The Policy Responses and Implications of the Global Financial Crisis in Asia: A Case Study for Malaysia

Abstract

1. Introduction Asia is hit by another major crisis barely ten years after the devastating Asian financial crisis (AFC). This time, the crisis emanates from the United States. While no two crises are identical, they share some basic common conditions, among which are a build up of excess liquidity, from either domestic sources such as loose monetary policy, or external sources such as rapid capital inflow, that invariably lead to poor credit discipline, misallocation of capital, and the consequent rise and collapse of asset bubbles (see Reinhart and Rogoff, 2008, Thalassinos et al., 2010, and 2006a, 2006b). They also exhibit quite similar financial practices, namely, excessive use of maturity mismatch (funding long-term assets with short-term funds) and unsustainable leverage, and the use of inappropriate and unregulated financial instruments. In the case of the AFC, the problem of maturity mismatch was aggravated by currency mismatch, i.e., borrowing in short-term foreign denominated loans to invest in long-term local currency assets. As a result the AFC was not only a banking crisis but also a currency crisis. As a consequence of this huge inflow of capital and double mismatch, many companies not only had high debt-to-equity ratios but also exposure to currency risks (Lau, 2005). A currency crisis was looming in Thailand when doubts were cast on the ability of borrowers to repay their loans. A massive outflow of portfolio capital coupled with speculative attacks on the Thai currency culminated in a currency crisis that led to a banking crisis. The Thai government, short of dollar reserves, allowed its currency, the baht, to depreciate in order to cut it loose from the dollar (Kamer, 2004). The currency crisis soon spread to other Asian countries, including Malaysia. The Malaysian ringgit had depreciated by 40 percent against the US dollar and the stock market lost 80 percent between February 1997 and September 1998 (Tan, 2005). However, the AFC did not bring about the collapse of the financial and banking sectors in Malaysia with the exception of the tumbling of the stock market due to large outflow of portfolio investments by foreigners. In contrast to the 1997 AFC, the 2008 global financial crisis (GFC) stems from the weaknesses of the U.S. financial industry that escalated into a severe international financial crisis and caused global recession by late 2008. The crisis is triggered by the collapse of the U.S. housing asset bubble, in particular its subprime mortgages. The crisis that started in July 2007 was transmitted to the real economy as credit crunch and debt implosion led to job losses and a fall in consumer spending. The downturn effects of the US economy spread fast to other regions, especially export-driven countries like Malaysia, resulting in a crisis of exports with immediate impact on production and job losses. Malaysia was lucky in the sense that the GFC did not metamorphose into a currency or banking crisis due to the stronger macroeconomic fundamentals and financial systems built up after the painful experience of the AFC. But there were still structural weaknesses that made it difficult for the government to address the GFC. In the aftermath of the AFC, Malaysia's economy had become more trade-dependent where net export became a major driver of economic growth. However, in times of external recession, an export-oriented economy will became extremely vulnerable to the decline in the demand for exports. This is particularly evident in the GFC. Also, as a result of a slanted orientation towards export-led economic growth, private domestic investment had been neglected. All in all, these structural weaknesses had affected long-term economic growth and productivity and in turn, the ability of the government to offset the adverse impact of the GFC. This paper examines the impact of the GFC on Malaysia's economy as well as the effectiveness of countering measures undertaken by the government. …