KEY ISSUES Near-term outlook. Malaysia’s healthy, noninflationary growth continued in 2013, albeit at a somewhat slower clip than earlier years. While domestic demand remained robust, the economy was buffeted by external headwinds, including from volatile capital flows in spring-summer and weak export growth. The current account surplus continued to narrow, although it remains comfortably in surplus. Continued strength in domestic demand, especially investment, and a pickup in external demand should help maintain robust growth going forward despite the welcome fiscal tightening. Macroeconomic policy mix. Staff welcomes the timely, credible, and gradual recalibration of macroeconomic policies, which should help achieve a smooth transition to the post-UMP environment. The budget is being tightened and fiscal institutions strengthened. Bank Negara Malaysia (BNM), which maintains an accommodative monetary stance for now, possesses ample policy credibility and should be able to contain any second round price effects associated with fuel subsidy reductions. Fiscal policy breakthrough. Amidst concerns about Malaysia’s public finances and a sharp narrowing of the external surplus in spring-summer, the authorities took timely action to secure fiscal sustainability and assure markets. Staff welcomes the comprehensive and gradual approach to fiscal adjustment, which includes subsidy rationalization, broadening of revenue bases, and the strengthening of the social safety net. It urges the authorities to persevere in their efforts to rebuild fiscal buffers, improve the management of contingent liabilities, and address ageing-related fiscal challenges. Financial stability. Malaysia’s financial system is sound, supported by strong supervision and regulation. Targeted, yet escalating macroprudential policies (MAPs) are being employed to deal with the risks from high rates of credit growth and rising household debt. These risks, as well as the effectiveness of MAPs, should continue to be closely monitored. The exchange rate remains flexible and, together with Malaysia’s ample financial buffers and sound monetary and fiscal policies; should safeguard the economy from potentially volatile capital flows. Inclusive growth: the role of human capital. The authorities have designed and are implementing several ambitious transformation programs and blueprints to turn Malaysia into a high-income, knowledge and innovation based nation by 2020. Their efforts are on track, although skills mismatches need to be addressed through intensified human capital development efforts. Progress in education, as outlined in the Malaysia Education Blueprint, 2013-2025, is a high priority. This will call for achieving stronger performance in education in a tighter budgetary environment.