Financial Sector Reform in Malaysia
Financial Sector Reform in Malaysia document sample
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MALAYSIA: SOCIAL AND STRUCTURAL REVIEW UPDATE TABLE OF CONTENTS EXECUTIVE SUMMARY A. INTRODUCTION ......................................................................................................................... 1 B. MACRO GROWTH AND RECOVERY .......................................................................................... 1 C. POVERTY AND SOCIAL PROTECTION ....................................................................................... 8 Short Term Protection Measures................................................................................. 8 Medium Term Social Protection Measures............................................................... 12 D. FINANCIAL SECTOR STRENGTHENING AND CAPITAL MARKET DEVELOPMENT ............... 13 Financial Stabilization............................................................................................... 13 Structural Reform...................................................................................................... 15 Financial Sector Regulation and Supervision ........................................................... 17 Reform of the Capital Market .................................................................................. 19 Financial Stability Forum.......................................................................................... 21 E. CORPORATE RESTRUCTURING ............................................................................................... 22 Malaysian Performance in the Regional Context...................................................... 22 The Corporate Debt Restructuring Committee Process ............................................ 24 Danaharta ................................................................................................................. 25 Trends in Corporate Sector Performance.................................................................. 26 F. CORPORATE GOVERNANCE AND COMPETITION POLICY..................................................... 27 H. PUBLIC SECTOR PERFORMANCE AND MANAGEMENT.......................................................... 32 _______________________________________________________________________ The SSR Update was prepared by Ron Hood (EASPR). Peer reviewers were Jeffrey Hammer (DECRG) and William Mako (EASPS). The report was prepared under the general guidance of Ijaz Nabi (Country Manager, EASPR) and Homi Kharas (Sector Director, EASPR). Valuable comments and advice were received from Arvind Gupta and Saha Meyanathan (EASPS). TABLES Table 1: Employment Wages and Aggregate Earnings ................................................................... 3 Table 2: External Debt ..................................................................................................................... 4 Table 3: Federal Government Current Expenditure ...................................................................... 12 Table 4: Federal Government Development Expenditure ............................................................ 12 Table 5: Regional Comparison of Financial Sector Restructuring Strategies................................ 15 Table 6: Corporate Restructuring, August 1999 ............................................................................ 24 Table 7: Operational Performance of Publicly Traded Corporations and Share of Distressed Corporations.................................................................................................................... 24 Table 8: Corporate Debt Restructuring as of May 2, 2000 ............................................................ 25 Table 9: Asset Tenders Held by Danaharta (June 1999 to Present) .............................................. 25 Table 10: Malaysia: Financial Ratios of Listed Corporations ....................................................... 26 Table 11: Summary of Corporate Governance in Malaysia........................................................... 28 Table 12: Compliance with OECD Corporate Governance Principles.......................................... 30 Table 13: Macro Growth and Recovery......................................................................................... 34 Table 14: Social Protection and Poverty........................................................................................ 34 Table 15: Financial Sector Strengthening and Capital Market Development................................ 35 Table 16: Corporate Restructuring................................................................................................. 36 Table 17: Corporate Governance and Competition Policy ............................................................ 36 Table 18: Public Sector Management ............................................................................................ 37 FIGURES Figure 1: Quarterly GDP Growth .................................................................................................... 2 Figure 2: Contribution to GDP Growth ........................................................................................... 2 Figure 3: Federal Government Debt ................................................................................................ 3 Figure 4: Lending Rate Spread over T-bill Rate.............................................................................. 4 Figure 5: CPI and Food Prices ......................................................................................................... 8 Figure 6: Retrenchments and Vacancies........................................................................................ 10 Figure 7: School Enrollment.......................................................................................................... 11 Figure 8: Lending and NPLs.......................................................................................................... 13 Figure 9: Regional Interest Rates................................................................................................... 14 Figure 10: Outstanding Ringgit Bonds .......................................................................................... 20 BOXES Box 1: The Capital Controls Episode .............................................................................................. 6 Box 2: Regional Comparison of Asset Resolution Strategies....................................................... 