Introduction

The Malaysian economy has recovered solidly since the 1997–98 financial crisis; the recovery was made possible by numerous reforms as well as favorable external conditions. Ongoing reforms in the financial sector have made the economy more resilient. Operation of the securities markets is more efficient and the level of corporate governance enhanced. The banking system's delinquencies and exposure to double mismatches have been reduced. Smaller banks were merged with larger and more capitalized ones. Better risk management and prudential regulations were also implemented.¹ Distressed firms were either shut down or merged with stronger ones. Moreover, the exchange rate is increasingly flexible (McCauley, 2002).

From 1999 to 2007, Malaysia has generated a current account surplus, attracted a fair amount of foreign capital, and accumulated large international reserves. The last factor may act as a precautionary motive to prevent speculative attacks on Malaysia's currency, given its highly opened economy. While the running of a positive current account may tend to replace depleted foreign exchange reserves after the crisis, a recurrent current account surplus of more than 10% of GDP may indicate excess savings over investment. This is also evident by the downward trending loan-deposit ratio of the banking system. A persistent current account surplus also shows that the economy is driven by exports, with the domestic sector being anemic. A more dynamic domestic sector would lead to a smaller current account surplus through higher domestic consumption and investment.

While strong economic growth, and healthy corporate and household sectors, as well as continued global search for yields have led to massive inflows of capital into Asia, these inflows have posed both benefits and risks.² These inflows contributed to Malaysia's resilience by entering productive activities in the real economy, and by confronting external shocks through the build-up of reserves. Nevertheless, the regulator needs to pursue active monitoring and intervention to prevent excessive domestic liquidity, credit growth, a volatile or misaligned exchange rate, inflation, and possible overheating of the economy.

In addition, prolonged global imbalances could jeopardize the Malaysian economy. Large capital inflow combined with current account surplus can exert upward pressure on the ringgit exchange rate, which tend to erode the level of competitiveness. To moderate currency appreciation pressure, the monetary authority has intervened in the foreign exchange market as well as through bond issuance to absorb excess liquidity generated by large foreign inflows.³ This trend is expected to continue at least in the medium term, given ample global liquidity and a greater degree of risk-taking by investors. Global liquidity remains high due to structural weakening of the US economy and its financial assets, and the rising trend in carry trades encourages capital to flow into high-yielding emerging Asian economies.

Thus, it is timely to discuss how the monetary authority would manage surges in capital flows, while maintaining prudent macroeconomic and financial stability. Failing this, is there any scope for regional cooperation initiatives? The paper is organized as follows. Section II discusses issues pertaining to capital flows under a fixed exchange rate regime. Policy measures are also evaluated. The study of capital flows and policies under a managed float exchange rate regime is the subject of Section III. Section IV examines alternative policy measures to manage capital flows. The paper concludes in Section V. Appendix I lists key external policy milestones in Malaysia since 1999. Appendix II presents the old format of the balance of payments figures used by the authority.

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