Financial Liberalization and External
Shocks in the Malaysian Economy
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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
1. Keynes (1936) argued lucidly that markets are inherently imperfect; and the relationship
between economic agents are often asymmetric (Stiglitz, 2009)
2. 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
3. Malaysian economy fluctuated in a volatile manner as a consequence of heavy dependence
on the primary commodities of rubber and tin;
4. 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.
5. Ringgit was introduced in 1975
6. 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
7. 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.
8. 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 R&D facilities and HR development of human a la
the efforts by Taiwan
 Hence, export-oriented industrialization in Malaysia in the 1970s was dominated by lowvalue 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)
1. lacked the introduction of Schumpeterian-type innovation rents that Amsden
(1989) had argued were critical in South Korea’s catch up;
2. 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:
1. 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);
2. palm oil processing and oleo-chemicals industry grew because of
natural resource endowments, government support through crude oil
palm export tariffs, R&D 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
1. Export refinancing schemes
2. Double deduction tax exemptions
 Massive Capital Inflow
1. foreign-led manuf. sector grew strongly
2. Percentage share FDI in domestic investment rise from 10% in 1980-90 to 25% in 199195
 Export surges in
1. Electronics (S’gp and M’sia –biggest production platform)
2. Textile & Garment
3. Resource-based e.g. palm oil processing & wood product
4. 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,
1. Labour shortages began to mount as labour-saving technical change was slow.
2. 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.
7. Re-liberalization
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 Following Badawi’s 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.
Figure 1: Balance of Payments/GDP and Consumer Price Index,
Malaysia, 1960-2014 (%)
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200000
120
180000
100
140000
80
120000
100000
60
80000
60000
40
40000
20000
20
0
-20000
1950
1960
1970
1980
1990
Year
BOP
CPI
2000
2010
0
2020
Consumer Price Index (%)
Balance of Payments/GDP (%)
160000
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Percent (%)
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Figure 2: GFCF, GDP/Capita, Net FDI Inflow/GDP and PEI/GDP, Malaysia,
1960-2014 (%)
40
30
20
10
0
-10
-20
-30
-40
-50
Year
Change in GFCF
Change in GDP/Capita
Net FDI/GDP
PEI/GDP
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