Monetary and Fiscal Developments2

Monetary Developments

The progressive t ightening of monetarypolicy during the course of 1997, complementedby selective prudential measures resultedin a moderation in the growth rates of allmonetary aggregates by end-1997. Monetarydevelopments, however, showed distincttrends in the early and latter parts of the year.In the first half-year, monetary aggregatesmoderated only slightly, in response to measuresto address asset inflation. In the second half of1997, monetary developments were influencedsignificantly by the policy responses on both themonetary and fiscal fronts to restoremacroeconomic stability following turbulence in thefinancial markets in East Asia. The morepronounced tightening of monetary policy duringthis period was also to respond to risinginflationary pressures following the depreciation ofthe ringgit since July 1997. Liquidity conditionstightened considerably towards year-end asuncertainty and public concerns over the bankingsystem resulted in distortions to the intermediationprocess and the smooth operation of the moneymarket. These developments resulted in the rapidincrease in effective lending rates. Severalmeasures, including the reduction in the statutoryreserve requirement (SRR) by 3.5% in 1998,alleviated this trend.

The strong growth in money supply in thefirst half of 1997 reflected the high creditgrowth which became the main focus of monetarypolicy in early 1997. As the credit growthemanated mainly from loans for the purchase ofproperties and shares, pre-emptive measures wereimplemented with effect from 1 April 1997 tofacilitate adjustments of the exposure of the bankingsystem to these sectors to more prudent limits.Subsequently, the annual growth rates of all monetaryaggregates – M1, M2 and M3 – moderated butremained high, averaging 13.5%, 19% and 19.9%respectively during the first half of the year comparedwith the average of 15.1%, 23.2% and 23.8%respectively in 1996. The relatively slow responseof loan growth to these measures reflected thecontinued drawdown of earlier loan commitments ofthe banking system.

The need for a more rapid moderation of monetaryand credit growth became more urgent asexpectations of inflationary pressures increasedfollowing the intensification of the currency crisis inEast Asia. The high credit growth was also seenas a potential risk that could have adverseimplications on financial stability. Monetary policywas, therefore, tightened further during the latterpart of the year, through the firming of interest ratesand adoption of further prudential measures. Thesewere complemented by the requirements on bankinginstitutions to draw up credit plans which wereannounced in October. Banking institutions wererequired to observe the limits as contained in theirestimates for credit growth for the remaining partof 1997 and for 1998. As a result of these

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Graph 2.1Money Supply

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measures, the annual growth of M1 and M3 sloweddown substantially during the second half-year andended the year significantly lower, at 4.6% and18.5% respectively compared with 16.7% and 21.2%respectively at end-1996. Meanwhile, M2 remainedhigh at 22.7% (19.8% at end-1996), reflecting theshift in deposits from finance companies tocommercial banks. In absolute terms, M3 increasedby RM61 billion during the year (RM57.8 billionduring the previous year). The slower annual growthof M3 reflected mainly the moderation in demandfor transaction balances, while growth in broad quasi-money was sustained during the year. There wasalso a notable shift in the preference of the privatesector from transaction balances to interest-bearingdeposits. Transaction balances accounted for only4% of the increase in M3 (15% in 1996), followingthe higher interest rates and weak sentiments onthe stock market.

Demand for transaction balances (currencyholdings and demand deposits of the private sector)moderated significantly in 1997 to increase by onlyRM2.4 billion (RM7.7 billion in 1996). Except inJanuary and December when there occurred strongexpansion to meet cash requirements for the festiveseason, demand for transaction balances displayeda declining trend during the rest of the year. Thelargest decline was recorded in April, mainly as aresult of the bearish sentiments in the Kuala LumpurStock Exchange (KLSE). The downward trendcontinued in the second half-year in response to thepoor performance of the KLSE and the slowdownin economic activities, particularly in the lastquarter of the year. At the same time, theprivate sector also optimised holdings of transactionbalances as the opportunity cost of holding non-interest-bearing deposits became greater with theincreases in interest rates.

As interest rates firmed significantly during theyear, broad quasi-money (private sector holdings offixed and savings deposits, negotiable instrumentsof deposit (NIDs) and repurchase agreements (repos)with the banking system (excluding interbanktransactions)), expanded by RM58.6 billion or 21.8%(RM50 billion or 22.9% in 1996). The higher nominalinterest rates amidst lower inflation rates meanthigher real rates of return, thereby creating anincentive for the private sector to increase its holdingsof interest-bearing deposits. However, the increasein quasi-money was dampened, to some extent, bythe negative wealth effect arising from the markeddecline in share prices, the consequent outflows of

portfolio capital and the overall moderation in growthof disposable incomes.

In terms of instruments, fixed deposits remainedthe largest component of broad quasi-money. Anotable increase was also recorded in NIDs. Thetight liquidity situation, particularly in the final quarterof the year, made borrowing in the interbank marketrelatively more expensive. The banking institutions,therefore, focused on sourcing funds throughtraditional instruments such as longer maturity fixeddeposits and NIDs, in order to lock in funds forlonger tenures and at lower cost. In an environmentof tight liquidity, competition for funds among bankinginstitutions intensified. Consequently, fixed depositsand NIDs rates were raised significantly, especiallyin the second half of 1997. Apart from thesignificantly higher returns from these instruments,the expansion in both instruments also reflected theshift in preference among the institutional and retailinvestors of the KLSE to less risky portfolios. Duringthis period, savings rates were left virtuallyunchanged. The consequent higher differentialbetween savings and fixed deposit rates causedsavings deposits to decline significantly in 1997. Theinterest differentials between savings and 1-monthfixed deposits of the commercial banks and financecompanies widened to 4.6% and 4.8% respectivelyat the end of 1997 (3.1% and 2.3% respectivelyat end-1996).

In terms of determinants, claims on the privatesector continued to be the main impetus to monetaryexpansion, contributing about 27.3% of M3 growth.As demand for credit remained strong throughoutthe year, claims on the private sector increased byRM90 billion or 25.2% (RM72.4 billion or 25.4% in1996). Of the total increase, 89.7% was in theform of direct loans from the banking system,reflecting corporations’ continued reliance on bankcredit as a source of financing. Although theincrease of RM88.3 billion in total loans andadvances extended by the banking system wasbroad based, the bulk of the credit continued to bechannelled to the broad property sector, forconsumption purposes, for the purchase of securitiesand to the finance, insurance and business servicessector. At the same time, a significant amount ofloans was also channelled to the productive sectors,namely, the manufacturing sector, for generalcommerce, and transport and storage. While thepre-emptive prudential measures directed atcontaining credit for financing property and sharetransactions that were in effect from April did contain

further escalation in asset prices, it was noted thatlending to the asset markets only slowed downmoderately. Further measures were, therefore,required to slow down overall credit growth. Theregional crisis since the middle of the year, whichsaw increased volatility in the stock and foreignexchange markets, increased the potential risksassociated with lending to the asset markets. Amore rapid slowdown in credit growth was alsowarranted at a time when inflationary pressuresemanating from the weakening of the ringgit becamemore prevalent. Hence, prudential measures werefurther tightened with the implementation of voluntarycredit plans in October, in order to reduce overallloan growth to a level that would be more consistentwith the expansion in the real sector. As a resultof the restraint exercised by banking institutions, theannual growth of total loans extended by the bankingsystem moderated to 26.5% at the end of 1997from a peak of 30.5% at the end of March. Theslowdown in loan growth was particularly pronouncedin November and December creating fears of acredit crunch. Banking institutions were, therefore,encouraged to allocate the limited resources tolending for productive purposes, and to accord priorityto the manufacturing and services sectors, particularlyto export-oriented industries. While credit growthmoderated, it remained high exceeding the creditplan target of 25%. Loan approvals, however,decelerated towards the final quarter of 1997,auguring well for a further moderation of loan growthin 1998. During this period, the Government sectorhad a small expansionary impact on money supplyof RM451 million.

The expansionary influences of claims on theprivate sector and Government operations on moneysupply were partially offset by the contractionaryinfluences of other determinants. External operationsexerted a marked contractionary impact due to thesignificant decline in the country’s net foreign assetsof RM17.2 billion (RM1.5 billion in 1996). However,the impact of the fall in BNM's net external reservesof RM10.9 billion (RM6.2 billion in 1996) wasmoderated by an increase of RM6.3 billion in thenet external liabilities of the banking system. Thelatter increased largely as a result of higher foreigninterbank borrowings by the banking system.However, a significant amount of the borrowing wasfully hedged by forward purchases of foreigncurrencies from domestic exporters and swapoperations. The higher domestic interest rate vis-a-vis rates for the major foreign currencies createdan incentive for some banks to source offshoreringgit funds through swaps with offshore banks.

The large contractionary impact of RM12.2 billion,recorded in other influences, reflected mainly thehigher paid-up capital and undistributed profits ofthe banking system.

The further tightening of monetary policy in 1997reinforced the upward trend in interest rates thatbegan in 1995. In the first four months of 1997,interbank rates remained firm as the tight stanceof monetary policy was maintained to containinflationary pressures arising from the strong creditgrowth. This was supported by several prudentialmeasures introduced to contain credit growth tofinance purchases of assets. Consequently, the3-month interbank rate was traded in the range of7.22–7.55% during the period. However, therelatively stable trend was disrupted by a sharpspike in interest rates in May and again in July,following speculative pressures on the ringgit as aresult of the contagion effects of developments inthe region. As liquidity contracted in an environmentof increased volatility in the financial markets, theovernight and 3-month interbank rates rose sharplyto peak at 18.75% and 8.62% respectively in mid-May. As the pressure on the ringgit subsided andliquidity improved, interbank rates subsequently drifteddownwards with the 3-month interbank rate recording7.51% at the end of May and remaining relativelyunchanged in June. However, a second round ofspeculative activity on the ringgit occurred in Julythat caused an even sharper increase in interbankrates. On 10 July, the overnight and 3-month ratesrose to 40% and 8.6% respectively from 7.5% and7.9% the day before. On both occasions, there weretemporary inversions in the term structure of interbankrates whereby the shorter term rates increasedsignificantly to exceed the longer term rates. Incontrast, the relative stability of longer term ratesthroughout the period reflected expectations that thetightness in the money market would be temporary.To maintain stability in the domestic money marketand to insulate domestic interest rates from externaldevelopments, BNM introduced limits on non-commercial-related ringgit offer-side swap transactionswith foreign customers on 4 August. Following this,interbank rates eased further and by mid-August,the 3-month interbank rate returned close to thelevels prevailing prior to the emergence of excessivevolatility in the currency market.

Interbank rates, however, were adjusted upwardsprogressively from mid-September until the end ofthe year as monetary policy was tightened furtherto pre-empt inflationary pressures arising from the

ringgit depreciation and to maintain positive realrates of return on savings. The firming of interestrates was also due to tighter liquidity conditions inthe banking system. The resource gap that emergedfrom the slower growth of deposits relative to strongdemand for credit by the private sector, wasreinforced by the net issue of Malaysian GovernmentSecurities amounting to RM2 billion in November.Hence, the loan-deposit ratio of the banking systemincreased from 92.7% in August to 95.8% in

November. Liquidity conditions, therefore, tightenedin the last quarter. Smaller financial institutionsfaced higher borrowing cost due to a more selectivelending practice in a market that had becomesegmented. As a result of the overall tighter liquidityand higher rates faced by smaller institutions, the3-month interbank rate increased from 7.55% inmid-September to 8.3% at end-October, 8.5% atend-November, and eventually to 8.7% at end-December, the highest level recorded since 1986.

