l\'Ionetary Economics

nere were

some signs of
an overvalued
ru rrency.

,&
@

when it was at a level of 2.79, to 2.43 in August 1995. This was a gain of
almost 15 percent in its value.
One might arbitrarily take the value of the ringgit in the period of earlv
7994 to early 7995 as a benchmark value. It is worthwhile to point out that
the Malaysian economy registered a substantial current account deficit of
RM21.6 billion (US$8.6 billion), or L0.4 percent of nominal GNP in 1995. That
year, the balance on long-term capital (RM16.6 billion) was insufficient to
finance the current account deficit and the basic balance registered a deficit
of RM5.0 billion. Net private short-term capital amounted to only RM2.5

billion and the overall balance was in deficit by RM4.4 biltion. Despite
the overall balance being in deficit for two straig-ht years and the fears branalysts of a current account blow-out, the ringgit actually strengthened
against the U.S. dollar by the end of 1995 (2.54) compared to year-end 1993
(2.70). Flence, the ringgit appeared overvalued when the crisis unfolded.

5. State of the Banking Sector

Rapid credit
expa nsion

and increased
exposure to the
property sector
were getting
worrisome.

Despite the high loans growth over the preceding few years, the health of the
banking system appeared to be excellent. At the end of June 7997, the month
before the attack on the currency started, the net NPL ratio of the banking
system was at 2.2 percent. The risk-weighted capital ratio (RWCR) was 12
percent, significantly above the minimum requirement of eight percent.
Notwithstanding the favourable indicators above, there was rapid
credit expansion and increased exposure to the property sector. With the
economy being so highly leveraged, it was made more vulnerable to a
speculative attack on its currency as the central bank will be constrained
in the use of the interest rate instrument to defend the exchange rate. Also,
when there is rapid credit growth over a short span of time, especially in
view of an increasing exposure to the property r"itor, it may not be prudent
as some of the borrowers could be less creditworthy. Declining asset prices
in an economic downturn would also pose high risks to banks with loans
secured using property and shares as collateral. The central bank was slow
in responding to this uneasy trend, taking corrective action only in early
7997,just months before the first attack on the ringgit. The sluggishness in
policy response probably contributed to investors' nervousness.
The worries over excessive credit expansion through the banking
system and its implications on potential bad debt was also prompted
by concerns that the business sector is linked to the government with a
certain amount of tonnected lending' not necessarily based on commercial
criteria.@ Athukorala (1998a) also oplned that the reiilience of the banking
system to a crisis may have been 'weakened over the years because of the
growing dominance of local, relative to foreign, banks'. Presumably, he
was alluding to the perception that the foreign banks were less susceptible
to any pressure from the government to influence lending activities

@ S"" Athukoral a (7998a, p.

93). Gomez, et al. (7997) observed that influencing bank

lending activities has been part of the New Economic Policy (NEP) strategy of
restructuring business ownership. Athukorala (1998a) also mentioned that the
stock market has been a 'key instrument used ... to achieve the political goals of
restructuring wealth ownership in the economy'. Rasiah (2000) argued that the NEP
cultivated cronyism that was driven by patronage rather than performance.

\_

The Use of Monetary Policy

in Crisis Management

compared to local banks and, thus, had a lower risk profile. This perception
seemed to be also prevalent among depositors at the end of 7997 and early
1998 when smaller (domestic) financial institutions faced withdrawals
from concerned depositors and experienced some problems with their
liquidity.o Apart from the risks associated with the banking system, the
question of the independence of the central bank (and the related issue
of credibility) was brought to the fore. Athukorala (7998a), for example,
observed the 'long silence of BNM' on the issue of rapid credit expansion
until just months before the onset of the first attack on the ringgit in mid1997. The indications are that the central bank had been guilty of a lax
monetary policy in the period prior to the crisis.

6. Build-up of External Debt

tr:k

rrr
lJlq
5-_

mitc

fr
ln1

fr*r:
iJlr-

tr
Lrnr
iLlgi

Emi

['r.
ilr!'r
I

Ttfr

External debt exposure of the economy was not very high at the onset of
the crisis. Total external debt outstanding amounted to RM101.2 billion at
the end of March 1997 (38.8"h of GNP; 140.3% of net international reserves),
of which 71.5 percent was medium and long-term deb| the remaining 28.5
percent being short-term debt.
However, it is noted that there was a steady build-up of external debt
by the private sector and the non-financial public enterprises (NFPEs)
starting from 7992. Private sector medium and long-term external debt rose
from RM5.4 billion in March 7997 loRM37.7 billion in June 1997, an increase
of almost seven-fold. The NFPEs started accumulating external debt from
1993 onwards-medium and long-term debt rising from RM12.0 billion
in March 1993 to RM32.5 billion in June 7997; an increase of 2.7 times. As
for short-term external debt exposure, the banking sector's debt rose from
RM11.3 billion in December 1995 to RM27.B billion in June 7997; an increase
of almost 2.5 times over a short period of L8 months.
The rapid build-up in external debt in the years preceding the crisis in
7997 was probably facilitated by a very stable exchange rate of the ringgit
against the U.S. dollar. During this period, domestic interest rates were not
very high; otherwise there would have been added incentive to borrow
more from abroad.@

nms

W
hr a
[3ar.
rmlF

Cm

G*

WW

ONSET OF THE CRISIS

From the earlier section, it was clear that there were several signs of
vulnerability in the Malaysian economy prior to the currency crisis in7997.

.!L[

be

m
mt
tr

.uf

th

!il
!tslJ

significant extent, this perception that the foreign-owned banks are less exposed
to risks may have been justified if one looked at the list of banks which sold NPLs
to Danaharta (the asset management company set up to help in cleaning up bank
balance sheets)
- most of the foreign banks did not have to do so. For a couple of
foreign banks which did so, the value of the loan rights acquired amounted to only
0.15 percent of the total for the period June-December 1998. (Source: Danaharta,
Report: 20 June 7998-Sl December 1998)
^ Operations
@
1o*o (7gggb, p. 183) noted that much of the foreign debt was dollar-denominated,
short term and unhedged'.
To a

ffiThere was a
steady build-up of

external debt b'i' .

the private sector
and the NFPEs.

l,lcneiar\. Economics

The crisis

in Thailand
threatens to spill
over as investors

got nervous.

Following the Thai baht tumble, this caused serious concerns for investors'
particulaily portfolio investors. This was no doubt influenced by the facr
that most of the international financial community had failed to perceive
the very real risks in some of the crisis-hit economies. Ouattara (1995
remarked that 'in hindsight, it is clear that most of these (capital) inflo\\-'
(to East Asian economies) did not show sufficient concern for the potentia,
risks'. Thus, once the Thai crisis started to become full-blown, the prospecl:
for self-fulfilling panics were rife. As Dornbusch (1998) so aptly put it:

,vulnerability is in part an objective fact but, just as in the case cr

bank runs, in part, it is in the eyes of the beholder.'
,Safety first is the motto of investors when they smell a rat. Thus, one
vulnerable economy after another tumbles.'

