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p. 25 of 69 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia Southeast Asia Cambodia Indonesia Lao People's Democratic Republic Malaysia Myanmar Philippines Singapore Thailand Viet Nam South Asia Central Asia The Pacific III. Foreign Direct Investments in Developing Asia

Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia : Southeast Asia

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Malaysia

GDP growth exceeded forecasts in 2003, supported by solid expansion in manufacturing and strong demand for exports. With still faster growth expected in 2004, the economy should be able to reduce its reliance on government spending. The major concern is low rates of capital formation, as both foreign and domestic investment are below levels needed to sustain strong economic expansion.

Economic Assessment

In 2003, the economy extended and deepened the recovery that took hold in 2002, with GDP growth picking up to 5.2%. Consumption continued to be the main driver of demand growth, contributing 3.5 percentage points to the overall GDP strengthening. Private consumption rose by 5.1% and public consumption by 7.9% as the Government raised its spending. Net exports contributed 2.0 percentage points to the expansion in GDP. Gross fixed capital formation grew by 2.7% in the year, accounting for 0.8 percentage point of growth. Total investment actually declined by 0.9%, due to a drop in inventories.

On the production side, industrial output rose by 7.0% and accounted for 2.9 percentage points of GDP growth. Manufacturing increased by 8.2% as the global economic recovery accelerated in the second half of the year to lift demand for electronics goods, the county’s major export. Agriculture posted strong growth of 5.5%, of which 4.1 percentage points were generated by a 12.1% rise in crude palm oil production. Given higher world commodity prices in 2003, the nominal value of palm oil exports surged by 36.3% to RM20.2 billion, and agricultural products’ share of exports rose from 6.5% in 2002 to 8.4% in 2003. Services grew by 4.4%, as the damage done by the regional SARS outbreak to the tourism and retail sectors faded in the second half.

The Government had aimed to reduce its budget deficit in 2003, but the SARS-induced problems and weak international demand in the first half caused it to change course and adopt a policy of aggressive fiscal stimulus. A fiscal package announced in May included tax incentives for investment and consumption, directed lending programs, and extra public spending. The package cost the Government $1.7 billion, or nearly 2.0% of GDP, but helped keep the recovery on track. The 2003 budget deficit came in at 5.3% of GDP, considerably wider than the original target of 4.0%.

Economic growth was also lifted by an accommodative monetary policy, as interest rates remained low despite the wide budget deficit. The monetary policy of Bank Negara Malaysia (BNM) remained anchored to the ringgit-dollar peg. During 2003, the market began to see an upside risk for the ringgit, leading to large purchases of dollars by the central bank and a buildup in foreign reserves. Though the resulting expansion in the ringgit money supply was partially sterilized by BNM, narrow money (M1) still increased by 14.6% and broad money (M2) by 11.1% over the year. The accumulation of foreign reserves was the main source of money supply growth because credit from banks and other lending institutions grew by only 4.8%. Interest rates fell modestly in 2003; in May, BNM cut its intervention rate by 50 basis points to 4.5%, and at year-end the rate on 1-year treasury bills was 2.8%, down slightly over 12 months. The banking sector continued to strengthen its financial position, with NPLs at commercial banks declining to 6.4% from 7.4% (defining NPLs as loans that have been nonperforming for 6 months).

As a result of the ringgit’s peg to the weakening dollar, the domestic currency declined by 6.0% against a trade-weighted basket of currencies, improving the country’s export competitiveness after 2 years of ringgit appreciation. Inflation remained tame, despite the ringgit’s depreciation and the money supply growth. Consumer price inflation slowed to 1.2%; the small rise was mainly due to a modest rise in food prices. The producer price index rose by 5.7% because of increases in petroleum products and other commodities.

On the external side, the improvement in the global economic environment in the second half of the year, coupled with the ringgit’s depreciation, led to a doubling of growth in merchandise exports to 12.4%. Shipments to most traditional major markets grew in the 7-10% range, according to customs data, while exports to India jumped by 43.9% and to the PRC by 29.6%.

