rising to the challenge in asia: a study of financial markets · rising to the challenge in asia: a...

Rising to the Challenge in Asia:A Study of Financial Markets

Asian Development Bank1999

Volume 8

Malaysia

Asian Development BankP.O. Box 789

0980 Manila, Philippines

The views and opinions expressed in this publication are those of the individual authorsand do not necessarily represent the views of the Asian Development Bank.

Published by the Asian Development Bank

All rights reserved

Publication Stock No. 060599ISBN 971-561-235-0

Foreword

The Asian currency and financial crisis has had far-reaching effects on the regional economies and theirtrading partners. These effects have threatened to wash away the region’s significant social and economicadvancement achieved during the preceding years of rapid growth. The crisis has also unveiled many intri-cate problems and challenges in macroeconomic management, banking and capital markets management,institutional capacity, and governance of the financial systems in the region.

Recognizing the urgency of addressing these problems and challenges, the Economics and DevelopmentResource Center of the Asian Development Bank undertook a regional study of financial markets in ninedeveloping member countries: People’s Republic of China, India, Indonesia, Republic of Korea, Malaysia,Pakistan, Philippines, Thailand, and Viet Nam. The objectives of the study were to analyze and deepen theunderstanding of the sources of the crisis in currency and financial markets, to provide a useful basis fordesigning and implementing preventive measures and refocused country strategies, and to help the Bank andits member countries build robust and sustainable financial systems in the region.

The study was designed, supervised, and coordinated by S. Ghon Rhee, Resident Scholar, 1997–1999.A large number of Bank staff and renowned scholars and experts contributed to this study.

Regional policy issues and recommendations based on the findings of the study were discussed at theHigh-Level Workshop on the Asian Financial Crisis in Tokyo, on 25–26 March 1999. This workshop washosted by the Bank, the ADB Institute, and the Institute of Fiscal and Monetary Policy of the Ministry ofFinance of Japan.

The present series of publications seeks to bring the research findings to a much wider audience and hopesto contribute to a better understanding of the Asian financial crisis and how its recurrence can be preventedin the future.

Jungsoo LeeChief Economist

Preface

Rising to the Challenge in Asia: A Study of Financial Markets presents the findings of a study carried outunder Regional Technical Assistance 5770: Study of Financial Markets in Selected Member Coun-tries. Many Asian Development Bank staff members and outside experts contributed to the study’s success-ful completion.

The core members for the study were Ramesh Adhikari, David Edwards, Tobias Hoschka, Sudipto Mundle,Soo-Nam Oh, Pradumna Rana, Yutaka Shimomoto, Reza Siregar, Peggy Speck, Ramesh Subramaniam, andVo Van Cuong. The outside experts were Stephen Cheung (Hong Kong, China), Yoon Je Cho (Republic ofKorea), Jang-Bong Choi (Republic of Korea), Catherine Chou (Hong Kong, China), G.H. Deolalkar (India),Maria Socorro Gochoco-Bautista (Philippines), Akiyoshi Horiuchi (Japan), Masahiro Kawai (Japan),Mohammad Zubair Khan (Pakistan), Joseph Y. Lim (Philippines), Sang-Koo Nam (Republic of Korea),Anwar Nasution (Indonesia), Edward Ng (Singapore), Jaeha Park (Republic of Korea), Mohd. Haflah Piei(Malaysia), Ken-ichi Takayasu (Japan), Khee Giap Tan (Singapore), S. K. Tsang (Hong Kong, China),Stephen Wells (United Kingdom), Richard Werner (Germany), Min-Teh Yu (Taipei,China), and BarentsGroup LLC (KPMG).

Thirty-seven reports are contained in a series of 12 volumes:

Volume 1: Regional Overview• Macroeconomic Policy Issues• Banking Policy Issues• Capital Market Policy Issues

Volume 2: Special Issues• Asset Management Entities• Deposit Protection Schemes

The volumes benefited extensively from constructive comments from the Bank interdepartmental workinggroup, and the ministries of finance, central banks, and securities and exchange commissions of the ninemember countries that participated in the regional technical assistance study program and in the High-LevelWorkshop on the Asian Financial Crisis in Tokyo, on 25–26 March 1999. Mitsuo Sato, former President ofthe Asian Development Bank; Bong-Suh Lee, former Vice-President (Region West); and Peter Sullivan,Vice-President (Region East) provided strong support and guidance throughout this project.

Soo-Nam Oh coordinated the research and publication activities. Wilhelmina Paz, Lagrimas Cuevas,Anthony Ygrubay, Ruben Mercado, Virginia Pineda, and Rosalie Postadan provided administrative andtechnical support. The volumes were edited by Gloria Argosino, Mary Ann Asico, Graham Dwyer, andMuriel Ordoñez. Typesetting, computer graphics, and conceptualization of the cover design were done bySegundo de la Cruz, Jr.

S. Ghon RheeK. J. Luke Chair of International Finance and BankingUniversity of HawaiiResident Scholar of the Asian Development Bank(June 1997–June 1999)

Volume 3: Sound Practices• Corporate Governance (Hong Kong, China)• Currency Board (Hong Kong, China)• Central Provident Fund (Singapore)• Dichotomized Financial System (Singapore)• Banking Sector (Taipei,China)

Volumes 4–12: Country Studies• Macroeconomic Policy Issues• Banking Policy Issues• Capital Market Policy Issues

vi A STUDY OF FINANCIAL MARKETS

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Contents

Foreword iiiPreface vAcronyms and Abbreviations ix

An Insight into Macroeconomic Policy Management andDevelopments in Malaysia 1Mohd. Haflah Piei and Tiangchye Tan

INTRODUCTION 2OVERVIEW OF MACROECONOMIC POLICY MANAGEMENT IN THEYEARS PRECEDING THE CRISIS 3

Interest Rates and Credit Policy Instruments 3Exchange Rates 5The Financial Sector 5Fiscal Policy 6International Trade, Industrial and Investment Development 6

VULNERABILITY AND UNDERLYING WEAKNESSES 8Erosion in Competitiveness 10Resource Misallocation and Loss of Efficiency 10Excessive Credit Expansion and Diversion of Resources to Nonproductive Sectors 10Escalating Savings-Investment Gap and Current-Account Deficit 10Liberalization 11Lack of Institutional Infrastructure and Deficient Governance 11High Debt-Equity Ratios 11Further Comments 12

MACROECONOMIC DEVELOPMENTS DURING THE CRISIS 12Policy Initiatives 12

ISSUES AND POLICY RECOMMENDATIONS 19Macroeconomic Reforms 20Banking and Financial Sector Reforms 22Improving Risk Management and Capital Market Development 24Corporate Governance and Institutional Restructuring 25Improving Long-Term Competitiveness 26

FINAL WORDS 27APPENDIX 29NOTES 31REFERENCES 31

THE CAPITAL MARKET IN THE SOCIALIST REPUBLIC OF VIET NAM vii

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Towards a Sustainable Banking Sector—Malaysia 33Soo-Nam Oh

EXECUTIVE SUMMARY 34OVERVIEW OF THE BANKING SECTOR 35RECENT DEVELOPMENTS IN THE BANKING SECTOR 38

Initial Impact of the Asian Financial Crisis on the Banking Sector 38Financial Policy Responses to the Crisis 38Introduction of Capital Controls and Easy Monetary Policy 40

IMPROVEMENT OF ASSET QUALITY: POLICY ISSUES AND RECOMMENDATIONS 41Recent Trends in Banking Sector Indicators 41Prudential Regulations 43Trends in Nonperforming Loans 45Resource Implications of the Rising Nonperforming Loans 48Management of Nonperforming Loans and Recapitalization 51

SUPERVISION: POLICY ISSUES AND RECOMMENDATIONS 52Basle Core Principles 52Review of Mechanisms for Assessing and Monitoring Compliance with

Asset Quality Related Prudential Standards 53Assessment of Supervision 55

FURTHER ISSUES AND POLICY RECOMMENDATIONS 56Specific Issues with Regard to Asset Quality 56Opening of the Banking Industry 58Regulatory Fragmentation 58Credit Crunch 59Deposit Insurance 60Financial Innovation 61

APPENDIXES 63NOTES 77

The Capital Market in Malaysia 79Yutaka Shimomoto

INTRODUCTION 80OVERVIEW 80

Capital Market Development 80Financial Crisis and the Capital Market 81Capital Market Prospects 81

EQUITY MARKET 82Revival of Foreign Exchange Control 82

viii A STUDY OF FINANCIAL MARKETS

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Corporate Governance 84Legal Framework 85Recommended Measures 86

BOND MARKET 88Government Bond Market 88Private Debt Securities Market 91Overall Bond Market 95Recommended Measures 96

APPENDIX 100NOTES 112

THE CAPITAL MARKET IN THE SOCIALIST REPUBLIC OF VIET NAM ix

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Acronyms and Abbreviations

ABS asset-backed securitiesADR American Depository ReceiptAFTA ASEAN Free Trade AreaAPEC Asia-Pacific Economic CooperationASEAN Association of Southeast Asian NationsBAFIA Banking and Financial Institutions ActBI banking institutionBIDS Bond Information and Dissemination SystemBLR base lending rateBNB Bank Negara billsBNM Bank Negara MalaysiaBOP balance of paymentsbp basis pointCAMEL capital adequacy, asset quality, management, earnings, and liquidityCAR capital adequacy ratio/capital adequacy requirementCDRC Corporate Debt Restructuring CommitteeCGC Credit Guarantee CorporationCLASS Classified Loans and Advances SystemCLOB Central Limit Order BookCP commercial paperCPI consumer price indexDII domestic investment initiativeDVP delivery versus paymentEPF Employees’ Provident FundFAST Fully Automated System for TenderingFDI foreign direct investmentFIC Foreign Investment CommitteeFLR Frontline RegulationFRNCD floating rate negotiable certificate of depositFX foreign exchangeGATS General Agreement on Trade in ServicesGDP gross domestic productGDR global depository receiptGII government investment issueGNP gross national productGRI government-related institutionGSP generalized system of preferencesIFTS interbank fund transfer systemIMF International Monetary Fund

x A STUDY OF FINANCIAL MARKETS

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IMP Industrial Master PlanIMP2 Second Industrial Master PlanIPO initial public offeringISS Institutional Settlement ServiceKLIA Kuala Lumpur International AirportKLCE Kuala Lumpur Commodity ExchangeKLOFFE Kuala Lumpur Options and Financial Futures ExchangeKLSE Kuala Lumpur Stock ExchangeMARC Malaysia Rating CorporationM&A memorandum and articlesMASB Malaysia Accounting Standard BoardMBS mortgage-backed securitiesMCD Malaysian Central DepositoryMDCH Malaysian Derivatives Clearing HouseMGS Malaysian Government SecuritiesMHPI Malaysian house price indexMIDF Malaysian Industrial Development Finance BerhadMIER Malaysian Institute of Economic ResearchMME Malaysia Monetary ExchangeMOF Ministry of FinanceMOFI Ministry of Finance, Inc.MSC Multimedia Super CorridorMTN medium-term noteNBMC National Bond Market CommitteeNEAC National Economic Action CouncilNERP National Economic Recovery PlanNID negotiable instrument of depositNIE newly industrialized economyNPA nonperforming assetNPGS New Principal Guarantee SchemeNPL nonperforming loanO&M organization and methodOECD Organisation for Economic Co-operation and DevelopmentPD principal dealerPDS private debt securitiesPLC public listed companyPNB Permodalan Nasional Bhd.RAM Rating Agency Malaysia Bhd.RHB Rashid Hussain BankROC Registrar of CompaniesROI return on investmentRWCR risk-weighted capital ratio

THE CAPITAL MARKET IN THE SOCIALIST REPUBLIC OF VIET NAM xi

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SBC stockbroking companySC Securities CommissionSCANS Securities Clearing Automated Network ServicesSES Stock Exchange of SingaporeSMIs small- and medium-size industriesSPEEDS Sistema Pemindahan Elektronik untuk Dana dan Sekuriti

(electronic funds and securities transfer settlement system)SRR statutory reserve requirementSSTS Scripless Securities Trading SystemST stress testingTEB Time Engineering Bhd.TFP total factor productivityTNB Tenaga Nasioni BerhadTSR transferable subscription rightUEM United Engineers (Malaysia)VAT value-added taxWTO World Trade Organization

Unless noted otherwise, in this publication “$” refers to US dollars.Korea refers to the Republic of Korea.

The Capital Market in Malaysia

Yutaka Shimomoto

Yutaka Shimomoto is Economist, Asian Development Bank and Chief Economist, Nikko Securities Co., Ltd. (1997–1999)

80 A STUDY OF FINANCIAL MARKETS

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IntroductionThe capital market in Malaysia has undergone a ro-bust development since the late 1980s. The delistingof Malaysian and Singaporean companies from theirrespective stock exchanges at the end of 1989 wasa milestone in the development of Malaysia’s equitymarket. With the proliferation of privatization projectsand the equity boom in 1993, market capitalizationexceeded that of Singapore by the mid-1990s, mak-ing the Malaysian market one of the fastest growingin the region.

The equity market has contributed to the develop-ment of the private sector, with initial public offer-ings (IPOs) and issuances of new shares enablingmany companies to obtain cheap financing. Equityinvestments by individual, institutional, and foreigninvestors increased substantially, and market infra-structure was developed accordingly. Computerizedtrading, electronic clearing and settlement, and cen-tral depository systems were in place by the end of1997. The regulators, the Kuala Lumpur Stock Ex-change (KLSE) and Securities Commission (SC),have been improving standards on transparency, dis-closure, accounting, and corporate governance. Butthese standards still fall short of international stan-dards, as was revealed, for instance, by the Renong-United Engineers (Malaysia) (UEM) case in Novem-ber 1997, resulting in a loss of market confidence.

Meanwhile, various steps were taken in the late1980s to develop the bond market. Initially, effortswere focused on Government and Cagamas bonds.The central bank, Bank Negara Malaysia (BNM),played an important role in introducing the principaldealer and auction systems to develop the second-ary market for these bonds. However, BNM’s at-tempts were only partially successful. The statutoryrequirements for holding Government and Cagamasbonds have impeded market development. Moreover,the lack of benchmark yield curve and the issue ofriba (interest) had serious implications for bond mar-ket development. The latter was addressed in the

mid-1990s when new debt instruments based on Is-lamic principles were issued.

Since 1995, the Government has encouraged pri-vate and public entities to issue bonds to raise funds,while BNM has tried to develop market infrastruc-ture to support bond issues. During the financial cri-sis, some bonds issued by the private sector defaulted,hurting confidence in the market. As the financialcrisis deepened, many listed companies and stock-brokers became distressed and some private debtsecurities defaulted. Thus the capital market in Ma-laysia is facing serious challenges. The Governmentintroduced measures to curb speculation on foreigncurrency and to restrict the trading of Malaysianequities within KLSE on 1 September 1998, causingtemporary adverse effects on the capital market. Inorder to restore foreign investors’ market confidence,these measures need to be lifted.

OverviewCapital Market DevelopmentAs Singapore was once part of Malaysia, compa-nies in these two countries listed on both KLSE andthe Stock Exchange of Singapore (SES) until the endof 1989. Since then, KLSE has taken various mea-sures, including the introduction of computerized trad-ing, a central depository, and efficient clearing andsettlement systems, to develop market infrastructure.In addition, the regulatory framework has been re-viewed to promote IPOs and equity investments bydomestic and foreign investors. As a result, somebig privatized companies (e.g., Telekom MalaysiaBerhad and Tenaga Nasioni Berhad [TNB]) werelisted on KLSE, making it one of the fastest-growingmarkets in the region in the mid-1990s.

By the end of the 1980s, the primary market forGovernment bonds was relatively developed. TheGovernment introduced the principal dealer systemto develop the secondary market as well, and at thesame time, an auction system for Government secu-rities to promote fair pricing. Although the private

81THE CAPITAL MARKET IN MALAYSIA

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debt securities (PDS) market had deepened whenthe first Cagamas bonds were issued in October 1987,it did not develop until the mid-1990s. The Govern-ment has introduced various measures to enhancemarket infrastructure and put in place an appropri-ate regulatory framework. These included the es-tablishment of a credit rating agency (1990), guide-lines on PDS issues (1992), tax exemption on inter-est income from PDS (1993), scripless trading forunlisted PDS (1996), an auction system for the PDSprimary market (1996), and a bond information anddissemination system (1997). Despite Governmentefforts, a lack of benchmark yield curve hinders thedevelopment of the bond market.

Financial Crisis and the CapitalMarketThe financial crisis in Malaysia has predominantlyaffected the banking sector. At the end of 1997, bank-ing sector assets accounted for RM480 billion or 1.8times the gross national product (GNP). These fig-ures indicate that a substantial amount of funds hadbeen mobilized and provided to the private sector asloans. However, given the implicit control of BNM,external debts in the private sector are relatively small.The banking crisis was more a result of overlending,coupled with the lack of prudential regulation andsupervision.

The capital market, in particular the equity mar-ket, played an indirect role in increasing the numberof bank loans. Banks actively raised funds in theequity market, which expanded their capital base.With the development of the capital market and capi-tal account liberalization, disintermediation emergedto some extent. However, the role of bond and off-shore markets was not so significant except for bondswith warrants issued during the equity boom in themid-1990s.

Corporate entities, at the same time, activelytapped funds in the equity market, resorting to IPOsand new issues of shares for easy financing duringthe equity boom that began in 1992. Some corporate

players, in particular, obtained funds from the capitalmarket and banks to optimize their financial assets.They were successful in building up corporate em-pires while the boom lasted. However, when it wasover, they had to settle large debts from the bankingsector and bond market. With the bankruptcy of thesecorporate players, nonperforming loans (NPLs) ofcertain banks mounted.

Loans for share purchase contributed to an in-crease in banks’ NPLs. In addition, stockbrokers hadbeen providing their customers with credit facilitiesfor share trading. However, when share prices col-lapsed in the wake of the financial crisis starting inJuly 1997, banking institutions and stockbrokers in-curred losses resulting from loan defaults of custom-ers, in particular. The capital base of stockbrokerswas not sufficient to cope with the big losses. As aresult, some stockbrokers became distressed andwere suspended by KLSE.

Capital Market ProspectsThe market infrastructure for the equity market mightbe developed, but transparency, disclosure, and cor-porate governance need to be improved. In particu-lar, speedy and frequent disclosure of appropriateinformation is essential. In addition, the details of assetvalue and off-balance-sheet items should also be dis-closed. BNM has introduced a quarterly disclosurestandard for banks, for example, on profit and lossaccounts, and NPLs. Disclosure of the balance sheetis also necessary.

Since disclosure practices and corporate gover-nance do not conform to international standards, le-gal enforcement needs improvement. Most inves-tors are focused on short-term placements, makingit difficult to enhance corporate governance. Thepublic has to be encouraged to make long-term in-vestments. An increase in dividend payments couldbe considered. Dividends are subject to withholdingtax while interest income from long-term deposits,bonds, and capital gains from sale of shares aretax-exempt. Due to the withholding tax, companies,


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particularly major shareholders, are reluctant to payhigh dividends. They prefer to use the profit forfurther expansion, which leads to an increase in assetvalues (capital gains). In addition, they tend to maxi-mize their returns by injecting their family assets intothe listed company. If they were exempted from thetax on dividends, companies would increase their pay-out ratios and investors would be encouraged to holdshares for longer periods. In this case, shareholdersmust pay more attention to the management of com-panies in order to receive better dividends. This could,in turn, improve corporate governance.

Before the crisis, funds required by the privatesector were readily available from commercial banks,the equity market, and offshore markets as a resultof the deregulation and liberalization of financial mar-kets during the decade. However, the financial envi-ronment changed after the crisis began. The privatesector experienced difficulties securing funds because(i) commercial banks faced liquidity problems,(ii) bearish equity market made it difficult for com-panies to float new shares, and (iii) offshore loansbecame costly due to currency depreciations. As theGovernment has also suffered tight budgetary con-straints, partly because of a decline in revenues fromtraditional sources, it is seriously considering the bondmarket as an alternative source of funds for the pri-vate and public sectors.

Equity MarketRevival of Foreign ExchangeControlA shock wave hit the equity market when BNM andKLSE announced curbs on foreign exchange andtrading of shares respectively on 1 September 1998(the US dollar was fixed at RM3.80 the next day)with immediate effect. The measures included:

• restricting the trading of Malaysian shares withinKLSE, and

• allowing foreigners to sell shares any time butproceeds could not be converted into foreign cur-

rency unless the shares had been held for at leastone year.

BNM’s exchange control measures were intro-duced primarily to regain monetary independence andinsulate the Malaysian economy from possible furtherdeterioration in the world economic and financial en-vironment. Meanwhile, KLSE’s measures were aimedat restoring confidence by ensuring an orderly andfair market, and improving overall transparency in thestock market. These promote greater accountabilityand disclosure without compromising investor confi-dentiality. The critical issue is how to exit from thesecontrol measures with minimum disruption.

With KLSE recognizing the trading of Malaysianshares in KLSE only, the Central Limit Order Book(CLOB), the over-the-counter market in Singaporewhere many Malaysian shares have been traded,was badly hit. CLOB ceased the trading of Malay-sian shares on 4 September 1998.

As Malaysia needs foreign capital, foreign inves-tors have an important role to play. Without a robustequity market, corporate entities have to rely on thebanking sector for financing, putting an additionalburden on a liquidity-tight sector. For this reason, theauthorities should review the measures and put inplace an environment that will attract local and for-eign investors to the equity market.

STOCKBROKERSDuring the market downturn in 1997-1998, it wasgenerally found that stockbroking firms with insuffi-cient capitalization, poor risk-management capabili-ties, and substantial counterparty exposures experi-enced more severe difficulties in managing the fall-out from the crisis.

Stockbrokers’ faulty internal management and riskcontrol was a leading factor in these incidents. Thelack of supervision by KLSE may have also contrib-uted to the problems. KLSE subsequently introduceda new single client and single security limit for mar-gin financing on 19 January 1998. The single clientlimit was set at 30 percent of the adjusted capital


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while the single security limit was pegged at 20 per-cent of the adjusted capital or 10 percent of the paid-up capital of the listed company, whichever is lower.In addition, KLSE introduced a gearing ratio of twotimes against adjusted capital (1.5 times for utilizedborrowings). Stockbrokers were required to fullycomply with the ratios by the end of 1999. With thenew requirements, stockbrokers will be eventuallyforced to increase their capital bases, which are nowunder review by KLSE and SC.

KLSE sets the capital requirements and restric-tions for stockbrokers. They must have:

• paid-up capital of more than RM20 million;• minimum liquid assets of RM500,000 or 5 per-

cent of aggregate debt, whichever is larger; and• restrictions on single customer or single securi-

ties.Despite these requirements and restrictions, stock-

brokers still became distressed. Stockbrokers’ capi-tal should be increased to accommodate any futurelosses.

In addition, share-purchase financing became an-other source of problems. Stockbrokers had arrangedfor their customers to obtain credit facilities fromcommercial banks and finance companies. Share-purchase financing had been profitable for these fi-nancial institutions as well as stockbrokers. Hence,these financial institutions provided investors withcredit through stockbrokers, resulting in an increasein share-purchase financing. Although BNMannounced a ceiling on share-purchase financing on28 March 1997, it was too late to minimize the lossesof banks and finance companies.

BNM monitors share-purchase financing butKLSE should also review the margin trading ratiodepending on market conditions in order to betterregulate the market.

DISCLOSUREFrequency and timing of disclosure are urgent issuesto be addressed. The regulators, KLSE, SC, and theRegistrar of Companies (ROC), supervise and en-

force disclosure standards based on the SecuritiesIndustry Act, Companies Act, and rules and regula-tions set by KLSE and SC. There are three types ofdisclosure: initial, periodic, and continuous. KLSE isresponsible for day-to-day supervision and enforce-ment. An initial disclosure is required in the case ofIPOs, and the information that has to be disclosed ina prospectus is stipulated in the Companies Act. Whileinitial disclosure is deemed to conform to interna-tional standards, there are problems with periodic andcontinuous disclosures.

For periodic disclosure, listed companies are re-quired to disclose their profit and loss accounts twicea year and their balance sheets at the end of the fi-nancial year. Moreover, financial statements must bedisclosed within 90 days of the account book closing.

However, investors may not be able to get timelydetails of the financial condition of these companies.The urgency of providing timely information to in-vestors is illustrated by the case of Time EngineeringBhd (TEB), which was among the listed companiesannouncing financial results within the required pe-riod, only to be suspended by KLSE for insolvency.

The present disclosure standards were decided inthe days before the widespread use of computers.Current technology allows companies to discern theirfinancial positions more promptly. Regulators shouldrequire listed companies to report their unaudited fi-nancial records (profit and loss account and balancesheet) quarterly and within a month of the accountbeing closed, rather than within 90 days.

The TEB case also indicates that there are someproblems on continuous disclosure. When the unau-dited financial statement of TEB was disclosed inmid-March 1998, the company did not reveal anyspecific problems. However, by July, TEB was in-solvent, indicating a drastic deterioration of financialposition in the interim. In Chapter 6 of the SC Guide-lines, the requirement for timely disclosure of infor-mation is clearly stipulated. Under this rule, TEBshould have disclosed negative information within therequired period.


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KLSE, ROC, and SC have been improving ac-counting, auditing, financial reporting, and disclosurestandards. For instance, KLSE has introduced awatch list of companies.

1 These measures will help

investors obtain better information for their invest-ment decisions compared with a few years ago.

Meanwhile, BNM requires banks to disclose theirprofit and loss accounts and NPL ratio on a quar-terly basis. This will also help improve disclosurestandards. However, banks are not required to pub-lish their balance sheets quarterly. Off-balance-sheetitems are increasing, as the banking business becomesmore sophisticated. Similarly, asset value of securi-ties, asset-liability mismatches, credit risk, and liquidityrisk are not adequately disclosed. Investors need suchcritical information. Otherwise, they get a clear pic-ture of a bank’s financial condition only at the end ofthe financial year.

Corporate GovernanceWith disclosure practices not conforming to interna-tional standards, legal enforcement not adequately inplace, and most investors focused on short-termplacements, it is difficult to improve standards ofcorporate governance. A regulatory framework hasto be promptly put in place, while the public shouldbe encouraged to make long-term investments toenhance corporate governance.

INSTITUTIONAL INVESTORSInstitutional investors (e.g., Permodaran NasionalBhd. [PNB] and Employees’ Provident Fund [EPF])can play vital roles in enhancing corporate gover-nance, which has become an increasingly impor-tant issue in Malaysia. PNB was established to in-crease Bumiputras’ (indigenous people) share-holdings (up to 30 percent by 1990). It owns sizablestakes in listed companies in various sectors: bank-ing, manufacturing, services, transport, construction,trading, mining, plantation, and conglomerates. EPFand other Government-related investment institu-

tions have also mobilized their funds to attain na-tional goals, i.e., they are expected to increaseBumiputras’ shareholding up to 30 percent. For thisreason, these institutional investors are basicallylong-term investors.

Dividends are small and capital gains through thedisposal of shares are not expected, given the pas-sive investment policy. Nonetheless, PNB and otherpublic investment entities such as EPF have beenaggressively investing in equities. Despite a relativelylow return on investment (ROI) (EPF’s dividendsfell to 6.7 percent in 1997 from 7.7 percent in 1996),these institutional investors have not come under firefrom the public. Part of the reason is the book value/cost accounting system. However, the goal to in-crease Bumiputras’ shareholding up to 30 percentdiscourages them from selling shares in the market.As such, these institutional investors can exercisetheir rights to increase either or both dividends andthe asset values of the invested companies by im-proving corporate governance. Nevertheless, if theaccounting method were switched to the marked-to-market system, the investment behavior of PNB orEPF would have to change.

INDIVIDUAL INVESTORSMany listed companies are owned by one shareholderor a family group (referred to here as “ownergroup”). In contrast to the spirit of corporate gover-nance, these owner groups insist on exercising theirrights of share ownership, believing that they are le-gally entitled to control the company. This is a con-cept generally accepted by even small shareholders.Corporate governance poses a challenge to this con-cept. For instance, sales of overvalued properties andcompanies to the listed companies controlled by theowner groups take place occasionally. This is partlydue to the passiveness of individual investors whohold shares for a short period (they seldom attendgeneral meetings), and expectations that the dealswill contribute to increases in share prices.


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Many individual investors in Malaysia regard theequity market as a kind of casino, in which the publicacts as speculative and short-term investors. Sincethe onset of the equity boom in late 1992, many in-vestors have expressed their investment performancein terms of “win” or “lose.” This suggests that thepublic is concerned only with capital gains. It alsoindicates that many investors do not consider whethera company is financially sound or not. As long asshare prices are increasing, they do not care abouttransparency or corporate governance, even wel-coming “rumor-driven” speculative price movements.

The public generally stays clear of foreign-ownedcompanies, which tend to have conservative man-agement styles, and pay relatively high dividends.Individual investors are attracted by shares that carrythe expectation of sharp price hikes.

Given the public’s reluctance to demand or exer-cise their rights over their shares, an effective wayof improving corporate governance should be identi-fied. The distressed market sent a serious messageto the securities industries, bankers, regulators, andGovernment officials, who are considering how toregain market confidence. They are particularly con-cerned with foreign investors as their investmentsattract local investors to the market. For this reason,regulators are ready to take serious measures to en-hance corporate governance.

MAJORITY SHAREHOLDERSA listed company is a precious asset for an ownergroup, which will try to maximize profits from the firmthrough every possible means, causing conflict of in-terest between majority and minority shareholders.

Compensation for directors and executives inMalaysia is relatively low. Since dividends are sub-ject to tax, the owner group will want to maximizebenefits in other ways. Therefore, the provision oftax deductible nonpecuniary benefits (e.g., car, house,or travel) is not unusual in Malaysia and they areconsidered as equitable returns from investment in alisted company.

Owner groups also turn to other means to maxi-mize their profits, tending to sell products or servicesof the listed company to a connected company atbelow market price, or the listed company buys prod-ucts, services, or assets of a connected company atabove market price. During the equity boom of themid-1990s, there were many cases in which an ownergroup bought a listed company and sold connectedcompanies to the listed company in the form of shareswap. This practice provides the owner group withvarious profits, as follows:

• in addition to the sale of their assets at abovemarket price, the owner group is able to convertilliquid assets to liquid assets;

• it can use the shares of the listed company ascollateral and invest the borrowed money in otherbusinesses; and

• it can obtain more business opportunities fromthe listed company.

Such related party transactions are restricted bylaw; however, it is difficult to curb these practiceswithin the present legal framework. If new incen-tives for the owner group were devised, such as taxexemption on dividends and a reduction in incometax on directors’ fees, these issues would be ad-dressed to some extent.

Legal FrameworkRENONG-UEM DEAL AND THE WEAKNESSESOF THE LEGAL FRAMEWORKCorporate governance, transparency, and disclosurestandards will improve if an adequate regulatoryframework (legislation, supervision, market surveil-lance, law enforcement, and penalties) is put in place.Regulators must have a legal base on which to put inplace a robust market framework. The need for abetter regulatory environment is illustrated by theRenong-UEM deal.

UEM bought a 32.6 percent stake in cash-strappedRenong Bhd. for RM3.24 billion in November 1997.Some of the issues that emerged from the deal in-cluded the following:


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• UEM was given a waiver from making a gen-eral offer and purchased Renong’s stakes fromrelated parties; and

• UEM’s financial soundness will deteriorate asthe acquisition of Renong stakes was made atabove market price using borrowed money.

Fund managers and analysts were unhappy withthe deal, while investors expressed their disillusionand lack of confidence in the market.

Several issues concerning legal framework andcorporate governance arose from the Renong-UEMcase. According to the Companies Act, shareholderapproval is not required for cash transactions. Offi-cial approval for mergers and acquisitions and take-overs basically comes from SC. But in the case ofan acquisition paid for in cash, SC approval is notrequired, unless enforced by other regulatory authori-ties such as the Foreign Investment Committee (FIC)(SC guideline 17.05; Acquisitions by Cash). FIC hasthe power to waive a general offer in the nationalinterest. It used this power to approve the Renong-UEM deal, although it is questionable whether it wasall in the national interest.

Despite serious losses to the investors, theRenong-UEM deal was deemed legal by regulators.No directors or executives were charged by the au-thorities. UEM was fined only RM100,000 by KLSEfor a breach of disclosure requirements. If directorsand executives responsible for negligence or crimi-nal acts faced stiffer penalties, they might try harderto comply with the rules and regulations.

INSTITUTIONAL INVESTORS ANDUNLISTED BANKSAs EPF, PNB, and other Government-controlled in-stitutional investors are allowed to adopt the bookvalue/cost accounting system, their asset portfoliosdo not reflect market value. Thus, it is important touse instead the marked-to-market accounting sys-tem, and present a real picture of their performanceto the public. Institutional investors should reviewtheir investment policies to improve return on in-

vestment (ROI) by taking a more active governancerole.

The Ministry of Finance, Inc. (MOFI) andKhazanah Holdings Bhd. (Khazanah) were estab-lished by the Government as private entities to investin strategic projects such as infrastructure, publicutilities, and industrial projects (Telekom, Tenaga,Proton, etc.). Their investment policy of passive port-folio management is similar to those of EPF and PNB.Detailed information on MOFI and Khazanah arenot disclosed to the public. Since these entities’ ma-jor shareholder is the public, and their sources of fundsbelong to the taxpayers, full disclosure of their finan-cial statements would improve transparency and dis-closure standards.

As the financial crisis deepened, large NPLs ofunlisted commercial banks (e.g., Bank Bumiputra andSime Bank) have emerged. Although BNM sets vari-ous requirements to ensure the soundness of banks,unlisted commercial banks are not subject to require-ments set by SC and KLSE, resulting in their low de-gree of transparency, disclosure, and corporate gov-ernance standards. Such standards need to be im-proved because these banks retain sizable financialassets and provide listed companies with a substantialamount of loans and guarantees. Any difficulties willhave adverse impact on listed companies.

Recommended MeasuresFOREIGN EXCHANGE CONTROL ANDRESTRICTIONS ON FOREIGN INVESTORSAlthough capital control measures implemented byBNM were aimed to restore order in the economyand stockmarket, investors’ disappointment, in par-ticular that of foreign investors, resulted in panic sell-ing. The measures taken by KLSE to disallow trad-ing of Malaysian shares on CLOB in Singaporeproved a big blow to foreign investors. Although theMalaysian authorities had never officially sanctionedthe trading of Malaysian shares on CLOB, it hadhelped attract foreign investors to Malaysian shares.If the Malaysian authorities were unhappy with


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CLOB, they could have taken the same restrictivemeasures long ago.

The Government and KLSE must urgently takenecessary measures to attract foreign investors to themarket. First, restrictions on foreign exchange for port-folio investments should be lifted as soon as possible.Foreign investors had believed that the Malaysianmarket was undervalued. In fact, they had been care-fully planning to invest in the market once macroeco-nomic and political situations improved. Second, theCLOB issue should be solved urgently and amicably.Third, the Malaysian authorities should encourageMalaysian companies to be listed in overseas marketsas many Asian corporate companies had been pro-moting the idea of listing their shares on foreign mar-kets before the onset of the financial crisis.

STOCKBROKERSShare-purchase financing and margin trading financ-ing contributed to the banking crisis to some extent.The former is subject to the supervision of BNMand the latter is under SC regulation. Although bothregulators have tried to restore order, they have notbeen successful. KLSE has introduced measures toenhance prudential standards of stockbrokers. In turn,stockbrokers should improve their internal controlmeasures to avoid huge losses, particularly on mar-gin trading.

SC and KLSE should review the margin tradingratio depending on market conditions. As the StockExchange of Thailand had changed the margin ratiofrequently depending on market sentiment, KLSEshould follow suit.

LEGAL FRAMEWORKPriority has been given to sustaining share prices tostabilize the equity market. However, the authoritiesshould take long-term measures to promote a morerobust development of the market. As the Renong-UEM deal indicated, the lack of legal framework toenforce transparency, disclosure, and corporate gov-ernance has been challenged. It is important for regu-

lators to have a legal base from which to promote arobust market framework.

Investors want restoration of discipline in the mar-ket and the regulators should respond to this demandswiftly. In connection with this, FIC’s power shouldbe reviewed. FIC was established originally to as-sess the foreign investment from the viewpoint ofnational interest. But its power should be confined tomatters relating to foreign investments.

Moreover, an additional regulatory framework willbe required to enhance the transparency of Govern-ment-related institutional investors.

CORPORATE GOVERNANCEGiven that the disclosure practices and accountingsystems do not satisfy investors’ expectations, thelegal enforcement is not adequately in place, and mostinvestors are focused on short-term investments, itis difficult to improve the standard of corporate gov-ernance. A regulatory framework must be promptlyput in place. In addition, the general public should beencouraged to make long- term investments to en-hance corporate governance. Increasing the dividendpayments might be one answer.

As investors in many listed companies in such sec-tors as banking, manufacturing, services, transport,construction, trading, mining, plantation, and conglom-erates, public investment entities such as PNB, EPFand other government-related investment institutionsare basically long-term investors. With dividends pay-ments small and capital gains not expected, their roleis to increase Bumiputra’s shareholdings. This wasmade possible partly due to the book value/cost ac-counting system. If the accounting method werechanged to the market value (marked-to-market) sys-tem, the investment behavior of PNB or EPF wouldchange. These institutional investors could then ex-ercise their rights to increase either or both dividendsand the asset values of the companies. This wouldenable them to optimize the benefits to the public,while enhancing standards of transparency, disclo-sure, and corporate governance.


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Bond MarketGovernment Bond Market

ISSUES RELATED TO MONETARY POLICY

Monetary PolicyOf the 10 monetary policy instruments,

2 the most

common in Malaysia are reserve requirement, liquidityrequirement, credit control and guidelines on lending,and direct lendings/borrowings. Although the liquid-ity requirement was set by BNM to maintain pru-dential standards in banking institutions, it functionsas a monetary instrument.

Reserve and liquidity requirements for commer-cial banks were set at 4 and 15 percent of eligibleliabilities, respectively.

3 However, the liquidity require-

ment was replaced with a new framework in Janu-ary 1999. The new liquidity framework requires com-mercial banks to maintain certain liquid assets basedon the maturity profile of their assets, liabilities, andoff-balance sheet commitments, and to make a pro-jection of their liquidity surplus and shortfall. Theassessment will be based upon the ability of a com-mercial bank to match its short-term liquidity require-ment, which will be determined by reckoning thematuring obligations and assets. It is envisaged thatthe new framework will lead to commercial banksoptimizing their asset management in the secondarymarket.

When a certain sector of the economy overheats,credit to that sector is controlled. BNM has usedshort-term direct borrowings, generally with maturi-ties of between one and three months, to sterilizelarge capital inflows since late 1991. In some cases,however, the maturity has been lengthened to sixmonths. Since February 1993, BNM has also issuedBank Negara bills (BNBs) to mop up excess liquid-ity.

BNM’s use of direct instruments as primary in-struments for monetary regulation and indirect in-struments as supplementary instruments suggests thatthere are some impediments to the use of open mar-

ket operations in Malaysia as a tool of monetarypolicy. In fact, direct lending/borrowing has been amore effective monetary tool than open market op-erations. High reserve and liquidity requirement ra-tios and inefficient open market operations have hin-dered the development of the bond market.

In March 1998, BNM announced a new monetarypolicy with changes from direct instruments to indi-rect instruments (employing open market operationsand repurchase operations). With the policy changes,coupled with the deepening financial crisis, BNMreduced the reserve requirement from 13.5 to 4 per-cent (four times since February 1998) to supply li-quidity to the banking system. The liquidity require-ment ratio for commercial banks was also decreasedfrom 17 to 15 percent on 16 September. The reduc-tion in statutory requirements will help increase li-quidity in the banking system. Meanwhile, the bench-mark interest rate (three-month interbank rate) wascut to 8 percent to reduce the cost of funds. Thiswas made possible by fixing the foreign exchangerate at RM3.80 against $1 on 2 September.

Open Market OperationsOpen market operations are not often used as a

monetary tool in Malaysia due to underdevelopedsecondary market in Government bonds. The instru-ments used for open market operations are Treasurybills (T-bills), Malaysian Government securities(MGS), Government investment issues (GIIs), Ma-laysia Savings Bonds, BNBs, Cagamas papers,banker’s acceptance (BAs), negotiable certificatesof deposit, and Floating Rate Negotiable Certificatesof Deposit (FRNCDs). However, trading of Gov-ernment bonds has been limited, attributable to theissuance of bonds with low market yields.

4

To address this issue, a new issuing practice andother measures were introduced between 1986 and1989. With the introduction of the principal dealer on1 January 1989 involving selected commercial banks,merchant banks, and discount houses, open marketoperations began to take place between BNM and


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securities to meet the liquidity requirement. The Gov-ernment, BNM, and Cagamas Bhd. issue other se-curities such as T-bills, BNBs, Malaysia SavingsBonds, Cagamas bonds, and other papers to meetthis demand.

While the liquidity requirement helps maintain pru-dence among banking institutions, it also increasesthe costs of funds to them. They receive depositsfrom customers and are required to invest a certainportion of money in the eligible securities to complywith the liquidity requirement. Due to the illiquid sec-ondary market, banking institutions usually hold thesecurities until maturity. Thus they are exposed tomaturity mismatch and interest risks, resulting in high-cost investments.

