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p. 29 of 77 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. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia : Southeast Asia

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Malaysia

After recording strong growth in 2004, expansion will slow somewhat over 2005-2007. Robust private domestic demand will spur activity as external demand eases and the Government cuts spending. Challenges include achieving fiscal consolidation without abruptly slowing growth, maintaining FDI inflows, and reforming government-linked companies.

Macroeconomic assessment of 2004

Led by robust expansion in consumption spending, the economy accelerated to its fastest pace in 4 years in 2004. From a SARS-induced low base in 2003, growth picked up to 8.0% in the first half, with a combination of strong external and domestic demand outweighing a reduction in fiscal stimulus. As the benefit of the low base faded, growth slowed to 6.7% in the third quarter and 5.6% in the fourth. For the year as a whole, the economy grew by 7.1%.

Consumption spending, bolstered by strong household outlays, contributed 5.7 percentage points to GDP growth. Public investment bore the brunt of the fiscal consolidation, though a recovery in private investment was sufficient to keep total investment growth in positive territory; total investment contributed 3.8 percentage points to growth. Net exports subtracted 2.4 percentage points (Figure 2.9).

Exports expanded strongly in the first half, owing to the recovery of the global economy and the electronics cycle, before slowing in the second. Given the high import content of manufactured exports, import growth of 25.8% outpaced exports’ 20.5%. This resulted in a trade surplus of $26.8 billion in 2004. The current account surplus remained sizable, at 12.5% of GDP, underpinning a healthy balance-of-payments position. FDI increased to $4.7 billion in 2004 from $2.5 billion in 2003. Supported by the higher current account surplus and capital inflows, international reserves soared to $66.7 billion, a near doubling over 2 years.

By sector, the expansion was broad based. Manufacturing showed the greatest momentum for the second consecutive year, at 9.8%. Construction was the only major sector recording a contraction, of 1.9%, hurt by the cuts in public investment. Mining output climbed by 4.1%, shored up by higher production of crude oil, in turn supported by strong external demand and high prices. In agriculture, crude palm oil and rubber continued to perform well, while forestry production increased in response to higher demand from wood-based industries, bringing overall sector growth to 5.0%.

Strong consumption spending, tourism, and trade-related activities continued to fuel the services sector, which rose by 6.6%, particularly the transportation, storage, and communications subsector (8.4%) and the wholesale and retail trade, and restaurants and hotels subsector (7.1%). A better stock market performance, plus increased demand for bank loans and insurance, underlay 6.5% growth in the finance, insurance, real estate, and business services subsector.

With no need for further pump priming in 2004, the Government tightened fiscal policy. The budget deficit as a share of GDP narrowed to a 5-year low of 4.1%, or below the official target of 4.5%. To reduce external debt exposure, the bulk of the Government’s funding requirement was sourced domestically, which did not crowd out private investment because liquidity remained ample. Total outstanding federal government debt came down marginally to the equivalent of 46.6% of GDP at end-September from 47.8% a year earlier.

Monetary conditions were accommodative for a seventh straight year in 2004. The ringgit remained pegged to the US dollar and interest rates were kept stable at historically low levels. Year-on-year loan growth, mainly consumer credit, picked up to 8.5% in December from 5.3% in July.

Many companies opted to use internally generated funds and tap the capital markets, such that corporate borrowing was flat. Because of aggressive sterilization operations by Bank Negara Malaysia, the rise in monetary aggregates--M3 grew by 12.4% in December--was sustained at a level consistent with the pace of real economic activity.

The asset quality of the banking system continued to improve. A slowdown in new NPLs, better loan recovery, bad debt write-offs, and a widening loan base brought down the net NPL ratio of the banking system, based on 6-month arrears, to 5.9%, the lowest level since the 1997-98 Asian financial crisis. Also, the banking institutions’ risk-weighted capital ratio, at about 13.7%, was much higher than the Basle minimum requirement of 8%.

