MALAYSIA ECONOMIC MONITOR DECEMBER 2017 Turmoil to Transformation 20 Years after the Asian Financial Crisis CONNECT WITH US wbg.org/Malaysia @WorldBankMalaysia @WB_AsiaPacific blogs.worldbank.org/category/ countries/malaysia MALAYSIA ECONOMIC MONITOR DECEMBER 2017 Turmoil to Transformation 20 Years after the Asian Financial Crisis Acknowledgements This edition of the Malaysia Economic Monitor was prepared by Richard Record (task team leader), Wei Zhang, Yew Keat Chong, Jose De Luna Martinez, Gabriel Zaourak, Alan Lau, Nur Idayu Ibrahim, Boon Seong Lim, Nor Hidayah Abdul Rahman, Uma Rajoo, Ana Maria Aviles, Djauhari Sitorus, Ahmad Hafiz Abdul Aziz, Mohamed Rozani Mohamed Osman, Ashraf Arshad and Ilias Skamnelos. Norman Loayza, Samuel Fraiberger, Trevor Monroe, Kenneth Simler and Achim Schmillen provided additional contributions. Ulrich Zachau, Faris Hadad-Zervos and Deepak Mishra provided overall guidance. The team is grateful to Sudhir Shetty, Shabih Ali Mohib, Shakira Teh Sharifuddin, Jeeva Govindasamy, Congyan Tan and Ekaterine Vashakmadze for their constructive input. This report benefited from productive discussions with current and former officials in the Economic Planning Unit in the Prime Minister’s Department, Bank Negara Malaysia, the Ministry of Finance, the Securities Commission Malaysia, Bursa Malaysia and many other Government ministries and agencies, which provided valuable information and useful feedback. In particular, the team would like to thank the International Cooperation Section of the Economic Planning Unit and the Economics Department of Bank Negara Malaysia for close ongoing collaboration with the World Bank and crucial support to the launch of this report. The team would also like to express its gratitude to analysts at several private financial firms and rating institutions, whose participation in a constructive dialogue informed the preparation of this report. Joshua Foong, and Min Hui Lee led external communications, production and design of the report. Irfan Kortschak edited the document, and Gillian Gan provided administrative support. Cover & Report Design: Kane Chong Photography: Samuel Goh The findings, interpretations, and conclusions expressed in this report do not necessarily reflect the views of the Executive Directors of the World Bank or the Governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. The report is based on information current as of December 8, 2017. Enquiries Please contact Richard Record (rrecord@worldbank.org) or Yew Keat Chong (ychong@worldbank.org) if you have any questions or comments on the Malaysia Economic Monitor. 2 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 Abbreviations AFC Asian financial crisis AML/CFT Anti-Money Laundering and Counter Financing of Terrorism ASEAN Association of Southeast Asian Nations BNM Bank Negara Malaysia BR1M 1Malaysia People’s Aid (Bantuan Rakyat 1Malaysia) B40 Bottom 40 percent CDRC Corporate Debt Restructuring Committee CEIC Census and Economic Information Center CET1 Common Equity Tier 1 CMP Capital Markets Masterplan CPI Consumer Price Index CPO Crude Palm Oil DOSM Department of Statistics Malaysia E&E Electrical and Electronics EAP East Asia and Pacific FDI Foreign Direct Investment FSMP Financial Sector Master Plan GDP Gross Domestic Product GFC Global financial crisis GNI Gross National Income GST Goods and Services Tax IADI International Association of Deposit Insurers IBFC Labuan International Business and Financial Centre IMF International Monetary Fund IOSCO International Organization of Securities Commissions LCR Liquidity Coverage Ratio MEM Malaysia Economic Monitor MFRS Malaysia Financial Reporting Standards MOF Ministry of Finance NAPIC National Property Information Centre NFPCs Non-Financial Public Corporations NPLs Non-Performing Loans OPR Overnight Policy Rate PIDM Malaysia Deposit Insurance Corporation (Perbadanan Insurans Deposit Malaysia) Q/Q Quarter-on-Quarter RCEP Regional Comprehensive Economic Partnership SAAR Seasonally Adjusted Annual Rate SME Small and Medium Enterprises SRI Sustainable and Responsible Investment Y/Y Year-on-Year MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 3 Table of Contents Acknowledgements 2 Abbreviations 3 Summary 6 PART ONE 15 Recent economic developments 16 Stronger than expected growth across the region 16 Malaysia’s economy is expanding due to broad-based domestic and external demand 17 The current account surplus grew mainly due to a larger goods surplus 18 The headline inflation rate declined slightly due to lower inflation in the transportation category 22 Conditions in the domestic financial sector remain stable 26 The financial account recorded a net outflow due to increased resident outflows 27 Fiscal consolidation remains on track 28 Further reductions in the fiscal deficit will require deeper reforms 30 Economic outlook 34 With strong domestic and external demand, Malaysia’s growth is expected to remain strong into 2018 34 Risks relate primarily to unforeseen changes in the external environment 36 A strengthening economy offers an opportunity to focus on structural reforms for the transition to a high-income economy 36 PART TWO 39 Turmoil to Transformation: 20 Years after the Asian Financial Crisis 40 East Asia did not let a crisis go to waste 40 The origins of the Asian financial crisis 41 How Malaysia’s response differed from other affected countries 43 Strengthening macroeconomic management after the crisis 47 Building a more resilient financial sector after the crisis 51 Increasing the sophistication of Malaysia’s financial system 52 Diversifying the capital market after the crisis 55 Improving standards of corporate governance 58 Challenges ahead 59 Appendix 54 Additional tables 54 An index for measuring exchange rate flexibility and monetary independence 69 References 70 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 5 Summary Summary The Malaysia Economic Monitor presents an analysis of economic and structural development issues in Malaysia The aim of the Malaysia Economic Monitor (MEM) Malaysia’s experience, both during the crisis and in is to foster better-informed policy analysis and the years since, offers important insights for other debate regarding the key challenges that Malaysia countries. While sharing a common destination, not all faces in its endeavor to achieve rapid, inclusive and East Asian countries took the same path towards a more sustainable economic growth. The MEM consists of resilient set of macro-financial policies. Clearly not all of two parts: Part 1 presents a review of recent economic Malaysia’s experience is likely to be transferable to the developments and a macroeconomic outlook. Part specific contexts of other countries, but there are useful 2 focuses on a selected special topic that is key to lessons for other highly open trading economies that Malaysia’s development prospects, particularly as are exposed to the risks associated with international the country moves towards becoming a high-income capital flows. economy. The well-known adage “don’t let a crisis go to In this edition, the focus of the special topic is waste” is apt for Malaysia’s experience after the macro-financial policy. This year marks 20 years since events of 1997–98. This edition of the MEM highlights the onset of the Asian financial crisis (AFC), which caused the key lessons learned from Malaysia’s experience a major shock to Malaysia’s economy. At the time, of the AFC, and outlines how the crisis triggered a Malaysia’s policy response was considered unorthodox. series of deep macro-financial reforms that served to This response included the imposition of selective increase the country’s level of resilience from that of 20 capital controls, counter-cyclical fiscal policies as well as years ago. The MEM also highlights future challenges bank and corporate restructuring. Yet with the passage as Malaysia builds a modern and resilient financial of time, many of these policies have become part of the sector that will facilitate the achievement of its goal of standard toolkit for policymakers in both developing and becoming a high-income economy. developed economies when faced with a crisis. 6 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 Summary Recent economic Headline inflation declined slightly to 3.8 percent in 3Q 2017, but there are persistent concerns developments regarding the rising cost of living. Lower inflation in the transportation category during the second half of the year helped dampen the increase in the overall price index. However, relatively high food price inflation over the past years, combined with the rising costs of housing, have had a disproportionate impact on lower- In 2017, Malaysia experienced a significant income earners, particularly those in urban areas, who acceleration in growth due to a confluence of spend proportionately more on these two items. The domestic and external factors. The pace of GDP inflation rate is expected to stand at 3.9 percent in 2017. growth quickened during the first three quarters of 2017, supported by strengthening domestic and Conditions in the domestic financial sector remain external demand. Private consumption grew strongly, stable, with a monetary stance that is supportive driven by improved labor market conditions, sustained of growth. Financial intermediation in the economy wage growth, and the implementation of income- remains broadly healthy, with the stable cost of funds support measures to benefit the low- and medium- continuing to support financing to the private sector. income households. Capital expenditure also increased The pace of credit growth to both corporates and due to higher private and public investment. As a result, households has slowed somewhat. Malaysia’s economy is expected to grow by 5.8 percent in 2017. Malaysia’s economy is The current account recorded a surplus of 3.7 percent of GDP in 3Q 2017, reflecting a larger expected to grow by goods surplus as exports surged. A cyclical recovery 5.8 percent in 2017 in global trade resulted in a broad-based expansion in Malaysia’s manufactured exports, especially electrical and electronics (E&E ) exports. A similar trend has Fiscal consolidation remains on track due to been experienced across East Asia’s other open and higher-than-expected economic growth, together manufacturing-oriented economies. After a period of with incrementally higher oil prices. The fiscal deficit stagnation, higher commodity prices also contributed is projected at 3.0 percent of GDP in 2017. The stock to faster growth in Malaysia’s oil and gas export of Federal Government debt has continued to decline, earnings. reaching 51.1 percent of GDP at the end of 3Q 2017. MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 7 Summary Economic outlook fiscal reforms to narrow the deficit through a range of revenue diversification and expenditure rationalization measures. However, as the scope for further reductions to operating expenditures narrows, GST collection With both domestic and external demand expected plateaus, and stabilizing oil prices limit oil-related to remain robust, Malaysia’s growth is likely to revenue growth, further fiscal adjustments will become remain strong into 2018. Private consumption is increasingly challenging. As such, achieving a near- expected to remain the main driver of growth, supported balanced federal budget over the medium term would by stable labor market conditions and continued necessitate a second, deeper wave of reforms to income growth. Private investment is also projected enhance revenue collection and improve public sector to continue supporting growth, with sustained flows of efficiency. infrastructure projects and capacity expansion in the manufacturing and services sectors. The expansion of Malaysia’s exports is expected to continue into the first half of 2018, although at a lower rate. Malaysia’s economic rebound has helped to close the negative output gap and its output is now close to the economy’s potential output level. In aggregate, Malaysia is projected to record an economic growth rate of 5.2 percent in 2018. Malaysia is expected to achieve high-income country status in the next few years. Simulations indicate that this transition will occur between 2020 and 2024. However, while per capita income captures one dimension of economic well-being, it is important to also consider other measures of welfare for a country’s citizens. Risks relate primarily to the external environment. A slowdown in the advanced economies or a growing international shift toward protectionism would have a dampening effect on demand for Malaysia’s tradable sector. Similarly, a disorderly adjustment to global financial market conditions and advanced economy monetary tightening or commodity prices shocks would also affect the outlook. On the domestic front, downside risks relate mainly to the relatively high level of household and public-sector debt. A strengthening economy offers an opportunity to focus on structural reforms for sustained medium- term growth. As Malaysia becomes increasingly close to achieving high-income status, incremental growth It is also important for Malaysia to continue to will depend less on factor accumulation and more on implement measures to ensure that growth is raising the level of productivity. This may necessitate inclusive and provides access to opportunities for further effort to encourage innovation, to invest in all its citizens. While Malaysia has made good progress new skills, and to leverage the potential of the digital in sustaining economic growth and reducing poverty economy. in recent years, there remain concerns regarding the distribution of economic gains and perceived inequality Further reductions in the fiscal deficit will only of opportunity. Continued efforts to raise the rate of be possible with deeper reforms. Since the 2008-09 productivity growth and create high quality jobs are Global financial crisis (GFC) and the oil price slump, especially critical as Malaysians aspire to become a Malaysia has successfully implemented a series of middle-class society. 8 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 Summary Turmoil to rates and reserve requirements to inject more liquidity into the financial system. Expansionary fiscal policy Transformation: was introduced to support the economic recovery during the crisis, with a change in the fiscal balance of four percentage points over the course of a year. New 20 Years after institutional structures were established to streamline the management of Malaysia’s response to the crisis. the Asian In perhaps the most controversial measure at Financial Crisis the time, Malaysia introduced selective capital controls. The purpose of these measures was to discourage speculative investments in the short run, while safeguarding the interest of long-term investors. But the outcome of these policies was different from what most mainstream economists predicted. The The AFC was a major turning point for macro- controls allowed BNM to reduce interest rates to a financial policy in Malaysia. The year 2017 marks level that would have been impossible without the the 20th anniversary of the crisis and provides an imposition of capital controls. This alleviated the appropriate milestone to take stock of lessons learned credit crunch, affecting both strong and weak firms in Malaysia, which could be of particular relevance for alike, and implied that fewer firms went bankrupt and similar small and open developing economies around subsequently the costs of financial sector restructuring the world. and recapitalization were smaller. The crisis was the result of accumulating financial The economy rebounded strongly after the crisis, imbalances that spiraled out of control in an driven by the restored dynamism of Malaysia’s environment of weak financial regulation and export manufacturing sector. The combination of a rapid financial account liberalization. Rapid capital depreciated exchange rate together with a recovery in inflows created mismatches between the currency robust external demand generated the conditions for a of borrowing and the currency of investment returns. substantial increase in exports. Fixed exchange rates also built up risks. On top of the currency mismatches, mismatches in the maturity of loans compared to investment projects exacerbated the financial risks. However, capital account liberalization The year 2017 marks proceeded more slowly in Malaysia compared to other countries in the region, and external debt challenges the 20th anniversary of were less severe. the crisis and provides Malaysia did not engage in an IMF program. As the an appropriate milestone external debt situation was much less of a challenge to take stock of lessons than in other crisis-affected countries, Malaysia had a wider range of available policy options. The country’s learned in Malaysia initial response to the crisis was to implement measures consistent with the conventional wisdom at the time; including tight monetary and fiscal policies. However, The consolidation of Malaysia’s banking sector the initial policy response put significant pressure resulted in strong institutions anchored by a core on the real economy. The increase in interest rates group of domestic banks. Effective regulation and created a credit crunch that particularly affected small supervision has underpinned the stability of Malaysia’s and medium-sized firms and sapped the strength of financial system. The sector has adopted internationally Malaysia’s private sector. accepted practices, with a high degree of compliance with global standards for supervision and regulation of Malaysia’s response was to restore market financial institutions. confidence, restructure corporate debt, recapitalize the banking sector, and to stimulate Malaysia adopted an institutional framework to the economy through countercyclical fiscal and deal with the rising nonperforming loans in the monetary policies. The central bank reduced interest industry. The Government decided to assist domestic MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 9 Summary corporates and financial institutions that were facing The lessons from the crisis led to an evolution financial difficulties or imminent insolvency. The crisis in the consensus over the costs, benefits, and expedited planned reforms, resulting in a stronger, sequencing of capital account liberalization in more diversified and inclusive financial system. developing countries. Before the crisis, one of the “standard” set of policy recommendations was to Malaysia’s bond market expanded significantly rapidly liberalize the financial account in order to allow after the AFC to become a major financing source capital to flow across countries and take advantage of for corporates. There is now significantly less reliance the differences in marginal products of capital. Today, by corporates on banks for funding requirements, policy recommendations have turned toward a more which was one of the banking sector vulnerabilities cautious approach with measured pace of liberalization highlighted during the crisis. that is more nuanced with respect to country context. In particular, there is considerable emphasis on the need Malaysia has become a global leader in Islamic for adequate capacity at the country level to monitor finance, in parallel to and complementing the and control inflows of funds, as a pre-requisite to capital conventional financial system. With the well- account liberalization. established Islamic capital markets and regulatory frameworks, as well as the relevant incentives to The approach adopted in dealing with the AFC motivate market participants, Malaysia has been able to and in implementing the reforms in the financial support financial innovation in Islamic finance. One of sector in the last 20 years has served to transform the latest innovations is the issuance of the world’s first Malaysia’s financial sector into what it is today: green sukuk (shari’ah-compliant investment certificate) sound, resilient, and diversified. Malaysia emerged in 2017 to fund a renewable energy project in Malaysia. from the crisis with no bank closures, a high recovery rate on nonperforming loans, and stronger banking In 2017, Malaysia and the other economies institutions. Subsequent reforms in the financial sector affected by the AFC are more resilient to external after the crisis resulted in an improved regulatory and shocks and financial instability, having learned supervisory framework for the financial system, better many lessons from the crisis of 1997–98. Due to the capacity to monitor financial stability risks, a full- construction of buffers built and reforms undertaken fledged Islamic financial system, and a deeper capital during the last 20 years, the region is more resilient market. As a result, Malaysia was able to successfully and better prepared to react to external shocks and absorb the shocks of the GFC. financial turbulence. Five important lessons, in particular, have been learned from the AFC, and are commonly accepted The reforms implemented in among policy makers in developing countries: (a) flexible exchange rate regimes tend to lower the risk of the financial sector in the currency crashes; (b) a large “war-chest” of international last 20 years has served reserves can be a good insurance against future crisis; (c) selective and temporary capital controls may help to transform Malaysia’s stabilize capital flows during periods of crisis; (d) rapid financial sector into what financial account liberalization can be dangerous; and, and (e) strong oversight institutions and the careful and it is today: sound, resilient, prudential regulation of the domestic financial sector and diversified is essential. Following the regional trend, Malaysia has moved However, going forward Malaysia should remain to a more flexible exchange rate regime. Holdings attentive to new challenges and emerging areas of international reserves have grown significantly over of risk. Financial sector vulnerabilities and risks to time, while reliance on net capital inflows has declined. economic stability may develop as the economy Exposure to dollar-denominated debt has declined becomes significantly larger (three times larger in Malaysia, although reliance on short-term debt has since the crisis), and more closely integrated into the increased somewhat. Today Malaysia is much less global economy. At the same time, an increasingly exposed to the risk of an exchange rate depreciation sophisticated financial sector with new instruments and triggering increased debt obligations, giving the financial innovations bring constant challenges to the authorities more space to adjust to external shocks. overall risk oversight framework. 