The Financial and Currency Crises in Malaysia and Structural Problems Therein

Megumi Suto


1. The Currency Crisis and Structural Problems

The currency crisis that surfaced in Thailand in July 1997, took no time in spreading to neighboring countries. As it extended to as far away countries as Hong Kong and South Korea, it brought apprehensions about serious affects it might have on advanced countries. The recent currency crises in Asia have been named 21st century type crises due to their unprecedented enormity in size and swiftness in dissemination.

As for Thailand, a possible crisis had long been anticipated because the real exchange rate had gone down since a year before as short-term capital began to flow increasingly into the country through the offshore market in Bangkok (BIBF) or the financial intermediaries due to the rapid financial liberalization. As for Indonesia, it was feared lest bad loans should become serious problems with its domestic banks under the inflow of capital brought about by a drastic liberalization policy.

Among the ASEAN countries, Malaysia was not only highly acclaimed for its sustainable growth and stability but also its short-term foreign debts were smaller than the other countries and the money influx through the banks was strictly controlled. Nevertheless, it had to meet with stock plunges and the fall of its currency through the rush to sell ringgit and the sudden capital flight.

In regards to the factors commonly shared by those Asian countries that are faced with a currency crisis, two mistakes in policy-making have been recognized ; one is their foreign exchange system that pegged to US dollars and the other, the sequences in financial liberalization, which bring about the sudden inflows and outflows of private capital. In addition to these, the blame has been laid on the fragility of the financial sector that has resulted from the weak foundations of banking business, the regulation / supervision system that is yet to be completed, and the delay in building the basis for a capital market, which includes an inadequate disclosure system, bankruptcy procedure and so on. These are mentioned as the common structural problems ; a prevailing view is that the banking crisis and the currency crisis are two sides of the same coin.

The Malaysian government has hammered out one emergency policy after another to deal with the currency crisis ; it set forth measures to reduce the deficits of the current-account balance of payment and to implement a tight fiscal squeeze, and publicly announced that it would introduce a deposit insurance system. It also made an effort to stabilize its economy and recover confidence in the market. Malaysia's financial system, however, is not free from a structural problem of its own, which must be addressed immediately. It is a financial issue that derives from Bumiputra First Policy, or a social policy designed to treat native Malaysians more favorably. Bumiputra, which means native children, has played a decisive role in leveling off incomes, thus maintaining social stability and sustaining economic growth. But the policy has created various inconsistencies in the financial sector.

2. The Bumiputra First Policy and Economic Growth

Malaysia is a multiracial nation. Malays who occupy 60% of the population have economically been in the shade, and to elevate their social position has become a national policy since it was made a clear national goal in Malaysia's second five-year plan that was initiated in 1971. Among the countries in East Asia, Malaysia's uniqueness is considered to lie in the fact that it set out to build a financial system from a relatively early stage in the 1960s soon after its independence, in order to establish the basis of national savings for economic growth and realize the equalization of incomes and of assets for social stability.

With the spontaneous savings based upon a nation-wide network of banks and the compulsory savings whose basis was social welfare funds, Malaysia succeeded in mobilizing domestic small savings, and in bringing its national savings rate to a remarkable height. The Malaysian government, at the same time, worked wonders achieving its goal to improve native Malays' social status. The domestic savings rate recorded only a gradual increase in the early 1970s but since the late 1970s it has started to grow rapidly and the average rate reached as high a level as 34% in 1991-1995. It can safely be said from either of the indexes, the GNP growth rate or per capita income, that Malaysia entered the phase of taking-off in the late 1970s after the preparatory period of the 1960s.

The trade-off between stability and efficiency in the economic growth process is one of the biggest problems a developing country is faced with. Taking this into consideration, Malaysia's choice is noteworthy in building a financial system. But the successful Bumiputra First Policy begot inefficiency in financial intermediary because of the strictest restrictions the government had to impose on competition with a view to protect the domestic banking business, the favorable loans to Malaysians' businesses and housing loans favorable to Malaysian families, diverse measures in pension funds and the national investment trusts scheme instituted in order to let Malaysians form their personal assets. These favorable measures distorted the growing capital market and resulted in a fragile banking sector.

