Swimming against the Tide: Crisis Management in Malaysia

Abstract

Unlike Thailand, Indonesia and Korea, Malaysia succumbed to the financial crisis with only a little foreign debt exposure of its banking system. For this reason, it has so far managed to muddle through without an IMF-sponsored rescue package. In the absence of a clear policy anchor, indecisiveness has adversely affected Malaysia's recovery process. The recent dramatic policy shift could usher in long-term recovery only if the breathing space provided by capital controls and pump priming is appropriately used for the speedy implementation of required adjustment policies, in particular recapitalization of troubled domestic banks and revitalizing the debt-laden corporate sector. Until the onset of the currency crisis, Malaysia was considered the best success story among the second-tier newly industrializing economies (NIEs) in East Asia. While Malaysia's economic performance was impressive by developing-country standards throughout the post-independence period, the achievements were truly remarkable from the late 1980s when there was a decisive shift towards greater outward-- orientation of economic policy. During 1987-96, the Malaysian economy grew at an average annual rate of 8.8%, lifting per capita income from US$1,850 to US$4,425. The economy was at virtual full employment for the last six years, with modest inflation (4.5%). Rapid economic growth was accompanied by rising living standards, and improvement in the distribution of income, ameliorating the twin problems of poverty and racial imbalances. In terms of political stability and policy continuity, the stage was well set for advance through an outward-oriented development strategy. Infrastructure bottlenecks, while important, did not seem impenetrable. Malaysia's aim of entering the league of developed industrial nations by 2020 (as envisaged in Prime Minister Dr Mahathir's Vision 2020 Speech) was generally considered feasible (Athukorala forthcoming). This impressive growth trajectory changed dramatically with the onset of the currency crisis. The currency and stock market turmoil that began in July 1997 was quickly translated into economic collapse. Unlike the other three crisis countries, Malaysia succumbed to the crisis with only a little foreign debt exposure of its banking system (discussed below). For this reason, it has so far managed to muddle through without an IMF-- sponsored rescue package. But in the absence of a clear policy anchor, indecisiveness has adversely affected Malaysia's recovery process. By mid1998, the economy was in recession and there were no signs of achieving currency and share price stability. The stage was set for a dramatic policy turnaround in favour of an unorthodox (and risky) policy posture whose key elements were capital controls and expansionary macroeconomic policy. Ironically, as of mid-1998 prospects for economic recovery in Malaysia in the immediate future were less promising than in Korea and Thailand, which were forced to follow the conventional (IMF) reform. What happened to Malaysia? Did it simply succumb to a wild speculative attack in the wake of the Thai crisis or were there some fundamental weaknesses in the pre-crisis Malaysian economy that made it vulnerable to the Thai contagion? Has the recovery process been hampered by inappropriate policy responses? What triggered particular policy responses? What are the likely implications of the dramatic policy shift in September? This paper sets out to answer these and related issues. The paper is broadly organized into three parts. The following section briefly surveys the onset of the crisis and subsequent economic collapse. The next section examines the sources of vulnerability to the crisis and policy responses, with emphasis on their political and institutional underpinnings. The final section discusses the recent policy U-- turn and its likely implications. From Financial Crisis to Economic Collapse For over five years prior to the onset of the recent currency crisis, the exchange rate of the ringgit varied in the narrow range of 2. …