10 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 Summary The balance sheets of households and corporations will need to be carefully monitored for signs of stress. Although the slowdown in credit growth has stabilized the ratio of credit to the private sector to GDP, and it has not reached levels observed during the AFC, close monitoring is necessary to avoid systemic problems, particularly given the rapid increases in real house prices since 2008. Efforts to further strengthen governance of financial institutions will need to continue. Overall, the post-crisis reforms have strengthened the financial system, but sustained measures are needed to address new systemic risks from a more modern financial sector. For example, the transition to a digital economy introduces new cybersecurity risks from technology- enabled innovation in financial services. Finally, efforts to strengthen fiscal space should continue in order to preserve flexibility for future contractionary shocks. While the Government has made significant progress toward fiscal consolidation since the GFC, the overall public debt stock has remained relatively elevated due to continued accumulation of fiscal deficits and increased public infrastructure spending. MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 11 Recent trends in Malaysia’s economy GDP grew by 6.2 percent (y/y) in the ...driven by private consumption, third quarter of 2017... exports and investment GDP, q/q SAAR, y/y, % Contribution to GDP, y/y, % 8 8 7 7 6 6 5 5 4 3 4 2 3 1 2 0 -1 1 -2 0 -3 Q3-2014 Q4-2014 Q1-2015 Q2-2015 Q3-2015 Q4-2015 Q1-2016 Q2-2016 Q3-2016 Q4-2016 Q1-2017 Q2-2017 Q3-2017 Q3-2015 Q4-2015 Q1-2016 Q2-2016 Q3-2016 Q4-2016 Q1-2017 Q2-2017 Q3-2017 q/q SAAR, % Real GDP, y/y Private Consumption Change in Inventory Net Exports Fixed Investment Government Real GDP, y/y Source: World Bank staff calculations based on CEIC and DOSM data Source: World Bank staff calculations based on CEIC and DOSM data The current account surplus expanded ...helped by surging exports to 3.7 percent of GDP... Balance, % of GDP Contribution to Growth, y/y, % 12 25 10 20 8 6 15 4 2 10 0 5 -2 -4 0 -6 -5 -8 -10 -10 Q2-2017 Q3-2014 Q4-2014 Q1-2015 Q2-2015 Q3-2015 Q4-2015 Q1-2016 Q2-2016 Q3-2016 Q4-2016 Q1-2017 Q2-2017 Q3-2017 Q3-2015 Q4-2015 Q1-2016 Q2-2016 Q3-2016 Q4-2016 Q1-2017 Q3-2017 Goods Primary & Secondary Income Account E&E Commodities Services Current Account Non E&E Exports, y/y Source: World Bank staff calculations based on DOSM data Source: World Bank staff calculations based on DOSM data Economic growth is expanded to remain ...with the transition to high income status strong at 5.2 percent in 2018... likely to occur between 2020 and 2024 GDP, y/y, % Three scenarios for when GNI per capita will pass the high income threshold 18,000 High 6 6.0 5.8 Baseline 5 16,000 5.0 5.2 5.0 4.7 4 4.2 14,000 High income Low threshold 3 12,000 2 10,000 1 0 8,000 2013 2014 2015 2016 2017f 2018f 2019f 2017f 2018f 2019f 2020f 2021f 2022f 2023f 2024f 2025f 2026f 2016 Source: World Bank staff calculations and projections Source: World Bank staff projections 12 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 Turmoil to Transformation: 20 Years after the Asian Financial Crisis Rapid liberalization led to net capital inflows... ...that were used to finance investment Financial Account as % of GDP Contribution of investment to real GDP growth, % 15 19 10 9 5 0 -1 -5 Indonesia Malaysia Malaysia ASEAN + Korea, Rep. -10 Thailand Korea, Rep. -11 Philippines -15 -20 -21 1991 1991 1990 1992 1993 1994 1995 1996 1997 1998 1990 1992 1993 1994 1995 1996 1997 1998 Source: World Bank Source: International financial statistics, IMF As a response to the crisis, exchange rates ...international reserve holdings have gone up have become more flexible... Exchange Rate Stability Index International Reserves as a percentage of GDP 1.0 60 Higher buffer of International 0.9 reserves More 50 0.8 flexible exchange Thailand Average 2015 - 2017 0.7 rate Average 2015 - 2017 40 0.6 Malaysia 0.5 30 Thailand Philippines 0.4 Philippines Korea, 20 Rep. 0.3 Indonesia Korea, Rep. Indonesia 0.2 Malaysia 10 0.1 0.0 0 0.0 0.2 0.4 0.6 0.8 1.0 0 10 20 30 40 50 60 Average 1990 - 1996 Average 1990 - 1996 Source: World Bank staff elaboration Source: World Bank staff calculations based on authorities’ data Note: Lower values mean more flexible exchange rates ...reliance on net capital inflows ....and most countries in the region have has declined... gained monetary independence Current account balance as a percentage of GDP Monetary Independence Index 13.0 0.70 0.60 8.0 0.50 0.40 3.0 0.30 -2.0 0.20 0.10 -7.0 0.00 Indonesia Malaysia Thailand Korea, Rep. Philippines Indonesia Malaysia Thailand Korea, Rep. Philippines Average 1990-1996 Average 2015-2017 Average 1990-1996 Average 2015-2017 Source: World Bank staff calculations based on international financial statistics Source: World Bank staff calculations based on international debt statistics and IMF data Note: Higher values mean more monetary independence. MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 13 PART ONE Recent Economic Developments and Outlook MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 15 PART ONE - Recent Economic Developments and Outlook Recent economic developments Stronger than expected growth across the region Since mid-2016, the world economy has been Growth in the developing economies in East Asia experiencing a cyclical recovery, which gained and the Pacific (EAP) has accelerated, due to momentum during 2017 (see Figure 1). In the third better-than-expected external conditions. In the quarter of 2017, the global growth rate increased to third quarter of 2017, the regional growth rate stood 3.3 percent (y/y) (2Q 2017: 3.1 percent). This increased at 6.5 percent (y/y) (2Q 2017: 6.6 percent), with broad- growth was supported by a synchronized investment- based growth across most major economies (see Figure led recovery in the advanced economies and by early 2). Private consumption continued to be the primary signs of a recovery among most major commodity driver of growth across most of the region’s major exporters. Following two years of subdued growth, economies. The increased growth of the advanced global trade activity rebounded, largely as a result of a economies and China’s continued robust growth also cyclical pickup in global manufacturing and investment contributed to a strong demand for the region’s exports growth. With this recovery, it is expected that the throughout the period. annual global trade growth rate will be higher than at any point since 2011. Commodity prices have begun to recover and global financial conditions have remained broadly favorable, with improving economic prospects and market sentiment. FIGURE 1 FIGURE 2 The global economy continued to strengthen …with stronger-than-anticipated growth in the third quarter of 2017… experienced across the region GDP, y/y, % GDP, y/y, % 5 8 5 7 4 6 4 3 5 3 4 2 3 2 2 1 1 1 0 0 Q4-2014 Q1-2015 Q2-2015 Q3-2015 Q4-2015 Q1-2016 Q2-2016 Q3-2016 Q4-2016 Q1-2017 Q2-2017 Q3-2017 Q4-2014 Q1-2015 Q2-2015 Q3-2015 Q4-2015 Q1-2016 Q2-2016 Q3-2016 Q4-2016 Q1-2017 Q2-2017 Q3-2017 World Advanced Emerging and China Indonesia Malaysia Economies Developing Economies Philippines Thailand Vietnam Source: World Bank staff calculations based on World Bank Global Source: World Bank staff calculations based on World Bank Global Economic Monitor data Economic Monitor data 16 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART ONE - Recent Economic Developments and Outlook Malaysia’s economy is expanding due to broad-based domestic and external demand The economy continued to grow robustly at 6.2 7.9 percent in the third quarter (y/y) (2Q 2017: percent in the third quarter of the year (y/y) (2Q 7.4 percent). In addition to the sustained high level of 2017: 5.8 percent), underpinned by strong domestic capital expenditure in these sectors, this growth was and external demand (see Figure 3). Private sector supported by the implementation of both new and expenditure remained strong, while the ongoing global ongoing infrastructure projects. During the quarter, recovery continued to support external demand. the investment climate was broadly positive, reflecting Domestic growth was broad-based, with strong growth in part the increased external demand and high level across a range of diversified economic sectors. Public of private consumption. In the manufacturing sector, sector expenditure also registered a higher growth in there were increases in investments across both export- 3Q 2017 on account of continued expansion in public and domestic-oriented subsectors, while capital consumption and a turnaround in public investment. expenditure in the services sector was supported by the transport and storage, utilities, accommodation and Private consumption continues to be the primary wholesale and retail trade subsectors. driver of economic growth (see Figure 4). In 3Q 2017, private consumption grew at a rate of 7.2 percent Public consumption and investment also expanded (y/y) (2Q 2017: 7.1 percent). This increase was primarily at a faster pace. In 3Q 2017, public consumption driven by improved labor market conditions and grew at an increased rate of 4.2 percent (y/y) (2Q 2017: sustained wage growth. The Government’s ongoing 3.3 percent), reflecting mainly higher growth in the implementation of income-support measures to spending on emoluments. Meanwhile, public sector benefit low-income and middle-income households investment recorded a turnaround from its contraction also supported domestic consumption, partially in the preceding quarter and grew at the rate of 4.1 alleviating the effects of increased prices on household percent (y/y) in 3Q 2017 (2Q 2017: -5.0 percent), due expenditure. mainly to increased capital expenditure by both the Federal Government and public corporations. With the sustained high level of capital expenditure in the manufacturing and services sectors, overall On the supply side, all major economic sectors saw private investment continued to grow strongly at an expansion through the third quarter of 2017. FIGURE 3 FIGURE 4 Malaysia’s economy grew strongly through the …with private consumption acting as the primary first three quarters of 2017… anchor of growth GDP, q/q SAAR, y/y, % Contribution to GDP, y/y, % 8 8 7 7 6 6 5 5 4 3 4 2 3 1 0 2 -1 1 -2 0 -3 Q3-2014 Q4-2014 Q1-2015 Q2-2015 Q3-2015 Q4-2015 Q1-2016 Q2-2016 Q3-2016 Q4-2016 Q1-2017 Q2-2017 Q3-2017 Q3-2015 Q4-2015 Q1-2016 Q2-2016 Q3-2016 Q4-2016 Q1-2017 Q2-2017 Q3-2017 q/q SAAR Real GDP, y/y Private Consumption Change in Inventory Net Exports Fixed Investment Government Real GDP, y/y Source: World Bank staff calculations based on CEIC and DOSM data Source: World Bank staff calculations based on CEIC and DOSM data MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 17 PART ONE - Recent Economic Developments and Outlook The increased growth of the services sector was mainly the growth of domestic-orientated industries was driven by the continued high rate of expansion of the supported by the sustained growth of the food- wholesale and retail, information and communication, related subsectors, amid strong private consumption. and transportation and storage subsectors. The The growth of the mining sector was higher during manufacturing sector also experienced sustained the quarter, supported by increased overall natural expansion during the period. Growth in the export- gas production. In addition, growth in the agriculture oriented industries was largely driven by the robust sector contracted during the quarter, as CPO and performance of the E&E subsector, with the growth of rubber production were impacted by adverse weather this subsector largely due to the ongoing cyclical upturn conditions. in global demand for semiconductors. Meanwhile, TABLE 1 GDP growth decomposition SAAR, q/q, y/y, % 1Q 2Q 3Q 4Q 1Q 2Q 3Q   2015 2016 2016 2016 2016 2016 2017 2017 2017 GDP 5.0 3.1 4.3 5.7 5.1 4.2 7.5 5.2 7.3 Consumption Private Sector 6.0 9.6 4.2 2.7 8.1 6.0 11.7 6.3 2.8 Public Sector 4.4 6.0 12.0 -10.9 -19.5 0.9 65.2 -4.1 -7.9 Gross Fixed Capital Formation 3.6 -2.9 3.8 0.3 10.7 2.7 24.9 -18.0 14.3 Exports of Goods & Services 0.3 -9.3 -0.9 7.9 11.8 1.1 21.8 -1.4 16.6 Imports of Goods & Services 0.8 -4.0 -6.9 5.2 11.7 1.1 48.5 -13.6 15.3 Sectoral Agriculture 1.3 -18.9 13.5 -3.7 3.3 -5.1 23.6 3.6 -11.5 Mining 5.3 4.8 8.1 2.9 4.4 2.2 -7.8 1.3 15.8 Manufacturing 4.9 3.4 3.5 5.4 6.7 4.4 6.3 5.5 9.5 Construction 8.2 10.8 4.4 8.3 -2.1 7.4 14.5 14.9 -2.2 Services 5.1 6.3 4.0 7.1 4.7 5.6 7.4 6.2 8.2 Source: World Bank staff calculations based on CEIC, BNM and DOSM data The current account surplus grew mainly due to a larger goods surplus Malaysia’s gross exports grew very strongly, at increased during the quarter, driven by higher regional the rate of 22.1 percent (y/y) in the third quarter demand for petroleum products. Non-resource based (2Q 2017: 20.5 percent). This growth, primarily manufactured exports also expanded at a faster pace, driven by the cyclical recovery of global trade activity, driven largely by increased exports of metal products was broad-based, with double-digit rates for both E&E as well as machinery and equipment. and non-E&E manufactured exports (see Figure 5). The growth of Malaysia’s E&E exports was underpinned The strong performance of the export sector and by the sustained global demand for semiconductors high levels of domestic private sector consumption in smartphones and storage devices (see Box 1). The drove sustained import growth. Gross imports growth of resource-based manufactured exports continued to increase at a high rate of 19.8 percent 18 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART ONE - Recent Economic Developments and Outlook (y/y) during the quarter (2Q 2017: 19.0 percent), with goods surplus increased to RM 31.7 billion (2Q 2017: double-digit rates for both intermediate goods and RM 27.0 billion), with the increase in exports continuing consumption goods. Imports of intermediate goods, to outpace the increase in imports during the quarter. which accounted for 58 percent of total imports, grew The services account deficit was sustained at RM 4.9 at 20.9 percent in 3Q 2017 (2Q 2017: 23.9 percent) as a billion (2Q 2017: -RM 5.0 billion), as an increased surplus result of the increased global demand for manufactured in travel receipts during the quarter was partially offset exports. During the quarter, consumption imports by a higher deficit in construction services. Meanwhile, also expanded firmly, at the rate of 14.9 percent (2Q both the primary income account deficit and the 2017: 1.5 percent), driven by the sustained high level of secondary income account deficit widened from the consumer expenditure. levels recorded in the previous quarter, largely due to the lower income accrued to Malaysian firms investing Overall, Malaysia’s current account surplus abroad and to larger foreign worker remittances. stood at 3.7 percent of GDP in the third quarter (2Q 2017: 2.9 percent of GDP) (see Figure 6). The FIGURE 5 FIGURE 6 Robust export growth has been underpinned by …contributing to an improvement in the current strong demand for manufactured goods… account surplus Contribution to Growth, y/y, % Balance, % of GDP 25 12 10 20 8 15 6 4 10 2 0 5 -2 0 -4 -6 -5 -8 -10 -10 Q3-2014 Q4-2014 Q1-2015 Q2-2015 Q3-2015 Q4-2015 Q1-2016 Q2-2016 Q3-2016 Q4-2016 Q1-2017 Q2-2017 Q3-2017 Q2-2017 Q3-2015 Q4-2015 Q1-2016 Q2-2016 Q3-2016 Q4-2016 Q1-2017 Q3-2017 E&E Commodities Goods Primary & Secondary Income Account Non E&E Exports, y/y Services Current Account Source: World Bank staff calculations based on DOSM data Source: World Bank staff calculations based on DOSM data TABLE 2 Selected external sector indicators 1Q 2Q 3Q 4Q 1Q 2Q 3Q   2016 2016 2016 2016 2017 2017 2017 Balance of Goods & Services (% of GDP) 6.1 5.5 7.2 7.8 5.9 6.7 7.8 Current Account Balance (% of GDP) 2.1 1.0 2.3 3.8 1.6 2.9 3.7 Total Exports (% of GDP) 67.7 66.7 67.0 69.1 71.3 71.5 72.3 Total Imports (% of GDP) 61.7 61.3 59.7 61.3 65.4 64.8 64.5 Net Portfolio Investment (RM billion) 14.1 0.1 -10.6 -19.1 -31.9 16.0 -5.1 Gross Official Reserves (RM billion) 381.6 390.4 405.0 423.9 422.2 424.8 427.7 (US$ billion) 97 97.2 97.7 94.5 95.4 98.9 101.2 Source: World Bank staff calculations based on CEIC, BNM and DOSM data MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 19 PART ONE - Recent Economic Developments and Outlook BOX 1 Are domestic or external factors playing a greater role in driving growth in exports? Malaysia’s small, open economy makes it a major measured in terms of the differential between Malaysia’s beneficiary of global trade. Thus, to understand goods export growth rate and the global goods export Malaysia’s growth trajectory, it is important to growth rate, which is known as the domestic factor. In understand the drivers of the international demand the period from 2000 to 2013, the relative performance for exports. Malaysia is among the world’s most of Malaysian exports was characterized by a negative open and integrated economies. In 2016, the value domestic factor. However, this trend was reversed in of its merchandize trade stood at 121 percent of GDP, the period from 2014 to 2016. significantly above the global average of 50 percent. In the years prior to 2017, global merchandize trade grew Malaysia‘s top six export sectors, which constituted at low rates, reflected by Malaysia’s low rates of export around 60 percent of total exports in the period goods growth. However, in 2017, Malaysia‘s export from 2011 to 2016, all recorded a positive domestic growth picked up considerably. factor in 2016 (see Figure 8). Most notably, the domestic factor for oil and gas exports, which constitute The growth rate for Malaysia’s goods exports has around 20 percent of Malaysia’s total exports, was been relatively high compared to the global growth strongly positive. By contrast, the domestic factor for rate over the last few years (see Figure 7). The electrical machinery exports, which also constituted relative performance of Malaysia’s goods exports is around 20 percent of Malaysia’s total exports, was low, FIGURE 7 FIGURE 8 The domestic factor has turned positive in the last …and is strongly positive across the top six three years… export sectors Growth and Differences, % Differences, 2011-16, % 30 60 20 50 10 40 0 30 -10 -20 20 -30 10 -40 0 -50 Natural Gas Telecommunications and Sound Equipment Electrical Machinery Petroleum & Petroleum Products Office Machines Palm Oil & Other Vegetable Oils -60 2009 2006 2007 2008 2010 2011 2012 2014 2015 2016 2013 Malaysia Growth Global Growth Domestic Factor Source: World Bank staff calculations based on UN Comtrade data Source: World Bank staff calculations based on UN Comtrade data 20 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART ONE - Recent Economic Developments and Outlook indicating that the growth of this sector in Malaysia FIGURE 9 was only slightly higher than the average global Malaysia’s petroleum and petroleum products growth rate. A similar situation applies to Malaysia’s exports exhibited a strong domestic factor in telecommunications equipment and office machinery recent years exports. Growth and Differences, % The positive domestic factor suggests that 60 external factors have been the dominant driver of 40 the growth in Malaysia’s goods exports over the past few years. External factors, such as the global 20 level of demand for goods or trade policies in other 0 countries, are more likely to have played a bigger role than domestic factors. Also, interestingly, Malaysia’s -20 relative performance was heavily driven by the strong -40 performance of its oil and gas exports. The decline in the growth of its petroleum and petroleum products -60 exports was significantly lower than the global rate in 2016 (see Figure 9). Over the past few years, there -80 2010 2011 2012 2013 2014 2015 2016 has been a drastic drop in global oil and gas exports, coming at a period of sharply lower prices. Malaysia Growth Global Growth Domestic Factor Source: World Bank staff calculations based on UN Comtrade data MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 21 PART ONE - Recent Economic Developments and Outlook The headline inflation rate declined slightly due to lower inflation in the transportation category The headline inflation rate has been on a declining income households’ total expenditure (see Box 2). trend since 1Q 2017, with an average rate of The effect is more pronounced among households in 3.8 percent (y/y) in the third quarter (2Q 2017: highly urbanized areas, with higher inflation rates for 3.9 percent) (see Figure 10). The decline is largely this category in these areas over the past years. These attributable to the lower average inflation rate in pressures have been compounded by elevated housing the transportation category in July 2017 amid lower costs, with a structural undersupply of housing at the global oil prices in the middle of the year, with this rate lower end of the property market. standing at 7.7 percent (y/y) (2Q 2017: 13.4 percent) (see Figure 11). However, this trend has reversed in the Labor market conditions have remained broadly subsequent months, as a result of the gradual increases stable, with continued growth in real wages. In in domestic fuel prices following the recent recovery 3Q 2017, the labor force participation rate was slightly in global oil prices. Meanwhile, the rate for the food higher at 67.9 percent of the working age population and non-alcoholic beverages category was sustained (2Q 2017: 67.7 percent) (see Figure 12). In the same at around 4.4 percent (y/y) (2Q 2017: 4.3 percent), with quarter, the unemployment rate remained low at 3.4 inflation in this category partly driven by higher prices percent (y/y) of the labor force (2Q 2017: 3.4 percent), in the food away from home sub-category. although this was marginally higher than the average figure of 3.1 percent recorded for the 2010-2016 period. While underlying inflation has remained contained, There was sustained growth in private sector wages there are persistent concerns regarding the rising during the quarter across both domestic- and export- cost of living. The sustained high food inflation rate oriented manufacturing subsectors (10.6 percent; 2Q is particularly concerning, as expenditure in this 2017: 11.2 percent) and the major services subsectors category accounts for almost 40 percent of low- (5.9 percent; 2Q 2017: 5.6 percent) (see Figure 13). FIGURE 10 FIGURE 11 The rate of headline inflation has deviated from …due mainly to higher costs in the transportation core inflation… category Inflation, y/y, % Contribution to Headline Inflation, y/y, % 6 6 5 5 4 3 4 2 3 1 0 2 -1 1 -2 01/2016 02/2016 03/2016 04/2016 05/2016 06/2016 07/2016 08/2016 09/2016 10/2016 11/2016 12/2016 01/2017 02/2017 03/2017 04/2017 05/2017 06/2017 07/2017 08/2017 09/2017 10/2017 0 01/2016 02/2016 03/2016 04/2016 05/2016 06/2016 07/2016 08/2016 09/2016 10/2016 11/2016 12/2016 01/2017 02/2017 03/2017 04/2017 05/2017 06/2017 07/2017 08/2017 09/2017 10/2017 Food and Non Alcoholic Beverages Transport Housing, Water, Electricity, Others Gas & Other Fuels Headline Inflation Core Inflation Headline Inflation Source: CEIC and DOSM data Source: World Bank staff calculations based on CEIC and DOSM data 22 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART ONE - Recent Economic Developments and Outlook FIGURE 12 FIGURE 13 Labor market conditions remain broadly stable… …with stronger growth in private sector wages Unemployment Rate, % Labor Force Patricipation Rate, % Private Sector Wage, y/y, % 4.0 Labor Force Participation Unemployment Rate 68.1 12 3.8 11.2 68.0 10 10.6 3.6 67.9 3.4 8 67.8 7.3 7.3 3.2 6 5.9 5.9 3.0 67.7 5.6 5.1 4 4.4 4.5 2.8 67.6 3.7 3.2 2.6 2 67.5 2.4 67.4 0 2.2 Q4-2016 Q1-2017 Q2-2017 Q3-2017 Q4-2016 Q1-2017 Q2-2017 Q3-2017 Q4-2016 Q1-2017 Q2-2017 Q3-2017 2.0 67.3 09/2015 11/2015 01/2016 03/2016 05/2016 07/2016 09/2016 11/2016 01/2017 03/2017 05/2017 07/2017 09/2017 Overall Manufacturing Major Services Subsectors Source: World Bank staff calculations based on CEIC and DOSM data Source: World Bank staff calculations based on CEIC and BNM data MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 23 PART ONE - Recent Economic Developments and Outlook BOX 2 Urban low-income households experience relatively high inflation The buildup of inflationary pressures over the The adverse impact of higher inflation on low- past years have had a disproportionate impact income households has been further compounded on lower-income households, especially those in by the persistent deterioration in the affordability urban areas, who spend a larger proportion of of housing since 2012 (see Figure 16) as a result of their income on the goods and services that have a structural undersupply of affordable homes, which recorded the most significant price increases. The has become especially acute in the highly-urbanized 2016 Household Expenditure Survey Report indicated regions. a marked unevenness in the composition of household expenditure across income brackets, with households The rising cost of living for low income households in the lowest-income deciles spending close to 40 underscores the need for better targeted social percent of their expenditure on food, compared to assistance measures to support the poorest about 25 percent among the highest-income deciles households, particularly those residing in the urban (see Figure 14). As a result, the poorest households areas. The Government’s shift in emphasis away have been disproportionately affected by the build-up from blanket subsidies and towards targeted social of inflationary pressures over the past years with higher assistance programs has been a significant step forward relative increases in food prices. This effect has been towards the achievement of this, with the efficiency of even more pronounced in urban areas as food price this approach being well-supported by international inflation has been higher compared to in rural areas evidence. However, there are still a number of areas (see Figure 15). where fine-tuning these initiatives could improve their 24 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART ONE - Recent Economic Developments and Outlook FIGURE 14 FIGURE 15 Low-income households tend to spend a higher …and so experienced higher inflation due to share of expenditure on food… higher relative increases in food prices over the past years Household Expenditure Composition 2016, % Cumulative Change to Consumer Price since 2010, as at October 2017, % 100 35 90 25 27 29 32 32 33 33 34 35 36 80 38 30 31 29 70 7 10 13 12 60 13 14 14 14 25 14 15 24 29 16 50 25 24 23 23 40 23 23 23 23 20 23 30 26 18 17 17 17 15 16 20 39 37 34 33 14 32 30 29 28 27 26 10 19 10 11 11 -1 9 < RM2k RM2k < x < RM3k RM3k < x < RM4k RM4k < x < RM5k RM5k < x < RM6k RM6k < x < RM7k RM7k < x < RM8k RM8k < x < RM9k RM9k < x < RM10k RM10k < x < RM15k > RM15k 5 0 Overall Urban Rural Food and Non Alcoholic Beverages Transport Food and Non Alcoholic Beverages Transport Housing, Water, Electricity, Gas & Other Fuels Others Housing, Water, Electricity, Gas & Other Fuels Others Source: World Bank staff calculations based on DOSM data Source: World Bank staff calculations based on DOSM data Note: Food and non-alcoholic beverages includes food away from home Note: Others excludes alcoholic beverages and tobacco effectiveness. For instance, at present the primary FIGURE 16 Government cash transfer scheme, Bantuan Rakyat The rise in house prices has continued to outpace 1Malaysia (BR1M), makes no distinction between high- the growth in household income cost and low-cost areas, in terms of either income Index, Base 2007=100 eligibility thresholds or benefit levels. 