A notable development towards year-end werethe distortions that emerged in the intermediationprocess, which affected the smooth functioning ofthe money market, following the increased uncertaintyand tight liquidity conditions. As a result, smallerfinancial institutions faced considerable difficulty inobtaining interbank funds due to growingsegmentation in the money market and the shift ofdeposits to the larger financial institutions.Subsequently, interest rates in the interbank marketwere generally higher. Arising from thesedevelopments, the term structure of interbank andlending rates was no longer reflective of marketconditions. The shorter-end interbank rates reflectedthe exceptionally tight liquidity situation of a smallnumber of banking institutions. The 1-week raterose significantly from 6.66% in mid-September to7.34% at end-October, 7.41% at end-November andto 14.94% at end-December. These developmentsresulted in a rapid increase in lending rates forloans priced on a cost-plus basis. To addressthese distortions, a package of monetary measureswas introduced in February 1998, including thereduction of the SRR.

As domestic interbank rates rose progressively inMalaysia, the 3-month interbank interest ratedifferential with the United States widened by 103basis points to 2.86 percentage points. In contrast,the interest differential with Singapore narrowedsignificantly by 181 basis points to 2.45 percentagepoints as the interbank rate in Singapore increasedsharply during this period. Although the differentialwith the United States widened, it was significantlyless than the average differential of 4.1 percentagepoints during the surge of capital inflows in 1992–93. Nevertheless, there was an inflow of funds in1997, as reflected in the higher net external liabilitiesof the banking system. These inflows, however, didnot have a destabilising impact on the bankingsystem and the economy as a whole since asignificant amount of the funds was for tradefinancing and was fully hedged.

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Graph 2.2Interest Rates

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Pre-emptive Prudential Measures inApril 1997

With effect from 1 April 1997, Bank NegaraMalaysia (BNM) implemented prudential measuresto complement the overall policy of continuedmonetary restraint. Specifically, the objectives ofthe measures were to ensure that any downwardtrend in asset prices would not threaten thestrength and stability of the financial institutions,and that available resources were channelled forproductive activities. In addition, the measureswere introduced following concerns over thestrong increase in lending by financial institutionsto less productive sectors. Lending to thebroad property sector (comprising real estate,construction and housing) increased sharply by29.9% in 1996. At the same time, loansgranted for the purchase of stocks andshares and units of unit trust funds, including toholding and investment companies, rose stronglyby 30.5%.

• Credit facilities granted for the purchaseof stocks and shares and units of unittrust funds: With effect from 1 April 1997,ceilings of 15% of total outstanding loansfor commercial banks and finance companies,and 30% for merchant banks were set forcredit facilities secured by stocks and shares.These limits were defined to cover creditfacilities granted for the purchase of stocksand shares and units of unit trust funds,including loans to holding and investmentcompanies. Loans extended for the purchaseof Amanah Saham Nasional, AmanahSaham Bumiputera, Amanah Wawasan 2020and units of unit trust funds established bythe state governments were exempted fromthe limits.

• Credit facilities extended to financing ofspecified types of property: Bankinginstitutions were also required to observe alimit on credit facilities extended to theproperty sector (excluding houses andapartments costing RM150,000 and below,infrastructure projects and industrial buildings

Monetary Measures in 1997

and factories) of 20% of their totaloutstanding loans. The term “credit facilities”was defined to include all forms of lending,including the issue of guarantees, privatedebt securities and commercial papers.

Limit on Non-commercial Related SwapTransactions

Banks were required with effect from 4 August1997, to observe a limit of US$2 million onoutstanding non-commercial related ringgit offer-side swap transactions with each foreign customeron a group basis. Banks that exceeded the limitwere not allowed to transact in any further non-commercial related ringgit offer-side swaps withsuch foreign customers until the outstandingamount had been reduced to below the limit.Hedging requirements of foreigners for traderelated and genuine portfolio and directinvestments in Malaysia were not affected by thismeasure. The purpose of introducing thismeasure was to maintain stability in the domesticmoney market and to allow domestic interestrates to be more reflective of domestic conditions,and hence, promote an environment that wasstable and more predictable for genuineinvestments.

Credit Plan

In the light of prevailing developments in thefinancial markets, the need to slow down theoverall credit growth became more urgent andimportant, especially in reducing the leverage ofthe economy and curbing inflationary pressures.In this regard, in October 1997, bankinginstitutions were requested to submit their creditplans for the remaining quarter of 1997 and forthe year 1998. The credit plans were drawnup by the banking institutions based on theindividual institution’s business strategy and theirassessment of the opportunities and risks. Basedon the projections submitted, the annual loangrowth of the banking system as a whole wouldmoderate to 25% by the end of 1997, 20% by

the end of the first quarter of 1998, and 15%by the end of 1998.

In the implementation of the credit plans,lending for productive and export-relatedmanufacturing activities, the productive servicessector, small- and medium-sized industries aswell as low- and medium-cost housing, includingend-financing for owner-occupied residentialproperties, was to be accorded priority.

Guidelines on Hire-Purchase Loans forNon-commercial Passenger Vehicles

Effective 20 October 1997, BNM tightenedfurther the conditions on hire-purchase loans forthe purchase of non-commercial passengervehicles (both new and second-hand). Financecompanies were only allowed to provide financingfor up to 70% of the purchase price of thevehicles. In addition, the repayment period ofthese hire-purchase loans was restricted to notmore than five years. The same conditions appliedto the provision of block discounting for hire-purchase loans granted for the purchase of non-commercial passenger vehicles. This measurewas introduced as part of an effort to strengthenexisting prudential guidelines.

Guidelines on Lending to the PropertySector

In December 1997, BNM laid down guidingprinciples for banking institutions in extendingloans to the property sector, as follows:

(i) No credit facilities should be grantedto property projects where constructionhad not started, including for theconstruction of low- and medium-costresidential properties costing RM150,000and below;

(ii) For property projects where constructionhad started, banking institutions shouldassess the viability of such projects underthe changed economic conditions. Understrict selectivity, credit could be extendedfor the construction and purchase ofresidential properties costing RM150,000and below. Other projects should preferablybe deferred. Where such projects were

no longer viable under the changedeconomic conditions, banking institutionsshould review the projects and theirfinancing; and

(iii) Notwithstanding the above, bankinginstitutions might continue to extend creditfor the construction and extension offactories and industrial buildings which wereneeded to expand productive capacity.

With a more noticeable slowdown in overallcredit growth, the Guidelines on lending to theproperty sector were modified on 26 January1998, to exempt bridging loans and end-financingfor the construction and purchase of houses andapartments costing RM150,000 and below.

Appointment of Principal Dealers

With effect from 1 January 1997, 16 newprincipal dealers (PDs) were appointed, comprisingnine commercial banks, four merchant banks andthree discount houses, for a one-year period.The PDs were required to bid for at least 10%of the instruments specified by BNM, to providereasonable two-way price quotations, to keepand manage records separately and to provideinformation as required by BNM.

The PDs were granted several privileges suchas eligibility to bid for instruments in the ScriplessSecurities Trading System (SSTS) at primaryauctions, undertake repos of less than one-monthmaturity from non-interbank customers, andparticipate in money market auctions, as well asaccess to the Bank’s discount window facility,and ability to net off 15% of the sales andpurchases of specified instruments in thesecondary market, whichever was lower, fromthe eligible liabilities (EL) base, up to a maximumof 1% of the EL base. The specified instrumentscomprised Malaysian Government Securities,Malaysian Treasury Bills, Bank Negara Bills, andany other instrument specified by BNM.

Monetary Measures Announced on6 February 1998

On 6 February 1998, BNM announced theimplementation of a number of monetarymeasures. The objectives of the measures were

Following the upward movement in interbank rates,commercial banks and finance companies postedsignificantly higher fixed deposit rates and baselending rates (BLR) during the year. The increasein savings deposit rates was marginal. The stabilityin interbank rates in the early part of the year wastranslated into relatively stable fixed deposit ratesin the first four months of 1997. However, in linewith developments in the interbank market, therewas a sustained inversion in the term structure offixed deposit rates between May and July duringwhich the shorter-term rates were higher than thelonger-term rates. In August, as interbank ratesreverted to levels more reflective of domesticconditions, the term structure of fixed deposit rateswas once again upward sloping. Following furthertightening of monetary policy and the firming ofinterbank rates since mid-September, borrowing fromthe interbank market became more expensive. Asa result, there was intense competition for fixeddeposits in the market, as reflected in the rapidincrease in both short- and long-term fixed depositrates since September. The average fixed depositrates of commercial banks (1-month to 12-month)rose significantly in the last four months of 1997by 135–177 basis points to 8.81–9.33% (7.18–7.26%at end-1996), while those of finance companies roseeven faster, by 257–272 basis points to 10.23–

10.32% (7.28–7.36% at end-1996). The average3-month fixed deposit rates of both commercial banksand finance companies began to exceed the3-month interbank rate by mid-October. Expectationsof continued tight liquidity were also reflected in thebanking institutions’ greater focus on attracting longer-term deposits. Consequently, the faster increase inlonger-term rates caused a steepening of the termstructure of fixed deposit rates of commercial banks,with the spread between the average 12-month and1-month fixed deposit rates increasing from 10 basispoints at end-August to 52 basis points at end-December. In spite of fixed deposit rates increasingsignificantly, the weighted average savings depositrates remained relatively stable throughout 1997,increasing only marginally by 13 basis points to4.23% for commercial banks and 47 basis pointsto 5.49% for finance companies.

Under the existing BLR framework, BLRs quotedby banking institutions are subject to a ceiling ratewhich is calculated based on the average 3-monthinterbank rate of the previous month, allowing forSRR cost, a fixed charge and also the reductionin funding cost due to zero-interest current accountbalances. In line with the higher 3-month interbankrate, for the year as a whole, the average BLR of

to remove distortions in the intermediation processin providing financing to productive economicactivities as well as to enhance the efficiencyof the operations of the money market to allowinterest rates to reflect underlying liquidityconditions. The measures were also aimed atreinforcing the fundamental thrust of policy toachieve the objectives of monetary and financialstability. The measures were as follows:

• Streamlining the interest rate structure:The interest rate structure was streamlinedto reflect liquidity conditions in the market.Arising from recent developments, the termstructures of interbank and lending rateswere no longer reflective of prevailing marketconditions. The shorter-end interbank ratesmainly reflected the exceptionally tightliquidity situation of a small number ofbanking institutions. However, because ofuncertainties, there was a tendency forlending rates to be based on these short-term rates on a cost-plus basis. To improvethe flow of liquidity in the system, andtherefore, generate a more orderly term

structure of interest rates that would betterreflect the liquidity in the financial system,the 3-month BNM intervention rate wasadjusted upwards to 11% from 10%.

• Reduction in the Statutory ReserveRequirement: With effect from 16 February1998, the statutory reserve requirement (SRR)for all commercial banks, finance companiesand merchant banks was reduced from 13.5%to 10% of their eligible liabilities. This wasaimed at enhancing the efficiency of theintermediation process and not to provideadditional liquidity to the system. BNM in effectneutralised the additional liquidity to the bankingsystem following the reduction in the SRR byreducing its direct interbank lending, therebyslowing down base money growth.