Constrained by fuel-price subsidies and price controls, Malaysia’s inflation rate in 2004--an average of 1.4% over the year--was the lowest in Southeast Asia. Demand pressures were generally benign, but cost pressures, reflected in higher food prices and transport charges, nudged up inflation from 1.2% in May to a 5-year high of 2.1% in December. Job creation outstripped additions to the workforce, and the unemployment rate fell to 3.5% from 3.6% in 2003. However, under- and unemployment among university graduates remain a problem.

Spared the worst of the Asian tsunami, the economy is likely to feel only a slight impact because key industries and infrastructure were left unscathed. The knock-on effect from countries more seriously affected by the tsunami will also be limited.

Macroeconomic policy developments

The Government has focused on providing infrastructure and an enabling environment for businesses to compete globally. This focus involves laying out a reform agenda to fight corruption, improving the delivery of government services, reducing red tape, helping improve efficiency, and lowering the cost of doing business. Efforts are being made to limit broader fiscal risks by reforming the government-linked corporations (GLCs). The new administration has moved away from huge, prestige projects to smaller ones that have a higher multiplier effect. It is also putting greater emphasis on diversifying sources of growth into sectors such as services and agriculture.

Preventing an excessive buildup in liquidity remains the key challenge for the central bank. The strong current account position, the inflow of foreign direct and portfolio investment, and strong tourist receipts have sharply pushed up foreign reserves. Most of these inflows have been sterilized, as indicated by the limited rise in base money relative to the upsurge in reserves. As of mid-December, the central bank had absorbed an estimated RM130.6 billion from the banking system, mainly through interbank borrowings.

On the exchange rate front, strong economic fundamentals, marginal misalignment against regional currencies, and narrowing interest-rate differentials between domestic and US interest rates suggest little pressure on the ringgit peg. Despite that, and while the ringgit peg arguably offers an environment of stability against the background of volatile global foreign exchange markets, a shift to a basket peg with a more flexible rate may put the economy in a better position in the event of serious exchange rate corrections and could help manage excess liquidity. The longer the peg is maintained, the larger the adjustment and the associated costs are likely to be upon exit.

With the banking system having recovered from the Asian financial crisis, Danamodal, the agency established during the crisis to recapitalize financial institutions, was closed in early 2004. The Corporate Debt Restructuring Committee, established to help corporate debt resolution, had already been closed in late 2002. Danaharta, the national asset management agency, is on track to cease operations by the end of 2005.

Signaling a shift to a more market-driven approach to interest rate determination, a new interest rate framework was introduced with the overnight policy rate replacing the 3-month intervention rate as the policy benchmark.

Legislation was amended to allow mergers of commercial banks and finance companies within the same banking group, in order to improve operational efficiencies. This cleared the way for five such mergers in 2004. Another significant development was the acquisition by Temasek Holdings, Singapore’s state-owned investment company, of a substantial stake in Alliance Bank, evidence that Malaysia is gradually opening its financial services to foreign participation. Taking a step toward greater bilateral trade and economic cooperation, the Singapore and Malaysia securities exchanges agreed to jointly develop a cross-trading link, which will increase liquidity and access to capital.

The major challenge for fiscal policy is to rein in the deficit in the medium term without derailing economic growth, through a focus on projects with high returns, low-import content, and strong industrial linkages. This would involve small projects awarded to Malaysians in areas such as agriculture and rural development. Deficit reduction is being carried out on two fronts, by cutting spending and by improving revenue-collection efforts through improved compliance. Other steps include a gradual reduction of subsidies on gasoline and diesel fuels, and in the longer term, changes to the tax structure. A goods and services tax is proposed, starting in January 2007, to broaden the tax base.

To improve their efficiency and profitability, the GLCs were put under the oversight of Khazanah, the Government’s investment corporation, which will revamp their operations so as to turn them ultimately into market-driven entities. This will involve further board and management changes and the introduction of key performance indicators, such as fixed-term contracts and performance-linked compensation for management. Privatization, another strategy aimed at improving economic efficiency, has slowed, but the reform of the GLCs may be initial steps in preparing some for divestment in the future.