240 As such, there remains scope to improve the 220 224 redistributive efficiency of the BR1M program by addressing the underlying design bias against 200 205 200 urban households, both in terms of inclusion in BR1M and the price-level adjusted value of the benefits 180 180 received. The design of the scheme could also be 160 improved to better account for household size and composition. For example, at present, a single mother 140 142 with five children is subject to the same eligibility 120 125 requirements and receives the same level of benefits as a household with two working-age adults and a 111 111 100 single child. Concurrently, while the Government 2009 2012 2014 2016 has implemented a number of measures to address the structural undersupply of affordable housing by Median House Price Median Household Income increasing new low-cost constructions, the rate of supply could be accelerated to bridge the immediate Source: World Bank staff calculations based on DOSM and NAPIC data supply-demand gap. MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 25 PART ONE - Recent Economic Developments and Outlook Conditions in the domestic financial sector remain stable Monetary policy has remained stable, with the percent), while the Tier 1 and Total Capital Ratio were Overnight Policy Rate (OPR) held at three percent. also marginally higher than in the previous quarter, at In its November 2017 monetary policy statement, 14.1 percent (2Q 2017: 13.8 percent) and 17.1 percent BNM noted that Malaysia’s economic growth has (2Q 2017: 17.0 percent) respectively. The overall quality become more entrenched, with growth driven by the of banking system loans also remained broadly stable, robust performance of both the domestic and external with the share of net impaired loans remaining at sectors. An assessment of recent indicators suggests around 1.2 percent. Inter-bank obligations continued that Malaysia’s current rates of growth will be sustained to account for the bulk of total external borrowings, into 2018, with private consumption continuing to be minimizing funding and rollover risks. Banking system the primary driver of growth. Meanwhile, the headline liquidity remained adequate and the Basel III Liquidity inflation rate is projected to decline, with expectations Coverage Ratio (LCR) was at 136 percent in 3Q 2017, far of a reduced effect from global cost factors. At the same above the statutory minimum of 80. However, this was a time, underlying inflation is expected to be sustained marginal decrease from 141 percent in 2Q 2017. by strong domestic demand. BNM also indicated the possibility of a review of its current monetary policy In 3Q 2017, the banking system’s overall stance in future meetings, with the review intended to outstanding loans expanded at a slower pace ensure the sustainability of domestic growth. of 5.0 percent (y/y) (2Q 2017: 5.6 percent) (see Figure 17). This reflects primarily a lower growth rate Financial soundness indicators show that the for outstanding business loans at 5.4 percent (y/y) banking system remains resilient. Throughout during the quarter (2Q 2017: 6.6 percent), with broad- the quarter, the banking system’s capacity to absorb based decline in loan growth across all sectors. At 7.0 losses remained robust, with levels of capitalization percent (y/y) (2Q 2017: 7.0 percent), the expansion of significantly in excess of the statutory minimum. As of loans to the small and medium enterprise (SME) sector 3Q 2017, the Common Equity Tier 1 (CET1) Capital Ratio continued to accelerate at a faster rate than the overall was marginally higher at 13.2 percent (2Q 2017: 12.9 loan growth rate. FIGURE 17 FIGURE 18 Growth in total outstanding loans moderated …with lower financing growth for non-residential further in 3Q 2017… properties and passenger cars Outstanding Loans, y/y, % Banking System Loans, y/y, % 14 15 12 10 10 5 8 0 6 -5 4 -10 2 03/2015 05/2015 07/2015 09/2015 11/2015 01/2016 03/2016 05/2016 07/2016 09/2016 11/2016 01/2017 03/2017 05/2017 07/2017 09/2017 0 Q3-2015 Q4-2015 Q1-2016 Q2-2016 Q3-2016 Q4-2016 Q1-2017 Q2-2017 Q3-2017 Passenger Cars Personal Use Residential Properties Credit Card Total Loans Business Loans Household Loans Non Residential Properties Securities Source: World Bank staff calculations based on CEIC and DOSM data Source: World Bank staff calculations based on CEIC and DOSM data 26 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART ONE - Recent Economic Developments and Outlook During the third quarter, household credit growth remain broadly stable, supported by favorable labor continued to moderate, with the growth rate market conditions and sustained income growth. As declining to 4.9 percent (y/y) (2Q 2017: 5.1 of October 2017, the aggregate level of impaired and percent). The decline was largely attributable to the delinquent loans improved slightly to 1.6 percent (June ongoing moderation in the growth of financing for non- 2017: 1.6 percent) and 1.4 percent (June 2017: 1.5 residential properties, passenger cars, and personal percent) of total household debt, respectively. loans. The debt servicing capacity of households The financial account recorded a net outflow due to increased resident outflows In 3Q 2017, the portfolio investment account were mainly channeled to the real estate, mining and recorded a net outflow of RM 5.1 billion (2Q 2017: manufacturing subsectors. net inflow of RM 16.0 billion) (see Figure 19). The net inflow of portfolio investments by non-residents During the third quarter, the ringgit appreciated by declined to RM 3.7 billion in 3Q 2017 (2Q 2017: RM18.8 an additional 1.6 percent against the US dollar (2Q billion), as the continued foreign interest in domestic 2017: 3.1 percent) (see Figure 20). This appreciation financial markets was partially offset by increased was supported by the ongoing strength in Malaysia’s maturities of Government securities over the period. In trade performance and sustained non-resident the same quarter, the net outflow of resident portfolio interest in the domestic financial markets. The ringgit investments increased to RM 8.8 billion (2Q 2017: RM depreciated slightly against the euro (-1.4 percent) and 2.8 billion), reflecting the net acquisition of financial the UK pound sterling (-1.4 percent), but appreciated assets abroad by domestic institutional investors. Net against the Japanese yen (2.3 percent) and against inflows of foreign direct investment (FDI) increased to most regional currencies, with the exception of the Thai RM 11.2 billion (2Q 2017: RM 8.3 billion). These inflows baht (-0.3 percent). FIGURE 19 FIGURE 20 There was a net outflow of portfolio investments After a period of weakness, the Ringgit is now in 3Q 2017 beginning to appreciate Portfolio Flows, RM Billion Currency/US$, Rebase Jan 2017=100 30 105 20 103 101 10 99 0 97 -10 95 -20 93 -30 91 -40 89 Q3-2015 Q4-2015 Q1-2016 Q2-2016 Q3-2016 Q4-2016 Q1-2017 Q2-2017 Q3-2017 04/01/2017 04/03/2017 04/05/2017 04/07/2017 04/09/2017 04/11/2017 Residents Non-residents Net Portfolio Investments Malaysia Thailand Indonesia Philippines Source: World Bank staff calculations based on CEIC and BNM data Source: World Bank staff calculations based on CEIC data MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 27 PART ONE - Recent Economic Developments and Outlook Fiscal consolidation remains on track In proportion to GDP, the overall annual value of percent), with the removal of the cooking oil subsidy for fiscal revenue has been declining since 2012. In 1 to 5 kilogram bottled packaging in November 2016 2017, this trend is expected to continue, with and the shift from the monthly- to weekly-managed revenue amounting to 16.8 percent of GDP in 2017 floating system for the retail prices of RON 95 petrol (2016: 17.3 percent). Despite an estimated increase and diesel in March 2017 to minimize fiscal losses due in absolute terms, it is anticipated that in proportion to the lag effect from daily fluctuations in oil prices. to GDP, there will be a broad-based decline in Federal However, the wage bill (emoluments and retirement Government revenue collection across both tax receipts charges) is projected to remain relatively sizeable at and non-tax revenues (see Figure 21). This primarily 7.6 percent of GDP in 2017 (2016: 7.7 percent). At this reflects the decline in 2017 in corporate income tax level, it accounts for 46.6 percent of total operating collection to 5.0 percent of GDP (2016: 5.2 percent) expenditure, with the increase mainly due to salary and the decline in GST collection to 3.1 percent of increments, the implementation of minimum wage and GDP (2016: 3.3 percent). Meanwhile, petroleum-related pension payments and revisions to selected service revenue is estimated to be sustained at 2.5 percent of schemes for support staff beginning July 2016. GDP (2016: 2.5 percent). In 2017, as a proportion of GDP, public sector The decline in fiscal receipts in proportion to development expenditure is projected to decline GDP has been offset by a similar reduction in the marginally to 11.3 percent (2016: 11.6 percent). share of operating expenditure, although the wage This projected decline is due to a more modest bill continues to constitute a large proportion of growth of capital outlays by public enterprises expenditure (see Figure 22). In 2017, as a proportion (see Figure 23). As a proportion of GDP, capital of GDP, operating expenditure is projected to decline expenditure by non-financial public corporations to 16.4 percent (2016; 17.1 percent). This decline is (NFPCs) is projected to decline to 7.1 percent (2016: consistent with the Government’s ongoing commitment 7.7 percent), with expenditure mainly driven by existing to fiscal consolidation. It is largely attributable to infrastructure projects in the transportation, oil and gas reductions in subsidies to 1.7 percent of GDP (2016: 2.0 and utilities subsectors. At the same time, the Federal FIGURE 21 FIGURE 22 Fiscal revenue as a share of GDP is projected to …accompanied by continued reductions in moderate further… operating expenditure % of GDP % of GDP % of OE 25 25 50 21.4 20.9 21.2 20.7 45 19.9 19.8 18.9 1.4 1.5 40 20 20 18.7 3.6 1.6 3.5 17.3 2.0 17.1 3.4 16.8 16.6 2.0 1.6 2.0 16.4 16.2 35 4.6 3.3 2.1 1.7 3.3 1.8 1.7 30 15 5.7 5.3 4.9 15 3.1 4.9 4.6 4.4 2.2 3.1 2.1 2.1 3.8 25 4.4 3.6 2.4 3.4 2.4 2.3 10 3.3 3.1 3.1 10 3.4 20 2.9 4.5 2.5 2.8 4.3 3.6 2.4 15 2.0 1.7 12.0 1.8 11.8 11.5 5 9.7 8.9 8.9 8.8 5 10 6.2 6.0 6.1 6.1 5.9 5.9 5.5 5 0 0 0 2012 2013 2014 2015 2016 2017e 2018f 2012 2013 2014 2015 2016 2017e 2018f Direct Taxes Non-Revenue Receipts Salaries Debt Service Charges Salaries and Pensions Indirect Taxes Non-Tax Revenue Pensions Subsidies (% of OE) Supplies & Services Others Source: World Bank staff calculations based on MoF data Source: World Bank staff calculations based on MoF data 28 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART ONE - Recent Economic Developments and Outlook FIGURE 23 FIGURE 24 Declining public-sector development spending as Federal Government development spending is a share of GDP has been driven by lower growth estimated to be broadly sustained in 2017 of capital outlays from NFPCs % of GDP NFPCs General Government % of GDP Economic Social Defence General Services Services & Security Administration 16 6 14.9 14.3 14 13.7 5 4.8 4.5 12.1 12 11.6 11.3 0.5 5.5 4.1 4.9 4 9.9 3.6 10 4.1 0.5 3.5 3.4 3.9 1.3 3.4 4.2 3.2 0.4 0.4 3 0.4 0.4 8 3.9 1.1 0.4 0.9 1.0 0.8 0.9 6 0.8 10.4 2 8.8 8.8 4 8.0 7.7 3.0 7.1 2.4 6.0 2.1 2.0 1 2.0 1.9 1.8 2 0 0 2012 2013 2014 2015 2016 2017e 2018f 2012 2013 2014 2015 2016 2017e 2018f Source: World Bank staff calculations based on MoF data Source: World Bank staff calculations based on MoF data Government’s development expenditure is expected public confidence regarding medium-term fiscal to remain stable, at 3.4 percent of GDP (2016: 3.4 sustainability. percent). Increased fiscal resources were allocated to the transport and education subsectors, with the Malaysia’s fiscal position is projected to continue intention being to enhance the future productive to improve over the medium term, with the capacity of the economy through improvements to Government remaining committed to ongoing fiscal physical infrastructure and human capital (see Figure reforms. The fiscal deficit is projected to continue 24). to consolidate, reaching 2.8 percent of GDP in 2018 (2017e: 3.0 percent) (see Figure 26). Correspondingly, The Government’s financial position has remained in proportion to GDP, Federal Government debt is broadly stable, with risks appearing to be projected to reach about 50 percent of GDP over the manageable. In proportion to GDP, the Federal year. The Government’s projections are premised Government debt stock narrowed over 2017, standing upon expectations of increased revenue collection at 51.1 percent as of 3Q 2017 (2Q2017: 50.9 percent) (see in the context of sustained strong economic growth Figure 25). Ringgit-denominated papers constituted and higher crude oil prices. In particular, the budget 96.8 percent of the Federal Government borrowing, forecasts assume that the domestic economy will which implies that the risks arising from exchange grow at rates in the range of 5.0 to 5.5 percent and rate fluctuations are limited. The Government’s debt that the average crude oil price will stand at US$ 52 profile also continues to be skewed towards longer per barrel in 2018 (2017e: US$ 50). In proportion to maturity issuances, with an average maturity period GDP, Government revenue collection and operating of 7.2 years and with 66 percent of outstanding debt expenditure are projected to continue to decline in having a remaining maturity period of more than three 2018, largely reflecting the lower contributions from years, limiting exposure to rollover risk. Large domestic GST receipts and a smaller increase in the wage bill. institutional investors accounted for almost two-thirds Public sector development expenditure is also expected of total Government securities as of 3Q 2017, reducing to decline in proportion to GDP next year, primarily risks associated with shifting foreign investor sentiment. due to a projected decline in capital expenditure by Contingent liabilities have remained relatively sizable, public corporations and to a slower growth in Federal mainly reflecting increased public loan guarantees to Government capital expenditure with lower allocations facilitate the funding of ongoing infrastructure projects in the education, trade and industry, and transport by NFPCs. The continued monitoring and transparent categories.   assessment of the associated fiscal risks would enhance MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 29 PART ONE - Recent Economic Developments and Outlook FIGURE 25 FIGURE 26 Federal Government debt as a share of GDP has The fiscal deficit is expected to continue to lowered but Government guaranteed debt has narrow in 2018 increased % of GDP Government Guaranteed Debt Federal Government Debt % of GDP 80 0 70 -1 15.4 15.4 60 14.7 15.5 15.2 16.2* 50 -2 40 -2.8 -3.0 -3 -3.2 -3.1 30 54.5 -3.4 51.6 53.0 52.7 52.7 51.1 20 -3.8 -4 -4.3 10 0 -5 2012 2013 2014 2015 2016 Q3-2017 2012 2013 2014 2015 2016 2017e 2018f Source: World Bank staff calculations based on MoF data Source: World Bank staff calculations based on MoF data Note: *As of 2Q 2017 Further reductions in the fiscal deficit will require deeper reforms With the more favorable domestic growth its tax base from the current two million income tax outlook over the coming years, there is a window payers out of 15 million of the nation’s total workforce. of opportunity for Malaysia to accelerate fiscal While in developed economies, the total value of reforms and thereby achieve the Government’s personal income tax collection amounts to about medium-term objectives. Since the GFC and the oil eight percent of GDP, in Malaysia, the corresponding price slump, Malaysia has been successfully endeavoring figure is projected to stand at 2.2 percent in 2018. By to implement a series of fiscal reforms to narrow its fiscal contrast, the total value of Malaysia’s corporate income deficit through a range of revenue diversification and tax collection is projected to account for five percent expenditure rationalization measures. However, as the of GDP in 2018, compared to the developed country scope for further reduction to operating expenditure average of three percent. This suggests that there may narrows, GST collection plateaus and stabilizing oil be limited potential to increase corporate income tax prices limit oil-related revenue growth, further fiscal revenue without overburdening local enterprises. GST adjustments will become increasingly challenging. As implementation has played an instrumental role in such, achieving a near-balanced federal budget over diversifying Malaysia’s fiscal revenue base, reducing the medium term would necessitate a second, deeper its heavy dependence on income taxes and oil-related wave of reforms to enhance revenue collection and to collections while enabling it to maintain relatively improve public sector efficiency. low tax rates. However, the efficiency of Malaysia’s GST system could be improved by rationalizing its Broadening the coverage of personal income expanded list of tax exemptions and zero-rated tax and reducing GST exemptions could further items. While these exemptions lessen the regressivity diversify and strengthen the Government’s revenue of GST to the extent that the excluded products base. The overall efficiency of Malaysia’s personal constitute a larger share in the consumption basket of income tax system could be enhanced by widening lower-income households, they are costly in terms of 1 The threshold value of the B40 households increased from RM 3,860 in 2014 to RM 4,360 in 2016 – 2017. 30 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART ONE - Recent Economic Developments and Outlook foregone revenue and administrative expenses. These proportion to total operating expenditure, Malaysia’s exemptions also constrain fiscal resources that could current allocations for emoluments, pension and otherwise be channeled towards providing targeted gratuities are higher than those of its regional welfare assistance and strengthening social safety nets comparators. Containing the growth of the wage bill for vulnerable segments of the population. Meanwhile, may call for a comprehensive review of the existing civil the rapid expansion of the digital economy offers service hiring and retention policies, and of the pension opportunities for Malaysia to extend GST collection system. Additional reforms to enhance the efficiency to online transactions and thereby to ensure equal tax and redistributive capacity of operating expenditure treatment across both the digital and the traditional could also include a further shift from regressive economy. blanket subsidies to a more targeted protection system for vulnerable groups. Meanwhile, greater emphasis The further rationalization of operating should be placed on directing development resources expenditure could create additional fiscal space for towards improving human capital development and the Government to address critical development addressing the skills deficits, which are among the key areas and thereby enhance Malaysia’s longer-term constraints on Malaysia’s medium-term productive growth potential. Measures to address the rising capacity. cost of civil service salaries and pensions are intended to contain the expanding operating expenditure. In TABLE 3 Federal Government financial position RM billion % of GDP (current prices)   2015 2016 2017e 2018f 2015 2016 2017e 2018f Revenue 219.1 212.4 225.3 239.9 18.9 17.3 16.8 16.6 Direct Taxes 111.8 109.6 119.7 127.7 9.7 8.9 8.9 8.8 Companies Income Tax 63.7 63.6 67.8 72.5 5.5 5.2 5.0 5.0 Petroleum Income Tax 11.6 8.4 10.9 11.4 1.0 0.7 0.8 0.8 Individual Income Tax 26.3 27.6 30.1 32.2 2.3 2.2 2.2 2.2 Others 10.2 10.0 10.9 11.6  0.9  0.8  0.8 0.8 Indirect Taxes 53.7 59.7 60.5 63.9 4.6 4.9 4.5 4.4 Goods and Services Tax 27.0 41.2 41.5 43.8 2.3 3.4 3.1 3.0 Excise Duties 11.9 11.7 11.8 12.3 1.0 1.0 0.9 0.9 Others 14.8 6.8 7.2 7.7 1.3 0.6 0.5 0.5 Non-Tax Revenue 51.5 40.0 41.9 44.9 4.5 3.3 3.1 3.1 Non-Revenue Receipts 2.2 3.1 3.2 3.4 0.2 0.3 0.2 0.2               Operating Expenditure 217.0 210.2 219.9 234.3 18.7 17.1 16.4 16.2 Emoluments 70.1 73.1 78.8 79.1 6.1 5.9 5.9 5.5 Retirement Charges 18.9 21.0 23.6 24.6 1.6 1.7 1.8 1.7 Debt Service Charges 24.3 26.5 28.9 30.9 2.1 2.2 2.1 2.1 Supplies and Services 36.4 30.1 32.6 33.6 3.1 2.4 2.4 2.3 Subsidies and Social Assistance 27.3 24.7 23.1 26.5 2.4 2.0 1.7 1.8 Others 40.0 34.8 32.9 39.6 3.4 2.9 2.5 2.8 Gross Development Expenditure 40.8 42.0 46.0 46.0 3.5 3.4 3.4 3.2 Economic Services 23.3 25.1 25.9 26.3 2.0 2.0 1.9 1.8 Defense and Security 4.8 4.8 5.3 5.2 0.4 0.4 0.4 0.4 Social Services 11.2 10.4 12.1 11.7 1.0 0.8 0.9 0.8 General Administration 2.8 2.8 2.7 2.8 0.1 0.2 0.2 0.2 Less: Loan Recoveries 1.5 1.3 0.6 0.6 0.1 0.1 0.0 0.0 Net Development Expenditure 39.3 40.6 45.3 45.4 3.4 3.3 3.4 3.2 Overall Balance -37.2 -38.4 -39.9 -39.8 -3.2 -3.1 -3.0 -2.8 Source: World Bank staff calculations based on MOF data MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 31 PART ONE - Recent Economic Developments and Outlook BOX 3 How can big data improve analysis of macroeconomic trends in Malaysia? Governments and private actors depend heavily In the past decade, there has been a significant on official statistics for the optimal allocation proliferation of large and often unstructured of resources. However, these statistics are costly datasets. These may be generated from sources to produce and are therefore generated at a such as news articles, satellite images, mobile phone low frequency. In the absence of official statistics, call records, social media data, and web searches policymakers typically rely on analysts’ forecasts, and may contain valuable information on collective which may not give an accurate picture of economic human behavior. While these datasets have mostly conditions. Following the AFC, Malaysia’s annual GDP been utilized by private companies, they can also be growth rate declined drastically, going down from 7.3 leveraged by policymakers to improve the measurement percent in 1997 to -7.4 percent in 1998. However, the and assessment of economic conditions and to inform consensus forecast for the GDP growth rate in 1998 policy decisions. remained at -4.8 percent in September 1998 and at -6 percent in December 1998, a few weeks prior to the Staff of the World Bank’s Big Data program have official statistics being released. A similar phenomenon collected a vast body of media reports, containing occurred during the GFC, when the consensus forecast around four million news articles on issues related for the 2008 GDP growth rate stood at 5.5 percent in to the economy by Reuters in the period from 1996 September 2008 and at 5.3 percent in December 2008. to 2015. Information derived from media reports has When an official assessment of the rate was released, two main advantages compared to official statistics. it stood at 3.3 percent. Dependence on unreliable First, measurements of economic conditions can be forecasts can have serious implications for the economy, calculated in real time, at a daily frequency, and across including hampering the effective implementation of a large number of countries. Second, this information interventions during a crisis. enables the measurement of economic forces that 32 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART ONE - Recent Economic Developments and Outlook might not be easily captured by traditional data sources, approaches have been successfully applied using providing insight into factors such as the collective other forms of unstructured data, derived from