Public Information Notice No. 05/33

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with Malaysia

March 14, 2005

On February 7, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Malaysia.¹

Background

Economic growth has been the highest in four years. Real GDP growth, which peaked at 8¼ percent (year-on-year, or y/y) in the second quarter of 2004, is expected to have reached 7 percent for 2004 as a whole. Initially led by strong exports, the growth momentum has subsequently been driven by robust private consumption on the back of rising consumer lending, higher proceeds from commodity exports, low unemployment and strengthened confidence. Preliminary indicators also suggest an emerging recovery of private investment activity after several years of decline. Growth moderated somewhat in the third quarter to 6¾ percent (y/y) in line with regional trends. CPI inflation was generally subdued, but nudged up since the third quarter, partly reflecting the government's decision to raise retail prices of petroleum products and taxes on tobacco and alcohol. Core CPI inflation (excluding food, beverages, and transportation) has remained stable at an annual rate of around a ½ percent. Producer prices rose led by higher commodity prices. The impact of the regional tsunami disaster is unlikely to affect Malaysia's macroeconomic performance.

The trade and current account surpluses have remained large. Through September 2004 export growth has been strong (28¾ percent y/y), but outpaced by higher import growth (34¾ percent). Since then both export and import growth have begun to slow down, recording 12¾ percent (y/y) and 13¾ percent (y/y), respectively in December. Services receipts rose, mainly driven by a strong recovery in tourism. The capital account has improved. FDI inflows have strengthened somewhat through the third quarter, but remained low by historical standards. FDI inflows have changed in nature from the more capital-intensive manufacturing sector to less capital-intensive services (but with higher value added). Portfolio inflows surged in the first quarter, particularly into equity, money market instruments, private debt, and government securities, in line with regional trends. After subsiding through mid-year, portfolio inflows have begun to rebound in the third quarter. Gross international reserves have risen steadily to reach US$66¾ billion (end-December). Reserves are sufficient to cover more than 6 months of next year's total imports and 4½ times short-term external debt (by remaining maturity).

Market sentiment continues to be favorable. The Kuala Lumpur Composite Index has gained more than 14¼ percent in 2004. Sovereign bond spreads have remained below 100 basis points. Fitch and Moody's have raised Malaysia's sovereign debt rating by one notch to A- and A3, respectively (while Standard and Poors maintained Malaysia's sovereign ratings at A-).

Fiscal consolidation is proceeding, but with an adjusted pace. On preliminary data, the federal government deficit is estimated to have amounted to 4¼ percent of GDP, about 1 percent of GDP lower than in 2003, but 1 percent of GDP higher than originally budgeted. Deviations mainly reflect the adverse combined effect of higher oil prices on subsidies and sales tax revenue under the Automatic Pricing Mechanism, and a decline in corporate tax revenue. In contrast, the consolidated public sector deficit is expected to decline to about a ½ percent of GDP, with a higher-than-anticipated surplus of non-financial public enterprises (NFPEs), in particular regarding the petroleum company, expected to offset the reduction in the federal government deficit.

The 2005 budget envisages a further consolidation. The federal government deficit is targeted at 3¾ percent of GDP. The adjustment relies on expenditure control, as revenues are projected to weaken further, with existing incentives and new ones, announced with the 2005 budget to promote agriculture and domestic capital markets, expected to weigh on corporate tax performance. The decline in expenditures is expected to be primarily driven by a decline in subsidies and transfers (mainly on account of lower subsidies on petroleum products), a reduction in tax refunds reflecting strengthened tax administration, and a modest decline in development expenditures as the government is reviewing its overall investment strategy ahead of the Ninth 5-year development plan. The consolidated public sector deficit is expected to turn into surplus (about 1 percent of GDP), reflecting the improvement in the federal government balance and a continued high surplus of the NFPEs owing to favorable oil prices and early benefits from performance-enhancing reforms launched for listed government-linked companies (GLCs) earlier this year.

Total public debt has remained high at about 69 percent of GDP, but is manageable. Based on the authorities' commitment to fiscal consolidation and the assumption that the federal government budget will approach balance in 2007/08, public sector debt is projected to decline from 69 percent of GDP in 2003 to 46 percent of GDP in 2009, while debt of the federal government would peak at 49½ percent of GDP in 2004 and then decline steadily to 38 percent by end -2009. Stress tests indicate that total public sector debt appears robust under most shocks considered, with a shock to real GDP growth (GDP growth at two standard deviations below historical average for two consecutive years) posing the biggest risk. If account were taken of the sizable assets of the leading NFPEs and the likely further asset buildup from future NFPE surpluses, the net debt of the consolidated public sector would be significantly lower.

Bank Negara Malaysia (BNM) continues to manage domestic credit prudently and interest rates have begun to play a more traditional signaling role. Base money growth has remained low, averaging 7½ percent during the year through November, as BNM has continued to effectively counter the monetary impact of reserve increases. Broad money (M3) grew by an average of 9¾ percent during the same period, while growth in private sector credit (5¼ percent on average), remained relatively robust, in particular to households and small and medium-sized enterprises (SMEs). With the introduction of the new interest rate framework, the spread between the policy rate and interbank rates has narrowed. At the same time, the KLIBOR's premium over the LIBOR has declined to less than 10 basis points, following the recent increases in US interest rates.