LACK OF BENCHMARK YIELD CURVEInterest Rate StructureA three-month interbank rate, determined through

direct lendings/borrowings by BNM, is a major de-terminant of other interest rates in Malaysia. Thereis a strong correlation between the three-month in-terbank rate, base lending rate, and deposit rate (seeFigure). Even the market yields of medium- and long-term Government bonds have shown a strong corre-lation with the three-month interbank rate since 1992.This sets Malaysia’s interest rate structure apart fromthat of developed countries.

principal dealers (PDs).5 PDs were given access to

BNM’s rediscount window. In turn, PDs were re-quired to underwrite and make markets for Govern-ment bonds by providing two-way quotations in thesecondary market within a 15-sen spread. Since 1January 1996, the PDs have been appointed annu-ally.

Market yields of Government bonds are deter-mined through auction by PDs. However, the com-pulsory subscription by PDs and the limited supplyof Government bonds have left the yields low. Sup-ply is limited by compulsory holdings of Governmentbonds arising from the high liquidity requirement. Thismeans that BNM cannot effectively use Governmentbonds for open market operations. As a result, BNMhas encouraged the development of a secondarymarket under which Government bonds are tradedamong financial institutions.

In some countries where Government bonds arenot issued due to fiscal surpluses, central banks of-ten issue short-term papers to mop up excess liquid-ity. BNM since 1993 has issued BNBs to mop upexcess liquidity. However, it does not issue BNBsoften because they are costly. Hence, it relies moreon instruments such as the reserve and liquidity re-quirements as well as direct lendings/borrowings tocontrol liquidity.

Liquidity RequirementMalaysia’s liquidity requirement, which was not

adjusted between 15 October 1986 and 15 Septem-ber 1998, is an effective instrument of monetarypolicy. Of the eligible securities, Government bondsmake up the biggest share. As commercial banks’deposits rise, they are required to increase their hold-ing of eligible assets to meet the liquidity require-ment. The rapid growth in deposits held by commer-cial banks since the late 1980s has resulted in anaccumulation of Government bonds. However, theissuance of Government bonds has declined due tothe budget surpluses since 1993. Hence, commer-cial banks have been forced to invest in other eligible

Interest Rate Structure

1990 1991 1992 1993 1994 1995 1996 19970

2

4

6

8

10

12

Deposit rate (1 year)Base lending rateInterbank rate (3 months)Government bond (10 years) yield

Percent

Source: Bank Negara Malaysia.


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But the interest rate structure poses a problem tothe Government bond market. Despite the Govern-ment’s insistence that its bonds be issued at marketrates, the market yields clearly indicate the presenceof distortions in the interest rate structure. As com-mercial banks are required by BNM to hold a cer-tain amount of Government bonds that carry lowyields, they are paying the cost of the distortion. Thisis eventually passed on to their depositors and bor-rowers. If the Government takes appropriate mea-sures to correct the distortions, institutional inves-tors, who hold a large amount of the low-yield bonds,may also be forced to accept substantial losses. Arise in interest rates in 1989 left banking institutionswith large capital losses because of the low yieldbond requirement. To cope with the difficulties, BNMintroduced in April 1989 a new accounting systemfor the valuation of bonds. Commercial banks areallowed to book the value of Government bonds atcost, adjusted for amortization of premiums or ac-cretion of discount. They are permitted to amortizethe gains or losses over the maturity period. Althoughthe fundamental issue of the low yield Governmentbonds remained unresolved, this new accounting sys-tem gave an incentive for commercial banks to in-vest in the bonds.

Auction System for Government BondsAlong with the PD system, the Government intro-

duced an auction system in January 1989 to put apricing structure in place. Government bonds, withmaturity period of up to 10 years, are issued by auc-tion through PDs. In turn, financial institutions haveto purchase the securities through PDs. Governmentbonds with a maturity period exceeding 10 years aresubject to advance subscription by EPF and the Na-tional Savings Bank (NSB). The auction system andthe principal dealer system have, to a certain extent,contributed to the development of the Governmentbond market.

These systems worked well during the period ofstable interest rates, and trading of Government bonds

has gradually increased. But when interest rates rosebetween 1990 and 1992, the PD system did not serveits purpose. The auction system operated as if therewas fair pricing of Government bonds. In an auctionof Government bonds, PDs have the obligation tounderwrite the entire amount of primary issue. Asthere are 14 PDs, appointed in 1998, each PD isrequired to subscribe to a minimum of 10 percent ofthe entire issue (this means that the total biddingamount will be at least 140 percent of the amountissued). Therefore, undersubscription has not becomean issue. PDs submit the notation at the market interms of yields. The market yield is determined bythe weighted average yield of successful bids. Mean-while, the issuer reserves the right to accept or re-ject any or all the bids submitted by PDs. Thus, it isdifficult to obtain a fair market yield.

In addition, an underlying factor has distortedmarket yield. Liquidity requirements for banking in-stitutions and statutory requirements for EPF andNSB have created high demand for Governmentbonds. However, there have been fewer issuancesof bonds by the Government due to the fiscal sur-pluses since 1993. The high demand and short sup-ply have made the issuance of Government bondswith low market yields possible and prevented thecreation of a benchmark yield curve, which is impor-tant for the development of the overall bond market.This has been identified as an important issue and assuch, the liquidity requirement is being reviewed.

INACTIVE BOND TRADINGNarrow Investor BaseCommercial banks, finance companies, and mer-

chant banks have to comply with statutory require-ments and invest in eligible securities (mostly Gov-ernment and Cagamas bonds). The Government alsorequires EPF and NSB to hold a certain percentageof their funds in Government bonds. EPF has beenthe biggest subscriber to Government bonds, althoughits holdings have declined due to limited supply. Gov-ernment bonds’ share of the total funds managed


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had fallen to 29.4 percent (RM38.1 billion) at theend of 1997.

In fact, when a new EPF Act was introduced inJune 1991, holdings of “eligible securities” were re-duced from 70 to 50 percent, “provided that the totalamount of funds invested in such securities at anyone time shall not be less than 70 percent of the Fund’stotal investments” (Section 26, EPF Act, 1991). Thisclause gave EPF a broader flexibility in portfoliomanagement. Eligible securities include loans that arefully guaranteed by the federal Government, BNMpapers with a maturity of at least three years fromthe date of issue, and any instrument issued by astate government or local authorities with a maturityof at least three years from the date of issue. Sincethen, EPF has diversified its portfolio and invested inother instruments, a policy change made due to itsincreasing funds. As the issuance of Governmentbonds declined due to fiscal surpluses, these institu-tions are confronted with a shortage of eligible secu-rities and as a result, have maintained a captive in-vestment policy on Government bonds and seldomtraded in the markets.

Ineffective Principal Dealer SystemA new principal dealer system, with an annual

review of the dealership, was introduced in January1996 to promote trading in the secondary market.However, the trading volume declined to RM12.4billion in 1997 from RM25.4 billion in 1996 while theamount outstanding fell to RM69.9 billion in 1997 fromRM72.2 billion in 1996. This was attributed to fewerGovernment bonds outstanding, and commercialbanks’ tendency to hold Government bonds untilmaturity. Inactive bond trading has made it difficultfor the PD system to develop a robust secondarymarket.

Through repurchase agreements with BNM, PDsare allowed to secure funds from BNM for a periodof less than one month. This is an attractive incen-tive. However, PDs cannot hedge the interest risksthrough a bond futures market, because it does not

exist in Malaysia. Similarly, PDs’ main sources offunds are short-term deposits, and the lack of a fu-tures market has contributed to increased interestrisks. As a result, PDs have been incorporating thecost of risks in their price quotations.

PDs are composed of commercial banks, mer-chant banks, and discount houses. Commercial andmerchant banks are subject to reserve and liquidityrequirements. These requirements push up the costsof funds, which result in higher price quotations. AsPDs are required to play the role of market makers,they are expected to accommodate any amount ofsale or purchase orders placed by customers. How-ever, since the prices offered by PDs are not attrac-tive to investors, bonds are seldom traded. High costsand risks associated with bond holdings are the majorreasons for the ineffectiveness of the PD system.

Lack of Borrowing, Short Selling, andFutures MarketThe lack of borrowing and short selling as well as

the absence of a futures market have hindered thedevelopment of the secondary market in Malaysia.If the framework of borrowing bonds is improved,investors can borrow bonds against the collateral ofcash for short selling.

Malaysia Monetary Exchange (MME) is planningto introduce bond futures to make the borrowing ofbonds an attractive investment option in Malaysia. Ifbond borrowing is institutionalized and short selling isencouraged, demand for bonds will increase. A well-developed futures market plays an important role forthe development of a secondary market.

Private Debt Securities MarketUNDERDEVELOPED PRIVATE DEBT SECURITIESMARKETThe types of private debt securities (PDS) issued inMalaysia are straight bonds, bonds with warrants(BWs), convertible bonds, Islamic bonds, andCagamas bonds. Cagamas bonds, BWs, and straightbonds were the most common PDS issued until 1993,


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up to which time the PDS market was relatively in-active. The outstanding amount of PDS increasedsharply from RM15.1 billion in 1993 to RM63.3 bil-lion in 1997 (see Table) and since 1994, Islamic bondshave comprised the biggest share of PDS issues. Asubstantial amount of BWs was also issued whenthe equity market was bullish before the onset of thefinancial crisis. Despite a relatively large issue ofIslamic bonds, they are predominantly issued as pri-vate placements.

Cagamas bonds are issued regularly by CagamasBhd., a secondary mortgage market institution. De-mand for Cagamas bonds is high because of theirAAA rating and those of the shareholders (BNM,commercial banks, and finance companies) of theissuing company. However, the main reason for theirattractiveness is that BNM recognizes Cagamasbonds as eligible assets for meeting liquidity require-ments. As such, they are treated virtually like Gov-ernment bonds. If they were not recognized as eli-gible assets, Cagamas bonds would be issued withmuch higher market yields.

LACK OF CONFIDENCE OVER PDSInvestors never had full confidence in the MalaysianPDS market due to various risks, including price,default, and liquidity. This is despite the efforts ofregulators to establish confidence. The Rating AgencyMalaysia Bhd. (RAM) was established in Novem-ber 1990 to assess credit risks of PDS issuers. Asratings became compulsory for issuing PDS, RAMboosted confidence in the PDS market. A secondrating agency, Malaysia Rating Corporation Bhd.(MARC), was established in 1995 to cope with anincreasing demand for PDS.

Despite the efforts of RAM and MARC to buildconfidence in the PDS market, they face certain con-straints. While they have tried to obtain as much in-formation as possible to improve the accuracy ofratings, insufficient disclosure standards hinder theirefforts. Nevertheless, due to BNM’s efforts sincethe onset of the financial crisis, the banking sector’sdisclosure standards have improved.

But investors remain skeptical about PDS. About50 percent of PDS are issued with a bank guaran-tee. It is a common practice that bank guaranteesare used to lower the cost of funds further and tomeet the trust deed requirements of certain institu-tional investors. However, this practice may hinderthe development of the bond market. If an issuerimproves its rating, it is not required to obtain a bankguarantee, resulting in a cost reduction. In turn, in-vestors should review their portfolio policy by en-hancing fund management skills. Nevertheless, thiswould not be sufficient to quell investors’ fears aboutthe various risks in the PDS market. In particular,with the rising number of corporate defaults due tothe financial crisis, investors are particularly concernedabout default risks.

FRAGMENTATION OF THE REGULATORYFRAMEWORKRegulation of the PDS market in Malaysia is splitbetween BNM and SC. BNM’s concern is creditallocation to the private sector while that of SC iscapital market development. One of the major con-cerns of BNM and SC is the utilization of funds raisedin the PDS market. BNM requires all PDS issuersto seek its approval for issues as well as ratings. Ifthe issuers are public companies, they are also sub-

Private Debt Securities: Amount Outstanding (RM million)

Item 1993 1994 1995 1996 1997

Cagamas Bonds 5,015 8,925 9,312 13,227 16,756Other Private Debt Securities 10,081 15,131 22,701 33,517 46,543Total 15,096 24,056 32,013 46,744 63,299



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ject to the approval of SC. As most of issuers arelisted (public) companies, they have to obtain approv-als from the two regulators.

A third force in the regulation of PDS issues isROC. Although BNM and SC have set guidelinesfor the PDS market, the details of PDS issues arestipulated in the Companies Act of 1965. In particu-lar, ROC requires issuers to register prospectusesunless PDS are either guaranteed by the federal Gov-ernment or issued in private placement. It also re-quires an issuer to provide certain information in theprospectus that complies with the requirements setby BNM and SC.

BNM set guidelines on the issuance of PDS inDecember 1988. The main requirements are:

• minimum shareholders’ funds for issuers set atRM25 million;

• disclosure of proceeds’ utilization and sourcesof repayment;

• minimum size of an issue set at RM25 million;• debt-equity ratio of issuers kept within pruden-

tial limits;• underwriting requirements; and• minimum rating of BBB for long-term papers

and P3 for short-term papers.In addition, approval should be obtained from the

Controller of Foreign Exchange if PDS are issuedon a bearer basis and by a nonresident (foreign) con-trolled company. Although the Banking Departmentof BNM acts as one-stop coordinating departmentand a separate application for approval from theController of Foreign Exchange is not required, thisrequirement has become a stumbling block in gettingswift approval.

Even if issuers comply with the requirements setby BNM and SC, they (except Cagamas Bhd.) arerequired to obtain approvals from the two bodies.The approval process usually takes a few months(sometimes up to six). This delay is an importantimpediment to issuers who may miss an opportunityto issue PDS at low cost and may have to seek fresh

ratings if there is a change in the financial environ-ment in the meantime.

BNM, SC, and the departments concerned haverecognized some of these problems and organizedinterdepartmental meetings twice a year on the de-velopment of the bond market.

NARROW INVESTOR BASESome investors were restricted from investing in PDSuntil June 1997, when the Minister of Domestic Tradeand Consumer Affairs made an order to lift the re-strictions stipulated in section 47B of the CompaniesAct of 1965. These restricted investors included fundmanagers, individuals, and corporate entities withincertain criteria, offshore banks, and offshore insur-ance companies. Nevertheless, some institutional in-vestors are still reluctant to invest in PDS. For in-stance, Pilgrims Fund was established to invest inequities because its unit holders are unwilling to re-ceive interest income. PNB invests in Islamic bondsbut will not diversify its portfolio.

The Government has reviewed its policy of re-quiring EPF to hold Government bonds. EPF isnow allowed to invest more funds in other securi-ties such as equities and PDS. In fact, EPF hasbeen providing private entities engaged in infra-structure projects with a large amount of funds inthe form of loans and PDS. However, EPF’s port-folio management has come under fire over its lowdividend rate of 6.7 percent in 1997 (one-year fixeddeposit rate was 9.3 percent at the end of 1997).Consequently, EPF has reviewed its fund manage-ment policy.

Both EPF and PNB have adopted an accountingsystem based on cost/book value. They have dividedtheir portfolio investments into two categories: short-term and long-term. Securities in the long-term cat-egory are recorded in book or cost value. However,the differences between the book/cost value andmarket value are adjusted (but not fully) in the in-vestment revaluation reserve item. This accounting


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method does not reflect the clear financial positionsof these institutions. Subsequently, the institutionsmanage their funds without paying much attention toperformance. As these are public funds, they mayhave to reconsider their investment policies whenthe accounting system is reviewed. Despite beingexempted from paying stamp duty and income taxon interest earnings, individuals are not investing muchin the PDS market. Investment in PDS by unit trustshas not been actively promoted and this is also con-tributing to the low level of individual investments inthe PDS market.

MARKET INFRASTRUCTUREBNM has been trying to develop a market infrastruc-ture for PDS, improving the trading, clearing, settle-ment, and depository systems. To this end, BNM in-troduced SPEEDS (Sistem Pemindahan Elektronikuntuk Dana dan Sekuriti: the electronic funds andsecurities transfer settlement system) in the PDSmarket (unlisted bonds only) in January 1996.SPEEDS comprises two components: InterbankFund Transfer System (IFTS) and Scripless Securi-ties Trading System (SSTS). All new issues of un-listed long-term bonds are required to be made inscripless form and traded under SPEEDS to facili-tate the transfer of securities, payment of interest,and redemptions. In the near future, it is planned thatall unlisted PDS will be issued in scripless form.

With the introduction of the Fully Automated Sys-tem for Tendering (FAST) of PDS in 1997, all com-mercial papers (CPs), medium-term notes (MTNs)and Islamic CPs (including private placements),except long-term bonds, are issued through FAST.The system was introduced to provide a uniform setof procedures to govern the issuance and tenderingof PDS.

The Bond Information and Dissemination System(BIDS) was launched in October 1997. BIDS hasbeen providing information on primary and second-ary markets including information on all outstandingPDS, Government bonds, T-bills, and Cagamas pa-

pers. It helps to improve the liquidity and efficiencyof the markets.

While most of PDS trading takes place in over-the-counter markets, Cagamas bonds, like all Gov-ernment bonds, are traded in SPEEDS. As the Ma-laysian Institute of Bond Dealers was incorporatedin 1996, a trading facility similar to the Thai BondDealing Center could be introduced when BIDS isfully installed. BNM should speed up the remainingwork of market infrastructure development to facili-tate PDS trading.

UNDERWRITERSMerchant banks generally carry out underwriting ofPDS, although some discount houses are also allowedto underwrite. They were required to earn at least30 percent of their income from fee-based businessactivities until the end of 1996. In the mid-1990s, theypreferred to underwrite equities rather than PDS dueto the equity boom and the limited demand for PDSby institutional investors.

With the increasing variety of PDS, merchantbanks now have more business opportunities to un-derwrite them, especially as Islamic bonds are ac-ceptable to a wide variety of institutional investors.However, merchant banks have relatively small capi-tal bases, such that an unsuccessful underwriting couldendanger their position. This is a disincentive for themand other underwriters to actively participate in un-derwriting and market making.

Reserve and liquidity requirements are also animpediment to underwriting in the PDS market. Anunderwriter subscribes to PDS, then allots them tovarious investors. If the underwriter failed to allotthe PDS immediately, it would have to secure thenecessary funds to pay the issuer. It usually obtainsthe funds in interbank markets. Although the moneyis borrowed for underwriting, it is considered as aneligible liability and is subject to reserve and liquidityrequirements. This increases the cost to issuers; thusunderwriters request BNM to waive the statutoryrequirements.


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SINGLE CUSTOMER LIMITBanking institutions such as commercial banks, mer-chant banks, and finance companies are subject tothe single customer limit under which they cannotprovide a single customer with loans exceeding 25percent of shareholders’ funds. Since PDS are con-sidered as loans to BNM, banking institutions aresubject to this limit but discount houses are not.Hence, discount houses usually take positions on PDS,thereby limiting the market players.

If a banking institution would like to take a posi-tion on a specific PDS that exceeds the single cus-tomer limit, it has to request BNM to waive the limit.This issue has not arisen much since most bankinginstitutions do not invest in PDS. However, as BNMis planning to abolish discount houses, it will have toreview the regulation.

Overall Bond MarketINTERESTAs the majority of Malaysians (mostly Malays) areMoslems, whose teachings prohibit payment of in-terest, many are reluctant to invest in interest-bear-ing instruments. Motivated primarily by the riba is-sue, the Government established PNB, the biggestunit trust company, to encourage the bumiputras(mostly Moslems) to mobilize their savings throughunit trusts that invest mostly in equities.

The Government started issuing Government In-vestment Notes in 1983 and BNM has also imple-mented a similar scheme. These instruments aresimilar to Government bonds and BNBs. However,they do not carry coupons but instead, pay dividends,which are roughly equivalent. In March 1993,commercial banks introduced noninterest bearingaccounts. A similar innovation has emerged inthe PDS market and the first Islamic bond was is-sued in 1990. Since then, the volume of Islamicbond issues has increased steadily, and in 1997,RM5.2 billion was raised by Islamic bond issues,representing the biggest share (26.9 percent) in thePDS market.

ISLAMIC BONDSThe increasing volume of Islamic bonds has contrib-uted to the development of the PDS market over thelast few years. However, PDS trading remains rela-tively inactive. Islamic bonds are issued through pri-vate placement, allotting the bonds to Governmentinstitutions. For instance, Kuala Lumpur InternationalAirport Bhd. (KLIA) issued a RM2.2 billion Islamicbond in 1996. KLIA, a company developing the newKuala Lumpur International Airport, can obtain fi-nancial support from the Government since it is anational project. As a result, a large portion of theKLIA Islamic bond was allotted to EPF. Similarly,many Islamic bonds (especially if the amount involvedis large) have been issued with Government support.This implies that the market yield of most Islamicbonds is below that of the market, which createsadverse effects on the secondary market.

KHAZANAH BONDSGiven the lack of a benchmark yield curve andshortage of Government bonds, the Government de-cided to issue khazanah bonds to help foster a ro-bust bond market. The first khazanah bonds wereissued in September 1997, based on the Islamicmudharabah concept (no coupon or interest pay-ment), with a face value of RM1 billion and matu-rity of three years. Khazanah bonds were expectedto be issued every quarter and the maturity to ex-tend from three to 10 years within five years. Dueto the financial crisis, however, the issuance ofkhazanah bonds was temporarily stopped in De-cember 1997, but resumed in March 1998 (RM1billion, with a three-year zero coupon).

DISTORTION OF YIELDDespite BNM’s persistence in deregulating interestrates, long-term rates (yields) are not yet fully liber-alized in Malaysia. Yields are determined throughthe auction of Government bonds but the auction isconducted through compulsory subscription by PDs.In addition, the auction reflects a high demand for


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Government bonds by banking institutions and theshort supply of Government bonds, resulting in lowyields.

The distortion can also be observed in the PDSmarket. For instance, Cagamas papers are also is-sued by auctions, producing yields similar to those ofGovernment bonds. Most Islamic bonds are issued byprivate placement, and issuers and investors—basi-cally Govemment-related companies or institutions—are influenced by the Government. As a result, inves-tors are expected to accept the offered price of bonds.Hence, bond yields in Malaysia, regardless of whetherthey are Government bonds or PDS, have been sys-tematically distorted by the Government.

The secondary market is adversely affected by thedistorted yields. Despite the Government’s introduc-tion of a new accounting system for valuation of Gov-ernment bonds held by banking institutions, many bankshave not actively traded in the secondary market partlyto avoid losses. As PDS are issued in a manner simi-lar to Government bonds, trading remains inactive.

Recommended MeasuresMONETARY POLICYBNM has been employing direct lendings/borrow-ings as a major instrument for monetary regulation.In March 1998, it announced, in a policy change, thatopen market operations would be used as a majorinstrument for monetary management. However, toachieve this, there has to be a sufficient supply offinancial instruments in the market. The large out-standing Government bonds (RM69.9 billion at theend of 1997), Cagamas papers, and khazanah bondscannot be used for open market operations now sincethey have been issued at lower yields than prevailingmarket rates. Thus, BNM has to depend on short-term papers, such as T-bills, BNBs, BAs, and NCDS.BNM should issue more BNBs for open market op-erations.

In line with the policy change, reserve and liquid-ity requirements were reviewed in July 1998. To ad-just the liquidity requirement, a marking system should

be introduced to spare existing Government bond-holders from incurring big losses. For instance, a cer-tain percentage of Government bonds held by com-mercial banks, finance companies, merchant banks,EPF, and NSB should be defined as permanent hold-ings and these institutions should be required to holdthe bonds until maturity. This measure should remainin force until the yields of financial institutions’ hold-ings of Government bonds become market-based orinterest rates decline to levels below the marketyields.

PRIMARY MARKET AND BENCHMARKINTEREST RATESA short-term benchmark interest rate can be obtainedthrough open market operations. However, the cre-ation of a long-term benchmark yield curve shouldbe the target. BNM has studied the possibility of cre-ating a benchmark yield curve through Cagamaspapers. But it realized that the demand for Cagamaspapers would decline substantially if they were to beexcluded from the list of eligible securities. More-over, Cagamas papers should be issued with highmarket yields. Since September 1997, the Govern-ment has started issuing khazanah bonds, which arenot recognized as eligible securities, hoping that theywill help to create a benchmark yield curve.

The existing auction system by PDs has hinderedthe creation of a benchmark yield curve. PDs’ com-pulsory subscription should be eliminated, and thestatutory requirements for banking institutions, insur-ance companies, EPF, and NSB should be reduced.With a new auction framework to improve price quo-tations, Government bonds, Cagamas papers, andkhazanah bonds would be issued at market rates.

With the July 1998 changes in policy, the capabil-ity of khazanah bonds to create a benchmark yieldcurve was enhanced. In addition, if a new auctionsystem without compulsory subscription to Govern-ment bonds, Cagamas papers, and other papers wereintroduced, it would help successfully launch the is-suance of debt securities at market rate.


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With the introduction of Islamic bonds, the pri-mary market for PDS has developed rapidly. How-ever, the demand for Islamic bonds has been artifi-cially created through either or both statutory require-ments and Government guidelines in the case of bigissues. This has resulted in large issues of these bondsat distorted rates. The Government should thoroughlyreview the issuance of Islamic bonds. A fair yieldcurve would be reinstated if Government bonds,Cagamas papers, and Khazanah bonds would beissued at fair market rates.

Cagamas bonds are issued to finance the purchaseof mortgage loans from commercial banks and fi-nance companies. Their role is important in address-ing certain issues in the banking sector, such as ma-turity mismatch and liquidity enhancement. Never-theless, the sale of housing loans is undertaken withrecourse. This means that the sold loans still remainin the seller’s balance sheet. Since Cagamas Bhd.has addressed the recourse issue, BNM should takenecessary measures to facilitate the sale of mort-gage loans without recourse.

UNDERWRITERS AND MARKETINFRASTRUCTUREAs the Government achieved a fiscal surplus since1993, the development of the PDS market became afocal issue. Nevertheless, the market frameworkwas designed to ease the issuance of Governmentbonds; for example, EPF and NSB are subject to thestatutory requirements. A new intermediary, withoutthe statutory requirements, should be introduced toprompt the development of the PDS market.

With the existing PDS auction system, the ap-proved FAST members, commercial banks, merchantbanks, discount houses, insurance companies, devel-opment banks/finance institutions, EPF, CagamasBhd., and Khazanah Nasional Bhd., can bid at auc-tions for short- and mid-term PDS (it is expectedthat long-term PDS would be included in the nearfuture). This auction system has helped improve theprimary market. Here the role of underwriters is

important. However, the regulatory framework forunderwriters has remained unchanged.

Commercial banks, merchant banks, and discounthouses can underwrite PDS, but merchant banks domi-nate the market. They are subject to statutory require-ments and their capital bases are generally small rela-tive to commercial banks, leaving them reluctant toexpand their underwriting business in PDS. Merchantbanks should increase their capital bases to cope withtheir roles as underwriters and market makers. BNMshould waive its statutory requirements when it un-derwrites PDS. To improve their regulation, stockbro-kers should be encouraged to underwrite PDS.

With the improvement in the market infrastruc-ture, particularly the auction, settlement, and clear-ing systems for PDS, the demand for Islamic PDShas increased. In addition, the introduction of a newtrading system, similar to the Thai Bond DealersCenter, may help develop the secondary market.BNM should speed up its remaining work on marketinfrastructure development.

REGULATORY FRAMEWORKBNM, SC, and ROC are the joint regulators of PDS.In addition to complying with their requirements, is-suers must obtain approvals from these authorities.This approval process is time-consuming and hasbecome a constraint on the timely issue of PDS. Is-suers who comply with the requirements should beallowed to issue PDS without approval.

It is recommended that:• BNM and SC should consolidate the two sets of

requirements into a single set;• approval from the Controller of Foreign Exchange

should be eliminated;• all the sections related to securities businesses

in the Companies Act of 1965 should be incor-porated into a new law, and the power of theRegistrar of Companies should be transferred toSC; and

• SC solely should be given the responsibility toregulate the PDS market.


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Furthermore, BNM should relinquish all of itsoperational tasks to a private sector entity to de-velop a self-regulatory organization and the amountof funds raised should be determined by the mar-ket. In the case of an issuer violating any require-ment, including the utilization of funds, SC shouldprosecute.

BORROWING OF BONDS AND THEFUTURES MARKETThe borrowing of bonds against cash collateral isseldom used in Malaysia. If this practice is encour-aged and institutionalized, a more active and liquidcash market in Government bonds and PDS can becreated. It will help investors to take a long or shortbond position with or without having the requiredbonds in their physical possession. It is difficult todevelop a futures market without a well-developedcash market. MME is planning to introduce a suit-able bond futures market.

The borrowing of bonds will create a new dimen-sion in the securities industry. Long-term bondhold-ers, such as EPF, NSB, and commercial banks, cangenerate extra income from lending bonds. Whilethey are required to hold Government and Cagamasbonds to meet statutory requirements, the lending ofbonds does not breach the requirements since bor-rowers sell the bonds in the repurchase market. Ifthe Government will make the income from bondlending tax-exempt, this will serve as an incentivefor investors to use the new scheme.

CONFIDENCE ON PDSDespite the introduction of a rating system, confi-dence about PDS has not been fully established andabout 50 percent of PDS have been issued with bankguarantees. BNM is trying to disseminate informa-tion on PDS to investors on a real-time basis throughBIDS. A new auction system for PDS has been in-troduced, and clearing, settlement, and depositorysystems are being improved to enhance the effi-ciency of trading. Nevertheless, it is important to

enhance the disclosure and corporate governancestandards to restore confidence on PDS.

INVESTORSThe roles of market players such as banking institu-tions, discount houses, insurance companies, EPF,and NSB should be reviewed. Commercial banks,for instance, are expected to mobilize depositors’funds on a short-term basis. However, because ofstatutory requirements, BNM forces them to allo-cate a certain portion of funds for long-term invest-ment, resulting in maturity mismatches. In addition,as their funds are subject to the reserve requirement,the costs of funds become higher compared withthose of nonbanking institutions.

BNM should waive the single customer limit formerchant and commercial banks when they under-write or invest in PDS. It should also review the roleof banking institutions and encourage nonbanking in-stitutions to invest in bonds.

EPF, Pilgrims Fund, Armed Forces Fund, and PNBare expected to play active roles in the bond market.However, these institutions, with the exception of EPF,place their funds in the equity market or short-terminstruments. Moreover, their accounting system isbased upon book value/cost and losses from invest-ments in the equity market are not clearly reflectedin their balance sheets. Their accounting systemshould be reviewed and they should be encouragedto invest in Government bonds and high-quality PDSto sustain stable portfolio management.

SECONDARY MARKETThe development of the secondary market hingeson policy changes in monetary instruments (for ex-ample, open market operations, liquidity and reserverequirements), the creation of a benchmark yieldcurve, and the restoration of confidence in the PDSmarket. With limited Government bonds availablein the market, BNM should rely on short-term pa-pers, Cagamas papers, and khazanah bonds foropen market operations, provided that Cagamas


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papers and khazanah bonds are issued at marketrates. Meanwhile, with an increase in PDS, BNMand the Government should take the necessary stepsto encourage PDS institutional investors. In par-ticular, EPF, PNB, insurance companies, and vari-ous pension funds should review their portfolio in-vestment policies, and increase their investments inhigh rated PDS.

Unit trusts investing in bonds should also be cre-ated to encourage individual investors. In addition,there is a need to educate the staff of other institu-tions, such as pension funds, mutual funds, insurancecompanies, cash-rich corporations, and high net worthindividuals, on the advantages of investing and trad-ing in bonds, rather than having them simply leavetheir surplus funds in fixed deposits or shares.


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Appendix

Supplementary Report

INTRODUCTIONThe Malaysian authorities took two significant mea-sures on 1 September 1998: the introduction of capi-tal controls and the restriction of trading of Malay-sian shares to the Kuala Lumpur Stock Exchange(KLSE). Bank Negara Malaysia’s (BNM’s) capitalcontrols helped to insulate the Malaysian economyfrom the Asian crisis while lowering market interestrates and expanding liquidity in the banking sector.

Nonperforming loans (NPLs) in the banking sec-tor have increased since the onset of the financialcrisis, fueled partly by loans related to share trading.This implies that the banking system had been vul-nerable to depreciation of asset values. Individuals,corporate entities, and Government-related portfoliomanagement institutions invested heavily in equities,thus the collapse in share prices had a significantimpact.

The 1 September measures also had an adverseeffect on the equity market. The capital controls re-stricted foreign investors from selling their Malay-sian shares, as those traded in the Central Limit Or-der Book (CLOB) were frozen. As a result, foreigninvestors since then have been reluctant to invest inMalaysian shares. However, given the limited sharesavailable in the market due to the restrictions, shareprices have recovered.

Meanwhile, the authorities have been address-ing issues connected with the capital market. TheGovernment formulated the National Economic Re-covery Plan (NERP) on 21 July 1998. NERP spellsout overall policy directions, and those pertaining tothe capital market aim to (i) improve transparencyand the regulatory environment, (ii) improve thecapital market, and (iii) develop the private debtsecurities (PDS) market. Implementation of NERPstarted in the fourth quarter of 1998, resulting in arestoration of market confidence and financial mar-ket stability.

The Securities Commission (SC) and KLSE haveemphasized the improvement of transparency andthe regulatory environment, and are focusing on cor-porate disclosure, corporate governance, and pru-dence of stockbroking companies (SBCs). With alarge amount of NPLs in the banking sector, theauthorities have taken various steps to strengthenthis sector. Bond market development, in particular,the development of the PDS market, has becomean urgent agenda.

This supplement outlines the various measurestaken by the authorities in line with the policy direc-tions of NERP. In addition, issues not specificallydealt with in NERP are described.

NATIONAL ECONOMIC RECOVERY PLAN ANDTHE CAPITAL MARKET

Equity MarketStockbroking CompaniesCapital Adequacy. The distress of SBCs was

the most urgent issue facing authorities in restoringmarket confidence. On 7 January 1999, SC approvedthe new capital adequacy requirements (CAR) sub-ject to the condition that the basis of computation(adjusted capital) be harmonized with that of the newCAR. The new CAR, which is determined in rela-tion to levels of daily risk exposure of SBCs, wasintroduced by KLSE.

The new CAR was implemented in two stages:(i) Stage One: The issuance and dissemination

of Rule 17G on Capital Adequacy Require-ments of KLSE Rules Relating to MemberCompanies (KLSE Business Rules) took ef-fect on 28 May 1999; and

(ii) Stage Two: Complete shift to the new CARrules and the full enforcement of Rule 17G,which replaced Rule 17A of the KLSE Busi-ness Rules on Minimum Liquid Funds Require-ments, on 1December 1999.

With the introduction of the new CAR, it is ex-pected that the monitoring of SBCs will be improvedand enhanced by the following:


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(i) incorporating internationally recognized ap-proaches and measures, thus setting the stan-dards for an overall risk control frameworkfor SBCs;

(ii) promoting an environment of enhanced riskmanagement by enabling SBCs to identify thecapital available to cover the risks of theirbusiness; and

(iii) providing a proactive alert mechanism forSBCs to quantify, manage, and address therisks of their business.

Nonperforming Account, Bad Debt, andDoubtful Debt. With the collapse of share prices,coupled with the lack of risk management, manySBCs experienced financial distress. However, theauthorities could not ascertain the financial positionof SBCs quickly as there were no standards for thetreatment of interest on nonperforming accounts, orprovisions for bad and doubtful debts in financialstatements. Thus, KLSE announced the introductionof a new Rule 16A of Rules Relating to MemberCompanies on 29 June 1999. In order to achievesmooth implementation of the new rule, KLSE, inconsultation with SC, agreed to allow SBCs a transi-tion period of one year, starting 1 July 1999.

KLSE consulted industry participants such as theMalaysian Institute of Accountants, Malaysian As-sociation of Certified Public Accountants, and Ma-laysia Accounting Standards Board on the formula-tion of the rule concerning the Suspension of Inter-est and Provision for Bad and Doubtful Debts. Italso sought and obtained Ministry of Finance approvalfor 50 percent tax relief on interest suspended bySBCs for a two-year period.

With the implementation of the rule on 1 July 2000,SBCs will be required to comply with Rule 16A inrespect of disclosures in their monthly accounts andin their audited accounts for the financial year. Thenew rule will provide the authorities with the basisfor the assessment of SCBs’ financial positions. Itcovers the following areas:

(i) classification as a nonperforming account,(ii) suspension of interest on nonperforming ac-

counts,(iii) specific provision for bad and doubtful debts,(iv) reclassification of nonperforming accounts to

performing accounts, and(v) general provision for bad and doubtful debts.

Gearing Ratio. Excessive borrowing by SBCsresulted in distress and an increase in NPLs in thebanking sector. The authorities set up a new rule tocap the ceiling on the borrowing by SBCs. Underthe previous rule, SBCs were required to comply witha gearing ratio on utilized level of 2.5 times by end-1998, 2.0 times by 30 June 1999, and 1.5 times bythe end of 1999.

However, with the introduction of the new CARand considering the rule’s negative impact on the eq-uity market, the rule was revised as follows:

(i) SC has approved the abolishment of the gear-ing ratio on approved limit for SBCs and hasalso made the gearing ratio on utilized levelless stringent to no more than 2.5 times. Therevised gearing ratio is in line with the Na-tional Economic Action Committee’s recom-mendations; and

(ii) a comprehensive review on the need for gear-ing ratios will take place after the full imple-mentation of CAR.

Merger of Stockbroking Companies. Thereare 62 SBCs and most of them are undercapitalized.With the introduction of the new CAR, the under-capitalized SBCs cannot cope with large amounts oftransactions. Moreover, the financial services mar-ket will be liberalized within three years under theWorld Trade Organization (WTO) agreement. Assuch, increasing the capital base has become anurgent issue facing SBCs. In fact, BNM announceda merger plan for the banking sector on 29 July 1999.

On 8 August 1999, the Malaysian authorities en-couraged SBCs to merge into stronger and larger


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entities to enhance their capability in handling largervolumes of transactions. To protect the business in-terests of small SBCs, the opening of branch officesby SBCs is not allowed, resulting in limited access toretail investors. It is envisaged that small SBCs mayresist the mergers. However, it is an inevitable pro-cess for the survival of the stockbroking industry.

Broker’s Commission and Remisiers. Remi-siers are recognized commission agents belonging toSBCs. They submit security deposits (usually bankguarantees) to SBCs and execute orders from theircustomers. Although remisiers are capped on theirtrading limits by SBCs subject to the amount of theirsecurity deposits, the lack of legal certainty has al-lowed them to exceed the limits. To address this is-sue, KLSE has amended its rules to bring into forcea new standard remisiers agreement that aims toenhance the legal certainty in relationships betweenSBCs and remisiers. The main features of the newagreement include:

(i) the rate of commission for remisiers will befixed and standardized;

(ii) remisiers’ security deposits are segregatedfrom clients’ assets;

(iii) remisiers are responsible for any losses in-curred by SBCs arising from any transactionin securities dealt by, or through, the remisiers;and

(iv) remisiers are exonerated from liability in re-spect of losses through the willful default, neg-ligence, instruction, or incorrect administra-tive procedures and accounting statementsissued by the directors, officers, and employ-ees of SBCs.

To protect the commission and rebate, only SBCs,remisiers, financial institutions, and their wholly ownedsubsidiaries were allowed to enjoy commissions andrebates on brokerage. The authorities took steps tobroaden the institutional base in equity investmentsby allowing the institutions to be entitled to broker-age commission. This measure is expected to supple-

ment the new guideline on remisiers. KLSE extendedthe categories of institutions eligible for rebates onbrokerage commission effective 16 November 1998.

Under the previous rule, the rebates for institu-tions were set in the range of 0.25 to 0.5 percent ofthe brokerage commission, depending on the deal be-tween the financial institutions concerned and SBCs.The new rule was expanded to include life insurancecompanies, general insurance companies, superan-nuation of employees provident funds, finance com-panies, asset management companies and unit trustmanagement companies, and trust companies or in-stitutions in the categories of institutions eligible forrebate.

Quarterly Reporting of Financial Position.KLSE announced on 28 November 1998 that it wouldundertake quarterly reporting of the financial posi-tion of SBCs to promote investor protection throughgreater transparency in the stockbroking industry,with effect from 4 January 1999. This measure willhelp enhance the disclosure standard and supplementthe monitoring of SBCs.

Strengthening the Stockbroking Industry.KLSE announced its new Memorandum & Articles(M & A) and Rules on 14 June 1999, which cameinto effect on 1 July 1999. The new rules had incor-porated new and enhanced measures adopted in 1998to strengthen the stockbroking industry. They con-sisted of new regulatory requirements and resultedin a consolidated and comprehensive set of rules.Among the key areas covered in the new rules forSBCs include:

(i) best business practice,(ii) dealing in securities,(iii) rules on trading,(iv) delivery and settlement,(v) financial resources and accounting require-

ments,(vi) audit regulations, and(vii)disciplinary action.


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Corporate GovernanceControlling shareholders in Malaysia have occa-

sionally engaged in abuses of the system, reflectingthe weak regulatory environment and weaknesses incorporate governance. Investors, local as well as for-eign, are understandably upset whenever such abusesand exploitations emerge. The authorities have recog-nized the weaknesses of the existing legal frameworkand regulatory environment. As such, they have takendecisive and comprehensive measures to protect in-vestors in line with the formation of NERP.