sources sentiment regarding economic prospects. ranging from satellite images to cell phone records, twitter steams, or web searches. However, this work is Measures of economic sentiment can be derived still at an early stage. An important next step will be through an analysis of the proportion of positive to carefully combine the signals obtained from multiple words (“gain”, “improve”, “agreement”, etc...) relative data sources to reduce the risk of bias stemming from to the proportion of negative words (“concern”, each source taken individually. “fear”, “decline”, etc...) appearing in these articles. By restricting the sample to articles focusing only on Given the potential to improve estimates of one specific country, it can be demonstrated that the economic indicators, Governments and development resulting index closely follows variations in yearly GDP organizations should consider investing in the growth (see Figure 27). The index may provide better acquisition of large unstructured datasets and forecasts of GDP growth than consensus forecasts in the tools and human resources necessary to (see Figure 28). In the case of Malaysia, the average analyze them. This would enable them to produce a reduction in the out-of-sample one month-ahead set of relatively low cost, accurate, and high-resolution forecast error is 5.3 percent. measures of economic indicators in real time, which could complement traditional sources of data and These results indicate the potential value of the information and enable policymakers to react faster use of large unstructured datasets to improve and more effectively to evolving economic conditions. estimates of macroeconomic trends. Similar FIGURE 27 FIGURE 28 A news based sentiment index provides a leading …resulting in reduced forecast errors indicator for growth… News based sentiment index for Malaysia Percentage reduction in forecast error, selected countries 0.12 1.5 0.3 0.1 0.08 1 0.25 0.06 0.5 0.2 0.04 0.02 0 0.15 0 -0.02 0.1 -0.5 -0.04 -0.06 0.05 -1 -0.08 GDP Growth 0 -0.1 -1.5 Chile Peru Japan Thailand Malaysia Argentina Korea, Rep. 1/1/1995 1/1/1997 1/1/1999 1/1/2001 1/1/2003 1/1/2005 1/1/2007 1/1/2009 1/1/2011 1/1/2013 1/1/2015 Source: World Bank big data program staff calculations Source: World Bank big data program staff calculations Note: Fraction of positive minus negative words appearing in a corpus of Note: Comparison of out-of-sample forecast errors of yearly GDP growth four million economic news articles from Reuters focusing on Malaysia. using two models. The first model uses the one month ahead consensus The resulting sentiment index is averaged at a yearly frequency and tracks forecast of GDP growth. The second model also includes the news-based fluctuations in yearly GDP growth. sentiment index, averaged during the month prior to the one month ahead consensus forecast. Both models are estimated on a panel dataset during the period 1996-T for T>2003; out of sample forecast errors are averaged during the period T-2015 at the country level. The plot shows that including the sentiment index reduces the forecast error. MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 33 PART ONE - Recent Economic Developments and Outlook Economic outlook With strong domestic and external demand, Malaysia’s growth is expected to remain strong into 2018 The global economic recovery is expected to The growth outlook for regional economies remains continue at least into the near-term future. The favorable, with strong growth driven by robust global economic growth rate is projected to reach 3.0 private sector expenditure and increased external percent in 2018 (2017f: 3.0 percent), with increased demand. China’s economy is projected to grow at growth driven by continued recovery in the advanced the slightly lower rate of 6.4 percent in 2018 (2017f: economies and sustained growth in the developing 6.8 percent), with the economy gradually rebalancing economies (see Figure 29). The favorable global towards domestic consumption and away from growth outlook, with a cyclical upswing in investment investment and external demand. Excluding China, the and manufacturing activities, will continue to have a average growth rate for developing EAP economies is positive impact on global trade flows. Global financial projected to increase to 5.3 percent in 2018 (2017f: 5.2 conditions are anticipated to tighten gradually following percent). The favorable outlook for these economies improvements to market expectations regarding is predicated on expectations of continued high levels growth momentum and a return to a more gradual of private sector expenditure, which will remain the pace of monetary policy normalization in the advanced primary driver of growth, with further impetus from economies. Commodity prices are expected to recover increased global trade and manufacturing activity. As moderately, reflecting the prospects of increased a result of these factors, expectations for Malaysia’s production of US shale and lower production costs. growth outlook have also increased (see Figure 30). FIGURE 29 FIGURE 30 Robust global growth is expected to continue into Consensus forecasts for Malaysia’s growth have 2018 moved sharply upwards Annual GDP Growth, % Annual GDP Growth, % 5.0 6.2 4.5 5.7 4.0 3.5 5.2 3.0 2.5 4.7 2.0 4.2 1.5 1.0 3.7 0.5 0.0 3.2 2016 2017f 2018f 2016 2017f 2018f 2016 2017f 2018f Advanced Emerging & Jan 16 Feb 16 Mar 16 Apr 16 May 16 Jun 16 Jul 16 Aug 16 Sep 16 Oct 16 Nov 16 Dec 16 Jan 17 Feb 17 Mar 17 Apr 17 May 17 Jun 17 Jul 17 Aug 17 Sep 17 Oct 17 Nov 17 Dec 17 World Economies Developing Economies Previous Estimates (April 2017) Median Consensus Forecast WB Forecasts Source: World Bank staff calculations and projections Source: Consensus Economics and World Bank staff calculations and Note: Columns indicate current estimates projections 34 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART ONE - Recent Economic Developments and Outlook TABLE 4 GDP growth and contribution to growth Growth Rates (y/y, %) Contribution to GDP Growth (% points) 2016 2017f 2018f 2019f 2016 2017f 2018f 2019f GDP 4.2 5.8 5.2 5.0 GDP 4.2 5.8 5.2 5.0 Domestic Demand Domestic Demand (including 4.5 6.4 5.7 5.2 4.1 5.8 5.3 4.9 (including stocks) stocks) Final Consumption 4.9 6.3 6.0 5.9 Final Consumption 3.2 4.2 4.0 4.0 Private Sector 6.0 6.9 6.6 6.5 Private Sector 3.1 3.7 3.6 3.6 Public Sector 0.9 3.7 3.3 3.3 Public Sector 0.1 0.5 0.4 0.4 Gross Fixed Capital Formation 2.7 6.8 4.9 4.5 Gross Fixed Capital Formation 0.7 1.7 1.3 1.2 Change in Stocks 0.2 -0.1 0.0 -0.3 External Demand 1.5 -0.8 -0.7 1.4 External Demand 0.1 -0.1 -0.1 0.1 Exports of Goods & Services 1.1 10.2 4.1 3.9 Exports of Goods & Services 0.8 7.2 3.0 2.8 Imports of Goods & Services 1.1 11.7 4.7 4.2 Imports of Goods & Services -0.7 -7.2 -3.1 -2.7 Source: World Bank staff calculations Malaysia is forecast to record an economic growth investment activity will be primarily driven by the rate of 5.2 percent in 2018 (2017f: 5.8 percent), ongoing capacity expansion in the domestic-oriented with this growth driven primarily by continued subsectors amid the ongoing increase in domestic high levels of private sector expenditure (see Table consumption. By contrast, public investment is 4). Domestic demand is expected to remain the main projected to contract over the period, reflecting lower driver of growth. Favorable labor market conditions levels of capital expenditure by public corporations. and income growth, improved consumer sentiment and ongoing income support measures are expected In 2018, the current account surplus is projected to continue to sustain the private consumption growth to remain roughly stable at 2.4 percent of GDP. rate at 6.6 percent in 2018 (2017f: 6.9 percent). Measures The expansion of Malaysia’s exports is anticipated to under the 2018 budget to reduce income tax rates for continue with the ongoing improvement in global trade, individuals in the lower income brackets and to provide albeit at a lower rate than in the previous year, given the cash bonuses to current and former public servants relatively high base in that year. This is expected to be will also support private consumption. Meanwhile, the partially offset by the continued growth in intermediate public expenditure growth rate is projected to decline imports due to increased demand for manufactured to 3.3 percent over the period (2017f: 3.7 percent). exports. Meanwhile, consumption and capital imports This mainly reflects a more moderate expansion in are expected to expand further, reflecting the sustained emoluments and expenditure on supplies and services, high level of private sector expenditure. The persistent in line with the Government’s efforts to contain the deficits in the services and income accounts, reflecting size of the civil service and to rationalize non-critical Malaysia’s continued reliance on foreign services and expenditure. income accrued to non-resident investors, are also expected to exert a negative impact on the surplus in With the anticipated decline in public investment, Malaysia’s current account balance. gross fixed capital formation will be primarily driven by the sustained high levels of private sector The headline inflation rate is expected to decline as capital expenditure. Gross fixed capital formation the price pressures arising from global cost factors is projected to increase at the rate of 4.9 percent in recede. While global crude oil prices are projected to 2018 (2017f: 6.8 percent), with this increase supported increase slightly in 2018, the impact of this on retail fuel by investment in the new and existing infrastructure prices and therefore on domestic inflation is anticipated projects, as well as the continued flows of private sector to be relatively moderate, largely due to the base effect capital investments, particularly in the manufacturing of the relatively high inflation rate in the transportation and services sectors. With increased external demand category recorded in 2017. It is expected that underlying and improved business sentiment, capital expenditure inflationary pressures will be sustained by the continued in the manufacturing sector is expected to be driven strength in domestic demand conditions, though it is by export-oriented industries particularly by E&E anticipated that these pressures will remain broadly and resource-based clusters. In the services sector, contained over the coming quarters. MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 35 PART ONE - Recent Economic Developments and Outlook Risks relate primarily to unforeseen changes in the external environment Malaysia‘s economy continues to face risks related On the domestic front, downside risks to growth to uncertainty in the external environment. In relate mainly to the relatively high level of household particular, the growing shift towards protectionism and public-sector debt. Despite a recent decline, could have a dampening effect on global trade and Malaysia’s high level of household debt in proportion investment flows, with disproportionate adverse to GDP in the context of persistent property market spillovers on Malaysia, given its high level of integration imbalances continues to pose a risk to the maintenance with the global economy and financial markets. Within of macroeconomic and financial stability. This could the developing EAP, heightened geopolitical risks, also have an impact on private consumption if prices mainly related to an increase in tensions in the Korean increase, particularly as domestic financial conditions peninsula, could have severe economic implications are likely to tighten as a result of BNM’s monetary for regional economies if these tensions escalate. policy normalization measures. In terms of public sector Other significant downside risks include a disorderly debt, while the level of Federal Government debt has adjustment to global financial market conditions, declined over the recent years, contingent federal weaker-than-anticipated growth by Malaysia‘s major liabilities remains relatively high, presenting a potential trading partners, including China, and/or renewed source of medium-term fiscal risks. Lastly, political decline in global commodity prices and export demand uncertainties related to Malaysia’s upcoming general if cyclical factors diminish. Conversely, a stronger-than- election, which is scheduled to be held by August 2018, expected recovery in the advanced and emerging may lead to some near-term financial market volatility. market economies could lead to continued strong demand for Malaysia’s exports. A strengthening economy offers an opportunity to focus on structural reforms for the transition to a high-income economy Malaysia’s stronger-than-expected growth creates returns from its factor-accumulation-led growth model. opportunities for the Government to increase Reforms to enhance productivity could be intensified its initiatives to address the deeper structural to address the key constraints, such as a lack of challenges that limit the economy’s growth competition in key markets and critical human capital potential. With both strong domestic and external and skills deficits. While Malaysia’s increased fiscal demand, Malaysia’s economic rebound has helped to space creates opportunities to increase its investment close the negative output gap and its output is now in these areas, it is important to recognize that in many close to the economy’s potential output level. areas, particularly in the areas of education and training, the challenge relates as much to the quality of spending A strong growth environment, therefore, offers as to the quantity. a crucial window of opportunity to accelerate structural reforms that will facilitate Malaysia’s It is also important for Malaysia to continue to transition towards the achievement of high-income implement measures to ensure that growth is status in the coming years. Simulations suggest that inclusive and provides access to opportunities for Malaysia will likely pass the high-income threshold all its citizens. While Malaysia has achieved good between 2020 and 2024 (see Box 4). However, while per progress in sustaining economic growth and reducing capita income is a useful proxy for economic well-being, poverty over the past years, there remain concerns there are many additional dimensions of development regarding the distribution of economic gains and that will also need to be taken into account. perceived inequality of opportunity. In particular, the income share of households in the bottom 40 percent A key area of policy focus are measures to (B40) fell from 16.8 percent in 2014 to 16.4 percent in increase productivity growth and to strengthen 2016–171, after having increased steadily from 13.5 competitiveness, as Malaysia faces diminishing percent since 2004. 1 The threshold value of the B40 households increased from RM 3,860 in 2014 to RM 4,360 in 2016 – 2017. 36 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART ONE - Recent Economic Developments and Outlook In order to improve the well-being of the B40, problem solving, critical thinking, non-cognitive and attention will need to be paid to both incomes and soft skills. The introduction of employment insurance, the cost of living. Income growth among the B40 if adequately funded, also has the potential to improve continues to be constrained by skills deficits, with many the functioning of labor markets and to increase workers not qualified to take up more remunerative employment earnings, especially during job transitions. employment. It is also constrained by skill mismatches, To address issues related to the cost of living, the with workers taking sub-optimal jobs because of weak ongoing removal or reduction of costly blanket subsidies labor demand in their field (e.g., oil and gas). While provides space for the Government to implement more initiatives such as TalentCorp’s Critical Occupations targeted and progressive subsidies and transfers. List help to identify skill needs, given the anticipated The Government should consider implementing dynamism in the nature of work, there is also a pressing further measures to address the structural shortage of need to expand training, including through measures affordable housing to ensure real income gains among to improve skills in less job-specific areas such as the B40. BOX 4 When can Malaysia expect to achieve high-income country status? According to simulations conducted by the World As such, it is important that GNI is complemented Bank, Malaysia is projected to exceed the threshold by other indicators and measures to obtain a that defines high-income economy status at some more rounded, multidimensional assessment of the point in the period from 2020 to 2024. The World economy’s true prosperity and the well-being of its Bank currently defines high-income economies as those citizens. whose gross national income (GNI) per capita stands at US$ 12,236 or more, based on estimates using the FIGURE 31 Atlas method.2 In 2017, Malaysia‘s average GNI per Three scenarios for when Malaysia can expect to capita is estimated to stand at US$ 9,660, or US$ 2,576 pass the high-income country threshold short of the defined threshold level. World Bank Staff projections3 suggest that Malaysia could achieve this GNI per capita, World Bank Atlas methodology (US$) threshold level by 2021 under the baseline scenario, or 18,000 High by 2020 in the high episode scenario and by 2024 in the low episode scenario (see Figure 31). Baseline 16,000 While it is widely recognized as an indicative proxy of economic well-being, GNI does not holistically 14,000 High income Low summarize a country’s overall level of development. threshold In particular, GNI does not fully reflect the broader 12,000 aspects of well-being, such as general health and environmental sustainability, which contribute towards the overall welfare of a country’s citizens, though it is 10,000 often closely correlated with some of these dimensions. Nor does it capture the distribution of wealth and 8,000 2017f 2018f prosperity across geographical regions and segments 2019f 2020f 2021f 2022f 2023f 2024f 2025f 2026f 2016 of the population. Source: World Bank staff projections 2 In calculating GNI in US dollar terms, the World Bank uses the Atlas conversion factor instead of simple exchange rates. The Atlas conversion factor for any given year is the average of a country’s exchange rate for the year and its exchange rates for the two preceding years, adjusted for the difference between the rate of domestic inflation and international inflation. The purpose of the adjustment is to lessen the effect of exchange rate variability in the cross-country comparison of national incomes. 3 In addition to GDP growth and Ringgit exchange rate forecasts, these projections are predicated upon the World Bank staff forecasts of the population growth, primary income, GDP deflator and IMF’s Special Drawing Rights deflator. MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 37 PART TWO Turmoil to Transformation: 20 Years after the Asian Financial Crisis MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 39 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis Turmoil to Transformation: 20 Years after the Asian Financial Crisis East Asia did not let poverty, which affected almost half the population in 1990, has been almost eliminated by 2017.5 Amidst the a crisis go to waste economic turnaround, these countries also became more democratic and open societies than they were 20 years ago. During the GFC, not surprisingly, most East The AFC was a watershed moment for East Asia’s Asian countries escaped relatively unscathed from the major economies. What started as an isolated event, financial shock waves that swept through the countries when the Thai baht lost its peg to the US dollar on July of Europe and North America. The transformation is 2, 1997, quickly became a crisis that spread to engulf nearly complete: the gloom and doom of the late 1990s Indonesia, Malaysia, the Philippines, and the Republic has been replaced by exuberance and confidence in of Korea, decimating their currencies, damaging their the 2010s.6 economies, devastating their financial sector, and plunging each of these countries into deep recession. In While sharing a common destination, not all East a matter of months, thousands of firms went bankrupt, Asian countries took the same path toward a bank runs became endemic, millions of people lost jobs, more resilient set of macro-financial policies. It and a large percentage of the population was thrown is here that Malaysia stands out. It is the only country into poverty. The economic crisis eventually turned that didn’t request an IMF rescue package during the political, ending the tenure of some of the longest crisis. While its initial policy response was like the rest serving political leaders in the region, fundamentally – standard measures to tighten monetary and fiscal altering the future course of these nations. policies – the country gradually trod a different path. It surprised the world by returning, at least temporarily, The East Asian economies did not let the crisis to a fixed exchange rate regime, imposing capital go to waste – rather, they turned the events of controls and pursuing relatively more accommodative 1997-98 into an opportunity. The affected countries fiscal and monetary policies. In the years that followed, strengthened their macroeconomic management, Malaysia went through major financial sector reforms reduced dependence on external capital, rebuilt with significant Government interventions and financial domestic capital markets, erected defenses against support to the banking sector and local businesses. speculative attacks by accumulating massive reserves, floated their exchange rates, and took advantage of This edition of the Malaysia Economic Monitor depreciated currencies to redouble exports. They also takes stock of the macro-financial policies accelerated regional integration, including regional adopted during and after the crisis. With Malaysia financial cooperation in crisis management and at the center, the analysis aims to explain what resolution, which resulted in the Chiang Mai Initiative.4 happened, what responses were adopted, and how they differed from those employed by other affected While the impact of the crisis on the affected countries. A key aim is to highlight how Malaysia’s countries was rapid and severe, the region was experience helped leverage reforms and achieve quick to recover. By 1999, GDP growth in all of the transformation, a process that might be appropriate affected countries had become positive once again. for other small, open, developing economies during a The region quickly returned to brisk growth, rapid period of financial turmoil. The analysis also assesses job creation, and steady poverty reduction. Extreme Malaysia’s comparative resilience to future economic 4 A multilateral currency swap arrangement among the ten members of the Association of Southeast Asia Nations (ASEAN), plus China, Japan and the Republic of Korea. 5 Defined as the proportion of the population living below US$1.90 a day in 2011 PPP terms. 6 The region, however, faces new challenges. Productivity growth is low, the export-led growth model is threatened by rising protectionism, automation is destroying jobs, and political freedom is shrinking in some East Asian countries. These issues are, however, beyond the scope of this report, which is exclusively focused on Malaysia and is largely a retrospective analysis. 