The ringgit has remained undervalued, although the extent is difficult to gauge with precision. The sizable current account surplus could be seen as a sign of substantial undervaluation. However, other indicators suggest that the undervaluation of the ringgit is modest. In particular, the sharp increase in the current account surplus in 2003 leveled off in 2004 as import growth significantly outpaced that of exports, Malaysia's export share in key markets has remained broadly stable, and the forward premium has continued to decline in recent months. In real effective terms, the ringgit is estimated at about 3-5 percent below its neutral level (as at end-September 2004).

In the structural reform area, indicators of financial and corporate sector soundness have continued to improve, while progress has been made in enhancing the business climate. Capital adequacy of banks is strong, the ratio of nonperforming loans has continued to decline, and capital markets have remained relatively deep by regional standards. The implementation of the Capital Market and Financial Sector Master Plans is on track with recent key measures aimed at improving the prudential and regulatory framework. Efforts have also continued in mitigating finance companies' relatively high exposure to interest rate risks and banks' potential exposure to credit risks in the household sector. Exposure to foreign exchange risk remains limited given both limits on banks' open foreign exchange positions and the requirement of a natural hedge for borrowing in foreign exchange. Banking soundness has also benefited from improvements in the financial health of the corporate sector, reflecting the strong economic recovery and the completion of the post Asian crisis restructuring. Further liberalization of foreign exchange regulations and additional steps to improve the delivery of public services and governance have contributed to a more conducive environment for private investment.

Executive Board Assessment

Executive Directors expressed their sympathies to the Malaysian people for the loss of life resulting from the recent tsunami disaster. Turning to recent economic developments and policy issues, they took note of Malaysia's impressive economic performance in recent years. Directors complimented the authorities on their skillful and pragmatic macroeconomic management and decisive efforts to deepen structural reform, which they considered to have supported the ongoing recovery and to have provided a sound basis for sustaining high growth. Directors welcomed the strength of the recovery, the low rates of unemployment and inflation, and the continued favorable balance of payments performance. They noted the increasing role of the private sector in supporting growth, and the significant further progress made in enhancing the soundness of the financial and corporate sectors.

Directors agreed that, despite some recent moderation in growth in line with global trends, Malaysia's prospects are favorable and the risks to the outlook are balanced. They also observed that the government's commitment to a decisive pursuit of fiscal consolidation and the measures undertaken to enhance governance and the rule of law have helped to improve confidence and medium-term prospects.

Directors noted that the estimated reduction in the federal government deficit for 2004 as well as that planned for 2005, while representing a more gradual pace than envisaged a year ago, imply a substantial consolidation effort. They were encouraged by the authorities' readiness to explore all options and measures to offset potentially adverse effects of higher-than-anticipated oil prices on the federal budget. Directors emphasized the importance of expeditiously implementing measures to meet the 2005 fiscal targets, including to secure revenue collections, to keep current expenditures streamlined, to make public investment more efficient, and to enhance the financial performance of government-linked companies.

Looking ahead, Directors welcomed the government's plans to introduce a broad-based value added tax by 2007, streamline tax incentives, and further strengthen revenue administration. They encouraged the authorities to announce a medium-term path for fiscal consolidation in order to enhance credibility. Directors also recommended further steps to strengthen fiscal transparency, including through a compilation and more timely dissemination of key fiscal data, and a number of Directors encouraged the authorities to participate in a fiscal Report on the Observance of Standards and Codes (ROSC).

Directors supported Bank Negara Malaysia's prudent approach to managing domestic credit consistent with maintaining the peg. They welcomed the successful liberalization of banks' lending rates and the further liberalization of foreign exchange regulations. Directors were encouraged by the authorities' plans to develop alternative market-based savings instruments. Directors considered that, with the interest rate structure increasingly market determined, the authorities have rightly focused on strengthening the monitoring of asset prices and market expectations, as well as the management of credit risks.

Directors agreed that Malaysia's fixed exchange rate system continues to be supported by strong fundamentals. They shared the authorities' views that the credibility of the peg has been enhanced by the pursuit of prudent fiscal and financial policies, the measured ongoing liberalization of foreign exchange regulations, and the gains in the flexibility of goods and factor markets. Nevertheless, most Directors considered that, over time, and in due course, a well-prepared move to greater exchange rate flexibility can be beneficial for Malaysia. A more flexible arrangement would help the authorities manage risks associated with increasing capital flows, complement fiscal policy in addressing shocks, and facilitate adjustment to structural changes. Directors encouraged the authorities to continue to exchange views with Fund staff on technical issues concerning exchange rate policy alternatives.

Directors welcomed Malaysia's progress in strengthening further the financial system and the authorities' continued commitment to reform. They agreed that ongoing mergers in the financial market place, the introduction of pricing innovations for Islamic instruments, and the establishment of a credit reporting system have contributed to make the system more resilient and have helped strengthen risk management. Directors endorsed the authorities' recent decisions to enhance the functioning of the ringgit bond market, open Malaysian capital markets to major foreign stockbrokers and global fund managers, and adopt corporate governance standards, which together will help to enhance the liquidity and efficiency of these markets.

Directors welcomed measures to further improve Malaysia's business climate and competitiveness in order to help sustain high growth in the medium term. They welcomed recent steps taken to meet Malaysia's commitments under the Association of South East Asian Nations (ASEAN) in the automotive sector. Directors underscored the importance of an early adoption of measures aimed at further liberalizing the trade and investment regime, reducing skills mismatches, improving the delivery of public services, and enhancing governance.

Directors welcomed the authorities' steps for expanding the reporting requirements under the framework for anti-money laundering and combating the financing of terrorism to include capital market intermediaries, lawyers, accountants and company secretaries.