Ringgit Fell Under Pressure

The ringgit

plunged to an all-

time low against

the U.S. dollar in
early 1998.

x/

ringgit fell against the u.s. dollar and most of the

major currencies. From a level of 2.48 against the U.s. dollar in March
speculative attacks on the ringgit saw it depreciating to an average tf
Z.SZ inJuly. By the end of that year, the ringgit's exchange rate against the
greenback had plunged to an astonishing3.77. The worst had yet to come
In early January 1998, the ringgit sank to an all-time low of 4.88 agains:
the U.S. dollar. This triggered the panic button in the business sector as
well as among policymakers. In August, the ringgit was at an average c:
4.20 against the greenback. This was prior to the announcement o{ the
capitaicontrol mJasures on 1 September and the subsequent fixing of the
rate at 3.80 to the U.S. dollar the next day'
"*"hutlg"

Since March 7997, the

Stock Market Plunged

Together with

the ringgit
depreciation,
the stock market
plunged.

confidence on the ringgit shattered, investors in the stock market

began mass selling on the KLSE, causing the market to tumble. The KLSE
Colnposite Index IKLSE CI), which stood at 1,,216.7 points at the end of
lanuiry 1997, ended the year at 894.4 points. In August 1998, the month
tefore the imposition of the capital control measules, the KLSE CI was
just 302.9 points. Average daily turnover had plunged from about RM2-3
tiliior"r in the first three months of 1997 to just RM193 million in August
1998. The market capitalisation of the KLSE, at RM826 billion in Januarr7997,had shrunk to RM200 billion in August 1998.
Most would agree that the ringgit had fallen way beyond what one might
term aS reflective of economic 'fundamentals'. The circumstances in which
the regional currency turmoil occurred and the resulting sentiments that
uppeaied to influenie fund managers and currency traders were indeed
r-iq.t". with the seed of the crisis sown in the dramatic fall of the Thai baht
andihe Korean won following closely, stock market investors and currencrtraders wele shocked at the apparent lack of prudential supervision on the
part of the authorities. Added to this, there were instances pointing to poor

with

'r11unug"*"r1t

of the economy and allegations of lack of transparency. To be

fair, sJme of these allegations were well grounded in some countries. This,

coupled with an obvious lack of ability to differentiate the circumstances

between the various economies in the region, resulted in market players

The Use of Monetary Policy

ffirl',
!nuri
!fiUilrrl'

seeking to highlight similarities with the Thai and Korean cases. The result
was a massive sell-down of stocks and the dumping of domestic currencies.
Both these developments fed on each other. It was a typical demonstration

ffiLm''

of herd behaviour by fund managers and curlency tradels alike. To a

certain extent, there were probably self-fulfilling prophecies. These were

!tul[il$

augmented by imperfect knowledge of country-specific circumstances and

{llPlur.i

mnlfl:r

tjit

$,

ltmri

rti-r',

in Crisis

unlavourable sentiments partially fed by the inappropriate handling of

the crisis by some governments at the initial stage. The vulnerabilities in
the Malaysian economy highlighted in the earlier section caused investors
to become nervous over potential problems in the economy, following the
Tha i baht debacle.@

The falling ringgit and the stock market collapse reinforced each
other's downward momentum and had a profound impact on businesses.
The financial system, in turn, was hit by the rising number of business
failures or company closures. The much weaker ringgit also inflated the
size of foreign debt obligations.

[unr:l-

t* **li

llllillttl

illlLlli:,
[;'!."

i.".

f, th'r
f 1lq

frl:Nd

r.:si

Dannpened Business Confidence and Gonsumer

$entiments
What started out as an exchange rate problem that some initially thought
to be transitory quickly exerted a negative impact on the real sector.
Following the onset of the crisis in mid-1997, beginning from the third
quarter o] thut year up until the first quarter of 7998, business confidence
oJ manufacturers, as gauged by the Malaysian Institute of Economic
Research's (MIER) Business Conditions Index (BCI), dipped sharply for
three consecutive quarters. Likewise, the impact on consumer confidence
was telling. The MIER Consumer Sentiments Index (CSf plunged for
four conseiutive quarters beginning in the third quarter of 1997 until the
second quarter otlggl. The index reached an all-time low in 2Q:98 and the
quarterly drop in the previous quarter was the steepest recorded since the
inception of the survey.

".:
t..

4*rl'

,'l:-'
N-*i

-'

i.: t-

:.-,.:i

l-

*.

: r" l -t:
;

:{_:\

rNrrrAL PoLrcY REsPoNsE

The initial policy lesponse was one of stabilisation measules, in particular

to address the current account deficit, contain inflationary pressures
resulting from the ringgit depreciation, stabilise the exchange rate and
prevent large outflow of short-term capital.
@

mentioned sending out tonfusing signals" giving the impression of the

,authorities, wiliingness to change the rules in'mid-game' and,'bending of the rules'
in the uEM-Renong case, as examples of undermining confidence and ad-"ersely

1o1no (1998b)

affecting sentiments at valious stages of the crisis. In the UEM-Renong case, cashrich UEM (United Engineers Malaysia, a favourite KlSElisted comPany among
foreign fund managers up till then) was allowed to execute a reverse-take-over of its
heavily-indebted parent firm, Renong, in a move that was seen as detrimental to the
interests of its minority (foreign) shareholders. It attracted much bad publicity-see
for example, Fox (1998).

?e

..

Busi ness

confidence as
well as consumer
sentiments took a
bie hit.

!lonetary Economics

Monetary Policy Response

:

lnitial policy
response by

central bank
was to slabilise
exchange rate,

contain inflation
and ensure
soundness of the
banking system.

In response to the currency crisis and its impact on the real sector, the
central bank implemented several measures designed to stabilise the
exchange rate, control inflation and ensure the soundness of the banking
system. It is noted that from the very beginning of the crisis, monetar)policy was not as tight as that recommended by the International Monetarl'
Fund (IMF). At the onset of the crisis, the central bank's stance in monetary
policy has been to keep interest rates at a relatively high level to contain
any inflationary pressures arising from the ringgit depreciation. This
was to maintain positive real interest rates to encourage saving and to

prevent capital outflow. BNM was of the opinion that raising interest
rates excessively would not be effective in supporting the exchange rate,
given the strong external factors, and was mindful of the need to provide
sufficient liquidity to finance economic activities. However, beginning
September 7997, when the ringgit breached the 3.00 level against the U.S.
dollar beyond most expectations, the central bank acted to raise interest
rates gradually. The benchmark 3-month interbank rate, BNM's policv
rate, was raised from 7.55 percent in mid-September to 8.7 percent by the
end o{ 1997. Negative sentiments {ollowing external developments such
as the deprecration oi the l(orean won in December 199? and the ream
collapse of the Indonesian rupiah in early 1998 exerted a powerful impact
on the ringgit. In 1998, following the shock decline of the ringgit to 4.88
against the U.S. dollar on 7 January, the 3-month rate rose to ten percent
and further to 11 percent in February. Interest rates were raised to stem
inflationary pressures arising from the higher cost of imports and also to
prevent outflow of short-term capital.
In April 7997, concerned with the strong growth in bank lending to the
'less productive' sectors and the sharp rise in asset prices, BNM imposed
quantitative restrictions on loans to the property sector and for the purchase
of stocks and shares. Following speculative attacks on the ringgit since July
7997,banks were also subjected to limits on outstanding non-commercial
ringgit offer-side swap transactions with foreign customers effective 4
August 7997. However, transactions for trade and direct investment were
not subjected to the restriction. The objective was to reduce the supply of
offshore ringgit used to mount speculative attacks on the currency.
In view of the continued strong credit and money supply growth and
the further weakening of the ringgit, BNM enforced further measures in
October 7997. Financing on hire-purchase loans for the purchase of noncommercial vehicles was reduced to 70 percent of the purchase price. The
repayment period was shortened to not more than five years. Banks were
also advised to prioritise lending to activities such as the export-oriented
manufacturing sector. Additional lending guidelines were announced
in December 1997 stating that credit should not be extended to property
projects which have not started construction. As for on-going property
projects, strict selectivity and viability assessment were advised'
In order to detect problem loans early, the classification of nonperforming loans (NPLs) for banking institutions was reduced from
6-months arrears to 3-months arrears effective 1 january 1998. The
disclosure requirements for the financial statements of banking institutions
were increased to include more information. This was to improve the level
of transparency.

re1

to
efj

thr
m(

rer

fir

uI

a\'
J-

ea

P(

re
le

P(

CI

bi

The Use of Monetary Policy

in Crisrs Management

The central bank was also determined to ensure that the cost of funds
reflects supply-demand conditions and that credit be made available
to productive economic activities. To remove distortions and enhance
efficiency in the money market so that interest rates would better reflect
the market's liquidity conditions, BNM announced a number of monetary
measures in February 1998. The statutory reserve requirement (SRR) was
reduced from 13.5 percent to 10.0 percent on 16 February 7998, to provide
financial institutions greater access to funds that were previously locked
up with the central bank. However, as a form of compensatory measure to
avert any undue easing of monetary policy due to the SRR reduction, BNM's
3-month intervention rate was raised by 100 basis points to 11 percent
earlier on 6 February. The central bank also reiterated that tight monetary
policy will be maintained in order to contain inflationary Pressures as a
result of the weaker ringgit. Following these measures adopted by BNM,
lending rates fell from as high as 22percent in early February to about 16
percent at the end of February.@
Beginning late March 1998, in a move to enhance transparency and to
enable better supervision of the banking sector, banking institutions were
required to publish data to indicate financial soundness on a quarterly
basis. These included NPLs and capital adequacy daia. They were also
required to maintain, on a quarterly basis, a minimum 8.0 percent riskweighted capital ratio.

