IMF Executive Board Concludes 2005 Article IV Consultation
with MalaysiaPublic Information Notice (PIN) No. 06/30
March 20, 2006
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 March 13, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Malaysia.1
In recent years, Malaysia's economic performance has been robust, underpinned by prudent macroeconomic management and structural reform. In 2005, economic conditions were generally favorable. After a slowdown in the first half, real GDP growth rebounded and is estimated at 5¼ percent. Buoyant private consumption, together with a recovery in private fixed investment, more than offset lower government spending. Although headline inflation rose due to administered price adjustments, core inflation remained subdued.
Malaysia's external position and its resilience to shocks strengthened further in 2005. The current account is estimated to have exceeded 14 percent of GDP, while reserves are sufficient to cover 6 months of imports and four times short-term external debt by remaining maturity. Other indicators also point to low external vulnerability. Foreign direct investment continued to recover in 2005, while earlier portfolio inflows were reversed as expectation of exchange rate appreciation receded. At the same time, foreign exchange regulations were eased further.
Since the exit from the exchange rate peg on July 21, 2005, the ringgit continued to appreciate slowly against the US. dollar, with a cumulative appreciation of 2½ percent. The Bank Negara Malaysia has raised its policy interest rate twice by 55 basis points since last November, but the monetary stance remains accommodative.
Fiscal consolidation is expected to have met the 2005 budget target. The federal government deficit is likely to have declined to 3¾ percent of GDP and the surplus of the consolidated public sector to have stabilized at about 4 percent of GDP, aided by large nonfinancial enterprises' surpluses resulting mainly from high world oil prices. Nevertheless, Malaysia's reliance on oil and gas revenue remained high, as evidenced by the sizable federal government non-oil primary deficit estimated at 7 percent of GDP. Sluggish corporate tax revenue and an overrun in current spending due to rising fuel subsidies contributed to this outcome. Public sector gross debt is expected to have dropped to below 60 percent of GDP at end-2005.
Financial sector soundness continued to strengthen and the implementation of financial sector reform advanced. The banking system's capital adequacy remained strong and asset quality improved. Supervision frameworks were refined and a new deposit insurance system was successfully introduced. Measures were also taken to open the financial system to foreign competition.
Better liquidity indicators point to lower vulnerability of the nonfinancial corporate sector, but profitability measures are still weak by historical and regional standards. The government's efforts in advancing corporate sector reform are focused on Government-Linked Companies (GLCs). The extensive GLC reform program is aimed at achieving better profitability, performance, and corporate governance in GLCs. Efforts to improve the investment climate have also been made, including by streamlining business approval procedures and land administration.
Executive Board Assessment
Executive Directors commended the authorities for their skillful, pragmatic, and fully owned stance of sound macroeconomic policies which, combined with continued structural reforms, have helped further strengthen Malaysia's economic position. Economic growth has remained robust, unemployment is low, the external current account surplus has increased substantially, and the consolidated public sector balance has moved to a large surplus, due mainly to higher profits of the national oil company. Directors observed that the near-term outlook is generally favorable, with expectations that recovery of private investment and domestic consumption will drive a broad-based expansion. The downside risks stem mainly from the effects of continued high oil prices on trading partners' demand for Malaysia's exports.
Directors complimented the authorities for the smooth exit of the ringgit from its peg to the U.S. dollar. Directors considered this to be a vital first step toward greater exchange rate flexibility, and encouraged the authorities to utilize the flexibility afforded by the change in the exchange rate regime. This should facilitate smooth adjustment to structural changes and broader-based growth in Malaysia, and contribute to a shared effort aimed at an orderly resolution of global imbalances. They accordingly welcomed the authorities' commitment to allow the exchange rate to be determined by economic fundamentals, and the Bank Negara Malaysia's intention to pursue an intervention policy aimed at reducing exchange rate volatility while avoiding sustained one-sided intervention. Directors acknowledged that the estimation of equilibrium exchange rates is inherently imprecise, and accordingly encouraged the staff, in dialogue with the authorities, to continue to analyze the appropriate value of the ringgit, and its impact on the Malaysian economy.
Directors had an extensive discussion of the appropriate framework for monetary policy going forward in light of Malaysia's exit from the exchange rate peg. They agreed that the maintenance of price stability should remain the primary objective of monetary policy. Most Directors noted that the focus on using interest rates to achieve the authorities' primary policy objective of price stability, with due consideration given to economic growth, has served Malaysia well, and welcomed in this context the recent increases in the overnight policy rate, along with steps being taken to enhance communication to promote greater understanding by markets and the public of monetary policy objectives to anchor inflation expectations. Most Directors felt that the current framework is sufficiently flexible to accommodate greater exchange rate flexibility going forward, provided communication on monetary policy objectives and policy formulation continues to be enhanced, including by publication of a measure of core inflation at the same frequency as the monetary policy statements.
Directors noted that strong fiscal revenues from oil and gas production have improved markedly the position of the consolidated public sector. Nevertheless, a continued gradual reduction of the federal government deficit is needed. Directors recommended raising the efficiency of the tax system, including by introducing a revenue-neutral value-added goods and services tax, and by streamlining tax incentives. On the expenditure side, fuel subsidies should be phased out, to be replaced with well-targeted support for the most-affected poor. Directors welcomed the recent substantial increase in retail fuel prices, which will reduce budgetary pressures and encourage more efficient energy use.
Directors agreed on the usefulness of setting in place a medium-term fiscal framework to sustain the federal government deficit reduction efforts and safeguard Malaysia's oil and gas wealth for future generations. In that connection, they recommended that consideration be given to the establishment of a petroleum fund that would be fully integrated into the budget, and supported by clear rules regarding the deposit and withdrawal of hydrocarbon revenues into and out of the fund. The petroleum fund would also help ensure effective governmental oversight of the operations and assets of the national oil company, which will be a key element of the fiscal consolidation effort.
Directors considered that the financial sector is sound, and welcomed the decline in nonperforming loans and strengthened capital adequacy ratios in the banking system. They recommended that efforts be continued to strengthen financial sector surveillance, especially with respect to lending to households and small and medium-size enterprises, and over the growing Islamic banking sector. Directors noted that enhanced risk management capabilities have placed domestic banks on a stronger footing to compete with foreign banks. In that regard, they welcomed the plans to lift gradually the restrictions on foreign participation in the banking sector, beginning in 2007.
Directors underscored the importance of deepening structural reforms to maintain the recovery of private investment, enhance economic efficiency, and sustain growth over the medium term. They supported the authorities' emphasis on enhancing the investment climate, upgrading human capital, and reforming government-linked companies. They recommended that the social obligations and privileges of GLCs be reduced in order to allow them to be run on a fully commercial basis, and to open up new fields for private sector initiatives. Directors welcomed the recent efforts to improve governance, public service delivery, and the quality of and access to tertiary education.