23 MALAYSIA: SOCIAL AND STRUCTURAL REVIEW UPDATE 1 Executive Summary A Structural Policy Review (SPR) for Malaysia was released in June 1999 covering short and medium term structural issues that emerged during the first 14 months of the crisis. Since then, however, events have evolved. In particular the recovery is now firmly established both in Malaysia and in other countries of the region. The objective of this report is to review the progress made on structural issues over the last year and place these in the context of what is happening a) in other countries in the region managing the same crisis and b) in the discussions of the new international financial architecture. This perspective is used to assess the quality of the current recovery and structural basis for sustained medium term growth and poverty reduction. The conclusions regarding developments in the six main areas identified in the SPR are as follows. Maintaining sound macroeconomic policies and resuming growth. Although fiscal stimulus was applied with some implementation lag, pre-crisis levels of growth have now been reached without a buildup of unsustainable public sector debt. The strength of exports has been an important factor as has the well-established flexibility of labor markets. An accommodative monetary policy since Q3-1998 has aided in the recovery and eased the NPL situation without creating price instability. The output gap in Malaysia in 1999 was only 7.2% of GDP compared with 12.9% in Korea, 14.5% in Thailand and 16.6% in Indonesia2. This reflects both Malaysia’s more favorable initial conditions and the faster pace at which it has been able to close the gap. Capacity utilization is tightening and on current trends the Malaysia will close its output gap completely by 2002, ahead of the other three countries. Remaining challenges include completion of the exit from capital controls and managing an orderly transition to a consistent regime of exchange and monetary policies that avoids a buildup of external pressures and is done in coordination with financial sector reforms. Managing the social impact of the crisis. The speed of the recovery sharply reduced the likelihood of a deep and lasting reduction in living standards. The authorities have been slow to release household survey data that would corroborate this, but available information on education participation rates, unemployment and infant mortality all suggest that the negative impact of the crisis on the poor was less than had been feared. The average real wage fell by only 1.1% in 1998 compared with 4.6% in Thailand, 9.3% in South Korea and 41.0% in Indonesia. As the recovery began, wages rose and the average real wage in manufacturing increased by 3.0% in 1999. Health and education budgets were well protected throughout the crisis and an extensive package of targeted spending programs was launched, albeit with a lag in some instances. Financial sector restructuring. BNM moved quickly to stabilize the financial sector by injecting capital into the banks via Danamodal. The regulatory forbearance allowed at the time may have been necessary as a temporary measure but classification and provisioning standards should be tightened again as soon as practical. The Risk Weighted Capital Ratio of the banking system has increased steadily from the low of 10.3% at the end of 1997 to 12.9% as of June 2000. Malaysia is actively participating in the Financial Stability Forum FSF and is a member of the Working Group on Capital Flows. Malaysia is seeking to adopt the new standards of international 1 The original study was entitled Structural Policy Review (SPR). The current update is entitled Social and Structural Review Update (SSR Update) to conform to the new titling convention at the World Bank. 2 World Bank, 2000, East Asia Recovery and Beyond, p. 7. - ii - best practice as they emerge from the work of the FSF and has launched an important and comprehensive medium term program of financial sector reform including many positive elements such as consolidated reporting, credit risk management and the new liquid asset management framework. Much of this agenda and the banking sector consolidation exercise will take several years to implement fully. Corporate restructuring. Danaharta was given strong legal powers that have enabled it to complete its assets acquisition phase quickly and it has made significant progress on case resolution and asset sales. Major revisions to bankruptcy legislation and establishment of new courts have helped with voluntary case resolution and have moved Malaysia closer to international best practice. However, much restructuring has been in the form of debt rescheduling and despite Danaharta’s work in carving out NPLs the proportion of NPLs remaining on banks books has fallen only slowly to 16.7% (Q1-2000) from its peak of 18.9% (Q4-1998). This performance is better than that of Indonesia and Thailand where NPLs remain in excess of 30% although these countries had much higher peak NPL ratios at the outset. Strengthening corporate governance and competitiveness. The laws and regulations for corporate governance have always been strong in Malaysia relative to other countries in the region. Further refinements and improvements have been made as the country has implemented the recommendations of the High Level Committee on Corporate Governance including law reforms (prospectus disclosure, investor civil actions against directors), issuance of a (voluntary) Code on Corporate Governance, and mandatory accreditation of directors. Weaknesses in autonomy and transparency of the regulatory authorities have been addressed through enhancement of the enforcement capacity of the Securities Commission and broadening of the powers of the KLSE as defined by the Securities Industry Act. Strengthening public sector management and performance. Malaysia has strong public sector institutions and a civil administration that is well regarded and has contributed to the private sector’s perception of the government as being friendly to business. In response to issues raised in the SPR initial steps have been taken to address the problem of contingent liabilities in the public sector. The Treasury is creating unit dealing specifically with privatization and contingent liabilities. It has begun a study to identify and evaluate all contingent liabilities and a trust fund has been created so that the Government can make early provision for contingent liabilities expected to be realized in the future. In the area of performance evaluation Treasury is: i) issuing a circular on the Guidelines