Information about Asia and the Pacific Asia y el Pacífico
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II Comparative Review of Policies and Performance, 1997–2000

Author(s):
Yougesh Khatri, Il Lee, O. Liu, Kanitta Meesook, and Natalia Tamirisa
Published Date:
August 2001
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Information about Asia and the Pacific Asia y el Pacífico
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Author(s)
Kanitta Meesook

Malaysia has received much attention since September 1998 when, in response to a deteriorating economic situation emanating from the Asian crisis, it introduced capital and exchange controls. Also, Prime Minister Mahathir Mohamad rebuked policy advice from the IMF that Malaysia had followed up to then.1 Initially there was concern that these controls might be used to avoid needed policy adjustment, and investors and market analysts reacted negatively. Market assessment turned more positive, however, as it became clear that Malaysia’s macroeconomic policies were not out of line, that the undervalued pegged exchange rate was contributing to the rapid recovery of exports and output, and that financial sector reforms were being vigorously pursued.

This section reviews the developments from the emergence of the Asian crisis to end-2000, comparing Malaysia’s initial conditions, policy responses, and recent performance with those of the other crisis countries.

Initial Conditions and Economic Structure

Malaysia’s economic structure and performance were relatively strong prior to the crisis (see Appendix Figure A.2.1). Real GDP grew rapidly, while inflation was low. At the same time, fiscal policy was prudent, domestic savings were high, international reserves were robust, and external debt was well managed. The legal and regulatory frameworks were also comparatively well developed.

Underlying these positive features, however, were signs of overheating and structural vulnerability, broadly similar to the other crisis countries (Appendix Figure A.2.2). A predictably stable exchange rate encouraged foreign borrowing and discouraged the use of hedging instruments. From the early 1990s, this allowed large current account deficits–brought about in part by the appreciation of the real effective exchange rate (Figure 2.1)—to be sustained by short-term capital inflows, including through the stock market. Rapid credit growth led to excessive investment and resource misallocation, fueling asset price bubbles in property and stock markets. As the financial system and capital markets were liberalized, the important aspects of supervision and regulation remained weak, allowing extensive connected lending and obscuring the true scale of financial and corporate problems. Furthermore, an active—but largely unregulated—offshore market for the ringgit exposed the currency market to information asymmetries and excessive risk taking by private investors. All these elements contributed to Malaysia’s susceptibility to contagion by the crisis.

Figure 2.1.Exchange Rate Developments

Sources: IMF Information Notice System and Asia and Pacific Department database.

After Thailand was forced to float the baht in July 1997, Malaysia’s exchange and stock markets came under severe pressure. Large capital outflows that had started in April that year continued, inducing a rapid adjustment in the current account and a significant depreciation of the ringgit along with other regional currencies (Appendix Figure A.2.3). Arbitrage between domestic and offshore ringgit markets became more active; in anticipation of further weakening of the currency, the premium on offshore ringgit interest rates increased sharply, exacerbating outflows of ringgit funds and the domestic liquidity shortage.

Moreover, domestic demand collapsed because of negative wealth effects from falling equity and property prices and uncertain economic prospects (Appendix Figure A.2.4). External demand also declined, consistent with financial difficulties and falling demand in other crisis countries. As a result of the ringgit’s depreciation, higher borrowing costs, declines in equity price, and the drop in demand, corporate balance sheets deteriorated further. Thus, the financial system came under increasing stress (Figure 2.2), reflecting in part high corporate leverage, and signs of bank runs emerged in late 1997. As the market recognized that the asset quality of both the banks and corporations was worse than it appeared, confidence eroded further.

Figure 2.2.Bank Lending

Source: CEIC Data Company Limited.

Malaysia’s relative strengths going into the crisis nonetheless helped contain the severity of its impact. Although Malaysia suffered serious currency and financial crises, it was spared from an external debt crisis. Thus, unlike the other countries, Malaysia did not require a large official financing package or debt rescheduling.2 In addition to overall financial prudence, the credibility of the financial system benefited from a widespread bank restructuring undertaken in the 1980s. These strong features protected the country’s external position and may have lessened the extent of the overall output decline. The magnitude of domestic unemployment and potential social disruption was moderated further by a significant migrant workforce that acted as a buffer.

Capital Account Regime and Reserve Management

Malaysia’s initial low level of short-term external debt enabled it to maintain foreign reserves at a reasonably high level, and this contributed to relatively robust external and domestic confidence early on in the crisis. As a consequence of financial vigilance exercised through prudential regulation of capital movements.3 the exposure of the financial and corporate systems was contained. Management of foreign exchange reserves has been cautious, entailing no forward sales or other off-balance-sheet liabilities, so that all reserves have been usable.

The capital account was nevertheless liberal in ways that left Malaysia vulnerable to contagion. Like the other countries, portfolio flows were free of restrictions; in Malaysia, these were the main channel for capital outflows in mid-and late 1997. Furthermore, cross-border activities in ringgit were treated liberally, permitting the use of the currency in trade and financial transactions with nonresidents, and in offshore trading of securities listed on local exchanges. As a consequence, an offshore ringgit market developed and became more active than those in other affected countries.

Openness and Structure of Exports

Malaysia is the most open among the crisis countries (Table 2.1), and this feature was beneficial in leading output recovery in early 1999 even as domestic demand remained relatively weak. However, the country’s export base has become more dependent on electronic and electrical products, whose share in total exports reached more than 60 percent that year. Thus, like the other countries, Malaysia could become more vulnerable to adverse world developments in the period ahead, especially in regard to the technology sector.

