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«Financial Policy and Management of Capital Flows: The Case of Malaysia MARTIN KHOR TWN Third World Network Financial Policy and Management of Capital ...»

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TWN Global Economy Series

Financial Policy and Management of

Capital Flows: The Case of Malaysia



Third World Network

Financial Policy and Management of Capital

Flows: The Case of Malaysia



Third World Network

Financial Policy and Management of Capital Flows: The Case

of Malaysia

is published by

Third World Network

131 Jalan Macalister

10400 Penang, Malaysia.

Website: www.twnside.org.sg © Martin Khor, 2009 Printed by Jutaprint 2 Solok Sungei Pinang 3, Sg. Pinang 11600 Penang, Malaysia.

ISBN: 978-983-2729-82-2



2. THE 1997-99 CRISIS AND POLICY RESPONSE 3 a. The financial and economic crisis 3 b. The Malaysian counter-crisis strategy 4 c. Lessons from the Malaysian policy response 10


SINCE 1998 12 a. Introduction 12 b. The exchange rate regime 14 c. Liberalization of foreign exchange rules and foreign investment 15


FLOWS 27 a. General 27 b. Flows of direct investment 27 c. External loans and external debt 30 d. Volatility in portfolio flows 34 e. “Other investments”: Outflows of banking deposits abroad 35



EXCHANGE RATE 48 a. Managing the effects of capital flows 48 b. Capital outflows as a means to lower the pressure of inflows 52 c. Managing the exchange rate and interest rates in a liberalized environment 53 d. Increasing buildup of foreign exchange reserves 55 e. Strengthening the surveillance and risk management system 57


a. Vulnerability to global financial turmoil

–  –  –

THE management of capital flows and related issues such as the exchange rate and macroeconomic policies have become important to developing countries as they increasingly interact with the global economy, especially global finance. While finance has usually been seen as an important tool for economic development, in recent years it has also been an area of concern as the economies of many countries were destabilized because of problems or shocks originating from the financial sector.

This paper reviews the evolution of Malaysian financial policy, focusing especially on policies regarding various types of capital flows. Related issues such as management of the exchange rate and macroeconomic policies are also examined.

The paper describes the main features of the policies instituted by the Malaysian government in response to the financial crisis of 1997-99. An innovative mixture of policies relating to stabilizing the exchange rate, selective capital controls, counter-cyclical macroeconomic policies, and the revival of financial institutions and corporations was adopted. This set of policies was unorthodox as they were contrary to the usual policy mix that the International Monetary Fund (IMF) has been prescribing.

The paper then discusses changes in policies since the mid-1990s crisis. In recent years, there has been a liberalization of the capital account, with increasing freedom given for both inflows and outflows of funds. As at 2008, the economy is more financially liberalized than at 1997, on the eve of the crisis. As a result, the economy has become more vulnerable to sudden and significant shifts in capital. In particular, there have been large outflows of funds by domestic banks and residents in the past few years, adding to the more traditional outflows of profits by foreign firms. While these capital outflows have been covered by the large trade surpluses of recent years, they could contribute to weaknesses in the balance of payments should the trade surplus decline as a result of adverse conditions in the global economy, and if this is also accompanied by outflows of foreign portfolio capital. The volatility of foreign portfolio flows became rather extreme in 2008 with the onset of the global financial crisis, with massive outflows in the second and third quarters following large inflows in the first quarter. Mainly as a result of these huge outflows, the overall balance of payments slipped into deficit in the second half of 2008.

–  –  –

THE 1997-99 CRISIS AND POLICY RESPONSE a. The financial and economic crisis IN 1997 several East Asian countries began to experience serious financial problems. They had received large inflows of capital, including bank loans (denominated in foreign currencies) and portfolio capital (especially foreign purchase of equity in the local stock exchanges). A significant part of the foreign loans was not channelled to activities that yielded revenue in foreign exchange, and thus a mismatch occurred, at least in the short term, so that pressures built up on foreign reserves. Sharp declines in the currencies triggered by speculative attacks started a chain of events leading to financial and economic crises.

Like other East Asian countries, Malaysia had a relatively open capital account. However, local companies were allowed to obtain foreign loans only with central bank permission, which would be given only if and to the extent that the loans were used for activities that would yield revenue in foreign exchange that could be used for loan servicing. This regulation prevented the country from having the scale of private-sector external debt that brought Indonesia, Thailand and South Korea to the brink of external debt default. Malaysia’s debt situation remained manageable although there was a possibility of debt-servicing difficulty if the domestic currency, the ringgit (RM), depreciated even more sharply.

The ringgit, which had for years been stable at RM2.40-2.50 to the US dollar, depreciated and reached a low point of 4.88 on 7 January 1998. A major cause was speculation as the ringgit was subjected to short-selling by financial institutions. The currency depreciation increased the burden of external debt servicing. There was also a large reversal of foreign portfolio capital flows.

Although the country did not resort to an IMF loan, the government nevertheless undertook IMF-type policies in the first year of the crisis (midto mid-1998). These included: allowing the currency to float with minimal intervention; maintaining an open capital account regime; increasing interest rates; a tight monetary policy; and a drastic reduction in government budget expenditure.

The orthodox policies led the economy into a sharp decline. The jump in interest rates raised the debt-servicing burden of local companies. The banking system was hit by an increase in non-performing loans and some banks came under stress. The stock market fell, and consumer demand declined. Real GDP growth turned from plus 7.3% in 1997 to minus 7.4% in

1998. Local savings were channelled abroad.

From mid-1998 the orthodox policies started to be reversed. Bank Negara Malaysia, the country’s central bank, eased its monetary policy by reducing the statutory reserve requirement and by reducing the three-month intervention interest rate, whilst fiscal policy also became expansionary. In September 1998, measures were taken to fix the exchange rate and institute selective capital controls.

