Financial Liberalization and External Shocks in the Malaysian Economy

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Financial Liberalization and External Shocks in
the Malaysian Economy

• Rajah Rasiah, Miao Zhang
• University of Malaya, Malaysia

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Outline

1. Introduction
2. Liberalization to Attract FDI
3. Heavy Industry Promotion behind External Exposure
   
4. Return to Export-orientation
5. The Asian Financial Crisis
6. Capital Controls
7. Revival of Deregulation
8. Conclusions

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1. Introduction

• Keynes (1936) argued lucidly that markets are
  inherently imperfect and the relationship
  between economic agents are often asymmetric
  (Stiglitz, 2009)
• Keynesians call for interventions to ensure
  stability in both currency and capital markets so
  that the real economy is not subjected to
  turbulence. The call for this has become strong
  especially after 2007-08 global financial crisis
• Malaysian economy fluctuated in a volatile manner
  as a consequence of heavy dependence on the
  primary commodities of rubber and tin
• fixed exchange rate mechanism shielded its
  incipient economy from externally driven
  financial bubbles until 1971 when the fixed
  exchange rate mechanism was abandoned after the
  United States withdrew the dollar and depreciated
  it.
• Ringgit was introduced in 1975
• Exchange rate began to fluctuate since 1973 when
  BNM withdrew from the currency union with Brunei
  and Singapore-- Keynesian exchange rate
  instruments were largely abandoned
• Malaysian has had a mixed experience with
  financial liberalization with capital controls
  introduced between 1998-2005 being the only time
  when a serious attempt was made by the government
  to regulate the financial market.
• This paper presents an analytical assessment of
  deregulation in the financial market with its
  consequent impact on the real economy over the
  period 1960s till 2014.

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2. Liberalization to Attract FDI 1970s

• Behind interventions through NEP, the
  liberalization of manufacturing targeted at
  attracting FDI for stimulating job creation, no
  significant limitation on manuf. firms until
  1975.
• Despite of NEP conditions imposed in 1975 on
  firms equity, the government relaxed ownership
  conditions on firms exporting at least 80 of
  sales.
• Exchange rates and investment regulations were
  also made liberal in the 1970s.
• However, no introduction of innovation rents to
  stimulate technological upgrading
  (Schumpeter,1934, 1943). E.g. grants for RD
  facilities and HR development of human a la the
  efforts by Taiwan
• Hence, export-oriented industrialization in
  Malaysia in the 1970s was dominated by low-value
  added activities.
• The only semblance of Keynesian policy use in the
  1970s-- the usage of fiscal policies to create
  employment
• Heavy integration to the global economy
  exposed the economy to external shocks, e.g. the
  price fluctuation of rubber and oil.

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3. Heavy Industry Promotion the 1980s

• Mahathir Mohamad Look East Policy in 1981 to
  spearhead national-ownership based heavy
  industrialization
• Protection and state ownership targeted at
  leaving control to Bumiputeras became the call of
  the government to industrialize.
• High commodity prices enabled such policy, inclu.
  Infrastructure across western Malaysia
• Such Import-substitution policies resembled the
  type advocated by structural economists failed
  (example Perwaja Proton)
• lacked the introduction of Schumpeterian-type
  innovation rents that Amsden (1989) had argued
  were critical in South Koreas catch up
• lacked the use of discipline (stick) required for
  rents (carrot) to be translated into performance
  (Chakravaty, 1986).

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3. Heavy Industry Promotion the 1980s (cont.)

• Hence, export-oriented manufacturing industries
  did not experience strong growth in value added
• Exception
• some inward-oriented manufacturing industries
  became successful from second round
  import-substitution. Domestic rents helped offer
  the scale for learning in klinker and cement
  production (e.g. YTL ) and highway construction
  (e.g. UEM)
• palm oil processing and oleo-chemicals industry
  grew because of natural resource endowments,
  government support through crude oil palm export
  tariffs, RD rents and price stabilization
  policies

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3. Heavy Industry Promotion--the 1980s (cont.)

• By the mid-1980s commodity prices had crashed to
  make debt service difficult as the balance of
  payment deficit began to soar. Its impact was
  Malaysia facing a recession for the first time as
  GDP contracted in 1985-86
• Unlike S. Korea imposing export quota,
  neo-liberal policies a la the type Bhagwati
  (1975), Friedman (1986), Krueger (1980) promoted
  were quickly back to dominate the Malaysian
  economy e.g. (renewed tax break incentives to FDI
  and devalued the ringgit in 1986)
• Consequence sales rents from taxes and tariffs
  continued to buffer the heavy industries, their
  relative costs soared as the fallen ringgit made
  payments for imported capital equipment and
  licensing fees extremely expensive
• The lack of effective human capital development
  policies and pressure to upgrade left these firms
  to remain dependent on foreign technology.

