MALAYSIA. million small holder families in the rubber, palm, and cocoa sectors. Summary

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1 MALAYSIA Summary Malaysia appears to be maintaining the momentum of economic recovery in 2003, supported by sound economic fundamentals and a healthy external position. Given the openness of its economy and the structure of its exports, Malaysia is well positioned to benefit from global recovery and improvements in its terms of trade. Macro policies continue to be supportive of recovery. Domestic demand led by the fiscal stimulus package of RM 7.3 billion (2% of GDP) has supported growth in the first half of Private investment and FDI recovery remains sluggish. Some items on the medium-term policy agenda include further improvements in the investment climate, specifically to reduce the regulatory burden on firms, reduce skills shortages and mismatch, and strengthen innovative capacity; and further strengthening of public debt management. Macroeconomic Developments A broad based recovery gained momentum in 2002 and continues in In 2002, real GDP grew by 4.2%, up from 0.4% in. From the supply side, growth was supported by the rapid expansion in the services and mining sectors and the favorable expansion in the manufacturing sector. The services sector grew by 4.5% in 2002, supported by the recovery in domestic demand, the expansion in trade related activity and the growth in tourist arrivals. The manufacturing sector turned around with an expansion of 4.1% in 2002 compared to the 6.2% contraction in. Mining sector grew by 4.5% thanks to increased production from new oil and gas fields, the increase in demand and favorable prices. From the demand side, growth was also broad-based, helped by expansionary fiscal policy and continued strength in private consumption. Fiscal policy remains the main countercyclical instrument under the current exchange rate regime. Increases in public expenditures were largely channeled to development purposes. Private consumption was helped by favorable labor market conditions (unemployment rate fell to 3.5% in 2002), lower income taxes, low interest rates, higher disposable incomes in the urban areas, higher rural incomes as a result of the sharp increase in agricultural commodity prices, and increased access to credit as a result of the improved banking sector. Higher commodities prices brought benefits to about half a million small holder families in the rubber, palm, and cocoa sectors. In 2003, the economy expanded at 4.4% in the 2nd quarter (4.6% in the 1 st quarter). For the first half of the year, GDP growth reached 4.5% (compared with 2.6% for the same period in 2002), despite the Severe Acute Respiratory Syndrome (SARS) epidemic and the uncertain global situation. It is expected that growth for 2003 will reach 4.6%. Both fiscal and monetary policy measures contributed to stimulate domestic demand. Private consumption remained resilient with 3% growth in the 2 nd quarter, and 4.4% for the first half of the year (compared with same period in 2002). Manufacturing performed well at 6.5% compared with 5.2% for the 1 st quarter, driven by growth in the resource-based industries. Manufacturing growth rates were positive since the 2 nd quarter of Construction activities increased, stimulated by higher public expenditure in infrastructure projects. Other sectors show improvement as well: agriculture at 10.4% and mining at 10.5%. The services sector sustained more moderate growth of 2.8% due perhaps to the SARS impact after a broad-based growth of 4.5% in the 1 st quarter. Aggregate domestic demand expanded by 3%, reinforced by exports (5.8%). Public sector consumption remained strong at 7.2% from expenditures on salaries, defense and goods purchases. Inflation recorded a 1.1% increase for the first seven months of 2003 compared with same period in The exchange rate remains fixed to the US dollar. The government argues that the exchange rate should remain fixed in the interest of stability and because a high portion of exports are made to the US. Exports grew by 6% in 2002 and continue to expand in 2003, compared to the sharp 10 % fall in US$ terms in. For 2003 as a whole, exports are projected to continue to grow at the same rate at 6%. Between January and July 2003, export growth of crude oil, liquefied natural gas, rubber and palm oil has been strong, helped by the increased intra-regional trade and the accession of China into WTO. China share in Malaysia s trade, while small (4.7% of total trade in ) has been increasing, reaching 5.6% in The terms of trade effect of China s accession into WTO is likely to be positive for Malaysia, given