40 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis shocks, especially now that the economy is larger and The AFC stood out from similar crises in the past in more interconnected than in the past. Today, Malaysia two important ways: it was unconventional and it enjoys an overall sound banking sector with one of was contagious. Most past financial crises other than the more sophisticated capital markets in the region. the 1992 European exchange rate mechanism crisis The financial system supports a significantly larger and were due to conventional macroeconomic disorders, more interconnected economy than 20 years ago, and particularly balance-of-payment problems as a result the authorities remain committed to financial stability. of the monetization of fiscal imbalances and the Malaysia’s experience and lessons learned could be maintenance of unsustainable exchange rates.7 Such very relevant for economies of similar characteristics, in traditional imbalances were, however, not present particular, small and open developing economies. during the crisis. The ASEAN-4 (Indonesia, Malaysia, the Philippines, and Thailand) and the Republic of Korea had low inflation rates, relatively healthy fiscal positions, solid GDP growth, and manageable current The origins of the account deficits (see Appendix Table 7).8 The sources of vulnerabilities also differed across crisis-hit countries, Asian Financial though there were enough similarities to make it the first full-blown contagion currency crisis in the developing Crisis world.9 Large and sudden capital flows, which supported T he crisis was caused by a combination very high rates of investment in these countries, of m a croeconomic im b a l a nce s , ex ter n a l were part of the problem (see Figure 32 and developments, and weak financial regulation in an Figure 33). Rapid and generalized financial account environment of rapid financial liberalization. The liberalization across Asian countries generated a large external imbalances were a reflection both of strong increase in credit demand. In turn, this increase was private capital inflows and of high domestic private driven by the willingness of firms to take on excessive investment rates, and were exacerbated, prior to the foreign debt – often of short-term maturity and crisis, by the appreciation of the US dollar, to which the unhedged – encouraged by the fixed exchange rate currencies of the economies concerned were formally regimes (for example, Thailand, Republic of Korea) or or informally pegged. stable exchange rates (Malaysia). Capital flows were FIGURE 32 FIGURE 33 Rapid liberalization led to net capital inflows… …that were used to finance investment Financial Account as % of GDP Contribution of investment to real GDP growth, % 15 19 10 5 9 0 -1 -5 -10 Malaysia ASEAN + Korea, Rep. Indonesia Malaysia -11 Thailand Korea, Rep. -15 Philippines -20 -21 1991 1991 1990 1992 1993 1994 1995 1996 1997 1998 1990 1992 1993 1994 1995 1996 1997 1998 Source: World Bank Source: International Financial Statistics, IMF 7 See Lorenzoni (2014) in the Handbook of International Economics, Volume 4. 8 Throughout the rest of the chapter, we will use ASEAN+Korea to reference these five countries. 9 This is the view shared by most economists in Asia. See Khor (2005), Jeasakul et al. (2014), or Mohamad (2000) for further details. An opposing view emphasizes that the cause of the crisis was the defective model of development in Asia that deviated from free market economics. For those favoring this view, the crisis was a symptom and a consequence of crony capitalism where politicians interfered with the market allocation of resources. The features of those economies included political connections which were key for success in business, the financial systems were not transparent with bailouts of politically connected firms, the creation of artificial monopolies, and the allocation of privatized assets to relatives or friends of political leaders. See Eichengreen (2017) and Lee (2001) for details. MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 41 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis also attracted by strong economic performance and by In addition to the currency mismatches, maturity the consolidation of the region as an important player mismatches exacerbated the financial risks. A in the global economy. significant share of the inflows involved loans with short-term maturities that were channeled through the The unsustainable inflows of capital resulted in banking system. With commercial banks tending to on currency mismatches and price bubbles. Following lend these funds to commercial borrowers for longer financial deregulation, many countries in the region time periods, maturity mismatches also emerged (see received large inflows of capital in the form of bank Table 5). loans denominated in foreign currency, with portfolio investment targeting local equity or corporate debt. In Malaysia, the process of capital account Most of these bank loans were allocated to projects liberalization was not as fast as in other countries, that generated revenues in local currency. This resulted thus allowing the economy to better manage and in a currency mismatch, with a latent risk related to absorb shocks. In particular, domestic companies changes in the exchange rate. The increase inflows of were allowed to contract foreign loans only with the capital into the economy also created price bubbles, approval of BNM. Approval was only granted if BNM with excessive investment in the real estate market determined that the project would yield sufficient and in equities. This resulted in a further relaxing of revenues to repay the loan, even if the exchange rate collateral constraints, which amplified the increase in were to depreciate. Thus, the Malaysian economy was credit and capital flows. less vulnerable and had a lower level of external debt than did Thailand, Indonesia or the Republic of Korea The imposition of fixed exchange rates regimes (see Table 5). However, the nature of the AFC was that and tightly managed exchange rates resulted in the contagion spread to Malaysia regardless of the the building up of risk. By eliminating or reducing differing fundamentals. exchange rate volatility, governments provided borrowers with an implicit incentive to contract loans denominated in foreign currency. As a result, these policies created unintended currency mismatches on corporate balance sheets. In addition, at the time, the region’s central banks did not implement foreign exchange accumulation policies, leaving the region’s economies vulnerable to speculative attacks. TABLE 5 External indicators of vulnerability for selected economies affected by the AFC Short-term Short-term debt Dollar Short-term debt External debt debt to foreign as a fraction of denominated to total debt (% of GDP) reserves exports debt (%) (%) (%) (% of GDP) 1996 2017 1996 2017 1996 2017 1996 2015 1996 2017 Indonesia 46.9 31.9 167.2 37.6 50.7 23.7 24.3 77.3 25.0 14.3 Malaysia 38.2 70.6 40.8 95.1 12.5 40.5 55.6 37.0 27.9 42.8 Thailand 61.7 31.1 123.5 29.0 66.8 18.3 32.4 86.8 42.3 41.4 Korea, Rep. 19.4 24.5 195.4 36.3 44.0 20.4 - - 57.5 35.3 Philippines 48.0 26.0 67.7 21.7 25.5 17.6 29.6 70.4 18.1 21.9 Source: World Bank staff calculations based on International Financial Statistics and national authorities 42 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis How Malaysia’s the crisis compared to other affected countries. response differed The establishment of new coordinating institutions helped ensure streamlined decision making and to other affected timely policy responses as the crisis evolved, allowing for course corrections once it became countries clear that the initial response was not working. In January 1998, a National Economic Action Council was established. The Council was chaired by the Prime Minister and took responsibility for implementing a series Malaysia’s initial response to the crisis was similar of stabilization measures over the following six months. to that of other affected countries. As the external Following the implementation of these measures, in debt situation was much less challenging than in other July 1998, the National Economic Recovery Plan was affected countries, Malaysia could choose whether announced. This plan was intended to restore market or not to participate in an IMF supported program. confidence, to facilitate the restructuring of corporate Nevertheless, the Government initially responded to debt, to recapitalize and restructure the banking sector, the Crisis by taking steps consistent with conventional to stabilize the ringgit and to stimulate the economy economic wisdom at the time. In particular, Malaysia through counter-cyclical fiscal and monetary policies. implemented the following measures: (i) increasing interest rates in order to contain the outflow of capital, To stimulate an economic recovery, BNM changed combined with the imposition of a tight monetary policy; its approach and implemented a series of (ii) making fiscal adjustments to reduce Government expansionary measures. First, the BNM gradually expenditure; (iii) allowing the currency to float with reduced interest rates, with these rates going down minimal intervention; (iv) liberalizing the capital account; from 11 percent in July 1998 to 5.5 percent in August and (v) tightening credit reporting requirements, with 1999. Second, the monetary authorities reduced a reduction in the number of months for a loan to be reserve requirements to increase liquidity in the in arrears to be classified as non-performing (from six financial system, with the reserve requirement being months to three months), resulting in a reduction in reduced from 13.5 percent in February 1998 to four credit flows to the real economy. The objective of these percent by September of that year. Also, to revitalize measures was to restore investor confidence in the the credit market, BNM established targets for banks to Malaysian economy and to restrain the capital outflows. achieve a minimum loan growth rate of eight percent for 1998. Finally, to increase the banking sector’s flexibility However, Malaysia’s implementation of these to operate in the stressed market, BNM reversed the measures did not produce the intended results. In decision it had initially made related to the definition of particular, the increased interest rates resulted in a credit non-performing loans, when it had reduced the number crunch that particularly affected small and medium of months for a loan to be in arrears to be classified as sized firms and that generally sapped the strength non-performing from six months to three months. of Malaysia’s private sector. This undermined the prospects of a recovery, including in export-orientated To support economic recovery, the Government businesses. As a result, the economy contracted by 7.4 also implemented an expansionary fiscal policy, percent in real terms, with a sharp decline in investment synchronized with the accommodative monetary and private consumption. With the tightening of public policy stance. In order to revitalize the economy and expenditure, the Government announced a three to restore confidence, the Government implemented percent surplus to the 1998 budget. The stock market a counter-cyclical fiscal policy that included both tax lost 60 percent of its value and the ringgit depreciated incentives and investments in infrastructure. In July sharply as a result of market speculation. By the 1998, the Government launched a fiscal stimulus beginning of 1998, it had become clear that far from package that implied a reduction in the fiscal balance facilitating recovery, the adopted policies were hurting by 4.2 percentage points, going from a surplus of 2.4 the economy. Confidence continued to decline and the percent of GDP in 1997 to a deficit of 1.8 percent in credit crunch exacted a heavy toll on the private sector, 1998. By 1999, with the economic situation demanding resulting in loss of employment and a fall in living increased efforts from the treasury, the fiscal budget standards. It became clear that a new approach was was increased to 3.2 percent of GDP (see Figure 34 and needed. Importantly, Malaysia’s differing fundamentals, Figure 35). In short, Malaysia adopted a much more including the relatively lower level of foreign debt and aggressive fiscal response to the crisis than did the larger reserve coverage, meant that the country was other crisis-affected countries. able to consider a different set of policy responses to MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 43 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis FIGURE 34 FIGURE 35 Fiscal stances in the region… …with a declining public sector burden Fiscal Balance as % of GDP Public sector debt as % to GDP 3% ASEAN + Korea, Rep. 1998 Malaysia 2% 1997 1% 1996 0% 1995 1994 -1% 1993 -2% Malaysia 1992 ASEAN + Korea, Rep. -3% 1991 -4% 1990 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 0 10 20 30 40 50 60 70 80 Source: World Bank staff calculations based on national authorities’ data Source: World Bank staff calculations based on national authorities’ data The stabilization of the ringgit was crucial for the offshore markets and set a new parity between the success of the Government’s plan. During the first ringgit and the dollar. Prior to the imposition of this months of the crisis, there was a substantial capital measure, the ringgit was traded in these markets with outflow, with the ringgit depreciating significantly. To a positive interest differential relative to the internal stabilize the currency and to create a higher degree of market. Thus, capital flew out of the economy, putting certainty for exporters and importers to enable them pressure on the exchange rate. The Government also to more accurately forecast revenues and costs, the imposed strict limits on residents moving capital abroad, Government fixed the exchange rate at RM 3.8 to US$ 1. together with a time limit to repatriate ringgit deposits in offshore markets. In addition, it prohibited the Perhaps Malaysia’s most controversial measure repatriation of portfolio investments by non-residents was to introduce selective capital controls. The for 12 months. However, when the situation began to implementation of this measure was intended to enable stabilize, the 12-month rule was substituted with an exit Malaysia to regain monetary independence. To control tax on the repatriation of portfolio investments, with the interest rates and to facilitate economic recovery while rate decreasing relative to the duration of investment. at the same time stabilizing the exchange rate, the Hence, the capital controls were termed “selective.” Malaysian Government introduced capital controls. In this manner, the Malaysian Government tried to These measures were intended to discourage short- address the so-called “impossibility trilemma,” which term speculative investments, while continuing refers to the supposed impossibility of achieving more to attract long-term investments. In practice, this than two out of three of exchange rate stability; free meant that foreign currency was readily available to international capital mobility; and national monetary- investors who intended to repatriate dividends, earned policy independence. This “trilemma” is premised on interest and profits from foreign direct investment the concept that with no barriers to capital movement, in Malaysia. Also, the capital controls did not affect an interest rate that is lower than the international current account transactions. interest rate, adjusted by country risk, would encourage outward capital flows and hence a lower exchange rate, In general, the international financial community and vice versa. responded skeptically to the selective capital controls, with many observers expecting The Government implemented a number of negative economic consequences. At the time additional measures to regulate the movement of their implementation, the measures were highly of capital across borders. In September 1998, as controversial. Many observers predicted that the the contagion spread across the globe, the Malaysian measures would scare off foreign investors; that they Government prohibited the trade of the ringgit in would have a long-term negative impact on foreign 44 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis investments, output, backspace and the stock market; sharply. As a result, several banks needed to be and that they would lead to the emergence of a black recapitalized to prevent insolvency. market. Some observers predicted that as much as US$ 10 billion of portfolio capital might leave the country One of the immediate reform measures undertaken by September 1999, possibly leading to another round by the authorities was to consolidate the highly- of speculative attacks on the ringgit and forcing the fragmented banking system (see Figure 44). Prior Government to return to conventional policies and to to 1997, there were more than 77 banks and the implement other drastic measures to resolve the crisis authorities decided to consolidate the sector. At that (see Rodrik and Kaplan 2001 and references therein). time, existing institutions did not have the resources to compete with their regional peers or provide a wide However, these negative expectations regarding array of products and services. Following the crisis, the impact of the controls were not fulfilled. Instead, many of the institutions were burdened with high NPLs the controls enabled BNM to reduce interest rates to and could not focus on lending. In order to become a level that would have been impossible without their more competitive and to facilitate Malaysia’s economic imposition. The reduced interest rates alleviated the transformation, the authorities put in place a set of credit crunch, affecting both strong and weak firms policies which facilitated banking sector consolidation alike. As a result, fewer firms went bankrupt and the leading to the number of institutions falling to 34 from 77 subsequent costs of restructuring and recapitalizing prior to 1997. By 2003, the banking sector had emerged the financial sector were smaller. In addition, after the with fewer but stronger and larger domestic institutions initial stimulus package, the combination of policies as a core group of 10 well-capitalized domestic anchor allowed the economy to recover with less reliance banking groups. on fiscal expansion. Finally, there is little evidence to suggest that the introduction of the capital controls A steering committee chaired by BNM led the affected investors’ decisions as to whether to mobilize restructuring initiative, which was implemented capital to Malaysia. by three newly-established institutions. A comprehensive framework and well-coordinated Unsurprisingly, the crisis had a major short-term mechanism for the resolution of NPLs and for the impact on Malaysia’s real sector and thus on credit restructuring of the debts of the distressed companies quality, which necessitated the major restructuring was developed and executed by three agencies, these of the financial sector. With local companies and being Danaharta (the Asset Management Company); consumers facing difficulties in servicing their loans Danamodal (the Bank Recapitalization Agency); and due to the initial increase in interest rates, to the sharp a Corporate Debt Restructuring Committee (CDRC), currency depreciation and to the recession in the real which acted as a coordinating agency to facilitate the economy, the proportion of banks’ NPLs increased restructuring of corporate debt (see Figure 36). FIGURE 36 Malaysia’s mechanism for restructuring distressed financial assets after the AFC Corporates Danamodal New Loans Restructure Rehabilitate Borrowers Existing Facilities New Capital Banks CDRC - Sell NPLs at Creditor Issue Bonds Comittees Fair Market Value Danaharta Source: World Bank (1999a) MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 45 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis To enable commercial banks to unload their non- During its operations, Danamodal injected a total of performing loans and foreclosed assets, the RM 7.6 billion into 10 banking institutions. It was wound Government passed the Pengurusan Danaharta down at the end of 2003, after having redeemed all its National Berhad Act in August 1998. This Act bonds by October 2003. As a strategic shareholder provided the basis for the establishment of Malaysia’s in the recapitalized banks, Danamodal could seek the first public asset management company. It also mergers of selected banks to expedite the consolidation conferred upon Danaharta three special abilities: (i) the of the banking sector. By the end of 2000, the banking ability to buy assets through statutory vesting, which sector consolidation initiative had successfully seen a was essential to enable Danaharta to acquire assets reduction in the number of domestic banks from more with certainty of title and to maximize value; (ii) the than 70 to 10 banking groups. These banks were backed ability to appoint Special Administrators to manage by stronger, more resilient institutional shareholders the affairs of distressed companies; and (iii) the ability and would now have the financial resources to compete to sell foreclosed assets quickly through the disposal regionally. of properties by private treaty. Danaharta‘s NPL initiative commenced in September 1998 and ended in Thirdly, the Corporate Debt Restructuring December 2001, at which time the value of its portfolio Committee (CDRC) was established to provide a of NPLs stood at RM 47.7 billion. By September 2005, mechanism for banking institutions and debtors Danaharta had received RM 30.4 billion in recoveries, to formulate feasible debt restructuring schemes representing a commendable 58 percent recovery rate. outside the court system. As such, it was established In 2005, Danaharta closed its operation, a few years as a voluntary corporate debt restructuring mechanism. earlier than planned (see Appendix Table 8). Banks would share information and voluntarily grant corporate entities a moratorium, during which A second institution, Danamodal Nasional Berhad consultants would assess the viability and devise (Danamodal), was established as a special purpose feasible restructuring schemes for the company. vehicle under BNM to facilitate the recapitalization Corporations that had not been placed under of viable banking institutions. Danamodal’s main role receivership or liquidation with viable businesses; with was to facilitate the consolidation and rationalization of outstanding debt in excess of RM50 million; and with the banking sector. It raised funds through the issuance of loans from more than one creditor could approach RM 11 billion worth of five-year zero-coupon unsecured CDRC to facilitate a debt workout arrangement. redeemable bonds and injected capital into domestic banks in the form of equity or hybrid instruments. Once As a result, Malaysia emerged from the AFC with its objective was achieved, it was intended that it would a significantly stronger banking sector. The country sell its stakes in the banks. Recapitalized banks would emerged from the crisis with no bank closures, with have Danamodal representatives on their boards and a high recovery rate on non-performing loans, and would be required to sell all eligible NPLs to Danaharta. stronger banking institutions. 