Public Information Notice No. 04/27

Public Information Notice: IMF Concludes 2003 Article IV Consultation with Malaysia

March 24, 2004

On February 9, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Malaysia.¹

Background

Following a slowdown in early 2003, economic activity is recovering strongly. In the first half of 2003, real GDP growth slowed to 4½ percent (year-on-year), and unemployment edged up to 4 percent, reflecting the adverse impact of the global slowdown, the Iraq war, and the SARS outbreak on private domestic demand. Private consumption and investment growth decelerated visibly; and the service sector weakened. Most macroeconomic indicators turned favorable starting in the third quarter of 2003. Real GDP accelerated to around 5 percent (year-on-year), reflecting a strengthening domestic demand, and the unemployment rate declined to 3½ percent. Growth in services rebounded, while that of agriculture and industry remained strong. Monthly CPI inflation, which averaged about 1 percent in 2003, has remained subdued. More recently, industrial production growth has accelerated further (11¾ percent, year-on-year, in November).

The trade and current accounts strengthened in the first half of 2003. Export growth remained robust at 7 percent (year-on-year) despite the global slow down, while imports declined moderately by about 1½ percent (year-on-year). Tourism receipts fell sharply, mainly due to SARS. The capital account also weakened, recording a deficit of about US$2.75 billion compared with a deficit of around US$2.5 billion in the second half of 2002. Increased public debt repayments and lower net foreign direct investment inflows, due in part to the one-off acquisition of foreign interests in the oil and gas sector by a Malaysian company, have more than offset reduced portfolio and other short-term outflows. Gross international reserves rose by about US$2.5 billion to US$37 billion.

The trade and current account balances continued to strengthen in the third quarter of 2003. Imports further declined by about 5¾ percent (year-on-year), while export growth slowed to about 1¾ percent (year-on-year), and service receipts rose in line with the rebound in tourism receipts. The capital account also strengthened, reflecting higher foreign direct investment (FDI) and portfolio flows, offsetting continued public debt repayments. Both exports and imports rose by 36 percent, year-on-year, in December, bringing the trade balance surplus to about US$24.25 billion for 2003 (compared with US$18 billion in 2002). External debt declined (to 50¼ percent of GDP in the third quarter of 2003), and the debt-service ratio remained low (at only about 6 percent of exports of goods and nonfactor services). Gross international reserves reached US$44.9 billion at end-2003, equivalent to 5½ months of prospective imports of goods and nonfactor services.

Market sentiment has improved markedly. Equity prices have risen since May 2003, reaching a three-year high in November. Sovereign spreads have narrowed to less than 100 basis points in early December, and Standard & Poor has maintained Malaysia's sovereign ratings at A- since its early October 2003 upgrade.

An expansionary fiscal policy has continued to support economic activity. Preliminary estimates available in early February indicate that the federal government deficit for 2003 may have been slightly above the revised budget target (5.4 percent of GDP)², following the adoption in May 2003 of an economic stimulus package (ESP). Both revenues and expenditures exceeded their nominal annual targets by about 4 percent. The consolidated public sector deficit is projected to double to 1¾ percent of GDP in 2003, providing a positive fiscal impulse to the economy. The ESP also included off-budget lending programs equivalent to 1½ percent of GDP on an annualized basis (60 percent of which channeled through development financial institutions (DFIs). The gross debt of the federal government and the nonfinancial public sector (projected to reach 48 and 67 percent of GDP in 2003, respectively) is high but manageable. Federal government debt carries a low debt service (11¾ percent of fiscal revenue in 2002). Debt of the nonfinancial public enterprises (NFPEs) is owed mostly by the three largest NFPEs (Petronas, Tenaga, and Malaysia Telecom), whose capacity to repay is sound. Contingent liabilities at 6¾ percent of GDP in 2002 are mostly related to bank restructuring.