Outlook for 2005-2007 and medium-term trends

A slowing global economy in 2005 implies an easing of growth for Malaysia because the economy remains vulnerable to the global economic slowdown and to the technology down-cycle. (Exports as a share of GDP increased to 114% in the fourth quarter of 2004 from 97% in 1995, and the share of electronics exports in total manufactured exports increased to 49% during the first 3 quarters of 2004 from 39% in 1995.) To diversify the economic base away from overreliance on external trade, the Government has been encouraging domestic demand and providing tax incentives and funding for new growth areas, such as education, tourism, and ICT.

Forward-looking indicators also suggest a softening in growth in the first half of 2005. The rise in the leading composite index, which suggests business activity 6-9 months ahead, slowed sharply to 3.8% in December 2004 from 15.4% in March 2004. The Malaysian Institute of Economic Research’s forward-looking business conditions and consumer sentiment indexes also fell in the fourth quarter of 2004.

Still, the downturn in the electronics cycle is expected to be mild and brief, so that by the second half of 2005 the economy will likely have recovered momentum. GDP growth for the year is forecast at a respectable 5.7%. With slower growth in external demand and cuts in government spending, the economy will rely more heavily on private domestic demand for growth. Expansion in the private sector is expected to remain favorable, as public investment shrinks for the second year running. Complementing the predicted rise in household spending, the recovery in private investment is seen as continuing, albeit at a slower pace. Looking further ahead, growth in 2006-2007 is forecast to average about 5.5%.

A stronger domestic economy relative to the external sector will result in a slightly lower trade surplus. On that basis, the current account surplus will also decline, but remain substantial. Hence, the country’s foreign reserves position is set to improve further, providing strong support to the ringgit peg.

On the supply side, growth in all major sectors is projected to slow in 2005. Manufacturing and services will be the engines of growth in the next 3 years. Manufacturing expansion is estimated to moderate to 7.5% in 2005, supported by the recovery in external demand in the second half and a still buoyant domestic economy. Services sector growth is forecast to ease to 5.7% in 2005. Agriculture is also likely to decelerate, while firm prices and demand, and new oil and gas fields, will enhance mining growth. Construction is expected to post a mild recovery in 2005, reflecting demand for residential housing.

Fiscal consolidation is expected to be gradual, so that government spending can make a contribution during a time of uncertain external conditions and slower growth in the next 3 years. The fiscal deficit is projected to narrow from 4.1% in 2004 to 1.5% in 2007, in steps that do not hurt the economy. Government spending as a percentage of GDP is expected to decline, while the share of revenue will remain stable at around 19% of GDP in view of the moderate economic growth. The Government will finance the deficit mainly from domestic sources, with a small portion from foreign sources. The level of total external debt is expected to rise in the forecast period as the private sector seeks some funding from abroad. Relative to GDP, though, external debt will probably decline slightly as the economy expands.

The Government, under little external pressure and wanting to help exporters compete in the face of falling demand, appears likely to favor an undervalued currency and so maintain the ringgit peg, at least through the first half of 2005. Likewise, Bank Negara Malaysia has room to keep interest rates steady for some months. However, inflation is expected to accelerate to 2.4% in 2005, pushed by rising inflationary expectations, higher transport charges, withdrawal of subsidies and, possibly, an electricity tariff increase. That would lead to a decline in real deposit rates. And with interest rate differentials narrowing, the central bank may raise rates by perhaps 50 basis points in the second half of the year.

Challenges include handling fiscal consolidation without slowing the economy too abruptly and competing for FDI against subregional neighbors and the much larger economies of the PRC and India. A fall in FDI would mean lower growth than forecast in 2005. The authorities also need to consider alternatives to the current exchange rate peg.

A near-term challenge is replacing an estimated 450,000 illegal overseas workers who left Malaysia under an amnesty, prompting concerns about potential labor shortages on plantations, on building sites, and in factories. As part of a longer-term strategy, the education system needs to be reformed to correct labor demand-supply mismatches, especially among graduates.

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