Public Information Notice No. 01/114

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Malaysia

November 2, 2001

On August 29, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Malaysia.¹

Background

Malaysia's economic recovery gained momentum during 2000 with real GDP growing by 8.3 percent, sustained by strong expansion in consumption and investment, and supported by stimulative macroeconomic policies and a favorable trend in exports. Since late last year, however, the economy has been adversely affected by the global slowdown. The impact has been significant, as Malaysia's exports are highly dependent on electronics. Real GDP growth in the first quarter of 2001 decelerated to 3.1 percent as sluggish export earnings combined with deteriorating consumer sentiment weakened private consumption, while private investment also slowed sharply, reflecting, in part, an adjustment to overstocking in the previous year. Inflation has remained low and capacity utilization has fallen in recent months.

While the current account remained in large surplus during 2000, capital outflows intensified in the second half of last year, leading to losses in gross official reserves. These outflows were caused to a large extent by repayment of external debt, overseas investments by Malaysians, and some delays in the conversion of export proceeds to ringgit. The capital outflows continued into the first few months of 2001, particularly during late March/early April as the yen and other regional currencies weakened and the ringgit appreciated markedly in real effective terms, raising concerns about the sustainability of the ringgit peg. However, the subsequent stability in the Japanese yen as well as regional currencies from late April and the further narrowing of interest rate differentials between Malaysia and the United States in recent months have helped to mitigate capital outflows. Official reserves as of mid-August 2001 stood at $27½ billion, covering 3½ months of this year's imports of goods and nonfactor services, or three times short-term external liabilities.

Macroeconomic policies were expansionary in 2000, supportive of economic recovery in a low inflationary environment. To mitigate the impact of the recent global slowdown on domestic activities, the authorities announced a package of additional fiscal stimulus in a March 2001 supplement to the year's expansionary budget. Interest rates are also kept low to balance the need to support economic growth, sustain domestic savings, and indirectly to maintain adequate profit margin for banks.

During 2000, significant progress made in financial sector reforms included the near completion of the bank merger program and ongoing enhancement of regulation and supervision. By August 2001, 51 banking institutions were consolidated. Capital-asset ratios reached 12.4 percent by year-end and have since remained above 12 percent, well above the minimum 8 percent; and the level of nonperforming loans has been generally contained. Strengthening of banking regulation and supervision has continued to focus on risk-based and consolidated supervision. The financial sector and capital markets master plans released in early 2001 propose to achieve full integration of the domestic financial system into the globalized market over a ten-year period.

In early May 2001, the authorities abolished the 10 percent exit levy on repatriated profits from portfolio investment of less than a year and eased the rules governing the purchase of property by foreigners.

Corporate financial positions benefited from the strong recovery and corporate debt restructuring in 2000. Nevertheless, corporate governance issues have been brought to the fore by a few high-profile cases, which have been cited as having a dampening effect on the stock market and delaying corporate recapitalization efforts. This situation improved significantly in 2001. A series of coordinated measures aimed at intensifying and accelerating corporate debt and operational restructuring, combined with previously introduced measures related to market-based listing and other capital market regulations by the Kuala Lumpur Stock Exchange (KLSE), the Securities Commission, and Bank Negara Malaysia, have resulted in an improved market sentiment. The KLSE index rebounded by more than 10 percent in June/July, making up for much of the losses earlier in the year.

Executive Board Assessment

Executive Directors noted that, following a strong recovery in 2000, Malaysia's growth and exports had slowed sharply owing to the deteriorating global environment. Official reserves, however, have recently increased and continue to be adequate to cover Malaysia's modest short-term debt, while speculation against the ringgit has abated since end-May.

Directors had a broad-ranging discussion of Malaysia's exchange rate regime. They generally saw no immediate problem in maintaining the pegged exchange rate system in view of the assessment that the current level of the ringgit is not misaligned from its long-term equilibrium, and that economic fundamentals remain strong. Directors considered that maintaining consistent macroeconomic policies over time, combined with steadfast structural reforms, will be key to sustaining market confidence and helping Malaysia manage external and domestic risks, forestall excessive output contraction, and provide a basis for sustainable growth. Further diversification of the export base will make the economy more resilient to external shocks.

Directors recognized that the ringgit has appreciated since late 2000, and that there were pressures on Malaysia's international reserves early this year. Directors noted that, if the weakening of regional currencies recommenced or instability in emerging markets surfaced, the pressure on the ringgit and official reserves could be renewed. A few Directors proposed that the authorities should consider the merit of introducing greater flexibility in the management of the exchange rate regime, but they agreed with others that the timing of such a move was an important issue, noting that any shift in the exchange regime at the prevailing highly uncertain global economic outlook and unsettled international financial markets could be destabilizing.

Directors also welcomed the recent removal of the remaining levy on profit repatriation of portfolio capital, and a few Directors urged the authorities not to resort to capital controls in the event of a deteriorating external position in the future.

Directors considered that fiscal expansion appears to be an appropriate policy stance in the current environment. Accordingly, they recognized that a temporary delay in fiscal consolidation is needed to avoid too sharp an economic slowdown and the risk of corporate and financial distress. Directors also noted that, given the nature of the spending, the fiscal expansion should not significantly weaken the balance of payments. Nevertheless, they cautioned that the authorities should monitor developments in the balance of payments on an ongoing basis and be prepared to exercise fiscal restraint in order to safeguard the external position.

Directors welcomed the authorities' plan to begin fiscal consolidation next year. This shift should help to reassure investors about Malaysia's fiscal sustainability in the medium term. A number of Directors expressed concern, however, about the use of public funds to acquire a commercial airline and the contingent liabilities that the government may be taking on in connection with a number of other privatized infrastructure projects, which could adversely affect the country's long-term growth prospects. They urged the government to extend support to these projects only as a last resort, and to identify clearly all potential public sector liabilities.

Directors welcomed the authorities' intention to rely more on market-based instruments in the conduct of monetary policy, and noted that efforts to develop the domestic bond market would facilitate this goal. They supported the adoption of a system of risk-based management by banks, which should permit the liberalization of Malaysia's interest rate structure, with banks setting deposit and lending rates more freely, without jeopardizing loan quality. Directors also welcomed the authorities' intention to apply the credit growth target flexibly, so as not to distort resource allocation decisions.

Directors supported the government's financial sector and capital markets master plans. If implemented effectively, the deregulation measures proposed in the plans would enhance the competitiveness and efficiency of the financial system, and lay the groundwork for eventual full integration into global financial markets. They encouraged the finalization of the proposed deposit insurance scheme in light of the moral hazard problems associated with the current blanket deposit guarantee. A number of Directors also encouraged the authorities to participate in the Financial Sector Assessment Program.

Directors welcomed Malaysia's efforts to adopt best practices of corporate governance and the recent steps taken to restructure operations of corporations. Some Directors were concerned about the remaining negative market sentiment owing to perceived poor corporate governance practices in a few high-profile cases. Directors considered that demonstrable progress in improving corporate governance will play an essential role in strengthening investor confidence and attracting foreign direct investment. They encouraged the authorities to accelerate corporate restructuring, and welcomed the authorities' plan to provide key data on progress with operational restructuring.

Directors considered that the overall quality of Malaysia's economic statistics is good. They welcomed the improvements that have been made in recent years to broaden data dissemination. Directors looked forward to seeing progress in the quality and timeliness of the balance of payments and external debt data, and urged the authorities to collect and publish comprehensive data on off-budget activities and contingent liabilities of the public sector.