Malaysia: Crisis, Collapse, And Responses


Dr Prema-chandra Athukorala

Malaysia's impressive growth trajectory has changed dramatically with the onset of the financial crisis. The currency and stock market turmoil that began in Kuala Lumpur in July 1997 was quickly translated into economic collapse, and involved the biggest stock market plunge among the five 'crisis' countries.

Domestic market-oriented industries and the construction and services sectors were affected by the contraction in domestic demand resulting from the negative wealth effect of weaker stock prices and property market slump, and the net contractionary impact of the significant currency depreciation.

The increase in non-performing loans of the financial sector reflected in a sharp downturn in borrowing and financing, contributing to the liquidity squeeze. Both traditional export industries (that account for 10 per cent of GDP) and export-oriented manufacturing (30 per cent of GDP) have since expanded significantly, reflecting the significant gain in competitiveness through real exchange rate appreciation, but this has not been adequate to compensate for the growth-retarding effect of domestic deflation. The national accounts for the first and second quarters of 1998 have recorded 2.6 per cent and 6.8 per cent contraction in the economy compared to the corresponding quarters in the previous years.

Based on these figures, the economy is likely to contract by 5 per cent in 1998 - the first recession for 13 years.

Since mid-1998, the degree of freedom available to the Malaysian government has become severely limited. The economy is clearly in recession. A planned attempt to issue sovereign bonds in the USA and Europe to raise USD$2 billion for implementing the banking-sector restructuring program had to be shelved in late August because of unanticipated downgrading of Malaysia's credit rating by international rating agencies.

Dr. Mahathir has now abandoned policy tinkering along conventional lines and embarked on an unorthodox (and risky) path of reform whose key elements are capital controls and expansionary macroeconomic policy.

After the onset of the crisis a conflict became apparent between Dr. Mahathir and his deputy and Finance Minister (and heir apparent), Anwar Ibrahim, over how to manage the crisis. This contributed to policy indecisiveness, and reduced the effectiveness of whatever policy measures were taken by increasing the 'political risk premium'. To set the stage for the policy turnaround, Anwar was sidelined from the policy scene by the appointment of Daim Zainuddin (Mahathir's long time adviser) as the special minister in charge of economic recovery. Anwar was removed from the positions of Deputy Prime Minister and Finance Minister, then expelled from the ruling UMNO, and subsequently arrested. Since September, Mahathir has been the First Finance Minister, but the position of deputy Prime Minister still remains vacant.

The new strategy is risky, for a number of reasons.

First, the rationale behind the imposition of capital control is to avert a painful economic collapse and to provide a conducive setting for the implementation of the required adjustment policies, in particular banking sector restructuring. The danger is that the complacency induced by possible temporary recovery through expansionary policies may lead to postponement of long-term structural reforms, and thus to long-term economic deterioration.

Second, any form of market intervention of this nature involves economic costs associated with bureaucratic controls and related rent-seeking activities. And prolonged use of controls invariably compounds the economic costs.

Third, the scope for avoidance and evasion is vast. In an economy like Malaysia's, that remains highly integrated in the world economy through trade in goods and services, through foreign direct investment, and through flows of remittances from migrant workers, controls on capital flows are difficult to enforce.

Until recently, Malaysia had the vast advantage over other Southeast Asian countries of political stability and policy continuity. Politically, Dr. Mahathir still holds all the cards and would probably win the general election due in early 2000. But serious doubts raised by recent events about the democratic and legal process of the country will continue to pervade the policy scene for some time.

WATCHPOINT: Policy uncertainty created by the ousting of Anwar and the subsequent legal actions against him may prove to be damaging to the confidence of long-term investors in the Malaysian economy.


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