The 2004 budget signals a return to a path of fiscal consolidation in line with the expected recovery. The federal government deficit is targeted to decline to 3½ percent of GDP in 2004, with the consolidated public sector balance envisaged to shift to a small surplus (¼ percent of GDP). The 2004 budget also provides for off-budget lending programs amounting to ½ percent of GDP, down by one-third from 2003. About half of the lending programs are to be channeled through DFIs. The improvement in both the federal government and the consolidated public sector balances in 2004 is projected to result from reductions in development expenditures, while current expenditures in relation to GDP continue to rise moderately. The budget contains several tax changes and incentives, but their net fiscal effect is basically neutral and the federal government revenue is expected to remain broadly unchanged as a share in GDP. The government has also announced a plan for the deficit to decline to 1¾ percent of GDP in 2005, before reaching balance in 2006.

The projected economic recovery and strict implementation of fiscal plans for 2003 and 2004 should help substantially reduce the burden of public sector debt. More specifically, based on the targeted turnaround in the consolidated public sector deficit to a surplus in 2004 and the projected acceleration in GDP growth, public sector debt is expected to decline to about 63 percent of GDP in 2004 and to lower levels over the medium term. However, the historical trend continues to indicate that public sector debt has been growing at a faster pace than implied by the net financing requirements of the consolidated public sector reflecting—in part—operations not captured by the consolidated accounts, including the acquisition of public assets and the assumption of debts by the federal government.

Monetary management has been prudent, and consistent with maintaining the fixed exchange rate regime while providing adequate liquidity. BNM reduced its intervention rate by ½ percentage point to 4½ percent in May 2003 as part of the ESP, leading to a ¼ percentage point decline in lending rates. The spread between KLIBOR and LIBOR has remained at about 2 percentage points since September 2001. Together with improved economic fundamentals, this has helped reduce capital outflows and contributed to the rise in international reserves since mid-2001. Owing mainly to the impact of rising foreign reserves, base money has increased since end-2002. Broad money growth has also accelerated, reflecting rising private sector credit.

The ringgit exchange rate does not appear to be substantially misaligned. Despite a sizable depreciation in the last year and a half, the ringgit REER remains close to its long-term trend, and supported by relatively strong fundamentals. In addition to a large current account surplus, a comfortable level of reserves, and low inflation, Malaysia has a relatively sound financial system, manageable external debt, and is gradually diversifying its economy. Malaysian export market shares in Europe, Japan, and the U.S. have been broadly stable, while rising in the rest of Asia.

Significant progress has been made in reforming the financial and corporate sectors, developing capital markets, and enhancing the business climate. Bank soundness has continued to improve, and implementation of the Financial Sector Master Plan is proceeding. Net nonperforming loans (NPLs) (based on a three-month classification) have declined steadily to about 9 percent of total loans at end-November 2003 (from 10¼ percent at end-2002). The aggregate risk-weighted capital adequacy ratio, at 13 percent, is robust. In 2002, a legislative framework for the regulation and supervision of DFIs was introduced. All corporate debt cases registered for the voluntary out-of-court restructuring process (about RM 53 billion or 18½ percent of 1998 GDP) have been resolved and most of the agreed debt workouts have been implemented. The overall financial health of the corporate sector shows some improvements, but the full benefits of restructuring have not yet fully materialized. It is encouraging, however, that loans restructured by Danaharta (the asset management company) have so far performed satisfactorily, with only 4 percent falling more than 60 days overdue. Important advances were also made in enhancing corporate governance and implementing the Capital Markets Master Plan, particularly on improving infrastructure and enhancing the regulatory and legal framework. Steps have also been taken to liberalize foreign equity participation and foreign exchange regulations. The labor market remains highly flexible overall. However, skills mismatches—evidenced in part by the recent rise in unemployment of university graduates—and shortages pose concerns.

Executive Board Assessment

Executive Directors congratulated the authorities for Malaysia's strong economic performance and their skillful and prudent macroeconomic management. Following a slowdown in the first half of 2003, the economy is recovering strongly, and is well placed to benefit from the ongoing global upturn, with the medium-term prospect being favorable. Directors welcomed the continued strength of the trade and current accounts, the reduction in capital outflows, the rise in gross official reserves, and the continued progress toward public and external debt sustainability.