for Evaluation Program; ii) providing training on evaluation for agencies commencing from October 1999; iii) appointing a consultant to assist with the implementation of Evaluation of Programs; and preparing a standard manual on Program Evaluation and Evaluation Audits. Overall performance. Malaysia’s structural policies were similar in nature to other countries in the region. They have been pursued vigorously and the Malaysian recession was shallower and shorter than Thailand’s and Indonesia’s although this partly reflects the better initial conditions that Malaysia had. The distinctive features of Malaysian policy were the capital controls and fixing of the exchange rate. However, these were adopted late in the course of the crisis. It is the assessment of this report that Malaysia’s success over the last year are due to the strong implementation its structural polices and the that capital control and exchange rate policies were of secondary importance. MALAYSIA: SOCIAL AND STRUCTURAL REVIEW UPDATE A. INTRODUCTION 1. A Structural Policy Review (SPR) for Malaysia, prepared in late 1998 and early 1999, was shared with the Government in February 1999 and subsequently appeared in gray cover in June 1999. The report covered developments in the following six areas: • Maintaining sound macroeconomic policies and resuming growth • Managing the social impact of the crisis • Financial sector restructuring • Corporate restructuring • Strengthening corporate governance and competitiveness • Strengthening public sector management and performance 2. The SPR examined these short and medium term structural issues as they came to light during the first 14 months of the crisis. At the time the report was written the government had formulated responses to the crisis across a wide variety of policy instruments. Since then, however, events have evolved. GDP, which was still falling when the report was being prepared, has now rebounded sharply. The foreign portfolio capital controls imposed in September 1998 have now largely been eliminated. Unemployment has begun to fall, the stock market has surged upward and non- performing loans (NPLs) have peaked. Not only have the effects of past policy changes become more clear during this period, there have been further adjustments in policies themselves. A number refinements of financial sector regulation and supervision have been introduced. Another budget has been brought down and a start has been made on the operational restructuring of firms whose NPLs are held by Danaharta. 3. The objective of this report is to review the progress made over the last year on structural issues in each of the six areas covered in the original SPR and place these in the context of what is happening a) in other countries in the region managing the same crisis and b) in the discussions of the new international financial architecture. This perspective is used to assess the quality of the current recovery and structural basis for sustained medium term growth and poverty reduction. The draft report will be presented to the Government for comment and subsequently made available to the board and released in gray cover. B. MACRO GROWTH AND RECOVERY 4. As the SSR was being drafted in the first quarter of 1999, the economy was still contracting. It has since rebounded sharply and GDP growth stood at 5.8% for 1999 as a whole. Estimates of growth for 2000 and 2001 have been revised upwards and are now expected to top 6% in both years. The recovery pattern is similar to that of other countries -2- in the region. It came a bit later than Korea and the slump was less pronounced than in Thailand and especially Indonesia. Recent World Bank estimates of the output gap between actual trend or potential output in 1999 were less for Malaysia (7.2%) than for Korea (12.9%), Thailand (14.5%) and Indonesia (16.6%) (Figure 1). Malaysia has shown the fastest and strongest recovery and on current trends it will close the output gap by 2002 ahead of the other three countries. 3 Figure1: Quarterly GDP Grow th (% yoy) 5. In Malaysia the sharp drop in domestic demand in 1998 was offset Korea 15.0 to some degree by a 20% rise in net 10.0 Malaysia exports, although this was due 5.0 largely to the compression of imports Philippines 0.0 -5.0 (Figure 2). However, in 1999 Thailand -10.0 exports expanded quickly, lead by -15.0 the electronics sector. In part this Indonesia -20.0 growth was attributable to Y2K -25.0 1997 1997 1997 1997 1998 1998 related buying, but the sales have 1998 1998 1999 1999 1999 1999 2000 Q1 Q2 Q3 Q4 Q1 Q2 remained strong into 2000. Import Q3 Q4 Q1 Q2 Q3 Q4 Q1 demand increased as well with a Source: BNM. return of consumer confidence. Overall, 1999 demand returned to a % Figure 2: Contribution to GDP Growth more balanced pattern with small 30.0 positive growth in both the domestic 20.0 Return to more and net foreign components. In balanced 10.0 grow th addition, the recovery became more 0.0 broadly based across sectors. In the -10.0 domestic demand second quarter both domestic and -20.0 net exports export oriented industries were -30.0 92 93 94 95 96 97 98 99 growing again, and all sectors except mining and construction reported positive growth. By the third quarter Source: BNM. even the construction sector began to grow again, partly in response to government spending programs for roads, utilities, and housing. 6. The government adopted a counter cyclical fiscal policy in 1998 with a planned deficit of 3.4% of GDP. However, because of expenditure delays the actual deficit turned out to be only 1.8% of GDP. In 1999 the government managed to apply greater fiscal stimulus, although a pattern similar to that of 1998 emerged. The planned 1999 deficit of 6.0% of GDP turned out to be only 4.0% Again, part of the reason was the lag in spending, particularly in the development budget. However, the unanticipated strength of the recovery also lifted tax revenues more than expected. The budget for 2000 provides for a deficit of 5.8% of GDP. However, this may have to be trimmed if growth continues at current pace and if inflationary pressures emerge. 