To further reduce distortions in the financial system and improve

liquidity managemenf the central bank introduced new features in its

1 :l
"i

-,li::

money market operations. Effective 1 May 1998, the band on the required
balances to meet the SRR requirement was widened to 2.0 percent from
the previous 0.5 percent. This was to provide banks greater flexibility in
their liquidity management. BNM also mentioned that it will maintain
real deposit rates at pre-crisis levels to prevent outflow of funds, increase
savings and stabilise the exchange rate.
The first hint of a change in the stance of monetary policy was on 1
JuIy 7998, when the central bank further reduced the SRR to eight percent.
Unlike the SRR reduction in February, which was done to improve the
liquidity situation of some banks, this was done to reduce the cost of funds.

,1.

Gosrdlna&ed FXseal Policy Respomse

.ll\lFnm'e''

[:]!{'1"

alUL

tlt

T'

r'

Malaysia had six years of fiscal surpluses up tlII 7997. When the crisis
unfolded in mid-7997 and escalated as the year progressed, the concerns
that policymakers had was one of maintaining macroeconomic stability
through containing inflationary pressures and addressing the current
account deficit, as well as maintaining investor confidence. Even by the
third quarter of 1997, Malaysia was still experiencing healthy economic
growth. Thus, the government budget for calendar year 1998, proposed
in October 7997, showed fiscal restraint, not unlike that prescribed by
the IMF for the other crisis-hit countries. In line with the anticipation
that government revenue will be affected by an economic slowdown, the
Finance Minister proposed a scaling down of public expenditure through

iLil"lliu rll'

@ Bnnk

Negarn Malnysia Annunl Report 1998,

p. 92.

lnitial fiscal policy

response was
one of restraint,
consistent with
ll\4F

prescription

for other crisis-hit

economies.

Llonetarv Economics

restraining consumption spending and deferring projects that u.er.

deemed as non-critical, as well as privatising government activities. -{
fiscal surplus of two percent of GNP was proposed in Budget 1998. Then
by December, this fiscal restraint was tightened further by implementin:
an austerity drive which saw expenditures reduced by ten percent across
the board and a further cutback of eight percent on a selective basis.
By the end of March 1998, it was evident to the authorities that the
economy is slowing down faster than anticipated. Real GDP had contractei
in the first quarter of 1998 by 1.8 percent compared to a year ago (this u'as

later revised to a contraction of 2.87'). Although the government reducei

the fiscal surplus to just 0.5 percent of GNP, it allocated an additional R\11
billion for socio-economic projects to benefit the more vulnerable groups

in society.
The tight fiscal policy maintained at the beginning stages of the
crisis, to a certain extent, may have been dictated to by financial market
expectations.o The economic slowdown would have caused government
revenue to fall and, hence, there certainly was merit in containing public
sector expenditure. Nevertheless, given the fact that the economy \\,as
going into a steep downturn and the poor investment climate even then,
the likelihood of crowding-out from running a budget deficit was much
less. Thus, fiscal policy could have played a more stimulating role even
at that early stage, in view of the government's strong fiscal record of the
past.@

lmpact sf lnitial Poliey Stance

Despite the early

monetary and
fiscal measures,
the ringgit
continued its
slide.

Despite the earlier fiscal and monetary measures, the ringgit's exchange
rate continued to be affected by external factors beyond the control oi
policymakers. After hitting an all-time low of 4.88 against the greenback
in early January 1998, the ringgit was still weak in August, when it was at
4.20. The riots in Indonesia in May, the weakening of the japanese yen in
june and the devaluation of the Russian ruble all exerted negative impact
on sentiments on the ringgit.

The tight monetary and fiscal policies allowed the current account
deficit in the balance of payments to be contained (subsequently registering
a huge surplus for the year due to a slump in demand for imports) and
also helped to contain inflationary pressures at reasonable levels. Flowever,
@ Garnaut (1998,p.19) noted that there 'seemed to be discordance between good policy,
on the one hand, and international market perceptions of good policy, on the other'.
iomo (1998b, p. 190) pointed out that 'it is not as if the government did not respond
at all, but rather that it did not respond in the manner desired by "the market", i.e.
mainlv the Western financial communitv'.
@ th" .rle of u more stimulating fiscal poli.y *u. noted in mid-1998 by Ariff, et nt.
(1998a): '...in the event of a significant slowdown in the economy, fiscal policy may
have to be more stimulating. The cash-strapped private sector is not in a position to
stimulate a flagging economy. Thus, the public sector will have to play this role. The
surplus budgets that we had in the past few years were appropriate in light of the
robust economic growth. However, if the economy slows down significantly, then
a mild expansionary fiscal policy r) /a Keynesian economics may be in order. ... A
balanced or even a small deficit budget is clearly more appropriate than a surplus
budget under the present circumstances.'

The Use of Monetary Policy

:,tr!

:'

-:
i,:- * -

in Crtsis llanagement

together with the effect of a massive depreciation in the exchange rate and
th! negative wealth effect of the stock market plunge, this was achieved at
the coJt of exacerbating the fall in aggregate demand. if left unchecked, the
recession would have become deeper and the banking sector saddled with
higher bad debts. That would have prevented it from continuing to play its
,ol" us financial intermediary and severely ieopardised economic recovery
prospects.
-

current account balance turned around sharply in the first quartel

of 7998, registering a surplus of RM6.5 billion compared to a deficit of
RM1.9 billion in the pr"rrions quarter. This was achieved through ihe
improvement in the merchandise balance which more than offset the
deficit in the services balance. However, the adjustment in the current
account balance was not well reflected in the net international reserve
position of the country. This was due to the large outflow of,short-term
iapital in the first q.tuit"t of 7998. Net private short-term capital registered
a deficit of RM9.2 billior-t that quarter.In 4Q:97, there was a huge outflow
of RM9 billion which was unaccounted for and placed under 'errors and
omissions'. This item may well reflect short-term capital flows (or capital
flight) that were not captured. Net international reserves in the first quarter
of 7998 declined by RM1.9 billion.
In the second quarter of 1998, although the current account balance
showed a larger surplus amounting to RM8.5 billion, private short-term
capital again iecorded u d"ficit of RM4.6 billion. Nevertheless, the large
cuirent account surplus and the positive net inflow of long-term capital
were still not well captured in the net international reserve position. There
was a huge negative amount that was unaccounted for that quarter, with
,errors and omissions' recording a deficit of RM6.3 billion. This may again
indicate a large net outflow of short-term capital or tapital flight'.
The outflow of short-term capital from the financial system was linked
to the liquidation by foreign portfolio investors in the KLSE as confidence
wus dampened and uncerlainties increased.O The Co-posite Index of the
KLSE plunged from 745.4 points in February 1998 to 455.6 points by endattractive
|une. However, the ringgit outflow was also triggered by very
hefty
premium
a
provided
which
percent,
20-40
between
offshore rates of
over domestic rates of about 11 percent at that time.@ The large outflows
of portfolio investment were especially evident in the second and third

in"

I*.
lj-,i

" r.l,
::1-:'

:r

:.-

._.

t *.
_.r
::"1*,

l:":"
t'{ i'

i4.

::r
nULer

[i il:

rer
J.: ti/

d[

u: il{lLi

1l

ilcalir

.,

iii

,.i

anl

ili$ri r

''

trtr0iiIj!

