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.)