BNM also emphasised that banking institutionsshould channel their resources to productiveactivities to support economic recovery, and tobe more transparent in their loan pricingmechanisms and not charge excessively highlending rates on a cost-plus formula.

commercial banks and finance companies edgedupwards by 115 and 157 basis points to 10.33%and 12.22% respectively. In view of the volatility ininterbank rates in July due to developments in theregional currency markets, the BLR ceiling for Augustwas temporarily capped at the July level. Themove to contain fluctuations in the BLR was aimedat limiting the impact of external developments onthe stability of domestic interest rates. The cap onBLR was subsequently removed and from September,the computation of the BLR ceiling reverted to theprevious basis.

The average cost of deposits (ACD) of bothcommercial banks and finance companies increasedin 1997 by 122 and 120 basis points to 6.52% and8.28% respectively, consistent with the upward trendin deposit rates. While the BLRs of both institutionsalso increased in 1997, the subsequent effect ontheir respective average lending rates (ALR) wasnot symmetrical, with the ALR of commercial banksincreasing more significantly by 139 basis points to11.51%. In contrast, the ALR of finance companiesincreased more modestly by 23 basis points to12.16%, as the bulk of their loans was in the formof fixed rate hire-purchase loans. As a result ofthese developments, the interest margin ofcommercial banks was relatively unchanged (increaseof 17 basis points to 4.99%) while that of financecompanies declined significantly (decline of 97 basispoints to 3.88%).

Monetary Policy in 1997

In the conduct of monetary policy in 1997, BNMfaced the difficult task of maintaining domestic andexternal stability in the context of the unprecedentedturbulence in the region’s financial markets. Thecontagion impact and prolonged regionaluncertainties, which accentuated the depreciation ofthe ringgit, aggravated inflationary pressures andadversely affected confidence, thereby increasing thecomplexity of monetary policy implementation.

While the implementation of monetary policy wasunusually complex in 1997, its objectives remainedunchanged. Price stability remained the primaryobjective of monetary policy. This became evenmore critical as the year progressed and the effectsof the depreciation of the ringgit began to filter intodomestic prices. Of importance, however, was torestore stability in the financial markets, not onlyenhance the efficient functioning of the intermediation

process and thereby facilitate business operations,but also to enhance the effectiveness of monetarypolicy. Under normal circumstances of stablefinancial markets amidst a low inflation environment,the ringgit is left to find its level under the flexibleexchange rate regime.

Against this background, the implementation ofmonetary policy in 1997 should be analysed in twoseparate periods. In the first half of 1997, monetarypolicy focused mainly on asset inflation. In theperiod after July, monetary policy responses were

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directed at restoring stability to overcome thedisruptions to economic activities caused byuncertainties in the foreign exchange and stockmarkets. Towards year-end and in the early part of1998, monetary policy focused on addressing thetight liquidity situation and inefficiencies in theintermediation process that had emerged in thebanking system.

In early 1997, growth in the economy wasexpected to slow down further to about 8% for theyear as a whole, compared with 8.6% in 1996. Itwas envisaged then that this moderation in economicgrowth, supported by a continuing firm monetarypolicy and supply side policies to increase capacity,would contain inflationary expectations and allow theeconomy to adjust to a more sustainable growthpath. The threat of asset inflation was also expectedto wane as several pre-emptive measures had beenput in place since 1995. The increases in assetprices were driven mainly by the rapid increasesin incomes and expectations of speculative windfallgains on the property and stock markets. Thesewere evident in the rising prices of properties andexcessive overvaluations of stock prices, particularlyin the Second Board counter and during primaryoffers. Meanwhile, the increase in the ConsumerPrice Index had been contained by an appropriatemix of contractionary macroeconomic policies. Theappreciation in the exchange rate also reinforcedthis trend. However, the wealth effects from thewindfall gains in the asset markets resulted in risingdomestic consumption, as reflected in rising importsof consumption goods and strong growth in carsales. If left unchecked, such a rapid growth indomestic spending, financed in part through credit,would increase the vulnerability of the banking systemto any downward shift in demand, and if prolonged,could also contribute to inflationary pressures.

The focus of monetary policy was, therefore, todampen the inflationary impulses emanating fromthese sources. The main objective of monetary policywas to slow down the overall credit growth to levelsthat were more reflective of the moderation in GDPgrowth as well as to encourage available resourcesinto productive uses. The redirection of credit wasimportant because the disproportionate concentrationof loans in 1996 and 1997 to finance purchasesof property and shares had tended to crowd outlending for more productive purposes, such as forexpanding the manufacturing and services industries.Indeed, the annual credit growth for the purchaseof properties and shares exceeded 29% and 30%

respectively. Bank lending to the broad propertysector, and for consumption and for the purchaseof stocks and shares accounted for nearly half ofthe increase in total loans in the first quarter of1997. The proportion of total outstanding loansallocated to the property and share markets aloneamounted to 43%. Even after excluding loans tomeet social objectives and loans deemed asproductive, namely loans for residential propertiescosting RM150,000 and below, infrastructure andindustrial buildings and factories, the total outstandingloans of the banking system for property and sharesexceeded 35%. At the same time, house prices in1996 rose by 12.9%, while share prices on the Mainand Second Boards of the KLSE rose by 24.4%and 93% respectively. While interest rates wereraised during this period, lending to these sectorscontinued to increase as expected gains from assetprice increases far exceeded the higher interestcost. The higher interest rates in turn were seento be dampening investment in the productive sectorin which excesses were not evident.

Interest rate increases were therefore reinforcedwith further prudential measures in the form of creditceilings. These measures aimed to limit furtherexposure of the banking system to these sectorsin order to minimise its vulnerability to any reversalin price movements in the asset markets. Effective1 April 1997, banking institutions were not allowedto exceed 20% of their outstanding loans to thebroad property sector and not more than 15% (30%in the case of merchant banks) for the purchaseof shares. At the end of 1997, outstanding loansfor property and shares subject to the guidelinesaccounted for 13.1% and 8.9% of total loansrespectively. There were also indications that pricepressures in the asset markets had moderated.The Bank also disseminated the latest availableinformation on estimates of the supply of office andretail space in the market. The information on thepotential over-supply situation together with the limitson credit had the effect of scaling down projectsand the postponement of others. More importantly,these pre-emptive measures curtailed furtherincreases in lending for financing of purchases ofproperty and shares, thereby providing bankinginstitutions with greater margins to withstand thesubsequent declines in stock prices that followedthe sharp ringgit depreciation towards the endof the year.

After the outbreak of the region’s currency turmoilin July, the focus of monetary policy became much

broader and was aimed at restoring stability in thefinancial markets and addressing inefficiencies thathad emerged in the financial markets and in theintermediation process. During this period, the Bankraised interest rates sharply to support the ringgitas it came under several bouts of speculativepressure. The speculative pressure on the ringgitwas further exacerbated by the outflow of short-termforeign funds through divestment in the stock market.By the end of 1997, the ringgit had depreciated bymore than 34% against the United States dollar. Inthe initial two weeks of the speculation in July,intervention in the foreign exchange markets absorbeda significant amount of liquidity from the bankingsystem, which caused interest rates in the interbankmarket to rise to as high as 40% for overnightmoney. However, following the floatation of thePhilippine peso on 11 July, it was recognised thatthe uncertainty in the currency markets would beprolonged. Given the prevailing circumstances, theBank placed emphasis on restoring stability in thedomestic financial markets in order to minimise theeffects of currency speculative activities on the realsector. By mid-August, interest rates were reducedto levels just above the levels prior to the crisis.To insulate domestic interest rates from developmentsin the foreign exchange markets, effective from4 August, banking institutions were required toobserve a US$2 million limit on outstanding non-commercial related ringgit offer-side swap transactionswith each foreign customer. The 3-month interbankrate, which was the indicator rate of the Bank’smonetary policy, remained relatively stable duringAugust and September. Towards the end ofSeptember, the rate was adjusted upwards asinflationary expectations increased as the ringgitdepreciated further to reach US$1=RM3.40.

Although faced with a similar currency crisis, therewere significant differences in the policy approachadopted by countries in the region. In Malaysia, itwas decided early in the crisis that interest rateswould not be raised for the sole purpose ofsupporting the ringgit. Under normal circumstancesof isolated and limited currency pressures, raisinginterest rates to sharply higher levels and for ashort duration would be effective in curtailingspeculation against the exchange rate. It wasassessed, however, that the speculative activitiesthat engulfed the region in 1997 would persist overan extended period and that an interest rate policyon its own would not contribute to stabilising thecurrency market. The large foreign share of portfolioinvestment in the Malaysian stock market providedadditional sources of the domestic currency, so that

the pressures on the equities and currency marketsreinforced each other.

Investor concerns on the economic vulnerabilityof the region also meant that higher interest rateswere unlikely to provide support for the currency.The pressures on ringgit exchange rates essentiallyreflected negative sentiment on the ringgit exchangerate. The outflows of capital that occurred involvedmainly short-term foreign investment with someoutflows of funds by Malaysians. Long-term directforeign investment in Malaysia was for the main partunaffected. There was no evidence of significantoutflows of resident funds, and deposits in thedomestic banking system continued to increase athigh rates. Economic fundamentals during this periodremained favourable and activity in the export sectorremained generally insulated from the currencyturmoil. The loss of confidence occurred mainlyamong portfolio investors.

The uncertainties in the external sector made iteven more critical for the Bank to ensure that itspolicies did not create further risks in the domesticeconomy. In the environment of a depreciatedcurrency, exceptionally high interest rates for anextended period would add to the cost of doingbusiness, dampen investment and constrain growthin the real sector. At the corporate level, this wouldaffect export performance and income levels, andcause a greater contraction of excess demand thanrequired to restore stability.

However, a firm interest rate environment wasessential to contain inflationary expectations and tocontinue to promote a positive real rate of returnto encourage savings. Moreover, it was felt thatraising interest rates as a policy option could beeffective only if implemented with a package ofconsistent macroeconomic policies to correct theimbalances in the economy. A comprehensive policypackage was announced in early December tosupplement the measures announced in the 1998Budget, two months earlier. This policy packagewas aimed at addressing the imbalances in theeconomy as reflected in the current account deficitin the balance of payments, risks in the bankingsystem, higher inflation due to the ringgit depreciationand high monetary growth.

With the adoption of a macroeconomic policypackage in December, it was felt that higher interest

Volatility refers to the short-term deviationsaround a long-term trend. Some degree of volatilityis expected in financial markets as part of thenormal process of “price discovery” that ensuresfinancial resources are allocated in an efficientmanner. However, when prices of financial assetsbecome excessively volatile, the signals providedby these prices no longer convey the requiredinformation for markets to efficiently allocatefinancial resources amongst the many competinguses. This article looks at volatility in the twotypes of financial prices that are most relevant tomonetary policy: volatility in the domestic price ofmoney (interest rates) and volatility in the externalprice of money (exchange rates). It examines thecauses of volatility in these prices and thechallenges volatility poses for the conduct ofmonetary policy. Lastly, it looks at the role ofmonetary policy in mitigating excessive volatilityand containing its adverse effects.

Interest Rate and Exchange RateVolatility

As in the case of the price of any good, theexchange rate of a currency is determined bythe conditions of demand and supply for thatcurrency. For an open economy like Malaysia,the level of the exchange rate has importantimplications for the competitiveness of its exportsand for domestic price inflation. Even moreimportant is the need to avoid extreme volatilityin the exchange rate, which would distort decisionmaking in international transactions, particularlyin trade and foreign investment.