46 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis Strengthening back to the AFC: macroeconomic a. Flexible exchange rate regimes tend to lower the risk of currency crashes; management after b. A large “war-chest” of international reserves can be a good insurance against future crisis; the crisis c. The imposition of selective and temporary capital controls can stabilize capital flows during period of crisis has become more acceptable; d. There is an awareness that rapid financial account liberalization can be dangerous; and The impact of the AFC on the economies of e. The need for strong oversight institutions and affected countries was severe, but also short- careful and prudential regulation of the domestic lived. Within two years, all had seen a return to growth. financial sector is recognized. However, the crisis had a lasting impact on East Asia’s policymakers, with many important lessons learned Following regional trends, Malaysia has now during the period with respect to macro-financial implemented a more flexible exchange rate regime. policy. In the years after, deep reforms were undertaken To evaluate the flexibility of the exchange rate, this to build resilience against future shocks by addressing report uses the exchange rate stability index developed some of the fundamental vulnerabilities that made the by Aizenmann et al.10 According to the index developed affected countries vulnerable, and to limit the scope for by these authors, a lower value implies a more volatile contagion to spread across borders. and flexible exchange rate. In terms of this indicator, Malaysia is judged to now have a more flexible The lessons of crisis have aged well in the economies exchange rate than it did prior to 2007 (see Figure affected by the AFC. Due to the construction of buffers 37). All the countries affected by the AFC have shifted built and reforms undertaken in the last two decades, from de jure or de facto fixed exchange rates to more most East Asian economies are better prepared today flexible mechanisms. This is significant, given that fixed to react to external shocks and financial turbulence exchange rate regimes and financial imbalances may than at the onset of AFC. In particular, five important expose countries to boom-and-bust cycles, as became macroeconomic management lessons can be traced particularly apparent during the AFC. FIGURE 37 FIGURE 38 Exchange rates have become more flexible… …while international reserve holdings have gone up Exchange Rate Stability Index International Reserves as a % of GDP 1.0 60 Higher buffer of International 0.9 reserves More flexible 50 0.8 exchange Average 2015 - 2017 rate Thailand Average 2015 - 2017 0.7 40 0.6 Malaysia 0.5 30 Thailand Philippines 0.4 Philippines Korea, 20 Rep. 0.3 Indonesia Korea, Rep. 0.2 Indonesia Malaysia 10 0.1 0.0 0 0.0 0.2 0.4 0.6 0.8 1.0 0 10 20 30 40 50 60 Average 1990 - 1996 Average 1990 - 1996 Source: World Bank staff elaboration Source: World Bank staff calculations based on national authorities’ data Note: Lower values mean more flexible exchange rates 10 See Appendix for further discussion of the methodology employed. MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 47 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis The East Asian countries have accumulated advanced economies running large current account massive international reserves as an insurance deficits that are financed by emerging economies against future crises. To build buffers in case of (mainly in Asia and in oil exporting countries) through liquidity shocks and to ensure the stability of exchange foreign asset accumulation. Also, it is reflected in the rates, these countries have accumulated international decline of external debt in proportion to GDP in most reserves as a precautionary measure (see Figure 38). In countries.. For the case of Malaysia, while in 1997 the part, these reserves have been increased as a result of offshore borrowing to GDP ratio was 36.8 percent, it the lessons learnt from the AFC in a measure to avoid is currently estimated to stand at 60 percent. However, the imposition of conditions in order to obtain liquidity if we look at the external debt to GDP ratio this has funds during periods of financial turmoil. While capital slightly increased since 2009 (see Figure 40).11 accumulation can be a buffer when there is volatility in the exchange rate, it is not clear the extent to which Since the AFC, Malaysia’s exposure to dollar- these reserves can isolate countries from financial crises denominated debt has declined, but its reliance on if there is a massive swing in sentiment at the regional short-term debt has increased. However, while the level. share of short-term debt has increased relative from the levels recorded in the period prior to the AFC, this is a Reliance on net capital inflows has also declined low macroeconomic risk factor, given that it represents over time. With the exception of Indonesia, since 1998, about 40 percent of Malaysia’s total external debt (see countries affected by the AFC have been running current Figure 41). On the other hand, the proportion of dollar- account surpluses. This is partly associated with the denominated debt has declined to well below the increase in the international reserves holdings that has levels recorded prior to the AFC (see Figure 42). The characterized these countries during the last few years deleveraging that occurred in Malaysia during recent and partly with a worldwide phenomenon of global years means that the country is much less exposed to imbalances (see Figure 39), which has resulted from exchange rate fluctuations that might trigger increased FIGURE 39 FIGURE 40 Reliance on net capital inflows has declined in the …and external debt has stabilized or declined region… across the region Current account balance as a % of GDP External debt as a % of GDP 13 140.0 Average 1990-1996 Indonesia 11 Average 2015-2017 Korea, Rep. 120.0 Philippines 9 Thailand 7 100.0 Malaysia Post-2009 5 80.0 Malaysia Pre-2009 3 60.0 1 -1 40.0 -3 20.0 -5 -7 0.0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Indonesia Malaysia Thailand Korea, Rep. Philippines Source: World Bank staff calculations based on international financial Source: World Bank staff calculations based on international debt statistics statistics and IMF data and CEIC data 11 In 2014 Malaysia redefined the computation of external debt following the IMF BPM6 and recalculated the series starting in 2009. Before that redefinition, external debt only included offshore borrowing (foreign currency loans, and bond and notes issued abroad). Since the new definition is more comprehensive, it is by construction higher than offshore borrowing. 48 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis debt obligations. This provides the authorities with capital controls successfully and the controls were greater space to adjust to external shocks, given the selective, designed to achieve specific objectives, more flexible exchange rate management regime that without affecting foreign direct investment, while the Malaysia has adopted. current account remained fully convertible. Since the AFC, the imposition of capital controls However, it is also clear that capital controls has become a more accepted part of economists’ are not a panacea and that their use should be and policymakers’ toolkits. During the AFC, the highly selective. Research has demonstrated that Malaysian Government was strongly criticized for its capital controls can reduce vulnerability to financial imposition of capital controls. However, perceptions crises by reducing the proportion of short-term debt have since changed significantly. Recent research denominated in foreign currency (Chamon et al. 2011). clearly demonstrates that the selective and temporary However, research also shows that these controls are use of capital management controls can be useful under ineffective in preventing lending booms, which might certain circumstances (Farhi and Werning 2014).12 Thus, also be a source of vulnerability. For this reason, other many countries experiencing large capital inflows have domestic macroprudential measures, such as increasing introduced some form of capital controls during recent banks’ capital requirements during economic boom years. Examples of countries introducing mechanisms periods or capping mortgage lending to a specified to provide policy-driven disincentives on capital inflows proportion of the property’s value, may be necessary include Brazil, Indonesia, the Republic of Korea and to reduce the level of risk of financial liabilities.13 Thailand. Since the AFC, the consensus opinion regarding Malaysia’s experience has also shown that policies the costs, benefits and appropriate sequencing of must be flexible and proactive, rather than rigid the process of capital liberalization in developing and reactive. The Government was able to implement countries has also evolved. Before the AFC, the FIGURE 41 FIGURE 42 Malaysia’s reliance on short-term debt has …but dollar denominated debt has declined increased… Short-term debt as a % of total public and publicly guaranteed Average 1990-1996 Average 2015-2017 % of total external debt external debt, U.S. Dollars 45 100 Malaysia 40 90 Thailand 35 80 Indonesia Philippines 30 70 25 60 20 50 15 40 10 30 5 20 0 10 Indonesia Malaysia Thailand Korea, Rep. Philippines 1990 1995 2000 2005 2010 2015 Source: World Bank staff calculations based on international debt statistics Source: World Bank staff calculations based on international debt statistics 12 In a world where there are shocks to the risk premium, a flexible exchange rate allows you to mitigate the contractionary effects. However, when an economy has a fixed exchange rate capital control allows you to regain monetary autonomy. In addition, capital controls can play a role even with flexible exchange rates: they allow you to have a smaller depreciation of the exchange rate and a smaller increase in the interest rate, which can help the economy to recover than might otherwise be possible. 13 See Korinek and Sandri 2016 for a rich and interesting discussion of when it is optimal to use capital controls and macroprudential regulations. MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 49 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis standard policy recommendations favored the rapid rate (which is typically the US federal funds rate). In liberalization of a country’s financial account in order practice, it is also a measure of the extent to which to allow capital to flow across countries and to take central banks can implement measures to stabilize the advantage of the differences in marginal products of economy in response to external economic shocks capital. However, based on the experience of the AFC independently of other economies’ macroeconomic and its repercussions, policy recommendations now management measures.14 The importance of this favor a slower, more nuanced process of liberalization, measure is a lesson that emerging countries have with adjustments according to the specific country learned from the experience of the AFC. context. In particular, there is greater emphasis on the need for adequate capacity at the country level Countries affected by the AFC have implemented to monitor and control inflows of funds, with capacity a range of fiscal reforms in the period since the required at both at the Government level and in the crisis. Most countries in the region have conducted financial sector as a prerequisite to capital account a range of expenditure and revenue management liberalization. reforms to restructure their fiscal positions. These reforms include the introduction of fiscal rules and To have more space to manage fluctuations in ceilings on fiscal deficits and/or the diversification economic activity, the region has moved to more of the tax base. In Malaysia, the decline in oil and independent monetary policy frameworks (see gas prices severely affected its fiscal position and Figure 43). The Monetary Independence Index, prompted the Government to introduce a goods and developed by Aizenmann et al (2008), is widely used to service tax and to reduce subsidies to close the gap. evaluate the level of independence of central banks in In order to develop resilience to crisis, it is important determining monetary policy. According to this index, for developing countries to have policy space and a higher value indicates that a central bank has greater flexibility. powers to establish the country’s own policy interest rate target at a different level from the reference interest FIGURE 43 FIGURE 44 Countries in the region have gained monetary Post-AFC consolidation of Malaysia’s banking independence sector resulted in a stronger financial sector Monetary Independence Index Average 1990 - 1996 Number of banks, before and after the AFC 1986 Domestic Average 2015 - 2017 1986 Foreign 0.70 70 2017 Domestic 60 0.60 10 2017 Foreign 50 0.50 5 40 0.40 30 16 53 0.30 20 20 42 19 6 0.20 10 22 3 13 12 11 10 8 1 1 8 1 5 7 3 0 2 1 2 0.10 Insurance Co Fin Co Commercial Bank Inv/Merchant Bank Islamic Bank Takaful Op Reinsurer Discount House Retakaful Op Int;. Islamic Bank 0.00 Indonesia Malaysia Thailand Korea, Rep. Philippines Source: World Bank staff calculations based on international financial Source: BNM data statistics, IMF Note: A higher value means that the central bank has more monetary independence 14 See Appendix for further discussion of the methodology employed. 50 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis Building a more resilient financial sector after the crisis The financial sector in Malaysia has undergone capacity, to increase the number of Islamic banks and major transformation since the AFC. These post- to deepen the Islamic financial market as an alternative crisis reforms have enhanced financial stability and means of financing. facilitated the emergence of a more resilient banking sector and deeper capital and bond markets (see The second Financial Sector Blueprint (2011-2020) Appendix Table 9). The basis for the transformation has continues to build on the foundations laid by the been strategic long-term planning and programming in FSMP and broadly aims to strengthen the financial the financial sector, with a comprehensive vision for its sector as a key enabler and catalyst of economic development, a framework for the orderly sequencing growth. The focus of reforms changed from a sector- of deregulation and liberalization of markets, and the based approach adopted during the previous decade strategic positioning of the Malaysian financial sector, to one that reflected a more integrated financial sector. both domestically and internationally. During this period, the main reforms have included greater regional and international financial integration In the period from 2000 to 2017, two blueprints of the Malaysian financial sector, the internationalization that set out plans for the medium and long-term of the Islamic financial sector, improving financial development of the financial sector were issued. inclusion and promoting electronic payments as a Both these 10-year masterplans were conceived means towards improving efficiency through cashless after a comprehensive review of the vulnerabilities payment systems. and limitations of the financial sector that surfaced during the Crisis and of the key challenges preventing More recently, the banking sector has experienced the financial sector from contributing positively to gradual liberalization. Measures include the granting economic growth. of new banking licenses; increasing foreign equity limits for investment banks, insurance companies and The first 10-year Financial Sector Master takaful operators to encourage greater participation of Plan (FSMP) (2001-2010) was aimed at foreign players in domestic institutions; and allowing diversification, strengthening resilience, and foreign banks to establish new branches to intensify increasing the efficiency of the financial system. competition. In the period from 2005 to 2016, eight new Recommendations were directed at the banking sector, conventional banking licenses and three new Islamic with the clear objective of enhancing soundness and banking licenses were issued, increasing the number of competitiveness. Similarly, for Islamic banking and foreign owned banks from 16 to 25 in total. financing, recommendations were formulated to build MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 51 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis Increasing the sophistication of Malaysia’s financial system The banking sector has expanded rapidly in line and businesses. Since its establishment, Danajamin has with the expansion of the economy in the past 20 provided guarantees of RM 9 billion for 32 company years. Total outstanding loans in the banking system bonds and sukuk programs.19 at the end of 2016 stood at RM1,521 billion, expanding 3.7 times, from RM416 billion at the end of 2000.15 With Malaysia has become a global leader in Islamic a more vibrant capital market, there is less reliance on banking and finance. The Government’s commitment banks by corporates for financing, and the Malaysian to using Islamic banking as an integral part of its banking sector has seen a shift in its focus as lending economic agenda has seen the development of a to the household sector accounted for 56.8 percent vibrant Islamic banking sector. Malaysia has emerged of total financing in 2016 compared to 33.5 percent in as the leading market for sukuk issuances accounting 1997. Financing by banks is undertaken mainly through for 50.6 percent of global Islamic bonds (sukuk) customer deposits. issuance as at the end of 2016. In the banking sector, the contribution of Islamic banking and financing has The Malaysian financial system is now stronger, increased significantly, both in terms of the number diversified and more resilient than at the time of of players and in financing market share. The number the AFC. From 2000 to 2016, the capitalization ratio for of full-fledged Islamic banks increased from two in banks increased from 11.7 to 16.5 percent. The ratio of 2000, with a market share of less than 10 percent, non-performing loans in the banking system declined to 16 at the end of 2016, with a market share of 28.6 from 9.2 to 1.2 percent.16 The banking sector’s Basel percent.20 Islamic banking operations were initially III liquidity coverage ratio stood at 124.8 percent as undertaken as part of the conventional bank operations at end of December 2016, which is above the BNM’s through Islamic windows, but these windows were later regulatory minimum target.17 transformed into Islamic subsidiaries under the FSMP. Domestic capital markets have seen significant To support the long-term growth prospects of the deepening. The development of the Malaysian bond financial sector, the development of human capital market has been an important part of efforts to has been critically important as a means to enhance diversify the sources of funding available to support the efficiency and competitiveness of financial business activity. It is the fifth largest bond market institutions. Financial institutions’ ability to compete in Asia with outstanding bonds of RM 1.16 trillion, or depends on their capacity to innovate new products, 95 percent of GDP, at the end of 2016.18 Malaysia’s on their ability to adapt to new environments, and on bond market has grown at an annual average rate of the quality of the employees. BNM has implemented a 10.2 percent with total bonds outstanding almost range of human capital development strategies to build tripling in size, from RM 440 billion in 2006. There is the necessary capacities to meet the evolving needs of significantly less reliance by corporates on banks for the market as it grows in size and complexity. BNM has funding requirements, which was one of the banking helped to improve the skills and competencies of the sector vulnerabilities highlighted during the crisis. The financial sector industry’s human resources through corporate bond market has developed as an alternative partnerships with this industry’s associations. Banks source of financing for the corporate sector, expanding have been encouraged to hire competent employees 2.8 times from RM 189 billion in 2006 to RM 534 billion and to develop their skills. Charges equivalent to six outstanding in 2016, or approximately 43 percent of months’ salary per employee are imposed to deter GDP. Also, in 2009, to further enhance access to capital the poaching of staff between banks, which is used market financing, Malaysia established its first financial to supplement the industry’s staff training fund run guarantee institution, Danajamin Nasional Berhad, to by the Asian Institute of Chartered Bankers. BNM, in provide credit enhancements to viable corporations collaboration with financial sector industry associations, 15 BNM Monthly Statistical Bulletin 2015. 16 BNM Financial Stability and Payment Systems Report 2016 and Annual Report 2000. 17 BNM, Liquidity Coverage Ratio policy document, 2016. 18 Asianbondsonline. 19 Danajamin Nasional Berhad. 20 BNM Monthly Statistical Bulletin, September 2017 and Annual Report 2000. 52 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis has actively supported the establishment of various The Financial Services Act and Islamic Financial institutions to build capacity, address the expertise Services Act 2013 provided clarity in mandates for gap as well as provide a constant supply of talent to consumer protection, requirements to comply with the industry which currently provides employment to business conduct standards, and effective tools to 128,000 people (see Appendix Table 11). enforce standards. Prior to the Act, legal provisions were mainly requirements for financial institutions to The legal, regulatory and supervisory framework comply with prudential regulatory prescriptions that of the financial system has been strengthened promote safety and soundness. Another significant since the AFC. Existing laws were reassessed and development in the banking sector was the emergence the temporary measures announced during the crisis of financial conglomerates after the crisis. The key were addressed through revised legislation. Prudential provisions for supervising these conglomerates includes regulations have been enhanced to reflect the changes approving financial holding companies, applying in the financial sector with strengthened requirements prudential standards to holding companies or other and assessments on shareholder suitability, criteria and subsidiaries, including requiring corrective measures to processes for verifying the fitness and propriety of Board address risks posed to the licensed institution or the and senior management, acquisition of substantial financial group. interest, large exposures and loan classification and provisioning. In 2005 the Government guarantee Malaysia’s financial sector has adopted was replaced with a deposit insurance scheme with internationally accepted practices and has a high the establishment of the Malaysia Deposit Insurance degree of compliance with global standards for Corporation (PIDM). PIDM was mandated to insure regulation and supervision of financial institutions. both deposits and benefit payments under insurance Malaysia underwent the Financial Sector Assessment and takaful in the case of banks’ and insurance Program in 2013 and was judged to be in compliance companies’ failing. PIDM covers deposits up to US$ with major international standards, including the 62,500 per depositor (per bank) and up to US$ 125,000 Core Principles for Effective Banking Supervision, per policyholder in insurance and takaful benefits. International Organization of Securities Commissions PIDM is also the resolution authority in Malaysia for its (IOSCO), International Association of Deposit Insurers member institutions. The temporary powers accorded (IADI) and Anti-Money Laundering and Counter to Danaharta during the crisis have been written into Financing of Terrorism (AML/CFT). The authorities are its Act. supportive of commitment to adopt and implement global standards, and banks are preparing for the The Central Banking Act 2009 was also revised to adoption of MFRS 9. allow the regulators more powers to better manage financial stability. In Malaysia, the financial stability The reforms undertaken by Malaysian authorities mandate falls under the BNM and revisions have have had a positive impact on financial inclusion and been made since the crisis to future-proof financial facilitated the emergence of a strong, increasingly stability. The central bank now has extensive powers market-oriented banking system. At the same time, and tools to safeguard financial stability and provide it is important to highlight that the process according to liquidity assistance including to non-banking entities, which these reforms were conceived and implemented overseas subsidiaries or branches of Malaysian financial has been equally important for Malaysia’s success in institutions, to contain liquidity shocks. Major changes financial inclusion (see Box 5). were also made to the regulatory and supervisory framework to adapt to the changing dynamics of the market place. MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 53 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis BOX 5 Achieving high levels of financial inclusion in Malaysia Among middle-income countries, Malaysia has achieved one of the highest levels of financial inclusion. The World Bank’s Global Findex Database, which collects data related to financial inclusion in countries around the world every three years, shows that in 2014, 81 percent of Malaysia’s adults had an account at a licensed financial institution, up from the figure of 66 percent recorded in the previous survey, conducted in 2011.21 TABLE 6 Malaysia’s Selected Financial Inclusion Indicators Indicator 2011 2014 Variation (p.p.) Population, adults age 15+ (millions) 20.9 22.0 N/A Account Holders (% of adults) All adults 66.2 80.7 14.5 Women 63.1 78.1 15.0 Men 69.2 83.0 13.8 Young adults (15-24) 57.1 76.2 19.1 Older adults (older than 24) 70.5 82.0 11.5 Source: Global Findex database Malaysia’s high level of financial inclusion has been the result of a range of actions and initiatives. Since the AFC, Malaysia has undertaken a wide range of reforms to modernize, strengthen and expand its financial system while ensuring that financial institutions serve the poor by offering convenient products and services to them at reduced fees, with some services provided on a commission-free basis. The most relevant actions undertaken by authorities in the past two decades to expand financial inclusion include the following: • Reducing the number of banks in order to increase their strength and size and to make them better equipped to compete with regional peers in ASEAN; • Amending the mandate of Malaysia’s central bank to grant it the legal authority to pro-actively implement measures to expand financial inclusion; • Reducing the use of cash and checks in the economy through the modernization and expansion of the national payment system infrastructure; • Reforming and strengthening development finance institutions by refocusing their policy mandates and enhancing their corporate governance; • Issuing the Guideline for Basic Banking Services, which requires banks to serve low-income households; • Encouraging higher levels of competition in the marketplace; • Strengthening the regulatory and supervisory standards for the banking sector in line with international standards; • Introducing new financial products and expand the outreach of Islamic finance; • Leveraging technology to develop new instruments and innovative solutions to serve low-income households (e.g. agent banking model) in a cost-effective manner; and: • Strengthening consumer protection systems and financial literacy through the establishment of a new agency and a new regulatory framework. Source: World Bank (2017a) 21 Note that there are some differences between results from the Findex and BNM’s own data sources, reflecting slight differences in methodology. However, the overall trend – reflecting Malaysia’s very rate of financial inclusion – is broadly the same, regardless of source data. Another important difference between the two databases is that BNM’s data covers only Malaysian citizens, whereas Findex makes no distinction between Malaysian and non-Malaysian adults. 