Public Information Notice No. 02/135

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Malaysia

December 10, 2002

On October 16, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Malaysia.¹

Background

The Malaysian economy is entering a recovery phase. Following two consecutive quarters of negative growth, real GDP growth turned positive to 1.1 percent year-on-year (y-o-y) in the first quarter of 2002 and accelerated to 3.8 percent (y-o-y) in the second quarter, driven by growth in consumption and public investment, as well as rising external demand, whereas private investment remains somewhat weak. Unemployment has been moderate (below 4 percent) and inflation remains subdued (below 2 percent). The output gap is narrowing with capacity utilization at 80 percent at end-June. The recovery has been broad-based, with a significant contribution from domestic demand-driven sectors, and more recently a pick-up in external demand.

The external sector remained relatively robust in 2001 and early 2002 despite an adverse global environment. Both the external trade and current accounts recorded large surpluses, and these have remained relatively stable during the first half of 2002 (compared with the same period in 2001). Growth in exports has turned positive since March 2002 and remains strong (at 13 percent in August, y-o-y), while growth in imports accelerated (to 22½ percent in August, from 18½ percent in July), reflecting a recovery in domestic economic activities. Net capital outflows stabilized in early 2001 and have declined since the second half of 2001, reflecting in part an improved market sentiment regarding the strength of Malaysia's economic fundamentals, and in part the reversal of the interest rate differential (vis-à-vis the United States) in favor of Malaysia. The capital account, however, weakened somewhat during the first half of 2002, recording a deficit of about $0.9 billion compared with a surplus of around $2 billion in the second half of 2001. Profit-taking by portfolio investors, lower net public sector borrowing, redemption of debt securities, and repayments of loans by the private sector have more than offset positive, albeit subdued, net foreign direct investment inflows.

Malaysia's external debt has increased moderately (to 51 percent of GDP in 2001), but remains manageable. Total external debt as a ratio to exports is at a low of 43 percent, and total external debt service represents only about 6 percent of exports of goods and nonfactor services. Gross international reserves, which declined sharply in the period ending May 2001, have since recovered to $34 billion at end-September 2002, sufficient to cover nearly four months of imports of goods and nonfactor services and three times short-term external liabilities by remaining maturity.

The emerging recovery has been supported by a timely and carefully formulated expansion in fiscal policy, which remains the main countercyclical tool available under the current fixed exchange rate system. Despite the two fiscal stimulus packages amounting to 2¼ percent of GDP, the overall central government deficit (5½ percent of GDP) was smaller than anticipated under the revised 2001 budget and marginally lower than its level in 2000. However, the consolidated public sector deficit shifted from a surplus of ¾ percent of GDP in 2000 to a deficit of 3 percent of GDP in 2001, providing a sizable fiscal impulse to the economy.

The original 2002 budget envisaged some moderate fiscal consolidation for both the central government and consolidated public sector, with deficits targeted at 5¼ percent of GDP and 2¾ percent of GDP, respectively. The revised 2002 budget, announced in late September, targets a further moderate reduction in the central government deficit (to 4¾ percent of GDP) and a much faster pace of consolidation for the consolidated public sector (to a deficit of 1 percent of GDP).

The central government deficit is expected to decline further in 2003 (to 4.1 percent of GDP), while the consolidated public sector balance is projected to shift to an overall surplus (½ percent of GDP). The improvement in both the central government and the consolidated public sector balances in 2003 is projected to result from reductions in development expenditures and virtually unchanged current expenditures in relation to GDP, while revenue is expected to remain high, despite a modest decline as a share in GDP. With the 2003 budget, the government announced its intention to balance the central government budget in 2005.

Total public sector debt reached 70¾ percent of GDP in 2001 (up from 61 percent of GDP a year earlier). The increase was due to: (i) deficit financing of about 3 percent of GDP; (ii) the government's assumption of debt (about 3½ percent of GDP) associated with the debt restructuring of Malaysia Airline System and two other large infrastructure projects (Putra and Star Light Rail), which until recently were managed and operated by the private sector; and (iii) a decline in nominal GDP (the remaining 3 percent of GDP). Nearly 70 percent of the increase was in the form of either direct or guaranteed debt by the central government, and about a half of the increase was funded from external sources. Central government debt, at 43½ percent of GDP, appears manageable given that debt service accounts for 12 percent of budget revenue and 14 percent of operating expenditure. Debt of the nonfinancial public enterprises (NFPEs), at 26¾ percent of GDP in 2001, is owed mostly by the three largest NFPEs (Petronas, Tenaga, and Malaysia Telecom), whose capacity to repay have been sound.

