Phase IV: From the 1997 Crisis, to Recovery, to the Present

The Asian financial crisis that started in Thailand on 2 July 1997 spread relatively quickly to neighboring countries, including Malaysia. The BNM intervened heavily to try and stem the speculative attacks on the ringgit that followed the collapse of the baht, but finally gave way on 14 July and allowed the currency to float. Between the float and January 1998, the ringgit had depreciated by about 50% against the US dollar. The crisis in Malaysia was characterized by a significant and dramatic reversal in foreign portfolio capital, a reflection of the stock market boom that preceded the crisis.

Another distinguishing feature of the Malaysian crisis was that its banking sector had only very limited exposure to foreign debt. Perhaps as a result of this, Malaysia was able to deal with the initial phase of the crisis without an IMF-sponsored rescue package. After “muddling through” the crisis for about five months, then-Finance Minister Anwar Ibrahim announced an IMF-like policy package to deal with the crisis. Some of the key elements of this package included cutting government spending by 18%; postponing indefinitely all public sector investment projects; freezing new company share issues and company restructuring; and banning new overseas investment by Malaysian firms. The fiscal tightening was accompanied by monetary tightening by the BNM. BNM increased its inter-bank lending rate from 7.6% to 8.7% in December 1997, and then 10% in January and 11% in February 1998.

Following a growing and much publicized rift between then-Finance Minister Anwar Ibrahim and Prime Minister Mahathir, which culminated in the dramatic dismissal and incarceration of the former, a policy rethink ensued. With the Malaysian economy contracting by 7.4% in 1998 (Table 1 [ PDF 14.3KB | 1 page ]), the effectiveness of the IMF-type policy prescriptions in delivering recovery were being questioned.

In a radical turnaround, Malaysia opted for a Keynesian-style reflationary program, on the premise that financial markets had over-shot. In order to implement this program, capital controls had to be introduced in order to circumvent additional capital outflow associated with loosening monetary policy and the lowering of interest rates. In short, the government chose to temporarily disconnect the domestic capital market from the global economy in order to pursue its stimulatory policies (Hill, 2005).

The expansionary macroeconomic policy package involved both increased spending and loosening of monetary policy. The 1999 Budget, presented in October 1998, foreshadowed increasing the budget deficit from 1.8% to a target 3.2% in 1999, while the 2000 budget predicted a further increase to 4.4% of GNP. On the monetary front, the BNM successively cut the statutory reserve requirement from a pre-crisis level of 13.5% to 4% by late 1998. The inter-bank lending rate, which had risen to 11% in February 1998, was brought down gradually to 4% by early 1999. An assortment of other monetary measures was also introduced to reduce the cost of bank credit, free-up capital for banks, and boost credit expansion (see Athukorala, 2001, for details). It would appear that monetary policy was assigned the greater role in stimulating the economy, and this was only possible with capital controls in place. Unlike fiscal policy, the impact lags associated with monetary policy are shorter, and rather than running the risk of crowding-out private investment, lower interest rates would work to stimulate it.

With these measures in place, recovery came relatively quickly. GDP growth returned to positive territory by the second quarter of 1999, and annual growth for the year was an impressive 5.4%. This was massive turnaround, especially when considering that the economy had contracted by 7.4% the previous year. Growth accelerated in 2000 to a remarkable 8.9%, and the economy had regained its pre-crisis level of GDP by mid-2000 (Table 1 [ PDF 14.3KB | 1 page ]).

Contrary to initial and widespread skepticism, the radical reform measures centering on the use of capital controls appeared to have worked in Malaysia. So why did they work? A number of commentators, such as Athukorala (2001), Zainal-Abidin (2002) and Hill (2005), identify a number of factors that may have contributed to the success of this unorthodox response to the crisis. Three such factors are often highlighted.

The first relates to the exchange rate peg itself. The level at which the exchange rate was pegged, at RM3.8 to the US dollar, was considered to be on the “low” side, thus conferring a major competitive boost to the tradable goods sector. The second relates to the implementation of the controls. It was made very clear that the target of the controls was purely short-term flows. The government went out of its way to reassure foreign equity investors of this. It would seem that they succeeded because FDI flows actually increased in the wake of the controls. The final point relates to policy credibility and institutions. The government was at pains to avoid being seen as playing political favorites with its bail-outs and expenditure projects. This has been a long-standing concern relating to corporate governance in Malaysia. In the context of a financial crisis involving an unorthodox policy response, it was paramount that the reflationary program did not appear to be politically tainted. In this context, and as highlighted by Hill (2005), it was highly beneficial that the two key macroeconomic policy institutions, BNM and the Ministry of Finance, both had longestablished policy credibility.