54 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis Diversifying the streamline the issuance procedures for corporate bonds, including conventional and Islamic products (see Box 6). capital market Malaysia has become a global leader in Islamic after the crisis finance, which operates in parallel and is complementary to the conventional financial system. Data from the Islamic Financial Services To generate a more resilient capital market, the Board shows that by the end of 2016, Malaysia holds Government introduced major reforms. The Capital 9.3 percent of the global Islamic banking assets, 50.6 Market Masterplan (CMP1) and the Capital Market percent of global sukuk (bond) issuances, and 29.0 Masterplan 2 (CMP2) introduced in 2001-2010 and percent of Islamic fund assets.22 2011-2020 provided direction and strategy to develop and position the financial market in the global sphere. With the robust growth of Islamic finance, Malaysia Through these strategies, the capital markets have been has proven that both Islamic and conventional recognized and positioned clearly to be an important finance can run in parallel and as complements complement to the banking sector in Malaysia to to each other. The evolution of Islamic finance in support the nation’s financing needs and to diversify Malaysia started with the establishment of Pilgrimage financial assets holding in the financial system. Fund (Tabung Haji) in 1963 as the first Islamic savings institution. The Islamic Banking Act 1983 paved the way Malaysia’s bond market expanded significantly for Malaysia’s first Islamic bank (Bank Islam Malaysia after the AFC to become an important financing Berhad). The Government Funding Act 1983 was source for corporates. Corporate bonds have been introduced to facilitate the issuance of Government issued to support a wide range of sectors, with the papers based on Islamic principles, enabling better financial sector being the largest issuer, followed liquidity management by the Islamic banks. In 1984, by infrastructure, construction and housing finance. Syarikat Takaful Malaysia was established in accordance Large institutional investors, such as pension funds, with the Takaful Act 1984. Since then, more initiatives government-linked special purpose funds, and banks have been taken by the BNM and Securities Commission and insurance companies, have been the major Malaysia to provide a conducive business environment investors in bonds in Malaysia.  for Islamic finance. Shell issued the country‘s first Islamic bond in 1990, the Interest-free Banking Scheme (Islamic The development of the bond market in Malaysia windows) in 1993; Malaysia‘s first full-fledged Islamic was driven by national economic development stock broking company (BIMB Securities) was formed strategy and capital market development plans. in 1994; the Shariah Advisory Council of the Securities Once again, Malaysia’s development of the bond Commission Malaysia was established in 1996; the market was predicated on the basis of a strong first shari’ah-compliant securities were issued at Bursa national economic development strategy and capital Malaysia in June 1997; and the Kuala Lumpur Shariah market development plan. A high-level National Bond Index was established in 1999, to name a few. Market Committee chaired by the Secretary General of Treasury and consisting of senior officials from Bank A robust regulatory framework, together with Negara Malaysia, the Registrar of Companies (now market-oriented incentives to promote innovations the Companies Commission of Malaysia), Foreign in products and services and a strong emphasis on Investment Committee, Ministry of Finance, Kuala professional skills development in Islamic finance, Lumpur Stock Exchange (now Bursa Malaysia) and are some of the key success factors in developing the Securities Commission Malaysia coordinated the a full-fledged Islamic finance market in Malaysia. implementation of this strategy. BNM and Securities Commission Malaysia have led reforms to develop Islamic finance markets over the In 2000, the Securities Commission Malaysia last two decades. A series of regulations and guidelines became the lead regulator for the corporate bond to establish a comprehensive shari’ah framework have market, when a full disclosure-based regulatory been gradually introduced to ensure the soundness and approach was adopted to streamline and stability of the Islamic financial industry. Bursa Malaysia simplify the corporate bonds issuance. This greatly and Labuan International Business and Financial Centre accelerated the development of Malaysia’s corporate (IBFC) have also contributed to the development of bond market. A series of regulations and guidelines Islamic finance by providing a comprehensive range were subsequently issued to further consolidate and of Islamic finance products and services. Services 22 Islamic Finance Services Board, Islamic Financial Services Industry Stability Report 2017 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 55 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis BOX 6 Malaysia’s framework for developing the bond market The Securities Commission Malaysia undertook several key steps to facilitate the development of Malaysia’s corporate bond market. These steps have been invaluable towards achieving the diversification of financing for private sector activity outside the banking sector since the advent of the AFC. They include the following: Rationalizing the issuance process: The modernization of the fund-raising regime through the introduction of a new regulatory framework for the issuance of corporate bonds generated: (a) a rationalization of the fragmented regulatory structure; (b) an agile approval process for corporate bond issuances with introduction of the Lodge and Launch Framework for the wholesale segment; (c) the imposition of more stringent disclosure requirements; (d) an enhancement of the legal protection framework granted to bond investors; (e) an encouragement to issuers to tap the bond market; (f) greater opportunities for secondary market liquidity. Establishing a reliable and efficient benchmark yield curve: The Government constructed a benchmark yield curve out of large and liquid, sovereign-credit bond issuances, with a transparent auction calendar to provide ease and accuracy in the pricing of corporate bonds. Widening the issuer and investor base: A virtual platform was established to connect issuers with investors, generating more competition to bring down the cost of financing. Improving liquidity in the secondary market: This included efforts to enhance market infrastructure, trading and operational procedures for the creation of an organized and active bond market that efficiently and effectively promotes and attracts both active and secondary market transactions. Facilitating the introduction of risk management instruments: These instruments were developed to provide an avenue for issuers and investors to hedge their respective exposures to the bond market in a most effective and timely manner. Source: Securities Commission Malaysia (2010) provided by Bursa through the Bursa Suq Al-Sila’ incentives for Islamic financial services and products, (BSAS), Bursa Malaysia-i, Shariah Compliant Exchange have a positive impact in motivating the industry to Traded Funds (i-ETFs), Islamic Real Estate Investment tap Islamic finance as a preferred instrument. Malaysia Trusts (i-REITs) and sukuk listings. IBFC offers a wide has always put strong emphasis on human capital range of business and investment structures facilitating development in Islamic finance, with several educational cross-border transactions, business dealings and wealth and technical training institutions being established to management needs. These unique qualities offer sound develop Islamic finance professionals to meet the need options for regional businesses going global or global for Islamic finance experts, locally and globally. businesses aiming to penetrate Asia’s burgeoning markets. Supportive incentives, including both With the well-established Islamic capital markets fiscal incentives and tax neutrality policy, have been and regulatory frameworks, as well as the relevant introduced under the Capital Market Development incentives to motivate market participants, Master Plans. Liberalization measures included allowing Malaysia has been able to support financial the participation of foreign corporations, multinational innovation in Islamic finance. One of the latest corporations and multilateral agencies in the form innovations is the issuance of the world’s first green of new licenses, increase in foreign equity limits and sukuk in 2017, to fund a renewable energy project in operational flexibilities have been introduced. The Malaysia (see Box 7). facilitative tax framework, such as tax neutrality and tax 56 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis BOX 7 Financing a green future: The development of the green sukuk market in Malaysia The world’s first green sukuk was issued in July 2017 in Malaysia, with a RM 250 million issuance by a private energy company for investment in a solar power generation plant in Sabah. Since then, green sukuk with a total additional value of RM 3 billion have been issued or announced for both renewal energy projects and green buildings. Half of all green bond issues in the ASEAN region have originated from Malaysia, pointing to the growing acceptance of green bonds/sukuk in financial markets. There is tremendous potential for the ongoing growth of the green sukuk market, given the massive infrastructure financing needs of the East Asian region, with a range of green projects that could be financed through this means. A deep commitment to reducing greenhouse gas emissions, together with its strong experience in regulating Islamic finance, has helped Malaysia to become the world leader in the green sukuk market. Malaysia’s commitment to unconditionally reducing the country’s greenhouse gas emissions intensity of GDP by 35 percent by 2030 from the level recorded in 2005 marked a watershed moment in the country’s green development.23 Malaysia launched the National Green Technology Policy in 2009, followed by the RM 3.5 billion Green Technology Financing Scheme, which was established to provide funding assistance to green technology companies. The early development of a regulatory framework has helped to provide a new mechanism for financing green investments in Malaysia. On the regulatory side, the Securities Commission Malaysia introduced the Sustainable and Responsible Investment (SRI) sukuk framework in 2014, providing clear guidelines and criteria for sustainable and responsible investment. These guidelines and criteria are compatible with the International Capital Market Association’s Green Bond Principles. Financial and non-financial incentives were later introduced for SRI sukuk issuers and investors. In addition, the Ministry of Energy, Green Technology and Water began the rollout of new solar power generation capacity in 2017, with a target a total of 1200MW of new generation capacity by 2020. Various tax incentives for the issuance of SRI sukuk and for the adoption of green technologies have been put in place. The favorable policy and regulatory landscape was developed in the context of the dynamic and vibrant domestic bond market, the total value of which stood at RM 1.17 trillion at the end of 2016, providing fertile ground for the development of the world’s first green sukuk. 23 45 percent upon receipt of climate finance, technology transfer and capacity building from developed countries. MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 57 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis Improving standards In addition, in 2014, a non-binding protocol, the Malaysian Code for Institutional Investors, of corporate was introduced with the particular intention of strengthening minority shareholder rights. The governance code defines general principles of effective stewardship by institutional investors. These include issues such as the disclosure of stewardship policies, monitoring of and engagement with investee companies, managing Poor corporate governance was cited as one of the conflict of interests, amongst others. In 2010, an Audit factors leading to the AFC, with one criticism being Oversight Board was also established to strengthen that “crony capitalism” contributed to vulnerability oversight over external auditors of public listed entities. across East Asia. In order to establish higher corporate governance standards, after the crisis, the Government Further, Malaysia has also tightened regulatory implemented a number of measures to raise standards. measures to strengthen corporate governance As a first step, a high-level Finance Committee on standards. For instance, the Securities Commission Corporate Governance was established in 1998. Malaysia has incorporated corporate governance One of its earliest recommendations was to establish provisions into listing requirements, with these the Malaysian Institute of Corporate Governance to provisions establishing the criteria for directors and promote and encourage the development of corporate governing related party transactions concerning listed governance in the country. Subsequently, in 1999, entities. It has also amended the relevant securities the Committee published a report which a pathway laws to instill relevant statutory powers for actions to be to strengthen the corporate governance agenda in taken against not just the listed entity, but also against Malaysia. directors and/or individuals in cases of dishonest conduct and contravention of the listing rules. In 2000, the Securities Commission Malaysia issued the Malaysian Code on Corporate Governance. Since the AFC, Malaysia has come a long way This Code provided guidance on best practices to towards improving corporate governance practices. strengthen Malaysia’s corporate culture to achieve Although there is still room for further improvements, compliance with international standards. The Code the detailed initiatives undertaken to date have helped has been reviewed and updated on several occasions, to improve transparency and standards in business including in 2007, 2012 and 2016, to ensure that it kept oversight. up with the continuing demands for improved corporate governance in the country. The most recent update, published in April 2017, emphasizes the strengthening of corporate governance in non-listed firms and SMEs, and encourages licensed intermediaries to adopt the Malaysia Code on Corporate Governance. Implementation of the Code was accelerated under a 5-year Corporate Governance Blueprint adopted by the Securities Commission Malaysia in 2011. The Blueprint emphasized self and market discipline and promoted the greater internalization of a good corporate governance culture. This was achieved by moving away from a rule-based approach to a more principle-based approach and by deepening the trust between companies and its stakeholders. The blueprint focused on six key areas: shareholder rights; the role of institutional investors; the role of boards; disclosure and transparency; gatekeepers and influencers; and enforcement. 58 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis Challenges ahead The rapid increases in real housing prices since 2008 could be a source of future instability. Increases in housing prices can relax borrowing Although Malaysia has made significant progress constraints and allow existing homeowners to increase since the AFC towards building resilience against consumption, thereby boosting the economy. However, future shocks, it still faces a number of challenges the rapid increase in prices creates incentives for the and risks. In particular, Malaysia’s economy has construction of new properties, which could potentially grown significantly (three times larger) since the crisis, lead to a burst in prices and an abrupt adjustment to and become even more closely integrated into an economic activity. This risk warrants close monitoring, increasingly volatile global economy. especially since prices are still increasing, albeit at a lower rate (see Figure 46). Given debt levels, the balance sheets of households and corporations will need to be monitored for Efforts to further strengthen the governance signs of stress. The slowdown in credit growth has of financial institutions should continue. The stabilized the ratio of credit to the private sector to Government remains an important shareholder in GDP, and it has not reached the levels recorded prior to various financial institutions in Malaysia, including the AFC. However, Malaysia could become vulnerable select banks, development financial institutions, and to abrupt tightening of global and domestic conditions other specialized institutions. Safeguards exist, with in the context of a slowdown in growth. Therefore, close all banks and development finance institutions subject monitoring is required to avoid systemic problems, to the same regulations and governance standards, since high levels of leverage makes the financial system regardless of ownership. However, governance of highly sensitive to changes in fundamentals (see Figure a number of financial institutions could be further 45). Similarly, although current corporate debt levels are improved by: i) promoting more independent boards; far from those recorded during the AFC, which stood at ii) applying more stringent transparency requirements; 131 percent in 1998, careful monitoring and supervision iii) requiring timely disclosures, e.g., of assets by board is required due to the potential ramifications of members and managers; and iv) ensuring a clear corporate debt to the whole economy (see Appendix separation of roles between owners and regulators. Table 10). FIGURE 45 FIGURE 46 Credit to the private sector has stabilized at …but house prices have seen a significant medium risk levels… increase in real terms Private Sector Credit Change in private Real Growth of Housing Prices, y/y, % as a % of GDP credit, y/y, % 0.14 180 35 Private sector Credit as % of GDP 0.12 160 30 Credit Growth % y/y 0.10 140 25 0.08 120 20 0.06 100 15 0.04 80 10 0.02 60 5 0 40 0 -0.02 20 -5 -0.04 0 -10 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: World Bank estimates based on CEIC data Source: World Bank estimates based on Haver data MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 59 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis Overall, the post-crisis reforms significantly liabilities since 2009, reflecting largely the increased strengthened Malaysia’s financial system. issuances of sovereign guarantees to facilitate the However, sustained monitoring and new measures implementation of major development projects by are needed to address emerging risks from the NFPCs. These government liability exposures are likely continued financial sector transformation. Banking to expand over the coming years with the incoming sector assets are concentrated in a few banking groups, flows of large-scale infrastructure commitments such making a number of these financial conglomerates as the East Coast Rail Link and the Kuala Lumpur- systemically too-important-to-fail. Malaysia may Singapore High Speed Rail. Managing the associated choose to expedite the finalization of its framework fiscal risks would call for the continuous monitoring and for domestic systemically important banks. The BNM transparent disclosure of contingent liabilities, along is currently working on developing a recovery planning with a comprehensive, orderly, medium-term resolution framework while the primary resolution authority, PIDM, to gradually unwind guarantees going forward. is developing a resolution planning framework. A pilot exercise with selected banks is currently underway to test the recovery planning framework. While the policies adopted The transition to a digital economy introduces by Malaysia in response new cyber-security risks from technology-enabled innovation in financial services. These risks are to the AFC were seen compounded by the greater interconnectedness of as radical at the time, all parts of the financial system. Identity theft, hacking of data systems, and fraud, to name a few, are no they have now come to longer mere IT risks. A comprehensive framework and be seen as rather more stronger regulations will be important to safeguard the conduct of transactions through digital channels. This is mainstream necessary to preserve confidence in the financial sector and to advance the modernization of the financial sector. In the longer term, the diversification of Malaysia’s cross-border export and investment structure would Responsible financial access should also be a key be an important way to enhance external sector theme going forward, with financial inclusion and resilience. Since the AFC, the market composition for consumer protection being two very important Malaysia’s trade has increasingly shifted away from and interrelated elements. As competition and the advanced economies to East Asia. Nevertheless, innovation delivers financial services to a wider group Malaysia’s trade is still largely concentrated in its of customers, effective market conduct and consumer top five trade partners, with China being the largest, protection regulations are needed to protect these accounting for 16 percent of Malaysia’s total trade. customers from excessive risk. Financial literacy Similar patterns are apparent for inward investment.24 As programs will need to reflect the changing landscape China rebalances its growth model from an investment- and to manage the potential risks of financial exclusion and credit-driven model towards a model that focuses as risk profiling and risk management tools become on services and consumer demand, external demand more sophisticated. from China is likely to moderate. Moreover, global growth is increasingly contributed by the developing Efforts to strengthen fiscal space should continue economies amid potential inward policies in the in order to ensure flexibility for the management advanced economies. Given Malaysia’s high degree of of future contractionary shocks. While the trade openness with the advanced economies and with Government has made significant progress towards China, these major developments are likely to weigh on fiscal consolidation since the GFC, the overall public Malaysia’s exports and growth prospects. debt stock has remained relatively elevated due to the continued accumulation of fiscal deficits and As such, Malaysia should look towards continuing increased public infrastructure spending. Further economic integration with the region and fiscal adjustments would necessitate deeper reforms enhancing its export base. In that regard, Malaysia to ensure more efficient and effective public finance should leverage existing and new initiatives such management. Another key source of fiscal risks relates as the ASEAN Economic Community, bilateral and to the steady expansion of the Government’s contingent multilateral trade agreements, the proposed Regional 24 China, Singapore, EU, US, and Japan collectively account for ~50 percent of Malaysia’s total trade. 