Malaysia's expansionary policy leads to economic recovery
Malaysia's expansionary policy leads to economic recovery
Just before the East Asian crisis broke out in mid-1997,
Malaysia was being lauded as a "miracle economy" and a model
worthy of emulation by developing countries. The country had one
of the most remarkable growth records known to modern history and
was weaned from an agro-based economy to become a reputed
exporter of manufactured products. Its social achievements were
astounding. Within a short time, it had pulled millions out of
poverty and spread the benefits of growth equitably across
society. But how quickly the tone changed. Accolades gave way to
cries of crony capitalism, a lack of transparency and incompetent
companies. All this on a country that had never failed in its
commitment to international trade and with an economy as open as
any in the world.
It soon dawned that having strong economic fundamentals did
not provide sufficient defense against the speculators, and the
destabilization and consequent devastation they spread. The
sudden exodus of short-term portfolio funds, and a drop in the
ringgit due to the currency speculators, did the most damage. The
overreaction and "herd behavior" of short-term investors were
largely driven by irrational changes in perceptions of risks.
They had little regard for the country's strong economic
fundamentals. But thankfully, having strong fundamentals did, to
some extent, lessen the severity of the crisis. Malaysia's banks
did not face the same degree of systemic risk as others in the
region. The Government's coffers were in good shape, domestic
savings traditionally high and short-term foreign debt
manageable.
So, why then did Malaysia succumb to the crisis? The mistake
was in adopting an ala-IMF type of fiscal and monetary restraint
in late 1997 to stabilize the financial market and contain
inflationary pressures. Interest rates were raised, public
spending was cut and large investment projects deferred. This
proved to be a major error of judgment, serving to depress
confidence and increase uncertainty. The economy went into a
tailspin and output contracted sharply. It was soon obvious that
the IMF's orthodox, conventional wisdom of tight monetary and
fiscal policies was inappropriate to the situation.
High interest rates only dampened investments and further
constrained growth. Exports slackened and income levels dropped,
causing a greater contraction in domestic demand. Spending,
especially on consumer durable, crumbled as income and employment
uncertainty took hold on Malaysians. The country's openness to
foreign trade -- its ratio of exports plus imports amounted to a
whopping 200 percent -- did not help either. It only exacerbated
the adverse impact of the crisis. It was obvious, from the
benefit of hindsight of course, that an expansionary policy was a
better choice. It was time to be heterodox.
The damage caused by the crisis was much more than anyone
anticipated. The ringgit depreciated by 40 percent against the
U.S. dollar. There was enormous wealth loss as the stock market
plunged nearly 70 percent and market capitalization fell by more
than 200 percent of the Gross Domestic Product (GDP). This loss,
combined with rising unemployment, contributed to a harsh
contraction in consumption and investment. Real GDP contracted by
7.5 percent in 1998, a major drop from a 7.5 percent growth the
previous year. Annual loan growth fell to virtual stagnation and
nonperforming loans in the banking system rose to 11.4 percent
compared with 4.1 percent at the end of 1997.
Taking little comfort from this misjudgment, the Government
wasted little time in taking the bull by the horns. It recognized
that what the economy needed was lower interest rates to spur
economic activity and a fiscal kick start. This was only possible
if interest rates were decoupled from the exchange rate. With
lower interest rates and a stable ringgit, businesspeople and
manufacturers could operate with some certainty. Their debt-
servicing burden need no longer be at compelling levels. The
country also had to ponder what to do with hot money that zipped
into the country and rushed out at the first signs of trouble,
leaving in its trail massive destruction.
Malaysia decided to go against the grain. Immediately after
its formation in January 1998, the National Economic Action
Council (NEAC) met with different groups representing different
industries and segments of society. The feedback from these
meetings provided the basis for the National Economic Recovery
Plan (NERP) launched on July 23, 1998. The NERP offered a radical
homegrown remedy for overcoming the crisis. A countercyclical
approach was adopted. In essence, the strategy was to lower
interest rates and raise liquidity, increase public sector
spending, especially on infrastructure projects with high
multiplier effects, and nurse ailing banks and corporations back
to health. The most controversial of the lot was the imposition
of selective capital control measures to eliminate volatility in
the ringgit and control short-term capital flows. The economy had
to be insulated from the marauding hands of currency speculators.