Minority Shareholders. The President of KLSEannounced on 4 October 1999 the complete revampof KLSE’s listing rules regarding related party andinterested party transactions to better protect minor-ity shareholders. His decision was made given thatthe existing rules could not prevent abuses by con-trolling shareholders. The new rules require:

(i) the appointment of an independent corporateadviser to advise minority shareholders of thecompany as to whether transactions are fairand reasonable or are to the detriment of mi-nority shareholders;

(ii) the board of directors to be mindful of a col-lective responsibility to ensure that such trans-actions are in the best interests of the com-pany; and

(iii) interested directors, substantial shareholders,or connected persons with any interest, director indirect, in such transactions not to vote onthe resolution of the transactions.

SC introduced a new takeover code on 1 January1999 that should improve regulation on takeovers andmergers. The code provides minority shareholders witha fair opportunity to consider an offer. It also includesprovisions imposing certain criminal liabilities and dis-courages “creeping” control of a company.

Controlling Shareholders. Amended proce-dures and regulations for direct business transactionsin relation to the restriction of directorship came into

force on 22 March 1999. Directors of public listedcompanies (PLCs) shall hold no more than 25 direc-torships in companies of which:

(i) the number of directorships held in PLCs shallnot be more than 10, and

(ii) the number in other companies (i.e., other thanPLCs) shall not be more than 15.

A high-level Finance Committee on CorporateGovernance released a “Report on Corporate Gov-ernance” on 25 March 1999 that provides 70 explicitrecommendations on three areas, in particular:

(i) strengthening of the statutory and regulatoryframework for corporate governance;

(ii) enhancement of the self-regulatory mecha-nisms that promote good governance; and

(iii) establishment of training and education pro-grams to develop the corporate culture in re-lation to corporate governance, as well as toensure that there is the necessary human andinstitutional capital available.

Work is currently underway on implementing thecommittee’s recommendations as follows:

(i) the primary duty of a nominee director is toact in the best interests of the company, notthe party that made the nomination. However,a nominee director has often faced difficul-ties due to status. On 20 August 1999, theChairman of SC issued a stern warning tonominee directors to report all wrongdoingsin their companies to the authorities or facethe consequences of inaction;

(ii) all directors have to attend approved coursesas a condition for mandatory accreditation;and

(iii) the proposed Institutional Shareholder Watch-dog Committee will monitor and combat abusesby company insiders against minority share-holders. The Employees Provident Fund (EPF)has been asked by the Ministry of Finance toinitiate the setting up of the watchdog group.

There are recommendations in the report withregard to the level and composition of directors’


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remuneration, procedures, and disclosure for remu-neration. Among other things, the report suggeststhat the level of remuneration should be sufficientto attract and retain directors needed to run the com-pany successfully. It also recommends that remu-neration be linked to corporate and individual per-formances for executive directors, and the level ofexperience and responsibilities for nonexecutive di-rectors.

Central Limit Order BookWith the measure taken on 1 September 1998 to

concentrate share trading in KLSE, Malaysian sharestraded in CLOB have been frozen. The authoritiesin Malaysia and Singapore have been negotiating toreach an amicable agreement to solve the issue. Themeasure was effective in stabilizing share prices inKLSE as the supply of shares was limited. But for-eign investors were disillusioned by this drastic mea-sure taken by the Malaysian authorities, resulting ina lack of confidence in the market.

With an announcement on 12 August 1999 thatthe Malaysian shares would be included in MorganStanley Capital International (MSCI), resolution ofthe CLOB issue became an urgent one for the au-thorities. This was because the announcement con-tained a condition that the CLOB issue should besolved before the shares’ inclusion in MSCI. SC ap-proved a proposal concerning the purchase of thefrozen CLOB shares by Telekom Malaysia Bhd.(Telekom) and United Engineers (Malaysia) Bhd.(UEM) on 21 September 1999. However, Telekompulled out from the proposal on 19 October 1999 whileUEM proceeded with the negotiations. It is antici-pated that an agreement will be reached soon giventhat the share prices have recovered tremendouslycompared to September 1998 and that investors cancompromise with the offered prices.

New Accounting StandardsThe development of sound accounting standards

through the Malaysian Accounting Standards Board

(MASB) is essential. All PLCs have to comply withnew accounting standards regulations, the SecuritiesIndustry (Compliance with Approved AccountingStandards) Regulations of 1999, which came intoforce on 18 June 1999. SC established the FinancialReporting Surveillance and Compliance Departmentin April 1999 to ensure PLCs’ compliance. It is ex-pected that corporate disclosure and transparencywill be enhanced as a result.

On 22 June 1999, MASB issued a notice on theapplication of the approved accounting standards inthe preparation of financial statements. The follow-ing standards, which came into force on 1 July 1999,are required to be prepared or lodged under any lawadministered by SC, BNM, or the Registrar of Com-panies (ROC) pursuant to subsection 7(1) of the Fi-nancial Reporting Act of 1997 and regulation 3 ofthe Financial Reporting (Publication of Approved Ac-counting Standards) Regulations of 1999:

(i) MASB Standard 1: Presentation of FinancialStatements;

(ii) MASS Standard 2: Inventories;(iii) MASB Standard 3: Net Profit or Loss for the

Period, Fundamental Errors and Changes inAccounting Policies;

(iv) MASB Standard 4: Research and Develop-ment Costs;

(v) MASB Standard 5: Cash Flow Statements;(vi) MASB Standard 6: The Effect of Changes in

Foreign Exchange Rules; and(vii)MASB Standard 7: Construction Contracts.

DisclosureKLSE announced new disclosure rules on

12 March 1999 to facilitate the move towards dis-closure-based regulation. Quarterly reporting of fi-nancial statements will be mandatory for all PLCs.The reports include balance sheets, income state-ments and explanatory notes on purchase or dis-posal of shares, corporate proposal status and groupborrowings, debt securities, and off-balance-sheetitems.


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The reports must be filed with KLSE for publicrelease within two months from the end of everyfinancial quarter. These quarterly reports are aimedat providing timely information to assist investors intheir decisions and to enhance the accountabilityand corporate governance of PLCs. PLCs will alsobe required to issue their audited annual accounts,and auditors’ and directors’ reports within fourmonths from the end of a financial year, with effectfrom the financial year ending on or after 31 July1999.

Clearing and SettlementA swift and accurate clearing and settlement sys-

tem is one of the most important aspects in securi-ties trading. The current clearing and settlement sys-tem of KLSE enables a delivery versus payment(DVP) environment or a same day securities andcash settlement for direct members of the systemthrough its clearing house, Securities Clearing Auto-mated Network Services (SCANS). However, mem-bership to the clearing and settlement system of KLSEhas been restricted to SBCs. In order to extend thebenefits of DVP to other investors, KLSE has helddiscussions with selected custodian banks and rep-resentatives of the Association of Stockbroking Com-panies of Malaysia to obtain feedback before finaliz-ing the Institutional Settlement Service (ISS) Busi-ness Requirements Definition document. A discus-sion on the ISS mock run strategy was also held on14 May 1999 with selected custodian banks.

The new SCANS Rules to revamp SCANS wereapproved by SC on 5 July 1999. The new rules in-clude the enhancement of DVP with ISS as follows:

(i) to facilitate the settlement of trades of institu-tional investors directly with the clearing house,KLSE launched ISS on 15 July 1999. ISS,which will be offered by KLSE throughSCANS, will enhance the current DVP envi-ronment by extending the clearing member-ship to include resident custodian banks andinstitutional investors. The new category of

membership will be known as NontradingClearing Members; and

(ii) on 28 July 1999, KLSE formally approvedeight banks and a custodian services companyto settle their trades directly with its clearinghouse via ISS. Nontrading Clearing Membershave direct access to the clearing and settle-ment facilities of KLSE via the ISS and willbe able to achieve same day settlement forcash and securities.

Amendments to the Malaysian Central Deposi-tory (MCD) Rules took effect on 3 May 1999 toallow local custodian banks to hold underlying secu-rities for American depository receipts (ADRs) andglobal depository receipts (GDRs) programs with cer-tain conditions attached, including the following:

(i) the underlying securities must be a sponsoreddepository receipt program;

(ii) the approval of MCDs must be obtained forholding underlying shares in a GDR;

(iii) the underlying securities for each depositoryreceipt program are held by not more thanfive custodians;

(iv) the total number of underlying securities for alldepository receipts entered into by an issueron the stock exchange is not more than 5 per-cent of the total issued and paid-up capital ofthe issuer as defined in the rules of KLSE; and

(v) each custodian shall hold the underlying se-curities for a depository receipt program in asecurities account opened solely for that pur-pose and is clearly designated in the mannerprescribed by MCD.

SuspensionThe suspension of trading is important to restrain

volatility and to maintain a fair and orderly market.However, the suspension period should be minimizedto ensure a fair and orderly market. For this purpose,KLSE issued a Practice Note No 1/1999—Requestfor Suspension, which took effect from 14 June 1999.This practice note clearly addresses the following:


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(i) strengthened policy of KLSE on suspension,(ii) reasons for suspension,(iii) period of suspension,(iv) procedures for making a request for suspen-

sion, and(v) obligations of PLCs with respect to announce-

ments.The strengthened policy was developed in consul-

tation with SC and with feedback and cooperation fromrelevant industry participants. This will benefit share-holders and investors by enabling greater control inthe conduct of their investments through the contin-ued trading of securities, unless suspension is neces-sary to maintain a fair and orderly market.

The policy will also enhance the responsibility andaccountability of PLCs in making company announce-ments to ensure that investors are better informed,resulting in the sustained growth and the promotion oflong-term investment interest in the stock market.

Share Buy-back SchemeIn conjunction with the enforcement of the amend-

ments of the Companies Act of 1965, KLSE issuedguidelines on 1 November 1998 governing purchaseof own shares by listed companies. The new guide-lines provide for the utilization of share premium ac-count for share buy-back and the option to treat re-purchased shares as Treasury shares. Treasury sharescan be retained, distributed as dividends, or resold.

The new guidelines also contain antimanipulationrules as follows:

(i) the purchase price must not be more than 15percent above the weighted average marketprice of the shares for the five market daysimmediately prior to the purchase;

(ii) the resale price of Treasury shares must notbe less than the weighted average price ofthe shares for the five market days immedi-ately prior to the resale; and

(iii) the provision of financial assistance byPLCs to buy back their own shares is nowprohibited.

Front-line Regulation Task ForceCapacity building and strengthening of KLSE as a

frontline regulatory organization have been an urgentagenda. To achieve this objective, a study was under-taken to review the functions of divisions/departmentswithin the KLSE Group. An Organization and Meth-ods (O & M) Department has been set up to reviewsystems and methodology to streamline functions.

On 2 October 1998, a KLSE Frontline Regulation(FLR) Task Force presented to SC a draft report onthe overall direction and the measures/strategies thatthe KLSE Group has undertaken and intends to un-dertake in order to become a frontline regulatory or-ganization. The areas covered included self-regula-tion, enforcement of rules and regulations, regulationof behavior of issuers, regulation of behavior of mar-ket intermediaries, and regulatory management ofthe secondary market.

Monitoring and EnforcementBefore the formulation of NERP, the regulators

had been monitoring activities in the equity marketand there was law enforcement against breaches ofregulations. However, the NERP recommendationshave intensified these further and strict law enforce-ment is now taking place.

Pending ActionsThe regulators have achieved great progress in

implementing various recommendations of NERP.Their efforts should be adequately appraised. How-ever, there are some pending actions to be under-taken. These pending actions include the following:

(i) Fund management capability. Greater ef-forts, including a relaxation of bureaucraticand procedural controls, should be undertakento realize the creation of a vigorous fund man-agement capability in Kuala Lumpur.

(ii) Problems with warrants and transferablesubscription rights (TSRs). Currently en-forced restrictions on capital raising by issu-ing warrants and TSRs should be lifted.


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(iii) Circuit breakers. A broader based circuitbreaker mechanism should be considered toaddress the problem of excessive volatility inthe market (work in progress).

(iv) Corporate exercises. In a dynamic market,corporate exercises and restructuring shouldbe allowed to continue, especially in the pro-ductive and strategic sectors of the economy.Restrictions on initial public offerings (IPOs),rights issues, and corporate restructuring ex-ercises should be lifted to allow PLCs to re-structure and raise funds in the market.

(v) Review of the Second Board. There is a caseto be made for tightening qualitative criteriafor admission to the Second Board in order torestore order, discipline, and credibility as wellas to refocus on original intentions. Only com-panies with the best attributes and growthpotential ought to be given an opportunity totake the short cut route of raising public capi-tal through the Second Board. The authoritiesshould consider reducing the number of com-panies on the Board by weeding out those thatfailed to perform up to the profit forecasts,etc. A consolidation and merger exercise couldalso be encouraged (work in progress).

Bond MarketMeasures by BNM, CDRC, and National BondMarket CommitteeCompared with the emphasis given to the equity

market by the authorities to regain market confidence,the measures taken to develop the bond market havebeen limited. Although the authorities have recog-nized the importance of the development of the bondmarket, the Government and BNM have been moreconcerned about economic recovery and soundnessof the banking system.

BNM has been increasing the foreign reserves tocope with any “ringgit attack” once foreign exchangecontrols are lifted. In turn, it is taking the funds out ofthe banking system as deposits for sterilization. The

sterilization has two aspects: (i) it confines the in-crease in loans to the private sector, and (ii) it allowscommercial banks to improve profits by enjoying in-terest margins without risks.

Meanwhile, the Government needs funds to fi-nance the budget deficit. It tends to raise funds atlow cost by taking the traditional steps of issuingGovernment bonds. However, the review of interestrate structures has not been initiated. The CorporateDebt Restructuring Committee (CDRC) has beenundertaking debt restructuring, and its efforts will con-tribute greatly to the soundness of the banking sys-tem. One of the measures taken by CDRC is to havedistressed companies issue bonds with the proceedsto be used for the settlement of debts. BNM allowsbanking institutions to invest in bonds issued by com-panies with a BB rating as part of their debt restruc-turing process.

BNM has set various targets on credit extensionto banking institutions. Investment in bonds is deemedto be credit extension and it is an easy process forbanking institutions given that the investment doesnot require any time-consuming processes and costsare minimized as the size of bonds is relatively big.The CDRC’s measure will help develop the primarymarket for PDS. However, the secondary marketfor PDS may remain underdeveloped.

After taking measures to enhance market confi-dence in the equity market, the authorities have shiftedtheir attention to the bond market. It is envisagedthat effective and comprehensive policy measuresfor the robust development of the bond market willbe undertaken in the near future.

An initiative by the authorities to develop the bondmarket emerged in August 1999. The 1999 Malay-sian Capital Market Summit was held from 10 to 11August 1999 in which various papers about address-ing the bottleneck and pending issues for the devel-opment of the bond market were presented. Giventhe need for innovation in the bond market, an an-nouncement was made on 7 September 1999 thatthe National Bond Market Committee (NBMC) had


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commenced work. The Committee is now workingon an overall policy direction and rationalization ofthe regulatory framework for the development of thePDS market. It is expected that issues connectedwith interest rate structure, monetary tools, auctionsystem of Government bonds, regulatory framework,and market infrastructure, etc., will be included onthe agenda.

In addition, a seven-member committee on theformulation of the Capital Market Masterplan wasformed by the First Finance Minister on 23 Septem-ber 1999. The masterplan will tackle various weak-nesses of the capital market as a whole but it willfocus on the bond market.

Shelf Registration SchemeAs one of the efforts to develop the bond market,

a “shelf registration” scheme will be introduced togive greater flexibility to companies qualified to is-sue serial bonds on their own within a certain timeframe. This step is also aimed to deepen the repomarket and increase choices for investors. BNM hasalso issued guidelines on asset securities. Compa-nies are allowed to issue bonds with the rating BB inorder to ease debt restructuring.

Regulatory FrameworkA centralized approval system for PDS issues is

under consideration and necessary law amendmentsare being proposed. Under the existing system, anissuer has to obtain approvals from BNM, SC, andROC. This system is time consuming and may resultin missed opportunities to issue PDS at low cost.The new system and the shelf registration schemewill help considerably to develop the PDS market.

Investor BaseFollowing the move by BNM to allow companies

to issue bonds with a BB rating for their debt re-structuring process, commercial banks, merchantbanks, and discount companies are permitted to in-vest in BB rated bonds and retain bonds where the

rating has been reduced to BB. However, financecompanies are allowed to do so only if the bonds arefully secured and backed by commercial banks orlicensed merchant banks.

Pending ActionsRegulators have been making progress in imple-

menting various recommendations of NERP. How-ever, there are some actions still to be taken. Theseinclude the following:

(i) Reducing the inventory cost for marketmakers. The PDS market will get a big boostif the holdings of Government bonds and PDSby the commercial and merchant banks couldbe exempted from the requirement of statu-tory reserves and liquidity ratio.

(ii) More active role for commercial and mer-chant banks in the PDS market. As a quidpro quo for the exemption, commercial andmerchant banks should play a more active rolein trading of PDS. At present, when a com-mercial bank arranges for a PDS issue, PDSare traded for a while among the discounthouses but they inevitably end up quickly inthe vaults of EPF and the insurance compa-nies.

(iii) Promotion of PDS among foreign fundmanagers. PDS should continue to be pro-moted among foreign fund managers, whoshould be allowed to purchase PDS irrespec-tive of their sources of ringgit. Foreigners havebeen active participants in the developmentof the PDS market. Even PDS issued on anIslamic basis, for instance, the PetronasIslamic bonds, used to be taken up by them.

(iv) Institutional participation in the PDS mar-ket. Increasing institutional participation, suchas by EPF, Khazanah, Tabung Haji, and Po-lice Cooperative.

(v) Repo market. Increasing liquidity in the sec-ondary market by facilitating a more activerepurchase agreement (repo) market.


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(vi) Benchmark yield curve. Reviving thebenchmark program through KhazanahNasional.

Derivatives MarketEarly Warning SystemAn early warning system for “Adjusted Net Capi-

tal” of futures brokers has been devised by SC, KualaLumpur Options and Financial Futures Exchange(KLOFFE), Malaysian Derivatives Clearing House(MDCH), Kuala Lumpur Commodity Exchange(KLCE), and Malaysia Monetary Exchange (MME).It allows bourses and the derivatives clearing houseto monitor capital and liquidity situations of futuresbrokers, and enable early precautionary steps to betaken.

The early warning system came into effect on4 January 1999 and is monitored by KLOFFE, Com-modity and Monetary Exchange (COMMEX),MDCH, and SC.

Circuit BreakersKLSE has studied the issues relating to circuit

breakers. The study has been conducted withKLOFFE, KLCE, MME, and MDCH to come upwith a working paper for further discussion with SC.

Pending ActionsOther pending actions to be taken in the imple-

mentation of NERP include the following:(i) Securities borrowing and lending, and

regulated short-selling. While the suspen-sion of these activities is necessary under thepresent market environment, they should bereintroduced when stability and confidenceare restored because they promote the long-term development of the capital market.

(ii) Put and call transactions. Relevant authori-ties, particularly SC and ROC, should vigor-ously pursue and punish all parties involved inthe abuse of “put and call” transactions torestore public confidence.

ISSUES AND POLICY RECOMMENDATIONSEquity MarketThe authorities have made various efforts to re-

store confidence in the equity market. However, twoissues still need to be addressed: portfolio manage-ment policies of Government-related institutions(GRIs) and low dividend payment.

Portfolio Management Policies of Government-Related InstitutionsGRIs, such as EPF, PNB, Tabung Haji, and the

Ministry of Finance Inc. (MOFI), have invested agreat deal of funds in equities, sometimes to complywith their statutory requirements. As GRIs are man-aging funds from the general public, their portfoliomanagement policies should be conservative. Equityinvestment is risky and share prices are always vola-tile. As such, GRIs stand to make big losses or gainsdepending upon market conditions.

The institutions’ portfolio consists of long-terminvestments. GRIs do not trade shares often. Thismeans that they do not contribute to any increase intrading volumes. Dividend payments by PLCs arerelatively low. As a result, income generation of GRIsin terms of dividends and capital gains is limited.

With an increase in bond issues, along with im-provements in the standards of disclosure and cor-porate governance and efficiency of the equity mar-ket, GRIs should review their portfolio managementpolicies to (i) increase investments in bonds as rec-ommended in NERP, (ii) trade shares actively, and(iii) demand that PLCs increase their dividend pay-ments. GRIs’ policy changes will, in particular, helpenhance the standards of corporate disclosure andgovernance as well as increase trading volume.

Low Dividend Payment. Individual investors in-vest in shares on a short-term basis with the expec-tation of capital gains. Their primary concern is anincrease in share prices. On the other hand, manyGRIs are long-term investors as some of them arerequired to comply with statutory requirements. The


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low dividend payment is attributable to the lack ofincentives for controlling shareholders of PLCs asdividend income is subject to tax. If tax cuts or ex-emptions were offered for dividend income, dividendpayments would increase. This would give investorsmore options in determining their investments, mod-erate price fluctuations, and enhance corporate gov-ernance as investors would hold shares for longerperiods.

Bond MarketDespite the measures taken by the authorities so

far, the most important issue—interest rate struc-ture—has remained unchanged. The authorities haverecognized the importance of the benchmark yieldcurve, and efforts have been made to establish thisby issuing khazanah bonds. Government bonds area natural strategy for reestablishing a benchmark yieldcurve. However, the Government has been raisingurgently needed funds by placing the bonds with tra-ditional subscribers. Thus, a review of the interestrate structure is necessary for the development ofthe bond market.

The mortgage-backed securities (MBS) marketis relatively well developed in Malaysia. However,the authorities should take into account the followingconsiderations for the deepening of the PDS market:

(i) mortgage loans should be sold to the NationalMortgage Corporation (Cagamas Bhd.) with-out recourse, and

(ii) Cagamas bonds should be excluded from theeligible securities that can comply with the li-quidity requirements imposed by BNM.

The authorities should also take measures to de-velop an asset-backed securities market to improvebalance sheets of banking institutions as well as cor-porate entities that will contribute to further develop-ment of the PDS market.

Distorted Interest Rate Structure. It is im-portant to have an appropriate interest rate structureif a robust bond market is to be developed. Despite

various measures taken by BNM, the establishmentof a benchmark yield curve has not yet materialized.Market forces can bring about an interest rate struc-ture. However, distortions will emerge as the authori-ties tackle the financial crisis.

With the introduction of capital controls on 1 Sep-tember 1998, BNM is at liberty to determine interestrates. In fact, it reduced the interest rates substan-tially to stimulate the economy. However, the mon-etary tools used to reduce interest rates were inap-propriate. BNM tapped funds from banking institu-tions by accepting a large amount of deposits at the“intervention rate” (a three-month rate). It also in-tervened by imposing a margin limit on the base lend-ing rate. As the banking sector has been sufferingfrom mounting NPLs, BNM has moved to tightenliquidity to curb loans and to restore a prudential bank-ing system.

BNM has set loan targets to the banking insti-tutions to stimulate the economy. Since a bond isdeemed as a form of loan and banking institutionsare cautious in extending new credits to corporateentities, a new directive set by BNM has becomean attractive option. BNM has allowed commer-cial banks, merchant banks, and discount compa-nies to invest in bonds issued by companies with aBB rating for their debt restructuring process, andretain bonds where the rating has been reduced toBB.

The low interest rate policy is beneficial to thepublic and private sectors as it reduces the cost offunds. The Government as well as Government en-tities have issued bonds to finance the State cof-fers and various development projects. Various fi-nancial institutions and provident funds have sub-scribed to these bonds. In turn, the financial institu-tions are allowed to invest in bonds that carry a BBrating or above. In the process, BNM’s new direc-tive may contribute to a distortion in interest rates.Measures should be taken to establish a benchmarkyield curve and bonds should be issued in line withthis.


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Open Market Operations and Auction Sys-tem for Government Bonds. With the new ruleson liquidity requirement effective 1 January 1999,banking institutions can now adopt a flexible approachto Treasury management. However, BNM’s directborrowing and lending is the main tool to regulatemoney, and open market operations are limited. BNMshould change the system of direct intervention tothe indirect tool of open market operations.

BNM should also eliminate the existing auctionsystem, which results in oversubscription in eachauction. The principal dealers should bid in the auc-tion at their determined prices, which would be afirst step towards establishing a benchmark yieldcurve.

As for BNM’s new rule pertaining to investmentin PDS issued by companies with a BB rating orabove as part of their debt restructuring, this will helpdevelop the bond market. However, it is not clearhow prices of these bonds should be determined, inparticular, in the secondary market.

Mortgage-backed Securities/Asset-backedSecuritiesThe MBS market has been developing since the

first issue of Cagamas bonds in October 1987.Cagamas bonds are issued to finance the purchase

of mortgage loans from commercial banks and fi-nance companies. MBS help reduce maturity mis-matches and enhance liquidity in the banking sector.However, the sale of housing loans to Cagamas Bhd.from banking institutions is undertaken with recourse.This means that the sold loans still remain in theseller’s balance sheet. BNM should move towardsthe sale of mortgage loans without recourse.

Cagamas bonds are recognized as eligible securi-ties by BNM. Thus the demand for Cagamas bondsby banking institutions is significant as the holdingsof these bonds comply with liquidity requirements.As such, the yield curve of Cagamas bonds is similarto that of Government bonds. The authorities shouldreview the status of Cagamas bonds in the contextof eligible securities and have Cagamas Bhd. issuebonds at market rates.

The authorities should also seriously study thedevelopment of the asset-backed securities (ABS)market. With the onset of the financial crisis, im-proving balance sheets has become an importantagenda. ABS will help convert loans and receivablesinto cash assets through the securitization process,and thus contribute to the diversification and deep-ening of the PDS market. The authorities shouldtherefore put in place a regulatory environment forthe development of MBS/ABS markets.


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Notes1Watch list triggers are based on financial data disclosedin periodic financial statements and include shareholderfunds under 50 percent of paid-up capital, gearing ratio offour or greater, significant losses over two years, and sig-nificant amounts of bonds or loans due for repayment inthe following year.

2The monetary instruments used by BNM are as follows:(i) reserve requirement, (ii) liquidity requirement, (iii) creditcontrol and guidelines on lending, (iv) open market opera-tions, (v) direct lendings/borrowings, (vi) centralizationof Government and EPF deposits with BNM, (vii) discountoperations, (viii) limits on swap transactions with foreigncustomers, (ix) interest rate regulations, and (x) moral sua-sion.

3Commercial banks, finance companies, and merchantbanks are required to maintain a certain percentage of(i) eligible assets in the form of cash deposits without

interest in the Central Bank and (ii) eligible liquidities inthe form of eligible liquid assets. Eligible assets com-prise deposits (including negotiable certificates of depositand repurchase agreements) and net interbank borrow-ings. Eligible liquid assets include cash, clearing bal-ances with the Central Bank, money at call, Treasurybills, Government securities, Government investmentcertificates, Cagamas bonds, bills discounted or pur-chased, Bank Negara bills, Bank Negara Malaysia cer-tificates, and State Government securities.

4Malaysian Government securities, Malaysia investmentissues, and Malaysia savings bonds are referred to hereas Government bonds, unless otherwise specified.

5A market yield is determined through auction. Principaldealers are invited to bid in the auction of Governmentbonds by submitting the prices on yield basis. Theweighted average of the successful yields will become themarket yield of the Government bonds. The principal dealersystem was also introduced to facilitate the developmentof a secondary market in Government bonds.

Towards a SustainableBanking Sector—Malaysia

Soo-Nam Oh

Soo-Nam Oh is Economist at the Asian Development Bank. The author gratefully acknowledgesthe help of Ramesh Subramaniam and Peggy Speck who contributed inputs to this report.


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Executive SummaryThe Malaysian banking sector has played a leadingrole in indirect financing, while experiencing problemssimilar to those of other Asian countries suffering fromthe financial crisis. The direct reasons for the prob-lems include a downturn of the economy and collapseof the property and stock markets. However, morefundamental reasons are state-directed loan policies,lack of competition, and lack of prudential regulations.

Recently, Bank Negara Malaysia (BNM) movedto improve the soundness of banking institutions(BIs). Each measure falls roughly into one of threecategories:

• improvement in credit allocation,• strengthening of prudential regulations, and• resolution of nonperforming loans (NPLs) and

recapitalization and consolidation of the bankingsector.

As the crisis escalated and began to infect the eco-nomy, BNM relaxed monetary policy on 27 August1998. On 1 September 1998, the authorities announcedcapital control measures with two primary objectives:

• elimination of speculative flows, and• allowance of a progressive reduction in interest

rates.BNM took additional banking measures to pro-

mote economic recovery on 23 September 1998.The Malaysian banking sector was fairly healthy

at the onset of the regional financial turmoil. How-ever, finance companies have been particularly over-exposed to broad property and consumption credit.Banks have also overextended themselves to politi-cally well-connected corporate entities backed byvolatile assets in the form of shares and real estate.The share of substandard loans in NPLs for thesefinancial institutions has risen, with the increase forfinance companies and merchant banks substantialcompared to that for commercial banks.

One of the crucial indicators of asset quality is col-lateral exposure, and it is likely that the collateral posi-tion has also significantly deteriorated. On the other hand,

a tight monetary policy has had an adverse effect oncredit generation. There are two steps in resolving theNPL problems faced by the banking system:

• recovery of assets behind the NPLs, and• recapitalization if some or all of the capital and

reserves are wiped out due to deteriorating as-set quality.

The Government has taken the right steps by es-tablishing asset management company PendurusanDanaharta Nasional Berhad (Danaharta) and specialpurpose vehicle Danamodal Nasional Berhad(Danamodal) to deal with NPLs and recapitalization.However, the financing arrangements for these agen-cies are still being finalized. In this regard, recourse toBNM financing or lending to insolvent banks shouldbe avoided. The Government should draft a compre-hensive recapitalization plan, which should include pro-visions for direct Government equity participation inthe short run, if necessary. Any such interventionshould be financed through the issuance of Govern-ment bonds. At a more fundamental level, free entryand firm exit policies are essential in solving these prob-lems. Danaharta has to function independently with-out any Government interference. And it should nottake an unduly long time to maximize the value of theassets purchased while in the process holding on tothose assets until the domestic economy revives, giventhe slow process of liberalization to allow entry of for-eign investors. Also, the pricing of NPLs should bebased on a transparent rule.

In response to the financial crisis, many policymeasures were taken to limit the amount of credit tothe more volatile sectors of the economy, to moder-ate continued high credit growth, to put in place morestringent prudential requirements, and to enhance fi-nancial disclosure by financial institutions. In particu-lar, stringent prudential measures were imposed tofoster quicker recognition of asset quality problems,and to allow for appropriate and timely actions to betaken by bank managements.

Regarding the five core principles for credit riskmanagement, BNM has a well-developed program

35TOWARDS A SUSTAINABLE BANKING SECTOR—MALAYSIA

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for compliance with all but country/transfer risk man-agement. Potential areas of concern that banks couldaddress with regard to country/transfer risk include:to assess the nature of the risks for individual coun-tries, to have systems in place to measure the vari-ous types of exposures, and to have a mechanismfor establishing and reviewing country limits with theflexibility to incorporate rapidly changing conditions.

BNM remains informed about key developmentsin the financial sector. Its supervisory functions are wellestablished. However, given the adverse economiccircumstances, BNM should continue to accelerate theon-site examination schedule to verify the quality ofassets and overall soundness of Malaysian BIs.

Other major policy recommendations are as fol-lows:

• policy loans and commitments need to be trans-ferred to the Government budget, to resolve anypolitical problems. This will also help BIs to re-cover their screening and monitoring functions;

• there must be greater disclosure of the shortfallsbetween the collateral values and the loans forshare purchases;

• the legal framework must be strengthened in linewith international best practices;

• a prudential limit such as the single party ceilinghas to be rationalized with the prevention of cir-cumvention in mind;

• a good fraction of the nonresident component ofthe Labuan loans seemed to go to Malaysian com-panies investing abroad, but such loans do not comeunder the purview of BNM. The scale of dollardenominated lending undertaken by Malaysianbanks based in Labuan needs to be disclosed;

• given the rapid changes in asset quality, detailsof NPLs and collateral exposure must be madepublicly available;

• the Government should set up a concrete plan ofwhen and how to open the financial markets;

• in order to ensure transparent policy decisions,the Central Bank of Malaysia Act needs to berevised to clarify the composition of the Board

of Directors. And BNM needs to disclose theminutes of the decision of the highest policymaking body;

• BNM supervises insurance companies accord-ing to the Central Bank of Malaysia Act. Anindependent supervisory agency for insurancecompanies should be established;

• regarding a credit crunch, more fundamental andcontingency plans have to be considered to-gether;

• the amount of the principal and accrued inter-ests completely insured by the Government needsto be reduced;

• more efforts should be directed to financial in-novations. Country specifics including the tradi-tion of Islamic banking and the Bumiputra policycould be utilized for inventing new financial prod-ucts; and

• apart from deposits, BIs’ bond issuance shouldbe examined to encourage savings mobilizationby satisfying the customer’s preference and todiversify the sources of funds. BIs can inventgood saving instruments, providing greater vari-ety and profits to depositors, by linking commer-cial banking business with securities business.

Overview of theBanking Sector1

The financial crisis in Asia has shown that a robustfinancial system is one of the key components of eco-nomic progress. Without it, misallocation of investmentscould seriously disrupt development. This study pro-vides a closer look at the Malaysian banking systemwith a view to analyzing and deepening understandingof the causes of the currency and financial crisis andrecommending suitable preventive measures.

The Malaysian banking system comprises mon-etary and nonmonetary institutions. The monetaryinstitutions are the central bank, Bank Negara Ma-laysia (BNM), and the commercial banks (includingBank Islam). The nonmonetary institutions fall into


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two groups. The first group is supervised by BNM:finance companies, merchant banks, discount houses,foreign banks representative offices, and offshorebanks in the International Offshore Financial Centrein Labuan. The second group under supervision ofvarious government departments and agencies includesdevelopment finance institutions, savings institutions,provident and pension funds, insurance companies, andother financial intermediaries. The insurance industrywas brought under the supervision of BNM from 1May 1988.

As of the end of 1997, the licensed banking systemconsists of 35 commercial banks, of which 22 are do-mestic banks and 13 are foreign-controlled (or 44 per-cent of total financial system assets), 39 finance com-panies (14 percent), 12 merchant banks (4 percent),7 discount houses (2 percent), and money and ex-change brokers (Appendix 1 and Table A2.1). Amongthese banking institutions (BIs), only commercial bankscan accept demand deposits from the public or en-gage in foreign exchange operations. Hire-purchaselending is the exclusive business of the finance com-panies and constitutes their main line of business; whilemerchant banks concentrate on investment banking.

BIs are closely connected through subsidiaries orparent company relationships. Several banks are sub-sidiaries of corporate conglomerates, while numer-ous finance companies and merchant banks are sub-sidiaries of commercial banks. In addition, some fi-nancial groups have securities trading subsidiariesand branches in offshore Labuan. Government andother public sector involvement in the banking sectoris high—the Government owns Bank Bumiputra, thesecond largest commercial bank, and through an in-vestment trust holds a controlling stake in Maybank,the largest commercial bank, among others.

Banks play a leading role in indirect financing.Their share measured by M2/M3 is about 75 per-cent, which is high compared with other countries(e.g., 30 percent in Korea). This simple ratio hastwo implications. First, BNM could control monetarytargets relatively easily and implement effective

monetary policy. Second, the development of thebanking sector has been heavily dependent on BNM’spolicies. In terms of growth, total assets of BIs havegrown 3.8 times on average in the period 1990–1997,equivalent to 2.4 times the nominal gross domesticproduct (GDP).

Among the 35 commercial banks operating in thecountry as of the end of July 1997, the total number ofbranch offices of domestic banks was 1,480 and thatof foreign-controlled banks was 144. As of the end of1997, 10 commercial banks have been accordedtier-1 status and allowed to undertake a number ofactivities subject to prudential limits and conditions de-termined by BNM. These activities include issuing ne-gotiable instruments of deposit (NIDs) up to five timestheir capital funds, participating in equity derivatives,undertaking securities borrowing and lending activi-ties subject to Securities Commission approvals, andexpanding their operations through setting up of branchoffices, representative offices, subsidiaries, or on ajoint venture basis (Appendix 3).

BIs have shown remarkable growth (Table 1),but in common with banks of other Asian countriessuffering in the financial crisis, there has been asurge in nonperforming loans (NPLs) (Table 2). Asof the end of May 1998, the ratio of NPLs to totalloans was 8.5 percent. Direct reasons for the NPLsinclude downturn of the economy and collapse ofproperty and stock markets. But more fundamentalreasons for the large NPLs are state-directed loanpolicies, lack of competition, and lack of prudentialregulations.

However, the authorities have not been completelycomplacent. For example, in the Seventh Plan for1996–2000 prepared in 1996, it was emphasized thatthe financial sector had to be further strengthenedand modernized to provide new instruments of fund-ing and promote savings.

2 Confronting increasing glo-

balization, the future operating environment for thebanking industry was expected to be more dynamicand competitive. So BIs were encouraged to increasetheir competitiveness by enhancing operational effi-


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Table 1: Total Assets, Deposits, and Loans of the Banking System

NID = negotiable instrument of deposit.Source: Bank Negara Malaysia, Monthly Bulletin, various issues.

Loans-DepositsTotal Assets Total Deposits + NIDs (A) Loans and Advances (B) Ratio (B/A)

Financial Institution 1985 1990 1997 1985 1990 1997 1985 1990 1997 1985 1990 1997

Amount (RM million)

Commercial Banks 74,233 129,285 481,114 47,994 74,272 283,472 48,982 80,758 276,111 1.02 1.09 0.97Financial Companies 17,833 39,448 152,404 14,541 28,437 79,661 12,327 27,023 102,546 0.85 0.95 1.29Merchant Banks 6,296 11,063 44,329 4,569 5,709 22,346 4,489 6,252 23,052 0.98 1.10 1.03Total 98,362 179,796 677,847 67,104 108,418 385,479 65,798 114,033 401,709 0.98 1.05 1.04

Percent share

Commercial Banks 75.5 71.9 71.0 71.5 68.5 73.5 74.4 70.8 68.7Financial Companies 18.1 21.9 22.5 21.7 26.2 20.7 18.7 23.7 25.5Merchant Banks 6.4 6.2 6.5 6.8 5.3 5.8 6.8 5.5 5.7Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Table 2: Performance of the Banking System, 1990–1997


Item 1990 1991 1992 1993 1994 1995 1996 1997

Amount (RM million)

Net Interest Income 4,115 4,832 5,658 6,973 8,868 10,392 13,389 16,637Pretax Profit 1,985 2,271 2,657 3,788 5,205 6,869 8,721 7,949

Percent

Return on Assets 1.4 1.3 1.3 1.5 1.7 1.9 2.0 1.3Return on Equity 21.5 17.6 16.8 20.2 24.2 26.2 27.5 19.0Specific Provision/Total Loans 5.3 3.6 3.4 3.2 2.2 1.6 1.0 1.0General Provision/Total Loans 0.7 0.9 1.1 1.3 1.6 1.6 1.9 2.0Nonperforming Loans/Total Loans 20.3 15.6 14.9 12.6 8.1 5.5 3.9 5.7

ciency and being more innovative in developing com-petitively priced financial products. The need to servethe increasingly diverse and sophisticated needs ofconsumers and businesses was also realized.

In an effort to contain the impact of the Asianfinancial crisis, the main focus of recent financialpolicy has been on improving the soundness of thefinancial system through strengthening preemptiveand prudential regulations. The Government has notsought rescue funds from international financial in-stitutions, and therefore has not come under directpressure to implement specific economic reforms.But since early 1997, BNM has taken a series ofmeasures to help strengthen prudential regulation andtransparency. Basically in line with InternationalMonetary Fund (IMF) packages forced on Indone-

sia, Korea, and Thailand, the measures concern NPLclassification and provisioning standards, capital ad-equacy ratio (CAR), lending to the property sectorand for the purchase of stocks and shares, singlecustomer limits, disclosure and monitoring, and es-tablishment of asset management company (Appen-dix 5). These measures, on the one hand, have greatlycontributed to stabilizing financial markets. On theother hand, they brought about an extremely passiveattitude to the management of banking.

Such a financial policy may cut the long-term prof-its of the BIs. The authorities need to insert dynam-ics into the financial market by promoting local aswell as global competition. In parallel with strength-ening of the prudential regulations, it is necessary topursue deregulation and liberalization.


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Recent Developmentsin the Banking SectorInitial Impact of the Asian FinancialCrisis on the Banking Sector

Until the onset of the Asian crisis, Malaysia’s bankswere regarded as having a well-developed supervi-sory and regulatory framework. As a result, NPLsremained at only 4 percent of the total loans at theend of 1996. However, rapid credit expansion (par-ticularly by smaller tier-2 financial institutions) to theproperty sector and to the stock market, as well asconsumer lending at fixed interest rates by financecompanies, has placed Malaysia’s financial systemat considerable risk from deflation in property andother asset markets. As the crisis has evolved, moreproblems of the weak banking system have beenexposed. The economy had more domestic debts thanother economies in Southeast Asia, reaching about170 percent as a proportion of GDP. It was expectedthat the soundness of the financial institutions coulddeteriorate quickly in the event of a slow recovery inthe real estate sector.

As the property bubble burst, shares fell, and loansto borrowers in Thailand and Indonesia turned bad,market concerns about vulnerability in the financialsystem grew during the second half of 1997. To-wards the end of the year, there were signs of a shiftin deposits from domestic financial institutions to for-eign banks, and from smaller to larger financial insti-tutions. Against this background, BNM extended sig-nificant liquidity support to affected institutions—pri-marily tier-2 commercial banks and finance compa-nies—and announced in January 1998 that all de-positors would be guaranteed. The authorities alsotightened provisioning and disclosure standards andput forward a merger plan for finance companies byend-March 1998.