60 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis Comprehensive Economic Partnership (RCEP) and post- better prepared for the for the GFC (see Box 8). While Trans Pacific Partnership agreements. Forging ahead, the policies adopted by Malaysia in response to the greater emphasis should also be placed on raising the AFC were seen as radical at the time, they have now complexity of Malaysia’s exports in high-technology come to be seen as rather more mainstream. Policies industries, such as machinery and chemical products, such as prudential reserve management, robust and on increasing services trade. To further diversify domestic capital market regulations, counter-cyclical and advance its export product-mix, Malaysia should fiscal policies, short-term capital controls, exchange prioritize investments that increase the capabilities of rate management and banking sector rationalization domestic firms or attract foreign direct investment in were regarded as heterodox in 1997. However, new areas. they are now part of the mainstream policy toolkit for emerging market policymakers aiming to both Malaysia’s experience during the AFC transformed reduce vulnerability to crises and to reduce the the tools and approaches available for developing likelihood of contagion spreading. This is perhaps countries to respond to and prepare for future the most significant legacy from Malaysia’s external market shocks. Important lessons were experience of the AFC twenty years ago. learned not just in Malaysia, but also by many other developing countries, many of which became much MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 61 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis BOX 8 Lessons from other countries in building resilience to global economic shocks The global financial system can be characterized by its propensity for crisis. In the period from 1970 to 2011, there have been 147 banking crises in 116 countries, with large economic costs. The average cumulative loss of output during the first three years of crises was, in average, about 30 percent of GDP. While the recent global economic downturn did not spare developing countries, they were more resilient to the 2008 global crisis than to previous crises. The East Asian countries, including Malaysia, managed systemic risk especially well, but the performance of several countries in Central Europe, Latin America, and Sub-Saharan Africa has also been remarkable. This box examines the experiences of three of them, from different regions and levels of development, with these three being the Czech Republic, Peru, and Kenya. The Czech Republic started building stronger foundations for aggregate risk management following major lessons learned from the 1997–98 banking crisis. In 1997, the Czech Republic abandoned its fixed exchange rate regime in favor of a monetary policy framework based on inflation targeting. Credible monetary policy and price stability translated into low interest rates that, along with improved fiscal discipline, enabled the country to maintain a strong external position. Unlike the Czech Republic, until 2008, Peru had not experienced major economic turmoil for almost two decades. However, until the late 1980s, Peru had experienced hyperinflation, severe macroeconomic imbalances, and massive capital outflows. In the 1990s, Peru put in place key reforms to stabilize the economy. It brought hyperinflation under control, with the Central Bank adopting an inflation-targeting regime and a flexible exchange rate. The tax system and the financial sector were reformed, as a result of which banks built up adequate levels of capitalization and sufficient levels of liquidity. Peru liberalized foreign trade in the early 1990s, drastically reducing tariff rates and eliminating non-tariff barriers. This increased openness enables Peru to benefit from a more favorable economic environment. Increasing demand for the country’s commodities (mineral ores and metals) from emerging markets in East Asia produced a large positive income shock. Peru saved part of these revenues, thus building large international reserves and fiscal primary surpluses. As in the case of Peru, Kenya’s economy was in deep trouble during the 1980s and early 1990s, with GDP growth stagnating, agricultural production sharply contracting, and hyperinflation flaring. The Government decided to implement economic reforms to stabilize the financial sector and to restore sustainable growth. The banking system was strengthened, notably through the substantial capitalization of the banks, and access to finance was expanded. Kenya also managed to decrease its public debt stock and to accumulate a high level of international reserves by adopting prudent fiscal policies and by maintaining a healthy external position, with strong surpluses in the service balance (mainly tourism and information technology) and massive inflows of foreign capital that compensated for the trade deficit. The resilience of these three countries to the global crisis in 2008 was the result of an arduous process undertaken over the period of a decade or more prior to the shock. Although political leaders may have been tempted to adopt pro-cyclical measures during good economic times, they understood the necessity of strengthening their financial and macroeconomic systems to prepare for serious economic turmoil. 62 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 PART TWO - Turmoil to Transformation: 20 Years after the Asian Financial Crisis The Czech Republic demonstrated the utility of establishing an institution with a mandate for integrated supervision at the national level within a strong and independent central bank. Overall, the Czech Government did not have to undertake any major reforms, with a simple relaxation of monetary policy proving sufficient to ensure adequate liquidity when the global crisis hit. The adequate loan-to-deposit ratio of the banking sector and low dollarization of loans were also key factors in enabling the country to weather the global economic shock, enabling banks to cope with a significant increase in the share of non-performing loans. In Peru, the Government was able to respond in an efficient and counter-cyclical manner to sustain the national economy during the global crisis. The Central Bank injected liquidity into the financial system, in both local currency and US dollars, to prevent a liquidity squeeze and a credit crunch. The monetary policy rate was lowered and a fiscal stimulus plan was enacted in 2009, financed by Government savings. By investing in infrastructure, by providing incentives for non-traditional exporters, and by increasing expenditures on social programs, the Government aimed to sustain domestic demand and to boost business confidence. Kenya’s performance in the area of risk management has been arguably even more impressive, considering the quadruple shock it faced within a very short period, with postelection violence in early 2008, oil and food price increases, catastrophic drought, and the impact of the GFC. Although an increased perception of risk in the market was reflected by increases in the commercial bank lending rates, the Central Bank successfully implemented counter-cyclical monetary policies, reducing its rate and injecting liquidity into the market. The banking sector was sufficiently strong to maintain capital adequacy ratios and to keep the share of nonperforming loans low. With public debt under control, and buoyed by large international reserves, the Government could implement an ambitious fiscal stimulus program, thereby protecting key social expenditures and increasing spending on infrastructure. Policies to Support Risk Management FOUNDATIONAL ADVANCED Data collection and dissemination Knowledge Monetary policy transparency Improve quality of data Disclosure of fiscal risks Inflation targeting Central bank independence Flexible exchange rate regime Protection Build strong fiscal frameworks/institutions Debt/deficit reduction Counter-cyclical monetary policy; reserve Hedging mechanisms; contingent bonds accumulation Insurance Strengthen automatic stabilizers and Design better automatic stabilizers discretionary social spending Counter-cyclical social spending Coping Support from international financial institutions Contingent credit lines Developing countries that were able to successfully reform their financial and macroeconomic policies in the 2000s have demonstrated an impressive ability to manage macro-financial risks, offering lessons that would benefit even developed countries: First, they demonstrated that pursuing macroprudential policies in good times, while continuously strengthening the domestic financial system, is key to building resilience to severe economic downturns. Second, they demonstrated that implementation of counter-cyclical macro policies stabilizes the economy by saving fiscal resources during good times and mitigating macroeconomic and financial crises in bad times. Source: World Bank (2013) MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 63 Appendix Additional tables TABLE 7 Main economic fundamentals of selected economies affected by the Asian financial crisis 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Malaysia Real GDP Growth (%) 9.0 9.5 8.9 9.9 9.2 9.8 10.0 7.3 -7.4 6.1 Inflation (%) 3.1 4.2 4.8 3.6 3.9 3.5 3.5 2.5 5.2 2.8 Current Account Balance (% of GDP) -1.9 -8.3 -3.6 -4.3 -5.9 -9.4 -4.3 -5.8 12.8 15.5 Budget Balance (% of GDP) -2.9 -2.0 -0.8 0.2 2.3 0.8 0.7 2.4 -1.8 -3.2 M2 growth (%) 12.8 14.5 19.1 22.1 14.7 24.0 19.8 22.7 1.5 13.7 Private sector credit (% of GDP) 69.4 73.8 108.5 106.5 109.2 124.4 141.6 158.4 158.5 149.2 Indonesia Real GDP Growth (%) 9.0 8.9 6.6 8.0 7.6 8.2 7.9 4.8 -13.0 0.7 Inflation (%) 7.8 9.4 7.5 9.7 8.5 9.4 8.0 6.2 58.5 20.4 Current Account Balance (% of GDP) -2.2 -2.8 -1.7 -1.1 -1.3 -2.6 -2.8 -2.0 3.6 3.4 Budget Balance (% of GDP) 1.0 0.0 -1.2 -0.7 0.0 0.8 1.2 -0.7 -4.5 -6.5 M2 growth (%) 44.2 17.0 20.2 22.0 20.2 27.6 29.6 23.2 62.3 11.9 Private sector credit (% of GDP) 51.8 51.9 49.5 49.0 51.9 53.5 55.5 60.8 53.2 20.6 Philippines Real GDP Growth (%) 3.2 -0.6 0.4 2.1 4.4 4.7 5.8 5.2 -0.5 3.0 Inflation (%) 12.2 19.3 8.6 6.7 10.4 6.8 7.5 5.6 9.2 6.0 Current Account Balance (% of GDP) -5.5 -2.1 -1.7 -5.0 -4.2 -2.4 -4.3 -4.8 2.1 -3.5 Budget Balance (% of GDP) -3.1 -1.9 -1.1 -1.3 0.9 0.5 0.3 0.1 -1.7 -3.4 M2 growth (%) 18.4 15.7 11.0 24.6 26.8 25.2 15.8 20.5 8.0 19.3 Private sector credit (% of GDP) 19.3 17.8 20.6 26.4 29.1 37.5 49.0 56.5 43.3 38.5 Korea, Rep. Real GDP Growth (%) 9.8 10.4 6.2 6.8 9.2 9.6 7.6 5.9 -5.5 11.3 Inflation (%) 8.6 9.3 6.2 4.8 6.3 4.5 4.9 4.4 7.5 0.8 Current Account Balance (% of GDP) -0.9 -2.3 -0.7 0.5 -1.0 -1.8 -4.0 -1.8 10.7 4.5 Budget Balance (% of GDP) 1.6 0.5 1.1 1.9 2.0 2.3 2.5 2.2 1.1 1.2 M2 growth (%) 25.3 19.5 21.5 17.4 21.1 23.3 16.7 19.7 23.7 5.1 Private sector credit (% of GDP) 51.5 51.1 49.7 49.6 50.2 49.5 52.9 57.9 63.3 68.5 Thailand Real GDP Growth (%) 11.2 8.6 8.1 8.3 8.0 8.1 5.7 -2.7 -7.7 4.6 Inflation (%) 5.9 5.7 4.1 3.3 5.1 5.8 5.8 5.6 8.0 0.3 Current Account Balance (% of GDP) -8.3 -7.5 -5.5 -4.9 -5.5 -8.0 -8.0 -2.0 12.5 9.8 Budget Balance (% of GDP) 4.8 3.9 2.4 1.7 2.8 3.2 0.7 -1.8 -2.7 -2.5 M2 growth (%) 26.7 19.8 15.6 18.4 12.9 17.0 12.6 16.4 9.5 2.1 Private sector credit (% of GDP) 83.4 89.1 98.5 108.0 125.7 138.8 146.3 166.5 153.4 127.7 Source: World Bank staff calculations based on International Financial Statistics and national authorities’ data 64 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 Appendix TABLE 8 The Danaharta operating model Approach • System wide carve out for all institutions, to remove the NPLs from the banking system and allow banks to focus on lending, and to actively manage the NPLs in its portfolio, on an account by account basis, with a view to maximizing the recovery on each. • This was in contrast to the rapid disposition strategy adopted by Resolution Trust Corporation of US and the warehousing agency structure, which held on to assets, waiting for the market to recover. Funding • RM3 billion in seed capital from MOF to establish Danaharta and borrowings from the Employees Provident Fund and Khazanah Nasional Berhad, the national investment agency. • The purchase of the NPLs was to be financed by the issuance of zero coupon bonds, guaranteed by the Government, directly to the selling financial institutions, in exchange for the loans. • Redemption of the bonds from proceeds of recovery operations. Acquisition of NPL • NPLs above RM5.0 million would be acquired and this addressed 70 percent of the NPLs in the banking system; • Acquisition of NPLs from banks was premised on a willing buyer-willing seller approach. Danaharta would only make one offer for each NPL. Should the banks reject the offer, they would have to: (i) Immediately write down the loans to 80 percent of Danaharta‘s valuation which would impact the bank’s profits; (ii) There would be no recapitalization from Danamodal. • No due diligence would be done but warranties were incorporated into the loan acquisitions agreements which would allow the NPLs to be returned if the loan documentation was not in place, e.g. security for a loan was not perfected Loan valuation Secured • Fair value of the underlying collateral of the NPL. Only loans shares and property were deemed eligible as collateral. (i) For property collateral, the fair value was set at 95 percent of the market value of the property as determined by an independent professional valuer; (ii) For shares, the price was determined between the market and net tangible asset value of the shares. Unsecured • Purchase price was equal to 10% of the principal amount loans outstanding. Sharing of NPL recoveries • Distributed on an 80 : 20 (financial institution : Danaharta) basis MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 65 Appendix Methods adopted for • For viable business, methods were recovery • Plain loan restructuring: recovery was by way of rehabilitating an NPL to become a performing loan. This could involve an extension of the loan repayment period, or rescheduling of loan repayments. • Settlement of loans cases where borrowers opted for a quick settlement of the loans, normally within 12 months.; and • Voluntary schemes formulated by both borrowers and creditors to restructure the loans. They included schemes under section 176 of the Companies Act 1965 and the CDRC. • If business deemed non-viable, or if a borrower failed to comply with the loan restructuring guidelines to restructure its loans, available options would involve the sale of the borrower‘s business and assets, or the underlying collateral of an NPL through the following: • Appointment of Special Administrators: Special Administrators assumed temporary control and management of the assets and affairs of the company and prepared a workout scheme aimed at maximizing the recovery value of the business. • Foreclosure and sale of property or share collateral pledged as security for a loan. Danaharta could foreclose on the collateral if a borrower failed to repay its loan. • Last resort measure if all options failed was to take legal action against a borrower • Others means available include partial resolution, liquidation of companies and appointments of Receivers and Managers over companies or assets. Governance • Loan recovery policies were established to address the issue of moral hazards whilst loan restructuring principles and guidelines were also formulated in consideration of the following objectives: • maximizing the overall recovery value and returns to Danaharta; • minimizing the involvement of taxpayers’ money; • ensuring fair treatment of all stakeholders; • utilizing where appropriate Danaharta’s special powers to leverage and benefit the banking system as a whole. • Disclosure of its operations on a timely basis through annual reports • The appointment and termination of Special Administrators’ services required the approval of an Oversight Committee, which had to be convinced that the route taken was in the best interest of all stakeholders. • Danaharta’s preferred approach in disposing foreclosed collateral was through an open tender exercise, with the sale going to the highest bidder. Source: Danaharta Final Report 2005 66 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 Appendix TABLE 9 Key financial soundness indicators for Malaysia As at end 2014 2015 2016   % (or otherwise stated) Banking System       Total Capital Ratio 15.9 16.6 16.5 Tier 1 Capital Ratio 14 14.2 14 Common Equity Tier 1 Capital Ratio 13.3 13.3 13.1 Return on Assets 1.5 1.3 1.3 Return on Equity 15.2 12.3 12.5 Liquidity Coverage Ratio n/a 127.4 124.8 Net Impaired Loans Ratio 1.2 1.2 1.2 Capital Charge on Interest Rate Risk in the Trading Book to Capital Base 1.4 1.2 1.1 Net Open Position in FCY to Capital Base 4.7 6.1 6.3 Equity Holdings to Capital Base 1.3 0.7 0.8         Insurance and Takaful Sector Capital Adequacy Ratio (conventional only) 251.9 251.6 248.5 Life Insurance and Family Takaful       Excess Income over Outgo (RM billion) 13.8 12 13.3 New Business Premiums / Contributions (RM billion) 12.9 13.2 14.2 Capital Adequacy Ratio (conventional only) 259.2 260.6 243.7 General Insurance and General Takaful Underwriting Profit (RM billion) 1.8 1.3 1.8 Operating Profit (RM billion) 3.2 2.7 3.4 Gross Direct Premiums / Contributions (RM billion) 19.1 19.5 19.7 Claims Ratio 57.5 60.2 56 Capital Adequacy Ratio (conventional only) 279.7 263.3 269.6         Household Sector       Debt (RM billion) 960.0 1,030.5 1,086.1 Financial Asset (RM billion) 2,015.0 2,119.3 2,232.4 Debt-to-GDP 86.8 89.0 88.3 Liquid Financial Asset to Total Household Debt Ratio 209.9 205.7 205.5 Impaired Loans Ratio of Household Sector (Banking System) 1.2 1.1 1.1         Business Sector       Return on Assets 6 4.9 3.5* Return on Equity 10.2 8.8 6.0* Debt-to-Equity Ratio 39.2 43.2 43.6* Interest Coverage Ratio (times) 12 10.6 9.4* Operating Margin 15.9 14.8 10.1* Impaired Loans Ratio of Business Sector 2.6 2.5 2.4         Development Financial Institutions       Lending to Targeted Sectors (% change) 7 5.5 5.7 Deposits Mobilized (% change) 5.3 2 6.4 Impaired Loans Ratio 5 4.8 5.5 Return on Assets 1.6 1.4 1.3 Source: BNM, Table A1 Financial Stability and Payment Systems Report 2016 * Based on data from January to September 2016 ** Refers to development financial institutions under the Development Financial Institutions Act 2002 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 67 Appendix TABLE 10 Indicators of credit expansion and financial vulnerability 2Q 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Non-Financial Corporate Debt 92.0 83.4 94.3 92.7 95.1 99.5 98.6 106.7 109.5 105.4 (% of GDP) Household Debt (% of GDP) 61.2 73.2 75.0 76.1 80.5 86.1 86.8 89.0 88.3 85.6 Source: World Bank staff calculations based on BNM data TABLE 11 Institutions for talent development in Malaysia’s financial sector Institution Training focus Financial Sector Talent Enrichment Training for top graduates to provide practical exposure and soft skills Program development in preparation for entry into the financial services workforce Asian Institute of Finance Enhance human capital development in the financial sector Asian Institute of Chartered Professional and educational body for the banking and financial services Bankers industry Malaysian Insurance Institute Education and training provider focusing on insurance Islamic Banking and Finance Islamic finance reference center for the industry and academia Institute Malaysia International Centre for Education Graduate Islamic Finance Programs for practitioners in Islamic Finance (i.e. Chartered Islamic Finance Professionals) International Shariah Research Promote applied research in shari’ah and Islamic finance Academy Securities Industry Development Capital markets education, training and information resource provide Corporation ICLIF leadership and Governance Training for senior management and Board of Directors in strategic and Center leadership management and to strengthen oversight functions Responsible for quality assurance of learning initiatives, including program, Finance Accreditation Agency individual and institutional accreditation 68 MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 Appendix     An index for measuring exchange rate index for and flexibility An An index for measuring independence monetary measuring exchange independence rate flexibility and exchange rate flexibility and monetary monetary independence To  measure  the  Monetary  independence  in  a  country  and  how  flexible  is  the  exchange  rate   To  measure  the  Monetary  independence  in  a  country  and  how  flexible  is  the  exchange  rate   regime  we  rely  on  the  methodology  developed  by  Aizenman  et  al.  (2008)  that  measure  the   To measure the Monetary independence in a country and how flexible is the exchange rate regime we rely on the regime  we  rely  on  the  methodology  developed  by  Aizenman  et  al.  (2008)  that  measure  the   methodology developed by Aizenman et al. (2008) that measure the degree to which each of the two policy choices degree   to   which   each   of   the   two   policy   choices   is   implemented   by   a   country   at   a   point   in   degree   to   which   is implemented each   of   by a country at a the   point two   policy   choices   is   implemented   by   a   country   at   a   point   in   in time. time.     time.         Monetary  independence  index   Monetary  independence  index     Monetary independence index   The   monetary   independence   index   (MI)   is   measured   as   the   reciprocal   of   the   annual   The   monetary   independence   index   (MI)   is   measured   as   the   reciprocal   of   the   annual   correlation   The monetary between   independence the  index monthly   measured rate   (MI) is interest   theof   a   country   with   the   base   country’s   interest   correlation   between   the   monthly   interest  as rate   reciprocal of   a   country   of the annual with   correlation the   between the base   country’s   monthly interest   rate  (in  general  this  is  the  US  fed  fund  rate).  The  index  is  defined  as:   interest rate of a country with the base country’s interest rate (in general this is the US fed fund rate). The index is rate  (in  general  this  is  the  US  fed  fund  rate).  The  index  is  defined  as:   defined as: ! , ! − (−1) = 1 − ! , ! − (−1)   = 1 − 1 − (− 1)   1 − (− 1) Where    refers  to  the  country  we  are  analyzing  and      is  the  base  country  (here  it  is  the  US).   Where    refers  to  the  country  we  are  analyzing  and   Where i refers to the country we are analyzing and j is the base country    is  the  base  country  (here  it  is  the  US).   (here it is the US). By definition, the maximum By  definition,  the  maximum  value  of  the  index  is  1  and  the  minimum  is  0.  When  monetary   By  definition,  the  maximum  value  of  the  index  is  1  and  the  minimum  is  0.  When  monetary   value of the index is 1 and the minimum is 0. When monetary policy depends completely on the base country (e.g. in policy  depends  completely  on  the  base  country  (e.g.  in  a  currency  board)  the  correlation  is  1   policy  depends  completely  on  the  base  country  (e.g.  in  a  currency  board)  the  correlation  is  1   a currency board) the correlation is 1 and therefore the index is 0. The interest rate used to construct the index is the and   moneytherefore   market, and theindex   the   is   0.   data comes from The  the interest   International rate   used   Statistics. Financial to   construct   the   index   is   the   money   and   therefore   the   index   is   0.   The   interest   rate   used   to   construct   the   index   is   the   money   market,  and  the  data  comes  from  the  International  Financial  Statistics.   market,  and  the  data  comes  from  the  International  Financial  Statistics.       Exchange  rate  stability  index   Exchange rate stability index Exchange  rate  stability  index   The  index  is  based  on  an  invert  of  exchange  rate  volatility,  that  is,  standard  deviations  of  the   The  index  is  based  on  an  invert  of  exchange  rate  volatility,  that  is,  standard  deviations  of  the   The index is based on an invert of exchange rate volatility, that is, standard deviations of the monthly rate of monthly   rate   of   depreciation   for   the   exchange   rate   between   a   country   and   the   base   monthly   depreciation rate   for theof   depreciation   exchange rate between for  athe   exchange   country and the base rate   between   economies (in thisa   case country   and   the   base   the US). economies  (in  this  case  the  US).     economies  (in  this  case  the  US).     0.01 = 0.01   = 0.01 + (Δ(log  (ℎ_ ))   0.01 + (Δ(log  (ℎ_ )) By  construction  the  index  is  between  0  and  1.     By  construction  the  index  is  between  0  and  1.     By construction the index is between 0 and 1.         MALAYSIA ECONOMIC MONITOR | DECEMBER 2017 69 References Abdelal, Rawi and Laura Alfaro (2003) ‘Malaysia: Capital and Control’, Harvard Business School Case Study No. 9-702- 040, Cambridge, Mass: Harvard Business School. 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