3 World Bank, 2000, East Asia: Recovery and Beyond. -3- 7. The rebound in the economy was partly attributable to the resurgence of export demand but there were other factors that helped to both buffer the shock of the crisis and to shorten it. Flexible labor markets have long been a feature of the Malaysian economy. During the crisis, wages adjusted quickly to the weakening demand. Average real wages in manufacturing fell by 2.4% in 1998 after three years of growth in excess of 5% per year. At the same time steps were taken to minimize the adverse impact of the recession on workers. Guidelines on retrenchment were issued in August 1998 to outline to employers some alternatives to retrenchment. Employment services were provided and vacancy lists published facilitate retrenched workers seeking work. The Employment Act of 1998 was amended to encourage more flexible working practices and use of productivity incentives. In the period from August-December 1998 over 22,000 workers accepted pay cuts, and cuts affecting a further 15,000 workers were made in 1999. The sharp decline in retrenchments in 1999 was facilitated by these wage reductions as well as the increased use of part time and flexi-time workers. Table 1: Employment Wages and Aggregate Earnings (1998) 8. The labor market impact Total Average Total was milder in Malaysia than in Employment Real Wage Earnings other countries. The contraction % annual change (share of change in total earnings) in total earnings was only 3.8% Indonesia 2.7 (-7) -41.0 (107) -38.3 (100) compared with 14.6% in South Korea and 38.3% in Indonesia South Korea -5.3 (36) -9.3 (64) -14.6 (100) 1998 (Table 1). A much higher share (71%) of the contraction Malaysia -2.5 (71) -1.1 (29) -3.8 (100) in total earnings was Thailand -3.0 (39) -4.6 (61) -7.6 (100) attributable to a drop in Sources: Betcherman and Islam (Indonesia, Malaysia, South Korea); employment (as opposed to Labor Force Survey (Thailand) wage rates) than was the case elsewhere in the region. However this does not signal proportionately higher unemployment in Malaysia. Rather it is due to the reduction in the number of foreign workers by over 300,000 or roughly 3% of the labor force. This provided a significant safety valve for the domestic labor market. 9. Figure 3: Federal Government Debt The SPR estimated that the public % GDP sector debt was sustainable (Figure 3 and 100 Figure 4). It cautioned however, about 80 the need to avoid a Japan-type problem in 60 which private domestic demand is 40 persistently sluggish as consumers anticipate future sharp tax increases as the 20 probable consequence of the debt build- 0 up during the fiscal stimulus period. 90 91 92 93 94 95 96 97 98 99 Analysis presented in the SPR indicated what level of primary surplus (net of Source: BNM. seignorage) would be needed to stabilize the debt-to-GDP ratio at 60% of GDP. Further calculations were provided to show the fiscal balance necessary to cut these debt-to-GDP ratios roughly in half over 10 years. The fact the recovery was more rapid than anticipated and fiscal spending targets were under fulfilled means that the debt-to-GDP ratios are not likely to reach these levels in -4- the medium term. The debt-to-GDP ratio at end 1999 was 37.9%, up just 1.6 points over 1998. The primary surplus net of seignorage was 1.3% of GDP, well within the range that would sustain the current debt-to-GDP ratio. 4 10. Total external debt has been % Figure 4: Lending Rate Spread over T-bill Rate declining for two quarters and stood 8 at 48.4% of GDP in Q2-2000 (Table 6 2). Short term external debt has been shrinking since Q3-1998 when 4 interest rates were lowered, and 2 commercial banks have sought less external financing in the face of 0 1997 1998 1999 2000 ample domestic liquidity. Short term external debt stood at US$5.2 billion or 15.2% of foreign exchange reserves. Overall, these figures Source: BNM. indicate that the public sector and the external debt situation are sustainable. Table 2. External Debt Medium and Long-Term Debt Short-Term Debt Private Non-Bank Total Fed. Gov NFPE Sector Total Bank Priv. Total 1996-Q1 33,914 5,080 10,453 11,742 27,275 3,883 2,756 6,639 Q2 36,698 4,913 10,826 11,756 27,495 6,606 2,597 9,203 Q3 36,330 4,524 9,902 12,062 26,488 7,121 2,721 9,842 Q4 38,692 4,140 11,561 13,038 28,739 6,743 3,210 9,953 1997-Q1 42,113 3,961 11,672 13,720 29,354 6,987 3,071 12,758 Q2 45,655 3,590 12,859 15,074 31,523 10,924 3,208 14,132 Q3 45,524 3,411 13,387 15,822 32,620 9,780 3,124 12,904 Q4 42,875 3,328 13,481 15,951 32,760 8,293 2,822 11,115 1998-Q1 43,012 3,045 13,304 15,605 31,953 7,246 3,562 10,799 Q2 41,377 3,265 13,158 15,456 31,879 5,889 3,599 9499 Q3 39,872 3,282 13,501 15,538 32,221 4,523 3,128 7,652 Q4 42,410 3,927 14,008 16,005 33,941 5,352 3,117 8,489 1999-Q1 41,975 3,557 14,189 15,903 33,649 4,790 3,536 8,326 Q2 42,744 4,584 14,071 16,061 34,716 4,756 3,272 8,029 Q3 43,822 4,722 15,221 16,242 36,185 4,374 3,264 7,637 Q4 42,237 4,834 15,432 15,825 35,890 3,686 2,660 6,346 2000-Q1 40,818 4,744 15,080 15,530 35,354 3,159 2,304 5,464 Q2 41,000 4,717 14,964 16,161 35,842 2,922 2,236 5,158 Source. BNM. 11. The SPR made the point that bank lending had slowed in the wake of the crisis. It reasoned that when the volume of lending contracts in the face of widening spreads, as 4 The SPR calculations assumed seignorage of 1.8% of GDP which is line with the historical relationship between base money and nominal GDP. However, recent changes in the regulation of financial institutions have meant sharp reductions in the reserve requirements as the liquid asset requirement was relaxed both as a means of providing additional liquidity as a reflection of the introduction of the new liquidity management framework. The result was a sharp reduction base money in 1999 much of which may be permanent and would therefore imply an ongoing loss of seignorage and hence a larger primary surplus necessary to achieve any given debt target. -5- was the case prior to the fall of 1998, it is likely caused by supply factors i.e. banks, concerned about NPLs and rebuilding capital and profits, were reluctant to make new loans or roll over existing ones. The spread peaked again in May 1999 but has been declining since. This would suggest that for the last year such supply side factors have become less constraining. Banks have become more willing to lend, but while there was excess capacity, loan demand was not strong. Through 1999 the sluggish loan growth is the net result of new lending offset by a high level of repayments, writeoffs and debt conversions. 