2 Malaysia Brief 2 that China s demand for food and energy imports is expected to rise significantly and Malaysia is an exporter of these products. However, the average growth rate of electronics products between January and July 2003 was negative (-6.6%). A similar trend is uncovered for electrical machinery and appliances (- 6.4%) over the same period. Declining exports in ITrelated fields may reflect the slower than expected recovery in the USA. It may also signal an increasing competition between Chinese and Malaysian exports in third country markets. China s entry into the WTO places a premium on the competitiveness of Malaysian firms and Malaysia s attractiveness as a destination for FDI and reinforces the need to nurture a sound investment climate. Imports recovered in 2002 with 8% growth after a dip of 1 in. In 2003, it is projected that imports would grow at about 6%. A healthy external position. In 2003, the overall balance of payments improved thanks to the large sustained surplus in the current account (7.6% of GDP in 2002 and a similar level estimated for 2003), larger inflows of long term capital and a lower net outflow of short term capital. The surplus in the goods account was more than sufficient to offset the deficit in the services account. Net international reserves with Bank Negara Malaysia (BNM) increased to $34.6 billion in 2002, adequate to finance 5.3 months of imports, and equivalent to 4.3 times the short-term external debt. These have increased further to $38.6 billion as of mid-august 2003, adequate to finance 6 months of imports and 4.3 times the short-term external debt. Total external debt increased modestly from US$ 45.7 billion in to US$ 48.8 billion, equivalent to 55% of GNP in 2002, but remains manageable. There are no arrears. Macroeconomic policy continues to be supportive of recovery. Timely fiscal and monetary stimuli have been instrumental in weathering the adverse impact of the global slowdown. The May 2003 fiscal stimulus package of RM 7.3 billion (2% of GDP) has helped to sustain high level of consumer spending and contributed to a stronger wages growth. Impact on domestic demand is expected to be higher in the second half of the year. The Bank Negara Malaysia intervention rate has remained stable and above international interest rates, helping to stem capital outflows and build foreign reserves. Outstanding loans by the banking sector increased in the fourth quarter of 2002, with loans to small borrowers increasing more rapidly. Lending by financial institutions to purchase residential property has steadily increased over time, rising from 13.4% of total lending in to 18.5% in, while lending for consumption credit increased from 11.5% to 14.8% during the same period. Another indicator of consumption spending, spending through credit cards, increased by 25.8%, continuing the high rate recorded in (22.3%). Growth was higher in both the number of credit cards in circulation as well as the value of transactions. This high growth notwithstanding, credit card balances have been settled thanks to higher disposable income. NPLs of credit card transactions, about 0.7% of total NPLs of the banking system, declined to 4.1% of total outstanding loans at end-2002 from a peak of 17.4% at end-. NPLs (6 months) in the banking system have declined further to 6.8% at end-june 2003 (compared with 7% at end-march). The risk weighted capital ratio of the banking system was at 13.1% at end June and decreasing slightly since December 2002 (13.2%). Fiscal policy has been the main counter-cyclical instrument of the Government. Fiscal policy played a central role in mitigating global uncertainties in 2002 with the Government s overall financial position registering a deficit of 5.6% in 2002 compared to 5.5% in. The high savings rate (gross national savings was 34 % of GNP in 2002) and ample liquidity in the banking system made it possible for the fiscal deficit to be largely financed domestically. Fiscal policy measures included increased development expenditures for projects with high employment potential, low import content, and a short gestation period. There was also a 2 percentage point reduction in pension contributions to the Employee s Provident Fund and higher individual tax rebates. Public debt remains within a manageable level. Total public sector debt reached 7 of GDP in 2002, consisting of borrowing either directly or guaranteed by the government. Total external debt increased slightly to $49.1 billion at end-march 2003 compared with US$48.8 billion as end-2002, but as a share of GDP, the ratio declines to 52.9% of GDP for end- March 2003 vs. about 56% of GDP at end-december Financial sector development Asset quality and capital position. The NPL ratio of the Malaysian banking system has declined steadily to 13.9 percent in mid About half of the decline in the NPL ratio over the past two years has been due to