Jntfift*'
Lrfifi0rn

!ll"

i,r,r

quarters of 1998.
Due to the high domestic debt level in the economy, the sharp rise in
interest rates by the central bank in response to the depreciating currency
had an adverse impact on the business sector and consumers. Firms that
borrowed from banks had higher debt obligations. The sharp rise in the
cost of imported input due to the ringgit's depreciation also contributed to
the business sectols difficulties. Infrastructure projects with high import
content were deferred. As the business climate deteriorated, consumels
became more cautious and spent less. This was worsened by the negative

[:lur[!l

ilfia,
r tinr'
!"
gi]l'0iltr01ii..

Dornb.rsch (1998) termed this type of phenomenon as a 'liquidation scramble'.

@ Ia i, unclear why such high offshore rates wete offered for ringgit deposits at that
time. one possibility waslhat speculators who had sold the ringgit short (and drove
its exchange rate dor.r,n) wanted to cover their forward contract obligations and thus
bid high for the ringgit but still made huge profits from the plunging exchange rate.

Detlatronarl
impact was felt
stronglv in the
real economv.

"

Short term capital

outflows were
registered in
the balance of
payments.

&....
wThe

stock market
continued to
plunge.

179

4i

lrTonetarv Economlcs

wealth effect following the collapse of the KLSE. |ob losses as companies
downsized or closed also added to the negative consumer sentiments.
On top of all this, the much hoped for export sector-led recovery never
materialised as external demand was hampered due to the widespread
crisis in East Asia. Japan, which many crisis-affected countries had hoped
to depend on as a growth pole to puII out of the recession, continued to be
mired in its own economic and financial problems.
Following the economic downturn which affected demand for loans
and coupled with the caution of the banks in extending further credit, loans
by the banking system fell sharply in 1998 to a contraction of 1.8 percent or
RM7.6 billion in quantum (7997: growth of 26.5'/"). As more companies and

Business and
co n5u m

er

confidence were
badly affected.

Credit growth
reversed and bad
loans increased.

individuals were affected by the economic crisis and encountered problems

with servicing their loans, the number of non-performing loans increased
The net NPL ratio of the banking system rose from 4.1 percent of total loans
outstanding at the end ol 1997 to nine percent as at the end of 1998. This,
together with the erosion of the capital base of some banks, restricted the
capacity of some banks to lend. For banks which were in a better position
to lend, their focus on maintaining their asset quality caused them to adopt
a very cautious attitude. As bank credit became more difficult to obtain,
this affected even well-run companies, especially small and medium-sized
ones.
;.:
Liquidity crunch
had a telling

effect on the real

economy.

Reflecting the decline in economic activities and loans growth, the

monetary aggregates continued its downward trend. Narrow rnoney, M7,
contracted by 16.0 percent (year-on-year) by August 7998, while growth
in broad money M2 and M3 had weakened significantly to 7.2 percent
and 4.3 percent, respectively. Hence, there was declining liquidity in the
economy. The impact of the credit and liquidity crunch on the real sector
of the economy was telling. The industrial production index dropped
by 77.6 percent (year-on-year) in August that year while manufacturing
production declined by 14.5 percent.
The economy started to contract in the first quarter of 1998. Real GDP
declined by 2.8 percent compared to the corresponding quarter of 1997.
This contraction became more pronounced in the second quarter when
GDP dipped by 6.8 percent (year-on-year).
For the year as a whole, real GDP declined by 6.7 percent. Private
consumption dipped by 72.4 percent while private investment slumped
by a phenomenal 57.8 percent. On the supply-side, the worst hit sector
was construction, which dipped by 24.5 percent, while manufacturing
contracted by 70.2 percent. In the external sector, exports declined
marginally by 0.7 percent while imports dropped sharply by 18.3 percent,
reflecting the adjustment to a weaker ringgit and especially the dip in
private investment.

cHANGE rN PoLrcY srANcE

By mid-1998, it became clear that the initial policy response had perhaps

outlived its use. The changing conditions, especially the sharper than
anticipated economic contraction caused by both depressed domestic
demand and sluggish export growth, together with concerns of declining

:EJ

l.:.':'
tr i l.:
Itt: :.:tr: ri-':" i:

t ,:.:

l-

'a.
!.t:'::

i.:rr"j
ll.. .:.-

iii"\

r-

t,"- i'-

:::"
irli.

l_-.1
'&fl

-ft1'-

l".
E-

.i.11r:

]:t:P i
i: :'t'*Tl
.L

i-*.i *

t*:'
n.. -1 r-

bank asset quality, suggested an urgent re-thinking of policy.response'

through
Stability ir-r tne io-"iil. financiai market was not obtained
volatile
be
to
continued
rate
exchange
the
and
the current policy stance
whilethestockmarketremaineddepressed.Continuedpursuanceofthe
policies would most likely have
fr"r"r,t course of monetary and fisial
situation
iu.rr"d a steeper decline in economic growth and destabilised the
be more
to
needed
policies
fiscal
and
monetaly
both
further. At this stage,
provide
to
economy
the
of
reflation
some
enable
is
to
expansionary. This
out'
carried
be
to
reforms
and
staUltity for consolidation
an
In an environment of extremely volatile exchange rates and with
to become
open capital account, the conduct of monetary pol1cy threatened

g',iato.t."a'Thecentralbankgrappledwitllthedilemmaoftwopossible
the exchange
Sptions: either maintaining hlgh interest rates to support
choking
further
proc,ess'
the
in
and,
siccess)
urr.rrld
.ut" 1b.rt without ur-ty
monetary
aggressively
or
recovery;
u.y prorp"cts of economic
.easing
a fiscal boost)'
conditions to boost aggregate demand' (complemented by

given the very

b.rt rur-t the very r"ut tlt"k oT seeing the exchange rate plunge'
that
time'
at
prevailing
negative external sentiments
" Choosirlg either option could prove to be disastrous as each was
Had
fraught witilextreme .isks that couid lead to adverse consequences.
have
likely
would
economy
the
option,
firsl
the
picked

ihe luthorities
closures cause
contracted further and faster as debts rise and company
individuals
and
firms
more
been
have
would
There
further unemployment.
deteriorate
to
system
banking
the
causing
thus
Jefaultir-tg orrbank loans,
banks
with
and
recession
into
deeper
further. An economy sinking
its
stabilising
of
task
a
daunting
woulJhavelaced
,.r""1"g into difficulties
would
premium
risk
the
as
rates)
interest
higher
e"chun[e rate (even with
attract
rise treinendously. Also, raising interest rates aggressively would
mostlyshort-termcapital,theverytypeoffundsthatarenotsoughtafter
at that stage due to its volatile nature'
meant more
Choos"ing the second policy option would probably have

of further
capital outflfw (due to lower interest rates and expectations
would
This
further.
falling
value
ringgit,s
the
..irr"'r.y depreciation) and
external
high
with
Companies
i"t-tllutiot-,.
have added to the cost of imported
will see their debt obligations rise further. Importers and
J"U,
"*por.rre
would have had to tolerate increasing exchange rate volatility.
through massive
"*port"i,
The stock market would have taken a further battering
This would put
well)'
as
ones
local
(probably
selling by foreign investors
in foreign
paying
Importers
ringgit'
ttre
on
even more downward pr",,t'i"
further
of
anticipation
in
positi,ons
their
currency would have hedged
in the
fall
to,the
further
contributing
J"pr".iutior-, of the ringgitjhereby
a
meant
have
would
path
this
along
to
proceed
domestic currency. Opting
foreign
needed
much
depleting
flight,
capital
strong possibility of u -ulot
in
."r"ti"r. A much *eakei "*thutlg" rate (and a very likely downgrade
hamper
it
would
as
costly
very
been
sovereign rating) would have
9ele"rely
for the fiscal
the gov?rnmeni;s ability to raise any- external funds needed
sector'
financial
the
in
stim"ulus and implement reforms
Analysingtheoptionswiththeirriskfactorsintheabovepolicy-setting
the link
environment, it was obvious that policymakers must first break

any measures
between domestic interest rates and the exchange rate before
from
economy
the
stop
and
demand
can be taken to stimulate aggregate

Tne:;"4:--

caliec ':' : '.think of tr.