Interest rates are the domestic price of money.They are a crucial element in determining thelevel of investment and real economic activity ina country. Of importance is the need to focuson real interest rates, i.e., nominal interest ratesafter excluding the inflation rate. As with theexchange rate, interest rates are determined bythe relative magnitude of the demand and supplyof liquidity.

Financial Volatility:The Challenge for Monetary Policy

What then causes exchange rate and interestrate volatility? In the case of exchange rates, theadvent of floating rates in many of the world’scurrencies in the 1970s augured in an era ofgreater volatility. Previously, under the BrettonWoods system, the values of most currencieswere stabilised at agreed par values. The choiceof an exchange rate regime will affect volatility.However, it is the economic fundamentals of acountry that determines the long-run value of acurrency. Economic fundamentals such as theinflation rate and the balance of payments, whichhave become more volatile in the 1980s andearly 1990s, by themselves are sources ofexchange rate volatility. More recently, increasedcross-border flows which have been facilitated bythe trend towards liberalisation of the capitalaccount and the advancement in technology havealso caused exchange rates to fluctuate.

As with exchange rates, volatility in interestrates can also reflect uncertainty in economicfundamentals. One of the most important of thesevariables is inflation, or rather, the public’sexpectations of the future rate of inflation. Thederegulation of interest rates and the removal ofcontrols such as interest ceilings is anotherimportant factor leading to increased interest ratevolatility. Higher volatility in interest rates couldalso result when the central bank changes itsoperating procedures in monetary policy. Targetinginterest rates could result in less volatility ininterest rates than would targeting money supply.This happened in the United States in the late-1970s and early-1980s. Similarly, unclear signalsabout the stance of monetary policy can generateuncertainty in the financial markets resulting ingreater fluctuations in interest rate levels.

Malaysian Experience

Graph IV.1 presents the volatility of the average3-month fixed deposit rate of the commercialbanks and the RM/US$ exchange rate. Volatilityis measured as the standard deviation of monthly

Box IV

percentage changes during each year in thecase of exchange rates. Volatility in interest ratesis measured as the standard deviation of theend-month interest rate during each year. Alsoindicated on the same chart are some of themajor shocks to the economy that could haveaffected the volatility of financial prices.

Graph IV.1 shows that the contemporaneouscorrelation between the volatility of interest ratesand the exchange rate is marginal. On average,volatility of interest rates is considerably lowerthan that for the exchange rate. This suggeststhat the exchange rate responds faster to shocksin the economy. This observation is evident bythe sharp increases in volatility of the exchangerate during each of the periods of external shocksexperienced in Malaysia’s economic history.

The exchange rate of the ringgit vis-a-vis theUnited States dollar was very volatile followingthe floating of the ringgit in June 1973. Thecommodity price shocks that occurred after thetransition to a floating exchange rate regime onlyserved to exaggerate this volatility. Apart fromthe two oil price shocks, economic recession andcurrency speculation were the other main shocks

influencing the volatility in the exchange rate ofthe ringgit against the United States dollar. Inparticular, the increase in volatility during themid-1980s reflected the effects of several factors,the most important being the sharp deteriorationin the terms of trade that triggered the recession.Speculative activity on the ringgit also contributedto the increased volatility.

Subsequently, volatility was on a declining trendand was lowest in 1990. Another period ofexchange rate volatility occurred during 1992–94,following substantial capital inflows during theperiod. Attempts by BNM to neutralise the impactof the flows on the exchange rate and domesticliquidity did little to reduce the volatility. However,Graph IV.1 shows a sharp increase in volatilityexperienced during 1997. Such a level of volatilitywas unprecedented. As elaborated elsewhere inthis Report, the movements in the exchange rateof the ringgit in 1997 were strongly influencedby the contagion effects of developments in theregion, which resulted in a loss of investorconfidence and large outflows of foreign short-term capital.

The assessment of the historical behaviour ofinterest rates in Malaysia is based on movementsof deposit rates. Volatility of these rates wasrelatively low during the 1970s. During this period,deposit rates of the commercial banks wereadministratively set through consultations betweenthe commercial banks and BNM. Consequently,interest rates were changed infrequently. Depositrates were liberalised in 1978 with commercialbanks free to set the deposit rates. Consequently,during most of the 1980s, interest rates wererelatively volatile, reflecting the competitive pricingof deposits in response to changing liquidityconditions in the banking system. There was abrief respite in this volatility during 1986–87 whenBNM introduced the pegged interest rate system.However, volatility increased again when thesystem was removed in 1987. The volatility ininterest rates has persisted into the 1990s,although at a lower level than in the 1980s. Partof the reason for the lower volatility was themore aggressive management of surplus liquidityby BNM. The persistent excess liquidity situationrequired the Bank to use all instruments at itsdisposal to mop up surplus funds from thebanking system. It also reflected the effect of thepolicy to allow banking institutions to move fromthe daily observation of the statutory reserve

1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997

0.00

1.00

2.00

3.00

4.00

5.00

6.00

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RM/US$ 3-month fixed deposit rate of commercial banks

Graph IV.1Volatility of Interest Rates and Exchange Rate: 1973-1997

Standard deviation

Note: For the exchange rate, volatility is measured in terms of the standard deviation of monthlypercentage change during each year. For interest rates, it is the standard deviation of the end-month rates during each year.

Standard deviation

requirement and the minimum liquidity requirementto a system whereby the banking institutions fulfilthese requirements based on a fortnightly average.This adjustment significantly reduced day-to-dayvolatility of short-term interest rates in theinterbank money market. It is also notable thatdespite the unprecedented nature of theturbulence in the financial markets in 1997, thevolatility of interest rates was not unusually highrelative to the rest of the 1990s. This largelyreflects BNM’s policies designed to ensure thatexternal developments do not destabilise thedomestic sector.

Overall, the experience in Malaysia showedthat as the country liberalised its interest ratesand became more integrated with the internationalfinancial system, it also experienced greatervolatility of both the exchange rate and interestrates. However, policy changes and improvedmanagement of liquidity allowed BNM to offsetsome of the volatility.

Financial Volatility and the Conduct ofMonetary Policy

The volatility in financial prices has significantimplications on the conduct of monetary policy.Higher flows and the consequent exchange ratevolatility have occurred when investors estimatethat such interest rate differentials wouldadequately compensate for the risks involved ininvesting in a foreign country, principally the risksof foreign exchange movements. Similarly, interestdifferentials would also encourage domesticresidents, financial institutions and corporationsto borrow from abroad. The recent financial crisisindicates the risk associated with such transactionsnot only for the borrowers but also for the financialsystem and the economy.

The liberalisation of the capital account andthe resulting inflows and outflows of funds greatlycomplicate the process of monetary policyformulation. When such inflows are large, thenatural tendency is for the exchange rate toappreciate. Should the flows reflect sentimentsrather than underlying fundamentals, authoritiesmay intervene to reduce the volatility of theexchange rate. In this situation, it would resultin a higher growth of money supply and a build-up of excess liquidity within the banking system.Unless the monetary authorities sterilise these

injections of liquidity from their foreign exchangeoperations, by absorbing the excess funds throughopen market operations, the result will be adecline in interest rates with the subsequenteffect of an increase in the growth of credit. Thegrowth of credit can in turn feed demand-drivenpressures on prices and work against theauthorities’ efforts to contain domestic inflationand maintain monetary stability.

When foreign funds flow out of the country,pressure on the exchange rate would occur inthe opposite direction. In the absence of centralbank intervention, the domestic currency willdepreciate. The depreciation can lead to importedinflation. If BNM does intervene to stabilise theexchange rate, it would result in a drain on itsforeign exchange reserves. Intervention in theforeign exchange market to support the currencywould also result in a contraction of liquidity inthe banking system. If not sterilised, this wouldresult in significantly higher interest rates, whichover a prolonged period would have adverseimplications on economic activity.

Malaysia has for a long time maintained arelatively open capital account with liberalexchange controls. In the early 1990s, highinterest rates to control inflation, a booming stockmarket, and an exchange rate that was expectedto appreciate created a one-way bet for foreigninvestors. Large amounts of foreign funds flowedinto the country in 1992 and 1993. The bulk ofthese short-term funds was invested in the KualaLumpur stock market, pushing its capitalisationto 375% of GDP at the end of 1993. Given theshort-term nature of the funds, BNM interventionaimed to reduce the potentially destabilisingimplications of these funds. Exchange rates shouldappreciate in response to long term economicfundamentals such as large inflows of corporateinvestments. Inflows in 1992–93 were mainlyshort-term capital seeking arbitrage profits.Following policies to discourage such inflows,this trend reversed and there was a gradualoutflow. In 1997, the reverse problem for monetarypolicy was experienced – a sudden tighteningof liquidity and sharply higher interest ratesfollowing the outflow of funds by non-residentportfolio investors.

Therefore, capital account liberalisation andthe resulting inflows and outflows of funds canresult in greater volatility of the exchange rate.

Since a central bank in an open economy cannotsimultaneously determine both the exchange rateand domestic interest rates, attempts to stabilisethe exchange rate will transfer the volatility todomestic interest rates. Therein lies the challengefor monetary policy. A balance in judgementis required to limit the volatility in the exchangerate or in domestic interest rates. The initialresponse of BNM to the contagion pressureson the ringgit arising from the floating of theThai baht was to intervene in the foreignexchange market to stabilise the exchange rate.However, the result of this intervention was muchhigher interest rates. The subsequent actionsof BNM showed that it decided to accept thevolatility in the foreign exchange market in orderto maintain the stability of domestic interest rates.This was in contrast to the mid-1980s, whenBNM had accepted short-term volatility in interestrates in order to stem speculative activity againstthe ringgit. In that instance, however, thespeculative activities were of a shorter duration,and involved smaller amounts.

Managing Financial Volatility

The growing global integration of both thefinancial markets, as well as the real economy,results in higher volatility of financial pricesas shocks in one market are quickly transmittedacross borders. The current financial crisis inAsia demonstrates this phenomenon. It doesnot imply that volatility of interest and exchangerates due to external shocks should be avoidedthrough economic isolation or capital controls.Rather, there is a general recognition thatsound domestic economic management is animportant element in reducing the risksassociated with this volatility. The impact ofpolicies in one country is even more relevantto other economies when market participantsperceive similarities in the characteristics ofthese economies. Hence, regional co-operationand co-ordination of policies among sucheconomies could reduce volatility in theirfinancial markets. In addition, no one policyinstrument can be relied on as a panaceafor all financial ills. The Malaysian experienceshows that monetary policy instruments canbe more effective in moderating the effectsof financial volatility on the banking systemwhen complemented by other policies. Inparticular, such complementary policies include

a combination of fiscal, administrative andprudential measures.

Greater transparency in policy-making can alsoremove much of the uncertainty that is associatedwith private decision-making. A government thathas clear objectives and shows a commitmentto achieving those objectives earns credibility. Inthis context, the Malaysian Government hasundertaken measures to increase the flow ofinformation to the private sector. This aims toreduce misinterpretation regarding the prioritiesand policies of the Government. More transparentdata will also ensure correct analysis ininterpreting the signals about the direction ofmonetary policy.

In Malaysia, the intermediate target is the 3-month interbank rate, which is also the Bank'sintervention rate. Currently, interest rates are ona rising trend due to tight liquidity and highdemand for loans. Despite the exchange ratevolatility, interest rates in Malaysia have remainedrelatively stable. The interest rate instrument isused to contain inflation. In the currentcircumstances, interest rates have not beenused to influence the exchange rate of the ringgit.The authorities are committed to a flexibleexchange rate regime that allows the exchangerate to move in response to market forces.However, the exchange rate should reflect theunderlying fundamentals of the economy.Currently, the exchange rate is viewed asbeing undervalued. Therefore, interventionoperations to restore stability to the currencyremains an option.