3 Malaysia Brief 3 growth in the outstanding loan volume. The level of distressed assets in the merchant banking sector however, has remained stubbornly high: the NPL ratio stood at 32 percent (24.4. percent net of interest in suspense and provisions) at end 2002, in large part because outstanding loans from the merchant banking sector has declined by 30 percent over the past two years. Interest margins in the Malaysian banking system have declined continually over the past four years through mid-2003, apparently squeezed by a combination of regulatory and market pressure, as merged entities compete for market share. A greater share of loans is now made at or near base lending rates. However, non-interest income is increasing relative to interest income and now contributes 30 percent to the bottom line. The rates of return to assets and equity have continued to improve and although they are still below pre-crisis levels, they are now relatively high. With the recapitalization of the banking system through a combination of interest spreads, market based investments and through the Government s special purpose vehicle, Danamodal, the risk-weighted capital adequacy ratio stood at 15.6 percent at the end of Malaysia: Non-Performing Loans (% of total loans) Including provisions and interest in suspense Dec Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Malaysia excl. Danaharta Excluding provisions and interest in suspense Dec Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Malaysia excl Danaharta Consolidation and restructuring. Malaysia s medium-term financial sector strategy is anchored in the gradual introduction of competition between domestic and foreign financial institutions that will require fewer, better capitalized, larger and more diversified domestic banks. Through the strategic action of Bank Negara Malaysia, the number of banks has been consolidated from 60 prior to the crisis to 30, grouped in ten financial groups. As is often the case in mergers, however, consolidation involving relatively equal sized counterparts has been more difficult and some deals have run into difficulties. Nonetheless overall progress in Malaysia s banking sector consolidation remains robust although it will now depend substantially on market forces including the ability of management to integrate back office systems and reap efficiencies of scale. The authorities have also launched reforms to consolidate the insurance and stock brokerage industries and convert them into better-capitalized universal brokers. Asset recovery. Danaharta, the national asset management company has now identified restructuring solutions for all of the loans in its portfolio and expects a recovery rate of 58 percent on total assets of Ringgit billion. Of the total portfolio, 42 percent was acquired from banks and 58 percent are assets of the defunct BBMB and Sime Bank Group, which Danaharta is managing on behalf of the Government. Corporate Sector Development Danaharta has identified restructuring solutions for all of its loans in its portfolio, and is now expected to focus on implementing approved recovery strategies and accelerating cash realization until its targeted closure date of Of the various methods of resolution, (loan restructuring, settlement, Special Administration under the Danaharta Act, schemes of arrangement, and foreclosure), foreclosure has

4 Malaysia Brief 4 accounted for the greatest percentage for loans acquired from banks, whereas for the managed assets (assets transferred from BBMB and Sime Bank Group), settlement and court approved schemes of arrangement have accounted for the greater proportion (at 22 percent and 23 percent respectively). Only 14 percent of managed loans have gone through foreclosure compared with 44 percent of the loans that were purchased from the banking system. The recovery rate, on average, has been highest for voluntary settlements, usually involving combinations of cash, assets and performing loans worth 89% of face value. Foreclosure has had the lowest yield, at 34%. As of July 2003, Danaharta had appointed 72 Special Administrators. Of these, 57 had been discharged after completing their workout tasks, nine were in the process of implementation and discharge of Special Administrator, 35 had approved workout proposals, and 22 were still at various stages of developing workout proposals. The Corporate Debt Restructuring Committee (CDRC), which was created in to assist in a voluntary, out-of-court restructuring of corporate debt of businesses considered viable, wound up its operations in August At the time of its closing, the CDRC had completed 48 cases (out of a total 50 cases) resolving 93 percent of the initial outstanding debt stock (RM 54.4 billion) entrusted to them. Eleven cases were transferred to Danaharta, and seven large cases were recently settled (with debts amounting to RM12 billion), including the resolution of the Putra and Star light rail projects, which involved the nationalization of their debt through the issuance of RM 5.5 billion of government-guaranteed bonds to their largest creditors and RM 4 billion guaranteed by Johar State Government. An important turning point for CDRC was new guidelines were issued in August, empowering the CDRC to complete corporate debt restructuring and activate operational restructuring (including disposal of non-core assets and separation of ownership and management). At this time the chairmanship was consolidated with that of Danaharta. Given that corporate