3. Factors that Support the High Savings Rate

The mainstay of domestic savings was household savings, a greater part of which exist in the form of bank deposits. Domestic banks contributed a great deal in mobilizing small household savings. But, in the 1980s as household incomes increased and consumption permeated, the savings rate in the private sector became unstable. The instability should be attributed mainly to the fluctuating spontaneous savings, and the money allocated to the pension funds or compulsory savings contributed to maintaining the national savings level as a built-in stabilizer for household savings.

In addition to this, it should be noted that the savings by the government have worked to supplement private savings in Malaysia. Malaysia's savings rate has long been stable at a high level through such governmental complementation. The governmental savings are chiefly composed of the general budget surplus and the surplus from Non-Financial Public Enterprises (NFPEs). From the late 1970s to the early 1980s there took place a hike in the prices of primary products, and the policy aimed to equip the country with chemical and heavy industries such as oil-well drilling increased surplus; these resulted in greater governmental savings during the period. The increase of the governmental savings seen during the period from the late 1980s to the early 1990s is due to such measures as the privatization of public businesses, restructuring for improvement of performance and setting up a supervisory organization the government took in response to the reduction of the fiscal budget and to the fall in prices of primary products.

However, when the restructuring of government and the privatization of public businesses come to an end, the governmental savings will shrink and cannot be expected to prop up domestic savings any longer. One lesson we have learned from the recent financial and currency crises in Asia is that the dependence upon foreign investment will amplify instability of the financial system. If the Malaysian economy expects to sustain growth, how to mobilize domestic savings especially spontaneous savings will be a more important challenge than it used to be.

4. A Turning Point in the Financial Policy

The most notable point in Malaysia's effort to build a financial system is its aggressive encouragement toward the growth of domestic banks. Since the central bank was established in 1959, it has been recognized as essential for stable, well-balanced economic and social growth to establish a sound, strong domestic bank system, and also to put into shape a nation-wide bank network and to nurture a habit for saving money among people in order to expand the basis for savings. A series of measures designed to let the domestic banks grow such as (1) the founding of two large size commercial banks financed by the government, (2) favors given to those who opened branches in local areas, (3) the restriction of competition in the regional market through regulation of new branches, and (4) strict regulation against foreign banks was implemented and established a banking system dominated by domestic commercial banks.

Thus, between 1970 and 1995 , the deposits of domestic banks multiplied 48 times, and those of commercial banks grew 94 times. Domestic commercial banks have constantly occupied about 40% of the total asset of the banking sector. Domestic commercial banks serve a highly concentrated banking market, and there are large discrepancies in size between a few larger banks and others. As of 1995, an oligopolistic market structure prevailed as the largest bank occupied 23% of the total balance, and the five top banks kept 48% of it. In addition, as of 1995, the main stock holders of the top two banks were the organizations that were under the strong influence of the government.

The restriction of competition, by assuring the banks of some rent, can be said to have been intended as a goal to lead banks to re-invest their surplus for developing a network of branches and expanding business. A nation-wide network of branches could not be built without investing a great deal of money and prepare for an uncertainty in profitability. To make banks feel like building up a branch network, just to grant such favorable ante conditions as preferential tax treatment or facility in obtaining permits would not be enough. Through guaranteeing rent and promising them such post conditions as strict restrictions against entry by others and regulations of branches, they had to heighten the franchise value of the network.

In Malaysia, however, while they strictly regulated against entry, they liberalized interest rates on deposits so as to give incentives to depositors in a relatively early time in the 1970s. The liberation was carried out at a time when banks were protected heavily by government policy and a supervisory system was yet to come. Competition for deposits, thus, took place and loose irresponsible lending operations followed. As a result, quite a few banks fell into financial difficulties. The liberalization was temporarily brought to a standstill. In the late 1980s control was tightened seeking healthier bank operations, and then interest rates on deposits were set free again.

Some consider that Malaysia is an example where the government interfered little with the banking and finance world as the liberalization of interest rates on deposits had been promoted from early times (cf. The World Bank The East Asian Miracles: Economic Growth and Public Policy, 1993). I must say this view has room for doubts.

Under a series of regulations that controlled competition, banks in Malaysia have been absorbing private savings while enjoying rent as a mobilization system for spontaneous savings since the1960s. On the other hand, their expansion strategies affected detrimentally their efforts to realize sound banking and after the late 1970s bank failures materialized. The oligopolistic market structure created factors which delayed construction of an efficient banking system.

5. Changes in Function Occurred in the Pension Funds

As I already pointed out, social security organizations centered around Employees' Pension Funds (EPF) which played a decisive role in mobilizing the long-term household savings for political banking. But the real function of EPF has undergone great changes in the 1980s.