12. Despite the apparent strength of the current recovery, the economy remains exposed to certain risks. The strength of the export sector has been a key factor in maintaining aggregate demand. However, the economy is vulnerable to a slowdown in US economic growth and to a global decline in for electronics and other IT-related products. The US is the largest single destination for exports accounting for 20% of the total, and its share of electronics and electrical products is even higher (29% and 28% respectively) 29. Exports of electronics accounted for 45% of total exports and electrical products a further 16%. Although Malaysia exports a range of products within the electronics sub sector including computers and peripherals (28% of electronics exports) integrated circuits (17%) memory chips (15%) and hard disks (10%) these are all likely to be negatively affected if reductions in corporate spending on IT products in the US are sustained. This will directly affect inflows of foreign direct investment which are concentrated in this sector. 13. Another area of concern is the property market. While the market for residential real estate has begun to recover, vacancy rates remain high for commercial space. In part this reflects excessive pre-crisis expansion and the long gestation times in commercial real estate planning and construction. In 1997 there was a 22% increase in the stock of purpose-built space. Despite the general economic downturn another 24% increase was recorded in 1998. At the same time occupancy rates fell from 95% in 1997 to 80% in 1998. They have continued to fall steadily since, and stood at 79% as of the end of Q1- 2000. Retail occupancy rates have begun to recover from the low of 62% in 1998 but were still only 73% in Q1-2000 as compared with rates well in excess of 90% prior to the crisis. -6- Box 1: The Capital Controls Episode On September 1, 1998 Bank Negara Malaysia (BNM) imposed a set of controls on foreign exchange transactions and the following Sovereign Spreads day fixed the exchange rate at RM3.8 to the dollar. The controls and Capital Controls included the following features: • A one year waiting period on repatriation of portfolio 1200 start of investment. 1000 controls feb. relaxation • Mandatory repatriation of all ringgit held abroad. 800 end of exit tax Korea • on principal Restriction on transfers of funds between external accounts. 600 Malaysia • Limits on transport of ringgit by travelers. Philippines Thailand 400 • Prohibition of resident/non-resident ringgit credit 200 arrangements. • Prohibition of trade settlement in ringgit. 0 Jun-98 Jun-99 Feb-99 Apr-98 Aug-98 Dec-98 Apr-99 Aug-99 Dec-99 Oct-98 Oct-99 • Prohibition of resident/non-resident offer side swaps and similar hedge transactions. A freeze was also imposed on CLOB share transactions. 3000 Portfolio Flows $US m. 15000 2000 end of controls 10000 feb. relaxation 1000 start of controls 5000 0 0 -1000 cumulative flows (RHS) -5000 net flows (LHS) -2000 -10000 -3000 -15000 1997 1998 1999 The immediate objective of the control policies was to provide stability and allow the authorities to pursue an independent monetary policy without having to worry about defending the exchange rate. These were regarded as temporary measures that would insulate the economy from an external shock and the contagion effects of the financial crisis in neighboring countries. On February 15, 1999 the ban on portfolio capital outflows was replaced with a set of graduated exit taxes which were further liberalized in September 1999..At that point a flat 10% tax was applied only to repatriated profits. The 2000/01 budget in October 27, 2000 further limited the tax to repatriated profits on assets held for less than one year. Controls on residents’ capital export remain subject to BNM approval. One criticism of the controls was that they would create uncertainty among foreign investors resulting an increase in the cost of capital. Sovereign spreads did rise by about 300 basis points relative to the spreads prevailing in other crisis countries. This gap narrowed in the following months but remained 150 basis points over comparable Korean and Thai bonds when Malaysia raised US$1billion in the European bond market in May 1999. FDI flows remain low relative to the pre-crisis period but this was true for other countries of the region and may reflect excessive pre-crisis investment and continuing excess capacity rather than the negative effect of controls on investor valuation of country risk. A second worry was that there would be a sharp exodus of portfolio capital with the expiration of controls. From September 1 to the end of October roughly USD 2 billion did leave the country. Much of this represented closing of positions in the stock market which fell by more than 20 percent between mid-July and early September. But the situation stabilized by early October and was fully reversed by portfolio inflows in early 2000. Moreover these flows were very small in relation to those in 1997 during the early stages of the crisis. The control regulations were complex and there was some confusion at the outset. However, BNM conducted an effective information campaign placing detailed descriptions of the control measures before the public including postings on its web site. Over time it provided updates, clarifications and worked examples detailing how the controls were to be applied to a variety of transactions. From a technical point of view the controls were administered in an efficient and effective manner and the costs of imposing them do not appear to have been high. However, the benefits may also have been modest. Controls were implemented late in the evolution of the crisis. The bulk of the portfolio outflows were already over. The exchange rate had depreciated sharply and was fixed at an undervalued level making further capital flight unlikely. The turnaround in the stock market, the return of positive GDP growth, the building of reserves and the relaxation of interest rates were all coincident with the imposition of controls. But these changes occurred in all the other crisis countries at about the same time, and the other countries did not adopt Malaysia’s control policies. In the absence of a counter factual (no-controls) case to observe, attributing a significant and distinct role to exchange controls in bringing about the recovery is difficult. However, the controls may have provided a safeguard against the possible instability. They created a breathing space for making necessary reforms and the authorities made good use of this time. The stabilization of the financial system through Danaharta and Danamodal was quick and complete. Throughout the control period the authorities pushed vigorously ahead with regulatory and supervisory reform for the financial sector and capital markets – an important prerequisite for full capital account liberalization. What remains for Malaysia now is to continue its phase-out of the exit levy and the controls that remain for resident capital exports, and to manage the transition to a consistent regime of exchange and monetary policies that avoids a buildup of external pressures, in coordination with financial sector reforms. There has been relaxation of certain limitations on currency used in border trade and on overdrafts, short term currency swaps and margin facilities open to foreign stock brokers and non-resident investors. However, the authorities appear committed to a policy of non-internationalization of the ringgit to prevent speculation. -7- 14. The KLSE index increased almost four-fold from its low of 263 in September 1998 reaching 1010 in February sparking fears that a new speculative bubble might be in the making. The index has since fallen and was down some 17% as of mid June. The markets remain vulnerable to adverse stock price movements in the US and Europe. 