A firm implementation of the fiscal plans for 2002 and 2003 should help substantially reduce the burden of public sector debt. More specifically, on the basis of the additional public sector borrowing requirements reflected in the approved budgets, total public sector debt would decline from 70¾ percent of GDP at end-2001 to 68⅓ percent of GDP at end-2002 and to lower levels over the medium term. However, the historical trend indicates that public sector debt has been growing at a faster pace than implied by the net financing requirements of the consolidated public sector reflecting, in part, operations not captured by the consolidated accounts, including the issuance of government bonds for the development of domestic capital markets and acquisition of public assets.

The Bank Negara Malaysia (BNM) intervention rate has remained stable and above international interest rates, notwithstanding a 50 basis point cut in September 2001. The resulting interest rate differential (1¼ percentage points above the corresponding LIBOR), together with improved economic fundamentals, helped stem capital outflows and facilitated a rebuilding of international reserves since June 2001. To address the monetary impact of a favorable balance of payments, BNM conducted sizable sterilization operations while ensuring adequate domestic liquidity. This action, coupled with a more liberal and competitive pricing of loans by commercial banks (resulting in lending rates below the base-lending rate for some sectors), has complemented the fiscal stimulus in helping the economy weather the impact of a global slowdown.

Banking and corporate sector reforms have been given renewed impetus. The banking system remains generally sound with capital adequacy ratios of 13.3 percent in August 2002 and satisfactory profitability levels. Net nonperforming loans (NPLs) (based on a three-month classification) declined to about 10.6 percent of total loans at end-August 2002 (from 11½ percent at end-2001). The bank merger program that began in 1999 was completed in 2001, with 54 banking institutions merged into ten banking groups. Operational integration within each group continues. Danaharta (the asset management company established in 1998) has restructured all of its holdings of NPLs, and the Corporate Debt Restructuring Committee (also established in 1998) closed down its operations as planned in-August 2002, completing all but one of the 48 debt restructuring cases.

Market sentiment on Malaysia, as reflected in its sovereign ratings, remains favorable. New placement of sovereign bonds in April and June 2002 were oversubscribed. Major international rating agencies upgraded Malaysia to BBB+/Baa1 during August-September. Spreads for Malaysia's sovereign bonds remain relatively low, fluctuating within a range of 150-200 bps since end-2001. However, the Kuala Lumpur Stock Exchange Composite Index has continued to decline (by about 10 percent during the period of September-early October). This development was broadly in line with equity price movements in other major regional markets, reflecting concerns about the risk of a slower-than-anticipated pace of global recovery and volatility in mature equity markets.

Executive Board Assessment

Directors noted that, following the externally induced slowdown in 2001, the Malaysian economy has entered a recovery phase, and appears to be well placed to benefit from a global recovery. Economic growth has picked up strongly in the first half of 2002, and capacity utilization has increased, although to date private investment has remained subdued. At the same time, the trade and current accounts remain in sizable surplus, and gross official reserves have strengthened to a comfortable position, despite some recent weakening in the capital account in the second quarter of 2002.

Directors commended the Malaysian authorities for pursuing a judicious macroeconomic policy strategy that has helped them weather the impact of the global slowdown, allayed earlier concerns of some Directors about the sustainability of the exchange rate, and laid the foundations for a positive economic outlook. In particular, Directors noted the provision of a timely fiscal impulse, coupled with the prudent management of the net domestic assets of the Central Bank, and the continued implementation of structural reforms, especially in the banking and corporate sectors. Looking ahead, Directors agreed that continued prudent macroeconomic policies, together with further structural efforts at enhancing economic resilience and diversifying the sources of growth will be key to sustaining favorable prospects over the medium term.