On 1 September 1998, measures were introduced which aimed at stabilizing the currency (through fixing of the exchange rate to the US dollar);

preventing overseas speculation on the value of the local currency and local shares (by banning the overseas trade in these); and reducing capital outflows (through selective capital controls). This set of measures was a watershed as until then it had been almost taboo for economists, let alone governments, to even discuss capital controls.

b. The Malaysian counter-crisis strategy The key elements of the Malaysian strategy included a full use of macroeconomic and financial policies, including capital controls, in order to stabilize the currency and facilitate a rapid recovery.

Monetary and fiscal policies A major part of the policies was the reduction in interest rates. The central bank three-month intervention rate was reduced from 11% at endJuly 1998 to 6% on 3 May 1999. After the introduction of capital controls, interest rates were reduced further throughout 1999, falling to some 3% in December, compared to 5% in Thailand, 6.7% in Korea and 13% in Indonesia.

The government also implemented an expansionary monetary and credit policy. During the initial phase of the crisis, credit flow had slowed to a trickle. The Malaysian alternative strategy was to increase liquidity in the system. The government reduced the statutory reserve requirement from 13.5% to 10% in February 1998 and 4% in October 1998. A target was set for the banks to increase their loans by 8% in 1999. The government also reverted to the original definition of non-performing loans as loans not serviced for six months (instead of the more stringent three-month criterion that had been introduced after the crisis broke out).

Finally, the government implemented an expansionary fiscal policy.

The initial contractionary fiscal policy (a cut in government expenditure by 18% in December 1997) was reversed from 1998. As a percentage of GNP, the federal budget surplus of 0.8% in 1996 rose to 2.5% in 1997, then reversed into deficits of 1.8% in 1998, 3.2% in 1999 and 5.5% in 2001.

Financial and capital control measures

Stabilizing the currency: Stabilizing the exchange rate became the most important objective. The ringgit was fixed to the US dollar at RM3.80 to US$1. The central bank used this rate in its dealings with the commercial banks, which in turn used the same rate in their currency dealings with the public. The fixed exchange rate system allowed monetary and fiscal policies to be taken on their own merit without being constrained by fears of a fall in the value of the currency. It also reduced the opportunity for speculation.

Explaining the introduction of the currency system, the then Prime Minister Dr Mahathir Mohamad said the aim was to cut the link between the interest rate and the exchange rate so that, for example, interest rates could be reduced without speculators devaluing the currency, and companies could revive.

Measures to prevent overseas speculation and trade in the ringgit (i.e., de-internationalizing the currency): Measures were taken to reduce and eliminate the international trade in ringgit, and to repatriate back to the country a large amount of ringgit-denominated financial assets (such as cash and savings deposits) that were held abroad in overseas banks and other institutions. The measures mainly comprised the non-recognition or nonacceptance of such assets in the country after the expiry of a one-month period, i.e., local financial institutions were not allowed to accept the entry of such assets after the deadline. (Permission to repatriate after this deadline would however be given under certain conditions.) This measure effectively put an end to the offshore trade in the ringgit and in assets denominated in ringgit (including the operation and holding of ringgit-denominated bank accounts abroad). Explaining the move to make the use of offshore ringgit invalid, the Prime Minister said normally it was offshore ringgit that was used by speculators to manipulate the currency.

The speculators held the ringgit in foreign banks abroad and had corresponding amounts in banks in Malaysia.

Selective capital controls: Several measures were introduced on 1 September 1998 to regulate the outflow of funds. Measures aimed at

foreigners and foreign-owned funds included the following:

• Non-residents holding shares in companies listed on the local stock exchange would have to retain the shares or the proceeds from the sale of the shares for a minimum period of one year from the purchase date.

The objectives of this measure were to discourage speculative shortterm trade in local shares, and to prevent capital outflow at least for one year.

• Domestic credit facilities to non-resident correspondent banks and nonresident stockbroking companies were no longer allowed (previously domestic credit up to RM5 million was allowed).

• Conditions were imposed on the operations and transfers of ringgitdenominated funds in external accounts, including those held by nonresidents. Transfers between external accounts held by non-resident corporations and individuals residing outside Malaysia required prior approval for any amount (previously freely allowed). Transfers from external accounts to resident accounts would require approval after 30 September 1998. Sources of funding external accounts were limited to proceeds from sale of ringgit instruments and other assets in Malaysia, salaries, interest and dividend and sale of foreign currency.

Measures aimed at local residents included the following:

• Resident travellers were allowed to import ringgit notes up to RM1,000 only and any amount of foreign currencies, and to export up to RM1,000 and foreign currencies up to RM10,000 equivalent.

• Except for payments for imports of goods and services, residents were freely allowed to make payments to non-residents only up to RM10,000 or its equivalent in foreign currency (previously the limit was set at RM100,000).

• Investments in any form abroad by residents and payments under a guarantee for non-trade purposes required approval.

• The prescribed mode of payment for exports would be in foreign currency only (previously it was allowed to be in foreign currency or ringgit from an external account).

• Residents required prior approval to make payments to non-residents for purposes of investing abroad for amounts exceeding RM10,000 equivalent in foreign exchange.

• Residents were not allowed to obtain ringgit credit facilities from nonresidents.

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