Article

Malaysia’s Successful Reform Experience

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1991
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The economic story was not an unfamiliar one: a growing developing economy runs into trouble during the first half of the turbulent 1980s. The result: economic imbalances, structural weaknesses, and poor prospects for growth. But, where many other developing countries—drafting demanding blueprints of reform but postponing difficult adjustments of their economies—continued to flounder, Malaysia succeeded, and its experience over 1986-90 offers a model for countries embarking on the implementation of reform. A far-reaching program of liberalization and structural reforms, backed by cautious macro-economic policies to ensure strict observance of resource constraints, controlled the economic slide and revived growth.

In the strategy pursued by the Malaysian authorities, the emphasis was on private sector activity as the main engine for growth. This was considered the best approach for developing new ventures, creating employment, and infusing new technologies and skills into the economy. The public sector, while continuing to consolidate its fiscal policies and operations, was geared to providing a supportive environment for healthy economic expansion. As a result of these efforts under the Fifth Malaysia Plan of 1986-90, by the latter part of the decade, Malaysia had achieved a spectacular turnaround: real GDP growth recovered, while the external imbalance was redressed, and inflation was controlled (see

The economic background

Malaysia had a remarkable economic record during the 1960s and 1970s. Initially, the authorities aimed to foster growth through investment in rural development and infrastructure. Following the outbreak of racial conflict in 1969, however, they formulated a broad development plan for 1971-90—the New Economic Policy—to strengthen national integration by emphasizing growth, while attempting to eradicate poverty and to reduce ethnic and regional disparities. The development strategy was managed by a prudent government with a liberal trade policy, a competitive exchange rate, and a judicious mix of fiscal discipline and conservative monetary policies. As a result, the economy grew at an annual average rate of about 8 percent during the 1970s, exceeding the performance of all but the four newly industrializing Asian economies, with inflation averaging about 5 percent and the external position remaining comfortable—that is close to equilibrium and with adequate resources.

Economic performance became unstable, however, during the early 1980s. The prospect of substantial oil revenues and the desire to counter the effect of the world recession encouraged the authorities to embark on an ambitious development program, launching a state-owned heavy industries sector, and raising total capital formation to 40 percent of GNP by 1983 (see charts). The ensuing expenditures created severe fiscal and external imbalances that were financed mainly by heavy foreign borrowing. These disequilibria were reduced sharply in 1983-84, as both foreign exchange earnings and budget revenues were boosted by strong external demand and improved terms of trade, and government spending was cut drastically.

But in the wake of an erosion of foreign demand and the fall in the prices of petroleum and other export commodities, the economy took an abrupt downturn in 1985-86: output growth faltered, investment dropped sharply, and unemployment soared. This interfered with the process of fiscal consolidation and led to further heavy foreign borrowing to finance the budget deficit. By the end of 1986, Malaysia’s external debt rose to $22 billion, or 84 percent of GNP, well above the average of 48 percent of GNP recorded by developing countries with recent debt servicing difficulties.

The resulting recession exposed structural weaknesses in the economy that had been disguised earlier by the buoyancy of demand. Notably, capital efficiency had deteriorated, largely because of a shift in the structure of investment. While public investment had been cut back in infrastructural projects, it expanded in manufacturing, as nonfinancial public enterprises (NPEs) diversified into activities in which government ownership had little comparative advantage. By 1986, the public enterprise sector had accounted for about one quarter of gross value added, one of the highest shares among nonsocialist countries. This added to Malaysia’s fiscal and external debt burdens and displaced private investment. Private investment activity was further hampered by a loss of competitiveness due to wage increases in excess of productivity gains, a marked effective appreciation of the exchange rate during the early 1980s, and by restrictions on new undertakings through licensing requirements and constraints on equity ownership. Business confidence was further eroded as the property market collapsed and, partly owing to a heavy concentration on lending to the property sector, a number of banks and finance companies were threatened by insolvency.

Reforms usher in recovery

When economic growth faltered, the authorities launched major reforms through the Fifth Malaysia Plan (covering the period 1986-90). The structural reforms were effected through various means.