Against this backdrop, Directors welcomed the government's intention to return to a path of fiscal consolidation. They supported the fiscal targets announced with the 2003 budget, and the stated objective of balancing the central government budget by 2005, and looked forward to a sustained improvement in the finances of the nonfinancial public enterprises and local governments. Directors encouraged the authorities to continue to monitor fiscal developments closely to ensure that the projected level of revenues is achieved, while containing the growth in operating expenditure and scaling back noncore development projects in the event of a revenue shortfall. Directors stressed the importance of better delineating the relationship between the central government and the rest of the public sector, of containing quasi-fiscal expenditures, and of ensuring that remaining quasi-fiscal operations are reflected transparently in the central government budget. A number of Directors also encouraged the authorities to adopt a multi-year budgeting framework. Some Directors saw scope for greater reliance on automatic stabilizers, rather than on discretionary fiscal measures. To support progress in these areas, the authorities were encouraged to undertake a full fiscal ROSC.

Directors noted the recent rapid increase in public debt levels, but agreed that central government debt appears to be manageable, and that most of the debt of public enterprises is held by units whose capacity to repay appears to be adequate. To enhance transparency and facilitate the assessment of debt sustainability, they strongly urged the authorities to move expeditiously to develop a full accounting framework that will reconcile the positive difference between public debt statistics and the implied debt stock derived from the accumulated net flows of deficit financing, and to step up efforts to compile the net worth of the public sector, including an estimate of the market value of all public sector assets and contingent liabilities.

Directors noted that the monetary policy stance to keep domestic interest rates broadly stable, while allowing some reductions in retail rates, has appropriately supported the recovery of private consumption. At the same time, improving market sentiment toward Malaysia's sovereign bonds, together with a favorable and sustained interest rate differential, has contributed to reduce the incentive for net capital outflows and has helped to strengthen the international reserve position. Directors welcomed the actions undertaken by Bank Negara Malaysia to move to a more market-oriented monetary policy framework, which should help to ensure adequate liquidity support for domestic activity. They looked forward to the full implementation of the Financial Sector Masterplan, including the liberalization of interest rates, which should help enhance competitiveness in the financial system, as well as further strengthening of the supervisory framework and the introduction of a market-based deposit insurance scheme.

Directors noted that Malaysia's strengthened fundamentals are supportive of the exchange rate peg as a stability anchor, and that the value of the ringgit does not appear to be misaligned. They welcomed the authorities' commitment to ensure competitiveness through deepening structural reforms, as well as their readiness to continue to monitor the situation closely. In light of this, a number of Directors supported maintaining the present policy. While they saw no imminent need to reconsider the peg at this time, many other Directors were of the view, however, that a carefully prepared move toward a more flexible exchange rate regime would broaden Malaysia's options over the medium term to cope with future shocks and manage risks associated with capital flows, including by alleviating the burden on fiscal policy to deal with future aggregate demand shocks. Any move toward a flexible exchange rate system should preferably take place from a position of strength, at a time of favorable market conditions, and be accompanied by the adoption of an alternative monetary policy framework. While recognizing that capital controls have played a role in helping Malaysia to regain financial stability, and that most of the remaining measures are mainly capital account regulations of a prudential nature, a few Directors encouraged the authorities to further relax them.

Directors commended the government's strong commitment to banking and corporate reform, which has been key to laying the foundations for a sustained recovery. They noted, in particular, that the asset management company (Danaharta) has restructured nearly all of its holdings, and that the Corporate Debt Restructuring Committee has recently closed its operations, completing virtually all its debt restructuring cases. Directors noted that Malaysia's banking sector remains well capitalized, and welcomed the substantial progress made in strengthening the supervisory and regulatory framework. In this regard, they encouraged the authorities to consider early participation in an FSAP exercise to help them assess the impact of ongoing reforms. Directors also welcomed the significant progress in developing the legislative framework and institutions to combat money laundering and the financing of terrorism, and looked forward to early accession to and implementation of the UN Convention for the suppression of the financing of terrorism.

Directors were encouraged by the authorities' commitment to wide-ranging structural reform. They noted that achieving the medium-term growth objectives will require, in addition to a steady pursuit of fiscal consolidation, continued efforts to further strengthen the financial and corporate sectors through operational integration of the recently consolidated banking sector and improvements in corporate governance. Director also underscored the importance of promoting greater flexibility in labor and factor markets, and of maintaining a liberal trade and investment regime that remains supportive of foreign direct investment inflows.