restructuring is now moving into a more market-driven phase, the efficient functioning of the court process will be of increasing importance. In Malaysia, creditors may petition the High Court to liquidate ( wind up ) a corporation for failure to pay its debts under the Malaysian 1965 Companies Act. Wind-up provisions of the Act have provided debtors the incentives to seek the protection of court-supervised reorganizations or to cooperate with out of court restructuring efforts. Under the Act, the High Court can enforce a reorganization or debt composition plan that is supported by 75 percent (debt weighted) of the company s creditors, and the Court can grant a stay or moratorium on creditor action to allow the restructuring plan to be implemented. Recent amendments to the Act have ensured that a distressed company cannot make an ex-parte application to a court for a restraining order against possible action by creditors. However, the Act still does not provide for the ready appointment of special administrators to manage the affairs of distressed companies except to a debenture holder. In order to address this, the Government introduced special powers under the Danaharta Act, which allows for a special administrator to prepare the workout proposal, an independent advisor and an oversight committee to ensure fairness. Once Danaharta approved the plan, the plan requires the support of a majority (debt weighted) of secured creditors, before it can be implemented. With Danaharta now wrapping up its operations, the strength of the formal insolvency system will again be of primary importance. Since the Government has been moving more aggressively and directly to address the restructuring problems of larger groups, and progress has been made with respect to several major restructuring cases over the past year. Renong, whose debt exceeded $1.15 billion at end-2002, will undertake a restructuring in which viable construction, property, health care and environmental assets will be transferred to a new firm with a more sustainable debt load. Pernas, whose debts exceed $650 million, will also restructure by divesting its hotel and petroleum assets and restructuring its financing. There is considerable Merger and Acquisition (M&A) activity in Malaysia: the $1.77 billion purchase of Petronas by Egyptian LNG, the Malaysia International Shipping s $1.1 billion purchase of American Eagle Tankers, as well M&As involving consolidation in banking and utilities. M&A activity was catalyzed by Kuala Lumpur Stock Exchange s (KLSE) Practice Note No. 4, which required financially distressed firms to have net positive financial positions by the end of A number of firms disposed of distressed assets through reverse takeovers. Importantly, regulators sought to ensure that the major shareholders of these firms would not benefit financially from reverse takeovers in an unfair manner. In many cases, this has resulted in changes in

5 Malaysia Brief 5 weak management, thereby helping to address the root causes of distress. Corporate Governance has been strengthened, including through issuance of the Malaysian Code of Corporate Governance in, amendments to the Securities Industry Act of 1983, and a new Malaysian Code on Takeovers and Mergers. The new Take-over Code greatly enhances the position and treatment of minority shareholders in public listed companies and larger private companies. Prospects Despite the continued geopolitical uncertainties, the strong economic fundamentals of the Malaysian economy, the restoration of macroeconomic stability, and progress achieved in the restructuring of financial and corporate sectors provide policy makers with greater flexibility to sustain economic recovery. The structure of the Malaysian economy is diversified with a strong traditional sector petroleum, gas, palm oil, and other commodities that will act as a buffer against uncertainty in the other modern sectors of the economy. Modest world economic growth, some pick-up in the global electronics industry, firmer commodity prices, and further expansion in intra-regional trade will help sustain economic growth in Malaysia. When the recovery in US, Japan and Europe gains momentum, Malaysia is likely to get a significant benefit, given its high level of integration into the global economy. Withstanding external shocks. Business confidence is currently high in Malaysia due to the sense that the economy has withstood a substantial set of economic shocks, including SARS, the war in Iraq, and the downturn in markets for electronic exports. Tourism comprises ten percent of the Malaysian economy, and was hard hit by the SARS epidemic, but Malaysia managed to avoid the SARS-related recessions that hit Taiwan and Singapore. Growth in services was mildly strained, but was offset by strong performances in manufacturing, agriculture and natural gas sectors. Strong prices for palm oil, rubber and gas boosted exports, and above all, growth was boosted by government spending, including the May 21 fiscal stimulus package