Revitalization of the private sector. The authorities sought to create a more attractive climate for local and foreign investors. They relaxed industrial licensing, guidelines on the acquisition of assets, and ownership rules for foreign direct investment. Fiscal reforms shifted the emphasis from direct and commodity-based taxation toward more broadly based consumption taxes. With the abolition of the excess profit tax and a re-duction of the corporate income tax rate during 1988-89, the taxation of profits was moved close to the dominant rates prevailing among East Asian economies. While Malaysia’s average level of tariff protection has been low relative to other developing countries, the rates varied widely. In order to improve resource allocation, the authorities reduced import duties on manufactures that had enjoyed extensive tariff protection over the previous ten years. Most revenue losses were offset by closing tax loopholes, improving revenue collection, widening the coverage of the sales tax, and streamlining tax incentives. Although some fiscal incentives were tightened or discontinued, the pioneer status incentives, encompassing tax exemptions on profits and dividends for up to ten years for high risk ventures fostering new technologies continued to remain attractive.

The authorities sought to create a more attractive climate for local and foreign investors.

Active external policies. The authorities’ exchange rate policy also contributed to boosting confidence in the business sector. The exchange rate was depreciated markedly against its currency basket, which, together with relatively restrained cost and price increases in Malaysia, restored external competitiveness. The real effective rate of the ringgit fell by 35 percent between the latter part of 1984 and the beginning of 1989, which more than reversed the real appreciation of the early 1980s. The economy’s growth prospects also benefited from liberal foreign trade and investment policies. Malaysia’s open trading system, with an average nominal tariff of about 13 percent, compares favorably with most countries in the region and restrictions affecting less than 5 percent of imports are regularly reviewed to identify possibilities to reduce the level of protection. Whereas Malaysia has maintained a competitive set of incentives to encourage foreign direct investment, a recent survey indicated that the current boom in the inflow of direct investment capital has been dominantly influenced by low labor costs, the sophistication of the labor force, and a relatively well-developed infrastructure.

Supported by the favorable development of the external current account balance and the inflow of equity capital in recent years, Malaysia’s external debt policy has concentrated on reducing foreign debt and the related exposure to exchange and interest rate risks. The strategy has included both reduced external borrowing and initiatives by the public and private sectors to prepay and refinance more expensive loans as well as to arrange interest and currency swaps.

Supportive role of public sector. The budget strategy to foster economic recovery was rooted in strict fiscal discipline regarding public expenditures, so that resources could be released to the private sector, and in the provision of adequate public services and infrastructure for private sector activity. The prudent management of operating expenditures included a freeze on public employment and a deferral of civil service salary adjustments in the initial period. Despite a drop of about 5 percent of GNP in government revenues attributable to the erosion of commodity prices during 1985-86, restraint on current spending brought about a shift of the current federal budget balance from a deficit of 0.5 percent of GNP in 1986 to a surplus estimated at about 1.5 percent of GNP in 1990. A decline of the overall deficit from 11.4 percent of GNP in 1986 to an estimated 5 percent of GNP in 1990 was also helped by a containment of development expenditures through 1988, as projects were scaled down and their implementation postponed. Significant increases were planned, however, in public investment during the subsequent two years. The emphasis was placed on avoiding bottlenecks in infrastructure, fostering education, and alleviating poverty, with the projects essentially complementing private sector investment.

Rehabilitation of public enterprises. The consolidation of public sector accounts was supported by efforts to scale down the dependence of NPEs on the budget. The financial difficulties of these enterprises had been exacerbated by a sharp fall in the aggregate operating surplus of this sector in 1986. While partly the result of the weakening of commodity prices, the operational and financial difficulties of NPEs also stemmed from structural distortions, inefficient management, and inadequate institutional supervision, as well as overindebtedness. Against this background, the creation of new public enterprises and the diversification of existing ones into new lines of activity was discontinued, and the authorities initiated a rehabilitation plan for the public enterprise sector. The reform package encompassed measures to restructure or liquidate certain enterprises and to develop a privatization program.

Although several major and small enterprises have already been privatized, in order to expedite the process, in 1990 the authorities adopted a comprehensive master plan that identifies for privatization in the next several years a significant group of NPEs, accounting for about 10 percent of the capitalization of the Kuala Lumpur Stock Exchange. Effective regulatory safeguards are in place to protect competition where monopolies arise in the privatization process. Employment in privatized companies will be protected for a transitional period and pension rights of staff remain guaranteed. The proceeds from privatization are to be used for retiring government debt.