Reflecting a worsening situation in banks, in Feb-ruary 1998 the authorities announced that five insti-tutions (two banks and three finance companies)

were in need of recapitalization, based on their posi-tion at end-1997. On 3 March 1998, BNM revealedthat Sime Bank, the country’s sixth largest, had lostRM1.6 billion ($420 million) in the second half of theprevious year and would need $320 million in newcapital. It also disclosed that Bank Bumiputra, thesecond largest, could need $200 million in new capi-tal, and that two small finance companies were indifficulties.

Financial Policy Responsesto the CrisisThe ultimate goal of measures taken by BNM hasbeen to improve the competitiveness of banks, thussetting up a market-driven order rather than the oldregulation-driven order. This has been pursued in threecategories:

• improvement in credit allocation,• strengthening of prudential regulations, and• resolution of NPLs and recapitalization and con-

solidation of the banking sector.

IMPROVEMENT IN CREDIT ALLOCATIONStrong monetary expansion was a concern during1997 because of the need to contain inflationary pres-sures. Increased access to bank financing could con-tribute to further price rises, fueling concerns aboutasset inflation and its potential destabilizing effectson the economy.

Hence, in April 1997, BNM limited the bankingsystem’s exposure to the broad property sector

3 at

20 percent of outstanding loans and to institutionaland individual purchases of stocks and shares at15 percent (30 percent in the case of merchantbanks). Also, financing of second houses was re-duced to 60 percent of the property value and a levyof RM100,000 was imposed on real estate purchasesby foreigners.

In aggregate terms, an indicative target was setfor growth in M2 at 25 percent by end-1997, 20 per-cent by end-March 1998, and 15 percent by end-1998, as given in the Credit Plan of October 1997.


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However, commercial banks continued to providecredit to the priority sectors of the economy, namely,the Bumiputra Business Community, housing, and tosmall-scale enterprises under the New PrincipalGuarantee Scheme (NPGS) of the Credit Guaran-tee Corporation (CGC).

STRENGTHENING OF PRUDENTIALREGULATION AND SUPERVISIONAmong the controls on BIs that BNM strengthened,most notable are greater transparency in monetaryoperations, the increased requirements for CARs,and stringent new mandatory provisions for “sub-standard” loans. BNM promised much more trans-parency in monetary policy, with daily statementsand better accounting between support operationsfor distressed banks and day-to-day monetary man-agement. It also reduced the time lag in the releaseof data and analysis of monetary trends from six tofour weeks, and launched a home page on theInternet containing up-to-date information on eco-nomic and financial developments. On the otherhand, BNM requested all financial institutions to dis-close quarterly data on NPLs and capital adequacyratios.

With effect from financial year beginning January1998, the classification of NPLs and suspension ofinterest in NPLs were tightened. Through this, thearrears period for classifying a loan as nonperformingwas reduced from six months to three months. Atthe same time, the minimum requirement for generalprovision for bad and doubtful debts has been raisedfrom 1 to 1.5 percent.

To regain market confidence, on 24 March 1998the authorities announced that the Employees Provi-dent Fund (EPF), the Permodalan Nasional Berhad(PNB) (a large unit trust fund), and other quasipublicfinancial institutions could take an interest in BIs, butonly if they would maximize value for their share-holders. They added that the Government would beresponsible only for injections of capital in Govern-ment-owned BIs. Earlier, in January 1998, BNM re-

affirmed that the Government would protect the prin-cipal and accrued interest of deposits.

RESOLUTION OF NONPERFORMING LOANS,AND RECAPITALIZATION AND CONSOLIDATIONOF THE BANKING SECTORThe Government on 16 July 1998 passed thePengurusan Danaharta Berhad Bill to pave the wayfor the establishment of a national asset managementcompany, Danaharta, to acquire NPLs and maximizetheir recovery value. Four days later, Danaharta wasincorporated with a paid-up capital of RM250 million.It will help BIs focus on giving out loans to viable busi-nesses by taking care of NPLs. It is likely to raiseabout RM25 billion through Government-guaranteedbonds on the domestic and international markets, es-pecially in the United States (US).

4 This would enable

the agency to purchase the assets behind almost allthe NPLs in the system (about RM42 billion), assum-ing a discount factor of about 40 percent.

Danaharta plans to complete its work within 5 to10 years. In the first stage, its acquisition processaddressed the secure NPLs and those in sectorsconsidered strategic to the nation, such as manufac-turing and infrastructure. This stage was scheduledto be completed by the end of March 1999. The sec-ond stage involved acquisition of unsecured loans,while the third covered more complicated facilitiessuch as foreign currency loans and guaranteed fa-cilities. To give transparency to the takeover pro-cess, an oversight committee was to be set up, con-sisting of a representative each from the Ministry ofFinance (MOF), BNM, and Security Commission.

Complementing Danaharta to strengthen the bank-ing system, Danamodal, a special purpose vehicle torecapitalize and consolidate the banking sector, be-gan operations in September 1998. The main objec-tives of Danamodal are to recapitalize and strengthenthe banking industry and help in the consolidation andrationalization of the banking system to support eco-nomic development. Danamodal’s proposed invest-ment budget is RM16 billion in the form of equity,


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hybrid instruments, or debt. With this, BNM expectsBIs to refocus on prudent lending, in the processaccelerating the pace of economic recovery.Danamodal will be the interim funding vehicle forthe injection of funds into troubled institutions. BNMwill provide seed capital of RM1.5 billion to startoperations, which will be according to market-basedprinciples and methodologies.

Introduction of Capital Controlsand Easy Monetary PolicyMalaysia has worried constantly about speculationand pursued a credit-financed growth policy. As thecrisis escalated and began to infect the real economy,the necessity for supervision of potentially destabi-lizing capital flows became ever more strident. Mat-ters came to a head when official data released on27 August 1998 revealed that the economy hadslipped into deep recession. BNM figures showedthat GDP contracted by 6.8 percent year-on-year inApril-June, and the bank revised the first quarter’scontraction from 1.8 to 2.8 percent. The deteriora-tion of the economy also put the effectiveness ofIMF-inspired austere monetary and fiscal policies indoubt. Under these circumstances, BNM relaxedmonetary policy that day.

5

Then the authorities announced capital controlmeasures on 1 September 1998.

6 The measures had

two primary objectives: first, they would eliminatespeculative flows that had battered the ringgit andthe stock market for more than a year; and second,by securing monetary independence, they could al-low a progressive reduction in interest rates (withoutthe risk of a deterioration in the exchange rate andcapital flight) to encourage increased investment andconsumption, and thus a reactivation of the economy.

As a consequence of the measures, on 3 Septem-ber 1998, BNM slashed its three-month interventionrate—the benchmark for commercial bank lending—from 9.5 to 8 percent and then to 7.5 percent, ex-pecting this to moderate the maximum basic lendingrate. The statutory reserve requirement (SRR) was

also lowered from 6 to 4 percent8 to boost liquidity

by reducing the cost of funds and by enhancing lend-ing capacity of BIs. At the same time, the liquid as-set ratio requirement of commercial banks was re-duced from 17 to 15 percent of total eligible liabili-ties. Also, lending for the construction or purchaseof residential properties costing RM250,000 and be-low was exempted from the 20 percent limit imposedon the broad property sector, to encourage BIs toprioritize lending for the construction or purchase ofresidential properties.

On 23 September 1998, BNM took additionalbanking measures to promote economic recovery asfollows:

• the default period for classifying a loan asnonperforming by BIs was increased from threemonths to six months;

• BIs would no longer be automatically requiredto provide a 20 percent specific provision on sub-standard loans. The quantum of provisioning forthe substandard loans would be assessed for eachBI by BNM during the approval of half-year andannual accounts. The amount of provisioning re-quired would be dependent on the adequacy ofthe respective BI’s loan-loss coverage;

• for NPLs that have been restructured or resched-uled, such loans might be reclassified as perform-ing when the repayments under the rescheduledterms were complied with for a continuous pe-riod of six months, instead of the current prac-tice, which requires 12 months of continuouspayment;

• the limit on loans for the purchase of shares andunits of unit trust funds would be increased from15 to 20 percent of total outstanding loans forthe commercial banks and finance companies.The limit for merchant banks remained at 30 per-cent; and

• to ensure continued financing for viable busi-nesses and projects, BIs should not withdrawfacilities from their customers, based solely onproblems that the customers have with other BIs.


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Improvement of AssetQuality: Policy Issuesand RecommendationsRecent Trends in BankingSector IndicatorsWhile no new financial institutions have entered theMalaysian banking sector since the early 1970s dueto restrictions on domestic and foreign entities, theincumbents have grown at a rapid rate, particularlyover the last four to five years. Loans and advancesin the banking system at the end of 1997 stood at152 percent of Malaysia’s GDP, with commercialbanks accounting for two thirds of the total creditoutstanding of RM421 billion. Appendix Tables A2.4and A2.5 present some historical patterns in totallending by commercial banks and finance compa-nies, disaggregated by major economic sectors. To-tal lending by commercial banks grew at a compoundrate of 17 percent per annum from 1980 to 1997,with a growth rate of 25 percent for the period 1993–1997, whereas lending by finance companies grewat 21 percent from 1982 to 1997 and 24 percent from1993 to 1997. The tables also present the annualgrowth rates by sector: commercial bank credit toalmost all the major sectors (such as broad property,manufacturing, financial services, and share pur-chases) has grown significantly in the last four years.Credit for consumption, manufacturing, and finan-cial services has fueled the growth of finance com-panies during this period.

BNM introduced in December 1994 a two-tierstructure for commercial banks, which was extendedto finance companies and merchant banks in 1996.Tier-1 BIs are allowed a wider range of businessesand easier branch opening (Appendix 3).

The introduction of the two-tier system is one ofthe main reasons for the rapid growth in banking loansand advances.

9 BNM’s primary objective in this pro-

cess was to consolidate the banking industry in orderto prepare the sector for external competition. It at-

tempted to do this by imposing high capital require-ments and creating the two tiers of institutions inwhich banks in tier 1 would be stronger and moreefficient than those in tier 2. Banks in tier 1 wereaccorded a number of incentives, the most importantof which was the operation of foreign exchange ac-counts of exporters. However, the two-tier systemhas not produced the desired result in that only onebank merger has been carried out since the systemwas introduced, and an agreement has been reachedfor another.

10

The smaller banks in tier 2, encouraged by thestrong profits due to solid economic growth, havenot been willing to merge with the larger banks intier 1. The shareholders of these banks instead havebeen augmenting their capital to graduate to tier-1status; and, in order to secure a sufficient return oncapital, several tier-2 banks have been aggressivelylending in the last three to four years.

Following the deepening of the financial crisis,the Government has taken stronger measures topromote (forced) merging of finance companies.BNM in January 1998 announced a merger plan,instead of closing affected institutions as Korea andThailand had done, in which 39 finance companieswere to be consolidated into eight.

11 However, it

remains to be seen if the move will be successful.The market’s perception is that the stronger financecompanies will suffer as they merge with theweaker ones. Similar views are expressed with re-gard to suggestions that banks be merged as a routetowards recapitalization.

Malaysia has been relatively less affected by therecent financial turmoil compared with Indonesia,Korea, and Thailand. It has avoided the currency-mismatch problems that the corporate sectors ofother economies have faced, through developmentof the primary bond market and prudent controls onforeign exchange.

The banking sector was fairly healthy at the onsetof the regional financial turmoil. The relatively stron-ger capital adequacy and profitability

12 indicators in


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the Malaysian banking sector have ensured that ittook somewhat longer for the fragility of the bankingsystem to surface. Table 3 presents data on risk-weighted and core capital ratios for Malaysian banks:there is considerable variation in many of the perfor-mance indicators within the banking sector betweensmall and large banks, with the risk-weighted capitalratio (RWCR), for example, in the range of 8 to14 percent. Malaysia ranks behind Hong Kong, China;Philippines; and Singapore, which have RWCRs inthe range of 16 to 20 percent, but above Indonesia,Korea, and Thailand.

But increasingly, the banking sector has facedproblems similar to those of other affected econo-mies, including poor risk management in the face ofrapid economic growth, maturity mismatch, and po-litically directed lending. Further, a lax monetary policyregime in the 1990s and the two-tier system of clas-sification of banks contributed to a significant growthin credit, much of which was directed to sectors proneto volatile asset-price cycles, such as broad property

and speculative activities. The economic crisis hasacted as a trigger point in bringing these banking prob-lems to the surface in the form of rapidly rising NPLs.

Table 4 presents the latest available data asof May 1998 on loans made by commercial banks,finance companies, and merchant banks to var-ious major economic sectors. Total loans stood atRM419 billion (representing a decline from the endof 1997). Broad property accounts for the largestshare for commercial banks and merchant banks,while consumption credit—primarily lending for hire-purchase activities—represents the largest compo-nent in the loan portfolios of finance companies.Commercial banks have lent a sizable share of theircredit to manufacturing activities followed by finan-cial services, whereas merchant banks have lentclose to 18 percent of their credit to the financialservices sector. In summary, finance companies havebeen particularly overexposed to two of the weakestsectors, namely, broad property and consumptioncredit, in the Malaysian economy.

Table 3: Capital Ratios of the Banking Sector, December 1996 and March 1998


Banking System Commercial Banks Finance Companies Merchant BanksDec Mar Dec Mar Dec Mar Dec Mar

Item 1996 1998 1996 1998 1996 1998 1996 1998

Risk-Weighted Capital Ratio (%) 10.6 10.6 10.8 11.0 9.8 10.7 11.7 14.1Tier-1 Core Capital Ratio (%) 9.3 9.0 9.3 9.2 8.1 8.5 10.3 12.1

Table 4: Loans By Major Economic Sectors, May 1998

Note: The figures do not add up to 100 percent since only the five major sectors are reported here.Source: Bank Negara Malaysia.

Sector Banking System Commercial Banks Finance Companies Merchant Banks

Amount (RM million)Broad Property 144,380 105,302 31,701 7,377Consumption 53,417 17,331 35,955 135Manufacturing 64,636 56,745 5,200 2,692Financial Services 35,922 28,098 3,781 4,043Share Purchases 37,546 24,428 9,142 3,977

Percentage share in total loans by institution

Broad Property 34.5 35.9 30.8 32.6Consumption 12.8 5.9 35.0 0.6

Manufacturing 15.4 19.3 5.1 11.9Financial Services 8.6 9.6 3 7 17.9Share Purchases 9.0 8.3 8.9 17.6


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Prudential RegulationsMalaysia went through a banking crisis in the sec-ond half of the 1980s, when NPLs rose above30 percent of the total loans. The sector subsequentlyhas experienced a recovery and rebound, whichlasted until the corporate sector difficulties becamesevere in 1998.

On 1 January 1998, BNM introduced major changesin the loan classification and provisioning requirementsfor commercial banks, finance companies, and mer-chant banks. The measures were recorded as revisionsto BNM/GP3 “Guidelines on the Suspension of Inter-est on Nonperforming Loans and Provision for Badand Doubtful Debts.” Key points were as follows:

• the period of arrears for classification of a loanas nonperforming was reduced from six monthsto three months. BIs were to “claw back” inter-est to day one for new NPLs effective from1 January 1998. “Claw back” means to reverseaccrued but not collected interest out of incomeand balance sheet accounts;

• for loans of RM1 million and below to be classi-fied as substandard, the period in arrears wasreduced from six months to three months; doubt-ful, from 12 months to six months; and bad, from24 months to 12 months. These classificationswould be in effect unless evidence to supportmore severe classification will be identified;

• accounts or portions classified bad or deemeduncollectible were to be written off;

• minimum general provision for bad and doubtfuldebts was raised to 1.5 percent of total loans (netof specific provisions and interest-in-suspense),from 1 percent in effect from 1 January 1986.

• specific provision on uncollateralized portion ofsubstandard loans was set at 20 percent; and

• provisions were required for off-balance sheetitems where the BI faces credit risk from failureof counterparts to meet contractual obligations.

The reduction of the period of arrears to threemonths for the classification of a loan as nonper-forming showed BNM’s intent to identify problem

assets early. When initially placed in effect on1 January 1986, the guidelines specified a period of12 months in arrears for a loan to be classified asnonperforming. The period of arrears was later re-duced to six months for financial accounts begin-ning 1 January 1990. This guideline is consistentwith US accounting standards, which specify thatloans and lease receivables are to be placed onnonaccrual if principal or interest has been in de-fault for 90 days or more, unless the loan is bothwell secured and in the process of collection. HongKong, China and Japan have also moved toward athree-month standard in reporting NPLs.

The requirement to “claw back” interest to day onefor loans newly categorized as nonperforming as of 1January 1998 represents a return to the more conser-vative approach that was in place from 1 January 1986through calendar year 1989. BNM did not require BIsto reverse out accrued but uncollected income for loansnewly categorized as nonperforming during the period1 January 1990 through calendar year 1997. In com-parison, it is generally the accounting practice in theUS to reverse out previously accrued but not collectedinterest income when a loan is placed nonaccrual.

The requirement to classify loans RM1 million andbelow as substandard when in arrears for threemonths, doubtful when in arrears for six months, andbad when in arrears for 12 months was instituted toexpedite the evaluation of loans and subsequent pro-visioning. The time frames for these classificationsin effect since 1 January 1990 were reduced fromsix months for substandard, 12 months for doubtful,and 24 months and above for bad loans. The guide-lines instruct BIs that the appropriate classificationfor an individual account will be determined on a case-by-case basis, and that the above standards applyunless there is evidence to support a worse-off clas-sification. As with other BNM guidelines, these areconsidered to be minimum standards and BIs areencouraged to adopt more stringent standards.

BNM supervision staff have clarified that for largerloans, case-by-case evaluation and classification is


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plicated by continued deterioration in the economicenvironment. This makes the determination of therisk of default more difficult, as well as more critical.And there is a need to determine appropriate levelsof provisions for the credit risk inherent in the vari-ety of off-balance sheet instruments. Under BNMguidance, financial institutions have begun the reviewof the various instruments in their off-balance sheetportfolios to assess for potential defaults.

Two additional areas of importance in ensuringthat BIs have assessed their asset portfolios in a pru-dent and conservative manner are the valuation ofcollateral and the treatment of restructured loans.Both of these items are addressed in the revision toGP3 that took into effect on 1 January 1990.

The “Guidelines on the Valuation of Security” is-sued as an annex to GP3 on 26 December 1989 indi-cate values for security in the context of asset clas-sifications and provisioning. With regard to assess-ing the value of property, the guidelines specify whento use forced sale value, fair market value, or thereserve price fixed when an auction is pending. Theguidelines also specify that in the absence of currentvaluation reports, defined as not more than two yearsold, the full Property Market Report quoted pricesshould be taken. This report is issued annually byMOF with data that represent a timelag of severalquarters. Given recent economic conditions in Ma-laysia in which the value of various sectors of theproperty market has deteriorated significantly, thevalues quoted in the Property Market Report or invaluation reports of up to two years in age would beunlikely to reflect appropriate collateral values forthe purposes of asset classification and provision-ing.

The need for current and conservative valuationof collateral is well recognized by BNM supervisionstaff. Examiners are instructed to seek current valu-ations during the on-site examination process forproperty securing extensions of credit of RM500,000and above. However, as noted by several commer-cial bankers, it is difficult to assess the fair market

expected, with a view to providing more rapid andconservative classification rather than relying on themechanics of past due status as noted for loansRM1 million and below. If the classification stan-dards are applied conservatively as defined, theyshould give a good indication of the extent of theproblem assets in a BI’s portfolio.

The revision to GP3 issued on 17 October 1997reiterated that accounts or portions thereof that areclassified as bad or deemed uncollectible should bewritten off. In previous guidelines BNM emphasizedthat BIs have the option of either writing off bad as-sets or covering them with a specific provision amount-ing to 100 percent of the amount outstanding. In caseswhere recovery was still possible, BNM encouragedinstitutions to retain the asset on the books but setaside the 100 percent specific provision. BNM’s statedobjective was to ensure that a liberal write-off policywas not used to suppress the true level of NPLs; thestated accounting practice provides for continued dis-closure of the bad assets in the portfolio.

Moving to the provisioning requirements of 20 per-cent against assets classified as substandard, 50 per-cent against doubtful assets and 100 percent againstbad (or loss) assets brings Malaysian standards inline with international standards for classified assets.In previous guidelines, no provision was required forassets classified as substandard. BNM supervisionstaff indicated that they were pleased with theprogress financial institutions had made in implement-ing these new standards, in advance of the effectivedateof 1 January 1998. The increase in the generalprovision for bad and doubtful debts to 1.5 percentof total loans is another sound step towards ensuringthat BIs are providing for potential losses in difficulteconomic times.

Instructing BIs to set aside provisions for off-bal-ance sheet items where credit risk of the counter-parts is evident is another prudent step, particularlyunder current economic conditions where counter-party defaults may rise. Implementation of off-bal-ance-sheet provisioning to appropriate levels is com-


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value of property at this time in Malaysia, since fewproperty sales have taken place to set these valuesunder current conditions. It is recommended that BNMprovide additional guidance to BIs and bank examin-ers with regard to the mechanisms and prudential stan-dards for the valuation of collateral, particularly of prop-erty. This could be accomplished through a compre-hensive update of the 1989 Guidelines.

BNM’s regulatory guidance on the treatment ofrestructured loans is conservative. Restructured loansclassified as nonperforming before the restructuring,remain as nonperforming until 12 months of paymentshave been received. During this time the credit fa-cilities continue to be classified at least as substan-dard until returned to performing status. Loans thatare restructured but have not been indicated to benonperforming remain in the performing category,unless there is an aggregate of three months in ar-rears noted before or after restructure, at which timethe loan will be accounted for as nonperforming. (Thethree-month period came into effect on 1 January1998; before this an aggregate of six months ofarrearages triggered nonperforming status.) Withinthe BNM regulatory reporting requirements there isno separate line item to track restructured loans. Thecurrent treatment does ensure that restructuredcredit facilities receive close monitoring to enablethe ultimate success of restructuring. However, tofacilitate tracking of restructured troubled debt fa-cilities, BNM may wish to consider enhancing regu-latory reporting to accomplish this task.

In conclusion, BNM has established in place anintegrated and increasingly conservative set of pru-dential guidelines over the course of the 1997/1998period. The continued reduction in the period of ar-rears for classifying credits as nonperforming, ac-companied by increases in specific and generalprovisions and instructions to BIs to make provisionagainst potential credit losses in the off-balance sheetportfolios, serve to foster increasingly prompt recog-nition of asset quality problems. To further supportthis objective, it is recommended that BNM provide

additional guidance to BIs and bank examiners withregard to the mechanisms and prudential standardsfor the valuation of collateral, particularly property,in the current economic environment. However, on23 September 1998, the Government increased thedefault period for classifying a loan as nonperformingfrom three to six months, and waived an automaticspecific provision of 20 percent on substandard loans.These measures were taken to promote economicrecovery, but obviously were against the current ofthe strengthening of prudential regulations.

Trends in Nonperforming LoansFor commercial banks, finance companies, andmerchant banks, the share of substandard loans inNPLs has risen since the start of 1997, as shown inTable 5. The increase has been particularly substantialfor finance companies and merchant banks comparedwith that for commercial banks.

Table 5: Nonperforming Loans by Type ofClassification, December 1996–March 1998

NPL = nonperforming loan.Source: Bank Negara Malaysia.

Dec Jun Dec MarNPL by Type 1996 1997 1997 1998

Amount (RM million)Commercial Banks

Bad NPL 3,388.9 2,935.0 3,884.1 6,559.1Doubtful NPL 1,064.9 1,217.5 1,848.1 3,882.3Substandard NPL 3,708.8 5,080.7 7,221.6 11,836.2Total NPL 8,162.6 9,233.2 12,953.8 22,277.6

Finance CompaniesBad NPL 2,710.5 2,419.6 3,539.2 4,162.2Doubtful NPL 400.8 441.5 1,090.1 2,879.2Substandard NPL 890.5 1,378.1 3,867.5 7,184.4Total NPL 4,001.8 4,239.2 8,496.8 14,225.8

Merchant BanksBad NPL 226.4 186.8 285.7 364.1Doubtful NPL 15.3 22.0 121.8 395.6Substandard NPL 73.0 224.1 631.1 1,034.6Total NPL 314.7 432.9 1,038.6 1,794.3

Percent share in total NPLsCommercial Banks

Bad NPL 41.5 31.8 30.0 29.4Doubtful NPL 13.0 13.2 14.3 17.4Substandard NPL 45.4 55.0 55.7 53.1

Finance CompaniesBad NPL 67.7 57.1 41.7 29.3Doubtful NPL 10.0 10.4 12.8 20.2Substandard NPL 22.3 32.5 45.5 50.5

Merchant BanksBad NPL 71.9 43.2 27.5 20.3Doubtful NPL 4.9 5.1 11.7 22.0Substandard NPL 23.2 51.8 60.8 57.7


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The reduction of the classification period has partlycontributed to the recent rise in NPLs, as shown inFigure 1, although the primary reason for the deterio-rating asset quality lies in real estate sector difficul-ties. The chart also presents the worsening trend inthe ratio of total provisions (comprising specific andgeneral provisions) to NPLs. The NPL ratio has de-clined from 30.1 percent in 1988 to about 12.3 percentin 1993, reaching a low of 3.7 percent by the thirdquarter of 1996. The sharp increase in the NPL ratiofrom the third to the fourth quarter in 1997, to 6 per-cent, is partly explained by the fact that many bankshad begun to report NPLs under the three-month clas-sification before its effectivity. The system-wide NPLratio stood at 9.1 percent at the end of the first quarterin 1998; and the ratio of total provisions (sum of inter-est in suspense, specific and general provisions) to theNPL has declined from 100.6 percent in March 1997to 49.3 percent in March 1998, reflecting the burdenplaced on banks by the rising NPLs.

Table 6 presents data on NPLs by major economicsectors from the end of December 1996 to March1998: absolute NPLs have more than doubled in com-mercial banks, tripled in finance companies, and in-creased fivefold for merchant banks. Provisions rela-tive to NPLs have declined significantly for the fi-nance companies and merchant banks. The sectoraldistribution of NPLs across the major economic ac-tivities appears to be similar to the pattern for total

Figure 1: Nonperforming Loan and Loan-LossProvisions

NPL = nonperforming loan.Source: Bank Negara Malaysia.

NPL (% of total loans) Provisions (% of NPL)

Total Provisions/NPLGross NPL Ratio

Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Jan-98 Mar-980

5

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loans (Table 4). The NPL share of the broad propertysector has remained almost the same for commercialbanks until the first quarter of 1998, while significantlyincreasing for merchant banks and declining in thecase of finance companies. The latter, on the otherhand, report a significant increase in the NPL sharesof consumption credit and share purchase activities.

How have the loans and advances been secured inthe banking system? One of the crucial indicators ofasset quality is collateral exposure. With rapidly dete-riorating asset prices, it is important to know the col-lateral cover of the financial institutions. BNM pub-lishes an aggregate table on the ratio of provisions andcollaterals to NPL: as of December 1997, this ratiowas 194 percent for commercial banks, 135 percentfor finance companies, 211 percent for merchant banks,and 174 percent for the banking system as a whole.However, as discussed above (in Figure 1), there wasa rapid decline in the ratio of total provisions to NPL in1998, and it is likely that the collateral position has alsosignificantly deteriorated. Table 7 presents some dataon banking system loans secured by different types ofcollateral. Commercial banks and merchant bankshave a fairly large share of their loans not secured byany collateral, and it is not clear from aggregate datawhat type of loan facilities are extended without anycollateral and if they are risky. The fraction of loansbacked by shares is also fairly high for all institutions,and particularly so for merchant banks. It should alsobe pointed out that a significant share of the lendingsecured by “other” collateral is likely to be backed byvolatile assets such as property.

The relative strength of the Malaysian economy(until the third quarter of 1997, at least) only delayed,but did not fully prevent, the impact of the regionalcrisis. As a result of the contagion, the ringgit depre-ciated after July 1997 by more than 34 percent. Thecentral bank has opted to follow a tight monetarypolicy to stabilize the currency and avoid inflation.The base lending rate (BLR) of commercial bankshas increased by about 2 percentage points fromDecember 1997; the overnight interbank money


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Table 6: Nonperforming Loans by Major Economic Sectors, December 1996–March 1998Banking System Commercial Banks Finance Companies Merchant Banks

Dec Mar Dec Mar Dec Mar Dec MarItem 1996 1998 1996 1998 1996 1998 1996 1998

Amount (RM million)Broad Property 5,288 14,010 3,066 8,223 2,172 4,966 50 821Consumption 1,891 6,931 872 1,860 1,010 5,004 9 67Manufacturing 2,093 4,929 1,737 3,801 241 878 115 250Financial Services 412 1,730 315 1,129 90 500 7 101Share Purchases 288 4,743 155 3,012 73 1,446 60 285NPL 12,480 38,298 8,163 22,278 4,002 14,226 315 1,794

Percent share in total NPLsBroad Property 42.4 36.6 37.6 36.9 54.3 34.9 15.8 45.8Consumption 15.2 18.1 10.7 8.3 25.2 35.2 3.0 3.8Manufacturing 16.8 12.9 21.3 17.1 6.0 6.2 36.5 13.9Financial Services 3.3 4.5 3.9 5.1 2.2 3.5 2.1 5.6Share Purchases 2.3 12.4 1.9 13.5 1.8 10.2 18.9 15.9

PercentNPL/Total Loans 3.7 9.1 3.6 7.6 4.7 13.5 1.7 7.9Provisions/NPL 100.6 49.3 98.3 55.8 87.9 37.7 155.6 60.4

NPL = nonperforming loan.The figures do not add up to 100 percent since only the five major sectors are reported here.Source: Bank Negara Malaysia.

Table 7: Loans by Type of Collateral,December 1996 and April 1998


Percent of Loans Secured

Type of Collateral Dec 1996 Apr 1998

Commercial BanksEntirely by Shares 6.8 7.1Partly by Shares 1.7 1.9Other Collateral 70.7 70.5Unsecured Loans 20.7 20.5

Finance CompaniesEntirely by Shares 10.6 8.6Partly by Shares 1.2 1.7Other Collateral 84.9 88.3Unsecured Loans 3.3 1.4

Merchant BanksEntirely by Shares 14.9 11.7Partly by Shares 1.8 3.5Other Collateral 42.8 53.7Unsecured Loans 40.5 31.2

market rate has sharply increased by about 5 per-centage points to about 10.5 percent (April 1998)since the onset of the crisis, and the three-monthinterbank rate rose to 11 percent, up from about8 percent in September 1997. While on the one handthe sharp increase in interest rates has had an ad-

verse effect on credit generation, the worsening NPLposition of a number of banks led to a flight in depos-its from the smaller to the larger banks, and a smallfraction also fled the banking system.

Figure 2 presents the recent trends in loans andadvances in the banking system; and Figure 3 pre-sents the same for deposits held by domestic andforeign commercial banks, finance companies, andmerchant banks. Year-on-year credit growth has beendecelerating in the system, from 16.9 percent inMarch 1998 to a little more than 12 percent in May1998, as against BNM’s credit growth target of15 percent by the end of 1998. Total deposits de-clined by about RM9 billion since December 1997,of which the domestic banks, foreign banks, andmerchant banks lost RM4.7 billion, RM0.1 billion, andRM1.2 billion, respectively, while the finance com-panies posted a growth of about RM2 billion. Whiledata are not available on individual institutions, thistrend is perhaps due to the higher deposit rates beingoffered by the smaller finance companies. Anotherimportant trend is the increase in loans-to-deposit ratioin the banking system, which went up from 93.2 per-cent in December 1996 to 98.8 percent in April 1998.


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Resource Implications of the RisingNonperforming LoansOf fundamental concern now is how much worsethe NPL situation will become in the next three tofour quarters, and what can be done about the dete-riorating capital positions of financial institutions.There are some good reasons as to why the peakNPLs will not exceed the level of 1988, when thebanking crisis was aggravated by significantly higherproperty sector exposure, and more important, by aweak supervisory regime. The consensus forecastfor NPLs was in the range of between a 15 and18 percent peak level by the end of 1998, and 20 to25 percent in 1999, as against the peak of 33 percentin 1988. Much of it would depend on interest rates,property developments, and corporate developments.With regard to interest rates there seems to be a

difference of opinion among policymakers, thoughthere has been a clear signal since the last week ofJune 1998 with the lowering of the SRR, which willinject much needed liquidity into the system.

Real estate companies are struggling to cope witha sizable excess supply as a result of overexpansion.Several new properties are under construction de-spite less than full occupancy rates. Property priceshave gone down by between about 10 and 15 per-cent, and a further equal decline is expected. Fur-thermore, while many positive developments havetaken place, such as the establishment of Danahartaand Danamodal to deal with recapitalization, merg-ers of finance companies, and strengthening of pru-dential standards, market participants are still con-cerned about political interference and decision mak-ing governed by insiders. Lack of transparency haspartly fueled such concerns.

13

There are two steps needed to resolve the NPLproblems in the banking system: recovery of assetsbehind the NPLs, followed by recapitalization if someor all of the capital and reserves are wiped out dueto deteriorating asset quality, a scenario that seemsalmost inevitable. The first step is crucial and willdetermine the impact on the banks’ capital posi-tions. This is where Danaharta has a leading role toplay, either by direct participation or by indirectlyproviding good benchmark levels for discounting.As of end-1997, BNM reported that the collateralexposure (value of collateral to NPLs) of the bank-ing system stood at 105 percent. However, this ra-tio is likely to be much smaller now, with the down-turn in the property and stock markets. In this re-gard, BNM has initiated a process of stress testing(ST) to estimate a recapitalization threshold for eachfinancial institution. On the basis of the tests, thecentral bank reported that Bank Bumiputra will needa recapitalization of RM750 million and that SimeBank will need RM1.2 billion in fresh capital injec-tion. The Government-owned Bank Bumiputra islikely to receive support from public funds, and therequired capital for Sime Bank will be provided

Figure 2: Recent Trends in Loans


RM billion

Dec-96

Mar-97

Jun-97

Sep-97

Dec-97

Jan-98

Feb-98

Mar-98

Apr-98

May-98

0

100

200

300

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500

AllCommercial BanksFinance CompaniesMerchant Banks

Figure 3: Recent Trends in Deposits

CB = commercial bank.Source: Bank Negara Malaysia.

RM billion

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Dec-97

Jan-98

Feb-98

Mar-98

Apr-98

0

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Domestic CBsFinance CompaniesForeign CBsMerchant Banks


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through its merger with the Rashid Hussain Bank-ing (RHB) Group.

BNM’s ST methodology or the results from theapplication of ST on individual banks have not beenmade available yet. However, there are some con-servatively estimated private sector figures avail-able for the banking system as a whole. The NikkoAdvisory Services Group (June 1998) estimated thatthe entire banking system can sustain an NPL levelof up to 34 percent of total loans before it financiallycollapses, on the assumption that 50 percent of theassets backing the NPLs is recoverable. The recapi-talization threshold for NPLs, or the level of NPLsup to which the banking system can sustain an RWCRof 8 percent without resorting to recapitalization, isestimated at 11.6 percent. Table 8 shows thesethreshold limits.

These numbers indicate that, while the financialcollapse threshold provides some cushion (based onthe premise that the crisis is not as severe as that ofthe 1980s), there is a need to prepare a recapitaliza-tion plan for the banking sector. In this regard, howmuch worse are the NPL figures likely to get, andwhat will be the recapitalization needs? Table 9 pre-sents five sets of private sector estimates, which pro-vide a conservative view based on reasonable as-sumptions with regard to asset recovery (50 percent),and loan and asset growth, taking into account thecurrent decline, sectoral NPL scenarios based oncurrent trends and evolution of asset prices, and clas-

Table 8: Banking System Financial Collapseand Recapitalization Thresholds forNonperforming Loans (%)a

NPL = nonperforming loan, RWCR = risk-weighted capital ratio.a Assumption: Asset recovery at 50 percent of NPLs.Source: Banking Sector Report: How Much Stress can the Banking System Take?Nikko Advisory Series (1 June 1998).

Recapitalization CurrentFinancial Threshold NPLCollapse (with RWCR (Mar

Financial Institution Threshold at 8 percent) 1998)

Banking System 34.0 11.6 9.1Commercial Banks 35.7 11.1 7.6Finance Companies 27.2 9.0 13.5Merchant Banks 43.2 18.7 7.9

sification of NPLs and provisioning. In this context,the Government has estimated that RM16 billion wouldhave to be spent over the next two years for recapi-talizing the banking system.

While all the above estimates are based on con-servative assumptions, their validity and certaintydepend on the actual outcomes with regard to prop-erty and other asset values of the NPLs as they un-fold, and much more so on the asset recovery possi-bilities. Based on a 20 percent estimate for NPLs,there is consensus that the amount required for re-capitalization is between about RM17 billion andRM19 billion. Taking into account the outlook forproperty and stock markets in particular, interest rates,and corporate sector difficulties, these estimateswould seem to be about right. NPLs could rise to the18 to 20 percent range by the end of 1998, and to22 to 25 percent by the end of 1999.

Market sentiment seems to be that the banksthemselves should take steps to boost their capital,with the Government playing a facilitating role increating an enabling policy environment. In addi-tion, Malaysian banks have fairly sizable off-balancesheet assets that could be reduced. Banks also needto change the risk profile of both off- and on-balance

Table 9: Peak Nonperforming Loans andEstimates of Recapitalization Needs(private sector estimates)

na = not available, NPL = nonperforming loan, RHB = Rashid Hussain Bank.a Estimated from the figures presented in the report, to derive the recapitalization

requirements to attain 9 percent RWCR; andb To attain 8 percent RWCR.c Only for commercial banks.

Peak NPL RecapitalizationEstimates (%) Estimates

Group 1998 1999 (RM billion)

SocGen Crosby(May 1998) 19 22.3 18.8a

Nikko Advisory Services(June 1998) 15–18 20–25 19–29b

Fitch-IBCA(May 1998) 15 20–25 11c

Goldman Sachs(March 1998) 18.5 22.5 naRHB Research Institute(April 1998) 15 20 18


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sheet assets. There seems to be political support aswell for banks calling in for new rights issues, thoughgiven the current market conditions it may be a costlyoption.

14

The Government (BNM) should prepare a sys-tematic plan with regard to recapitalization: if theCAR of a particular financial institution falls belowa stipulated minimum, then BNM should require thatinstitution to prepare a recapitalization plan withinthree to four weeks, and subject to BNM’s approval,the plan should be implemented within four to sixmonths. If any financial institution is unable to pre-pare and implement a satisfactory plan, then theGovernment should intervene by participating as ashareholder in that institution and its equity couldbe sold off subsequently. The Govern-ment’s par-ticipation in the recapitalization process will befacilitated by the issuance of bonds for this pur-pose. If the Government’s equity in an institutiongoes above a certain limit, to be determined relativeto that of the largest shareholder, the institution isnationalized and will be privatized at a later date. Itwould not be a sound practice for BNM to engagein any cash injection into institutions facing difficul-ties, as it has done in the past.

What are the resource implications of the esti-mated recapitalization costs? Various private sec-tor assessments indicate that the resources of themagnitude suggested in Table 9 could be met throughthe earnings and cash flows of a combination ofdomestic entities. EPF and the various pension funds,and Petronas have been suggested as potentialsources of assistance to the banking system. It isestimated that EPF and Petronas, between them,can utilize their annual inflows of about RM16.4billion in any recapitalization operations. Petronashas been called in to help Bank Bumiputra Malay-sia twice in the past (in 1982 with a RM2.5 billioncapital injection, and again in 1989 with RM1 billioninflow). However, there have been some indica-tions from the Government, but no clear signals yet,

that these agencies will not be called in to partici-pate this time. It is essential that the Governmentdraft an appropriate recapitalization plan, which willbe financed by the issuance of bonds rather thanthrough the use of EPF or Petronas. In this regard,it has been indicated that the Khazanah (Treasury)has an estimated potential of raising RM3 billionover two years through issuance of bonds. BNMdoes not have any resources at this point, barringthe use of its international reserves, which is likelyto be kept as the last option.

Several options have been suggested by marketparticipants for recapitalizing the banking system:

• financial sector liberalization to increase foreignparticipation;

• rights issues by Banks, as market conditions im-prove;

• asset securitization, which may prove benefi-cial, again depending on market conditions, inreducing the banking system assets. In this re-gard, however, there is a need to modify thecurrent full-recourse arrangement existing forloans sold to Cagamas, the national mortgagecorporation; and

• mergers and consolidation.The most preferred approach would be to en-

courage free entry of domestic as well as foreignparticipants. One of the key weaknesses of theMalaysian banking sector is restrictions on entry,with the result that there have been no new en-trants since the 1970s. In addition, there are stillmany restrictions on foreign banks, particularly interms of branch expansion, despite the fact that allthe incumbent foreign institutions have been in thecountry for more than two decades. Greater par-ticipation through new entry or mergers of strongforeign banks with domestic banks will promote in-stitutionalization of the shareholding structure in thefinancial institutions, besides freeing domestic re-sources for other needs. Efficiency of the domesticentities will also be enhanced.