To reduce the risks to the banking institutionsarising from the volatility, BNM has imposedstrict prudential requirements on the bankinginstitutions in Malaysia. The observation of therisk-weighted capital requirement (RWCR) ensuresthat the banking institutions are adequatelyinsulated against credit risk. Most bankinginstitutions in Malaysia meet or exceed the Bankfor International Settlements RWCR of 8%. Thesmaller less well-capitalised institutions havebeen actively encouraged by BNM to merge inorder to increase their competitiveness as wellas their resilience to adverse developments.Recent measures to increase general provisionsand shorten the default period for classifyingloans as non-performing from six to three monthsare also aimed at strengthening the balance

sheets of the banking institutions. Improvedliquidity management and the incorporation intothe RWCR of some measure of the vulnerabilityof different types of assets to interest rate volatilitywould further boost the resilience of bankinginstitutions.

Volatility tends to be exaggerated in thin marketswhere even small transactions can cause pricesto vary substantially. Therefore, efforts toward

developing deeper financial markets should resultin greater stability of financial prices. A large anddiverse base of financial institutions allows risksto be spread among many players. Institutionsthat are risk-averse can transfer these risks tothose that have the capacity to manage them.The introduction of financial instruments such asfutures and options provides the flexibility to hedgeand manage the risks associated with the volatilityof both the exchange rate and interest rate.

rates would have a greater role in restoring overalleconomic stability. During this period, the ringgit haddepreciated by a greater degree for a more extendedperiod, resulting in an increase in inflationaryexpectations. In this context, the 3-month interbankrate was raised from about 8.5% in November to10% by end-January 1998.

The tighter liquidity situation resulted in an increasein the loan-deposit ratio of the banking system,which rose from 92.2% at end-June to 95.8% atend-November. This caused increased competitionfor funds, with the average fixed deposit rates ofthe commercial banks for one to 12-month maturitiesincreasing by 127–195 basis points to 8.81–9.33%at end-December compared with their levels at end-June. There was also some shift in deposits fromsmaller institutions to larger institutions giving riseto higher interest rates as competition for depositsintensified. Following the Bank’s assurances on thesafety of all deposits in the banking system, thistrend was halted. The banking institutions that facedthe sudden withdrawal of deposits were providedwith temporary funding from the Bank.

The tight liquidity situation and the consequentflight to quality led to distortions in the intermediationprocess, especially towards year-end. Facedwith this scenario, the Bank injected liquiditythrough direct lending to banking institutions. Theseinstitutions were not facing solvency problemsbut rather a liquidity problem following uncertaintyin the financial markets.

In an effort to restore market confidence inan environment of increased volatility in thefinancial markets, banking institutions were requiredin October to submit plans for their credit growthfor the rest of the year and for 1998. Under thecredit plans, overall credit growth for the bankingsystem would moderate to 25% by the end of 1997,20% by the end of March 1998 and 15% by theend of 1998. As the plans were drawn up inOctober, loan growth in the final quarter continuedto be high following high drawdown of committedloans. By the end of December, total loans extendedby the banking system grew at a slightly higherrate of 26.5%.

The policy to slow down loan growth howeverwas not intended to curtail access to financing forproductive investments. Viable productive projects

are expected to continue to receive financing. Toensure this, banking institutions were encouragedto focus their lending towards financing productiveactivities. To discourage further concentrationof lending in the property sector, the Bank issuednew guidelines in December 1997, whereby nonew credit facilities were to be granted to propertyprojects where construction had not started. In casesof projects already being implemented, the bankinginstitutions were required to re-examine their viabilityin the changed economic environment. The guidelinesemphasised that the banking institutions shouldcontinue to lend for the construction and extensionof factories and industrial buildings needed to expandproductive capacity. As an additional measure toensure that credit would be available for productiveactivities, the Government has set up a specialRM1 billion fund to provide financing to the small-and medium-scale industries.

To avoid deterioration of asset quality, a seriesof prudential measures were also announced in theBudget in October 1997. These measures includeddisclosure requirements on banks, includingproviding information to the public on theirfinancial position, lending patterns, the level of non-performing loans, and provisioning against loanlosses. To further allay concerns regarding thesafety of deposits, a statement was issued by theBank whereby the principal and interest earned ondeposits placed with banking institutions wereguaranteed by the Government.

Fiscal Operations and Policy

In the formulation of the 1997 Budget, the FederalGovernment targeted for an increase in the overallfiscal surplus to 1.6% of GNP in 1997, comparedwith the surplus of 0.8% of GNP achieved in 1996.The actual outturn of a fiscal surplus of 2.5% ofGNP in 1997 exceeded expectations. Theachievement of an overall surplus for the fifthconsecutive year underscored the Government’scommitment to the policy of fiscal prudence andfinancial discipline. This was part of the overallstrategy to contain demand and inflationary pressures,with the broad aim of ensuring sustainable economicgrowth with price stability and external equilibriumover the long term. Achieving large budget surpluseswas aimed at strengthening the foundation formacroeconomic stability and increasing nationalsavings to strengthen the nation’s economic resilienceto meet future challenges. Following the emergenceof the regional financial difficulties, fiscal policy

assumed a bigger role to address the economy’sunderlying vulnerabilities, especially the currentaccount deficit and the national resource gap,and to restore macroeconomic stability andinvestor confidence.

The Government further tightened budgetaryoperations to bring about a more rapid downwardadjustment in the current account deficit and toreduce inflationary pressures arising from thedepreciation of the ringgit. Several fiscal measureswere introduced in the third quarter of 1997 tomanage the level of aggregate demand and tocontain the current account deficit. These measuresincluded an immediate 2% cut across the boardin Government spending, the deferment ofseveral large infrastructure projects (BakunHydroelectric project, the Kuala Lumpur Linear City,the Northern International Airport, Phase II of thePutrajaya project, the Hill Road project and theStraits of Malacca Malaysia-Indonesia Bridge) anda review of purchases of foreign goods by thepublic agencies, including the armed forces. The1998 Budget announced in October 1997 wasdesigned to further consolidate the public sectorto further strengthen economic fundamentals andthe nation’s resilience to overcome external shocks.Additional projects were identified for deferment,including highway projects and the Light RailTransit projects in Penang and Johor. Overall, thecost of projects deferred involved an estimatedRM65.6 billion. In addition, the implementation ofthe privatisation programme would be morecautious and selective, and only projects thatwould expand productive capacity and enhancelong-term growth prospects would be approved.The Budget also provided additional tax incentivesto support the strategy of productivity-driven growth,enhance international competitiveness and furtherstrengthen the balance of payments position.Among the key tax measures were a twopercentage reduction in the corporate andpetroleum income tax rates to 28% and 38%respectively to reduce the cost of doing business,tax incentives to boost exports and to expeditethe pace of industries to shift to knowledge- andtechnology-intensive processes, as well asimposition of higher import duties on a numberof goods to curb imports. In the wake of furtherregional uncertainties, the Government announcedin December the implementation of acomprehensive package of policies, including furtherfiscal austerity measures involving an 18% reductionin the 1998 Budget allocation, to further strengthenthe stabilisation process.

In the management of expenditure, public spendingand investment were prioritised to maintainexpenditure at a level consistent with the capacityto raise revenue and ensure that the public sectorwas not a source of inflationary pressures. Inparticular, the Government continued to exerciseprudence and stringent controls on operatingexpenditure, including stricter accountability ofexpenditure by departments aimed at avoidingwastage and curtailing less productive spending,while continuing to provide improved public servicesand amenities to facilitate private sector activities.Further progress was made in streamlining the publicsector through the wider use of office automationand information technology, organisationalrestructuring of Government departments, corporaterestructuring of public enterprises, as well as theprivatisation of public entities, projects and services.Furthermore, less essential projects were deferred.The Government continued to provide for essentialexpenditure to address supply constraints, raiseproductivity and enhance potential output. Higherinvestments were channelled towards infrastructure,education and training, and research and development,especially in science and technology. Priority wasalso accorded to socio-economic projects, especiallyagriculture and health, to eradicate poverty, reduceeconomic disparity and upgrade the quality of life.

Fiscal policy in 1997 was also aimed atmaintaining a tax structure that would provide anenvironment that was conducive to private sectorgrowth and investment, promote national savingsand reduce inflationary pressures. The tax packageimplemented in 1997 was designed to achievesustainable growth through enhanced productivity,and a strengthening of the balance of paymentsposition through improving the services sector andincreasing domestic production. Improved productivitywas also strategic to the nation’s effort in addressinga number of other challenges, especially to reduceinflationary pressures, maintain internationalcompetitiveness and overcome labour shortages.Several fiscal incentives were provided in the 1997Budget to foster the strategy of productivity- andquality-driven growth. These measures includedprovision of the reinvestment allowance to encouragemanufacturing and agriculture companies to reinvestin equipment which would significantly improve theirproductivity, as well as tax incentives to facilitatethe shift to high technology, capital-intensive andinformation-based industries (especially in theMultimedia Super Corridor (MSC)), and enhance thevalue chain of the manufacturing sector to strengthenindustrial linkages. Wide-ranging tax incentives and

exemptions were also introduced during the year topromote the services sector. Other fiscal measuresincluded the withdrawal of duty exemptions on inputsused in the manufacturing sector and reimpositionof import duties on heavy machinery to encouragedomestic production and reduce the dependence onimported capital and intermediate goods. To controlinflation and promote savings, the Governmenteliminated or reduced import duties and sales taxon a number of goods; exempted some inputs usedby manufacturers of selected goods from sales taxto reduce production cost; and removed restrictionson relief for life insurance premiums. Incentives werealso provided to enhance the effectiveness andefficiency of the financial markets to mobilise long-term savings to support the industrialisation drive.

The Government’s commitment to prudentbudgetary policies amidst favourable revenueperformance arising from sustained economic growthcontributed to another overall surplus position inthe consolidated public sector in 1997. The surplus,however, was lower than in 1996 due largely to thehigher development expenditure of the non-financialpublic enterprises (NFPEs).

The general government’s consolidated position,comprising the Federal Government, 13 stategovernments, statutory bodies and local governments,recorded a much larger current account surplus ofRM27.9 billion or 10.6% of GNP in 1997 (8.6% ofGNP in 1996). The strong performance was due toboth a large increase in revenue collection and asharp deceleration in operating expenditure.Following a strong growth of 21.9% in 1996,operating expenditure increased only marginally, by0.4% in 1997. This essentially reflected the tightbudgetary control on expenditure, especially on lessproductive spending, partly in response to theannouncement in September of an immediate 2%cut in expenditure. Increased outlays were channelledmainly to improve the quality of public services andamenities. The large surplus was generated mainlyby the Federal Government and to a lesser extent,the state governments. As in previous years, thestatutory bodies remained in deficit, attributable totheir narrow revenue base. With several major publicenterprises sustaining good performances during theyear, the NFPEs as a group also maintained a largeoperating surplus of RM21.7 billion or 8.3% of GNP.In aggregate, the consolidated public sector recordeda large surplus of RM49.6 billion or 18.9% of GNPin 1997. This was significantly larger than the surplusof 17.1% of GNP achieved in 1996.