15. In terms of establishing sustained growth over the longer term the Government is focusing on enhanced competitiveness through development of a knowledge-based economy (K-economy). This is partly in response to the forces of globalization which require firms to achieve higher standards of innovation, adaptation, reaction to changing market conditions, flexible response to customer needs, and shortened production cycles and delivery times. The right enabling environment for a K-economy can sustain higher value added and productivity growth. In Malaysia policy has been shaped by an understanding of the scale and network effects in the K-economy and the notion that unlike physical capital, some knowledge is a public good suggesting a special role for government in knowledge investment. One thrust of public policy has been development of human capital. The “smart school program” which was introduced in pilot form in 1999 seeks to introduce and enhance computer equipment and internet access to primary and secondary school students across the country. A wide variety of special programs and tax incentives have been offered to firms for training and skills development programs. Yet Malaysia lags regional competitors in several critical areas. Despite generous tax incentives, research and development expenditures are only 0.3% of GDP in Malaysia compared with 1.4% in Singapore, 1.9 % in Taiwan and 2.8% in Korea and Japan. 16. The Government has also developed the Multi Media Supercorridor which combines training institutions, IT, communications and transportation infrastructure support with tax concessions and subsidies in a large development zone in the Klang Valley south of Kuala Lumpur. These measures have been costly. As the Government formulates its K-Economy Master Plan it will need to ensure that the resources it devotes to the building the K-economy are effective in increasing total factor productivity rather than generating output increases through simple accumulation of factor inputs. -8- C. POVERTY AND SOCIAL PROTECTION Short Term Protection Measures 17. The SPR expressed two main Figure 5: CPI and Food Prices % change yoy themes regarding the poor and social 14% protection. The first was the need to 12% CPI food protect the poor during the economic 10% 8% contraction. Prior to 1998 Malaysia had 6% enjoyed a sustained period of high 4% CPI 2% growth and low unemployment. In 0% 1996 and 1997 labor markets were tight Jan-97 Jan-98 Jan-99 Jan00 May- May- May- Sep- Sep- Sep- and unemployment was just 2.5%. There had been significant advances in reducing poverty which was Source: BNM. concentrated in the rural sector. Increased agricultural productivity enhanced rural wages and sharp increases in job opportunities in the cities helped absorb some rural labor. The concern was that the crisis would strike hardest in the urban manufacturing and construction sectors, creating a growing problem of urban poverty. This in turn would cause back migration to the rural areas increasing unemployment there, and reversing the progress that had been made over the past decade. And indeed the SPR estimated that an additional quarter of a million people fell below the poverty line in 1998. By the end of the first quarter of 1999 unemployment reached 4.5% of the labor force, or more than 400,000 people. GDP growth was still negative. Moreover, at the beginning of 1998 food prices rose sharply placing a further burden on the urban poor although it may have benefited rural food producers (Figure 5). The government responded initially with a number of labor market stabilization measures which were introduced during 1998. These included retrenchment notification requirements to help with government monitoring, new retrenchment guidelines labor market flexibility, programs to facilitate job search, and promote wage adjustment, flexible hours and temporary lay-offs. 18. In the 1999 budget the government instituted a number of special anti-poverty programs: (a) Fund for Food scheme - RM 300 million. (b) Expansion of a programs for small scale subsidized loans to rural poor for income generation - RM100 million. (c) Micro credit program for urban poor - RM200 million. (d) Rural infrastructure projects - RM100 million. -9- 19. The government also had several programs intended to ensure continuity in the provision of social services during the crisis: (e) Construction of addition rural classrooms and teacher training - RM100 for five additional polytechnics. (f) Higher education loans to low-income groups - RM200 million. (g) Rural health clinics - RM100 million. 20. The 2000 budget included a range of further measures: (h) Rural water supply - RM129 million. (i) Rural clinics, mid-wife centers and other rural health facilities - RM153.84 million. (j) Supply of potable water and upgrading of health and treatment facilities RM21.1 million. (k) Scholarships and school uniforms for the Orang Asli - RM30.5 million ringgit. (l) Resettlement of Orang Asli villages and other socio-economic projects, including the provision of potable water - RM46 million. (m) Smallholders replanting and poverty reduction program - RM 201 million. (n) Establishment of a Smallholders Foundation Fund to assist smallholders with growing cash crops, raising livestock - RM 120 million ringgit. (o) Construction and upgrading of rural roads - RM201 million. (p) Construction of low-cost houses under several special funds, including the Housing Fund for Hardcore Poor, Revolving Fund for Low-Cost Housing, Special Scheme for Low and Medium-Cost Houses and also through the low-cost housing development fund of Syarikat Perumahan Negara - RM4.3 billion ringgit. To date, under these Funds, a total of 35,000 units has been completed, while another 52,000 units are at various stages of construction. (q) Increased pocket allowances for those in institutions under the Social Welfare Department and additional financial assistance for these groups - RM 34.29 million. (r) Increased loans for students in local private institutions (from 12,000 ringgit to 12,500 ringgit for the arts stream and from 16,000 ringgit to 16,500 ringgit for the science stream. - 10 - (s) Pension adjustments, additional assistance for the poor increased in scholarships and higher loans for overseas students - RM 370 million. 