Table 2.1.Asian Crisis Countries: Selected Structural Indicators, 1996–2000(In percent, unless otherwise indicated)
MalaysiaKoreaThailandPhilippinesIndonesia
External
Precrisis
Openness, sum of exports and imports as percent of GDP 199614854696342
Share of exports to Japan and other crisis countries, 19962321252738
Export growth in U.S. dollars, second half of 1995-second half of 19961-3-5166
Postcrisis
Openness, sum of exports and imports as percent of GDP. 200018670939864
Share of exports to Japan and other crisis countries, second half of 1999-first half of 20002219232434
Export growth in U.S. dollars. 1999–20001312111519
Banking system
Precrisis
Nonperforming loans as share of total loans, end-19971662357
Credit to private sector annual growth, average of 1993–962120314027
Credit to private sector, in percent of GDP 19961411501355259
Loan-to-deposit ratio (M2-based). end-19971.01.61.41.01.2
Postcrisis
External Nonperforming loans as share of total loans, end-20001, 2157151526
Impaired assets as shares of interest-earning assets, end-200032223382361
Credit to private sector annual growth, 200046-21817
Credit to private sector, in percent of GDP, 200041391331254623
Loan-to-deposit ratio (M2-based), end-200050.91.20.90.70.4
Corporate sector
Precrisis
Corporate debt/equity ratios, 1997638425440174334
Market capitalization in percent of GDP 199631758569841
Stock price changes, 1990–96145-63638553
Postcrisis
Corporate debt/equity ratios, 20006114235280186277
Market capitalization in percent of GDP 200013135267921
Stock price changes, mid-1997–end-2000-37-32-49-47-43
Sources: IMF, International Financial Statistics; World Economic Outlook; IMF staff estimates and CEIC database.

Definitions of nonperforming loans vary among different countries, and caution should be applied in making any comparison.

Data cover only loans that remain in the banking system, that is, not including nonperforming loans transferred to asset management agencies. Korea refers to end-September.

Data include nonperforming loans transferred to asset management agencies.

Unadjusted for transfers of nonperforming loans to asset management agencies. Thailand data refer to end-October.

Korea and Philippines refer to end-November, and Indonesia refers to end-August.

Nonfinancial companies. Malaysia, Thailand, and Indonesia are listed companies only.

Sources: IMF, International Financial Statistics; World Economic Outlook; IMF staff estimates and CEIC database.

Definitions of nonperforming loans vary among different countries, and caution should be applied in making any comparison.

Data cover only loans that remain in the banking system, that is, not including nonperforming loans transferred to asset management agencies. Korea refers to end-September.

Data include nonperforming loans transferred to asset management agencies.

Unadjusted for transfers of nonperforming loans to asset management agencies. Thailand data refer to end-October.

Korea and Philippines refer to end-November, and Indonesia refers to end-August.

Nonfinancial companies. Malaysia, Thailand, and Indonesia are listed companies only.

Investment-Based Growth Strategy

For two decades prior to the crisis, Malaysia pursued a policy strategy aimed at raising economic growth and eradicating poverty by promoting investment in priority sectors and equipping the bumiputras with capital and opportunities to engage in various economic activities. For a number of years, the investment ratio for Malaysia was the highest among the crisis countries (Figure 2.3). This strategy was successful in generating one of the highest precrisis growth rates and elevating the income and wealth of the bumiputras.

Figure 2.3.Domestic Investment in Selected Asian Countries

(In percent of GDP)

Source: IMF, World Economic Outlook.

Although much of the investment went into electronics and other export-oriented industries, a large portion went into capital-intensive infrastructure and the real estate sector. Investment quality, measured by the incremental capital output ratio and estimated total factor productivity growth, eroded significantly between 1990–97.4 As the Malaysian economy underwent an adjustment in response to the crisis, private investment declined sharply in 1998 and has remained subdued (Figure 2.4). This adjustment dampened short-term domestic demand during the recovery process, but reallocation from overinvested sectors would be desirable to improve the investment efficiency and achieve higher total factor productivity growth over the long term. In this connection, the planned move to a knowledge-based economy (K-economy) is intended both to raise the productivity of investment and to diversity exports, although its effects will not be immediate.

Figure 2.4.Investment and Real GDP Growth

Source: CEIC Data Company Limited.

Capital Market Development

Beginning in the early 1980s, a rapidly growing capital market emerged as a major funding source for higher investment (Figure 2.5). Its development was supported by a number of measures to strengthen, broaden, and deepen the market, which improved the regulatory framework, as well as the trading and settlement infrastructure.

Figure 2.5.Market Capitalization in Selected Asian Countries

(In percent of GDP)

Source: CEIC Data Company Limited.

Stock market capitalization in Malaysia grew to an extremely high level prior to the crisis, reflecting both the fast expansion of the capital market and liberal capital account regime. At the same time, the level of corporate bank (short-term) indebtedness was among the highest of the crisis countries (Figure 2.6). As the crisis emerged, sharp declines in the stock market led to relatively greater losses of wealth in Malaysia than in other countries. This had negative implications for corporate ability to roll over or service debt, because the value of stockholdings used as bank collateral fell abruptly and income streams from them diminished. Multiple leveraging—made possible by cross-holding structures—exacerbated the negative impact on corporate wealth and cash flows, and consequently on the extent of financial distress. This may explain, in part, the relative worsening of Malaysia’s corporate performance in 1997–98. Low rates of return on capital, stemming from overinvestment in the past, have likely contributed as well.