Directors observed that Malaysia's pragmatic approach to macroeconomic policy has been instrumental in increasing the resilience of the economy to external shocks, and creating the conditions for a sustained recovery. In particular, Directors supported the authorities' policy objective of balancing short-term domestic demand stimulus with a return to the path of medium-term fiscal consolidation. Directors welcomed the prudent management of domestic credit expansion, and the continued progress in structural reform. Directors noted that the financial position of the corporate sector has improved owing to the progress that has been made in corporate restructuring.

With the economy now recovering, Directors strongly supported the government's renewed commitment to fiscal consolidation starting in 2004, and the objective of balancing the federal government budget by 2006 in the context of a coherent medium-term fiscal framework. Directors stressed the importance of monitoring closely tax revenue performance and further exploring ways to rein in the growth of nonwage operational expenditures. Directors welcomed the recent steps taken to reduce noncore investment spending, and encouraged the authorities to persevere in their efforts to streamline the public investment program. Directors recommended that the authorities look into the scope for reining in the recent increases in expenditures on subsidies and transfers, while ensuring that an adequate social safety net remains in place to protect the most vulnerable groups. They welcomed the authorities' intention to review, in due course, the potential for enhancing the efficiency and efficacy of the tax system.

Directors noted that further efforts to enhance fiscal transparency would help ensure a successful medium-term fiscal consolidation and facilitate the assessment of fiscal sustainability. In particular, they encouraged the authorities to disseminate more detailed information on the fiscal costs of exemptions and implicit subsidies, and on the quasi-fiscal expenditures of the nonfinancial public enterprises. The government was encouraged to look into the scope for further divestment from major corporations. Directors supported the authorities' ongoing efforts to improve the prudential supervision and regulation of the development finance institutions, and encouraged them to move to incorporate their funding within the formal budget process. They welcomed the progress achieved in reconciling public debt data and financing flows and the improvements in the fiscal accounts, and recommended that these efforts be supported by a fiscal ROSC.

Directors supported Bank Negara Malaysia's prudent approach to managing domestic credit consistent with maintaining the exchange rate peg. Improving market sentiment toward Malaysia's sovereign bonds, together with a sustained interest rate differential in favor of Malaysia, has contributed to lower net capital outflows and helped to strengthen Malaysia's international reserve position. Directors welcomed the authorities' intention to bring forward the liberalization of interest rates, which should help enhance competitiveness in the financial system, and the actions taken by the authorities to ensure that the move will not be disruptive.

Directors agreed that Malaysia's fixed exchange rate system has served the economy well, and continues to be supported by strong fundamentals. They supported the authorities' approach to gradually liberalize the remaining administrative measures on capital flows and the trade and investment regimes. Against this background, many Directors supported the authorities in maintaining the exchange rate peg and some Directors saw no convincing case to reconsider the peg at this time. At the same time—and with a forward-looking perspective—many other Directors thought that a move toward greater exchange rate flexibility would be beneficial for Malaysia if it were well prepared, pursued from a position of strength, and carefully sequenced. Such flexibility would help to manage risks associated with capital flows, alleviate the burden of adjustment on fiscal policy to deal with shocks, and facilitate adjustment to structural changes in the economy.

Directors commended the progress made in strengthening the banking system and the government's continued commitment to financial sector reform. The financial system is well capitalized, and the exposure of finance companies has been reduced through their links with broader banking groups. Directors noted that further voluntary bank consolidation would help raise the sector's efficiency and resilience. Elimination of remaining restrictions on operations of foreign banks would help to enhance competition in the financial sector. Directors supported the planned adoption of a deposit insurance scheme in line with best practices, and further enhancements in the supervisory and regulatory framework.

Directors noted that boosting competitiveness will be key to sustaining high growth in the near and medium term. In that connection, Directors welcomed efforts being taken to address skills shortages through an expansion of tertiary education and training programs, as well as measures to lower the cost of doing business. They encouraged the authorities to further enhance the business climate, while maintaining a liberal trade and investment regime and undertaking progressive liberalization in the services sector. Directors supported ongoing efforts to develop capital markets, including by widening the retail and institutional investor base for domestic securities, strengthening further corporate balance sheets, and further enhancing corporate governance.

Directors commended Malaysia's progress in developing its framework for anti-money laundering and combating the financing of terrorism, and looked forward to Malaysia's accession to the UN convention on the Suppression of Financing of Terrorism.