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With regard to mergers and consolidations, it isessential to understand that recapitalization is a sys-temic issue that cannot be solved through mergers.Furthermore, it is not clear if there is a sufficientnumber of healthy banks with shareholders who arewilling to invest in weaker institutions, given the as-set quality situation. While the initial phase of themerger and acquisition process in the finance com-pany sector has taken place as planned, the impactof the mergers on the asset quality of the newgroups formed, and particularly on the anchor fi-nance companies, remains to be seen. The Gov-ernment has guaranteed the value of the assetsacquired by the anchor companies for one year.The six anchor finance companies have their ownNPLs to manage, in addition to those of the mergerpartners. Of these, the market seems to be watch-ing Hong Leong Finance, EON-CCM, and UnitedMerchant Finance with particular concern. Finan-cial institutions that have not received the Govern-ment guarantee are particularly vulnerable to fur-ther deterioration in their asset quality. The Gov-ernment must draft a clear strategy before takingany decisions on bank mergers.

To sum up, the route taken for recapitalizationshould not introduce new problems or aggravate ex-isting ones. The Government has taken the right stepsby establishing Danaharta and Danamodal to dealwith NPLs and recapitalization. However, the financ-ing arrangements for these agencies are still beingfinalized. In this regard, recourse to BNM financingor lending to insolvent banks should be avoided. TheGovernment should draft a comprehensive recapi-talization plan, which should include provisions fordirect Government equity participation in the shortrun, if necessary, and any such intervention shouldbe financed through the issuance of bonds. It shouldbe stressed that the market does not view favorablyany potential role for EPF or Petronas in the recapi-talization process. At a more fundamental level, freeentry and firm exit policies are essential in solvingthe current problems.

Management of NonperformingLoans and RecapitalizationFinancial markets have been concerned for sometime that BNM never fully recognized or acknowl-edged the scale of problems in the banking sectordue to the rising level of NPLs. Danaharta was es-tablished to manage and liquidate the NPLs under avalue-maximization approach, in order to derive thehighest returns possible from the assets. WhileDanaharta will inject much needed liquidity into thebanking system, it will also fill the gap in the skillsneeded in the financial sector to manage the prob-lem assets besides allowing financial institutions tofocus on the task of providing credit to the economy.

The preemptive nature of setting up the agency,the selection of private sector consultants for assetvaluation, and the principles on which it will functionare viewed in a positive light by market participants.But there are still some concerns as to the ability ofDanaharta to function independently, without Gov-ernment interference. Despite the Government’sannouncement to the contrary, the market worriesthat Danaharta will end up bailing out politically con-nected corporate sector entities. Private sector ana-lysts feel that the Government will sacrifice cur-rency, inflation, and financial sector stability in orderto assist corporate enterprises and promoters of majorinfrastructure projects that are in trouble. In this re-gard, Danaharta’s first few asset purchases will sendan important signal to the market. The market is alsoconcerned that Danaharta may take an unduly longtime to maximize the value of the assets purchasedand in the process hold on to those assets until thedomestic economy revives. Given the slow processof liberalization to allow entry of foreign investors, itwould be a big setback if Danaharta started runningbusinesses rather than quickly turning the assetsaround.

Pricing of loans is another area of concern: giventhe thin markets and uncertain times, private ana-lysts are concerned about Danaharta’s ability to de-termine a fair market value. While bank participation


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is voluntary, the market appears to feel that banksmay be forced to sell their best possible NPLs atdiscounted values, thus precluding any opportunityto recover them when the economy revives. On theother hand, banks may be left with many bad NPLsthat they will not be able to recover at any time.

Supervision: Policy Issuesand RecommendationsBasle Core PrinciplesThe Basle Committee on Banking Supervision re-leased the Basle Core Principles for Effective Bank-ing Supervision in September 1997. The Basle CorePrinciples address preconditions for effective bank-ing supervision, licensing and structure, prudentialregulations and requirements, methods of ongoingbanking supervision, information requirements, for-mal powers of supervisors, and cross-border bank-ing.

15 For the purposes of this review, reference is to

the five core principles for credit risk managementunder the prudential regulations and requirements.They are as follows, and BNM has a well-developedprogram for compliance with all but Principle 11.

Principle 7: An essential part of any supervisorysystem is the evaluation of a bank’s policies, prac-tices, and procedures related to the granting of loansand making of investments and the ongoing manage-ment of the loan and investment portfolios.

Principle 8: Banking supervisors must be satis-fied that banks establish and adhere to adequate poli-cies, practices, and procedures for evaluating thequality of assets and the adequacy of loan-loss pro-visions and loan-loss reserves.

Principle 9: Banking supervisors must be satis-fied that banks have management information sys-tems that enable management to identify concentra-tions within the portfolio and supervisors must setprudential limits to restrict bank exposures to singleborrowers or groups of related borrowers.

Principle 10: In order to prevent abuses arisingfrom connected lending, banking supervisors must

have in place requirements that banks lend to relatedcompanies and individuals on an arm’s-length basis,that such extensions of credit are effectively moni-tored, and that other appropriate steps are taken tocontrol or mitigate the risks.

Principle 11: Banking supervisors must be satis-fied that banks have adequate policies and proce-dures for identifying, monitoring, and controlling coun-try and transfer risks in their international lendingand investment activities, and for maintaining appro-priate reserves against such risks.

Through its program of on- and off-site supervi-sion, BNM evaluates the policies, practices, and pro-cedures of the BIs in the granting of loans, the mak-ing of investments, and the ongoing management ofthose portfolios (Principle 7). BNM is able to satisfyitself of the appropriate evaluation of the quality ofassets and the adequacy of provisions as set by theBIS (Principle 8).

16 BNM has acted to set prudential

limits to restrict bank exposures to single borrowersor groups of related borrowers (Principle 9).

17 In

addition, through the on-site examination process,examiners are expected to verify the identificationand tracking of concentrations in banking portfolios.With the reduction of the single customer limit to25 percent of a bank’s capital funds, effective March1998, the Malaysian guidance in this area has movedto the standard noted in the Basle Core Principle.Through the examination process, extensions of creditare monitored to prevent abuses arising from con-nected lending (Principle 10).

18

Principle 11 has not yet been specifically addressedin supervisory guidance from BNM. Guidance forthis area was to be considered as part of the reviewof regulations scheduled for completion by year-end1998. For on-site examination activities, country/transfer risk

19 is considered within the general pool

of credit risks reviewed in the asset portfolios. How-ever, specific instructions for this type of risk are notoutlined in the examination manual. According to sta-tistics cited in the BNM Annual Report 1997, thecountry/transfer risk exposure of Malaysian banks


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has been modest to date. The exposure of the Ma-laysian banks to the East Asian region at year-end1997 consisted of $2.4 billion or 2.9 percent of thetotal assets of seven Malaysian banks. Reportedly,20.5 percent of the exposure was classified asnonperforming as at year-end 1997. Potential areasof concern for the banking community to addresswith regard to country/transfer risk are (i) to assessthe nature of the risks for individual countries; (ii) tohave systems in place to measure the various typesof exposures; and (iii) to have a mechanism for es-tablishing and reviewing country limits with the flex-ibility to incorporate rapidly changing conditions.

20

Review of Mechanisms forAssessing and MonitoringCompliance with Asset QualityRelated Prudential StandardsThrough off-site monitoring and on-site examinationpresence, BNM keeps informed about the key de-velopments in the financial sector. Regulatory report-ing mechanisms are extensive and there are regularinternal reporting mechanisms in place to ensure trans-mission of supervisory information to BNM seniormanagement. BNM appears well-regarded as a su-pervisor and regulatory measures have been receivedgenerally favorably. One area noted for continuedattention is BNM’s effort to accelerate the on-siteexamination schedule to verify the quality of assetsand overall soundness of the population of Malay-sian BIs, given the changed economic circumstances.

OFF-SITE MONITORINGThe foundation of the off-site monitoring process isthe regulatory database that has been developed fromthe series of regular statistical reports submitted toBNM by commercial banks, merchant banks, financecompanies, and discount houses licensed under theBanking and Financial Institutions Act 1989 (BAFIA).These institutions submit weekly, monthly, quarterly,and annual reports to the Statistical Services De-partment of BNM as follows:

• weekly—Report on Domestic Assets and Liabili-ties;

• monthly—Report on Global Assets and Capital,Report on Domestic Interest Rates;

• quarterly—Report on Unaudited Income andExpenses; and

• annual—Report on Consolidated Assets andCapital, Report on Audited Income and Expenses.

A circular issued on 10 November 1997 increasedthe frequency of reporting monthly for asset qualityinformation on NPLs, provisions, market value of col-lateral, and loans in arrears. An additional regulatoryreporting mechanism, the Classified Loans and Ad-vances System (CLASS) requires periodic submis-sions of data by commercial banks, merchant banks,Islamic banks, and finance companies. CLASS report-ing provides BNM with detailed information on NPLsin the domestic banking system. BNM’s “Guidelineson the Suspension of Interest on Nonperforming Loansand Provisions for Bad and Doubtful Debts (BNM/GP3)” provide the minimum basis for the classifica-tion of loans reported in CLASS. CLASS reporting hasgenerally been for the third and fourth quarters of theyear; however, under current market conditions, BNMis considering increasing the reporting frequency tomonthly. The information from CLASS is utilized in avariety of formats, including review of NPLs by theamounts of shortfall in specific provisions, security,classification types, and aging of facilities.

The statistical database is also manipulated withinthe banking supervision function to provide additionalmonitoring reports for the off-site surveillance ofbanks. A series of reports is generated monthly. Thesereports provide comparative information to surveytrends on an institution-by-institution basis and on anindustry basis. Commercial banks, finance compa-nies, and merchant banks, tracking both percentagecomposition and changes in absolute amounts cangenerate the information. Key asset quality indica-tors tracked in these reports include classification ofloans by type, customer, and sector; and NPLs bysector, security, and classification.


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Further enhancements to the off-site monitoringmechanisms are being developed. In particular, asupervisory early warning system is in the processof development with the assistance of the WorldBank, targeted for year-end 1998 completion. Theintention of the system is to utilize the existing statis-tical database to produce management reports simi-lar to those currently produced by the reportingmechanism, but on a more automated basis.

BNM supervision staff indicated that during thefinancial crisis, additional ad-hoc reports have beengenerated to provide more current and focused in-formation on banking sector exposures to BNM se-nior management. These reports have included re-ports on large borrowers, exposures to the stockmarket, and regional exposures. In addition, a monthlyWatch List is being generated that provides the mostcurrent information on problem BIs such as thoserated CAMEL (capital adequacy, asset quality, man-agement, earnings, and liquidity) 4 or 5, or with spe-cial circumstances requiring close monitoring. TheWatch List reports are routed through the assistantgovernor, deputy governor, and governor level atBNM and can result in more frequent meetings withthe management of a particular BI.

The information generated by off-site monitoringis utilized as one of the planning tools before an on-site examination. Once an examination is completed,relevant information from the examination is incor-porated in the off-site monitoring process.

ON-SITE EXAMINATIONSThere are three broad categories of on-site examinations:

• normal/routine examinations,• nonroutine examinations usually conducted to in-

vestigate certain matters or follow-up on pastexamination findings, and

• the review of draft final accounts to assess theadequacy of provisions for loan losses.

On-site examinations are intended to assess aninstitution’s financial soundness as well as compli-ance with laws and regulations.

Within the last couple of years, BNM’s supervi-sion function has moved towards a risk-based su-pervision approach in which greater emphasis isplaced on the review of the BIs’ internal mecha-nisms for risk management. Risk-based supervisiontechniques also allow for a more dynamic monitor-ing of the circumstances of an institution and increas-ingly effective planning of examinations. This shift inapproach was outlined in a concept paper, which hasbeen followed by a series of modules on examina-tion techniques for specific areas of an institution’sactivities. These modules are in the process of beingincorporated in the examination manual.

Various new elements of examination planning areto be introduced as part of the risk-based supervi-sion process. These include a supervisory plan forindividual BIs/groups, an examination-planningmemorandum, and various risk assessment docu-ments. The supervisory plan is to be maintained bythe off-site officers in the Banking Supervision De-partments, to be utilized as a planning tool for theon-site examination work. The activities for the on-site work would be recorded in an examination-plan-ning memorandum. Risk assessment is a system-atic process for assessing and integrating profes-sional judgments about risks in institutions’ activi-ties. The financial crisis has placed a greater bur-den on BNM’s supervisory functions and requiredincreased on-site examinations. Thus, implementa-tion of various aspects of the risk-based supervi-sion process has been delayed.

As the risk-based supervision approach places anincreased emphasis on developing a profile of theinstitution to be examined, there is a greater need fora more open exchange of information with the man-agement of the institution. As a result, BNM hasbeen moving towards more scheduled rather thansurprise examinations, to allow for the informationexchange in advance of the on-site presence. Alsoas part of this open exchange of information, BNMstaff members have been scheduling annual meet-ings with the management of financial institutions and


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talk more frequently with the internal and externalauditors of the institutions.

The on-site examination process conducted byBNM consists of a full scope review within a one-to-three-year cycle, under normal circumstances, sup-plemented by more frequent on-site presence asneeded to investigate specific areas of concern. Themost problematic institutions (CAMEL rating 4 or 5)are subject to an annual on-site examination, whereasthose of least supervisory concern (CAMEL rating1 or 2) may not be examined on-site for up to a three-year period. An institution with a CAMEL rating of3 would generally be examined every 18 months.

As anticipated, given present financial sector con-cerns, the emphasis in current examinations has beenon asset quality reviews, adequacy of provisions, andstructure of liabilities. Also, BNM supervision staffindicated that the frequency of on-site examinationshas increased, particularly for large institutions. Con-tinued efforts to accelerate the on-site examinationschedule to verify the quality of assets and overallsoundness of the Malaysian BIs are particularly im-portant, given present conditions.

At the conclusion of an on-site examination, ameeting is held at BNM with BI management to re-view examination concerns and finalize the CAMELrating. Examination conclusions are then presentedto the institution’s board of directors, and a formalresponse to findings is provided to BNM. If thereare significant areas of concern, the board of direc-tors may be called in to BNM for a meeting.

The scope for coverage of asset portfolios, in-cluding loan portfolios, has generally been in therange of between 50 and 80 percent of the totalasset category. Problem loans are classified as sub-standard, doubtful or bad. Nonperforming assets(NPAs) are classified in one of these adverse cat-egories.

With regard to valuation of collateral for land andproperties, the examination manual indicates that thevalues offered as security are assessed either by theBIs or by professional property valuers. These re-

ports usually indicate two values: a fair market valueand a forced sale value. The former is normally ac-cepted for credit appraisal, whereas the forced salevalue is normally adopted for classification of creditsand determination of specific provision for loan losses.If valuation reports are out-of-date, examiners arereferred to the Property Market Report published an-nually by MOF. However, this report may not be thebest reference because its data have a time lag ofseveral quarters. Examiner judgment is to be used and,according to discussions with BNM supervision staff,a more current valuation is obtained during the courseof the examination for property securing extensionsof credit of RM500,000 and above.

In the case of valuation of quoted shares, theBIs are expected to use the closing price of a spe-cific day of the week to determine the values of theshares deposited as security. Examiners are ex-pected to use the lowest of the share values fromeither the commencement or the conclusion of theon-site examination.

Assessment of SupervisionBNM has a well-developed program for compliancewith the Basle Committee Core Principles for Ef-fective Banking Supervision in the area of credit riskmanagement of the domestic asset portfolios (Prin-ciples 7 through 10). With regard to Principle 11, whichaddresses country and transfer risks, BNM BankRegulation Department staff have identified the needfor additional supervisory guidance in this area andwere incorporating it as an item for the review ofregulations scheduled for year-end 1998 completion.

The supervisory functions at BNM are well es-tablished, with comprehensive regulatory reportingrequirements, a variety of off-site monitoring tools,and detailed guidance in the area of on-site exami-nation practices. Given the adverse economic cir-cumstances affecting banking, BNM should continueits efforts to accelerate the on-site examination sched-ule to verify the quality of assets and overall sound-ness of Malaysian BIs.


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Further Issues andPolicy RecommendationsSpecific Issues with Regard toAsset Quality

POLICY LOANSThe banking sector should not be utilized as a toolfor the Government’s industrial policy. Since the moralhazard problem is crucial in financial intermediation,every loan should be made under each BI’s respon-sibility. There is evidence that policy loans could pro-duce higher NPLs than regular loans. The main rea-son is that policy loans discourage screening andmonitoring, which are fundamental functions of fi-nancial institutions. In this sense, policy loans andcommitments such as loans to the Bumiputra com-munity need to be transferred to the Governmentbudget (Appendix Table A2.3). If so, any problemraised by political consideration could be resolvedpolitically. It will also help BIs to recover their screen-ing and monitoring functions.

LENDING FOR SHARE PURCHASESThis category, at 8.9 percent for the banking sector atthe end of May 1998, is still within BNM’s limit of15 percent on loans collateralized by stocks. How-ever, the true exposure is not known, as many finan-cial institutions with stockbroking subsidiaries are likelyto be affected. Any further decline in stock prices willalso affect banks through corporate sector difficultiesand direct margin financing. The number of corporatesector borrowers using ordinary business loans to as-sist their stockbroking companies is not known. Withregard to loans in this category, there is anecdotal evi-dence that banks are not making margin calls whenthe value of the collateral depreciates. Private sectoranalysts feel that banks are not calling in large, politi-cally connected entities to top up their share collateralthat has gone down in value. There must be greaterdisclosure of the shortfalls between the collateral val-ues and the loans extended.

FORECLOSURES/RECEIVERSHIPSIt appears that while political factors partly explainwhy banks do not resort to foreclosing on companiesor place them under receivership, there are also le-gal loopholes (particularly in Section 176) in the Com-pany Law that hinder financial institutions from tak-ing this route. It is essential that the legal frameworkin this regard is strengthened in line with interna-tional best practices. The recent foreclosure ofWembley Holdings by Phileo Allied Bank to recoverdebts reported at RM100 million is seen by the mar-ket as a hopeful sign. MBf Holdings Berhad, theparent company of MBf Finance Berhad, has soughtcourt protection from financial institutions coveringits debts of about RM500 million. There have beenreports that Time Telecoms Berhad, a subsidiary ofthe well known and politically connected RenongBerhad, may seek court protection from its creditorsto cover its debts of about RM5 billion. If companiescontinue utilizing the legal provisions in this way,NPLs are likely to exceed even the worst case sce-narios presented above.

SINGLE-PARTY LIMITBNM’s supervisory procedures reveal that a pru-dential limit such as the single party ceiling is strictlyenforced. However, there is anecdotal evidence thatMalaysian companies circumvent this ceiling by set-ting up third-party entities operating through nomi-nees,

21 who are difficult to trace for lending deci-

sions or for prudential purposes.

FOREIGN CURRENCY TRANSACTIONSThe seven major Malaysian banks

22 that have fa-

cilities in Labuan had lent about $2.36 billion atthe end of 1997 to the four affected and vulner-able East Asian economies (Indonesia, Korea,Philippines, and Thailand). This amounted to about2.2 percent of all outstanding loans in the bankingsystem. While the total loan size is relatively small,a significant share (20.5 percent) of this regionaltotal is classified as nonperforming. The total


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Labuan operations of the seven banks were tothe tune of $5.1 billion in December 1997. About66 percent of all loans and advances originating fromLabuan, or $11.6 billion out of the total $17.5 billion,was lent to corporate entities resident in Malaysiaat the end of 1997.

The limited exposure of Malaysian corporates toforeign currency debt, relative to their counterpartsin the other affected economies, has been a savinggrace in the Malaysian economy. However, whileno official numbers are available, there is anecdotalevidence that a good fraction of the nonresidentcomponent of the Labuan loans went to Malaysiancompanies investing abroad. An example is the$718 million loan made in 1997 by MayBank, BankBumiputra, RHB, and Bank of Commerce toHottick Investments, a company incorporated inHong Kong, China with links to the Malaysian-basedRenong Group. This loan facility was provided toHottick to buy a controlling stake in the Philippine-based National Steel Corporation. The loan has beenrestructured and repayment will be delayed for ayear. The concern is that such loans do not comeunder the purview of BNM. Another example is a$150 million loan made by Malaysian banks inLabuan to the Renong Group, which reportedly doesnot have any foreign exchange earnings. While amajor portion of the $11.6 billion, cited above, hasbeen lent for foreign investments or trade-relatedactivities of Malaysian entities, such practices oflending for apparently unrelated activities clearlydefeat the main purpose of Labuan. Another cru-cial problem in Labuan operations is disclosure ofinformation: market watchers feel that the scale ofdollar-denominated lending undertaken by Malay-sian banks based in Labuan is rarely disclosed. Anexample is the lack of transparency in Sime Bank’sLabuan operations, which reportedly lent more than$400 million to Indonesian and Thai companies.However, market analysts have favorably viewedthe transparent manner in which BNM announcedSime Bank’s financial problems.

RISK MANAGEMENT AND HUMAN RESOURCESThe rate at which some of the smaller, tier-2 bankshave expanded their credit and the resulting increasein NPLs are indications that risk management is notcarried out properly because of insufficient humanresources in a number of financial institutions. Whilethere is no hard evidence, market analysts in Malay-sia and outside feel that risk assessment, and evenroutine and important processes such as cash-flowanalysis, are not satisfactorily carried out in manyinstitutions, particularly in the case of lending to Gov-ernment-supported Bumiputra entities.

GOVERNMENT ASSISTANCE TO FAILINGINSTITUTIONSThe signals coming from the Government with re-gard to financial institutions and corporate entitiesthat are in trouble have been conflicting. In general,market participants strongly feel that since the coun-try does not have a large foreign debt, it will nation-alize the banking and corporate sector problems,though BNM and MOF officials have been present-ing quite sober economic forecasts and promisingcomprehensive reforms in banking. Further, the lackof transparency over some of the recent corporatedeals that took place with the Government’s supporthas created a negative impression and led to lowerconfidence. Examples are the directed bank lendingto United Engineers Malaysia (UEM) for purchas-ing a stake in the Renong Group, and the proposedrestructuring of the Malaysian Airlines System andaffiliated companies. To the extent that such trans-actions do not make any commercial sense, they haveserious implications on the financial health of the con-cerned entities and banks.

BANK NEGARA MALAYSIA’S BANKING SECTORDISCLOSURE OF INFORMATIONBNM has, over time, considerably strengthened thedisclosure and reporting requirements for financialinstitutions. Since the first quarter of 1998, finan-cial institutions are required to publish (unaudited)


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data on income and operating expenses, total loans,NPLs, and provisions on a quarterly basis. How-ever, BNM does not publish disaggregated NPL fig-ures by substandard, doubtful, or loss categories.Given the rapid changes in asset quality in the fi-nancial sector, it is essential that such data are madepublicly available. Another area is collateral expo-sure of financial institutions: BNM publications donot present any information in this regard. In thepresent context, this is particularly important forloans backed by shares.

Opening of the Banking IndustryIn Malaysia, it is widely believed that authorities ex-hibited caution in opening the banking sector. Thedifficulty of putting in place a concrete strategy planfor liberalization is also recognized. Foreign equityinvestment in financial institutions is limited to30 percent, and there are restrictions on the activi-ties of the 13 locally incorporated foreign banks (theseaccount for 22 percent of total assets of BIs) oper-ating in Malaysia. Foreign banks can extend loansonly in partnership with domestic banks. Since 1983,no new foreign (as well as domestic) bank licenseshave been granted and foreign banks are restrictedin their ability to open branches. The rationale ofthe measure was to protect domestic banks. Thispolicy has been maintained for more than 10 yearsand has forced foreign banks to get used to therestrictive business environment.

Opening the banking sector has potential risks.They include an increase in capital volatility andencouragement of excessive borrowing, which couldeventually destabilize the domestic financial mar-kets. These factors have been blamed as the primecauses of the Asian financial crisis. On the otherhand, if domestic banks compete with more ad-vanced foreign banks, they would likely strive towork for more efficient management and financialinnovation. At the same time they would introduceand develop a better supervision and regulation sys-

tem. These factors will contribute to improving fi-nancial services, economic growth, and a soundbanking system. Whether the positive or negativeeffects would prevail, particularly in the long run,remains an open question.

However, empirical studies support the view thatliberalization of banking will have favorable results.Effective and rapid improvement requires a certaingoal and counterparts to compete against. Self-strengthening of the BIs has a limit. Therefore, BIsin Malaysia are currently considered to be payinghigh implicit costs by delaying their internal reformsand neglecting financial innovations. BIs tend to re-gard competition as a factor that causes profits todecline. Instead, the value of competition has to beevaluated from the point of view of customers whocannot influence the market individually. However,since it is doubtful that BIs can achieve internationalcompetitiveness without a strong external stimulus,foreign banks can be utilized as a catalyst in devel-oping the banking sector. The Government shouldset up a concrete plan of when and how to open thefinancial markets. For example, in the first stage,which could be initiated within one year, foreign bankscould be encouraged to help domestic banks developspecific areas such as risk management, foreign ex-change, and derivative trades. In the next stage, cur-rent locally incorporated foreign banks could be al-lowed to open more branches according to their con-tribution in the first stage.

Regulatory FragmentationMOF and BNM share the overall supervision of BIs.Licensing of BIs is handled by MOF while regula-tion and supervision belong to BNM.

The main concern of BIs regarding regulation andsupervision is that the Government and BNM holdtoo much power. Primarily this perception arises fromlack of transparency in decision-making processes.Even though there have been intensive efforts toenhance transparency of policy making and supervi-


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sion during the crisis, there is room for improvement.One obvious example is the clause that BNM canapprove from time to time exemptions in the creditlimit to a single customer.

In order to ensure transparent policy decisions,the following measures could be introduced. First,the Central Bank of Malaysia Act needs to be re-vised to clarify the composition of the board of di-rectors of the bank for internal balance. Currentlythe board of directors is composed of the Governor,not more than three Deputy Governors, and five toeight directors. But there is no clarification on whateach director represents. Second, BNM needs todisclose the minutes of the decisions of the highestpolicy making body, in addition to the prudential regu-lation-related information. These measures will pre-vent forbearance of BNM that can easily be trans-formed into a bailout of the financial institutions.

Lack of consistency in financial policy is a prob-lem as serious as lack of transparency. Even thoughthe Government encourages mergers, it does notseem to have a clear exit policy. For example, oneauthority says the Government would support troubledbanks, but another authority indicates that ailing bankswould be allowed to fail. The current inconsistentstatements of the Government could be attributed tolack of a long-term financial reform plan. Thereforea long-term blueprint is necessary to ensure a moreconsistent set of regulations.

In a related issue, BNM supervises insurance com-panies according to the Central Bank of MalaysiaAct. However, the rationale behind this practiceseems not aligned with the roles normally assumedby central banks. A central bank is defined as a bankof banks, and has to play the role of a lender of lastresort to BIs when necessary. Insurance companiesare not categorized as BIs and, therefore, exemptedfrom reserve requirements, and not allowed accessto the discount window. At the same time businessesof BIs and insurance companies are clearly distin-guished. From BNM’s point of view, apart from thecost it has to pay for insurance sector specialists,

these factors can impair its credibility if insurancecompanies are confronted with problems. Therefore,it may be time to develop an independent supervi-sory agency for insurance companies.

Credit CrunchThe precise origin and nature of a credit crunchchanges from one time to another. There could bemultiple reasons for the current credit crunch. First,unstable foreign exchange markets require a policyof monetary restraint and high interest rates. Thesetend to reduce credits to the private sector by finan-cial institutions. Second, strict enforcement of theBIs’ capital adequacy ratio can reduce their creditcapacity. Since bank managements were unable toraise additional capital in these exigent circumstances,they had no choice but to call in loans to improvetheir capital adequacy ratios. Such calls might wellbe made on the soundest clients, since they were inthe best position to repay, whereas others might havebeen forced to default, occasioning still more write-downs. New lending, of course, was severely inhib-ited. Third, uncertainty in the economy as well as inthe corporate sector causes financial institutions tohesitate to provide credits to the potential borrow-ers. Fourth, instability of the currencies of People’sRepublic of China; Hong Kong, China; and Japanpotentially impairs foreign capital inflows into thecountry. In the case of Malaysia, the credit crunch isviewed to be not as serious as that of other affectedcountries, an indication that the factors causing it areless serious. However, there is a strong possibilitythat the current credit crunch could lead to a viciouscircle if the present economic and banking situationdeteriorates.

The Government has made several efforts to miti-gate the worsening credit crunch. Measures include:

• reduction of the SRR and the liquid asset ratiorequirement;

• lowering interest rates through the lowered BNMintervention rate and revision of the basic lend-ing rate framework;


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• encouragement of lending for the constructionor purchase of residential properties, and sharesand units of unit trust funds;

• freeing BIs to determine the margin of financingfor credit facilities granted for the purchase ofbroad properties;

• relaxation of the definition of NPLs;• removal of the specific provision requirement for

substandard loans; and• encouragement of credits by imposing a mini-

mum annual loan growth target of 8 percent tobe met by BIs by the end of 1998.

There is a limit for resorting to the supply of creditto revive the economy. Such measures could seri-ously weaken Malaysia’s already overstretched do-mestic banks. The new credit could find its way intospeculative investments and simply add to nationalleverage levels that are already unacceptably high.A change in the rules on NPLs and provisioningmeans the extent of the deterioration will be obscured.Moreover, pumping liquidity into the system couldconflict with efforts to reform the banking and cor-porate sectors.

As long as the credit crunch is explained by a hostof factors, fundamental and contingency plans haveto be considered together. First, the concept of profitmaximization of financial institutions needs to be re-considered. The credit crunch seems to be a naturalresult of the profit-maximizing management of BIs.However, considering the generic nature of BIs thatarises from long-term contracts with customers un-der informational asymmetry, insurance also has tobe taken into account in financial policy. This impliesthat BIs have to maximize their profits, not in theshort term but in the long term. In turn, this impliesthat it can be theoretically rationalized to encourageBIs to exert more effort to support their customersfacing temporary difficulties. Second, the authoritiescan adjust the growth rate of monetary aggregatesto a higher level. In order to measure the liquiditycondition properly, lowered velocities have to be takeninto account. Third, the burden to fulfill the BIs’ capi-

tal adequacy ratio needs to be lightened by allowingthem to have a lower capital adequacy ratio than theinternational standard of 8 percent, if they give upriskier businesses such as foreign exchange tradesand derivatives. Fourth, in order to avoid the exces-sively passive attitude of BIs towards lending, BNMneeds to prepare a guideline that credit examinersshould be exempted from punishment when the loanturns nonperforming. Their performance needs to beevaluated based on achievement for a certain pe-riod, for example, three years. Finally, the Govern-ment needs to increase the funds of CGC to pro-mote access to institutional credit for small-scale en-terprises and for Bumiputra entrepreneurs.

Deposit InsuranceThe flight of deposits to sound BIs as the financialcrisis develops proves that depositors’ confidence inindividual financial institutions is shaky. Shifts of fundsamong financial institutions are costly from thedepositor’s point of view. But they are more hazard-ous to financial institutions. There is evidence thattier-2 banks in Malaysia have been paying higherdeposit rates (of about 0.5 to 1 percent more on av-erage). These can cause even solvent banks to gobankrupt and eventually cause systemic risk. There-fore, it is important to prevent excessive disinter-mediation or shifts of financial assets.

Currently, the Government protects principals andaccrued interests on deposits in BIs. This blanketguarantee by the Government was confirmed on20 January 1998 to prevent excessive shifts of de-posits and possible bank runs. Considering the ex-treme lack of confidence of depositors, it was anindispensable measure from the Government’s pointof view. However, as the market stabilizes, protec-tion has to be accorded by the market instead ofthe Government. This implies that the marketmechanism should be allowed to work in the de-posit market.

Allowing the market mechanism to function canbe achieved step by step. In the first stage, the amount


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of the principal and accrued interests insured by theGovernment needs to be reduced from the entireamount to a certain small amount.

23 In the second

stage, a private deposit insurance company shouldreplace deposit insurance by the Government at acertain date. For instance, considering the currentcomposition of fixed deposits by maturity (averagematurity of around two years), 2001 would be theappropriate time for depositors to start to play a rolein monitoring BIs.

Another option is to extend Government protec-tion to a far later date, say, until 2003, and to recon-sider its extension in 2000, i.e., three years ahead of2003 and so on. The reason for the long grace periodand reconsideration is that the current difficulties inthe financial sector do not leave much room for BIsto contribute insurance premiums. This option canalso be rationalized by the following consideration:academics and practitioners have long discussed thepros and cons of deposit insurance. The key point inthe discussion is how to strike a balance betweenthe explicit financial costs and the implicit costs in-curred due to moral hazard. The current trend tostrengthen market discipline, in particular introduc-tion of a prompt corrective action, could take over arole of the deposit insurance.

Financial InnovationThe liabilities of BIs are sources of banking business.The availability of attractive deposit instruments andservices is as crucial as the soundness of BIs for op-eration. In the case of Malaysia, if the amount due toother financial institutions is excluded, deposits are vir-tually the only source of funds. (As of the end of 1997,deposits made up 74.8 percent of total resources forcommercial banks, 84 percent for finance companies,and 78.6 percent for merchant banks.)

Lack of competition due to the closed system isreflected in the lack of dynamism in the financialmarket. One measure of dynamism is changes inthe composition of monetary aggregates. In Ma-laysia, the relative shares of M1 and M2 in M3 are

stable. This indirectly proves not only BNM’s tightcontrol on BIs, but lack of competition among fi-nancial assets.

When the time comes to open up the financialmarket to foreigners, either by external pressure orby an internal voluntary decision after the soundnessof BIs is secured, primary competition among BIswill occur in deposit taking. In this context, financialinnovation surrounding deposits has to be encour-aged far in advance. Currently, many BIs do not re-alize the importance of financial innovation and someeven worry about the adverse effects on their prof-its. However, competition needs to be encouragedfor customers’ sake.

In most cases, an inner stimulus is not sufficientfor a fundamental structural change. Financial insti-tutions cannot be competitive enough without allow-ing foreign competition, even though they agree onthe importance of competitiveness. There is plentyof room for financial innovation in Malaysia. First,considering the influence of Islamic banking, depos-its would be presumably less sensitive to interest rates,and financial innovation can be promoted at less cost.Second, since BIs’ coverage of business is wide, in-venting new products is relatively easy. TheBumiputra policy will also provide a basis for invent-ing new and country specific financial products. It isa good idea to provide patent to an institution thatdevelops a new financial product/service.

Apart from deposits, BIs’ bond issuance needs tobe examined to encourage savings mobilization bysatisfying the customer’s preference and to diver-sify the sources of funds. Currently, the tedious pro-cesses and high cost of bond issuance are major ob-stacles to the issuance of private bonds by BIs. It isnecessary that BNM’s involvement in BIs’ bond is-suance be minimized. Greater bond issuance will alsocontribute to the deepening of the bond market aswell as financial innovation.

Since 1986, financial institution units have beenpermitted to engage in banking as well as in securi-ties business but under separate subsidiaries and


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regulatory agencies. BIs can invent good saving in-struments, providing greater variety and profits to de-positors, by linking commercial banking business withsecurities business. Fortunately, the current universal

banking system is better than a universal banking sys-tem that allows one entity to engage in various busi-nesses in terms of securing the stability of the bankingsystem and reducing the cost of supervision.


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a Supervised by Bank Negara Malaysia.Source: Bank Negara Malaysia.

Islamic Banka

Assets RM4.0 billionDeposits RM3.3 billionLoans RM2.4 billion

Number of branches 68

Commercial Banksa


Number of banks:Domestic 22Foreign 13

Total 35Number of branches 1,624

Finance Companiesa


Number of companies 39Number of offices 1,096

Merchant Banksa


Number of banks 12Number of branches 24

Discount Houses

Assets RM20.9 billion

Number 7

Foreign BanksRepresentative Officesa

Number of offices 38

Bank Negara Malaysia

Assets (of which external resource= RM59.2 billion) RM109.0 billion

Number of branch offices 6

Appendix 1

The Banking Institutions, as of end-December 1997


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Appendix 2: Statistical Tables

Table A2.1: Assets of the Financial System

( ) = negative values are enclosed in parentheses.The numbers above are based on old bank formats and may differ from those in Appendix 1.a Includes Bank Islam Malaysia Berhad.b Includes Malaysian Industrial Development Finance Berhad (MIDF), Bank Pertanian Malaysia, Borneo Development Corporation, Sabah Development Bank Berhad, Sabah

Credit Corporation, Export-Import Bank Malaysia Berhad, Bank Pembangunan Malaysia Berhad, and Bank Industri Malaysia Berhad.c Includes National Savings Bank, Bank Kerjasama Rakyat, and cooperative societies.d Includes unit trusts (ASN, ASB, ASW 2020, and ASM Mara), building societies, Pilgrims Fund Board, Credit Guarantee Corporation, Cagamas Berhad, leasing companies,

factoring companies, and venture capital companies.Source: Bank Negara Malaysia.

Annual Change (RM billion) As of End-1997

Financial Institution 1996 1997 Value (RM billion) Percentage Share

Banking System 116.1 181.4 813.2 72.8Bank Negara Malaysia 8.3 12.2 109.0 9.8Commercial Banksa 68.6 122.5 486.6 43.6Finance Companies 27.9 32.6 152.4 13.6Merchant Banks 7.0 10.3 44.3 4.0Discount Houses 4.3 3.8 20.9 1.9

Nonbank Financial Intermediaries 55.4 16.7 304.0 27.2Provident Pension and Insurance Funds 27.5 24.0 191.0 17.1

Employees Provident Fund 18.5 15.0 132.4 11.9Other Provident and Pension Funds 3.3 3.5 21.9 2.0Life Insurance Funds 3.4 3.6 24.5 2.2General Insurance Funds 2.3 1.9 12.2 1.1

Development Finance Institutionsb 1.4 2.0 15.3 1.4Savings Institutionsc 3.0 1.2 19.4 1.7Other Financial Intermediariesd 23.5 (10.5) 78.3 7.0

Total 171.5 198.1 1,117.2 100.0


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na = not available.a Under Lending Guidelines 1996, the target for loans to Bumiputra community has been increased from 20 to 30 percent, while the targets for housing loan commitments of

commercial banks and finance companies have been increased from 75,000 units and 25,000 units, to 100,000 units and 40,000 units, respectively.Source: Bank Negara Malaysia, Annual Report 1998.

Appendix 2

Table A2.2: Lending Guidelines

1994 1996(Compliance date: 31 March 1997) (Compliance date: end 1997)

Target Achieved Target AchievedItem (31 March 1999)

Loans to Bumiputra CommunityTotal Outstanding Loans (RM billion)

Commercial Banks 21.3 52.8 53.0 76.9Finance Companies 7.8 22.3 19.4 37.0

Total Outstanding Loans (percent)Commercial Banks 20.0 49.5 30a 43.5Finance Companies 20.0 57.2 30a 57.2

Noncompliance (no. of institutions)Commercial Banks na 1 na 9Finance Companies na na na 6

Housing Loan CommitmentsTotal Houses (units)

Commercial Banks 75,000 84,197 100,000 94,568Finance Companies 25,000 42,771 40,000 41,002

Noncompliance (no. of institutions)Commercial Banks na 10 na 12Finance Companies na 5 na 13

New Principal Guarantee SchemeTotal Guarantee Cover (RM million)

Commercial Banks 350.0 859.7 1,000.0 2,286.0Finance Companies 60.0 161.8 240.0 1,210.0


New Principal Guarantee Scheme (for Bumiputra Community)Total Guarantee Cover (RM million)

Commercial Banks 175.0 217.5 500.0 570.0Finance Companies 30.0 70.8 120.0 274.9



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Appendix 2

Table A2.3: Sources and Uses of Funds of the Financial System(outstanding in RM million)

Item 1993 1994 1995 1996 1997

Sources of FundsCapital, Reserves, and Profit 41,936.2 55,886.5 78,696.4 109,462.5 103,072.3Currency 14,649.0 17,170.3 18,913.2 21,065.6 24,532.3Demand Deposits 33,449.7 40,051.8 46,155.8 56,231.9 59,078.3Other Deposits 254,653.1 269,219.8 318,307.7 399,163.2 490,954.5

Of which:Public Sector 28,351.3 27,544.1 41,420.7 35,937.0 38,590.6Other Financial Institutions 95,506.1 90,081.0 99,506.0 124,716.7 160,807.6Private Sector 127,237.3 147,233.9 171,804.3 233,142.4 283,901.6Foreign 3,558.4 4,360.8 5,576.7 5,367.1 7,654.7

Borrowings 5,767.8 6,811.0 6,322.4 8,376.6 31,108.1Funds from other Financial Institutions 43,713.7 39,901.3 50,039.1 55,994.6 98,713.6

Domestic 14,324.7 24,245.5 33,611.8 34,043.4 57,702.2Foreign 29,389.0 15,655.8 16,427.3 21,951.2 41,011.4

Insurance, Provident, and Pension Funds 93,625.1 108,961.4 127,055.4 146,888.5 169,214.8Other Liabilities 84,361.9 87,417.6 102,074.0 121,917.8 140,550.9Total Liabilities 572,156.5 625,419.7 747,564.0 919,100.7 1,117,224.8Uses of FundsCurrency 1,597.2 1,383.4 1,929.3 2,812.3 4,112.3Deposits with other Financial Institutions 117,597.2 121,286.4 139,216.6 146,615.6 215,803.3

Domestic 110,537.3 113,453.2 130,830.7 139,231.8 197,682.5Foreign 7,059.9 7,833.2 8,385.9 7,383.8 18,120.8

Bills 7,824.8 12,081.1 16,391.6 16,312.6 21,327.6Treasury 2,737.0 4,061.2 3,887.4 1,916.8 3,912.2Commercial 5,087.8 8,019.9 12,504.2 14,395.8 17,415.4

Loans and Advances 209,801.6 242,498.2 305,751.1 384,269.2 486,698.8Public Sector 2,757.9 4,446.4 4,582.0 3,966.3 7,024.1Other Financial Institutions 21,535.3 19,467.7 26,069.8 13,615.5 20,615.3Private Sector 184,198.4 217,677.4 274,075.1 364,705.3 455,986.5Foreign 1,310.0 906.7 1,024.2 1,982.1 3,072.9

Securities 105,245.3 124,731.8 160,280.7 202,523.0 213,036.9Malaysian Government 61,046.5 61,056.1 61,532.8 67,626.9 66,818.9Foreign 68.8 91.6 92.8 385.9 790.6Corporate 41,703.1 56,061.0 53,575.6 124,565.9 138,543.2Others 2,426.9 7,523.1 45,079.5 9,944.3 6,884.2

Gold and Foreign Exchange Reserves 75,309.4 66,830.8 61,681.9 67,864.6 57,068.2Other Assets 54,781.0 56,608.0 62,312.8 98,703.4 119,177.7Total Assets 572,156.5 625,419.7 747,564.0 919,100.7 1,117,224.8


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a Inclusive of other sectors.Source: Bank Negara Malaysia.