Figure 2.6.Private Sector Credit in Selected Asian Countries

(In percent of GDP)

Source: CEIC Data Company Limited.

Figure for 2000 refers to October.

Legal and Regulatory Framework

Malaysia’s well-developed legal and regulatory frameworks, which provided reasonable protection to creditors and noncontrolling shareholders, permitted relatively speedy but orderly settlement of problem loans early on. Furthermore, priority had been given to strengthening and modernizing prudential safeguards even before the crisis. This, compared with the weaker systems (including the absence of enforceable bankruptcy laws) and lack of supervisory personnel in some other countries, helped maintain confidence in and facilitate the recovery process of Malaysia’s economy.

Still, as in the other countries, close connections between large corporations and the Malaysian government masked the extent of deterioration in the asset quality of financial and corporate systems before the crisis, and this situation appears to have continued even after the crisis. Implicit government guarantees associated with privatized infrastructure projects undertaken prior to 1998 may have deferred debt and operational restructuring by the concerned corporations even as they became financially illiquid. The government also influenced bank lending to certain projects that it deemed of social importance. These practices could have potentially adverse implications for future claims on the government.5

Social and Political Cohesion

The bumiputra policy, the presence of temporary migrant workers, and smooth relations between labor unions and employers help explain the low unemployment in Malaysia even at the depth of the crisis. Cost reductions in sectors facing output contraction were brought about through nonrenewal of contracts for migrant workers. However, as far as domestic labor was concerned, retrenchment was limited, as employers implemented other practices (also used in other crisis countries), such as part-time, flexi-time, and pay cuts, before resorting to layoffs. These “labor hoarding” practices were reversed as the economy recovered. Importantly, progress in poverty reduction over the past two decades has helped preserve overall social and political stability.

Policy Responses and Performance

The capital controls and the ringgit peg introduced in September 1998 were key policy measures that distinguished Malaysia from the rest of the crisis countries.6 At that time, it was difficult to tell whether financial instability in the region was likely to intensify or abate. Some measure of stability had by then begun to return to the regional financial markets (Appendix Figure A.2.5). From late August 1998, local currencies and stock markets had broadly calmed down, and forward exchange rate forecasts showed expectations that the ringgit—as well as the won and the baht—would stabilize. Short-term interest rates had declined to levels below 10 percent. Sovereign bond spreads had peaked for Thailand, Korea, and the Philippines. In both Thailand and Malaysia, the offshore swap differential was trending down; nevertheless, the differential was in a high range and financial market pressures also remained high.

Given the relative stability experienced by the region, Malaysia’s approach seems to have made little difference to the monetary policy outcomes or structural reforms. Crisis countries that did not introduce these measures have been just as able to carry out accommodating monetary policy and maintain stable exchange rates. Boosted by rising export demand for electronic goods, especially from the United States, economic recovery has been broadly similar across the Asian crisis countries (Appendix Figure A.2.6). Malaysia entered the crisis later, however, and the resumption of domestic demand also came later. All countries embarked on structural reforms, but Malaysia’s progress in financial restructuring with active involvement of the government has been more rapid. Malaysia’s prudential regulation and supervision, already reasonably well developed prior to the crisis, also seems to he superior, contributing to a relatively robust financial system that could help cushion Malaysia’s vulnerability against future crises.

The imposition of capital controls led to higher costs of external borrowing for Malaysia, but only temporarily. Bolstered by the pegged exchange rate at an undervalued level, the controls provided a safeguard to policymakers and domestic market participants at a time of financial volatility. Overall, the adverse impact of capital control measures was contained (Appendix Figure A.2.7).7

Fiscal and Monetary Policies

Macroeconomic policy responses were broadly similar in all the crisis countries. Sharp hikes in interest rates and fiscal tightening aimed at restoring confidence were implemented initially. As the severity of output declines became evident, the strategy shifted to fiscal expansion supported by accommodating monetary policies. The magnitude, timing, and degree of flexibility of policy responses in Malaysia, however, were different from the other countries to some extent. Later implementation of macroeconomic stimuli, consistent with the delayed output weakening and combined with rigidities in both the budget system and interest rate structure, may have led to relatively slow responses in domestic demand. In 2000–01. Malaysia continued to pursue fiscal expansion, whereas the other countries had moved to a more neutral stance (Appendix Figure A.2.8).

There were also delays in implementing fiscal stimulus measures in Malaysia. Fiscal restraint was pursued at the early stage of the crisis, consistent with the policy recommendations of the IMF. Once fiscal expansion was adopted, the delays arose from reliance on increased capital expenditures, which produced slower effects than higher current spending or the tax cuts applied in some other countries. This approach in turn reflects the policy of maintaining an operating surplus each year. The impact on private domestic demand of the 1998–99 fiscal impulse—estimated to be the largest among the crisis countries—was not fully felt until late 1999, reflecting the lags in carrying out capital spending. This may explain the lag in the recovery. Fiscal analysis is complicated, however, by the use of off-budget privatized infrastructure projects to stimulate the economy, the magnitude of which is not transparent.