These three factors, along with a host of other related circumstances, combined to ensure the success of Malaysia’s unique crisis management and recovery program.

Apart from a sharp drop in growth to 0.3% in 2001, mainly as a result of the downturn in the electronics cycle, Malaysia has been growing at a robust but slightly slower pace than in the years leading up to the crisis. Growth in the last few years has averaged about 5.5% and the Ninth Malaysia Plan, issued in 2006, targets an average annual growth rate of 6% for the period 2006-2010. Malaysia's decision in mid-2005 to move off the fixed currency peg came immediately after the People’s Republic of China announced that it would do the same. This was preceded by a gradual easing of various restrictions relating to capital movements. The ringgit has been appreciating steadily ever since then. Removing the peg has allowed greater flexibility in the conduct of monetary policy, especially in terms of curtailing inflation owing to higher energy prices. The fiscal deficit has also been falling, coming down from above 5% of GDP in the early part of this decade to 2.6% in 2006. Furthermore, as a net hydrocarbons exporter, high international energy prices have provided government with a windfall. ADB (2007) estimates that a US$1 per barrel rise in the price of crude oil corresponded to RM228 million (US$62 million) higher oil-related revenues in 2006. Such revenues represented 37% of central government income, although retail fuel subsidies could absorb up to one quarter of these receipts.

But FDI inflows have not returned to their pre-crisis levels, and the emergence of the People’s Republic of China as a major competitor in export markets suggests the need for change, going forward. Skills shortages and other bottlenecks also appear to be impeding Malaysia’s progression up the technology ladder. More recently, there has also been concern over rising inflation and crime.

It was against this backdrop that elections were called on 8 March 2008. The result of these elections were remarkable for a number of reasons. Not since 1969 had the ruling coalition lost its two-thirds majority in Parliament. Apart from Kelantan, which had been under opposition control, four additional states—Penang, Perak, Selangor and Kedah—also fell to the opposition. Indeed, the ruling coalition actually lost the popular vote by a narrow margin in Peninsula Malaysia. Such an outcome could not have been possible unless all three major ethnic communities had rejected the government and its programs, to varying degrees, and this is exactly what happened.

On the whole, the impact of the elections on the economy is likely to be relatively muted. This is mainly because regional and global conditions are likely to dominate domestic factors in determining Malaysia's economic performance. The current global financial volatility, swings in commodity prices and even more medium term issues like the emergence of the People’s Republic of China as a competitive threat are likely to be more important, and will continue to play the determining role.

But there will be impacts, and the degree of such impacts will be largely determined by how the government responds—both state and national. The broad based rejection of current policy implied by the election results itself provides an opportunity to make change and push forward with reforms. The most important policy change would be a revamping of the NEP. The focus should shift to eradication of poverty among the entire population, as the goal of reducing inter-ethnic income inequalities has been largely achieved. In its place, intra-ethnic income disparities have worsened (Hill, 2005), and some of this must be attributed to the way in which the NEP has been implemented. Like most affirmative action programs, the main beneficiaries are usually the ones least requiring support. They are not only inefficient, however, but tend to breed corruption and cronyism. In this respect, the moves by the new Penang state government to remove distortions in procurement of government contracts is a welcome reform. Hopefully it will spread to other states. Without a two-thirds majority, the ruling coalition may not be able to impede reform emanating from the more progressive states.

As noted earlier, the NEP has played an important signaling role, and has played its part in delivering the peace and stability that Malaysia has enjoyed. It is now past its expiry date however. Furthermore, changes to Malaysia’s demographics as a result of Chinese outmigration and significantly higher Malay fertility rates imply that the current system is simply unsustainable. As the share of the Malay population approaches 75%, up from just over 50% at the time of the Program’s introduction, it will no longer be easy, or fiscally responsible, to continue with this tax-transfer scheme. Unless Malaysia is willing to sacrifice macroeconomic stability, then the resource requirements of the current system will soon be too demanding. Malaysia has always opted for economic pragmatism during times of economic stress or impending crises and it is to be hoped that this approach will prevail this time as well.

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