Appendix 2

Table A2.4: Commercial Banks: Loans and Advances to Major Sectors,1980–1997 (RM million)

Annual Growth (percent)

Sector 1980 1985 1990 1995 1996 1997 1980–1997 1993–1997

Broad Property 5,349.2 16,995.5 24,205.7 46,363.3 58,919.7 76,372.9 17 21

Consumption Credit 147.1 590.6 1,906.3 6,390.3 8,097.2 7,016.4 25 16

Manufacturing 4,693.8 8,583.9 18,743.7 42,410.1 47,950.1 58,348.0 16 21

Financial Services 1,297.3 5,809.2 9,115.3 23,766.2 33,892.4 45,375.0 23 28

Share Purchases 201.7 1,073.7 2,280.6 7,998.6 9,409.8 10,788.5 26 37

Wholesale/Retail Trade 4,644.2 8,752.0 11,642.6 19,075.4 22,190.7 29,349.1 11 21

Total Lendinga 21,031.1 48,981.7 80,758.0 175,007.4 217,820.5 289.583.4 17 25

a Inclusive of other sectors.Source: Bank Negara Malaysia.

Appendix 2

Table A2.5: Finance Companies: Loans and Advances to Major Sectors,1982–1997 (RM million)

Annual Growth (percent)

Sector 1982 1985 1990 1995 1996 1997 1982–1997 1993–1997

Broad Property 2,449.7 5,061.3 8,430.1 15,070.3 18,336.0 21,437.2 16 14

Consumption Credit 1,414.5 2,964.9 11,588.4 32,605.2 43,179.9 48,429.0 27 23

Manufacturing 294.6 617.8 1,336.0 4,004.7 4,999.1 6,699.4 23 28

Financial Services 187.7 603.9 641.3 1,647.1 2,103.7 2,030.2 17 21

Total Lendinga 5,712.0 12,325.8 27,023.0 62,752.0 82,496.7 102,545.8 21 24


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ATM = automated teller machine, RWCR = risk-weighted capital ratio.Source: Bank Negara Malaysia.

Appendix 2

Table A2.6: Banking System: Key Data, as of Year-end, 1993–1997

Item 1993 1994 1995 1996 1997

Number of InstitutionsCommercial Banks 37 37 37 37 35Finance Companies 40 40 40 40 39Merchant Banks 12 12 12 12 12

RWCR (percent)Commercial Banks 12.4 11.3 11.1 10.8 10.3Finance Companies 8.8 10.1 9.7 9.8 10.6Merchant Banks 10.0 8.2 11.9 11.7 13.3

Number of Branch NetworkCommercial Banks 1,220 1,283 1,433 1,569 1,671Finance Companies 789 860 988 1,096 1,144Merchant Banks 17 17 18 24 24

Number of ATM NetworkCommercial Banks 1,558 1,975 2,230 2,326 2,573Finance Companies 299 345 402 525 627

Persons Served per OfficeCommercial Banks 15,614 15,191 14,024 13,492 12,986Finance Companies 24,100 22,849 20,341 19,314 18,969

Number of EmployeesCommercial Banks 54,569 59,674 64,461 68,068 73,530Finance Companies 20,500 22,488 24,593 26,322 27,937Merchant Banks 1,900 2,179 2,334 2,592 2,802


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Appendix 3

Capital Components andIncentives Accorded toTier-1 Banking Institutions

CAPITAL COMPONENTSThe key component of total bank capital is equity ortier capital, which has three subcomponents, as fol-lows:

• paid-up share capital;• share premium (the difference between the price

at which the common stock is sold and its parvalue, times the number of shares sold); and

• retained earnings through undivided profits.

INCENTIVES ACCORDED TOTIER-1 BANKING INSTITUTIONS

Commercial Banks• issuance of negotiable instruments of deposit up

to five times of their capital funds; participationin equity derivatives subject to compliance withthe Guideline on “Minimum Standards on RiskManagement Practices for Derivatives”;

• participation in the share borrowing and lendingactivities subject to the approval of the Securi-ties Commission; and

• for tier-1 domestic commercial banks, regionalexpansion of operations through the establish-ment of branch offices, representative offices,subsidiary companies, or on joint-venture basis.

Finance Companies• provision of factoring services;• provision of remittance service with Malaysia,

including bankers’ checks, demand drafts, pay-ment order, and telegraphic transfer. However,a finance company should use only the checksof the commercial bank belonging to the samegroup, or otherwise, the checks of tier-1 com-mercial banks;

• participation in special funds established by BNM(such as Fund for Food, Special Fund for Tour-ism, New Entrepreneurs Fund, and Bumiputra

Industrial Fund);• granting of unsecured business loans, up to a

maximum of RM500,000;• participation in venture capital financing; and• issuance of negotiable instruments of deposit up

to five times the capital funds.Merchant Banks• participation in the following foreign exchange

business with the prior approval from the Con-troller of Foreign Exchange:– trading on its own account in the foreign ex-

change market,– undertaking foreign exchange transactions with

any customer,– lending in foreign currency to resident and non-

resident customers other than for the purposeof trade financing subject to the approval ofother relevant authorities,

– borrowing any amount in foreign currencyfrom any licensed bank, licensed merchantbank, or nonresident, and

– underwriting foreign securities and holding thesecurities in the event of under subscription;

• participation in domestic and global derivativesmarkets, subject to compliance with the guide-line on “Minimum Standards on Risk Manage-ment Practices for Derivatives”;

• participation in share borrowing and lending ac-tivities subject to the approval of the SecuritiesCommission;

• investment in shares listed in the stock exchangesof Association of Southeast Asian Nations(ASEAN) countries subject to prudential limits;

• issuance of negotiable instruments of deposit upto five times the capital funds;

• acceptance of deposit from individuals subjectto minimum amount of RM1 million; and

• expansion of operations regionally through theestablishment of branch offices, subsidiary com-panies, or on joint venture basis.



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Appendix 4

The Evolution of Banking Regulations

Banking reforms were instituted in Malaysia sincethe 1980s. However, the banking crisis of the mid-1980s and the recent financial crisis have highlightedthe weaknesses in the banking sector that weremainly caused by lack of appropriate prudential regu-lations and adoption of best practices. Strengtheningthe banking sector will depend much on the effort ofthe authorities to implement essential structural andpolicy reforms and embracing global standards ofbanking practices.

Entry Requirement and Minimum CapitalCommercial banks have to be licensed and no new

license has been issued since the 1970s. The mini-mum shareholders funds of a commercial bank wasraised from RM2 million to RM10 million in Febru-ary 1982 and was further raised to RM20 million inNovember 1989. BNM has announced that the mini-mum capital funds for finance companies will beraised from RM5 million to RM600 million by yearend-2000 with an interim target of RM300 million tobe achieved by mid-1999, and that the required mini-mum capital for a commercial bank and a merchantbank is under review.

Capital AdequacyA minimum capital adequacy ratio was first intro-

duced in September 1981 in which local banks wererequired to maintain a ratio of “free” capital (share-holders funds less investments in long-term assets tototal assets) of 4 percent and for foreign banks,6 percent. In line with the Basle Capital Accord ofJuly 1988, the new guidelines required local and for-eign banks to maintain a risk-weighted capital ratio(RWCR) of 8 and 10 percent, respectively, by end-1992 and attain an immediate target of 7.25 and 9.25percent by end-1990. To reflect the higher risk profileof finance company business, Bank Negara Malaysia(BNM) announced on 25 March 1998 that the mini-

mum RWCR requirement for finance companies wouldbe raised from 8 to 10 percent by end-1999 with aninterim target of 9 percent to be achieved by end-1998. An announcement was also made to expandthe capital adequacy framework to incorporate mar-ket risks for all financial institutions (FIs).

Restriction in OwnershipLegal provisions to regulate the size of share-hold-

ings in an FI came into force in January 1986. Themaximum holding of an individual including family hold-ing companies in the equity of an FI is 10 percentwhile any company or cooperative may not hold morethan 20 percent. But there are provisions in the legis-lation to empower the authorities to exempt any per-son from these shareholding limits. This was aimed atmeeting the Government’s goal on equity ownershipwith respect to indigenous communities. However, inthe mid-1990s, nonindigenous groups were also allowedto acquire a majority interest in an FI. Although therewere no provisions in the legislation specifying whoshould or should not be shareholders, there was anunwritten consensus restricting cross-ownership be-tween banks and the corporate sector. This consen-sus had been broken in the mid-1990s with conglom-erates allowed to take majority stakes in FIs. But thisshould not create a moral hazard type of behavior be-cause of prohibitions on the granting of director orshareholder related loans (except in cases where theshareholding interest is nonmaterial).

Single Borrower LimitLending to a single customer (or to a group of re-

lated companies) was set at 30 percent of a bank’sshareholders funds and to large borrowers (each withloans of 15 percent or more of a bank’s capital funds)at 50 percent of its total credit facilities in September1984. The single customer limit was reduced to25 percent with effect from 25 March 1998 with theproviso that in cases where the consolidated limit ex-ceeded the 25 percent limit, banking institutions (BIs)would be allowed to run these facilities to maturity.


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Interest Suspension and Specific Provisionswith Respect to Nonperforming LoansAlthough the guidelines became effective in Janu-

ary 1986, compliance became mandatory only inJanuary 1990. Almost all financial institutions werecomplying even before it became mandatory. Until1989, the guidelines required that interest be sus-pended only after the loan has been nonperformingfor 12 months. However, on all such nonperformingloans (NPLs), the guidelines required a claw back today one of interest income that had been recognizedbut had not been collected. With effect from Janu-ary 1990, the claw back requirement was suspendedbut interest had to be suspended on all loans that hadbeen nonperforming for at least six months. In gen-eral, the guidelines on interest accrual, loan classifi-cation, and loan-loss provisioning did not meet thestandards of international best practice.

These guidelines were improved effective 1 Janu-ary 1998 but they still fall short of current internationalstandards. The default period for classifying a loan asa NPL and for suspending interest by a licensed FIhas been lowered from six to three months. FIs areallowed to claw back interest to day one only for newNPLs. With respect to loan-loss provisioning, startingJuly 1998, the requirement has been raised to 20 per-cent for a substandard loan, remains unchanged at50 percent for a doubtful account, and 100 percent fora bad account. The period of default beyond which aworse-off classification is required was reduced tosix from 12 months in case of a substandard loan andto 12 from 24 months for a doubtful account.

In 1990, foreign banks were required to maintaina general provision account amounting to at least1 percent of their total loans, net of specific provisionsfor bad and doubtful debts. This has been increased toa minimum of 1.5 percent beginning January 1998.

Financial Reporting andDisclosure RequirementsFinancial reporting improved from 1990 onwards

with the guidelines issued on interest accrual, loan

classification and loan-loss provisioning. Some dis-closure measures were also implemented to de-termine whether these guidelines were being ad-hered to.

Further disclosure requirements on loan qualitywere introduced in January 1998, to include the sizeof FIs’ NPLs (net of interest-in-suspense and spe-cific provision). With respect to the reporting stan-dards of FIs’ portfolio of investment securities (asopposed to trading securities), the guidelines needto be tightened as they are based on the higher ofcost or market value and there exists no clear dis-tinction between type of securities. The differenceis amortized over the remaining life of the securi-ties and charged to the profit and loss account. Like-wise, the reporting system for off-balance sheetitems is reportedly not meeting best internationalpractice.

FIs’ financial statements had been released on asemiannual basis but only year-end results were au-dited. Effective July 1998, the FIs have been requiredto release quarterly reports on their capital positionand the size of their NPLs.

Reserve and Liquidity RequirementsStatutory reserve requirement (SRR) as a per-

centage of the eligible liabilities base was 5 percentfrom 1980 to 1984 when Malaysia was pursuing atight monetary policy. This ratio declined to 3.5 per-cent in 1986 and remained at that level until 1988.Thereafter, the ratio was raised steadily but wasset at 13.5 percent in June 1996. The ratio wasagain reduced gradually to 4 percent in 1998 to mini-mize the problem of disintermediation.

From 1980 to 1985, a commercial bank was re-quired to hold a minimum overall liquid asset ratio of20 percent against its eligible liabilities base, of whichhalf had to be in the form of primary liquid assets.The minimum overall liquid asset ratio requirementwas reduced to 17 percent in 1986. The primary liq-uid asset requirement was reduced from 10 percentin 1986 to 8 percent in 1987 and 5 percent in 1988.


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No restriction has been placed on the composition ofoverall liquid assets from 1990.

The eligible liabilities are now defined morebroadly to capture all types of funding. These in-clude repos and the net inflow of funds from abroad,which together constituted 10 percent of the eli-gible liabilities base in 1995. This means that a SRRof 13.5 percent is equivalent, on a conservative basis,to a requirement of 15 percent on the more nar-rowly defined eligible liabilities base, which was inuse until 1989.

Restrictions on Banks Investingin Potentially Volatile SecuritiesFrom 1985, banks were permitted to invest in

trustee shares of up to 10 percent of the paid-upcapital of a publicly quoted company, or 10 percentof the shareholders’ funds of the concerned bankprovided that the aggregate of investments in trusteeshares did not exceed 25 percent of their share-holders’ funds. A bank could acquire any shares insatisfaction of debts and for a specified period onlywith the approval of the central bank. In 1989, abank’s investment in shares, units in property trusts,and fixed assets could not exceed 50 percent of itscapital base (net of investment in subsidiaries andin other FIs). Effective 30 April 1991, shares orproperties acquired involuntarily as a result of un-derwriting commitments in satisfaction of debts ordue to foreclosure were not required to be includedin the 50 percent limit provided the period for whichthey have been held did not exceed the allowabletime period. In February 1991, a limit was imposedon loans of merchant banks secured by shares to25 percent or less of their total credit facilities. Thecorresponding limit that applied to a commercialbank was 10 percent. Effective October 1994, thelimits on lending secured by shares and assets ofunit trust funds were raised to 15 percent for com-mercial banks and 30 percent for merchant banks.The limit for commercial banks was raised to 20percent in September 1998.

Mechanisms to Control Currencyand Maturity Risks, IncludingOff-Balance Sheet RisksBNM sets limits on banks’ foreign exchange (FX)

exposures, generally equivalent to RM400,000. Theadvantage of such limits was for banks to have littleor no currency risk. However, such limits were seento have curtailed the FX treasury operations of thebanking system and hampered the development ofits expertise in managing currency risks.

BNM does not set any specific limits on a bank’smaturity risks. The maturity mismatch when a bankfunds its long-term assets with short-term funds givesrise to a liquidity risk, rather than to an interest raterisk. Most loans including the long-term ones arepriced on a variable basis, which minimizes any in-terest rate risks.

In the management of the liquid asset portfolio, anFI is exposed to the highest degree of interest rate andliquidity risks. Under Malaysian regulations, 17 per-cent of an FI’s eligible liabilities has to be held in theform of certain designated liquid assets. Most FIs havebeen relying on fixed rate Malaysian Government se-curities of up to 10-year maturities to comply with theirliquid asset requirements. The lack of well-developedand liquid cash futures markets in bonds have made itimpossible for an FI to hedge the interest rate risk onits Malaysian Government securities portfolio. This isalso the case for FIs’ leasing portfolio and financecompanies’ hire-purchase portfolios as these loans arepriced on a fixed rate basis and are usually of three tofive years maturity. Cagamas Berhad has reduced theliquidity risk of the banking system from the big mis-match it faced in funding its sizable portfolio of long-term housing loans with short-term funds. CagamasBerhad is a national mortgage corporation establishedin 1987 that specializes in buying and refinancing hous-ing loans on a securitized basis through the issue ofCagamas bonds. In fact, the development of the mort-gage bond market has also enabled the banking sys-tem to raise long-term fixed rate funds from the saleof such housing loans to Cagamas Berhad.


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Until the mid-1990s, BNM did not impose any re-strictions on or have any reporting requirements tomonitor and control the off-balance sheet risks of abank, especially with respect to derivatives. Onshorebanks had been engaged in derivative trading withMalaysian corporates on a back-to-back basis withoffshore banks. Any Malaysian corporate could onlybuy an option but not write one, even if its underlyingposition could enable it to do so with little or no risk.After the much-publicized derivatives debacles of1994, BNM prohibited banks from engaging in de-rivative trade without its explicit approval. This blan-ket ban was lifted in 1996. A bank is permitted toengage in derivative trading as long as its board hassatisfied itself that it has the in-house resources sys-tems and dynamic hedging capability to manage riskexposures arising from such trades. The bank is alsorequired to submit regular reports on its net openpositions in derivative products. However, becauseof the underdeveloped domestic markets, even rudi-mentary value-at-risk analysis and dynamic hedgingwill be constrained by the illiquid markets and thepaucity of hedging tools.

Neutrality of the Regulatory FrameworkAcross Institutions and ActivitiesIn the mid-1980s, the regulatory framework was

not neutral across institutions and activities. Thereserve requirement was 5 percent for commercialbanks, 2.5 percent for finance companies, and1.5 percent for merchant banks; and the reservesearned no interest. The differential was reduced in1985 and eliminated in 1989.

Liquidity requirements were 20 percent for com-mercial banks, and 10 percent for finance compa-nies and merchant banks. There was no distinctionin the liquid assets held by merchant banks but com-mercial banks and finance companies had to holdhalf of their liquid assets in the form of primary liquidassets and the balance in secondary liquid assets.The average yield was higher on secondary liquidassets than on primary liquid assets. However, these

yields were often below their funding costs. From1986, the liquidity requirement of commercial bankswas reduced to 17 percent. The primary liquid assetrequirement was cut from 8 percent in 1987 and 5percent in 1988. No restrictions were imposed onthe composition of liquid assets from 1989.

Finance companies were no longer required tohold primary liquid assets from 1989. Although theliquidity requirement of finance companies and mer-chant banks has been set at 10 percent, finance com-panies and merchant banks with the authority to is-sue negotiable certificates of deposits since 1990 and1987, respectively, have been required to maintainthe ratio at 12.5 percent. Thus there has been still asignificant differential in liquidity requirements forcommercial banks, finance companies, and merchantbanks from 1989.

The priority sector lending requirements wereimposed only on commercial banks and finance com-panies but not on merchant banks. In 1985, about25 percent of the loan portfolios of commercial bankswere subject to an interest rate ceiling. This wasreduced to below 20 percent in 1989 and to below5 percent in 1995. But the interest rate ceilings wereless pernicious in the lower interest rate environmentduring the late 1980s and the 1990s. Likewise, thelending quotas were also set often below the marketclearings.

With respect to gearing, until the mid-1980s, acommercial bank was allowed to gear itself up to 25times its shareholders funds whereas a merchantbank or a finance company was allowed a gearingof only 15 to 20 times, respectively. From September1989, FIs were required to adhere to the same capi-tal adequacy framework based on the Basle CapitalAccord. Under this risk-weighted assets approach,a capital adequacy ratio (CAR) of 7.25 percent wasrequired to be attained by end-1990 and the mini-mum standard of 8 percent by end-1992.

An FI often incurs a funding loss on its holdings ofstatutory reserves and liquid assets. These assets donot contribute anything towards the recovery of an


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FI’s overhead or contribute any returns to its equitycapital. Although there are little or no losses in-curred on the funding of priority sector loans, theymake little or no contributions towards overhead orequity.

In the mid-1980s, the impact of existing regula-tions and guidelines was such that the worst hit werethe finance companies followed closely by the com-mercial banks while the least hit were the merchantbanks. With the easing of the interest rates from thelate 1980s, the cost of the regulatory burden has comedown and with the harmonization of regulations acrossinstitutions the differential cost burden has been re-duced considerably.

Audit and Replacement Capacityof the Regulatory InstitutionsThe supervisory process is conducted via on-site

examination as well as off-site supervision. On-siteexaminations cover credit risks, foreign exchange,interest rate, and liquidity risks from mismatches inassets and liabilities, as well as internal controls.

On-site examinations are confined not just to pru-dential concerns for the safety and soundness of abank. A great deal of time is also devoted to examin-ing if a bank is complying with BNM’s regulationsand directives. This is a factor undermining the ef-fectiveness of on-site examination strictly from aprudential standpoint.

The prudential reports of most off-site surveillanceactivities focus on the liquidity and statutory reserveratios and not enough on an ongoing assessment of abank’s asset quality or of its off-balance sheet expo-sures. But the blanket banning of derivative activi-ties from early 1995 and the extremely conservativelimits set on overnight foreign exchange exposureslimit the off-balance sheet risks of Malaysian banks.

Generally, it can be said that the off-site supervi-sory process relies not only on a static review butalso on a comparative analysis of data. AlthoughBNM has the power to suspend licenses, it has neverexercised this power although it has been preparedto change the board and management, or theshareholding of a bank when necessary. The finesand sanctions imposed are commensurate with theviolations and if warranted by the severity of the vio-lations, the sanctions are made public. Cease anddesist orders have also been issued and the censureshave been published.

The shortage of skilled personnel in the country, aremuneration package that is not market-determined,and overpreoccupation with distribution considerationsin its employment policy have undermined the quan-tity as well as the quality of BNM’s examination andenforcement activities in recent years.

Source: Thillainathan, The Current Malaysian Banking and DebtCrisis and the Way Forward, 1998.


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Measures

Loan Classification and Provisioning Standards• Minimum level of general provisions for bad and doubtful debts raised to 1.5 percent of

total loans.• Classification standards (including three months for nonperforming loans [NPLs])

brought to best practice.• A 20 percent provisioning required against the uncollateralized portion of substandard

loans.• Off-balance-sheet items incorporated in the loan classification and provisioning system.• Classification period for NPLs relaxed from three to six months.• Automatic 20 percent specific provision removed for substandard loans.

Capital Adequacy Framework• All banking institutions (BIs) required to value their credit exposure for interest rate and

foreign exchange related contracts by using “current exposure method” instead of the“original exposure method.”

• RWCR to be complied with on consolidated basis every financial quarter.• Capital adequacy framework expanded to incorporate market risk.• Minimum risk-weighted capital ratio (RWCR) of finance companies increased from

8 to 10 percent with interim compliance of 9 percent.• Minimum capital funds of finance companies increased from RM5 million to RM300 million

and subsequently to RM600 million.

Intensified Monitoring Institutions• Bond Information and Dissemination System launched to provide comprehensive market

information on domestic debt securities to market participants.• More intensive and rigorous supervision including conducting monthly stress tests on

individual BIs.• Surveillance system to be continually enhanced and refined to ensure early detection of

potential risks.• Cooperation and coordination to be enhanced with other supervisory authorities.

Liquidity Support and Management• Preemptive prudential measures to limit lending to the property sector and for the

purchase of stocks and shares.• Limits on noncommercial related ringgit offer-side swap transactions with foreign

customers.• Prudential standards to be strengthened by:– classifying NPLs in arrears from six to three months,– greater financial disclosure by BIs, and– increasing general provision to 1.5 percent.

• Credit plan introduced to limit loan growth to 15 percent by end-1998.• Rules tightened in hire-purchase financing.• Good corporate governance to be promoted through enhanced disclosure of information

and closer scrutiny for corporate restructuring.• Funds raised in the corporate market must be allocated to the productive sectors.• Statutory reserve requirement (SRR) reduced by 3.5 percent of eligible liabilities to

10 percent to enhance efficiency and effectiveness of the intermediation process. SRRamount offset by reducing Bank Negara Malaysia’s (BNM) lending to BIs by at least thesame amount.

• Single customer limit reduced from 30 to 25 percent of capital funds.

Status/Implementation Date

January 1998

January 1998

January 1998

March 1998September 1998September 1998

June 1997

April 1998July 19989 percent—end-199810 percent—end-1999RM300 million by mid-1999and RM600 by end-2000

October 1997

Ongoing

Ongoing

Ongoing

April 1997

August 1997

October 1997

October 1997October 1997December 1997

December 1997

February 1998

March 1998

Appendix 5

Recent Banking Sector Stabilization Measures

Continued next page


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Measures Status/Implementation Date

• Market participants to be provided with daily information on BNM’s operations and itsimpact on liquidity.

• BNM’s three-month intervention rate raised from 10 to 11 percent.• Daily band for averaging of balances to meet the SRR to be widened.• Liquidity framework reviewed to provide BIs with more efficient mechanism to manage

their own liquidity and provide BNM with more effective means to assess liquidityposition of BIs.

• Liquidity support to BIs to be separated from the normal liquidity operations of BNM in theconduct of monetary policy. Lending to BIs to be at penalty rates and fully collateralized.Support would be short-term with clear time frame for repayment.

• Role of SRR and liquid asset ratio requirement and measures to improve efficiency in theinterbank and loan markets under review.

• Base lending rate framework under revision.• A minimum loan growth rate of 8 percent to be achieved by the end of 1998.• BIs urged to accord priority in lending for the construction or purchase of residential

properties.• Limit on loans for the purchase of shares and units of unit trust funds increased from

15 to 20 percent for commercial banks and finance companies.• Indirect monetary instruments (open market operations and repurchase operations) to

be developed to replace uncollateralized deposit placements.

Disclosure• Statistics aggregated on NPLs, provisions, and capital position of commercial banks,

finance companies, and merchant banks.• Financial institutions (FIs) required to report and publish key indicators of financial

soundness such as NPL, capital adequacy, etc., both at bank level and on consolidatedbasis.

• Reserve money and its components from BNM.

Legal Framework• Relevant legislation to be reviewed to effect changes in monetary management and

measures to strengthen the banking system.• Regulations governing investment in authorized securities by FIs under review.• Further liberalization of rules to be undertaken at an appropriate time to enhance the

ability of businesses to manage their foreign exchange exposure.

Other Issues• Implementation of Real Time Gross Settlement System.• Establishment of a national asset management company.• Technical study to be conducted on international practices regarding depositor

protection and deposit insurance schemes, and examine possible implications forMalaysia.

April 1998

April 1998June 1998July 1998

July 1998

July 1998

September 1998September 1998September 1998

September 1998

1999

October 1997

October 1997 (everyfinancial quarter)

February 1998(implemented)

December 1998

December 1998Ongoing

January 1998June 1998November 1998

Appendix 5

Recent Banking Sector Stabilization Measures (Cont’d)


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Notes1The final revision of this report was made in October1998.

2The Seventh Plan’s major strategies with respect to thebanking sector include:

• maintaining financial stability and enhancing competi-tiveness of the banking system through increases in thecapital base and upgrading of management capabilities;

• increasing efficiency of the banking system throughthe use of information technology and development ofa reliable payments system;

• ensuring prudent management of derivatives activitiesby banking institutions to avoid financial instability;

• instilling market discipline in the banking systemthrough market forces; and

• developing Islamic banking into an effective avenuefor the mobilization and allocation of funds.

3Broad property sector excludes the construction of resi-dential properties costing RM150,000 and below; infra-structure projects, public utilities, and amenities; and in-dustrial buildings and factories.

4The initial paid-up capital of the agency is estimated atabout RM250 million. The seed financing will be from theGovernment, which will provide a start-up grant ofRM50 million to help in the establishment of the agency.Danaharta plans to raise about RM10 billion for its initialphase of operations through an international and domes-tic bond issue. Of this, $1 billion to $2 billion will be raisedin the international bond markets with a Government guar-antee and the remaining funds will be raised internallywithin the country. Private equity participation will be con-sidered in the succeeding phases.

5These measures included:• reduction of BNM intervention rate from 10 to 9.5 per-

cent;• reduction of statutory reserve requirement (SRR) from

8 to 6 percent; and• revision of the basic lending rate framework to allow a

faster transmission of changes in monetary policy oninterest rate levels, and reduction of the administra-tive margins of financial institutions from 2.5 to 2.25percent.

6These measures included:• the repatriation by 1 October 1998 of all ringgit held

abroad,

• an end to offshore trading in ringgit instruments and todomestic credit facilities for overseas banks and stock-brokers,

• the retention of the proceeds of the sale of Malaysiansecurities in the country for a year,

• payment in foreign currency for imports and exports,• central bank approval for the conversion of ringgit into

foreign currency, and• the fixing of the exchange rate at 3.8 ringgit to the dollar

(announced on 2 September 1998).

7The SRR declined from 13.5 percent in mid-February 1998.

8Unless otherwise stated, all the data used in this publica-tion are from Bank Negara Malaysia monthly and quar-terly statistical bulletins and annual reports.

9A bank had to show shareholders’ funds of RM500 mil-lion to qualify as a tier-1 bank when the scheme was intro-duced. In addition, the banks also have to fulfill certaincriteria based on the capital, adequacy, management, earn-ings, and liquidity (CAMEL) rating accorded to them. Cur-rently, shareholders’ funds should be RM1 billionby end-1998, and, further, the institution should haveRM1 billion in paid-up capital by end-2000.

10Rashid Hussain Bank (RHB) was formed out of a mergerbetween DCB Bank and Kwong Yik Bank, both tier-1 insti-tutions, and emerged as the second largest bank. RHBhas agreed to buy Sime Bank, which suffered a loss ofRM1.8 billion for the half-year ended December 1997 andwas in need of RM1.2 billion in additional capital.

11There will be six anchor companies: Maybank Finance,Public Finance, Hong Leong Finance, Arab Malayan Fi-nance. EON Finance, Credit Corporation, and United Mer-chant Finance.

12Malaysian banks posted an increase of 25 percent in1997 in their pretax income over 1996; and pretax return onequity increased from about 21 percent in 1993 to about 26percent in 1997.

13The views expressed here with regard to the market’sperception of the problems are based on the discussionswith a number of bankers and private sector analysts inMalaysia and Singapore.

14In an interview with Euromoney Magazine (10 April1998), the former Minister of Finance and now Minister ofCoordination stated that rights issues would allow banksto recapitalize on their own, which is a desirable option.


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15Supervisory authorities have been invited to endorsethe Core Principles, not later than October 1998. Endorse-ment includes undertaking a review of current supervi-sory arrangements against the Core Principles.

16Refer to BNM/GP3, “Guidelines on the Suspension ofInterest on Nonperforming Loans and Provision for Badand Doubtful Debts” and the on-site examination process.

17Refer to BNM/GP5, “Guidelines on the Credit Limit to aSingle Customer” and sectoral limits such as for the broadproperty sector and lending for the purchase of shares.

18Refer to BNM/GP6, “Guidelines on Prohibition of Loansto Directors, Staff and their Interested Parties.”

19Country risk refers to risks associated with the economic,social, and political environments of the borrower’s homecountry. Transfer risk arises when a borrower’s obligationis not denominated in the local currency; the currency ofthe obligation may become unavailable to the borrower re-gardless of the borrowers’ particular financial condition.

20BNM’s Bank Regulation Department will be consider-ing additional guidance on country/transfer risk via anamendment to BNM/GP3 “Guidelines on the Suspensionof Interest on Nonperforming Loans and Provision forBad and Doubtful Debts” to establish specific provisionsfor country/transfer risk. This would likely also result in arevision to examination procedures.

21As a private sector analyst commented, “Malaysianconglomerates have become masters at weaving complexforms of corporate restructuring, opening the possibilityof transferring the root of the problems from one companyto another.”

22Maybank International, Sime International Bank, BBMBInternational Bank, RHB Bank, Public Bank, Bank of Com-merce, and AMMB International are the Malaysian finan-cial institutions that have their subsidiaries operating inLabuan.

23Say, RM30,000, which is equivalent to four times of percapita gross domestic product.

An Insight intoMacroeconomic Policy Management

and Developments in Malaysia

Mohd. Haflah Piei and Tiangchye Tan

Mohd. Haflah Piei is Deputy Director, Malaysian Institute of Economic Research.Tiangchye Tan is Senior Research Officer, Malaysian Institute of Economic Research.


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IntroductionMaintaining the delicate balance between high growthand macroeconomic stability has become one of themost challenging tasks of the 1990s. Runaway growthsince the end of the 1980s has led to an overheatingof the Malaysian economy, resource constraints, andinfrastructure bottlenecks, especially in the early1990s. Shortages of labor became a serious concernfor investors. On the other hand, the increasing num-ber of immigrant workers gave rise to serious con-cerns. Eventually, limiting their recruitment becamea policy option to sustain growth. Instead, Malaysiabegan to recognize the importance of sustaining fu-ture growth and development through increasing pro-ductivity. This will be imperative in addressing thevarious challenges that have emerged during the pe-riod. Strategically, it will be necessary to tackle theprospective loss of competitiveness vis-à-vis otheremerging economies, inflationary pressures, and lag-ging labor productivity as a result of rising wages.

Growth in the Asia-Pacific region moderatedslightly in 1996, mainly as a result of a sharp slow-down in merchandise exports brought about by thedeclining demand for electronic products, especiallysemiconductors. Compared with robust growth of9.5 percent in 1995, the Malaysian economy’s growthfell to 8.6 percent in 1996. This was mainly due tomuch slower growth in domestic demand especiallyin private investment expenditure. As the secondlargest component of real gross domestic product(GDP), with a share of 32 percent in 1996, privateinvestment declined sharply from a high of 25.4percent in 1995 to only 7.2 percent the next year.In the trade sector, the deficit on net exports fell by18.6 percent following a rise in the deficit of 105.1percent in 1995. Higher growth in exports relativeto import growth contributed to a lower net deficit.

The federal Government budget was in surplusfor the fourth consecutive year in 1996 and the defi-cit in the external payments (current account) wasfully financed by a net inflow of long-term corporate

investment. Business confidence remained strong in1996 as seen in the continued increase in proposedinvestment from the manufacturing sector through-out the year. With the consumer price index (CPI)increasing a mere 3.5 percent, inflation remained low.

On the whole, economic growth in 1996 was stillconsidered rapid and the external position of theeconomy improved significantly due to a much lowergrowth in imports. The merchandise trade balanceregistered a much higher surplus of RM8.6 billion in1996 compared to the 1995 figure of only RM233million. The current account deficit narrowed con-siderably in 1996 to RM13 billion from the previousyear’s figure of RM18.7 billion as a result of a slightlyimproved services balance, which recorded a lowerdeficit that year. As a proportion of nominal grossnational product (GNP), this amounted to -5.5 per-cent in 1996 as compared to the previous year’s fig-ure of -9 percent. In macroeconomic terms, thesedevelopments indicated that the Malaysian economywas still expanding at a healthy rate in 1996.

As such, 1997 was ushered in with much opti-mism, despite indications that the peak was over.Growth was expected to continue to remain strongand was projected at 8 percent for the year. Funda-mentals could still be described as strong. Inflationcontinued to be low. The current account deficit wasexpected to further narrow as a percentage of GNP,while the public sector fiscal position was expectedto be in surplus. This optimism was probably due to astrong feeling that adjustment measures to addressthe existing economic imbalances would achieve asoft landing in terms of a more sustainable growthwith stability (Bank Negara Malaysia [BNM] 1998).

In a situation of full employment and capacity, andinfrastructure constraints, concern began to mounton the adverse impact of too rapid growth. Excessdemand pressures on the balance of payments andthe disproportionate expansion in bank credit, espe-cially loans to finance unproductive sectors, had be-gun to raise questions. Another issue concerned theintense competitive pressures on Malaysian exports

3AN INSIGHT INTO MACROECONOMIC POLICY MANAGEMENT AND DEVELOPMENTS IN MALAYSIA

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from lower-cost producers. Remedial measures in-stituted since 1995 to alleviate the situation seemedto have produced some results, including a signifi-cant improvement in the external balance as well asa moderation in the inflation rate in 1996. Furtherprudential measures announced in the beginning of1997 boosted confidence that measures were in placeto reduce credit and monetary growth as well as topreempt rises in asset inflation (BNM 1998).

Therefore, when the Thai baht was first hit by awave of speculative selling in mid-May 1997, andthe subsequent contagion effect was initially felt,Malaysians maintained a certain calm and optimism.After the free-floating of the baht in July and theensuing effect folded in, reality began to take hold.The Malaysian Government’s first reaction was totry to maintain the status quo by rushing in to defendthe national currency. After July, the regional eco-nomic situation took a radical turn for the worse.

In the half decade before the Asian crisis, the Ma-laysian ringgit exchange rate had been hovering in anarrow band of between RM2.36 and RM2.51 to thedollar. The slide of the Malaysian ringgit against thedollar and most other major currencies began in March1997. From a level of 2.48 against the dollar that month,the ringgit slid to 2.52 in June. In the face of a specu-lative attack in July, it then plunged to an average of2.57. The central bank, BNM, tried to uphold the cur-rency for about a week but was finally forced to floatit on 14 July, by which time the bank had already lostclose to $1.5 billion in its efforts to prop up the ringgit.By the end of 1997, the ringgit depreciated to a low ofRM3.77 against the dollar. Worse followed in 1998 asthe ringgit plunged to an all-time low of RM4.88 to thedollar on 7 January, a depreciation of 48 percent withinhalf a year. It eventually pegged at an average ofRM4.40 to the dollar for the month. By April 1998,the ringgit settled at an average of RM3.73 to thedollar. More wide swings continued. All these trig-gered panic among businesses and policymakers, se-verely undermining confidence in the country (Malay-sian Institute of Economic Research [MIER] 1998).

In tandem, the Malaysian bourse, the Kuala LumpurStock Exchange (KLSE), saw prices diving during theperiod. Thus the Malaysian economy, which had, untilearly 1997, been regarded as one of the star perform-ers of emerging East Asia, began to experience a turn-about in performance. Notwithstanding the acclaimedfundamentals, the economy succumbed.

The economic turmoil and instability following theonslaught of the crisis raised various questions onthe effectiveness of macroeconomic policies andgovernance in the region. The debate over East Asia’s“economic model” that brought years of phenom-enal growth to the region subsided. The cry of the“triumph” of Asian values over Western practicesdissipated into naught. Malaysia’s immediate con-cerns in the aftermath of the crisis were stabilizingfinancial markets, restoring investor confidence, andstrengthening the resilience of the economy to po-tential systemic risks arising from the contagion ef-fects. The initial focus of macroeconomic manage-ment was along these lines.

The first part of this paper will feature a briefoverview of macroeconomic policies in Malaysiabefore the crisis. Following this, it will deal with de-velopments during the crisis period, while comment-ing on and discussing measures taken by Malaysiato alleviate and remedy the situation.

Overview of MacroeconomicPolicy Management in theYears Preceding the CrisisThe main objective of Malaysia’s macroeconomicpolicy is to promote the highest sustainable rate ofgrowth consistent with exchange rate and price sta-bility, while at the same time keeping control on in-flationary trends and improving external balances.

Interest Rates and Credit PolicyInstrumentsIn 1987, guidelines and measures were instituted toimprove and rehabilitate the financial sector. The gap


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between lending and deposit rates narrowed andcompetition began to intensify. The central bank re-viewed the interest rate system and in February 1991,controls on the base lending rate (BLR) were lifted.The behavior of the BLR and interest rates fell morein line with the market, and the spread between av-erage lending rates and the average cost of funds ofcommercial banks further narrowed in the early1990s.

In 1989, the statutory reserve requirement (SRR)was revised to one uniform rate applicable to all com-mercial banks, merchant banks, and other financialinstitutions to level the playing field (Economic andSocial Commission for Asia and the Pacific 1997).The central bank was also able to make use of thisrequirement as an effective tool for monetary controland to contain inflationary expectations. Between 1992and 1994, Malaysia experienced large capital inflows.During this period, the central bank adopted a tightmonetary policy and increased the statutory require-ment to mop up excess liquidity in the system.

Among other monetary tools employed by BNMto reinforce the policy impact were the minimum li-quidity ratio, the management of the Government’sexcess funds, and the Employees’ Provident Fund(EPF). (At the end of 1993, excess funds from theEPF were placed in a money market account at thecentral bank.) The management of these funds al-lowed the Government to mop up liquidity at sourceto ensure consistency between its fund allocation andmonetary policy as well as to enhance flexibility inmonetary management.

Continuous capital inflow into the economy in thefirst half of the 1990s arising mainly out of relativelylow interest rates and liberal exchange control sys-tems in developed economies; Hong Kong, China;and Singapore increased pressure on BNM to con-trol money supply. There were then conflicting ob-jectives between a contractionary monetary stancemeant to control inflation and the need to maintainlow interest rates to discourage more speculativefunds. Similarly, monetary aggregates became in-

creasingly difficult to interpret as a result of theinteraction of externally induced growth of moneysupply with the rapid rise in money demand due tothe wealth effect of rapid economic growth and theneed to finance the buoyant stock market. The cen-tral bank, in its interventions, had to ensure that rais-ing interest rates to reduce consumption would notdampen investments. Thus, as part of its strategy,BNM intervened in the foreign exchange markets.When foreign interest rates were lower, local inter-est rates were reduced while maintaining the gap.