In the early stage of the crisis, Malaysia did not defend domestic currency as aggressively as the other countries. Nominal and real interest rates were raised, but reached lower peaks in Malaysia, and very high interest rates (reaching 35 percent) persisted for only a few days. The situation contrasted with those in Korea and Thailand, where high interest rates were maintained for some months without interruption. The difference reflects two factors inherent in the initial conditions of the three countries. First, Malaysia’s financing gap, if any, was modest, and the maintenance of high interest rates to attract capital inflows was less critical. Second, the Malaysian corporate sector relied more on domestic borrowing than external borrowing; therefore, Malaysia’s strategy helped mitigate the impact of the crisis on the sector’s financial distress, whereas the strategy used in the other countries helped in the stabilization of the exchange rates that was needed to contain external debt-service burden.

As monetary policy eased, real interest rates in Malaysia were brought down to a level slightly lower than in the other crisis countries (Appendix Figure A.2.9), but the interest rate structure in Malaysia remained rigid (as in Thailand). Slow credit growth was observed in all countries and does not appear to have constrained the recovery because demand for large investments was small. Interest rate rigidities, in particular, ceilings on banks’ lending rates, could have nevertheless hindered productive—but higher risk—activities and prevented faster output growth.

To counter the slow credit extension, Malaysia set nonbinding, minimum targets for loan growth, gave tax incentives, and made use of directed lending to target specific sectors. In the environment of subdued domestic demand and excess liquidity that prevailed through 2000, these measures appeared ineffective. Government involvement in negotiations to restructure bank debt of some privatized infrastructure projects, for example through the Corporate Debt Restructuring Committee, may have boosted credit extension, although it could also have implications for future claims on the government.

Capital Controls and Exchange Rate Regime

The effect of the September 1998 controls in curtailing speculative capital outflows appeared benign because much of this capital had already left Malaysia (Figure 2.7). Crisis countries that did not adopt capital controls were able to pursue a low interest rate policy and to keep exchange rates relatively stable as the surplus from the current account began to build up and capital outflows subsided. These countries also made some progress with financial and corporate sector restructuring. Nevertheless, the policies provided safety measures at a time of foreign exchange market instability. Domestic market participants reacted positively to the fixed exchange rate regime, although it had exposed them to exchange risks by discouraging hedging activities. The effects of control measures on raising funding costs for Malaysia and limiting capital inflows were reversed soon after the controls were eased.

Figure 2.7.Cumulative and Net Portfolio Flows

(In billions of U.S. dollars)

Source: Malaysian authorities.

The magnitude of the ringgit undervaluation appears to have been roughly similar to those of the other currencies. The undervalued ringgit benefited the Malaysian export sector, but it may have also discouraged imports and associated investment in other sectors and contributed to the slow pickup in private investment overall. Additionally, market expectations of an appreciation, which prevailed from early 1999 to mid-2000, are likely to have induced short-term speculative inflows that were subsequently followed by outflows and reserve losses.

Financial Sector Reforms

Policy responses to strengthen the financial system have also been broadly similar among the crisis countries. To prevent its collapse, all countries gave a blanket deposit guarantee and provided liquidity support early into the crisis. Subsequently, each country established some form of asset-management strategy to address nonperforming loan problems, gave high priority to the upgrading of supervisory and regulatory standards to international best practices, and sought to recapitalize their financial institutions based on those norms. In the process, bank closures or merger programs were undertaken to establish stronger financial systems.

Overall, the progress achieved by Malaysia and Korea compares favorably in some aspects to the other countries, contributing to the improved performance of the financial systems.8 This may be explained to some extent by the more centralized approach they adopted that permitted actions to be taken early and in a comprehensive manner, and, in the ease of Malaysia, by its better starting conditions as well. A more active involvement by the government, however, implies that it could be taking higher risks on contingent liabilities involved in the restructuring process and on implicit guarantees of the future health of the financial system and of corporations affected by these actions. Risks would diminish, to the extent that ongoing reforms of the regulatory and supervisory frameworks promote greater market discipline and better-managed financial institutions. The various aspects of Malaysia’s financial and corporate sector reforms can be summarized as follows:

  • The government announced a guarantee of bank deposits early in the crisis (January 1998) that was credible in view of the country’s legal and regulatory framework, and the country did not suffer the bank runs experienced in Indonesia, Korea, and Thailand.

  • Danamodal, the recapitalization agency, succeeded early in restoring the capital levels of domestic banks in Malaysia, whereas the capital standards had not fully been met in some of the other crisis countries that employed a more decentralized process. The agency’s mandate inspired confidence that all domestic financial institutions in Malaysia would be recapitalized to the required standards and that necessary operational restructuring would be imposed through the exercise of control over their managements.

  • The special legal power vested in Danaharta, the centralized asset management company, helped ensure that banks were left with a manageable level of problem loans and that acquired assets were rehabilitated; this contrasts with the more decentralized nonperforming loan workout in Thailand. The use of independent auditors to determine the value of assets acquired by Danaharta avoided the subsidies required in Indonesia and in Korea. The emphasis placed on the management of assets implies their disposal at a more measured pace, unlike the quick disposal of acquired assets by Danaharta’s counterparts in other crisis countries. The agency succeeded in the early closure of its window for acquiring nonperforming loans and achieved a relatively high recovery rate of disposed loans, but the risk of its becoming a nonperforming loan warehouse is greater under the current strategy unless assets are upgraded and sold before long.