21. The Government also announced a salary increase for civil servants of 10% and a bonus payment on 1999 wages. This was not so much an anti-poverty measure, although a 50% increase in the housing allowance was granted for government employees in the lower income categories, and the wage rises served to increase payments to pensioners. Rather, the wage hikes served to reverse the relative decline in civil service wages and provide a quick fiscal stimulus. 22. The Government is constrained in providing fiscal stimulus by the requirement that the current budget be balanced. Accordingly, many of the special targeted programs listed above were included in the development budget. In 1999 some difficulties were encountered initially in making the planned development expenditures and at the end of the first quarter only 3.6% of the total development budget had been utilized. However, steps such as streamlined contract tenders and faster payment systems were taken to overcome implementation constraints and the pace of spending was sharply accelerated in the second half of the year. The development spending fell 12.5% short of its target level and the overall deficit for 1999 was 3.5% of GDP instead of the targeted 6.1%. 23. However, the contraction no. Figure 6: Retrenchments and Vacancies 14000 turned out to be shorter in duration 12000 retrenchments vacancies than had originally been feared 10000 (Figure 6). Job retrenchments peaked at 12,000 in July of 1998 8000 and maintained a fairly steady 6000 downtrend thereafter. The vacancy 4000 rate climbed steadily for roughly 12 2000 months from the fall of 1998. The 0 first quarter of 1999 proved to be maximum for the unemployment rate and the number of unemployed fell from 407,800 to 276,300 by Source: EPU. December 1999. In all, the contractionary effects of the crisis lasted a little over one year which is not long enough to show up in indicators of serious hardship. For instance, preliminary data indicate that infant mortality continued its declining trend throughout the crisis period falling from 9.5 per 1,000 in 1997 to 8.3 in 1998 and 7.9 in 1999. Crude death rates show similar declines which are fairly uniform across ethnic groups. The only group to register an increase in infant mortality (and in the crude death rate) in 1998 was foreigners, many of whom are plantation workers from Indonesia. This group also has the highest infant mortality rate overall. - 11 - 24. School enrollments might be Figure 7: School Enrollment (government schools) expected reflect more subtle % reactions to economic stress as 100 Primary parents remove children from 80 school in order to work and Lower primary supplement family income, or to 60 Upper secondary avoid costs of uniforms textbooks 40 and fees (Figure 7). But 20 Post seconday and enrollments in government and college government assisted schools 0 University improved between 1997 and 1998 1994 1995 1996 1997 1998 in all categories except primary. And here the decrease was very Source: Ministry of Education. small and conforms to a longer term trend that reflects the increased role of private schools. Estimates of the school age population are not yet available for 1999 and 2000 but the raw enrollment figures for primary and secondary schools both continued to rise according to trend. 25. Further information on the impact of the crisis will become available when the results of the 1999 Household Survey are made public but on the basis of the available evidence it would appear that social impact of the crisis was milder than anticipated, largely because the contraction was short. However, this conclusion needs to be validated by further investigation. Private consumption as measured in the national accounts declined by 12% in 1998 - even more than GDP. It has since rebounded and if the contraction represents voluntary postponement of consumption motivated by economic uncertainty, the poverty impact may be small. If it represents involuntary reductions in consumption by credit-constrained poor the consequences may be more serious. Only direct measures of income and consumption by economic groups as contained in the Household Survey will reveal the reality. - 12 - Medium Term Social Protection Measures 26. The second major theme in developed in the social section of the SPR was the need to preserve the social protection system over the medium term and to invest in human capital through health and education. Although the current budget shrank slightly in 1998, the share devoted to social services was the highest in twenty years (Table 3). In the development budget too, social spending accounted for a the greatest share of the budget since 1986. Table 3: Federal Government Current Expenditure Year 1994 1995 1996 1997 1998 1999 2000 1994 1995 1996 1997 1998 1999 2000 (a) RM m. percent Defense and Security 5,498 6,004 6,622 6,607 5,896 6,108 6,587 15.7 16.4 15.1 14.8 13.2 13.1 12.6 Economic services 3,660 2,869 4,285 4,125 4,065 4,213 4,266 10.4 7.8 9.8 9.2 9.1 9.0 8.1 Agriculture and rural development 1,194 1,135 1,436 1,300 1,121 1,222 1,243 3.4 3.1 3.3 2.9 2.5 2.6 2.4 Commerce and industry 381 624 1,468 1,277 1,279 1,596 1,665 1.1 1.7 3.3 2.9 2.9 3.4 3.2 Transport 1,520 996 1,087 1,378 1,120 1,156 1,257 4.3 2.7 2.5 3.1 2.5 2.5 2.4 Other 565 114 294 170 545 239 101 1.6 0.3 0.7 0.4 1.2 0.5 0.2 Social services 11,541 12,141 14,824 15,051 15,062 16,612 17,774 32.9 33.2 33.8 33.7 33.8 35.6 34.0 Education 8,098 8,559 10,398 10,360 10,528 11,458 11,937 23.1 23.4 23.7 23.2 23.6 24.5 22.8 Health 2,175 2,384 3,015 3,278 3,331 3,626 4,040 6.2 6.5 6.9 7.3 7.5 7.8 7.7 Other 1,268 1,198 1,411 1,413 1,203 1,528 1,797 3.6 3.3 3.2 3.2 2.7 3.3 3.4 General administration 3,862 5,216 5,187 5,927 5,807 5,491 6,240 11.0 14.3 11.8 13.3 13.0 11.8 11.9 Other 10,503 10,343 12,947 12,955 13,754 14,275 17,484 30.0 28.3 29.5 29.0 30.8 30.6 33.4 of which Debt service 6,815 6,521 6,795 