Regions and Countries

	Table of Contents
p. 2 of 18 BACK | NEXT I. Country Performance Assessment A. Economic Performance Assessment B. Assessment of Socio-Environmental Performance C. Governance: Sound Development Management D. Implementation Assessment II. Country Operational Strategy III. Sector Strategies IV. Regional Cooperation V. Donor Activities and Aid Coordination VI. Cofinancing and Catalyzing External Resources VII. ADB’s Operational Program VIII. Economic and Sector Work Program IX. Local Cost Financing

Country Assistance Plans - Malaysia : I. Country Performance Assessment

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A. Economic Performance Assessment

1. Considering the strong initial macroeconomic conditions of Malaysia, the perception in July 1997 was that Malaysia would be able to weather the storm arising out of the Thai contagion with relative ease. In recent years the Government had exercised restraint on accumulating public debt. Prudent fiscal management enabled the Government to reduce the stock of public debt since 1991. Through careful and sound external debt management, total external debt was also kept well within prudent limits. The ratio of short-term debt to foreign exchange reserves was relatively low when the Asian economic crisis erupted. Banking institutions were not significantly exposed to foreign exchange risks and short-term corporate borrowers were reasonably hedged. Malaysia therefore did not experience an external liquidity crisis of the same extent as that affecting some other crisis countries, though large foreign holdings of domestic assets represented a potential vulnerability for exchange reserves management under an open capital account regime.

2. There were, however, indications prior to the crisis that the economy was growing in excess of its underlying potential, suggesting that it was overheating. Large current account deficits reflected domestic resource imbalances despite the impressive domestic savings rate. Though the stock of external debt was kept at manageable levels, external capital flows sustained the current account deficits. Private investment expanded at a torrid pace in 1990s fuelled by phenomenal credit growth. Credit growth substantially in excess of the GDP growth rates created significant risks in terms of higher corporate leverage and growing asset price inflation. The inherent risks would have been reduced had the banks operated in a somewhat more competitive environment, as well as followed better risk management and credit analysis practices. Large exposure of the banking institutions to real estate and the stock market reduced the resilience of the banking system to economic shock. The perception that the banking system was beset with such vulnerabilities contributed to deterioration of market sentiments despite the measures strengthening the prudential regulations taken in the second half of 1997.

3. The full impact of the crisis on the Malaysian economy was felt in 1998. Real GDP contracted by 7.5 percent, led by a strong contraction in domestic demand. Against the background of a rapid outflow of external capital, the Government adopted standard demand management measures since the beginning of the crisis through the first half of 1998. Negative export growth and the unexpectedly sharp adverse impact of higher interest rates on corporate borrowers led the Government to reorient its policy in mid-1998.

4. Exports in US dollar terms contracted by 6.9 percent in 1998. Slowdown in export growth was evident since 1995 in response to the cyclical downturn in the global demand for electronics, a major Malaysian export that continued through 1998. Domestic factors such as a rise in wages in an environment of unimpressive growth of labor productivity affected competitiveness of manufactured exports. Continued high import intensity of exports partly due to skill shortages in the domestic labor market negated the beneficial impact of the depreciation of the Malaysia ringgit (RM) on manufactured export industry. The regional economic crisis adversely impacted on the demand for Malaysian exports emanating from within the region.

5. Credit surges in recent years have increased corporate indebtedness. Between 1980 and 1997, while loans in the banking system rose from 51 percent to 161 percent of the gross national product, the share of private sector borrowing increased from 79 percent to 96 percent. 70 percent of bank loans were short-term in nature. High corporate leverage combined with dominance of short-term debt rendered corporate borrowers highly vulnerable to increases in interest rates.¹

6. The impact of an approximately 70 percent increase in interest rates between June 1997 to June 1998 contributed to contraction of the aggregate demand and the rapid increase in Nonperforming Loans (NPL) ratios. The combined effect of tighter prudential regulations and higher NPL ratios on credit growth was severe. Despite strong moral suasion by the Central Bank, loan growth at the end of 1998 was marginally negative.

7. Since a high interest policy did not succeed in stabilizing the exchange rate, the Government explored alternative approaches to stem the volatility in the foreign exchange market. At the same time, high interest rates contributed to increasing corporate distress. The Government felt that the demand compression strategy had resulted in overadjusting domestic demand and, if continued, would push Malaysia into a deeper recession (the economy had contracted in the first two quarters of 1998). While the initial steps towards relaxing monetary and fiscal policies were taken in the first two quarters of 1998, a comprehensive National Economic Recovery Plan (NERP) was announced in July 1998. Easing of inflationary pressures and emergence of current account surplus by the third quarter of 1998 facilitated the policy shift. As part of the recovery plan, fiscal and monetary policies were gradually relaxed. A fixed exchange rate was adopted and foreign exchange controls were imposed: the objective was to provide flexibility of monetary policy, limit speculative trading in domestic currency and control the short-term capital flows.