  • The bank consolidation program, tightly coordinated by Bank Negara Malaysia, aimed at creating larger and more efficient financial institutions ready to compete globally as new foreign competition is allowed. This contrasts with the strategy elsewhere, which entails bank closures and takeovers of existing banks—including by foreign investors—there by imposing market discipline and requiring financial institutions to become internationally competitive rapidly.9 Malaysia’s approach has been less disruptive, but the government’s reluctance to close banks could create moral hazard. Limited foreign equity participation in local banks could also slow the diffusion of technology transfers and the adoption of international best practices.

  • Malaysia moved ahead of the other crisis countries to strengthen prudential supervision and regulation. Bank Negara Malaysia’s move toward internal risk management by banks, including for cross-border transactions, and toward risk-based and consolidated supervision is a major step to enhance the soundness of the financial system, especially if financial innovations are to be increasingly embraced by the country’s banking system.

Corporate Reforms

Progress in corporate sector reforms in Malaysia has been mixed.10 Institutional frameworks have been upgraded, especially standards for corporate governance. The promotion of active bond markets is expected to help gradually rebalance the maturity profile of corporate debt and diversity system risks. However, like in the other crisis countries, improved corporate balance sheets have largely been a result of economic recovery and debt restructuring, whereas progress in operational restructuring has been slow. Furthermore, a few incidents of poor governance despite the upgraded standards have raised doubts about the government’s commitment to adhere to best practices and protect minority shareholders. Such incidents have in turn undermined confidence and stock market performance, and weakened the ability of corporations to raise equity to support the restructuring process.

Time Frame of Malaysia’s Response to the Crisis

Initial Policy Response

From the time the Thai baht was floated in July 1997 until February 1998, Malaysia’s policies (Table 2.2) broadly aimed at addressing external imbalances, alleviating pressures on the ringgit, and restoring market confidence. For a few days in July 1997, the authorities intervened in the exchange market and raised interbank interest rates sharply, but they quickly let the ringgit depreciate and lowered the interest rate to near precrisis levels. In August 1997, administrative measures were introduced to regulate foreign exchange swap transactions11 and restrict trading of blue chip stocks in the Kuala Lumpur stock exchange.

Table 2.2.Major Economic Policy Measures During Emergence of Crisis and Early Stage of Contagion
Date/BackgroundPolicy ObjectivesSpecific Measures
March 1997: Kuala Lumpur stock exchange price began to fallMonetary: To slow credit growth• Limits on lending to the real estate sector and for the purchase of stocks and shares
July 1997: That baht devaluedMonetary: To defend the ringgit• Interbank rate raised, reaching 35 percent for a couple of weeks, then lowered to around 10 percent
August 1997: Ringgit depreciation continued; Thailand’s program with IMFMonetary: To limit interest rate hikes and break links between domestic and offshore rates• Bank Negara Malaysia abandoned ringgit defense



• Limits imposed on ringgit swap transactions with nonresidents that were non trade related
Stock market: To stabilize and support Kuala Lumpur stock exchange price• Ban introduced on trading of blue-chip stocks comprising Kuala Lumpur stock exchange composite index



• Announcement of a large, publicly funded stock support scheme
September 1997: Prime minister’s statement that currency trading should be illegalFiscal To strengthen fiscal and external accounts• Government spending cut for 1997, and implementation of large privatized projects deferred
October 1997: Indonesia’s program with IMFFiscal: To continue cautious plan• 1998 budget announced, targeting a surplus of 2 percent of GDP (corresponding to a real growth rate of 7 percent)
Monetary: To limit credit growth• Credit plan introduced to limit loan growth gradually to 15 percent by end-1998, but with loans to specified sectors encouraged



• Base lending rates allowed to rise in response to higher interbank rates
November 1997: Further fall in stock pricesCorporate: To rescue Renong which was in financial trouble• Proposed takeover of Renong by United Engineers Malaysia announced
December 1997: Evidence of slowing activity: Korea’s program with IMFFiscal: To maintain broad fiscal target for 1998• Major cuts (18 percent) in government spending planfor 1998. offsetting lower revenue projections and corresponding to revised output growth of 4–5 percent
Monetary: To support the ringgit• Bank Negara Malaysia intervened in foreign exchange interbank market
January 1998: Signs of bank runsand flight to qualityFinancial To provide stability• National Economic Action Council set up as consultative body to deal with the Asian crisis



•Government announced a guarantee of deposits at all financial institutions



• Tighter restrictions imposed on stock broking companies including those on gearing ratios, margin financing, and total exposure
February 1998Corporate: To strength encorporate governance• High Level Finance Committee on Corporate Governance established
Monetary: To rebalance macro policy• Bank Negara Malaysia intervention rate raised to 11 percent from 10 percent: statutory reserve requirement cut to 10 percent from 13½ percent



• Bank Negara Malaysia set guidelines to ensure credit to priority bumiputra, housing, and small business sectors.



• Announcement that five financial institutions were in need of recapitalization, but no specific plans provided

As output expansion continued to be brisk through end-1997, macroeconomic policies during this period showed considerable restraint. Fiscal policy was tightened through sharp spending cuts. Steps were introduced to reduce loan growth through lending targets and directives to banks to cut credit for financing purchases of real estate and securities. To forestall bank runs and “flight to quality” the government announced a full deposit guarantee in January 1998.

