a more flexible exchange rate regime that would help insulate the economy from external shocks. Clearly, this was a key issue that needed to be kept under review.
Directors broadly agreed that the regime of capital controls--which was intended by the authorities to be temporary--had produced more positive results than many observers had initially expected. They welcomed the pragmatic and flexible way in which Malaysia had implemented and adjusted the controls, notably by replacing the quantitative restrictions on the repatriation of portfolio investments by an exit levy in February 1999. A number of Directors expressed support for the authorities' intention to maintain the control measures while preparing for an orderly exit from these controls. A number of other Directors, however, were more skeptical about the decision to impose capital controls, as they felt that the costs, in terms of an adverse impact on the prospects for recovery, may become more visible in the future. They therefore recommended that the authorities remove the exit levy applied to profits on portfolio investments. These Directors also considered that, since Malaysia is in a position of strength, an early exit would help to boost investor confidence in Malaysia and attract long-term capital.
Directors noted that the crisis had exposed some vulnerabilities in the economy, as well as a need for greater policy flexibility in responding to unanticipated economic and financial developments. They commended the authorities for the improvements they had made in the prudential and supervisory framework for the financial system, and stressed that continuation of the financial system reforms and corporate sector restructuring will help to support the recovery process. Directors therefore welcomed the progress made in relieving the banking system of nonperforming loans (NPLs) and in providing needed capital to viable institutions in the banking system. They stressed the need to dispose quickly of acquired NPLs and to consider the sale of government stakes in recapitalized institutions. To reinforce corporate restructuring efforts, Directors recommended more transparency in guidelines for debt workouts under the Corporate Debt Restructuring Committee, a proper balancing of creditor and borrower interests in the process, and a clearer linkage of debt workouts to operational restructuring of concerned corporations.