BNM also used direct short-term borrowing fromthe interbank money market on a large scale to ster-ilize the large inflow of funds. To prevent a furtherreduction of interest rates, Malaysian Governmentpapers were issued. In 1993, a series of Bank Negarabills (BNB) and Malaysia Saving Bonds comple-mented these. Nevertheless, short-term inflows per-sisted and such funds normally result in an immedi-ate increase in the monetary base without a corre-sponding increase in fixed investments. The volatil-ity of these funds creates instability in both the do-mestic and external sectors. In 1994, sterilizationmeasures were eased as tight liquidity was pushinginterest rates up, resulting in continuous capital in-flow. Direct controls were then imposed. These in-cluded the introduction of a ceiling on the net exter-nal liability position of commercial banks, prohibitionon the sale of short-term monetary instruments tononresidents, and prohibition on banks from buyingforeign currency forwards. Measures requiringnontrade related foreign funds to be subjected to theSRR were also imposed (nonspeculative funds andthose placed in noninterest bearing external accountswere exempted). Similarly, limits on swap transac-tions with foreign clients were imposed occasionally(e.g. in 1988/89 and 1992).

Malaysia also engaged in moral suasion to dis-courage excessive lending for speculation and toencourage long-term financing on the basis of viabil-ity rather than collateral as well as to increase lend-ing to priority sectors. By the second half of 1994,


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differentials between domestic and international in-terest rates had narrowed and even became nega-tive, resulting in a net outflow of short-term funds.Direct controls were then lifted in response. In 1995,the BLR framework was revised again and wasaimed at enhancing the responsiveness of the BLRto money market conditions and the liquidity situa-tion of the financial system. This was meant to en-hance institutions’ efficiency.

Exchange RatesIn 1989 and similarly in 1992, BNM imposed restric-tions on the liberalized exchange market to reducespeculation by limiting nontrade related currencyswap transactions (Claassen 1992). As the Malay-sian economy began its high growth path and theGovernment implemented deliberate policy measuresto curb capital outflows, the situation began to re-verse when the value of the ringgit appreciated atthe start of the 1990s. These measures included thesale of Government securities and increases in statu-tory reserves. The position was also helped by aweakening of most major currencies during the pe-riod. The ringgit’s rise began to reverse after 1991,mainly due to persistent current account deficits. Thesituation experienced a dramatic turn at the end ofApril 1997, affected by the now historic consolida-tion of the stock market and short-term capital out-flows.

Under a flexible exchange rate system, capitalinflows will lead to the appreciation of the recipientcountry’s currency, a reduction in the relative priceof imports, and a shift in consumption away fromnontradables. All these eventually tend to alleviateinflationary pressures. Under a fixed exchange ratesystem or a managed float, the impact depends onwhether the inflow leads to an expansion of the mon-etary base, heightened inflationary pressures, or adeterioration of the country’s external position. Ma-laysia does not maintain a fully flexible exchange rateregime. Occasional interventions by the Governmenttake place to smoothen fluctuations.

The Financial SectorThe Malaysian financial sector has experienced aradical transformation and deepening in tandem withthe development of its economy since the 1980s.Reflective of these developments, the current finan-cial intermediation regime has become much broader,deeper, better structured, and more purposefully or-ganized compared with the relatively simple struc-ture during the postindependence years.

Malaysia has not initiated full-scale financial lib-eralization. In the past, the main pillars of reformhave been the reinstatement of interest liberaliza-tion, the liberalization of foreign exchange and capi-tal transactions, the easing of restrictions on busi-ness, the improvement and expansion of regulatoryand supervisory structures, and the development ofthe capital market. Full-scale liberalization is inevi-table as the World Trade Organization (WTO) hasmade it mandatory for all member-nations to adopt afreer policy on services by the year 2003 through theGeneral Agreement on Trade in Services (GATS).(Under Malaysia’s offer schedule for services, nonew entrants are allowed into the banking subsector,except through share acquisition of existing firms.)

As the economy continued to improve in the late1980s and early 1990s, more vigorous measures wereinstituted to strengthen and modernize the system.They were also meant to promote greater competi-tion within the banking system. In the early 1990s,Malaysia began paving the way for a more devel-oped securities market infrastructure in line with itsdevelopment. In 1992, the Securities Commission(SC) Act was passed. The SC, set up to oversee theefficient and overall development of the capital mar-ket, began operations in March 1993. Its responsi-bilities include the regulation of the securities indus-try, unit trust schemes, and mergers and acquisitionsof companies. The Futures Industry Act, aimed atfacilitating financial innovations to develop the op-tions and financial futures markets, came into forcethe same year. This established the legal frameworkfor the protection of investors and stability in the


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marketplace by setting up the minimum standardswithin which the markets should operate (MIER1998).

As foreign funds continued to flood the country in1992–1993, the Government prohibited all residentsfrom selling short-term monetary instruments (thosewith remaining maturity of one year or less, namelyBNBs, Treasury bills [T-bills] and Government se-curities) to nonresidents with effect from 24 Janu-ary 1994 under the Exchange Control Act of 1953.This restriction was subsequently extended to coverprivate debt securities (PDS) including commercialpapers but excluded securities convertible into ordi-nary shares, effective 7 February 1994. The movewas meant to discourage substantial holdings of mon-etary instruments by nonresidents to enable the cen-tral bank to better manage liquidity.

When the Asian crisis hit, many claimed that theMalaysian economy would not have been so badlyaffected had the financial system been sound andbetter managed such as those of Singapore andTaipei,China. Such an assessment is not easy to quan-tify or prove. Nevertheless, it must be realized thatdespite the financial reforms and adjustments sincethe 1980s, weaknesses obviously prevailed and thequestion of efficiency still existed.

Fiscal PolicyCountries react differently to external shocks and inmany of those that have been successful in avertingcrises, sound fiscal management and stable exchangerates have been among the elements playing a vitalrole. In Malaysia, fiscal policy has generally beendirected at revenue generation and the provision ofexpenditures to support basic infrastructure as wellas maintaining law and order.

As the economy continued to grow rapidly afterthe crisis of the mid-1980s, there did not seem to beany need for large fiscal stimuli. When BNM cau-tioned that the economy might be overheating in theearly 1990s, prudence and measures to moderategrowth were recommended. This was, in fact, fol-

lowed by a tighter monetary policy. The high-growthclimate of the first half of the 1990s presented theopportunity for the Government to address tax re-forms. Paradoxically, however, fiscal policy did notmove in the direction it should have.

In the preceding years, liberal personal and cor-porate income-tax cuts, and other tax-based incen-tives were used to stimulate recovery. This under-mined the tax system as an essential source of rev-enue. Given the increasingly competitive economicenvironment among regional countries, any move toreverse this would most likely have affectedMalaysia’s competitiveness. However, an indirect taxsystem could have been introduced whereby the po-tential to raise revenue was restored. Although theneed for such a system was recognized earlier in thedecade, nothing came of it (Narayanan, 1998). Infact, from 1992, there was a move towards a fiscalloosening leading to further cuts in corporate andpersonal taxes, the lowering or abolition of importtaxes on a variety of imports (primarily consumptiongoods), and increased federal Government spend-ing. In 1992, expenditures increased with the deci-sion to raise the salaries of civil servants.

Continued high growth in 1993 yielded a surplusin the public sector budget and eventually blinded theGovernment from realizing the urgency and wisdomof a turnaround in fiscal spending. In such periods, arationalized indirect tax structure would have helpedto remove distortions, contributed to moderatinggrowth, and simultaneously curbed inflationary pres-sures. It would also have laid down the infrastruc-ture for an eventual introduction of a broad-basedtax on consumption such as the value-added tax(VAT). Politically it would have been the right mo-ment for such a move as incomes were fast rising. Itwas, however, not to be so.

International Trade, Industrial andInvestment DevelopmentTrade has been one of the essential elements con-tributing to Malaysia’s growth over the past two de-


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cades. The country has a small domestic market andas a trading nation, it has always adopted one of themost open policies in Asia. Essentially, its trade poli-cies are closely related to its industrial developmentpolicies.

INDUSTRIALIZATION AND INVESTMENTDEVELOPMENT POLICIESAfter the crisis of the mid-1980s, policy essentiallyshifted from an inward-looking, domestic-orientedstrategy to one that was outward-looking. The es-tablishment of the Industrial Master Plan (IMP) for1986–1995 provided a long-term indicative plan fordevelopment. It emphasized export-led growththrough industrial diversification, provision of a lib-eral investment climate, and promotion of industry-linkages. The second half of the 1980s thus saw theenhancement of private investment and the develop-ment of a more focused policy orientation. The liber-alization measures under the IMP were consolidatedin the 1990s and are considered to have been crucialin lifting the country out of the crisis.

Official policy has been the main driving force inthe determination of industrial and technological de-velopment in Malaysia. It has been substantiallygeared towards the promotion of foreign investmentin the country. The neoclassical approach often sug-gests an end to government regulation and interven-tion, or if not, only a market-enhancing role for theState. The State’s role should be limited to effectivedevelopment planning. Nonetheless, in most of EastAsia, government intervention in industrial and in-vestment planning has always been a widespreadpractice and in Malaysia, the success of industrialdevelopment has been largely attributed to the gov-ernment-business nexus.

The Plaza Accord1 signed in 1985 was one of the

first catalysts of the relocations of investment andproduction from Japan and the first-tier East Asiannewly industrialized economies (NIEs) to the region.This thrust was further exacerbated by the withdrawalof Generalized System of Preferences (GSP) privi-

leges from these NIEs in 1988 and the economicand financial deregulation undertaken by East Asiancountries in subsequent years. As manufacturing hasbeen pinpointed as the engine of growth since thelate 1980s, emerging and rapidly industrializing econo-mies in East Asia aggressively competed for foreigninvestment. As a consequence of this increased com-petition, the Malaysian Government launched thedomestic investment initiatives (DII) in 1993 to en-courage more domestic investment. Strategies underthe DII include increased domestic content in localoutput, strengthening and deepening of the local capi-tal market to support domestic investment as well asdeveloping domestic anchor companies, and small- andmedium-size industries (SMIs) to provide greater andenhanced industry linkages. In the same year, theamount of approved domestic investment exceededforeign investment approvals by 19 percent.

While pursuing active industrial policies and at thesame time promoting local industries, Malaysia con-tinued to adopt an effectively “open-door” policy inthe majority of sectors, encouraging foreign directinvestment (FDI) inflows. It became one of the larg-est host countries for FDI during the period and in1995 received the biggest share of FDI in the Asso-ciation of Southeast Asian Nations (ASEAN) region.In all, the electrical and electronics industry receiveda substantial chunk of foreign capital and the prod-ucts were mainly directed to the export market. Sincethe early 1980s, this industry has grown tremendously,and has generated massive growth and helped buildup downstream industries. It was also strongly in-strumental in contributing to overall manufacturingemployment. Besides transferring capital technologyto developing economies, foreign capital also con-tributes to locating new market outlets for the hostnations as a substantial proportion of FDI flowinginto Malaysia (as in most other Southeast Asian coun-tries) is export-oriented, and thus elemental in en-hancing international trade.

However, the high growth generated also meantan acute shortage of labor, and hence rapidly rising


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labor costs. Rising costs unmatched by productivityand inadequate skills became a serious concern tothe Government and investors alike. Recognizing theneed to phase out labor-intensive industries, the Ma-laysian Government embarked on a strategy to at-tract investments with high value-added by introduc-ing the Second Industrial Master Plan (IMP2). Thenew Master Plan promotes the “Manufacturing PlusPlus” concept and the cluster approach to enableMalaysia to reach industrialized status. It concen-trates on the qualitative trend of FDI and stressesglobal competitiveness and productivity as the primemotivators for the future (Institute of DevelopingEconomies [IDE] 1998). The cluster approach willprovide the basis for a more integrated and cohesiveframework for industrial development. The Govern-ment has also set a target for the share of domesticinvestment to make up 60 percent of total invest-ment in the long term. In 1996, the ratio of domesticinvestment to foreign investment stood at 50.1 per-cent (56.2 percent in 1995). The decline was due toa relatively high flow of foreign capital that year.

Overall, the new scenario is meant to develop andenable Malaysian manufacturing to rapidly adapt tothe globalized business and industrial environment.New incentives will be proposed to enable manufac-turing to remain competitive within the liberalizingtrade regime through the realization of the ASEANFree Trade Area (AFTA). In all, industrial policies inthe 1990s have been forward-looking and compre-hensive.

INTERNATIONAL TRADE POLICIES ANDLIBERALIZATIONThe post-Soviet era has witnessed dramatic changesin the international economy. As the process of glo-balization and internationalization of the worldeconomy intensifies, an increasing number of coun-tries are liberalizing their economies and adoptingexport-oriented growth strategies. During the 1990sand especially after 1995, export incentives and tar-iffs began to decline as a result of domestic policy

reforms as well as changes necessitated by WTO,and regional trading arrangements such as AFTAand Asia-Pacific Economic Cooperation (APEC).As a result, the real sector began experiencing ac-celerated trade liberalization (Rasiah 1998).

In order to benefit from better products and enjoyaccess to better inputs, components, and technology,it will be important for a country to accept the re-sponsibilities and obligations that come with its levelof development. Malaysia is thus committed toworldwide liberalization efforts. Nevertheless, it ad-heres to the doctrine that any liberalization will de-pend on each country’s capacity and ability to copewith competition (IDE 1998). Malaysia has madethe following commitments:

• continue to reduce tariffs on imports in line withtrade liberalization efforts and multilateral com-mitments under WTO and AFTA;

• review nontariff measures with a view to relax-ing them when appropriate;

• gradually liberalize the services sector underGATS;

• eventually allow greater foreign participation inthe stockbroking and leasing sectors under theinterim financial agreement;

• provide market access for various businessessuch as telecommunications and hospitality ser-vices; and

• undertake various facilitation measures in areassuch as standards and conformance, customs,and protection of intellectual property rights.

Vulnerability andUnderlying WeaknessesNobody would have expected at the onset of the cri-sis that its repercussions could have been so severe.The beginning of summer 1997 still saw companiesenthusiastic about investing in emerging Asia. Severaleconomists in the West had cautioned East Asia aboutthe possibility of the bubble bursting in the mid-1990s.Lau and Kim (1992) and Young (1994) commented


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that East Asia’s growth had been more “a matter ofperspiration than one of inspiration.” Nevertheless,when the going was still good, would most have takenheed of “academic” theories? Warning signs hademerged by the middle of the decade. Overheatingeconomies, severe infrastructure bottlenecks, and bigdeficits should have been the first signs for caution.

The regional macroeconomic environment hasmostly been considered favorable. Malaysia’s mac-roeconomic management was seen as sound by anystandards with considerable fiscal discipline andmonetary policy prudence. The economy posted bud-get surpluses for five years consecutively after 1993.At the same time, BNM was able to maintain finan-cial stability by successfully sterilizing short-termcapital flows. The Malaysian savings rate remainedat a high of nearly 40 percent of GNP. External debtswere low (about 42 percent of GNP) and externalreserves were at a comfortable level. Capital inflowscontinued, but over a very short period, a reversal offortune and confidence occurred.

Essentially, contagion was only part of the story.At the same time, it must not be denied that cur-rency speculators played a predatory role in the event.Unfortunately, investors tended to perceive that alleconomies in the region are identical. Herd behaviordriven by panic and hysteria led to a wholesale pull-out of funds from the region. Thus, the speculative

attack on the Thai baht amid concerns of a slow-down in exports, high short-term external debt posi-tion, overvaluation of the currency, and the decline inasset prices led to the belief that similar risks werepresent in other regional economies.

Looking at the situation, one must perhaps con-cede that currency speculators, after all, aremessengers with a message that all may not be wellat home (Ariff 1999). Were there reasons forMalaysia’s economy to be vulnerable then? To beginwith, macroeconomic figures can conceal underly-ing weaknesses. The economy was already over-heating due to the rapid high growth since the late1980s. This may be evidenced by the persistentlylarge balance of payments and current account defi-cits since 1990. In fact, it could be clearly inferredfrom an analysis of the situation before the crisisthat internal and external factors played a part inending Malaysia’s “miracle.”

During the initial phase of the crisis, Malaysiaadopted a set of stabilization measures and financialsector reforms that were similar to the InternationalMonetary Fund’s (IMF) prescription for the othercrisis-affected regional economies, though Malaysiawas not under the IMF program. The policy pack-age was essentially a combination of tight fiscal andmonetary policies accompanied by financial sectorreforms (Table 1).

Table 1: Wrong Turns Taken During the Initial Stage of the Crisis

Particulars

Measures were introduced to drastically reduce credit growth. Among them were the impositionsof stringent limits on lending to the property sector and for purchase of shares and the introductionof credit plan to limit loan growth.In January 1998, Bank Negara Malaysia (BNM) announced a merger program for finance compa-nies. This program, while intended to rationalize finance companies to increase their resilience,was untimely.BNM’s policy to increase interest rates by raising its three-month intervention rate from 8.7 percentat the end of 1997 to 11 percent in early February 1998, while intended to address inflationaryexpectations, raised the cost of loanable funds and debt service commitments.The reclassification of NPLs to strengthen prudential supervision was untimely. It increased lossesto financial institutions and weakened their lending capacity at a time when liquidity was tight.

In order to address the problem of tight liquidity in the financial system, BNM opted to lend its ownfunds to the banking system at prevailing market rates causing unnecessary losses to banks.Federal Government expenditure was reduced by 18 percent, resulting in the deferment of severalpublic sector projects and exacerbating the slowdown in economic activities.

Source: Malaysian Government 1999.

Measures

Curb of credit growth

Untimely merger programfor financial companies

Increase in interest rates

Revision of nonperformingloan (NPL) classificationfrom six to three monthsApproach used toincrease liquidityCut in Governmentexpenditure


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Erosion in CompetitivenessMalaysia’s exports began to experience an erosion incompetitiveness partly due to rising costs and partlybecause of the overvaluation of the ringgit. The de-valuation of the People’s Republic of China’s (PRC’s)yuan in 1994 and the depreciation of the Japanese yeneroded Malaysia’s export competitiveness. At the sametime, the dollar appreciated in the couple of years pre-ceding the crisis. With the ringgit and most East Asiancurrencies “quasi-pegged” to the dollar, this trend be-gan to undermine the region’s competitiveness.

Resource Misallocationand Loss of EfficiencyThe high GDP growth was essentially input-drivenand not productivity-driven. Total factor productivity(TFP) was beginning to plunge into negative terri-tory. Productivity could not keep up with rising wages.It averaged 0.9 percent per year between 1991 and1996 and 2.9 percent between 1987 and 1990. Itscontribution to GDP growth declined from 28.7 per-cent between 1991 and 1995 to 19.5 percent during1996-1997 (Malaysian Government 1999) .

As can be seen in the rising incremental capital-output ratio, there has been inefficiency in capitalallocation. There has also been a diversion of re-sources from the real sector into speculative activi-ties; while within the real sector itself, there was di-version into nontraded activities such as the propertysector and the construction of various mega-projects.Such an exaggerated expansion of investment led toa worsening of the current account deficit.

Excessive Credit Expansionand Diversion of Resourcesto Nonproductive SectorsOver the period, excessive credit disbursement by thebanking sector to nonproductive sectors (defined toinclude the broad property sector, consumption credit,and loans for the purchase of stocks and shares), be-came a major cause for concern. Between 1992 and1994, loans were growing at an average rate of 12.2

percent but by 1995, the rate had risen to 28.6 per-cent. In 1996, it eased slightly to 26.7 percent but inearly 1997, it increased again to reach a worrisomelevel of close to 30 percent. As a percentage of nomi-nal GDP, the loan-GDP ratio rose strongly from 103percent between 1992 and 1994 to an excessively highlevel of 135 percent in June 1997.

2 Loans disbursed

to the property sector accounted for the largest share,constituting 31.8 percent of total loans in June 1997and were growing at a high rate of above 30 percentfor most of 1997.

3 Substantial lending to the property

sector was attributed to the construction boom. Thesurge in property prices was reflected by the Malay-sian house price index (MHPI), which grew by 25.5percent and 12.2 percent in 1991 and 1992, respec-tively. This encouraged involvement in the propertymarket in view of profit expectations. “Moral hazard”also played a large part in the rise in unproductiveinvestment and loan disbursement, often leading banksto perform only a cursory review of projects and toprovide loans for unprofitable or unproductive sectorssuch as property development, stock market specula-tion, and consumption credit.

Escalating Savings-Investment Gapand Current-Account DeficitMalaysia may boast of one of the highest savingsrates in the world, hovering at about 38 to 40 per-cent; nevertheless, the rate of investments was con-sistently higher at above 45 percent during the 1995–1997 period. By the middle of the 1990s, the sav-ings-investment gap was behind the current accountdeficit. In the past, this gap was bridged by Malaysia’sheavy reliance on FDI. However, high inflows offoreign investment and foreign debt actually resultedin hefty investment income outflows overseas. (Whileexternal debts remained comparably low, domesticdebts were excessively high. They represented about160 percent of GDP by the end of 1997, which wasthe highest level of domestic indebtedness in South-east Asia [Athukorala and Warr 1999].) Arguably,the current account deficit per se may not be a prob-


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liberalization, the long-term costs seem to have out-weighed the benefits.

Lack of Institutional Infrastructureand Deficient GovernanceThere have been accusations of nepotism, cronyism,and bad governance prevailing in East Asian busi-ness and malpractices within governments in the wakeof the crisis. There may be a half truth in these alle-gations as many of these elements are not necessar-ily unknown in developed nations either. It must, nev-ertheless, be admitted that, in terms of governanceand institutions, Malaysia (and most of East Asia)still has a certain way to catch up. The country lacksthe necessary institutional infrastructure that shouldgo hand in hand with industrial deepening. Similarly,institutions necessary to generate the required hu-man resources for these industries remain underde-veloped. Even though Malaysia has launched sev-eral commendable initiatives to upgrade human re-sources through a strengthening of institutions andthe development of infrastructure and support sys-tems, real progress has often been limited or ham-pered by problems of coordination. The transition froma labor-intensive economy to a technology-based onenecessitates institutional support. Similarly, a higherdegree of transparency will provide more fertileground for good governance to breed.

High Debt-Equity RatiosAt the micro level, debt-equity ratios of many corpo-rate entities have been abnormally high. In addition,there have been chronic mismatches, with short-termborrowings being employed to finance long-term in-vestments (Ariff 1999). As a whole, nonperformingloans (NPLs) of the financial sector hovered at a not-too-alarming figure of 10 percent but certain bankshad NPL ratios exceeding 40 percent (based on theinternational definition of bad loans as those not ser-viced during the preceding three months). In spite ofthe sweeping reform measures carried out followingthe 1985–1986 crisis, unsound practices within the

lem but the financing of the deficit does matter. In1994 and 1995, the current-account deficit was onlypartially financed by net long-term capital inflows.Reliance on short-term capital to cover the current-account deficit is not tenable in the long term be-cause of the volatile nature of this form of capital.At the same time, sharp increases in the outflow of“reverse investments” between 1995 and 1997 byMalaysian companies to finance long-term projects(with no prospects of early returns) have inadvert-ently exacerbated the country’s balance of paymentproblems. In addition, many of these outward invest-ment projects in new emerging regions failed miser-ably because of the lack of proper analysis or de-tailed studies prior to investment.

LiberalizationSince 1996, there has been a sharp decline in FDIflowing into Malaysia. This has had significant reper-cussions on the economy. The downturn was causedby factors such as the reduction in Japanese invest-ments overseas following the fall in value of the yen,and perhaps more important, the tight labor supply inMalaysia. In the past, the country’s abundant laborsupply had been one of the main attractions for labor-intensive industries. To some extent, the decrease inFDI was offset by an increase in portfolio investment,which gained importance beginning in 1993 followingmeasures to liberalize the capital account. Short-termportfolio investments can be a source of instability asthey are notorious for being extremely “footloose” anddependent on investor sentiment. Any slight hint ofeconomic, political, or social instability in the countryor region may well result in capital flight.

Capital account liberalization may have its ben-efits, the most important of which would be accessto international savings, but it could also prove to bea precarious step if an economy is not ready for it.Malaysia has tended to walk the thin line betweenliberalization and the continued protection of certainkey industries at the same time, one of which is thefinancial sector. However, in terms of capital account


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financial system and poor corporate governance con-tinued. These, admittedly, also contributed to the fi-nancial crisis. Rising M2 relative to international re-serves, the ratio of which increased from 3 percent inthe early 1990s to 4.7 percent at the onset of the cri-sis, was another indication of the growing vulnerabil-ity of the Malaysian economy. This rise eroded theability of the economy to defend the currency(Athukorala and Warr 1999). Thus, not all was well.

Further CommentsGlobalization has become an inevitable phenomenonbut free and uncontrolled capital movements will poserisks to the international financial system in the fu-ture. Investors may have been blamed for their herdbehavior but are they not just behaving in a humanlyfashion when confronted with possible or impendinglosses? Malaysia and a few other countries havecalled for a revamp of the international financial sys-tem. While this may not be easy or readily accept-able to all, guidelines and prudential regulations couldand should be established gradually, in conformitywith international norms and practices, to reduce risksresulting from speculation and uncontrolled globalcapital flows. Politically, more transparency and lib-erty will also serve to enhance the situation and cre-ate a more fertile ground for better practices to breed.Internal as well as external elements had a hand inending Malaysia’s (and the region’s) “miracle.” Un-derstandably, as the country’s fundamentals havealways been considered to be good, the Government’sinitial response was to look for causes externally.But there is still much work in store internally.

MacroeconomicDevelopmentsDuring the CrisisPolicy InitiativesAs turbulence struck, a series of policy packageswas introduced (see Appendix). The measures, how-

ever, evolved with the changing circumstances dur-ing the course of the crisis. Although Malaysia re-jected the IMF aid package, the initial approach was,in fact, IMF-inspired. This section will discuss theevolution of Malaysian Government macroeconomicpolicies since the onset of the crisis to the present.

THE INITIAL MONTHS: INTERNATIONALMONETARY FUND-INSPIRED TIGHTMONETARY AND FISCAL POLICIESIn the initial phase of the crisis, macroeconomic policygenerally focused on addressing areas of vulnerabil-ity and priority, notably:

• restoring confidence and stability in the financialmarket,

• containing inflationary expectations associatedwith ringgit depreciation,

• controlling excess domestic demand resultingfrom rapid credit growth,

• managing the current-account deficit in the bal-ance of payments,

• strengthening the resilience of the financial sec-tor in order to avoid systemic risks, and

• maintaining export competitiveness and the stan-dard of living.

The tight monetary policy already in place beforethe crisis was further tightened. The policy pack-ages announced during the final quarter of 1997 andduring the presentation of the 1998 Budget weremainly directed at maintaining tight monetary and fis-cal policies while sustaining investor confidence inthe financial market. Further policy measures wereannounced as 1998 unfolded. The National EconomicAction Council (NEAC) was established to act as aconsultative body to the Cabinet to deal with the cri-sis in early January.

Interest rates were raised in line with the expectedhigher rate of inflation. This would then ensure apositive return rate to savers. The central bank fur-ther curbed loans and a credit plan was introducedto limit the growth of loans to 25 percent by the endof 1997, 20 percent by the end of the first quarter of


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1998, and 15 percent by the end of 1998. Stringentguidelines on hire purchase and property lending (ex-cluding low- and medium-cost residential properties,factories, and industrial buildings) were issued.

Fiscal spending was scaled down. Governmentexpenditure was reduced and the implementation ofvarious infrastructure projects was either cancelledor deferred. The objectives were to reduce importsand to address the problem of excessive credit growthas well as the high leverage of some corporations.

Simultaneously, prudential regulations of the finan-cial system were adjusted to bring them in line withinternational norms. NPLs were reclassified as loansin arrears for three months instead of six months asMalaysia had previously stipulated. The rate for gen-eral provisioning was increased and the central bankpursued a merger program for finance companies.

Nevertheless, maintaining this delicate balance ofpursuing tight monetary and fiscal policies withoutexcessively affecting the already slowing economicgrowth was made difficult by a volatile external fi-nancial environment.

The “virtual IMF policy” eventually brought morepain because it was contractionary. Given the strengthof the Government financial position, there was noneed for such a drastic slash on expenditure. Thecombination of a tight monetary policy, fiscal restraint,and financial sector restructuring measures managedto contain price increases and succeeded in bringingthe balance of payments from a deficit to a surplusposition, but they severely dampened private sectorbusiness activity. The measures only served to worsenthe cash flow problem of businesses already badlyaffected by the ringgit’s depreciation. The effects ofthe initial response could perhaps have been less se-vere if a more moderate policy had been imple-mented. Rapid increases in interest rates might haveseemed a short-term measure but eventually such amove would only further choke an already strugglingeconomy. The interest rate rises could have beenmore restrained while allowing other measures to bephased in.

THE EXPANSIONARY STAGEAny easing of interest rates to boost spending wouldhave sent the ringgit and investor confidence on afurther downward spiral while high interest rateswould have continued to choke the business com-munity. As the economy continued to plunge into adeep recession in the first half of 1998, declining4.8 percent, policymakers began doubting the fea-sibility of the combined tight monetary and fiscalpolicy regime. The second quarter contraction of6.8 percent in the GDP (MIER 1998) prompted arethink. After the brief experiment with IMF-stylemacroeconomic measures, the Malaysian Govern-ment moved in the opposite direction, initiating mon-etary and fiscal expansion as the middle of 1998unfolded. In July 1998, it launched the NationalEconomic Recovery Plan (NERP), providing a com-prehensive framework for an economic turnaround.Its objectives are to:

• strengthen macroeconomic fundamentals,• stabilize the national currency,• restore market confidence,• restore severely affected sectors,• continue with the socioeconomic agenda, and• maintain financial stability.NERP recommends the easing of monetary and

fiscal policies and lowering the cost of capital to re-vitalize the economy. Its recommendations include awide-ranging proposal for economic stabilization andstructural reforms while at the same time, address-ing socioeconomic priorities, the implementation ofwhich will be scrutinized by NEAC.

Interest rates peaked in June 1998. The three-month interbank rate, which rose to an average of11.05 percent in June 1998, declined to 10.22 per-cent in August. In the same month, there were threedownward revisions in the three-month interventionrate of the central bank, bringing the rate down by150 basis points (bp). By November 1998, it had fallento 7 percent. The lowering of the SRR had, in fact,begun in mid-February as it fell from a high of13.5 to 10 percent. It continued to be subsequently


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lowered in stages in the following months. The BLRfor commercial banks declined from 11.96 percentin March 1998 to 8.05 percent in March 1999. How-ever, BNM’s attempt to step up bank lending to8 percent as announced late in 1998 failed, mainlydue to depressed credit demand. Loans for the lowerend of the housing market were stepped up while amoratorium was imposed on loans for office andshopping malls, which faced an acute glut.

The lowering of interest rates, nonetheless,sparked accusations that investment flows would bediscouraged. Such accusations are unfounded as lowinterest rates are a boon for the bond market and ahigh interest rate is not the sole criteria to attractforeign capital during “abnormal circumstances.”These investment flows include portfolio funds de-spite the fact that interest rate considerations tend tobe one of the factors that they are sensitive to. (FDIis generally not influenced by the interest rate-ex-change rate factor. Foreign investors tend to look atthe regional market as a whole rather than focusingon an individual market.) High interest rates in Ma-

laysia in the months following the onslaught of thecrisis did not result in an inflow of capital. Rather,high interest rates during the period served to deter aflight of domestic funds in search of better returnsoffered by offshore facilities.

Simultaneously, the Government introduced a fis-cal stimulus package of RM7 billion (Table 2), ex-panded existing funds, and set up new specializedfunds targeted at specific priority sectors. The stimu-lus package would see the overall public sector ac-count registering a manageable deficit of 1.8 per-cent of GNP in 1998 and 5.5 percent in 1999 (Ma-laysian Government 1999). The Government also lib-eralized the equity policy for the manufacturing sec-tor to further promote FDI. Certain sectors includingtelecommunications, shipping and forwarding, insur-ance, tourism, and Multimedia Super Corridor (MSC)-approved activities saw a relaxation of the 30 per-cent limit imposed on foreign ownership. (The relax-ation in equity policy applies to applications receivedbetween 31 July 1998 and 31 December 2000, aswell as those already received but pending approval.)

Table 2: Fiscal Measures to Restore Economic Growth


• Restoration of the previous cut in the federal Government expenditure for 1998.• Provision of an additional allocation of RM7 billion for development expenditure for projects meeting the following criteria:

– enable import substitutions and increased exports of goods and services,– generate demand for domestic goods and services,– increase efficiency and national competitiveness,– short gestation period,– will not cause a decline in reserves nor outflow of liquidity, and– provide assistance to the poor and lower income group.

• Based on these criteria, the above allocation was channeled towards infrastructure and public facilities, industrialdevelopment, rural development, housing, education, and health.

• Provision by the National Housing Company Berhad of bridging finance to developers for the construction of housescosting RM150,000 and below.

• Establishment of an Infrastructure Development Fund, with initial allocation of RM5 billion, to assist in the financing ofinfrastructure projects.

• Tax exemptions on 70 percent of statutory income from the increased value of export sales for companies grantedinternational trading company status and that are at least 70 percent Malaysian-owned or using local facilities.

• Stamp duty exemption for the refinancing of loans for business purposes and for purchase of property under the HomeOwnership Campaign.

• Imposition of income tax on actuarial surpluses actually transferred to the Shareholders’ Fund as compared with thepresent practice, which is based on accrual principle.

• Abolition of excise duty on refrigerators, television sets, and air-conditioners to enable local manufacturers to competewith manufacturers from other Association of Southeast Asian Nations (ASEAN) countries when the ASEAN Free TradeArea (AFTA) is implemented.

• Change in the tax assessment system from one based on the income derived in the preceding year to the current yearbeginning from 2000.

• Introduction of tax incentives to promote domestic tourism.


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In recessions, expansionary fiscal policy makesconsiderable sense although the question of financ-ing large deficits may be of concern, especially sinceaccess to foreign funds is limited while there are otherdemands on domestic funds (Ariff 1999). Keynesianpolicies, too often derided in the recent past, couldhave gone down as a better remedy, and perhaps,helped avoid such a severe slide if they had beenprescribed much earlier. For the present, financingsuch budget deficits may not be a serious problem.The Government should, nevertheless, proceed withcaution as severe financial constraints may surfacein the future because budget deficits are more thanlikely to persist over the next few years.

SELECTIVE EXCHANGE CONTROLS—A MOVEINTO CONTROVERSYAfter the change in policy orientation, Malaysia be-gan to see some progress in containing inflation, im-proving its external balance, and maintaining lowexternal debt exposure, as well as keeping externalreserves intact. However, the economy continued toremain vulnerable to external developments, espe-cially the instability in regional financial markets. Simi-larly, this also affected the progress of the reforms inthe country. The increasing outflow of the ringgit,attracted by higher interest rates elsewhere withinthe region (international offshore centers were of-fering between 20 and 40 percent while the onshorerate was only 11 percent), was becoming a seriousthreat to the economy. With little room for maneu-ver, selective capital controls (Table 3) and the peg-ging of the national currency to the dollar were im-

posed on 1 September 1998 to insulate the economy.The dilemma was obviated. The controversial move,nonetheless, was both lauded and attacked by vari-ous quarters all over the world. The objectives werebasically to:

• eliminate speculation by declaring offshore ringgitnonlegal tender,

• contain speculative capital,• stabilize short-term capital flows, and• maintain the stability of the financial market in

order to proceed with reforms unhindered.Many countries have, in fact, begun to see the

urgency and the necessity for some form of mecha-nism or regulation on short-term volatile funds in or-der to avoid another crisis of this magnitude. Thiswas especially so after the effects of the Asian cri-sis spilled over to Latin America and Russia. Selec-tive controls may not necessarily be a bad thing pro-vided that they are implemented only to provide atemporary respite for the affected country to under-take reforms. It can then rejoin the world economyonce it is ready. However, distinction will have to bemade between measures to discourage inflows andthose to restrict outflows. As controls on outflowsare often imposed during times of crisis where thereis increased volatility in financial variables and ex-change rates, there is a possibility that they will dis-courage potential investors because they are some-times thought to indicate “worse times on the hori-zon.” Following the imposition of capital controls, thecentral bank’s three-month intervention rate droppedfurther to 7 percent. The controversial move enabledthe system to accommodate an expansionary policy.

Table 3: Selective Capital Controls


Controls On• Ringgit-denominated transactions among nonresidents via

nonresident external accounts.• Outflows of short-term capital by requiring such inflows to

remain in the country for a minimum period of a year.• Import and export of ringgit by travelers, residents, and

nonresidents.• Malaysian investment abroad by requiring approval as there

are insufficient funds to be taken out. Capital may, however,be raised abroad, collateralized by foreign assets.

No Controls On• Current account transactions. Amendments to rules

require only that trade transactions for goods andservices are to be settled only in foreign currencies andno longer in domestic currency.

• Repatriation of interest, dividends, fees, commissions,and the rental income from portfolio investments and otherforms of ringgit assets.

• Foreign direct investment inflows and outflows, includingincome and capital gains.


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INTRODUCTION OF THE GRADUATED EXIT LEVYAfter five and a half months of controversy, Malay-sia, on 4 February 1999, modified the rule on the one-year holding of portfolio capital. Foreign funds stuckin the country would be allowed to be repatriated sub-ject to a new graduated levy depending on the dura-tion of each investment and when the funds werebrought into the country, with effect from 15 February1999. The slow trickle of foreign funds seen over theprevious months while neighboring countries experi-enced renewed investor interest could have been oneof the reasons that propelled the Malaysian Govern-ment to initiate this move. The measures are also aimedat addressing the possible outflow of funds upon theexpiry of the 12-month moratorium on fund repatria-tion. This new levy is considered more “market-friendly” than the moratorium (Table 4).

The argument is that the top rate of 30 percent isonerous and as the levies are high, would investorsremain in the country up to 1 September 1999? Ifthey were low, then investors might decide to leavethe country. Similarly, would reinvesting in Malay-sian markets defer payment of the levy? The Gov-ernment feels that the exit tax would, in fact, en-courage a larger inflow of new capital rather thansee large outflows as the economy is stabilizing andrecovery is anticipated. Would this be a little too op-timistic despite the current positive economic vari-

ables? Also, the new measures would inevitably addto the already cumbersome administrative problemsin investing in Malaysia and, therefore, discourageinvestors. In any case, it is still too early to tell andshort-term outflows cannot be discounted. However,it would be unfair to dismiss the new measures out-right. The Malaysian economy has been recoveringsince the second quarter of 1999 and these mea-sures could be a start to reinstate Malaysia on theworld investment map.

FINANCIAL AND CORPORATE SECTORRESTRUCTURINGWhat began as a currency crisis evolved into a finan-cial crisis before transforming itself into a full-blowneconomic crisis, with banks and other financial institu-tions taking the center stage as the drama unfolded.The currency crisis fueled concerns about the healthof the banking system in the crisis-hit economies. Ex-cessive lending without adequate safeguards has beenthe main drawback of financial institutions, resultingin soaring NPLs and gross capital inadequacy. In sev-eral crisis-hit economies, the banking system took asevere beating with many institutions folding altogether,while the real sector in these economies suffered badlyas a consequence. Malaysia was, however, more for-tunate in the sense that none of the banks caved in.The toll on the corporate and financial sectors, never-theless, has been extensive.

While Malaysia may be credited for maintainingsound financial policies and good supervision, it mustnot be denied that inherent weaknesses do exist withinthe system. Thus, there are concerns about the healthof the banking system in the aftermath of the crisis.Rising NPLs in the banking sector prompted fearsof systemic bank failures. Nevertheless, the NPLproblem in Malaysia pales in comparison with that ofother crisis-hit countries in the region. It also pales incomparison with Malaysia’s own previous experi-ence in the mid-1980s crisis when NPLs rose as highas 33 percent of total loans. This time around, theNPL ratio was at most, about half of what it was in

Table 4: Exit Levy on Investments

Investments Before 15 February 1999• A levy of between 10 and 30 percent on the principal to

be repatriated within 12 months.• Repatriation after the 12-month period will not be

charged any levy.• Profits repatriated within the 12-month period will not be

levied but those repatriated after this period will becharged a 10 percent levy.

Investments After 15 February 1999• The repatriation of the principal will not be levied.• Profits repatriated within 12 months will be charged a

30 percent levy.• Thereafter, profits will be charged a 10 percent levy.

Source: Malaysian Treasury press release, Repatriation of Portfolio Capital,4 February 1999.


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the previous crisis (14.9 percent in November 1998if measured by the “three-months” classification).

The Government has, therefore, taken measuresto restructure and consolidate the financial and cor-porate sectors with the primary aim of:

• relieving institutions of their NPLs,• strengthening and recapitalizing banking institu-

tions,• facilitating corporate debt restructuring, and• enhancing efficiency within the system.The thrust of Malaysia’s banking and financial

sector reforms introduced during the crisis was two-fold. They aimed at stabilizing the banking system inthe immediate period, and building a strengthened,more resilient banking sector over the medium to longterm. Short-term measures were initiated to ensurethe smooth functioning of the intermediation process,while rationalization, consolidation, and reform of thefinancial and banking sectors were initiated throughthe setting up of an asset management company, abank recapitalization agency, a corporate debt re-structuring committee, and mergers. These repre-sented part of the long-term strategy to strengthenand consolidate the sectors.