Additional policy measures were put into place between March and August 1998 (Table 2.3). In response to signs of output slowdown, macroeconomic policy was rebalanced in March when fiscal policy was relaxed, whereas the credit policy remained tight relative to the previous trend. Also in March, the authorities adopted a strategy to safeguard the soundness of the financial system. Key measures included the upgrading of capital adequacy, prudential guidelines, and disclosure standards for banking institutions, as well as a merger program for finance companies. These were followed by a comprehensive approach to financial and corporate restructuring through the establishment of the asset management company. Danaharta, in June, and of the recapitalization agency, Danamodal, and the Corporate Debt Restructuring Committee in July. A new liquidity framework for banking institutions was also introduced in July, requiring banks to manage assets and liabilities prudently and efficiently.

Table 2.3.Major Economic Policy Measures, Initial Policy Responses, and Continued Turmoil
Date/BackgroundPolicy ObjectivesSpecific Measures
March 1998: Adoption of macro stabilization and financial sector packageFiscal and monetary: To rebalance macro economic policy• Revised fiscal plan implemented for 1998 aimed at a smaller surplus of ½ percent of GDP, allowing there instatement of previously cut social expenditures (of ½ percent of GDP) to protect most vulnerable groups



• Credit growth of 12–15 percent for 1998 reiterated
Financial: To safeguard banking system soundness• Strategy adopted for strengthening regulatory and prudential framework, disclosure standards, and monetary management



• Announcement of mergers of finance companies



• Announcement of planned improvement of monetary management, with timetable
May 1998: Political and economic turmoil in IndonesiaMonetary: To provide banks with flexibility in liquidity management• Bank Negara Malaysia began to provide daily reports on its money market operations, including its forecasts offinancial system cash flows, its liquidity operations, and money market tender results
June 1998: Increasing signs of policy divergence between prime-minister and deputy prime-ministerFinancial: To lessen the burden in dealing with nonperforming loans• Danaharta established to purchase the nonperforming loans of financial institutions
July 1998: Evidence of output collapse: equity markets in advanced countries began to declineFiscal and monetary: To provide strong stimulus• National Economic Recovery Plan issued



• Additional budgetary and off-budgetary expenditures introduced, aimed at achieving federal government deficit of 2½ percent of GDP



• Statutory reserve requirement reduced to 8 percent from 10 percent
Financial and corporate: To strengthen capital base of financial institutions and resolve bad debt problems• Danamodal established as a vehicle to recapitalize banks



• Corporate Debt Restructuring Committee established to encourage informal arrangement for debt restructuring
August 1998: Russia unilaterally announced debt-service emoratorium followed by emergency measures: yen vs dollar rate plunged; long-term capital management trouble publicizedMonetary: To stimulate economy further and to move gradually to prudential-based system• Bank Negara Malaysia intervention rate reduced in three steps to 9½ percent from 11 percent



• Prudential-based liquidity framework introduced, intended to replace liquid asset requirements by January 2000

Economic Performance Following Initial Policies

Although the financial reform measures would become important to the subsequent improvement of market sentiment, the overall policy package failed to restore confidence right away. Capital outflows continued from early 1997 to mid-1998, estimated at over $10 billion and representing over one-third of end-1996 reserves. The spread between onshore and offshore interest rates widened, suggesting heavy speculation in the currency market. By mid-1998, the ringgit had depreciated by 40 percent, and the stock market had declined by 75 percent from precrisis levels. In addition, output contraction was more severe than earlier anticipated, weakening further the financial and corporate sectors. Plagued by increasing nonperforming loans and liquidity constraints, bank lending was reduced beyond the credit plan, which aggravated financial problems in the corporate sector and further brought down investor confidence.

The crisis intensified, in part because of market qualms about the region, but Malaysia’s own political uncertainty and insufficient or unclear policies also contributed to the malaise. Investor confidence—already fragile—was shaken by the announcement in late 1997 of a United Engineers Malaysia-Renong deal, which lacked transparency and may have bent stock exchange rules.

From early 1998, the political conflict between the prime minister and the deputy prime minister became more visible and intense, creating doubts about Malaysia’s resolve to maintain its policy commitment. In February 1998m, it was announced that five financial institutions were in need of recapitalization, but no specific plans for their restructuring was given, sparking renewed concern about financial system vulnerability. The exchange rate and stock markets stabilized briefly around the time that the macroeconomic stabilization and financial sector package was put in place, but instability returned during April–August 1998 following the political turmoil in Indonesia, the fall of the Japanese yen, fears of a devaluation of the Chinese renminbi, and the Financial trouble in Russia. Moreover, given the difficulty in recognizing the sharp output slowdown, implementation of counter cyclical macroeconomic policies came with considerable delay.12 Fiscal policy remained relatively tight even after its relaxation in March, and reliance on quantitative monetary targets created problems, as credit was cut from firms that were potentially viable.

As output collapse became evident, macroeconomic policy became more supportive of economic revival. A fiscal stimulus package was launched in August 1998, entailing a significant increase in capital spending and tax reduction, and monetary policy became successively more accommodating.

Exchange and Capital Controls

In September 1998, Malaysia adopted an unorthodox approach that involved exchange and capital controls (Table 2.4) The ringgit was pegged at RM 3.8 per U.S. dollar, restrictions were imposed on the repatriation of portfolio capital, and offshore ringgit activities were prohibited. The strategy was designed to insulate monetary policy from external volatility and facilitate a low interest rate policy, to contain speculative capital movements, to provide certainty to market participants, and to give Malaysia some breathing space needed to carry out structural adjustment.