Public sector development spending expandedsignificantly in 1997, largely due to investments ininfrastructure to expand productive capacity to supporteconomic growth as well as to meet the socio-economic objectives of the nation. Both the generalgovernment and NFPEs contributed to the expansionin expenditure. In particular, the development outlayof the NFPEs escalated sharply (43%) in 1997, toaccount for a larger share of 55% of the total publicsector development expenditure. Several of the publicenterprises, especially Petroliam Nasional Berhad(PETRONAS), Tenaga Nasional Berhad (TNB),Telekom Malaysia Berhad, Keretapi Tanah MelayuBerhad and Malaysian International ShippingCorporation Berhad continued to undertake expansionprojects and modernisation programmes during theyear. A sizeable share of the expenditure was alsofor investment overseas, especially by PETRONASand Telekom, to complement their domestic activities.In the public sector, expenditure was mainly directedat several large infrastructure and related projectsunder construction, including the Kuala LumpurInternational Airport, Putrajaya and the Light RailTransit Systems. Meanwhile, higher capitalexpenditure of the general government was also forhuman resource development and infrastructureprojects. In aggregate, public sector developmentexpenditure expanded by 31.7% in 1997, comparedwith 3.4% a year ago. As a result, the overallsurplus of the consolidated public sector was slightly

Table 2.1Consolidated Public Sector Finance

1996 1997p 1998r

RM million

General government 1

Revenue 70,912 78,549 68,468Operating expenditure 50,463 50,647 44,204

Current surplus of general government 20,449 27,902 24,264

Current surplus of NFPEs 2 20,348 21,747 21,732

Public sector current surplus 40,797 49,649 45,996(% of GNP) 17.1 18.9 16.5

Net development expenditure 30,818 40,588 37,448General government 15,306 18,407 16,490NFPEs 15,512 22,181 20,958

Overall surplus 9,979 9,061 8,548(% of GNP) 4.2 3.4 3.1

1Refers to general government, comprising Federal and state governments,statutory authorities and local governments.

2Refers to 28 NFPEs in 1996 and 1997 respectively.

p Preliminaryr Revised based on 5 December 1997 announcement.

Source: Ministry of Finance, state governments and non-financial publicenterprises.

lower at RM9.1 billion or 3.4% of GNP in 1997,compared with 4.2% of GNP in 1996.

The financial position of the Federal Governmentstrengthened in 1997. Fiscal discipline and tightcontrols on expenditure amidst favourable revenueperformance resulted in an overall budget surplusfor the fifth consecutive year. The current accountsurplus increased to RM21 billion or 8% ofGNP (6.1% of GNP in 1996) and the overallsurplus to RM6.6 billion or 2.5% of GNP (0.8% ofGNP in 1996).

Federal revenue expanded further by 12.8% toreach RM65.7 billion or 25% of GNP. The strongrevenue collection in 1997 stemmed from thecontinued growth of the economy, the improved taxcollection machinery coupled with a large positivecontribution from petroleum-based revenue. Benefitingfrom higher petroleum prices and production in 1996(the tax base for 1997), petroleum-based revenueaccounted for nearly one-quarter of the increase intotal revenue collection during the year. In addition,several tax measures introduced in the 1997 Budgetwere estimated to have generated net additionalrevenue of RM321 million in 1997, compared withrevenue foregone of RM437 million in 1996. Thecurrency crisis in the latter part of the year hada marginal impact on revenue in 1997, given thatcollection of direct taxes, the largest component ofFederal revenue, was based on the corporateperformance in the previous year. However, indirecttax collections were somewhat affected, especiallyin the last two months of 1997. While collectionfrom export duties benefited due to gains in exportvalue in ringgit terms, receipts from import andexcise duties declined in November-Decemberdue to slower aggregate demand arisingfrom measures instituted to curb imports andexcessive consumption.

In aggregate, the favourable revenue performancewas contributed by all three broad categories ofrevenue, particularly receipts from direct taxes. Taxrevenue maintained its strong growth momentum in1997, due in part to measures to broaden the taxbase and the more efficient tax collection machinery.As a result, the Government’s tax effort, that is, theratio of tax receipts to GNP improved to 20.4%(19.9% in 1996). Receipts from direct taxesrecorded a stronger double-digit growth for the eighthconsecutive year to account for a higher share oftotal revenue (46%), although the increase was

moderated to some extent by a number ofconcessions implemented in the 1997 Budget toenhance productivity and international competitivenessas well as to strengthen the services sector. Thesefiscal measures included a review of reinvestmentallowance, tax incentives (investment tax allowanceor pioneer status) for selected tourism projects andinformation-based industries in the MSC, taxincentives for promoting industrial linkages andacquiring proprietary rights, and a concessionarytax rate for the local fund management industry.While these fiscal measures could result in someimmediate revenue loss, it is expected to contributeto additional revenue in the future through expansionof economic activities and growth. Receipts frompetroleum income tax recorded an exceptionally largeincrease (75%) in 1997. Collections from corporateincome tax, the single largest contributor ofrevenue (25%), remained buoyant, while receipts

Table 2.2Federal Government Finance

1996 1997p 1998r

RM million

Revenue 58,280 65,736 55,924Operating expenditure 43,865 44,665 38,899

Current surplus 14,415 21,071 17,025(% of GNP) 6.1 8.0 6.1

Development expenditure 12,600 14,445 12,967Gross development

expenditure 14,628 15,750 14,267Less Repayments 2,028 1,305 1,300

Overall surplus 1,815 6,626 4,058(% of GNP) 0.8 2.5 1.4

Sources of financing 1

Net domestic borrowing 1,291 –2,048 –Gross borrowing 6,000 3,000 –Less Repayments 4,709 5,048 –

Net foreign borrowing –2,177 –1,681 –Gross borrowing 749 462 –Less Repayments 2,926 2,143 –

Special receipts 475 91 –

Realisable assets 2 andadjustments –1,404 –2,988 –

Total –1,815 –6,626 –

1Data for 1998 are not given.

2Includes changes in Government's Trust Fund balances. An increase in theaccumulated realisable assets is indicated by a minus (–) sign.

p Preliminaryr Revised based on 5 December 1997 announcement.

Source: Ministry of Finance

from personal income tax were also higher.Overall, the improved income tax collectionreflected higher profits, business earnings andincomes in 1996, as well as the increasing numberof taxpayers included in the tax base. The InlandRevenue Board (IRB) is estimated to register 150,000new taxpayers in 1997. In addition, concerted effortswere made by IRB to further strengthen the taxcollection machinery, expand the tax base and raisethe tax compliance rate through stricter enforcementto reduce tax evasion and tax avoidance. Thesemeasures were successful in generating an additionalRM282 million in back taxes in 1997. Collectionfrom stamp duties stabilised at the previous year’slevel, with higher values in property transactionsbeing offset by the sharply lower value of shares

traded on the Kuala Lumpur Stock Exchange.The contribution from other components ofdirect taxes, including real property gains tax,increased in 1997.

Revenue from indirect taxes increased at a moremoderate pace in 1997, in tandem with the slightlyslower rate of increase in domestic demand.Collections from this source were affected, especiallyin the last two months of the year, following themeasures imposed on import demand, including thehigher rates of import duty on construction materials,consumer durables and motor vehicles introduced inthe 1998 Budget. Receipts from most majorcomponents of indirect taxes moderated during theyear. Receipts from export duties were sustainedat the previous year’s level, with the gains incollection from petroleum export duties (97% of totalexport duties) arising from the depreciation of theringgit, largely offset by the decline in petroleumprices and export volume.

Growth in receipts from import duties moderatedin 1997 consonant with the deceleration in importvolume. The abolition or reduction of import dutieson a number of goods in the 1997 and 1998Budgets to reduce inflationary pressures and reduceexcessive protection on domestic industries alsocontributed to the slower collection. The increasein revenue from indirect taxes was underpinned bythe reimposition of duties on heavy machineryand the withdrawal of exemptions on spares,consumables and components used in manufacturingand certain hotel equipment in the 1997 Budget.This was estimated to raise additional revenue ofRM326 million. However, the increase in duties onpetroleum and, in particular, on motor vehiclesslowed down sharply (4.4%; 26.8% in 1996) as aresult of a reduction in demand for vehiclestowards the end of the year in response to thetightening of financing facilities and the substantialincrease in import duty rates on motor vehiclesintroduced in October 1997. Receipts from exciseduties were similarly affected, with sharply lowercollections from petroleum and petroleum products,and a smaller increase in duties from motorvehicles. Collection from sales tax remained buoyantdespite the exemption of sales tax on inputs ofselected domestic manufactured goods to reduceproduction costs. The increase was largely onaccount of stronger growth in receipts from salestax on imported goods, partly due to the ringgitimpact. Receipts from service tax benefited from theimposition of a service tax on credit cards. However,

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Graph 2.4Federal Government Finance

1991 1992 1993 1994 1995 1996 1997

1991 1992 1993 1994 1995 1996 1997

Development expenditure

Current revenue

Operating expenditure

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Overall deficit/surplus

Government securities

Investment issues

receipts were partially offset by service taxexemptions given for the export of professionalservices and for approved companies undertakingresearch and development.

Non-tax revenue increased moderately in 1997.Collections from licences and permits remainedbuoyant with substantially higher receipts from thelevy on foreign workers following stricter enforcementby the authorities, as well as higher collections fromroad tax and petroleum royalty. Service fees alsorecorded an increase, while investment incomereceipts stabilised despite the further divestmentof Government-owned companies. Non-revenuereceipts, which included refunds of expenditure,receipts from Government agencies and revenuefrom the Federal territories, were marginally higherduring the year.

Total Federal Government expenditure increasedby a modest 4.7% in 1997, as budgetary policyduring the year continued to be one of consolidationin order to achieve a larger fiscal surplus. Severalmeasures taken in the third quarter also contributedto containing the increase in expenditure. Operatingexpenditure increased by 1.8% to RM44.6 billion

(19.9% in 1996), reflecting continued stringent controlson expenditure to avoid wastage and to curtail lessessential spending. Increased efficiency andeffectiveness of the government administrativemachinery as a result of the wider use of officeautomation and information technology also assistedin containing the growth in operating costs. Thetotal wage bill, the largest component of operatingexpenditure (34%), was 7.7% lower than the 1996expenditure level which included the payment ofarrears arising from the salary adjustment for civilservants. In addition, only part of the one monthbonus payment to civil servants (up to a maximumof RM500) was made in 1997, with the balance tobe paid out in 1998. The reduced wage bill alsoreflected the policy to rightsize and rationalise thecivil service through the privatisation of publicservices and projects as well as organisationalrestructuring and consolidation of departments.However, new recruitment continued in the essentialservices, especially in the health and educationsectors. Meanwhile, pension payments increasedmoderately, reflecting the increased number ofpensioners and the annual contribution to thePensions Trust Fund.