polic_r' respc r se

"

i\4aintaining
high interest
rates will choke
off economic

activities, but
easing off will see
the exchange rate
plunge.

t82

X4onetary Economrcs

Faced

with

the dilemma,
po

licyma kers

decided to break
the link between
interest rate and
exchange rate by

implementing
capital controls.
This enabled

the nursuit of
expa nsiona ry

monetary and
fiscal policies to
boost aggregate
d,emand.

going into a deeper recession.o This can be done through capital controls
ind pegging the ringgit exchange rate to a major international currencrsuch as the U.S. dollar. The Malaysian authorities decided on this option
on 1 Septemb er 1998, when the capital control measures wele announced
and enforced. The next day, the ringgit was pegged to the U.S. dollar at
3.80.@ This policy option was chosen so as to insulate the economy from
external situation and to regain some measure of
the continu"d udt
"ir"
monetary autonomy which will enable policymakers to better address
problemi in the economy and facilitate its recovery. Of particular concern
io policymakers was the disruptive nature of short-term speculative capital
flows on financial markets and economic activity. The capital control
measures did not disrupt trade and FDI flows, and the current account
remained fuliy convertible. The September measures enabled the pursuit
of an expansionary monetary policy and a complementary fiscal stimulus
to boost aggregate demand.

The capital
control measures

did not affect

foreign direct
i nvestment.

7;

It is important to note that the capital control measures affected onhshort-term iapital flows. Transactions for trade in goods and services were
not affected; neither were capital movements pertaining to foreign direct
investment (FDI). Foreign long-term investors were free to repatriate profits,
interest and dividenaJ. fne government had also reiterated on several
occasions that the measules wele temporary and would be removed when
its objectives were achieved. indicating that the measures introduced har-e
not dampened long-term foreign investors, net FDI inflows in the first four
months ottssg rose sharply to RM8 billion compared to RM9 billion for the
whole of 1998. In fact, the government actually liberalised foreign equitl'
investment guidelines in the manufacturing industry, telecommunications
and financial sectors to encourage further FDI it-tflo*t'o

Monetary PolicY Further Relaxed

As inflationary pressules showed signs of moderating, monetaly policl'
started to be eased in August 1998. The steep decline in loans growth had
to be arrested to resuscitate economic activities. Otherwise a credit crunch
situation will deepen and prolong the recession.
poinr was raised by Krugman (1998a) and discussed by Athukorala (1998b).
@ attho.rgll capital controls cun be enforced without fixing the exchange rate, in this
at 3'80 to
case, it was ob,riont that the increased certainty from pegging the ringgit
US$1 was needed judging from the continued Volatility in the currency markets.
Implementing the capital controls without pegging the exchange rate would not have
sewed the ultimate objective of providing the necessary stability. Also, given the
severe outflow of short-term capital and the very high off-shore interest rates offered
for ringgit deposits, the RM had to be made non-legal tender overseas. whatever
trading in cuirencies will then be done only domesticalty. If the authorities did
not fix the exchange rate against the U.S. dollar, the tendency for hoarding foreign

9 rni,

will be great.
100 percent ownership by foreigners was allowed for
applications received between 31 July 1998 and 31 December 2000. The share of
foreign equity investment in the telecommunications sector was raised to 49 percent
u .ur"-by-case basls, this can go up to 61 percent for a period of 5 years); in the

currency and
L-r

black market to develop

th" manufacturing sector,

1or-,

insurance industry, it was raised to 51 percent; and 49 percent in the stockbroking

sector.

The Use of Monetary Policy

t" t"'

':'
J

With the cover provided by the capital control measures, monetary policy
was further relaxed through lowering interest rates. This was achieved
through progressive reduction of the statutory reserve requirement (SRR)
and the intervention rate of the central bank in the domestic money market.
The easing of monetary policy complemented expansionary fiscal policy in
resuscitating the economy.

in Crisis Management

Nlonelar\ pcl (,
llas furtner t::.
through lor, er' '':
of interest
rates and other
ad min istratir e
measu res

Bank Negara reduced its intervention rate rapidly

i

.:

The central bank reduced its 3-month intervention rate three times in the
month of August 1998, from 11 percent to 9.5 percent. After the 1 September
capital control measures, the 3-month intervention rate was lowered more
aggressively by BNM. From eight percent in September 1998, it was reduced
to six percent in early ll/ay 7999.
The Statutory Reserve Requirement was also slashed from eight percent
to six percent on 1 September 1998 and further down to four percent on 16
September. The liquid asset requirement of the commercial banks was also
reduced by 200 basis points in early September.

BLR framework revised

The formula for computation of the base lending rate (BLR) was revised on
1 September 7998.Instead of being based on the 3-month Kuala Lumpur
interbank offer rate (KLIBOR), it was then based on the 3-month intervention
rate of Bank Negara Malaysia. This ensured a more speedy transmission of
changes in monetary policy via the interest rate tool to the lending rate of
banks. The flat administrative margin of 2.5 percent was also reduced by
25 basis points. The maximum margin over the quoted BLR was lowered
by 150 basis points, from four percent to 2.5 percent.

Loans growth target set for banking institutions

The central bank also enforced a loans growth target of eight percent to
be met by the banking institutions by year-end 1998. Subsequently, when
it became clear that in view of the sluggish loans growth in the first three
quarters of the year, the target cannot be met, BNM changed its stance to
that of encouraging banking institutions which have the capacity to meet
this target to do so. The iarget date for the eight percent loans growth was

then more realistically set at year-end 1999. This was also an industry
target and BNM reiterated that it did not intend to irnpose the target on
each and every single bank.

Relaxation of credit terms for purchasing property

The construction sector was perhaps the worst hit by the crisis. To boost
the sector, BNM relaxed the credit ceilings imposed earlier on the broad
property sector. With effect from 7 September 1998, lending for the
construction or purchase of residential properties costing up to RM25e000
were exempted from the 20 percent loan limit for the broad property sector.
From 5 october onwards, the 60 percent maximum margin of financing
was lifted for the purchase of non-owner occupied residential propertiei
costing RM150,000 and above, as well as the purchase of shophouses
costing RM300,000 and above which were not used for doing one,s own
business, and also for the purchase of land.

183

Monetary Economics

Relaxation of credit limits for the purchase of shares

boost the stock markef the credit limit on loans for buying shares and unit
trust funds was increased from 15 percent to 20 percent of total outstanding
loans for commercial banks and finance companies on 23 septemb er 1998.
The merchant banks'limit of 30 percent remained unchanged.
To

Easier financing for purchasing cars

The car industry was also badly affected by the economic downturn, with
sales of passenger cars plummeting by about 60-70 percent in the first
three quarters of 1998. To help sales pick up, the margin of financing for all
passenger cars was increased from 70 percent to 85 percent effective from 23
April 1998. This was further boosted by another measure on 28 July, when
the restriction on the maximum repayment period was removed. Then on
21 November, the margin of financing of 85 percent was abolished. Banks
could then fix the percentage of financing given to its customers based on

their own credit assessment.

b
1

tt

ir

rl
5

tr

i:

Assisting smaller industries and the lower-income groups

To assist the small and medium-scale industries which are more vulnerable

to the crisis, BNM cut the maximum lending rate under the Fund for small
and Medium Industries from ten percent to 8.5 percent. To alleviate the
burden of the lower income groups, the same was done for the Special
Scheme for Low and Medium Cost Houses, lowering the funding rate from
eight percent to six percent.

-I

Easier credit terms for credit card holders

To boost private consumption, the central bank reduced the minimum
monthly repayment on credit cards by a whole 10 percentage points, from
15 percent to five percent effective 20 November 1998. with effect from 30
December 1998, the maximum finance charge per month cannot exceed 1.5
percent (or 18% per annum).

Curbing finance on certain types of new property development

Due to the glut in certain segments of the property market, there was a
need to clear the backlog of properties. From 5 Janu ary 1999,bank financing
was not allowed in the development of new residential properties and
shophouses which cost more than RM250,000 each. Financing was also
curbed in the development of hotels, office buildings, resorts, clubs,
shopping complexes and golf courses.