Behind this strategy was the Government's concern that any
approach to dealing with the crisis must avoid systemic
dislocation and social upheaval that could beset this multiethnic
society. It could ill-afford the kind of sweeping change and
retrenchment experienced in neighboring countries, that could
prove particularly explosive in a multiethnic society. Besides,
the fruits of decades of painstaking work in social engineering
had to be safeguarded.
The Government's bold and determined approach turned the
table. The situation changed quickly after Malaysia adopted
capital control measures. There are now definite signs of
economic recovery. In the first quarter of this year, the GDP
moved up to minus 1.3 percent, a marked improvement to the 10.9
percent and 10.3 percent contraction respectively in the third
and fourth quarters of 1998. The first quarter contraction will
be the last quarter of negative growth for the country. The banks
are now healthy and back in the business of lending. Exports have
been the main savior, thanks to a stable and competitive ringgit.
International reserves have shot up to US$30 billion, sufficient
to pay for 6.9 months of retained imports. Industrial production
has risen and consumer confidence is back. The stock market is
once again a hive of activity. Investors, both local and foreign,
have pushed the KLSE Composite Index above the 840 mark and
market capitalization has breached RM 500 billion. Malaysia's GDP
will grow by at least 1 percent this year, although others are
more optimistic, stating 2 percent to 3 percent.
Against that backdrop, what is the outlook for the country?
Certainly the worst is over. Malaysia, as well as others in the
region who have been similarly afflicted by the crisis, are
seeing an upturn in activity. Yet any optimism must be seasoned
with realism at this point, as many challenges remain. In the
near-term, for how long will the United States sustain its bull
run without hitting capacity constraints that might renew fears
of inflation? When will Japan hit recovery? Can the European
Union revive its sluggish economies? The world can take comfort
that the financial meltdown did not occur. But the hedge funds
are far from diminished. They can resurrect easily, as there is
news that international banks are starting to lend to hedge funds
again. Equally critical is the issue of whether there will be any
durable change in the world financial order to protect developing
countries.
Looking back, the "unorthodox" Malaysian approach has gained
increasing support among the international community. In fact,
the "no gain, no pain" and "one size fits all" logic of the IMF
has been dismissed as totally inappropriate to any developing
country, more so those with multiethnic societies. The character
and intentions of the highly leveraged hedge funds are now better
understood. It has also become clear that some form of regulation
of short-term capital flows is necessary. On its part, Malaysia
has strongly argued for greater disclosure to instill greater
discipline on the part of currency traders.
The borrowing carried out by currency traders, including hedge
funds, must be captured in the capital adequacy framework to
limit the loans by financial institutions to hedge funds.
Malaysia is confident that the recovery will be sustained. But
the Government is far from complacent. It is pressing banks to
lend particularly to the productive sectors and firms are being
pushed to export more. Pressure is now on Government agencies to
expedite implementation of projects that will stimulate the
economy. Malaysia is still hopeful that some form of
international sanctioning of short-term capital flows will be
instituted soon. The G7 meeting in Cologne, Germany, on June 18
made some headway with an agreement reached on the need for
greater transparency in the operations of hedge funds and the
need for a foreign exchange regime that will protect developing
countries. But, this is far too little for Malaysia to gloat
over. Until some form of protection is put in place, it will keep
its selective capital controls to insulate it from further
attacks on its currency.
If anything can be called a miracle, it is Malaysia's ability
to turn around the economy in unexpectedly quick time without the
kind of social disruption and pain that has beset others in the
region. It has taken much courage and tenacity to go against
world opinion and to be labeled a heretic to pursue what the
country felt was a unique approach for unique circumstances. The
country's fundamentals have been restored and the economy is, at
the least, sheltered for the perils of currency speculators. For
sustained recovery, continued exchange rate stability may be
exactly what the doctor ordered. (NEAC Secretariat, Economic
Planning Unit, July 9, 1999.)