Expenditure on supplies and services was higher,largely for maintenance and enhancing the qualityand efficiency of public services. Transfer paymentsincreased moderately, due to larger grants andtransfers provided to the state governments andother government agencies for development andmaintenance purposes, increased subsidy payments,especially on petroleum products and the paddyfertiliser scheme to assist the lower incomeconsumers, a launching grant to the Higher Education

Table 2.3Federal Government Revenue

1996 1997p 1996 1997p

RM million Annual change (%)

Tax revenue 47,272 53,627 13.4 13.4

Direct taxes 25,851 30,432 13.9 17.7Income tax 22,661 27,121 12.3 19.7

Corporate 14,166 16,688 21.0 17.8Petroleum 2,203 3,861 0.8 75.3Personal 6,172 6,429 –0.5 4.2Co–operative 120 143 34.8 19.2

Stamp duties 2,708 2,714 23.5 0.2Other 482 597 48.8 23.9

Indirect taxes 21,421 23,195 12.9 8.3Export duties 1,041 1,053 22.2 1.2Import duties 6,132 6,524 9.1 6.4Excise duties 5,790 6,054 9.7 4.6Sales tax 5,473 6,167 12.4 12.7Service tax 1,231 1,475 21.2 19.8Other 1,754 1,922 31.7 9.6

Non–tax revenueand receipts 11,008 12,109 18.6 10.0

Total 58,280 65,736 14.4 12.8

p Preliminary

Source: Ministry of Finance

Table 2.4Federal Government Operating Expenditure by Object

1996 1997p 1996 1997p

RM million % share

Emolument 1 16,282 15,024 37.1 33.6Supplies and services 5,673 6,363 12.9 14.2Asset acquisition 874 905 2.0 2.0Public debt charges 6,795 6,425 15.5 14.4Pensions and gratuities 3,509 3,638 8.0 8.1Other grants and transfers 2 9,449 10,273 21.5 23.1Other expenditure 1,283 2,037 3.0 4.6

Total 43,865 44,665 100.0 100.0

1 Includes statutory bodies.2 Includes grants and transfers to state governments as well as public

agencies and enterprises.p Preliminary

Source: Ministry of Finance

Fund to assist students facing financial constraintsand higher allocation for the Fund for Food. Thereduction in the size of the Government domesticdebt contributed to the decline in public debt servicepayments in 1997. Both domestic and foreign interestpayments were lower during the year. The impactof the ringgit depreciation on the interest paymentburden was insignificant in 1997, largely due to thelow external indebtedness of the Federal Government.Debt servicing, however, remained the second largestcomponent of operating expenditure, although itsshare declined to 14.4%.

Gross development expenditure rosemoderately by 7.7% to RM15.8 billion, mainly onprojects to expand the productive base of theeconomy and alleviate supply constraints. Theincrease in expenditure was contained throughfurther privatisation and some deferment of theless essential projects. The emphasis ofdevelopment expenditure continued to focus onthe expansion of infrastructure, upgrading thequality of the workforce through human resourcedevelopment, and broadening and deepening theresearch, science and technology base. Prioritywas also accorded to achieving the socio-economicobjectives of the country, especially to eradicatepoverty and improve the quality of life of the ruralpopulation as well as to provide housing for thelow- and medium-income groups.

In terms of sectoral distribution, economic servicesremained the largest component of total developmentexpenditure, although its share declined to 49% duein large part to the on-going programme to privatisenew projects, especially the major infrastructureprojects. Disbursements on the transport sub-sectorwas maintained at about the previous year’s level,comprising mainly investments on transportationnetworks to facilitate the flow of goods and passengertraffic to support the industrialisation processand to overcome traffic congestion in the majortowns. The major share of the expenditure was forthe construction and improvement of Federal roads,and support loans for the development of the railsystem, including the light rail transit system projects,and the purchase of rolling stocks for the commutertrain system. Priority was also accorded to thedevelopment and expansion of ports and airports tostrengthen their capacity and efficiency inhandling the increasing volume of international andregional trade and passenger traffic. In terms ofexpenditure on trade and industry, attentioncontinued to focus on industrial development,

research and development, promotion of small- andmedium-scale industries and tourism projects. A largeportion of the expenditure was also channelled todeveloping technology infrastructure and toprogrammes to strengthen the technological base ofthe economy. As part of the continuing effortto reduce the poverty rate to 5.5% by the year 2000and raise the standard of living of the ruralpopulation, expenditure on agriculture and ruraldevelopment, including land development, andinvestment to improve rural roads, water supply andelectrification programmes remained high.

Capital outlay on the social services sectorrecorded a large increase of 23.5% in 1997,raising its share to 31% of total developmentexpenditure. Expenditure on education and trainingincreased significantly by 20.6% to absorb thesecond largest share of development expenditure(16%). The expenditure was mainly for theconstruction and upgrade of polytechnics,vocational and technical schools and industrialtraining institutes, the upgrading of educationalfacilities, including implementation of the computereducation programme. The development ofinstitutions of higher learning, including thedevelopment of University Malaysia Sabah, alsoabsorbed a larger share of the expenditure.Expenditure on housing was also higher, largelyon low- and medium-cost housing projects and

Table 2.5Federal Government Development Expenditure bySector

1996 1997p 1996 1997p

RM million % share

Defence and security 2,438 2,314 16.7 14.7

Economic services 7,693 7,800 52.6 49.5Agriculture and rural development 1,182 1,105 8.1 7.0Commerce and industry 1,212 1,286 8.3 8.2Transport 4,530 4,536 31.0 28.8Public utilities 733 837 5.0 5.3Other 36 36 0.2 0.2

Social services 3,984 4,919 27.2 31.2Education 2,091 2,521 14.3 16.0Health 459 449 3.1 2.9Housing 501 735 3.4 4.7Other 933 1,214 6.4 7.6

General administration 513 717 3.5 4.6

Total 14,628 15,750 100.0 100.0

p Preliminary

Source: Ministry of Finance

housing programmes for the armed forces, policeforce, customs and immigration officers andteachers in rural areas. The outlay on social andcommunity services included expenditure onprojects to conserve the environment and a largercontribution for the development of facilities forthe Commonwealth Games in 1998. Investment toprovide better quality health care services wasmainly on the construction and upgrading ofhospitals and health clinics and on the purchaseof medical facilities and equipment, includingequipping rural health clinics to serve as nervecentres for primary health care services. However,spending on this sector was marginally lower,reflecting the privatisation of support services suchas clinical waste management, engineering facilitiesand biomedical engineering maintenance. Outlayson defence and internal security were mainly forthe modernisation of the armed forces and thepolice force, as well as the construction of trainingcentres. Expenditure for general administrationwas higher, largely for the construction of officebuildings, including the development of the newadministrative centre at Putrajaya, and theintroduction of electronic government.

The large fiscal surplus recorded in 1997 providedthe resources for the Federal Government to furtherreduce its domestic borrowing while continuing withits external loan prepayment programme.Concomitantly, there was a large build-up in theGovernment’s accumulated financial assets whichcontributed to increasing national resources to funddevelopment and growth. As a result, total netborrowing of the Federal Government remainednegative for the sixth consecutive year, with anotherlarge net repayment of RM3.7 billion. The total debtposition of the Federal Government was, however,marginally higher due to an increase in theforeign debt in ringgit terms following thedepreciation of the ringgit. Total debt increased by0.3% to RM89.9 billion at the end of 1997. In termsof percentage of GNP, it declined further to 34%,from 38% at the end of 1996.

The favourable revenue position permitted theGovernment to review and subsequently reduceits planned domestic borrowing programme duringthe year. As in the previous year, the Government’sdomestic borrowing was mainly to accommodatemarket demand for Malaysian GovernmentSecurities (MGS). Gross funds raised through MGSwas reduced to RM3 billion, one-half the amountraised in 1996. Hence, for the first time, there

was a net repayment of domestic loans asmaturing MGS and Government Investment Issues(GII) totalling RM5 billion exceeded new issues.Similarly, no new funds were raised through GIIor Treasury bills (TB) during the year, while theTreasury Housing Loans Fund continued to recorda small net repayment of loans. Consequently, thetotal domestic debt of the Federal Governmentdeclined by 2.8% to RM77 billion at the end of1997, thereby accounting for a smaller share of86% of the total outstanding debt of the FederalGovernment.

In 1997, the Government floated two issues ofMGS worth RM1 billion and RM2 billion respectivelyby way of tender through the principal dealers. Theissues were for maturity of five and ten years. Again,longer-dated MGS were not offered to the long-terminstitutional investors such as the social securityinstitutions. After adjusting for loan redemptions, totalMGS outstanding declined by 1% to RM66.3 billionat the end of 1997 and accounted for 86% of thetotal domestic debt outstanding. In terms of theownership structure of MGS holders , the socialsecurity and insurance institutions maintained theirdominant position, although their share of the totaloutstanding MGS declined to 67%. This reflectedmainly the maturity of MGS held by the EmployeesProvident Fund (EPF), the Social SecurityOrganisation (SOCSO) and insurance companies. Thisdevelopment reflected the recent policy move toliberalise the investment guidelines of these institutionsto allow them to further diversify to non-Governmentsecurities assets such as private debt securities and

Table 2.6Public Debt of Federal Government

Annual change At end1997p

1996 1997p

Nominal value in RM million

Domestic debt 1,173 –2,243 76,968

Treasury bills 0 0 4,320Investment issues –900 –1,400 2,750Government securities 2,191 –648 66,262Treasury Housing Loans Fund –118 –195 3,636

External debt –2,860 2,480 12,951Market loans –1,072 1,312 6,472Project loans –1,788 1,168 6,479

Total –1,687 237 89,919

p Preliminary

Source: Ministry of Finance

equity. Nevertheless, the EPF remained the singlelargest institutional investor in 1997, holding a slightlylower share of 56% of the total MGS. The newissues of MGS during the year were absorbed mainlyby the banking institutions to meet their statutoryliquidity requirements following the maturity of BankNegara Bills of RM6 billion, which is an alternativeinstrument held to comply with their liquid assetrequirement. Consequently, their shareholding in MGSincreased further to 20%. The remaining MGS washeld mainly by the public enterprises, the non-bankfinancial institutions and foreign investors.

The balance of the domestic debt was in theform of TB (6%), the Treasury Housing Loans Fund(5%) and GII (3%). There was a significant shiftin the profile of holders of TB in 1997. Thetraditional holders, namely, the banking institutions,doubled their holdings to RM3.9 billion, to meet theirstatutory liquidity requirements. Hence, it regainedits position as the major investor to account for 90%of the total TB outstanding. The demand was offsetby net liquidations by the insurance companies,which reduced their holdings significantly to only 7%after a large increase of their shareholding to 56%in 1996. The composition of GII by holder alsoindicated an increase in the holdings of the bankinginstitutions participating in the Interest-free BankingScheme, to account for a larger share of 37% ofthe total GII outstanding. In contrast, the traditionalholders, comprising the Islamic financial institutions,such as Bank Islam, Syarikat Takaful and thePilgrims Fund Board, further reduced their holdingsdue to the increased availability of other higher-yielding instruments based on Islamic principles suchas Islamic bonds. Meanwhile, BNM's holdingsof GII was reduced to 58%, reflecting the large netredemptions of loans during the year. The mainlenders to the Treasury Housing Loans Fund wereCagamas Berhad, the EPF, the National SavingsBank and the commercial banks.

The prepayment of external loans and restrainton new external borrowing remained an integral partof the Government’s debt policy in 1997.Consequently, net external borrowing of the FederalGovernment continued to decline for the sixthconsecutive year, recording an outflow of RM1.7billion in 1997. Gross external borrowing was limitedto drawdowns on project loans. During the year,Malaysia signed one project loan agreement withthe Asian Development Bank (US$26.3 million) tofinance the Klang River Basin EnvironmentalImprovement and Flood Mitigation project. The

Federal Government also took advantage of theweaker yen in the early part of the year to prepaytwo market loans and two loans from the OverseasEconomic Co-operation Fund of Japan in additionto the maturing of two market loans. However, therecent significant depreciation of the ringgit led toan increase in the external debt in ringgit terms.For the first time in five years, the external debtof the Federal Government rose by 23.7% to RM12.9billion at the end of 1997.