Liquidity improved and interest rates declined

The benchmark 3-month interbank rate, which peaked at 11.3 percent in
May-]uly 1998, ended the year at an average of 6.48 percent in December. It
stood at around 3.2-3.3 percent inJuly 1999. One-week money and overnight
money/ which soared to a height of 35 percent and S0 percent inluly 1997
(when BNM unsuccessfully tried to defend the ringgit against speculative
attacks), declined to an average of 5.85 percent and 5.41 percent respectively
in December 7998. The 3-month intervention rate of BNM, at a peak of 11
percent for much of 7998, stood at 6.0 percent in June 1999. This lowered the

:q

e
1

The Use of Monetary Policy

in Crisis \{anagement

185
"d

base lending rate (BLR) of commercial banks to 8.04 percent

r: *.:
:lnnrrrrt
rp tltfl&u,

in December

1998, from a height of 72.27 percent in june. This lowering of interest rates
: -; ::--ncnic reco\rery would not have been possible had it not been
:,-: ine capital conttols and the fixrng of the ringgit exchange rate.

Financial Sector Restructuring

ll" ry ''

lri-',

;mlr

ilrumfl -,
d0rl[ ii'

hlgr
@

li'dtf

rF
ul'.ii?Tr

itfiT

mt 1"
mll'
!'

111 r-"

lLttrrt.ll -

r lill

ltilftr

rtilft
ti! i.t*

t I
i|( ,irl1
!ii."
ul

HI.T
!Ctr4'
':

rr n"
u*if,.

,!T

.l

Tne capital control measures and pegging of the exchange rate were done
:.!rt to merely bolster the economy by pursuing a high growth policy per
:r, Following this route would have been a mistake as there will come a
.ime when the authorities may need to lift the capital controls and float the
erchange rate again. If efforts to improve economic efficiency and reforms
,o clean up and strengthen the financial sector were not done promptly
and effectively, then the breathing space that the September 1998 measures
accorded Malaysia would have gone to waste. Hence, the government put
rn place a comprehensive programme to reform its banking sector and
accelerate progress in the implementation of these reforms.
Although the bankingsystem entered the crisis in what appeared to be
a strong position, with a low NPL ratio and adequately capitalised (above
the minimum required level), it was in a position of some vulnerability.

This was made more evident when the currency crisis dragged on and
the economy worsened. The lax monetary policy in the years before the
crisis had allowed high loans growth to continue unabated. It was not until
early 1997, months before the first speculative attack on the ringgit, that the
central bank acted to curb excessive credit expansion to certain vulnerable
sectors such as the broad property sector, loans for the purchase of stocks
and consumption credit. Thus, by 7997 the banking system had a high
loan exposure. Bank loans also constituted a large portion of the financing
requirement of the economy.
The increased cost of capital and higher cost of imports (particularly
imported input for the business sector) steadily took its toll on companies.
The deflationary impact exerted itself on the asset quality of the banking
system. By end-June 1998, the NPL ratio of the banking system had risen
to 8.9 percent of total loans. Banks became concerned with their balance
sheets and huge bad debts for some banking institutions had begun to
cause worries about their capital adequacy. Resulting from this, bank loans
growth began to slow down rapidly and even sound companies then ran
the risk of being unable to obtain much needed credit. These problems had
to be addressed quickly.
Together with an appropriate macroeconomic policy, a programme for
restructuring the financial system was absolutely crucial in the recovery
process. This was done through establishing an asset management
company (Pengurusan Danaharta Nasional Berhad), a special purpose
vehicle for recapitalising ailing banks (Danamodal Nasional Berhad), and
the Corporate Debt Restructuiing Committee (CDRC).@ A programme of
bank mergers was also announced, in order to create bigger and stronger
banking entities better able to face shocks. The functions of Danaharta,
Danamodal and the CDRC are briefly discussed as follows.
@

See Rasiah (2001).

A comprehensive

reform
programme for
the banking
sector was
needed.

An asset

management
company and a
special purpose
vehicle for
recapitalising

ailing banks were

set

p.

Monetary Economics

Danaharta
Pengurusan Danaharta Nasional Berhad (or Danaharta) was established on
20 June 1998; lts function being to purchase non-performing loans (NpLs)
from banking institutions so that they can be free to concentrate on their
lending activities in order to facilitate the economic recovery. Danaharta
also aimed to maximise the recovery value of these loans.
Danaharta was given statutory backing to perform its functions. In its
operations, it adopted a market-based approach and published details of

its acquisitions, including the amount of NPLs acquired from individual

financial institutions and the average discounts apphea.
In its acquisitions, Danaharta gave priority to the weaker financial
institutions. This included those seeking recapitalisation from Danamodal
Nasional Berhad (or Danamodal). It also managed loans of selected
financial instituti.ons on behalf of BNM or the government. This was done
to facilitate mergers between identified financial institutions by preserving
the strength of the acquiring institution. Danaharta did not purchase ai
the NPLs of the banking institutions but the remaining poition was at
manageable levels. However, banking institutions with a gross NpL ratio
exceeding ten percent had to sell all their eligible NpLs to Danaharta.
otherwise, the value of these loans would have to be written down and
restructured. Banks which required recapitalisation from Danamodal also
had to sell their eligible NPLs to Danaharta.
In acquiring NPLs from the banking institutions, Danaharta also
performed its other role of assisting in corporate sector restructuring. This
was because it had the power to impose conditions on borrowers, for eximple
in matters pertaining to restructuring of assets and improving cash flows.
It was also vested with the authority to appoint 'special administrators'
into viable companies facing temporary cash flow problems.
It has to be stressed that Danaharta purchased NpLs at fair market
value, which often meant that banking institutions selling their eligible
NPLs incurred losses. As payment for NPLs acquired from the financial
institutions, Danaharta paid cash and/or issues zero-coupon tradable
bonds which were government-guaranteed. These bonds carried yields
approximating those of Malaysian government securities (MGS) with
similar tenures. By end of ]une 1999, Danaharta had acquired a total of
RM28 billion of NPLs, which amounted to 32 percent of the total in the
banking system.
Danaharta completed its work and ceased operations on 31 December
2005. It had successfully achieved its objective of taking care of the NpL
problems of banking institutions resulting from the crisis. It resolved all
the NPLs acquired and recovered RM30.4 billion, at a recovery rate of 5g
percent.

Danamodal
Danamodal Nasionat Berhad (or Danamodal) was incorporated as a
wholly-owned subsidiary of Bank Negara Malaysia on 10 August 199g.
Its function was to recapitalise banking institutions with the objective of
ensuring that they were adequately capitalised at all times. This would
ensure that banking institutions were more resilient to shocks.
Danamodal had the twin objectives of recapitalising and strengthening
the banking sector, and consolidating the banking syri"-. It achieved the

The Use of Monetary Policy

in Crisis ).Ianager:ent

first by serving as an interim funding vehicle for banking institutions

adequacy requirements, based on market-driven
principles. To meet the second objective, Danamodal facilitated the
restructuring of banking institutions through its role as a strategic
shareholder in recapitalised banking institutions, and acted as a catalyst

to meet their capital

in merger exercises.
Danamodal carried out its operations based on certain guidelines.
These included minimising the use of public funds and siaring the
burden equitably among the stakeholders. In injecting capital into baiking
institutions, Danamodal followed strictly the principle of first{oss,
where existing shareholders were required to beir all losses before the
recapitalisation by Danamodal. It will also only inject capital into banking
institutions which have sold their NpLs to Danaharta where the existin[
shareholders bore the losses from the sale. Danamodal only recapitaliseJ
banking institutions that were viable, based on the assessment ind due
diligence exercise done by financial advisors of international repute. It
also set comprehensive performance targets and monitored progress of
these banking institutions. As in the case of Danaharta, Danamodal also
regularly published its own financial statements which were consistent
with international accounting standards.
Danamodal made steady progress and compreted its operations on 31
December 2003. It had injected RM7.6 billion into ten banking institutions
affected by the crisis. At the time when it ceased operationsl Danamodal
had recovered RM6.6 billion of its capital investment, with the remaining
RM1 billion expected to be fully divested within the following year.