Firstly, changes occurred in EPF's function of financial intermediary. Until the 1970s as much as 90% of the EPF was invested in government securities, providing funds for public finance. From the mid 1980s, restrictions imposed on EPF began to relax gradually and the degree of the private sector initiative increased as the government's operation went down in size. As of 1995, the percentage of investment in government securities dropped to 33%. But it is not always right to interpret this decline as the result of liberalized investment management, for the EPF was burdened with a role of a receiving apparatus or buffer for privatized government businesses. The deals were carried out in such expedient prices that it seemed that there was eminently an aspect of income re-distribution to the EPF by the government enterprises.

Secondly, the ability to mobilize long-term capital dwindled. As a means to stabilize society, the government encouraged people to possess their own houses and allowed them to draw money from their EPF before they retired. As a result, the amount of money thus drawn came to occupy 30-50% of that paid in. The EPF, thus, acquired a nature analogous to ordinary deposits and functioned less as a means for pension savings since they shrank before retirement.

Thirdly, the problem of moral hazard rose because of the increased liabilities of employers. The payment for EPF was originally equally divided between employers and employees, but since 1975 the employers' burden has been relatively increasing. As a result, I would like to point out, the employers who easily fall into default are on the increase.

6. Needs to Mobilize Savings in the Security Market

Obviously, the existing savings mobilizing system, whose principal targets are bank deposits and pension funds, stands at a turning point. One possible solution for the problems that have arisen in the course of re-directing the financial system toward the private sector initiatives would be to utilize the capital market and thereby absorb spontaneous savings. In order to achieve this, it will be necessary to make efficient use of fund management industry, which is represented by investment trusts.

The introduction of unit trusts goes back to relatively early 1959, but they did not begin to take root until the 1980s. In the late 1970s when the Bumiputra First Policy was launched, a state owned investment trust company was founded, and funds were designed to aid Bumiputra to acquire assets and equity capital. The aims of the establishment of the company lied in (1) to familiarize Bumiputra society with risk-taking involved in the possession of securities, and (2) to direct the savings thus collected toward equity holding.

The unit trusts, though they took the form of stock-investment trusts, were actually premium funds that could be bought back at fixed prices at any time, and guaranteed high dividends and entitled their owners to tax benefits. Moreover, when a state business was privatized, the unit trusts enjoyed a privilege to buy the company's stocks at a special discount price just like the EPF. The unit trusts, thus, were designed to become an asset because they were in fact a long-term, high interest bond with a government guarantee.

In the greater trends that move toward the economy of the private sector initiative, the EPF and the state-owned investment trust firm are still representative players in terms of the percentage of the securities they own and are required to act as institutional investors. While the EPF is, on one hand, expected to divert risks thanks to relaxed investment regulations, on the other hand, it cannot help but comply with demand for pre-retirement payments because of its role as a social security organization. The state-managed investment trusts cannot outgrow the originally imposed role of a means of re-distribution of incomes to Malaysians.

7. The Social Harmony Policy and Financial Reforms

The government takes the risks involved in investment trusts and the pension funds in reality are being used as short-term assets; these schemes thwart the healthy growth of capital markets. In the 1990s, they promoted private sector's mutual funds business, and, as a part of the social harmony policy, introduced the funds that non-Bumiputra people can buy. With that, private investment funds began to grow.

Malaysia must deal with two problems ; they have to refine the basic structure in order to secure people's confidence in the banks, and they also have to strengthen the function of capital markets which will facilitate to mobilize long-term capital. In order to achieve these goals, it is possible to say that they have come to a stage in development when they have to outgrow gradually the Bumiputra First Policy, which has effectively worked to stabilize society. A reform of national investment trusts scheme, privatization included, cannot be avoided. More efficient management of pension funds must be aggressively pursued.

The growth of fund management industry, including that of pension funds and investment trusts, is important because it provides a means to mobilize spontaneous savings in the capital market. For these organizations to act rationally as institutional investors will reinforce securities markets and enhance their function as capital market, and promote competition both in procurement and management of money. These are the essential conditions for strengthening the banking sector and capital market. It, however, takes time to change the financial structure. Taking this into consideration, I would like to keep observing how reform will be implemented in Malaysia's financial system.

(Chuo University, Fuculty of Economics)