Based on preliminary estimates, the consolidatedfinancial position of the 13 state governmentsremained in surplus in 1997, for the fifth consecutiveyear. Reflecting efforts to contain increases inoperating expenditure in line with revenue growth,the consolidated current account of the stategovernments recorded a larger surplus of RM4.6billion in 1997. Almost all the states achievedsurpluses in their current accounts, in line with theobjective of raising public sector savings to financedevelopment expenditure. However, with some statesrecording deficits in their overall balance, theconsolidated position showed a smaller overall surplusof RM529 million. The surplus position togetherwith Federal Government loans led to an increaseof RM1.2 billion in the accumulated financial assetsof the state governments.

Table 2.7Holdings of Federal Government Domestic Debt

1996 1997p 1996 1997p

Nominal value in % shareRM million

Treasury bills 4,320 4,320 100.0 100.0Insurance companies 2,431 304 56.3 7.0Banking sector 1,849 3,879 42.8 89.8Other 40 137 0.9 3.2

Government InvestmentIssues 4,150 2,750 100.0 100.0Insurance companies 63 119 1.5 4.3Banking sector 3,878 2,610 93.4 94.9of which:

Bank Negara Malaysia 2,938 1,588 70.8 57.7Commercial banks 611 930 14.7 33.8

Other 209 21 5.1 0.8

Malaysian GovernmentSecurities 66,910 66,262 100.0 100.0Social security and

insurance institutions 46,402 44,332 69.4 66.9of which:

Employees Provident Fund 38,743 37,055 57.9 55.9Insurance companies 5,447 5,279 8.1 8.0

Banking sector 11,541 13,196 17.2 19.9Other 8,967 8,734 13.4 13.2

p Preliminary

The consolidated state revenue rose by 1.4% toRM9.6 billion in 1997, on account of higher receiptsfrom both state sources and contributions fromFederal grants and transfers. The higher revenuereceipts from state sources were mainly from directtaxes, especially forest taxes, which remained thesingle largest source of state revenue (20%).However, receipts from indirect taxes were lower.Non-tax revenue also declined, largely due to lowerreceipts from commercial undertakings and theabsence of privatisation proceeds. Investment incomeand payment of petroleum and gas royalty toSabah, Sarawak and Terengganu Darul Iman werehigher during the year. The receipts from Federalsources were aimed at assisting the states inproviding infrastructure and other essential amenitiesto improve the quality of life and to support theindustrialisation process.

The total expenditure of the state governmentsas a group increased at a more moderate rate of6.3% in 1997, after recording double-digit growth inthe preceding two years. Reflecting tighter controlon consumption spending, the operating expenditureof the state governments increased marginally by0.7% to RM5 billion (18.9% in 1996). Emoluments,the single largest component of operating expenditure,

was lower than the 1996 level which included thepayment of salary arrears. The higher expenditurewas mainly on maintenance, as well as to providebetter facilities and improve the efficiency of stateservices and administration. Net developmentexpenditure increased by 14% to RM4.1 billion(3.8% in 1996), to expand the infrastructure andamenities required to support the high level ofindustrial development and urbanisation in the states.Most of the states increased their capital expenditure,reflecting their increasing role in the nation’sdevelopment process. The major share of theoutlay was channelled to the economic sector,especially infrastructure (roads, bridges and publicamenities), industrial and commercial investmentsand agriculture and rural development. Thebalance was for investment in the socialservices sector, including housing and social andcommunity programmes.

Preliminary estimates of the consolidated positionof 28 non-financial public enterprises (NFPEs)indicated that the overall financial position of theNFPEs as a group remained in surplus in 1997.However, the surplus was lower than the surplusachieved in 1996 due to the strong increase incapital expenditure by several major publicenterprises, mainly to finance capacity expansion.Several NFPEs continued to rationalise theiroperations during the year, including increasingcapacity utilisation by diversifying into upstream anddownstream products to improve quality, efficiencyand productivity. During the year, TNB completed acorporate restructuring exercise to strengthenperformance and consolidate its activities in orderto enhance efficiency, as well as optimise utilisationof its assets and human resources. Meanwhile,Telekom Malaysia Berhad also undertook a voluntaryredundancy programme to rightsize its workforce.PETRONAS acquired 29.3% shareholding inMalaysian International Shipping Corporation (MISC)to complement and strengthen the operations ofboth enterprises.

The consolidated revenue of the NFPEs expandedfurther by 7.2% to reach RM62 billion in 1997,supported by the expansion in business and otheractivities amidst sustained economic growth. A reviewof the electricity tariff rates, returns frominvestments, and gains from overseas operationsalso contributed to the higher revenue receipts. Thedepreciation of the ringgit also contributed to higherexport earnings of several enterprises during thelatter part of the year. Reflecting tight fiscal discipline

Table 2.8Consolidated State Government Finance

1996 1997p 1998f

RM million

Revenue 9,494 9,624 8,739State sources 7,974 8,023 7,283Federal grants and transfers 1,520 1,601 1,456

Expenditure 4,955 4,988 4,408

Current surplus 4,539 4,636 4,331

Development expenditure (net) 3,605 4,107 3,612

Gross development expenditure 4,137 4,433 3,923Less: Loan repayment 532 326 311

Overall surplus 934 529 719

Sources of financing

Federal loans 544 678 700Realisable assets 1 –1,478 –1,207 –1,419

Total –934 –529 –719

1 An increase in the accumulated realisable assets is indicated by a minus(-) sign.

p Preliminaryf Forecast

Source: State governments

as well as the restructuring exercises undertaken bysome public enterprises to improve productivity andefficiency, operating expenditure rose moremoderately by 7.2% to RM39.7 billion. The higherspending reflected the increased cost of businessexpansion and higher labour and supply costs,including higher import costs due to the weakerringgit in the latter part of the year. Debt servicingpayments, especially the foreign interest servicingburden, increased in 1997 due to the accumulationof a larger debt and the implications of thedepreciation of the ringgit.

The operating surplus of the NFPEs as a groupwas maintained at a high level of RM22.3 billionor 8.5% of GNP in 1997 (8.7% of GNP in 1996).The large surplus was contributed mainly by themajor NFPEs, notably PETRONAS, TNB, Telekomand MISC. A small number of enterprises continuedto experience losses in 1997.

During the year, several major public enterprisescontinued to undertake large capacity expansionand modernisation programmes, mainly oninfrastructure and utility projects, as well asinvestment in the oil and gas and manufacturingsectors. The NFPEs also diversified their investmentto include acquisition of companies related to theircore activities as well as overseas ventures,especially in emerging economies. Thesedevelopments contributed to a significant increasein the capital spending of the NFPEs, by 43% toRM22.2 billion in 1997 (13.8% in 1996).PETRONAS, TNB, Telekom and MISC accountedfor the major share of total capital expenditureduring the year. In particular, capital investment by

PETRONAS expanded in both upstream anddownstream activities. A substantial portion wasinvested in the gas sector, including the constructionof two new gas processing plants (GPP 5 and 6),and the completion of the Peninsular Gas Utilisationproject (PGU III); the completion of the MalaccaRefinery Centre; and investment in severalpetrochemical projects as well as PETRONASInstitute of Technology. Overseas investmentactivities also expanded during the year.Investments by TNB included outlays to expandthe power generating capacity and upgrade thetransmission and distribution networks to meet therapid growth in demand for electricity by thecommercial and industrial sectors. Major projectsunderway included the construction of Phases IIIand IV of the Port Klang Sultan Salahuddin AbdulAziz Power Station, the construction of two initialphases of the 500kv transmission line network, theconstruction and installation of gas turbines at thevarious load centres as well as the rehabilitationand conversion works at several power stations.Other projects included the development of theelectricity infrastructure for Putrajaya and theMSC projects and the construction of phase II ofthe TNB University complex. Other investmentsincluded power projects overseas, including thoseundertaken in Bosnia and Pakistan.

A major part of the expenditure of Telekom wasfor the expansion and upgrading of the internationaland local networks, as well as investment intelecommunication infrastructure for the MSC projects.Telekom continued to diversify its investments tooverseas emerging economies. MISC maintained itslong-term fleet expansion programme in 1997 toenhance its capacity to handle the growing volumeof international trade. Keretapi Tanah Melayu Berhadcontinued to enhance the quality and efficiency ofrail services as an alternative commuter transportsystem. The projects included the purchase of 44additional electric multiple units for the electriccommuter train service.

With these large capital investments, theconsolidated overall account of the NFPEs as agroup recorded a lower surplus of RM86 million orless than 0.1% of GNP in 1997 (2.2% of GNP in1996). These capital outlays were financed byinternally generated funds as well as recourse todomestic and external borrowing. In 1997, theoutstanding external debt of the public enterprisesincreased to RM52.5 billion, to account for 41% ofthe nation’s medium- and long-term external debt.

Table 2.9Consolidated NFPEs Finance1

1995 1996 1997p

RM million

Revenue 48,682 57,794 61,956Expenditure 32,343 37,032 39,689

Current surplus 16,339 20,762 22,267(% of GNP) 7.9 8.7 8.5

Development expenditure 13,630 15,512 22,181

Overall surplus 2,709 5,250 86(% of GNP) 1.3 2.2 –

1Refers to 32 NFPEs in 1995, 28 in 1996 and 1997 respectively.

p Preliminary

Source:Ministry of Finance, Economic Planning Unit and non-financial publicenterprises.

This increase reflected the increase in borrowing aswell as the increase due to the depreciation of theringgit. However, the external debt position of theNFPEs remained manageable as most of the loanswere utilised to fund productive investments, includingoverseas investments, which were expected tostrengthen the performance of the NFPEs as wellas generate additional revenue to service the debt.The expenditure, investment activities and borrowingsof the NFPEs were closely monitored by the FederalGovernment to ensure that the activities wereconsistent with the Government’s policy of fiscalprudence and financial discipline.

In 1997, the Government continued with theprivatisation programme as part of public policy toconsolidate the public sector while increasing privatesector participation to meet the country’s need forcapital investments. During the year, two governmentagencies, namely, Federal Land Consolidation andRehabilitation Authority (FELCRA) and the MaritimeAcademy were corporatised. Another 15 existing andnew projects were privatised, mainly involvinginfrastructure and construction projects. Majorprivatised projects included several highways such

as the Dedicated Kuala Lumpur-Sepang Highway,Western Traffic Dispersal System, Assam Jawa-Taman Rimba Templer Highway and Kajang-Seremban Highway. One state entity, namely,PASDEC was divested through listing in the KualaLumpur Stock Exchange. Following the emergenceof the regional financial crisis, the Governmentannounced the deferment of a number of largeprivatised projects, including the Bakun Hydroelectricproject, the Kuala Lumpur Linear City, the NorthernInternational Airport, Phase II of the Putrajayaproject and Light Rail Transit Systems in Penangand Johor. In addition, the privatisation programmewould now be more selective. New privatised projectswould be assessed critically in terms of theirmacroeconomic implications, especially on thebalance of payments position. Only projects with lowimport content, which would contribute to expandingproductive capacity and improve the long-termgrowth prospects would be approved. On-goingconstruction projects which were not strategic weredeferred. For large infrastructure projects that havebeen approved, the implementation would bestaggered and the emphasis would be placed onthe usage of domestic inputs and on projects thatwould generate export earnings.