8. Since mid-1998, the demand management policies shifted from a relatively tight stance to a more expansionary stance for supporting economic recovery. Monetary policy was eased; the interest rates were progressively lowered and the statutory reserve ratio was brought down in steps. The fiscal policy targeted deficit in the federal government budget as a countercyclical measure for stimulating domestic demand. The federal government budget deficit in 1998 amounted to 1.5 percent of GDP compared with a planned surplus when 1998 budget was approved in October 1997. Bulk of the additional expenditures targeted sectors providing a strong multiplier effect on household incomes and manufacturing activity, and benefiting the vulnerable groups. While the federal government expenditure on economic and social services increased in 1998 compared with 1997, expenditure on security (including defense and internal security) decreased over the same period.² A strong fiscal stimulus is planned for 1999. The public sector deficit is estimated at 5.5 percent of GDP.

9. The NERP identified financial market stability as one of its core objectives. It put forward an agenda for financial sector reforms including (i) tightening prudential and disclosure standards; (ii) consolidating the banking sector; (iii) recapitalizing banks; (iv) developing a private debt securities market, including the bond market for funding large infrastructure projects requiring long-term funds; (v) providing a framework for improving the capital market, including strengthening the corporate governance aspects; and (vi) establishing an institutional framework for deposit insurance. (See para. 27 also.)

10. Several measures were implemented in 1998 for strengthening the regulatory framework for the capital market. New rules on gearing ratios, exposures to a single client and a single security as well as margin financing aimed at instilling a greater sense of financial discipline among stockbroking companies were introduced. Changes to rules on related party and interested party transactions sought to enhance the overall framework for corporate governance. Amendments were made to Securities Laws and measures implemented by the Kuala Lumpur Stock Exchange to improve transparency in the stock market.

11. Progress in bank restructuring and recapitalization has been on track according to the Government's plan. Three agencies (Corporate Debt Restructuring Committee (CDRC), Danaharta and Danamodal) spearheading bank restructuring and recapitalization as well as corporate debt restructuring have started operations with a well-conceived and coherently formulated policy framework.³ Their publicly announced policies stipulate that (i) bank and corporate restructuring should be carried out speedily to minimize the eventual economic costs of growing weakness of banks; (ii) strategies for bank and corporate restructuring should be closely linked; debt workouts for viable corporate borrowers need to be proactively pursued with bank restructuring; (iii) only viable institutions should stay in business; (iv) for preventing recurrence and minimizing moral hazard, the burden should be equitably and transparently shared among all stakeholders; (v) bank recapitalization should be combined with credible steps for bank restructuring, improving credit discipline and strengthening bank supervision; and (vi) full fiscal implications of bank restructuring should be disclosed. International consulting firms are helping the Government implement this framework. The agency for recapitalizing the banks, Danamodal, has provided recapitalization assistance to 10 banking institutions out of the total of 21 banks, which in Danamodal’s assessment may potentially require recapitalization assistance. The remaining 11 banks are on the watch list, though it has been established that these 11 institutions do not require recapitalization funds from Danamodal. The asset management company, Danaharta, has taken over about 33 percent of the total NPLs outstanding at the end of May 1999. The CDRC may need to accelerate the debt restructuring process. Its role vis-à-vis Danaharta and Danamodal and its moral suasion authority are evolving.

12. Official and independent sources have forecast economic recovery in 1999, although the forecasts differ on the strength of such recovery. Prospects for export growth hinge on external factors. Rising imports of intermediate goods contributed to an increase in industrial production and augur well for export performance. Countercyclical fiscal measures and the revival of private consumption and investment demand are likely to boost domestic production of goods and services. Tangible improvements in consumer and business sentiments and transparent, objective and speedy resolution of bank and corporate sector debt problems, will be needed to consolidate the revival of market confidence and domestic demand on a sustained basis. The Government has replaced the one-year restriction on repatriation of external capital by an exit tax.⁴ This measure, the recent upgrading of Malaysia’s credit ratings by international rating agencies, and a general improvement in market sentiment towards emerging markets have helped Malaysia’s reentry into foreign capital market. Main macroeconomic management concerns in 1999 include: (i) mobilization of resources for financing countercyclical fiscal policy in a non-inflationary manner; (ii) keeping exchange rates at the market clearing levels and (iii) managing the restructuring of banking and corporate sectors at a pace allowing these sectors to adjust to lower asset prices, without letting the economy stagnate with heavily indebted corporate borrowers and banks which are reluctant to lend new money. Detailed country performance indicators are given in Appendix 1.

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