Two agencies, dubbed “special purpose vehicles,”namely, Danaharta and Danamodal, were establishedto deal with NPLs. While Danaharta (Table 5) wascreated to buy up bad loans and take over the sup-porting assets, Danamodal (Table 6) was establishedto inject capital into banks that had to bear lossesresulting from the sale of NPLs. By the end of July1999, Danaharta had acquired and managed loansamounting to RM39 billion from the financial sys-tem, representing 1,999 loan accounts. From the bank-ing system alone, it acquired and managed NPLsamounting to RM28.5 billion or 35 percent of totalNPLs in the banking system. With this, the net NPLratio moderated to 7.9 percent based on a six-monthclassification as at the end of June 1999 after peak-ing at 9 percent as at the end of November 1998. Ifbased on the international three-month classificationof bad loans, the NPL ratio would be about 13 per-

cent. At the same time, Danamodal pumped RM6.2billion into the banking system. The risk-weightedcapital ratio (RWCR) was also at fairly comfortablelevels, partly due to new capital injections and partlydue to the tendency for banks to avert high-risklendings. Thus Danaharta and Danamodal have per-formed fairly well so far and the overhaul of the fi-nancial sector has received cautious praise from someanalysts. Nevertheless, more needs to be done.

The arduous task of buying up bad loans at rea-sonably discounted prices and financing them withzero-coupon bonds may seem easy compared withthe more daunting task of managing the assets thathave been acquired in the process. In many cases,the restructuring of underlying businesses and as-sets are necessary. Thus, besides debt restructuring,operational restructuring is vital for the long term.As evidenced in the Mexican experience, restruc-turing and recapitalization are lengthy and compli-cated processes. Danaharta will be working alongthe lines of the successful Swedish Securum Asset

Table 5: Danaharta Nasional Berhad: Objectivesand Plans

Asset Management Company• Established 20 June 1998, Companies Act of 1965• Authorized share capital: RM10 billion• Paid-up capital: RM250 million

Main Objectives• Remove nonperforming loan (NPL) distractions from

financial institutions• Maximize recovery value of acquired assets

Stages of Acquisitions PlansStage 1 involves:

• secured loans,• strategic sectors.

Stage 2 involves:• unsecured loans.

Stage 3 involves:• foreign currency loans,• financial guarantees,• private debt securities.

Prioritization of Financial InstitutionsPhase 1: Weaker financial institutionsPhase 2: Local financial institutionsPhase 3: Financial institutions of moderate strengthPhase 4: Stronger banks



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Management Company and has projected to startselling NPLs as soon as the acquisition phase is overbut only after having first gone through an activerestructuring role.

4 Apparently, Danaharta has now

emerged as the biggest owner of real estates in thecountry in the process. Disposing of these propertiesin an orderly fashion without upsetting the market isnot going to be easy, given the supply glut. Also, forhow long will or can Danaharta continue to buy upbad loans?

The successful operation of these asset manage-ment outfits requires a private sector approach fo-cused on the following:

• complete autonomy,• full transparency in their workings,• commerciality,• best practice,• equal opportunity for investors, and• professionalism. .At the same time, the Corporate Debt Restruc-

turing Committee (CDRC) was established tocomplement the two agencies by providing a chan-nel for banks and debtors in distress to sort out anagreeable and workable loan restructuring exercise.As at 20 August 1999, 62 applications had been re-ceived, of which 10 restructuring schemes involvingdebts of RM10.2 billion had been completed and werein the process of being implemented. Three casesinvolving debts of RM1.1 billion have actually beensold to Danaharta, while 12 other cases involvingdebts of RM2.9 billion have been rejected. Never-

theless, without any empowerment, and being just afacilitator bringing creditors and debtors to the nego-tiating table, there is little that the CDRC can actu-ally do. The overhang of corporate debts is certainlya cause for concern. Banks and finance companiesare still saddled with about two thirds of the NPLsas Danaharta has managed to absorb only one third.Even though Malaysia’s external debts are not largerelative to GDP by developing country standards, itstotal domestic debt is large. Bank loans, which rep-resent the largest chunk of domestic debt, amount to145 percent of GDP (the precrisis peak was 135percent), which is, by far, the largest in SoutheastAsia. This does not go very well with the centralbank’s call for higher loan growth in order to stimu-late the economy. Higher loan growth will raise theloan-GDP ratio, which is already too high, therebyweakening the country’s macroeconomic fundamen-tals. One redeeming feature is that the central bank’sreserves have increased significantly within the lastyear.

For a small population of 22 million, Malaysia isconsidered overbanked with 21 commercial banks,12 merchant banks, and 25 finance companies, notto mention foreign-owned institutions. In order tofurther consolidate and rationalize the banking sys-tem to meet the challenges of an increasingly global-ized market, the central bank has encouraged banksand finance institutions to merge. In the initial phaseof the crisis, the number of finance companies wasreduced from 39 to 25 following central bank inter-

Table 6: Danamodal: Objectives and Tasks

Source: Danamodal Fact Sheet, 1998.

Restore and Revitalize theBanking Sector• Restore and improve solvency• Provide liquidity• Enhance profitability• Restore confidence• Refocus intermediation• Reenergize lending activities

Catalyze Improvements in theBanking Sector• Restructure the balance sheet• Restructure operations by

introducing better practices• Improve corporate governance• Improve technology• Influence and encourage bank

restructuring and consolidations• Institutionalize ownership

Operate on a CommerciallyViable Basis• Earn positive return commensurate

with risk• Meet Bank Negara Malaysia’s and

international banking standards• Achieve more independence and

transparency• Ensure effective corporate

governance


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vention. The central bank then announced plans toreduce the number of 58 domestic financial institu-tions to only six anchor institutions through mergers.This exercise will, nevertheless, not involve locallyincorporated foreign banks. The two main objectivesof this consolidation process are to enlarge the capi-tal bases thereby ensuring a better management ofrisks and enhancing the resilience of the system, andto cut costs and improve the competitiveness of lo-cal institutions. On 20 October 1999, the Malaysiancentral bank announced that all banking institutionswill, henceforth, be allowed the flexibility to form theirown merger groups, a reversal from the previousruling, which saw the Government’s hand in the pro-cess. Frequent changes and reversal of policies couldprompt perceptions of inconsistency and should beavoided.

It is true that a merger exercise of this size willenhance prudential supervision and reduce systemicrisks besides producing larger and stronger institu-tions capable of meeting future global competition.However, questions arise as to how the operationswill be funded and where the thousands of retrenchedemployees will go. More worrisome still will be theimplications of this exercise on the day-to-day man-agement of the institutions if attention is divertedaway from such pressing problems as bad loans, notto mention significant interbank cultural differencesthat would challenge postmerger harmonization. Fur-thermore, mergers alone cannot transform the bank-ing system into a formidable force overnight. Somesmall banks have performed better during the crisisthan some bigger ones. Size may still matter but it isnot synonymous with professionalism, competence,and the level of sophistication and efficiency. All thesehave much to do with the competitive environmentwithin which banks operate and underscore the im-portance of deregulation and liberalization in the bank-ing reform exercise. The merger exercise wouldbecome more meaningful if banking reforms includedan agenda to expose the sector to increased compe-tition, paving the way for a greater opening of the

sector to foreign competition. It is understandablethat Malaysia will not liberalize the banking sectorimmediately, but over the medium term, gradual lib-eralization will be necessary.

Issues and PolicyRecommendationsIt would not be accurate to simply say that contagionor a self-fulfilling prophecy prompted the Asian cri-sis. Though there may be some parallels and simi-larities in regional economies, they should not belumped together and considered as identical. Certaincountries were severely afflicted while others suf-fered ripple effects much later. It would, thus, beunfair to propound one theory to suit all cases. Ex-ternal and internal factors were responsible. But whywere some countries more vulnerable than others?

It is more appropriate to identify the elements thatcould have rendered an economy more vulnerableon a country-by-country basis. The magnitude of thecrisis itself posits that favorable macroeconomic gov-ernance is necessary to sustaining economic stabil-ity. Vulnerability itself would not have led any coun-try into a severe crisis. Vulnerability of an economyresulting from cracks within the system such as policyinefficiencies or policy errors may, nevertheless,when combined with some external factors, makean economy succumb.

Before the crisis, macroeconomic managementin Malaysia was considered sound by any standards.Fundamentals were strong. The country enjoyed rea-sonable price stability, fiscal surplus, high foreignexchange reserves, and high rates of savings andinvestment. The suddenness and the severity of thefinancial reversal have sparked a debate on past mac-roeconomic management as well as the appropriate-ness of policy responses to the crisis. Policy man-agement in Malaysia has, since, been focused onreducing risks in the economy to ensure macroeco-nomic stability and to promote a stronger financialsystem. It is targeted at maintaining price stability


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while preventing a further contraction of the economy.However, circumstances changed and the situationevolved along the way, so policies and measuresimplemented had to be modified.

Considering the various stages that the recoveryprocess has been through, it is clearly still too earlyto assess the success of the measures applied. Thecrisis has revealed serious shortcomings in theeconomy. Simultaneously, to a large extent, the crisisin Malaysia has become one of confidence. As aresult, like other afflicted economies in the region,the country now faces domestic policy reform chal-lenges in order to restore confidence and rekindlethe economy. There are various areas in which im-portant reforms and changes need to be targeted.Briefly, these may be identified as follows:

• macroeconomic policies,• financial sector reform,• improving risk management and maintaining fi-

nancial stability,• corporate governance and institutional restruc-

turing, and• improving long-term competitiveness.

Macroeconomic ReformsCAPITAL CONTROLS AND MAINTAININGEXCHANGE RATE STABILITYThe imposition of selective controls and the peggingof the national currency at RM3.80 to the dollar weremeant to provide the economy with a temporary re-spite from external volatility. The move also madethe Malaysian ringgit nonlegal tender outside of Ma-laysia and therefore encouraged ringgit parked abroadto be remitted back to the country. All receipts origi-nating from capital account transactions (but not in-cluding FDI) must be held in Malaysia for a yearfrom the date of purchase of ringgit-denominatedassets or securities before they are eligible for repa-triation.

In the meantime, the Malaysian economy has be-come anemic following the massive outflow of capi-tal between the onset of the crisis and the imposition

of selective controls in September 1998. There is,thus, an urgent need for capital infusion from exter-nal sources. This calls for policies to attract new for-eign capital. However, exchange controls are notconducive to a massive injection of capital fromabroad. Exchange controls and open economies areinherently incompatible. Therefore, when the intendedreforms have ultimately been completed, these con-trols should be phased out.

Fears and concerns of a large capital pullout on1 September 1999, exactly a year from the datecontrols were imposed, prompted the Governmentto ease its policy and implement a graduated exitlevy in February 1999. Nevertheless, the fears wereunfounded as there was no substantial outflow offunds on the designated date. The selective con-trols and the fixed exchange rate have been suc-cessful in bringing stability back to the economyand improved Malaysia’s external accounts. Busi-nesses involved in international trading no longerneeded to factor in an exorbitant exchange rate riskpremium into their business plans. Capital costs havereduced sharply and planning, into the medium termat least, has become easier. Business sentiments inthe manufacturing sector improved in the first halfof 1999 and are continuing to progress gradually,perked up by improved sales performance. Whilegeneral business conditions remain subdued follow-ing a sharp recession in 1998, manufacturers ap-pear to be cautiously optimistic. Business conditionsbegan to show an upward trend in the third quarterof 1999 but there was a slight moderation in thefourth quarter (according to the MIER QuarterlyBusiness Conditions Index). In all, the controver-sial capital control move has been largely lauded bythe local business community. Similarly, an upturnin consumer sentiments has been registered in theMIER Consumer Sentiments Index.

However, there is an argument that controls maybe a short-term dream that will be detrimental to theeconomy in the long run. The peg may have been aboon to businesses but they must not be led to be-


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lieve that the current euphoric situation will be per-manent, and be lulled into a false sense of security.In the long term, should the controls continue orrather, be refined? Should the ringgit peg be reviewedand if so, when?

If foreign exchange controls remain in place fortoo long, the ambition of turning KLSE into a re-gional bourse of significance will remain a pipe dream.Investor confidence will be dampened since othermarkets in the region do not impose controls. Notonly will speculative activity be curbed, long-termoverall investment activity will probably be affectedas well. Standard & Poor’s upgraded Malaysia on1 April 1999 and Moody’s upgrading followed threeweeks later. This may be good news, but the me-dium-term effects of controls and the ringgit peg stillremain uncertain. Currently, the large current accountsurplus and external borrowing have helped to alle-viate short-term concerns on capital needs but thelonger controls and the peg remain in place, thegreater the distortion in competitiveness and capitalflows into the country. Once imports begin to growagain, external liquidity would most likely be affected.At the same time, it is questionable if the positiveevents (stock market rally, balance of payments[BOP] current account surplus, increased foreignexchange reserves, interest rate reduction, etc.) sup-posedly due to the imposition of controls are actuallyattributable to these. Similar trends are present inother countries where there are no controls.

With the ringgit peg, it is difficult to determinereal exchange rates. Analysts believe that the ringgitis undervalued. At the same time, there has beenmuch speculation as to whether or when the ringgitpeg will be adjusted. The Malaysian Governmenthas said that the same rate would be maintained(unless some serious structural imbalances occurin the economy). In real terms, the exchange rateparity at RM3.80 to the dollar makes the ringgit thesecond cheapest currency in the region after theIndonesian rupiah. This undervaluation allows Ma-laysia to capitalize on competitiveness gains. While

this has greatly favored exporters, a low ringgitmakes imports more expensive.

Any decision to float the ringgit will depend onwhether it will subject the system to more volatility.The idea of the Government holding on to controlsand the peg until changes occur in the internationalfinancial architecture to address speculation and vola-tility may be unrealistic. As long as the BOP currentaccount remains in surplus, the capital controls andthe ringgit peg will remain sustainable. Nonetheless,such a policy flexibility will evaporate with a deterio-ration in the BOP position as the economy recovers,in which event, the capital account will have to beliberalized.

It is thus imperative that the Government moni-tors the situation closely in order to avoid severeshocks to the exchange rate system should and whenthese take place. The choice to peg or float the ex-change rate in the long run will have to be carefullyconsidered. Lessons can be learned from a fewcases. Pegs in Latin America have, in the recentpast, helped to bring inflation down. However, infla-tion is not a serious issue in Malaysia (and in mostEast Asian economies). Pegging brings out a risk inthat any sharp devaluation can prove fatal if the fi-nancial fundamentals are weak. On the other hand,under a pure floating regime, small daily adjustmentsexpose risks and encourage hedging but such flex-ible exchange rates allow a country to undertake in-dependent macroeconomic policies. A managed floatis not viable because it normally degenerates into asingle-currency peg. Malaysia has suggested peg-ging to a basket of currencies instead of just one,having been through the recent experience of de-pendence on the dollar. Eventually, floating exchangerates could be advisable though such a measure mayput the country through some initial turbulence suchas interest rate problems and bankruptcies. NewZealand experienced these when it freed capital flowsand floated exchange rates in the 1980s. However,as the economy was further opened and prudentialregulations, transparency, and good institutional


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infrastructure were put in place, the problems wereeventually smoothed out and the exchange rate sta-bilized.

FISCAL STIMULUSMalaysia’s main concern during the crisis was theunprecedented contraction of the real economy inthe first three quarters of 1998. A top priority in suchcircumstances would be to ensure that the economyis not trapped in a prolonged recession. Some impe-tus to rekindle the economy is necessary. The strat-egy of maintaining fiscal surpluses should be reversedin favor of a deficit budget. In pursuit of a deficitbudget, the Government project selection criteriashould be geared towards performance-based ac-tivities. As such, viable small-scale projects shouldbe encouraged as they entail greater risk diversifica-tion. (In this sense, some of the existing mega-projectsneed to be scaled down or even abandoned in orderto achieve a more moderate deficit budget.)

Financing a deficit from external sources at areasonable cost would have been difficult. Therewas also a need to avoid the crowding out of theprivate sectors’ sources of financing. Therefore,the overall deficit should be kept at a sustainablelevel. This would ensure that Malaysia’s externaldebt servicing ratio remained at a reasonable andprudential level.

MONETARY POLICYTo foster an economic recovery, domestic spendingneeds to be stimulated. To this end, a low interestrate regime is essential as it will lead to a reductionin the cost of financing economic activities. None-theless, a low interest rate regime may encouragethe problem of moral hazard. Such a problem ariseswhen lenders are unable to observe the actions ofborrowers after the granting of loans. To minimizethis problem, a more thorough and prudent assess-ment of lending practices should be implemented.This includes a stricter definition of risks and greatertransparency in disclosure of information.

Banking and Financial SectorReformsReforms and liberalization are not limited to the fi-nancial sector. Rather, they cut across the boardthough the financial sector would probably need toundergo extensive restructuring.

The crisis has revealed cracks in the financial sys-tem in Malaysia. In spite of the various reforms un-dertaken in the late 1980s and early 1990s, risky lend-ing practices persisted in the banking system. Struc-tural reforms and prudential measures to strengthenthe financial system are, therefore, imperative and needto be accelerated as the country rebuilds its economyin the postcrisis period. It is surprising that it has takenthe crisis to highlight the need for financial sector re-forms. The decade of high growth has led Malaysia(and other countries in the region) to gloss over seri-ous problems and practices in the financial sector.

Reforms must not be thought of only in termsof recapitalization or liberalization. In the shortterm, adequate measures for recapitalization havebeen undertaken (see Section on Danaharta andDanamodal). In the long term, reforms should be seenas an overhaul with new regulations put in place, andunhealthy and high-risk practices of the past weededout. The restructuring must facilitate a competitive,transparent, open, and stable structure in order tobetter withstand future shocks to the financial sys-tem. Similarly, market players must continue to en-hance their skills and knowledge. The infrastructureof the financial market must be constantly upgradedand complemented by dynamic, highly skilled, tech-nology savvy market players.

RESOLVING THE PROBLEM OFNONPERFORMING LOANSMuch effort has been poured into the managementand restructuring of NPLs and the recapitalizationof banks, which will be important in consolidatingand rationalizing the banking industry. Stringent poli-cies and checks to prevent future buildup of NPLsto unhealthy levels need to be implemented. While


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the move to revert to the precrisis definition of NPLsas those in arrears for six months may downsize themon paper for now, it would probably be prudent to letthe appraisal of NPLs be defined according to inter-national norms of classification once reforms havebeen completed and the situation has returned tonormal. A correct and consistent appraisal policy ofNPLs including an appraisal of lending to the corpo-rate sector and the State will be necessary.

IMPROVING REGULATION AND SUPERVISIONGreater transparency and accountability in the finan-cial system will be imperative for best practices togerminate. Before policies can be implemented, stan-dardized principles and regulations for supervisionneed to be defined. These could be undertakenthrough the adoption of the Basle core principles foreffective bank supervision and after effective com-parison with international norms, as well as finding asuitable balance between traditional prudential andmarket-based regulatory systems. It is necessary forBNM to ensure proper implementation of better su-pervision with a focus on the new global businessenvironment. Simultaneously, supervision and regu-lation must not be impaired by political interference.The issue on central bank independence is thus ofthe utmost importance. In the wake of the recentcrisis, emphasis on risk management will be impera-tive. With the implementation of AFTA, and the pros-pect of greater regional integration and economic con-vergence, new policies should be targeted towardsregional harmonization.

DEREGULATION AND LIBERALIZATIONWhile international financial interests have oftencalled for outright liberalization, this must not be swal-lowed whole without taking into consideration thelevel of development of the individual financial sys-tem. Too rapid a liberalization process when the sys-tem is still unable to cope may ultimately result in aweak domestic banking sector unable to withstandcompetition from abroad. Of late, many analysts have

said that early deregulation and liberalization of thefinancial sector have acted as a catalyst for crises.In Asia, particularly, this has meant a departure fromthe traditional norm of having the government’s guid-ing hand and intervention in external borrowing andcredit allocation before the national economy wasready. This may be true but in the long run, greaterliberalization will be inevitable. Nevertheless, it isimportant to ensure that the regulatory capacity ofthe system is developed and fully in place before anyeffort to liberalize is undertaken.

Malaysian policymakers are still reluctant to openup the services sector, in particular, the financial sec-tor. The argument is that the financial services sec-tor is not ready to face unfettered international com-petition. This argument is not without basis. The cri-sis has highlighted the need and importance of liber-alizing the banking industry in order for it to benefitfrom new capital injections. Arguably, liberalizationand deregulation in the financial sector should begradual. Gradual exposure to foreign competitionwould compel domestic institutions to be more com-petitive and innovative in the long term.

Foreign ownership of Malaysian banks is still lim-ited to 30 percent. But the insurance industry hasrecently been subjected to further liberalization withforeigners now permitted to own up to 51 percent ofequity (up from 49 percent in 1995 and 30 percent in1993). New entrants to the financial sector should,nevertheless, be allowed in on a gradual or a case-by-case basis as they are potential candidates forthe merging and recapitalizing of ailing institutions.The Government could offer two options: first, thenew entrant could be allowed in on condition that itmerges with an ailing domestic institution; or second,a limited number of new permits could be auctionedto the highest bidder, with the proceeds utilized in therehabilitation of the domestic banking system.

A main focus of new policies should now be onthe strengthening of the regulatory and supervisoryframework to ensure a sound financial and bankingsystem in order to avoid another crisis.


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Improving Risk Management andCapital Market DevelopmentShort-term speculative flows have played a role inundermining the stability of world capital and finan-cial markets. Widespread currency speculation wouldhave been impossible under the Bretton Woods sys-tem as almost all countries adopted strict capital con-trols. The abandonment of these controls during the1970s after the breakup of the system, and in the1980s, resulted in an explosion of speculation in worldmarkets. In its wake, currency trading has balloonedout of proportion; by 1995, foreign exchange trans-actions were estimated to be about 60 times greaterthan would have been necessary to fund internationaltrade in the same year. The volume of short-termtransactions has been increasing by about 50 per-cent every three years. In the 1980s, this was comple-mented by the gradual abolition of exchange con-trols, giving birth to a cornucopia of new financialinstruments and derivatives, all of which were de-signed to take advantage of a new liberal financialarchitecture conducive to short-term speculation.This was compounded by the appearance of hedgefunds, which have a particularly destabilizing effectdue to their highly leveraged positions.

As the frequency and magnitude of financial cri-ses intensify, they should no longer be accepted asmere aberrations in the world capital market. Inter-national financial markets are increasingly inherentlyunstable especially for those borrowing heavily fromexternal sources in foreign currencies and in the short-term. Such financing is suitable to finance trade flowsbut should not be used for long-term investments.The risk is even higher if such short-term flows areused to finance long-term on-lending by highly lever-aged financial institutions. Many of the East Asianeconomies overborrowed and as the short-term loanscould not be rolled over, the liquidity crunch rapidlydegenerated into a full-blown insolvency crisis. Thesharp nominal devaluations of domestic currencies thatfollowed led to a consequent increase in the local val-ues of the mainly dollar-denominated liabilities.

Problems in Malaysia’s financial sector could betraced to an overdependence on the sector to meetthe nation’s funding requirements, a phenomenonoften found in emerging economies. Deposits withthe financial institutions tended to be short-term. Onlya small percentage of deposits were those beyond12 months. However, projects with long gestationperiods (such as those in the property sector) werefinanced by syndication of loans among financial in-stitutions in Malaysia. There is thus a liquidity mis-match, where short-term deposits have been used tofinance long-term projects, exposed by the crisis. Atthe same time, cheap foreign borrowing meant thatthe economy was flushed with funds, most short-term. Easy credit led to a rallying of the stock mar-ket and also allowed the diversion of resources fromthe real productive sector into speculation. Thus, whenspeculators began pulling out at the onset of the cri-sis, the system fell apart.

More stringent supervision may serve as a goodcheck but will not, by itself, prevent future crises.Further policies to attract and encourage long-termcapital flows such as FDI and equity portfolio flowsshould be implemented. Speculative flows should bediscouraged and short-term flows should be limitedto financing short-term trade transactions. The Ma-laysian capital market needs to be further developed.The bond market should facilitate more efficient long-term funding. In the financial reforms of the late 1980sand the measures undertaken in the early 1990s, therewere efforts to develop the local bond market.Progress has, nonetheless, been slow. Also, the re-pressive regulatory processes and the lack of ad-equate bond market infrastructure in the country dis-courage the use of such fixed-income securities. TheBanking and Financial Institutions Act of 1989(BAFIA), defines the issuance of bonds as deposit-taking and forbids it without approval of BNM. Allnew issues of debt instruments require BNM ap-proval before applying for the approval of SC, whichregulates the capital market. This dual approval andthe delay involved discourages local companies from


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seeking capital market financing. Thus, while a moveto more secure financing in order to improve riskmanagement is imperative, new policies need to beimplemented to encourage the changeover. Substan-tial improvements in the infrastructure for the bondmarket with a special focus on secondary markettrading systems, a competitive auction system, thereinforcement of the role of credit rating agencies,and hedging instruments for short- and long-term in-terest rate risks, will be necessary.

While much effort has been made through poli-cies and prudential regulation to enhance and im-prove the soundness of financial systems in order tobetter manage risks, the magnitude of the Asian cri-sis has led some countries to call for reforms in theinternational financial architecture. Various recom-mendations have been made including levies on capi-tal flows. Reforms at international level are certainlynecessary, but the political will to arrive at an inter-national consensus remains far off. The process ofglobalization is supposed to bring about better oppor-tunities for the world economy through a more effi-cient allocation of funds across borders. Recent ex-perience has, however, shown that it has brought withit risks that can be destabilizing.

The international financial community is thusfaced with the challenge of ensuring an efficientfinancial system that is not vulnerable to marketfailures and volatile flows of capital. At the level ofindividual economies, the question is now how toparticipate in and be an integral part of this newinternational economy without being vulnerable todestabilizing developments. The push for a moreliberal international financial environment has notbeen matched by parallel development to establishrules to ensure the efficient functioning of marketsand improve safeguards to individual economiesfrom the adverse effects of volatile capital flows.It will not be an easy task to create a new interna-tional architecture to regulate capital flows andhedge funds. Any such attempt will most likely have

to involve not only governments, but also lendersand borrowers. World financial centers will prob-ably need to be brought under an international um-brella regulatory body where there is enforcementof transparent disclosures, and consistent interna-tional standards of cooperation and assessment.These will all be difficult to achieve.

Corporate Governance andInstitutional RestructuringThere has been much debate since the onset of thecrisis about the factors and the structural weaknessesin the afflicted economies that helped to trigger thecrisis. Although it may not have been the prime fac-tor, there is some truth in the claim that poor gover-nance was partly to blame. In mature economies,this issue is addressed through the existence of ad-equate institutions and the enforcement of a combi-nation of corporate laws and regulations. Economicdevelopment in many countries in Southeast Asiawas not always accompanied by the parallel devel-opment of necessary mechanisms of governance andadequate institutional infrastructure. These shortcom-ings have, to a certain extent, contributed to the vulner-ability of the Malaysian economy to external shocks.

Unlike in the crisis of the 1980s where blame wasprimarily on bad public sector governance, poor gov-ernance in the private sector has been a contributoryfactor to recent problems. The use of short-termborrowings to finance long-term lending, and thestrong preference for debt financing to equity-financ-ing have all been commonplace practices in Malay-sia. Borrowing and investment decisions based onnoncommercial considerations prevailed. Crony alli-ances enjoying relatively easy access to credit orother facilities have resulted in unproductive andunviable investments and ventures. It must, never-theless, be added that such practices know no bound-aries and are not restricted to or inherent only in Asianbusiness culture but are found in the developed worldas well.


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There is little that a government can do to actuallyensure good corporate governance other than put-ting regulations in place and enforcing them. Goodgovernance evolves through time and experience.However, it is important that such a regulatory frame-work, checks, and penalties are in place in order toeducate and instill the desired practice and conduct.Steps taken to improve standards of corporate gov-ernance and institutional infrastructure will not onlylead to healthier business practices, but more impor-tant, they will boost investor confidence, especiallyduring times when confidence has eroded.

It is imperative for Malaysia to complement mac-roeconomic policies by making greater efforts toimplement new rules and set up infrastructures thatwill function more efficiently in the provision of gov-ernance, supervision, and regulation. This should gohand in hand with increasing transparency. Thesemeasures may not be an antidote to future crises butthey will be a check on malpractices and irregulari-ties within the economy, which may otherwise ren-der it vulnerable to shocks. Recognizing the role ofenhanced corporate governance, a high-level FinanceCommittee on Corporate Governance was estab-lished by the Government in March 1998. It has comeup with some 70 recommendations aimed at improv-ing market practices, including principles for goodgovernance targeted at listed companies. SC re-viewed and strengthened the rules. These measuresmay be a relevant start but stringency and consis-tency over the long-term with periodic checks andreviews will be of great importance. Otherwise, itwould be pointless to continue.

Improving Long-TermCompetitivenessCompetitiveness will be a key issue in the post-crisisscenario for East Asia. Growing competition fromemerging economies in other regions of the world hasthreatened Malaysia’s export competitiveness. Withthe devaluation of East Asian currencies as a result ofthe crisis, competition has become even keener.

The World Competitiveness Report of 1997, pub-lished by the International Institute for ManagementDevelopment, ranked Malaysia 17th (up from 23rdplace in 1996) out of 46 developed and developingnations. Among the nonmembers of the Organisationfor Economic Co-operation and Development(OECD), Malaysia was third after Singapore andHong Kong, China in 1997. It was also favorablyplaced in several other studies. Nevertheless, its com-petitiveness is likely to be eroded over time.

Being an open economy, Malaysia’s macroeco-nomic performance will essentially and largely beinfluenced by external developments. This is provingto be increasingly the case for any economy as theprocess of globalization gathers pace. The globaliza-tion of markets and production centers, and the ad-vent of new technologies have intensified the com-petition. In view of this, the economy has to be pro-pelled towards a higher level of competitiveness inits role as an international player. The intense paceof growth during the boom years has exerted muchpressure on the economy. The increase in labor costsand staff shortages (both skilled and unskilled) haveposed serious threats to growth. Though current cri-sis conditions have alleviated this burden, it shouldbe a major lesson for the future once the situationhas stabilized if Malaysia intends to increase its mar-ket share. The country will eventually have to changefrom a labor-intensive and low-value input economyto a technology-intensive and knowledge-basedeconomy. The future trading environment calls notonly for an urgent improvement of competitivenessbut also greater resilience from industry. This meanssweeping changes, improvements, and facing up toinadequacies. New growth strategies will have to beengineered and adjustments made. The alternativeis losing out to regional competitors.

In the long run, Malaysia will have to face thechallenge of more efficient and optimal utilization ofits resources in order to increase productivity, andsustain and improve national competitiveness in thechanging global environment. Unlike some Asian


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newly industrialized economies, institutional inad-equacy is still lacking in various areas to sufficientlyand efficiently govern the pace of growth. New poli-cies and measures will be required to deal with this.In order to improve competitiveness, there are cer-tain long-term physical considerations to be takeninto account. These include, among others, the ur-gent need to improve human resource assets in termsof education, training, and skill upgrading. Skilledhuman resources are a crucial element in attractinginvestments into a country. Malaysia has a weak basein research and development. This has to be seri-ously dealt with. Simultaneously, a gradual openingto allow greater foreign equity participation couldeventually help bring in badly needed capital and ex-pertise. This will improve professionalism in thecountry’s corporations. Government measures needto be implemented to complement macroeconomicpolicies in order to spearhead Malaysia into the nextdecade of growth. This time around it should be pro-ductivity-led growth and not input-led growth.

Final WordsThe “virtual IMF policy” adopted by Malaysia dur-ing the initial period of the crisis produced negativeresults. It aggravated the situation and worsened thecrisis as it caused a rapid contraction of the economy.This failure of the combination of tight monetary andfiscal policies prompted the Government to changeits course and adopt an expansionary policy by themiddle of 1998. The Government continued to fine-tune macroeconomic policy instruments with the aimof strengthening economic and financial sector fun-damentals and restoring domestic and external sta-bility. Nevertheless, in spite of some positive devel-opments, namely, contained inflationary pressures andan improved external balance, the national currencyand the economy continued to remain vulnerable toexternal developments. Such a situation could gravelyaggravate the crisis and cause fundamental damageto the real economy. In response to this, selectivecapital controls and the pegging of the national cur-

rency to the dollar were imposed in September 1998.Both acrimoniously criticized as well as lauded by

many all over the world, the controversial measureshave given Malaysia a “breathing space” to concen-trate on addressing domestic economic problemswhile eliminating speculation and keeping externalinfluences at bay. Interest rates have significantlyfallen and the improvement in the country’s externalaccounts has boosted investor confidence.

The developments have so far been positive, withlow inflation, a favorable trade performance, in-creasing external reserves, improved labor marketconditions, and a low external debt position, espe-cially short-term debt. Reflecting this, market sen-timents have further improved as indicated byhigher capital market activities, continued loangrowth, higher private consumption, and an increasein property transactions.

The expansionary policies, therefore, went someway towards improving growth prospects for theeconomy. However, there may be some time lag be-fore the effectiveness of those policies fully filters intothe system. After a decline over five consecutive quar-ters, the economy recorded a positive growth of 4.1percent in real GDP in the second quarter of 1999. Infact, the uptrend has been evident since February 1999.GDP growth emanated both from a strong externaldemand as well as a recovery in domestic demand.Since the fourth quarter of 1998, the expansion in theexternal sector has further strengthened. This hasgenerated increases in income, which provided thebasis for a significant revival in private consumption.

Similarly, the domestic labor market situation im-proved in the second quarter of 1999 with a reportedincrease in job vacancies, mainly in the manufactur-ing sector, and fewer retrenchments. At the sametime, loan growth (including NPLs sold to Danaharta)has picked up again from a low of 0.4 percent inJanuary 1999 to reach about 1.8 percent in May(-4.3 percent if NPLs acquired by Danaharta wereexcluded). The gradual acceleration in loan growthin 1999 reflects a moderate increase in demand for


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loans as economic activities pick up. In fact, for com-mercial banks, loan growth has already reached alevel of 8 percent. Loan approvals were also main-tained at a higher quantum of RM7.6 billion in May1999, much higher than the RM4 billion–RM5 billionaverage in 1998.

Simultaneously, manufacturers have also reactedfavorably to the positive economic developments.After six quarters of lackluster performance, manu-facturers are ready to kick start operations in viewof the improving demand conditions. The MIER Busi-ness Confidence Index surged past the 50-pointbenchmark in the second quarter of 1999 to a levelof 60.3 points from 48.2 points registered in the pre-vious quarter. On a scale measuring up to 100 points,levels beyond 50 points are viewed as a plus factorin business activities. Against this backdrop, grossfixed capital formation is expected to expand at amoderate rate of 3.9 percent in 1999, rebounding froma steep 42.9 percent fall in 1998. On the supply side,recovery was broad-based with positive growth indomestic and export-oriented industries. In tandemwith increasing sales, manufacturing production rosesharply in the second quarter of 1999.

The stock market has also recovered strongly torecord new highs in trading. However, this might notnecessarily reflect the performance of the real sector.In this context, it is likely that the recovery in regionalmarkets has, in some way, contributed to the rebound.The Malaysian economy is now expected to post agrowth of about 3 percent in 1999, following a severe7.5 percent contraction in 1998. This growth is ex-pected to be mainly driven by public sector spendingrather than private sector expenditure.

However, one cannot rule out the possibility ofdownside risks. If the external environment does notturn out as expected and if Japan continues to re-main in deep recession, Malaysia’s exports will beaffected. The trade surplus would decline and for-eign reserves will be reduced. Under these condi-tions, it would be difficult to maintain the exchangerate peg and exchange controls. At the same time,

firms may not expand as much as hoped for despitethe low interest rates. They may be burdened bylarge debts and may not be willing to expand duringa recessionary period, while banks may be overcau-tious in lending and reduce funds needed for invest-ment and consumption. Moreover, funding require-ments for strengthening the banking sector and theadditional fiscal expenditure may not be enough.

Serious attention must continue to be paid to long-term reform measures. This is imperative in order torebuild and achieve the long-term goals of the coun-try. Various pertinent issues can be identified andthese range from the persistent issue of how Malay-sia can maximize management of its financial sys-tem and minimize risks to remaining competitive in arapidly changing global environment.

An important concern facing the Malaysianeconomy remains the issue of capital controls andthe fixing of the ringgit exchange rate. Even thoughthese measures have produced a certain calm withinthe storm and even with all due reforms in the finan-cial and the various other sectors achieved, what willhappen when the controls are lifted? When will orshould they be lifted? There has been little such pre-cedent and it is not possible to predict the outcomeof such a move in the medium to long term. A closescrutiny of the situation is warranted and the earliestphasing out of these measures would probably bethe best solution.

The present crisis, unlike the one in the previousdecade, has exposed deep crevices in private-sectorpractices. This provides the opportunity to overhauland restructure the wrongs of the recent past andconcentrate on building a competitive and resilientsystem to face the challenges of future shocks.Rather than adopting the single choice of monetaryor fiscal policy, a fiscal-monetary mix in combinationwith other measures would probably be a more ef-fective tool, judging from experiences of the recentpast. All said, the adversity that Malaysia is currentlyfacing will, no doubt, be an opportunity for improve-ment for the future.


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Appendix

Financial Measures to PromoteEconomic Recovery

1998February. Statutory reserve requirement (SRR)

reduced from 13.5 to 10 percent (16 February).April. Margin of financing for hire-purchase loans

on passenger cars costing RM40,000 or less raisedto 85 percent and repayment period lengthened toseven years (23 April).

June. Pengurusan Danaharta Nasional Berhad,the national asset management company, set up toacquire and manage nonperforming loans (NPLs) ofbanking institutions.

July. SRR further reduced from 10 to 8 percent(1 July). The 85 percent financing margin for hire-purchase loans for lower-cost passenger cars ex-tended to all passenger cars and the limit on the maxi-mum repayment period for cars completely removed(28 July). Introduction of a framework for liquiditymanagement to enable banking institutions to man-age their liquidity positions more flexibly without com-promising prudential standards (31 July).

August. Danamodal Nasional Berhad, a specialpurpose vehicle, established to recapitalize bankinginstitutions. Corporate Debt Restructuring Commit-tee, a joint public and private sector steering com-mittee, set up to facilitate and expedite corporate debtrestructuring. Bank Negara Malaysia’s (BNM’s) in-tervention rate reduced from 11 to 10.5 percent on 3August; 10 percent on 10 August; and 9.5 percenton 27 August.

September. Base lending rate framework re-vised to allow a faster transmission of changes inmonetary policy to lending rates (1 September). SRRreduced from 8 to 6 percent on 1 September withfurther reduction to 4 percent on 16 September.BNM’s intervention rate reduced again to 8 percent(3 September). Lending for the construction or pur-chase of residential properties costing RM250,000and below exempted from 20 percent limit on lend-

ing to the broad property sector (7 September). Bank-ing institutions with the capacity to lend required toachieve a minimum annual loan growth rate of 8 per-cent by the end of 1998 to ensure that viable projectsreceive financing (9 September). Liquid asset re-quirement of commercial banks reduced from 17 to15 percent of total eligible liabilities (16 September).Default period for classifying a loan as nonperformingby banking institutions increased from three to sixmonths (23 September).

October. Sixty percent maximum margin for fi-nancing the purchase of nonowner occupied resi-dential properties costing RM300,000 and above, andthe purchase of land lots abolished (5 October).BNM’s intervention rate further reduced to 7.5 per-cent (5 October).

November. Banking institutions required to es-tablish loan rehabilitation units to enable more in-tensive management of problem loans (20 Novem-ber). The minimum monthly repayment on creditcards reduced from 15 to 5 percent of the outstand-ing credit card balances (20 November). The hirepurchase guidelines for passenger cars abolished,allowing banking institutions to determine their ownterms and conditions for hire-purchase loans(21 November).

December. The maximum finance charges pay-able by cardholders reduced to not more than1.5 percent per month or 18 percent per annum from2 percent per month or 24 percent per annum (30December).

1999January. Banking institutions no longer allowed

to provide bridging finance for development of prop-erties costing above RM250,000, except for ongoingprojects (4 January). Banking institutions required toachieve a minimum loan growth of 8 percent by theend of 1999 (4 January). The tier system of bankinginstitutions discontinued. As part of efforts tostrengthen BNM’s banking supervisory function,additional staff recruited. Finance companies


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encouraged again to merge or be absorbed by banks,given that the liquidity situation had improved andother financial sector restructuring measures werealready in place. The process of absorption/mergerto be market-driven and intended to reduce their

number to a smaller group of large and strong insti-tutions. This process to be expedited to enable thefinancial system to function quickly.



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Notes1Agreement reached by France, Germany, Japan, UnitedKingdom, and United States to drive down the price of thedollar. Their coordinated efforts led to a 30 percent declineof the dollar in the subsequent two years.

2It further increased to 149 percent in December 1997 (BNM1998).

3The rate reached 33 percent in December 1997 (BNM 1998).

4Danaharta’s acquisition strategies and objectives involvevaluation methodology which was used as an asset valu-ation method in various countries. Among the more promi-nent ones are the Swedish Securum Asset ManagementCompany and the US Resolution Trust Corporation.

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