Banking and financial market reforms. To stimulate the economic recovery in which the private sector was designed to play the leading role, monetary policy was relaxed in 1986 and 1987 and the government adopted specific measures to finance new investment in manufacturing, agriculture, tourism, low-cost housing, and the export sector. However, financial institutions remained cautious in lending to private borrowers, given the banks’ overexposure to the property sector and a high level of nonperforming loans. The authorities took various steps to consolidate the banking system and to deepen and diversify financial intermediation. Capital requirements and banking supervision were strengthened, and the solvency of commercial banks and finance companies that had to set aside sizable provisions for bad and doubtful claims and interest in suspense was restored through the injection of new capital and a re-vamping of management. Key steps in the financial sector reform were the adoption in 1989 of a global approach in the supervision of all financial institutions and a uniform risk-based capital adequacy system that determines the capital requirement of financial institutions based on a weighting of on-and off-balance sheet items according to the risk of the exposure. Several other measures were taken to promote an active secondary market in government securities and to stimulate the development of a debt securities market for private corporations.

Malaysia: selected economisc indicators, 1980-90

Sources: Data provided by the Malaysian authorities; and staff estimates.

1 IMF staff estimates.

The positive response of the Malaysian economy to the structural policy initiatives was facilitated by the absence of deeply entrenched inflationary expectations and of trade policies favoring import substitution….

Recovery; improved outlook

The positive response of the Malaysian economy to the structural policy initiatives was facilitated by the absence of deeply entrenched inflationary expectations and of trade policies favoring import substitution—impediments that have hampered recovery in many other developing countries. In marked contrast to the shrinking per capita real incomes of developing countries with debt-servicing difficulties during the 1980s, a vigorous recovery started in Malaysia in 1987, led by a boom in manufactured exports. Beginning in 1988, domestic investment and consumption took over as the main forces behind the economic expansion. Manufactured exports remained strong, however, exceeding one half of total exports by 1989, thus moderating the vulnerability of the external accounts to sharp international commodity price fluctuations. Real GDP growth picked up sharply, with inflation kept well under control.

The external current account balance initially swung into a sizable surplus but weakened to approximate equilibrium by 1989, under the influence of rising imports of capital and consumer goods. The ratio of foreign debt to GNP continued to fall, reaching 43 percent by 1989, however, while gross external reserves were maintained at a comfortable level. The overall balance of payments was boosted by an unprecedented upturn of equity capital inflows, which more than doubled, to about 5 percent of GNP, in 1989. Foreign direct investment financed about one quarter of private capital formation, mainly channeled to the petroleum sector and export-oriented manu-facturing. Economic activity accelerated further in 1990, underpinned by accommodating financial policies, a continued surge in foreign direct investment, as well as the effect of the increase in petroleum prices. As capacity constraints have become more manifest and segments of the labor market have tightened, supply and demand imbalances have intensified, mainly reflected in a weakening of the external current balance.

The current investment boom and the gains in capital efficiency and labor productivity in recent years have laid a solid foundation for strong growth in the medium term. The principal conditions that will help attain this are a smooth transition from the current rapid expansion of demand to a more sustainable pace and the continued commitment of the authorities to the structural reform agenda, including a greater emphasis on human resource development and flexibility in arrangements between employers and employees concerning wage determination.

Malaysia has made considerable strides since independence in reducing the incidence of poverty, in equalizing access to educational opportunities, integrating the labor market, and broadening participation in all productive activities across ethnic groups, as well as in improving the availability of basic health services to the population. These notable successes have been chiefly attributable to and have, in turn, contributed to a generally strong economic performance. The latter was fostered by high investment rates and smooth structural changes, facilitated by stable macroeconomic conditions and a pragmatic approach to the implementation of long-term development plans. The broad thrust of policies in the 1990s is expected to be essentially unchanged, with a more selective targeting of aid programs and a continued pragmatic implementation of the overall strategy to preserve national unity in Malaysia’s multiracial society.

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