Corporate Debt Restructuring Committee

The Corporate Debt Restructuring Committee (CDRC) was set up in
July
1998. Its function was to provide a platform for borrowers and ireditors

to collectively work out an amicable solution to debt problems, without

resorting to legal proceedings. The solution must be to the mutual interest

of both parties. The final objective was to ensure that viable businesses
facing problems resulting from the currency crisis and the subsequent
economic downturn will continue to have access to financing.
The cDRC had a two-fold objective: to minimise lossei to creditors,
shareholders and other stakeholders through voluntary co-ordinated
workouts, and to preserve viable businesses. These
-et" u.hi"rred through
introducing and implementing a comprehensive framework for de-bt
restructuring. To perform the role of monitoring progress of the various
debt work-out exercises done through the CDRC, a iteering committee
comprising experts in banking, accounting and law was formed. It consisted
of representatives from BNM, the Finance Ministry and the private sector.
To represent the creditors and act on their behalf, a creditors' committee
was formed. It represented the interests of at least 25 percent of the total
debts of all creditors. A lead institution was appointed to manage and coordinate the debt restructuring process. The committee will issess the
viability of the debtor and come into agreement with it. It also decided on
the terms for the debtor to continue receiving financial support. once the
debtor's business was deemed as viable, the committ"" t-t"gbiiut"d with the
debtor to arrive at some agreed options. should the restructuring process
not obtain a consensus among ihe banking institutions, then Dinaharta

{:"
*

The CDRC allowed

borrowers and
creditors to work
out solutions
to their debr
problems without

litigation.

lg7

I8B

Monetary Economics

by purchasing those NPLs from the dissenting banks. This

facilitated the restructuring process.
By 31 May 7999, the CDRC had received 60 applications involving
corporate debts amounting to RM32.5 billion. The cDRC completed
its work and ceased operations on 15 August 2002.@ It had successfully
restructured the total of 48 cases referred to the committee.
assi-sted

Expansionary Fiscal Policy

Expa nsiona ry

fiscal policy
was used to
resuscitate the
economy.

.*

By the middle of 7998, it became increasingly clear that fiscar policy needed
to be more expansionary to compensate for the slack in private sector

demand. In |uly, the government responded with an additional fiscar

stimulus package worth RM7 billion. It was to be used for projects with
the following criteria: strong linkages within the domestic economy; 1ow
import content in its inputs; and shorter gestation periods. In addition,
the expenditures will also be used for meeting socio-economic objectives.
Hence, projects related to education, health, and rural and infrastructure
development were given priority. An infrastructure fund worth RMS billion
as an initial allocation was also established. This was to provide assistance
to financing infrastructure projects and large public facilities so as not
to delay their implementation. In the second half of 199g, forlowing the
change in fiscal policy to one of counter-cyclical, government expenditure
rose by a whopping 56.6 percent.
The new fiscal position was initially estimated to register a deficit
of 3.7 percent of GNP. (The actual figure turned out to be -7.9% of GNp
or RMS billion.) This reversed five consecutive years of fiscal surpluses.
Although Federal government revenue fell by 13.7 percent to RM56.7
billion, the current account position was maintained in surplus due to
the fiscal austerity measures implemented. Reflecting the fisial stimulus
package announced in mid-1998, the gross developrirent expenditure of
the Federal government increased by 74.9 percent to RM18.1 billion. Less
repayments, net borrowing amounted to RM12.g billion, of which g5.g
percent was from domestic sources and the remaining 14.1 percent from
foreign borrowing. This was the first increase in net borrowing, after six
consecutive years of net repayment of loans. At the end of 199g, the stock
of total debt outstanding of the government increase d by 747 percent to
RM103.1 billion or 39 percent of GNP (1997: RMB9.9 billion or 34"k of GNp).
Of this amount, 14.5 percent was external debt.

THE RECOVERY PROCESS,

PROSPECTS AND LESSONS
The task for policymakers following the capital control measures in

199g

was to encourage consumer spending and the banks to provide more loans.
Flowever, the authorities needed to be careful that it should not be overdone
@

Bank Negarn Malnysia Annunl Report (2002), p.8.

The Use of Monetary Pohcy

in Clisis l,i.:-- a ..:r:=:r

,8s T
_f,l

at the expense of prudence. Data at that time showed that loan approvals
by the banks picked up considerably. With interest rates at such low levels,
it was only a matter of time before demand picked up again especially
in view of the public sector spending providing the stimulus. The more
stable economic environment and improving job prospects saw consumer
confidence returning and spending rose accordingly. Growth prospects
in the economy for 1999 largely depended on the domestic sector rather
than the export market, with the public sector playing the leading role.
Downside risks at that time included a larger than anticipated slowdown
in some industrial countties, in particular the U.S., and a slower recovery
in East Asia, including ]apan, affecting external demand. The slow rate of
implementation of the fiscal stimulus package was another concern. Lastly,
the prirrate sector was likely to have been experiencing excess capacity and
still burdened by debts, constraining their ability to expand. Banks, on the
other hand, were still over-cautious in their lending. In spite of all these
challenges, the policy responses worked well as real GDP growth in 7999
quickly recovered to 6.1 percent and further to 8.9 percent in 2000. Inflation
was at 2.7 percent and 1.5 percent for the respective years.
The further easing of monetary policy following the capitai control
measures saw liquidity conditions improving and credit cost lowered.
Both the MIER surveys on consumer sentiments and business conditions

r
1".

showed significant improved outlook from the fourth quarter of 1998

onwards. Other private consumption indicators such as sales and
production of passenger cars, sales tax and import of consumption goods
showed a general improvement in the first quarter of 1999. Retrenchment
numbers had generally declined while job vacancies increased since late
1998. Industrial production increased to 5.3 percent growth (year-onyear) in May 7999 compared to a contraction of 8.9 percent in |anuary.
Manufacturing output went up by 8.5 percent in May, a sharp turnaround
from the 15.7 percent decline in January. The trade balance registered a
surplus of RM2B.2 billion in the first five months of 1999, up from RM16.3
billion in the corresponding period a year ago.
Inflationary pressures moderated significantly. The rate of change in
the consumer price index (CPI) declined from 5.3 percent (year-on-year)
in ]anuary 7999 to 2.9 percent in May, raising the prospect of an overall
inflation rate of about 2.5 percent for the whole year. This was significantly
lower than the implicit 4.0 percent forecast by the central bank. The
producer price index (PPI), meanwhile, showed a declining rate of growth
from February onwards. From a growth rate of 1.2 percent (year-on-year)
in ]anuary, it dipped to a decline of five percent in May. Indicating the
significantly lower risk of inflation in the domestic economy, the domestic
component of the PPI declined faster than the import component of the

Busi n ess

confid ence

and consumer
sentiments
improved
markedly as
the economy
stabi I ises.

index.

ll'r "'

tl''lt:

Following the capital control measures of September 1998, the net

international reserves of the country went up from US$20.2 billion in
August 1998 to US$31.1 billion in June 1999. Unlike the situation before the
capital control measures, short-term capital flows stabilised in the fourth
quarter of 1998 resulting from the implementation of the one-year holding
period for portfolio investment in the country effective from 1 September
1998. Thus, the foreign reserve position better reflected the surplus in the
current account balance. In spite of the capital controls, from 15 Februarv

Reserves went

up as capital
outf lows were
stem med.

190

Monetary Economics

to

16 July 1999, the net portfolio cumulative inflow was RM4.7 billion. The
KLSE Composite Index had also surged from542.2points in February 1999

--''''----''
Confidence in

-*3

the international
financial markets
improved as
lVa

significantly upwards. As a measure of foreign investor confidence in

laysia's

sovereign rating
goes up.

The issue of moral

to 851.7 points on 9 July.