Table 2.4.Major Economic Policy Measures, Exchange and Capital Controls, and Aftermath
Date/BackgroundPolicy ObjectivesSpecific Measures
September 1998: Deputy prime minister Anwar removed and arrested; Bank Negara Malaysia governor and deputy governor resigned; Malaysia removed from major investment indices causing its sovereign bond spreads to rise as those for other crisis countries fellExchange and capital controls: To deter speculation on the ringgit and gain monetary independence• Ringgit pegged at RM 3.8 per U.S. dollar



• Controls on transfers of funds from ringgit-denominated accounts for nonresidents not physically present in Malaysia, in effect imposing a one-year holding period for repatriation of portfolio capital, with retroactive effect



• Prohibition of off shore ringgit transactions
Monetary: To further ease and encourage credit growth• Reduction of Bank Negara Malaysia interventions rate to 8 percent from 9½ percent; modification of formula to link base lending rate to policy rate; reduction In statutory reserve requirement in two steps to 4percent from 8 percent reduction in liquid asset ratio requirement to 15 percent from 17 percent



• Individual banks’ minimum loan growth target set at 8 percent; relaxation of restrictions introduced inearly 1997 on bank lending to purchase property and shares



• Prudential regulations regarding nonperforming loans and disclosure requirements relaxed
October 1998-August 1999Fiscal and monetary: To stimulate economic activity• Announcement of 1999 federal government budget aimed at achieving deficit of 5½ percent of GDP



• Successive reductions of Bank Negara Malaysia intervention rate to 7 percent 10/98), to 7½ percent(11/98), to 6½ percent (4/99), to 6 percent (5/99), and to 5.5 percent (8/99)
January 1999Monetary: To contain investment in selected activities• New lending for residential development above a certain threshold was restricted by Bank Negara Malaysia
January-March 1999Corporate: To adopt best practices• Various measures to enhance disclosure for listed companies and to restrict the number of director ships held by an individual



• Report of High Level Finance Committee on Corporate Governance released to the public
February 1999: After the easing of capital controls, spread narrowed and plans to include Malaysia once again in investment indices announcedCapital controls: To preempt exodus of capital and reengage foreign investors• Easing of some controls, including replacement of 12-moth holding period for repatriation of portfolio capital by system of a graduated exit levy
April 1999Financial: To strengthen supervision and regulation• Measures included intensified supervision, performance reviews for bank CEOs, elimination of two-tier bank classification, and disallowing of bank lending to controlling shareholders
September 1999Capital controls: To provide further relaxation• Graduated exit levy on portfolio Investment simplified and replaced by a flat 10 percent levy on repatriation of profits



• Some relaxation in swap and forward transactions for the purpose of share purchases
November 1999: Malaysia reincluded in Dow Jones/IFC investment indicesFinancial: To strengthen management and supervision• Risk-based supervision initiated, with consultation between Bank Negara Malaysia and banks regarding minimum guidelines on credit risk-management practices
February 2000Capital controls: To resolve pending issue• Resolution on Central Limit Order Book that froze investors’ Kuala Lumpur Stock Exchange shares traded in Singapore as from 9/98
April 2000: Malaysia reincluded in Morgan Stanley Capital International investment index (May)Capital markets: To develop• Announcement of consolidation of stock broking companies, to 15 by end-2000 from 63 (deadline later extended)



• National Bond Market Committee established to provide policy direction and rationalize regulatory framework for bond market development
October 2000Fiscal To put in place another stimulus budget

Capital controls: To provide further easing
• Announcement of 2001 budget aimed at achieving federal government deficit of 4½ percent



• Proposal to remove 10 percent exit levy on portfolio capital profits repatriated after one year (effective 2/01)

The market welcomed the financial reform measures and expansionary macroeconomic policies, but the capital controls had an immediate negative impact. Rating agencies downgraded Malaysia, sovereign bond spreads increased relative to those of Korea and Thailand, and Malaysia was removed from major investment indices. This was in part due to investors’ uncertainty about the coverage of the controls and the potential impact on foreign direct investment, even though the latter was not to be affected by the controls. Controls on portfolio capital outflows were replaced by a price-based exit levy in February 1999, which was eased and simplified in September 1999 and February 2001 and finally eliminated in May 2001.

Recovery Stage and Recent Performance

The negative impact of capital control measures was nevertheless contained. Regional prospects, which had strengthened just prior to the introduction of capital controls, helped bolster confidence and aided in the recovery process of the crisis countries, including Malaysia. The ringgit turned out, expost, to have been undervalued, providing a boost to exports and an incentive for retaining funds in the country. Malaysian equities once again became fully liquid following the replacement of quantitative restrictions on their outflows by price-based controls. These equities were reincluded in major investment indices, and portfolio capital returned.

Thus, along with the rest of Asia, Malaysia staged a recovery beginning in 1999; financial sector performance strengthened, investor confidence improved, real output rebounded rapidly, and the inflation rate fell. A large external current account surplus and reduced capital outflows allowed a buildup of international reserves that continued until mid-2000. Although the real effective rate of the ringgit has appreciated in recent months, it remained broadly stable throughout 1999–2000, as exchange rates of trading partners that had also been affected by the crisis began to stabilize at about the same time as the pegging of the ringgit. Indications are that the ringgit has moved close to its fair value by March–April 2001.