Imports rose modestly by 5.4%, with most of the growth attributable to a late surge in imports of capital and intermediate goods. Imports for consumption rose by only 1.1% for the year, and made up only 5.9% of the total. The trade surplus widened sharply to $25.7 billion from $18.1 billion in 2002. The current account surplus soared to $13.4 billion, or 13.0% of GDP, nearly double the 2002 level, and was reflected in a sharp increase in net official foreign reserves to a record $44.9 billion. The buildup in reserves was reinforced by a rise in portfolio investment resulting from renewed interest by international investors in Asian equities, and the apparent undervaluation of the ringgit. External debt was little changed at $49.3 billion at end-2003, equivalent to less than 48% of GDP.

FDI approvals in 2003 rose by $1.1 billion to $4.1 billion, though the increase was entirely due to two large planned investments by United Arab Emirates firms, including an aluminum smelting facility in Sarawak. Gross FDI inflows rose to $5.7 billion in 2003 from $5.4 billion in 2002. Net FDI declined slightly to $1.1 billion, primarily due to a buyout by a Malaysian company of foreign stakes in an energy sector joint venture (Figure 2.9).

Policy Developments

Economic performance in 2003 was built upon expansionary fiscal and monetary policies, as well as strong demand for exports. A revival of investment is required to provide a more sustainable foundation for stronger economic growth, though the Government did unveil some new measures in this area in 2003, including a liberalization of FDI regulations and a relaxation of previous ethnicity-based ownership restrictions (but full implementation of that sensitive decision has been slow).

If the economy is to reach its estimated potential growth rate of 6.5-7%, the Government needs to secure improvements in productivity and competitiveness, stimulate investment, and upgrade technology and work force skills. This is increasingly important as the PRC and India become greater competitors for FDI, and because they already offer much larger domestic markets and considerably lower unit labor costs, particularly in labor-intensive manufacturing sectors. (At the same time, the rise of these large regional neighbors presents significant opportunities for Malaysian businesses.) Public investment is expected to fall by 4.2% a year in 2004 and 2005 as the Government trims its fiscal deficit. Sharp increases in private investment are needed to make up for this decline, given the dependence of the economy on government capital spending in the past 5 years.

There are two main challenges to overcome if investment is to reach the levels needed to support sustained higher growth. First, considerable improvement is needed in the investment climate, including a reduction and eventual elimination of regulatory barriers to business operations. Examples include tariff and nontariff trade barriers, privileges that have been granted to bumiputras, and lingering restrictions on capital flows. A shift to higher value-added sectors would also require stricter enforcement of intellectual property rights. Although the legal foundation exists for these rights, court enforcement of laws has been inadequate. Improvement in the investment climate will also require further sustained action to combat corruption.

Second, further progress in implementing key structural reforms will be essential. A privatization program review recently initiated by the Government-under which sales of controlling stakes in state enterprises are being postponed while independent consultants review the procedures and plans for future sales-could be a positive step if it results in a more transparent, competitive, and efficient process. If Malaysian companies are to continue growing into global competitors, they need greater exposure to market forces and competition, both domestic and foreign, and a more open privatization process would contribute to achieving that goal. Opening more sectors to foreign investment would also help attract capital and technology.

Some long-anticipated privatizations were deferred in 2003. A decision to publicly list Felda, a large state-owned palm oil producer, was announced in September, but then indefinitely postponed when the Government said it needed more time to assess the impact of such a move on plantation settlers who own more than half of the land managed by Felda. Other anticipated privatizations are still pending, such as those of water utilities, most of which need additional capital.

An expected cut in the corporate income tax rate to stimulate investment was put on hold in 2003 because of the fiscal pressures, and the plan to reduce the budget deficit in 2004 and 2005 makes it unlikely that this measure will be implemented in the near future. In another policy change, the Government decided in November 2003 to impose high excise taxes on imported cars to maintain protection of domestic manufacturers, even though AFTA-mandated cuts in automobile tariffs were implemented. This sent a signal that protection of some manufacturing sectors is going to continue for some time. Proton, the major beneficiary of that decision, has performed poorly in recent years, and any incentive for it to improve itself was harmed by this decision. The excise tax rates are effective for 1 year, so the decision on whether to extend them beyond 2004 will provide the Government with another chance to consider its policy in this area.