However, there were areas of concern. For example, there was a need
to speedily implement projects that were approved under the Budget for
1999.The rate of progress in bank mergers was also slow. Recognising the
need to speed things up, the governor of BNM announced on 30 July 1999 a
merger programme that will change the banking industry quite radically.
The central bank initiated a speeded-up merger programme to create just
six mega core banking groups and a memorandum of understanding was
signed by all banking institutions by the end of September 7999.@
The measures introduced since the capital control measures had brought
back a good measure of confidence among foreign investors and market
analysts. Since then, Malaysia's credit rating improved and stockbroking
analysts started revising economic growth forecasts of Malaysia in 1999

hazard has to be
looked at from
the viewpoints of
both borrowers
and lenders.

Malaysia's progress in handling the crisis, the issuance in late May 7999
of US$1 billion worth of bonds by the government was oversubscribed by
three times.
The Asian currency crisis episode resulted in several lessons to be
learnt by the various parties involved. One of these is on the question of
moral hazard. This should be looked at not just from the angle of the crisishit countries, where government guarantees, either explicit or implicit,
may have contributed to reckless corporate and banking sector behaviour.

Questions of moral hazatd and bailouts should be looked at from both

sides of the coin. The adjustment programmes suggested by institutions
such as the IMF should not be geared towards raising money in the
affected economies to repay foreign banks which extended large sums of
money to these countries out of their own free will. This should never be
made the priority and raises the issue of moral hazard as foreign banks
see this as an implicit guarantee.@ Stiglit, (1998) observed that'in spite of
repeated resolutions that lenders should bear more of the cost of their risky
decisions, the moral hazard problem in the 1990s is, if anything, larger, not
smaller than it was in the 1980s'.
Another clear lesson to emerge from the Asian currency crisis is that
the much lauded model of state-private sector collaboration in economic
development can result in undesirable outcomes if the necessary checks
and balances were not in place. In the context of the East Asian crisis,
reforms should aim to achieve a clear division between government and
business and to foster a vibrant entrepreneurial class through promoting
greater competition (and not by means of protection). As noted by ]omo
(1998), Malaysia is now forced by the forces of economic liberalisation to
interface competitively with the rest of the world economy'. There is much
to be gained from economic liberalisation, notwithstanding the fact that
the currency crisis has demonstrated the urgent need for some form of

(co-ordinated international) intervention

6

Source: The Star, 31. Jwly 1999.

Bhagwati (1998) spoke of what

in

some situations. However,

he termed as the 'Wall Street-Treasury complex',

being'unable to look much beyond the interest of Wall Street, which it equates with
the good of the world'.

The Use of Monetary Policy

the needed intervention is more along the lines of ensuring that

!i

'"n

1'l

"

"i

1l-"
fr :

:'"
,f.

:'
ta
'i-

in Crisis llanageneit

markets

function in a more orderly, regulated and transparent manner, and

where private costs are brought more in line with social costs to reduce
unwarranted or excessive risk-taking by market players (lured by high
profit margins). Globalisation and economic liberalisation may well be
an unstoppable tide. Together with its benefits, there will be risks which
countries will have to learn to deal with both individually and collectively
as members of the international community. The future of Malaysia as an
opery export-driven economy rests in its capability to reap the opportunities
::.:: the process of globalisation present, through harnessing the right
policy-mix' that balances domestic objectives with choices that will bring
about greater openness and encourage keener competition, enabling it to
eventually become a truly global competitor in international markets.
There are also lessons to be learnt regarding managing the international
monetary system. The events in financial markets during the period of
mid-7997 up to 1998 had clearly shown, especially in the case of Malaysia,
that domestic vulnerabilities by themselves were not able to fully explain
the extent and speed by which its currency depreciated. There were
defects in the international monetary system especially with regards to its
inability to adequately monitor and control short-term capital flows which
can have very destabilising effects on financial markets, causing great
damage to economies.@ Once the trigger was activated, widespread panic,
and then the herd behaviour so inherent in financial markets at a time
of crisis and uncertainty, took over and caused self-fulfilling prophecies.
There has to be internationally coordinated efforts to design and
implement a more appropriate and adequate framework to ensure more

orderly global financial markets.@ Some pressing issues include a proper

surveillance mechanism for short-term capital flows, an internationally
accepted standard and framework for prudential supervision of banking
institutions, and the proper sequencing of capital account liberalisation.
A convincing case can also be made in arguing for a more transparent
manner in which international rating agencies evaluate country risks and
determine the appropriate rating, given the far reaching consequences that
these assignea ratin[s have on therespective economies'@
The capital controls were gradually loosened through time and the
ringgit peg to the U.S. dollar was kept in place until 21 July 2005, when
BNM allowed the currency to float. It was a policy move that appeared to
coincide with the move by the Chinese authorities to decouple the yuan
from its long-time link to the greenback. BNM said the motivation for the

r'11

i-.

@ Stiglit, (1998) and Rasiah (1998) had argued over the debilitating consequences of a
massive expansion in portfolio equity capital in global capital flows, especially on
small ooen economies.
@ A, ur-r IMF eco.romic forum in October 1998 (see International Monetary Fund 1998),
Ricardo Hausmann, chief economist of the Inter-American Development Bank, said
that'this whole issue of international financial architecture is very deep and serious,
and ... if we do not act ..promptly and aggressively, we may be creating very serious
oroblems on a elobal basis'.
@ bornbrrr.h
1ro"98; said of the rating agencies: 'Their anaiysis of risk is absurdly
outdated, their competition to provide upbeat ratings to drum up demand for
business is very questionable.'

..

There shou d be
a clear dil'rsion

between the
government and
the business
sector; greater
open ness

and keener

competition can
instil discipline.

"il,

Better
surveillance,
a suitable
i

nternati

na

standard for
pru
su

d entia I
pervisio n

and proper
sequencing of
capital account
liberalisation
will enhance the
i

nternati

na

monetary system

191

Monetary Economics

change in policy was 'to better position Malaysia to respond and benefit
from the structural changes occurring in the region and in the international
environment' (Bank Negara Malaysia, 2005). The central bank had termed
the new exchange rate regime following the de-pegging against the US
dollar as 'a managed float against a basket of currencies'.@ Since then, the
ringgit had been on a general appreciating trend against the U.S. dollar and
a basket of currencies.@ The ringgit exchange rate against the U.S. dollar
was at an average of 3.76 in December 2011 (an appreciation of about 20'h

from 3.80).o

suMMARy

'It is perhaps worth noting that Malaysia's intervention to stem the outflow
of capital does not seem to have produced the dire consequences that its
ardent critics seem to have predicted, and perhaps wished for.'
- ]oseph Stiglltz, World Bank Chief Economist@
The Malaysian economy went through its steepest recession in 7998,
when real GDP slumpedby 6.7 percent.@ The government embarked on a
programme of monetary easing and fiscal spending to boost the economy.
This was helped by the imposition of selective capital control measures
in September and fixing the ringgit's exchange rate to the U.S. dollar,
which enabled the central bank to regain monetary autonomy. Despite
early scepticism the policy brought the much needed stability. Financial
restructuring was also undertaken by the authorities to clean up banking
institutions' balance sheets and recapitalise ailing banks to enable them
to resume their role as financial intermediaries. A programme of banking
institution mergers was also initiated by the authorities.
As indicated by the MIER surveys, consumer and business sector
sentiments picked up in early 1999 and further improved in the second
quarter of the year. This was supported by macroeconomic indicators
showing industrial production on the uptrend again not long after. On
the trade side, imports rose after a prolonged slump, reflecting the pickup in demand in the economy. The current account balance remained in
surplus in 7999, at 15.9 percent of GDP. This helped in providing liquidity
to the economy as well as enabling the authorities to maintain the capital
control measures. Inflationary pressures were well contained, giving the
central bank more room to continue pursuing an easy monetary policy.
The selective capital control measures by Malaysia were further relaxed as
economic recovery gained pace and signs of sustainable stability took root
in international f inancial markets.

@ BankNegara Malaysia Annunl Report 2005,p.74.

@ As measured by the e{fective exchange rate index computed

o
.D

by the IMF (source: IFS

database).
Source: IFS database by the IMF.

1999, as
]oseph stiglitz, the world Bank Chief Economist, said in Bangkok on 29 July
1999).
30
Times,
(Source:
Business
The
Reuters
by
luly
reported
@ R"nisea dutu tut"t put the recession at -7.4 percent.