Reflecting better market sentiment, the Kuala Lumpur stock exchange price index surged, alter having bottomed out, also around September 1998. As in the other crisis countries, the index has continued to fluctuate along with stock prices in major markets, especially in the United Stales, which have softened significantly since early 2000, Spreads for Malaysian sovereign bonds declined from their peak in September 1998, even if they have edged up in recent months.

Bank balance sheets have improved, reflecting both the economic turnaround and the achievements of Danaharta, Danamodal, and the Corporate Debt Restructuring Committee, which have allowed banks to be rid of nonperforming loans and to strengthen their capital base, and have allowed corporate debt to be removed. There are indications that Malaysia has moved ahead of other crisis countries in respect to formulation of prudential regulation, resolution of nonperforming loans, restoration of capital adequacy, and implementation of a bank consolidation program, all of which have helped reinforce investor confidence that the economy was undergoing fundamental adjustment.

There are indications, however, that the performance of Malaysian corporations, which had been more profitable and under less financial stress prior to the crisis than that of their counterparts in Korea and Thailand, deteriorated to a greater extent during the crisis and has recently fared no better than the others. Similar to the other countries, operational restructuring of the corporate sector has been slow and, reportedly, has not adhered fully to best corporate governance practices.

Appendix. Graphical Overview of Indicators During Precrisis, Crisis, and Recovery

Figure A.2.1.Selected Asian Countries: Precrisis Macroeconomic Indicators

Sources: IMF, World Economic Outlook; International Financial Statistics; and Asia and Pacific Department databases.

Figure A.2.2.Selected Asian Countries: Precrisis Financial Indicators

Sources: IMF, World Economic Outlook; International Financial Statistics, and Asia and Pacific Department databases; CEIC Data Company Limited; Bloomberg; and Robert Deckle and Kenneth Kletzer 2001, Domestic Bank Regulation and Financial Crises: Theory and Empirical Evidence from East Asia, IMF Working Paper 01/63 (Washington: International Monetary Fund).

House price index for Malaysia, real estate price for Thailand, and construction value index for Indonesia. Data are not available for Philippines.

Figure A.2.3.Selected Asian Countries: Economic indicators During the Crisis Period

Sources: IMF, Information Notice System and Asia and Pacific Department databases.

Figure A.2.4.Selected Asian Countries: Economic Developments

Sources: IMF, Asia and Pacific Department databases; and CEIC Data Company Limited.

1Data are not available for Indonesia.

Figure A.2.5.Selected Asian Countries: Financial Market Indicators During the Crisis Period

Sources: Data provided by country authorities; Consensus Economics Inc., Asia Pacific Consensus Forecasts; and IMF staff estimates.

1Export-Import Bank of Korea global bond spread is used as a proxy from September 1997 through March 1998.

Figure A.2.6.Selected Asian Countries: Economic Performance During the Recovery Stage

Sources: IMF, International Financial Statistics; and Asia and Pacific Department databases.

Figure A.2.7.Selected Asian Countries: Financial Indicators During the Recovery Stage

Sources: IMF, Information Notice System; Bloomberg; and Asia and Pacific Department databases.

1Export-Import Bank of Korea global bond spread is used as a proxy from September 1997 through March 1998.

2Sovereign bond issued September 19, 1990 that matured on September 27, 2000.

3Sovereign bond issued May 26, 1999 and maturing on June 1, 2009.

Figure A.2.8.Selected Asian Countries: Fiscal Indicators

Sources: IMF, World Economic Outlook; International Financial Statistics; and Asia and Pacific Department databases.

1For Indonesia, 1995 through 1999 are on a fiscal year basis (fiscal year ending March). Year 2000 contains data for three quarters. Figure for 2001 is on a calendar year basis.

2Thailand is on a fiscal year basis (fiscal year ending September).

Figure A.2.9.Selected Asian Countries: Monetary Indicators

Sources: International Financial Statistics; and Asia and Pacific Department databases.

1Temporary capital controls introduced in September 1998.

Deputy Prime Minister and Minister of Finance, Anwar Ibrahim, was Malaysia’s key contact with the IMF at that time. He was removed from office the day alter the capital and exchange controls were introduced.

Malaysias in was the only one of the five Asian countries severely affected to the crisis that did not resort to use of IMF resources.

Such regulation included limits on banks’ net foreign currency open position and monitoring of liahilities of domestic corporations to ensure their foreign exchange earning potential.

For total factor productivity growth estimates, see Michael Meow-Chun yap, 2000, Potential Output of the Malaysian Economy: Evaluating the Production Function Approach.” paper presented at the Malaysian Institute of Economic Research. November (Kuala LumpuR). The incremental capital output ratio reversed in 1998–99, which was attributed largely to Tailing investment.

See Section III for further discussions of fiscal issues.

See, below, the time frame of Malaysia’s policies in response to the crisis and economic performance that ensued.

See Section V for further discussions of the capital controls, and their impact.

See Section VI for more details on financial sector developments and reform measures.

The share pi foreign-owned banks in Malaysia was relatively high before the crisis, although their activities are more restricted than local banks. The approach to not allow foreign takeovers of banks may partly explain the low level of foreign direct investment flows into the country in 1998-2000, relative 10 recent history, in comparison with such flows into the other crisis countries.

See Section VII. for further analysis of the corporate sector and recent reform efforts.

In May 1997, Thailand imposed partial restrictions on offshore activities in order to stabilize the foreign exchange market and stem speculative attacks on the baht.

Macroeconomic restraint at this stage of the crisis was consistent with the policy recommendations of the IMF.

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