and bonuses for civil servants. The downturn in the electronics sector now also appears to be over chipmakers are announcing profits and Intel recently announced plans to expand in Malaysia. The Government appears focused on increasingly marketbased recovery of the corporate sector a fact made necessary by seven years of fiscal deficits. There was significant debate over the merits of a reduction in corporate income tax from 28%, but corporate income tax has remained stable in the proposed 2004 budget. Continued competition from China for FDI. Like most South East Asian economies, Malaysia has experienced increased competition for FDI from China. In FDI approvals declined 41% to $2.95 billion. In the latest UNCTAD report, Malaysia is noted as one of twelve countries in the world that have increased FDI amidst the long global slowdown. However, FDI inflows into Malaysia as a fraction of GDP and a share of total FDI into East Asia have shown a pronounced downward trend, suggesting that, relative to other countries in the region, Malaysia has become a less attractive destination for FDI. Net foreign direct investment fell from around 4% of GDP in to less than 0.5% in. Although there was a slight recovery in 2002 to about 1% and a projected 1.2% is expected for 2003, Malaysia is still far from pre-crisis investment levels. For the first quarter of 2003, available date show an outflow in direct investment of RM 2,130 million ($560 million), compared with an inflow of RM2,334 million ($614 million) in the first quarter of Portfolio investment for the first quarter of 2003 shows an outflow amounted to RM 703 million. This continues the outflow trend recorded since the second quarter of 2002.For the first five months of 2003, foreign applications of RM 3.5 billion were roughly half of total applications. The largest sector was electrical and electronic a sector in competition with China as an FDI destination. The government has committed to further strengthening FDI efforts by implementing a proactive marketing strategy for MIDA. Industry has asked for further liberalization of equity investment conditions in FDI, including removal of sectors on the negative list and reduction of administrative barriers, and some have called for phasing out the Foreign Investment Committee. Private investment remains sluggish. Five years after the financial crisis, private investment levels have yet to return to pre-crisis levels. Following the crisis, private gross fixed capital formation fell sharply from 32% of GDP in to around 4% in. It is slowly increasing to over 5% in 2002 and projected to reach about 8% in There is room for improving private investment to 2 of GDP by improving the investment climate.

6 Malaysia Brief 6 Weak private investment performance may be explained by micro-level rigidities in the system. A recent world Bank study suggests that the medium term growth and competitiveness prospects of Malaysia may be compromised by four factors. First, firms report that the investment climate is weakened by the presence of a significant regulatory burden. The cost of regulation is higher in Malaysia relative to other countries in which the World Bank has conducted similar surveys. This has distorted the incentives faced by the Malaysian firms to invest, innovate and grow. Second, Services specifically key business-support services are not well positioned to drive future growth. As Malaysia makes the transition from middle to high-income status, services sector will need play a bigger role in supporting GDP growth. Third, firms suffer from severe skills shortage. Evidence of skills shortages is the high wage premium paid for tertiary education graduates and the suboptimal distribution of skilled labor across firms. The stock of skills is not growing sufficiently quickly to make investment opportunities in Malaysia sufficiently attractive. Also, increases in the quality of the workforce and higher rates of productivity growth are required to support future growth. Fourth, firms display adequate adoptive and adaptive technological capabilities but are weak innovators. The share of sales from new products and new processes is well below that in more technologically advanced countries. In order to achieve its vision 2020, Malaysia needs to take appropriate measures to tackle these constraints.

7 Malaysia Brief 7 Malaysia: Selected Key Indicators Headcount (%) ($2-a day) Real GDP per Capita Index (1996=100) 2 18% 16% 14% 12% 1 8% 6% 4% 2% est Source: EASPR, World Bank Note: Estimates derived from income data. Source: Derived from BNM (end Aug) 12% 12% 11% 11% 1 1 9% 9% 8% Dec-01 Feb-02 Apr-02 Jun-02 Aug-02 Oct-02 Dec-02 Feb-03 Apr-03 Jun-03 Ratio of Gross Official Reserves to S-T Debt NPLs (3 mos/total Loans) Source: IMF Source: BNM p Public Debt/GDP 2003 e 35% 3 25% 2 15% 1 5% 2002p 2003e Private Investment/GDP % % % % 0. FDI/GDP 2002p 2003e Source: IMF. Source: IMF Source: IMF WB87803 N:\Bi-Annual Report Oct.2003\Country Briefs\Malaysia Brief Oct 10 Final.doc October 14, :50 AM