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4. Return to Export Orientation- the late 80s to
90s

• Export incentives were reintroduced to attract
  FDI
• Export refinancing schemes
• Double deduction tax exemptions
• Massive Capital Inflow
• foreign-led manuf. sector grew strongly
• Percentage share FDI in domestic investment rise
  from 10 in 1980-90 to 25 in 1991-95
• Export surges in
• Electronics (Sgp and Msia biggest production
  platform)
• Textile Garment
• Resource-based e.g. palm oil processing wood
  product
• Manufacturing driven by growing demand generated
  by export sector but also enjoyed by inward
  oriented firms e.g. car, steal cement

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4. Return to Export Orientation- the late 80s to
90s

• Massive expansion of export oriented industries
  in low value added activities,
• Labour shortages began to mount as labour-saving
  technical change was slow.
• Semi-skilled foreign labour inflows began to grow
  strongly

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5. The Asian Financial Crisis

• Between 1991 till July 2 1997 exchange rates
  began to appreciate strongly despite growing
  current account deficits
• Appreciating ringgit aggravated balance of
  payments (Figure 2)
• Eclectic industrial policy saw little
  technological upgrading to support higher
  ringgit. Foreign low skilled labour inflows drove
  competitiveness in low value added manufacturing
  activities with technological downgrading in the
  electronics industry
• Meso-organizations launched since 1991 became
  white elephants because of ethnic colouring.
• Economy further liberalized from 1995 as
  financial institutions embraced market-oriented
  measures.
• The contagion from the collapse of the Baht
  destabilized the ringgit, which became easy not
  just because of regional integration but more
  because of vulnerability from growing BOP
  deficits.
• Although NPLs and debt soared much of it were
  domestically denominated, and hence, Malaysian
  still had 60 international reserves after taking
  account of current account deficit and short-term
  debt service.

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6. Capital controls

• Government imposed capital controls on September
  2 1998 after recognizing that the loss of
  confidence and runs by speculators would deplete
  international reserves further
• Ringgit was fixed MYR3.8 to a USD, ringgit
  trading abroad was banned, foreign accounts by
  Malaysians can only be held upon approval by Bank
  Negara. Ringgit notes of MYR500 and MYR1000 were
  terminated
• Declaration and approval of ringgit sent abroad
  beyond MYR10,000 made mandatory
• NPLs were sharply reduced following the formation
  of Capita Fund and Asset Fund which acquired and
  restructured all NPLs entities
• Banks were merged to strengthen their financial
  capacities
• Interest rates were lowered, and the CGS was used
  to substitute for collateral requirements. Banks
  were forced to raise their portfolio of lending
  to approved national firms enjoying CGS support
  from Central Bank
• Current account began recording massive surpluses
• Foreign portfolio equity investment and FDI
  declined over the period 1997-2000
• Booming US economy helped as along with the other
  OECD countries it boosted exports.

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7. Re-liberalization

• Following Badawis appointment of Prime Minister,
  the government kept to its stance of liberalizing
  and democratizing the economy.
• Capital controls were abandoned and the focus on
  SMEs increased.
• Large High tech firms, including foreign firms
  were also approved grants upfront.
• The groundwork for the new stance was the New
  Economic Model prepared with the leadership of
  liberal economists.
• While on the one hand, the NEM recommended a
  great departure away from ethnic-based
  affirmative action, and called for a focus on
  human capital development policies, it also
  called for further liberalization
• The lack of emphasis on selective interventions
  to drive technological upgrading drove the
  economy further to a transition to low value
  added export manufacturing activities.
• This has led to electronics and clothing firms
  increasingly their reliance on cheap little
  skilled foreign workers.
• Firms, both national and foreign prefer this
  arrangement because Malaysia offers far better
  security and infrastructure than workers home
  countries.
• The 2007-08 global financial crisis caused a huge
  collapse in exports, which led a GDP conracting
  in 2008-09.
• The consequences include rising household and
  public debt, overheating in key economic
  conurbations

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8. Conclusions

• While it cannot be denied that Malaysia is
  generally a success story of rapid economic
  growth and poverty alleviation among the
  developing countries, it has to be also said that
  its eclectic exposure to external markets and
  mis-interventions has denied the country the
  regulatory control to shield from disruptive
  external economic shocks and to promote
  technological upgrading to become a developed
  country.
• On the one hand, there is strong push to
  liberalize the economy when the interests do not
  directly collide with the interests of the elites
  despite recognition that the capital system
  produces disruptive shocks from time to time.
• On the other hand, interventions are targeted at
  consolidating the interests of the political
  elites, which often generate unproductive
  outcomes.
• The nature of politics in the country, which is
  truncatedly driven by ethnic polarization and
  dominated by the Bumiputeras has been
  unproductive.
• This is the disruptive nature of evolution that
  is led by collusion rather than collaboration.
• Under such circumstances, the minority productive
  species among both majority and minority ethic
  groups are overwhelmed by a coalition of majority
  unproductive groups in such groups.

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