In contrast to such protectionists efforts, BNM moved to open the financial system when it lifted restrictions that had forced foreign banks to raise at least 50% of their banking credit from domestic banks, so prompting some foreign banks to consider expanding their Malaysian operations.

Corporate restructurings are entering a new phase, as the work of the state agencies established to manage problem assets is nearing completion. Danaharta, the Malaysian asset management agency, achieved 75% of its key recovery target of RM30 billion, and expects to complete this task in 2005. The Corporate Debt Restructuring Committee ended its operations in late 2002. Danamodal Nasional Berhad was closed at the end of December 2003, having strengthened commercial bank balance sheets through the injection of RM7.6 billion during its 5 years of operations. Malaysia will now rely more on market-based restructurings, including mergers and acquisitions and bankruptcy, which require a strong legal and corporate governance framework. BNM issued new regulations to improve such governance in the banking sector, including guidelines governing the functioning and composition of banks’ boards of directors. A new deposit insurance plan is being prepared and is expected to be implemented in 2004.

The changeover to a new prime minister on 31 October was smooth and the new leader took some decisive steps-including canceling a controversial RM14.5 billion railway proposal and cracking down on corruption-which were generally well received by the business community.

Outlook for 2004-2005

The improved economic performance of 2003, coupled with moves toward greater transparency in government decisions and a stronger anticorruption stance, has created favorable conditions for 2004. GDP growth is forecast to edge up to 5.8%, with strong export demand and private consumption projected to counteract the planned decline in government spending. In 2005, growth is forecast to slow slightly to 5.6%, due to further fiscal tightening.

The projections assume 12-15% growth in private investment, including increases in FDI of about $1 billion a year, offsetting the planned cuts in public investment but not generating a significant improvement in the ratio of gross capital formation to GDP. Better investment outcomes, which would be possible if policy is focused on investment-promoting initiatives, offer the opportunity for higher than projected economic growth.

The Government is targeting a reduction in the fiscal deficit to 3.3% of GDP in 2004, with revenues projected to increase by 7.2%. A planned 1.6% reduction in expenditures will be more difficult to achieve, although the Government’s decision to hold elections early in the year, and avoid an extended period of politically driven budget decisions, is encouraging in this regard. Planned cuts in the development budget are already deep, but further modest cuts may be possible if necessary. The Government aims to further narrow the 2005 budget deficit to 1.8% of GDP, and balance the budget the following year. Under any plausible growth projections this will require significant further spending cuts.

In the past year, as the dollar fell against most currencies with floating exchange rates, pressure has gradually built on BNM to consider a more flexible exchange rate and allow the ringgit to appreciate against the dollar. The rise in portfolio investment inflows into Malaysia, fueled by the market view that the ringgit is undervalued, is likely to reinforce this. Upward pressure on the ringgit will be contained, though, by a likely accommodative monetary policy in the context of low inflation and a narrowing fiscal deficit.

Interest rates are expected to remain at their current low levels, although a further reduction in the BNM intervention rate cannot be ruled out if growth falters. Inflation will probably not rise above 2.0% in the coming 2 years, but moderate increases are possible.

With world economic growth expected to strengthen further in 2004, the outlook for exports is positive. They are likely to expand by 8-10% in 2004, which would be a solid result after the strong improvement in 2003. Imports are also expected to grow by 8-10%. As the US continues to be the major export market, prospects would be undermined if the US economy unexpectedly hit a flat patch because no other market is yet positioned to take up this slack. The Government seems determined to stimulate domestic demand to reduce the economy’s exposure to external changes, though this will be a difficult goal in a period of fiscal consolidation. With indications that growth in the PRC may slow by 2005, and given the ripple effects that would be created in Malaysia’s other markets if the US and the PRC both slowed, external risks pose the main threat to the economy in the coming 2 years.

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