From Occasional Paper 207 (IMF 2001)
As an emerging market economy, Malaysia is clearly a success story. Malaysia’s development plans were implemented effectively from 1970 to the mid – 1990s, the country’s investment ratio was amongst the highest in the region, resulting in a dramatic shift in the structure of the economy from agriculture and mining to reliance on manufacturing. Liberalization measures were introduced across the board that helped improve competitiveness and productivity. Much of the investment went into electronics and other export oriented industries, while a large portion went into non tradable sectors including capital intensive infrastructure and the real estate sector.
Sustainable high growth during the 1980s brought significant improvements in living standards and social cohesion. Economic diversification, coupled with deregulation and liberalization of the financial system, also helped transform the country into a middle – income emerging market by the end of that decade.
Malaysia’s strong economic performance continued during the 1990s prior to the crisis. Real output growth averaged 81/2% per year, unemployment was below 3%; prices and the exchange rate remained stable; and international reserves were robust. However, there were also signs of stress as exports decelerated and a large current account deficit developed in the context of a gradual appreciation of the effective exchange rate. While the investment – led growth strategy was successful in raising output and income, investment quality had deteriorated. This eventually led to major balance sheet weaknesses in the banking and corporate sectors, exposing the economy to the contagion of the Asian crisis. Malaysia went through a currency crisis and a banking crisis, but its low level of the external debt spared it from an external debt crisis.
Malaysia’s economic vulnerability stepped up significantly from early 1997 through the period following the onset of the crisis in mid – 1997, as market confidence increasingly diminished along with the rest of the region. Large portfolio outflows took place, and equity and property values declined substantially. Large portfolio outflows took place and equity and property values declined substantially. The ringgit came under tremendous pressure. As currency traders took speculative positions in the offshore ringgit market in anticipation of a large devaluation, the offshore ringgit interest rates increased markedly relative to domestic rates. This heightened upward pressure on domestic interest rates, intensified outflows of ringgit funds, and exacerbated banks’ liquidity problems and overall financial distress.
The Malaysian corporate sector experienced significant loss of wealth as a result of sharp falls in the value of real estate and equities used as bank collateral. Corporate incomes and cash flows also declined, leaving some corporations unable to service their debt.
The initial response of the authorities was to hike interest rates and tighten fiscal policy in an attempt to anchor market confidence in the financial system. In early 1998, fiscal policy was revised to a more expansionary stance. This policy mix proved to be insufficient to correct external imbalances and bring about the needed economic adjustment. The contagion effects of the crisis and the associated economic contraction were far worse than anticipated. Domestic imbalances quickly emerged as growth rates slowed and then turned sharply negative in early 1998. Market confidence faltered and adverse regional developments and uncertainties. Anticipation of further devaluation of the ringgit heightened. By the summer of 1998, the stock market had fallen to its lowest level in recent history.
In 1998 September, the Malaysian authorities launched a policy package designed to insulate monetary policy from external volatility. Measures included an exchange rate pegged to the U.S dollar and selected exchange and capital controls, complemented by a fiscal stimulus package that stepped up capital spending. These measures permitted the subsequent lowering of interest rates. The authorities also pursued fundamental reforms in the financial and corporate sectors, including a bank consolidation program and an upgrading of prudential regulation and supervision in line with international best practices.
Malaysia’s recovery in 1999 – 2000 was among the strongest of the Asian crisis economies, led by buoyant world demand for electronics and supported by accommodating macro economic policies. The external current account turned into large surpluses, allowing a build up of international reserves. Unemployment declined, and inflation remained low. The strong growth and gradual easing of capital controls helped improve investor confidence. The recovery was also accompanied by reduced vulnerability of the financial system.
Looking a head, the issue is how Malaysia can better protect itself from future shocks and avoid another crisis while it seeks to regain its position as one of the fastest growing economies in the world. To these ends, its strategy should include continued structural reforms to achieve healthy balance sheets of the banking and corporate sectors; further deregulation to promote competition and efficiency; and consistent macro economic policies to maintain financial stability and sustainable fiscal and external positions.