6,426 6,928 7,941 9,630 19.4 17.8 15.5 14.4 15.5 17.0 18.4 Pensions 2,737 2,755 3,509 3,638 3,658 3,792 4,104 7.8 7.5 8.0 8.1 8.2 8.1 7.8 TOTAL 35,064 36,573 43,865 44,665 44,584 46,699 52,351 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Table 4: Federal Government Development Expenditure Year 1994 1995 1996 1997 1998 1999 2000 1994 1995 1996 1997 1998 1999 2000 RM m. percent Defense and Security 2,360 2,888 2,438 2,314 1,380 3,122 2,634 20.9 20.6 16.7 14.7 7.6 13.8 11.1 Economic services 5,289 6,440 7,693 7,501 9,243 8,970 10,875 46.9 45.8 52.6 47.6 51.1 39.7 45.9 Agriculture and rural development 1,342 1,360 1,182 1,105 960 1,089 1,258 11.9 9.7 8.1 7.0 5.3 4.8 5.3 Commerce and industry 961 1,218 1,212 1,285 3,227 2,798 3,762 8.5 8.7 8.3 8.2 17.8 12.4 15.9 Transport 2,158 3,151 4,530 3,578 3,062 2,893 4,643 19.1 22.4 31.0 22.7 16.9 12.8 19.6 Public utilities 790 654 733 1,496 1,968 1,850 1,013 7.0 4.7 5.0 9.5 10.9 8.2 4.3 Other 38 57 36 37 26 340 199 0.3 0.4 0.2 0.2 0.1 1.5 0.8 Social services 3,285 3,513 3,984 4,919 5,783 6,936 7,252 29.1 25.0 27.2 31.2 31.9 30.7 30.6 Education 2,010 2,044 2,091 2,521 2,915 3,865 3,695 17.8 14.5 14.3 16.0 16.1 17.1 15.6 Medical services 354 388 459 449 716 835 908 3.1 2.8 3.1 2.9 4.0 3.7 3.8 Housing 359 403 501 735 1,030 1,081 1,145 3.2 2.9 3.4 4.7 5.7 4.8 4.8 Social and community services 562 678 933 1,214 1,122 1,155 1,504 5.0 4.8 6.4 7.7 6.2 5.1 6.4 General administration 343 1,210 513 1,016 1,697 3,587 2,913 3.0 8.6 3.5 6.5 9.4 15.9 12.3 TOTAL 11,277 14,051 14,628 15,750 18,103 22,618 23,674 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source: Bank Negara Malaysia, Ministry of Finance (a) Budget allocation 27. The SPR included a number of recommendations that focussed on enhancing the social safety net. While the there may be scope for increasing the coverage of the EPF and the adjusting the terms on which withdrawals can be made, the authorities do not seem prepared at this stage to introduce more comprehensive measures such as unemployment insurance. Such schemes would provide greater automatic stabilization in the conduct of fiscal policy and would presumably be better targeted towards those most in need during periods of crisis. However, the government has expressed concern over the cost and negative work incentive effects that such programs may entail. They prefer to rely on labor market flexibility and rapid adjustment combined with selective ad hoc expenditures such as those included in the 1999 and 2000 budgets as a means of minimizing the impact on the poor, and maintenance of higher long term growth rates and high sustained investment in education and infrastructure as the best way to deliver opportunities to the broadest spectrum of the population over time. This approach has generated growth. However, it means placing greater reliance on informal social safety net mechanisms during times of stress. When the stress is moderate or of short duration - 13 - these coping mechanisms may be adequate. Under more severe and longer term pressure they may be over stretched. There is clearly a tradeoff here in as much as the disincentive effects of some formal support mechanisms may themselves prolong the adjustment period. D. FINANCIAL SECTOR STRENGTHENING AND CAPITAL MARKET DEVELOPMENT 28. The first phase of the financial and capital market program was well underway by June 1999. It was a short term program focussed on achieving stabilization of financial markets and is now essentially complete. The second phase includes a set of measures to improve the structure of financial markets and institutions, and to improve the regulation and supervision of financial and capital markets. It involves some immediate steps and others which will evolve over several years. Financial Stabilization 29. The main thrust of the RM b. Figure 8: Lending and NPLs stabilization policy was to arrest 500 the acceleration of NPLs in the Bank NPLs banking system and to recapitalize 400 Loans sold to the banks (Figure 8). The level of 300 Danaharta NPLs held by the banking system jumped sharply in the third quarter 200 Performing of 1998. The purchases of NPLs 100 Loans by Danaharta, which began in the at banks third quarter of 1998 and 0 increased significantly in the last Q3 Q3 Q3 97 Q1 98 Q1 99 Q1 00 Q1 quarter, helped to alleviate this problem. Even more significant however was the reduction in Source: BNM. interest rates in the latter part of 1998. This interest rate reduction was facilitated by the imposition of capital controls the elimination of currency swap transactions and the closure of the offshore market in Singapore. Although BNM fixed the exchange rate at the same time, the capital controls severed the arbitrage link between domestic and international interest rates and gave the central bank the flexibility to conduct an independent monetary policy. However, interest rates were falling generally throughout the region as demand collapsed as authorities began to develop policies to deal with NPLs and underlying structural problems (Figure 9). The effect of the Malaysian controls may have been limited to providing a safeguard against further instability (see Box 1). Malaysian interest rates fell sharply although somewhat later than in other countries and from lower peaks. The 3-month interbank rate declined from 10.97% and end July 1998 to 3.15% the end of 1999. Standard and Poor’s estimated that without the interest rate reductions after September 1998, NPLs would - 14 - have risen to over 30% of total Figure 9: Regional Interest Rates (%) loans (on a 3-month basis including Danaharta sales)5. This 30 Korea compares with an actual NPL 25 ratio on the same basis of about Thailand 20 Philippines 23%. 15 10 30. The purchase of NPLs by 5 Malaysia controls Danaharta forced banks to record losses on their balance sheets 0 thereby reducing capital. Jan-97 Jan-98 Jan-99 Jan-00 Jul-97 Jul-98 Jul-99 Apr-97 Apr-98 Apr-99 Apr-00 Oct-97 Oct-98 Oct-99 Initially it was estimated that, under the worst case scenario RM 16 billion would be needed Source: BNM. for recapitalization through Danamodal. In the end the actual amount required fell far short of this figure and only RM7.1 billion was injected in the form of equity, preference shares and exchangeable subordinated capital loans. As at end June 2000 the net capital injection by Danamodal stood at RM 4.9 billion as compared with 5.3 and end December 1999 due to early repayments. A number of the institutions originally identified as undercapitalized were able to raise capital on their own and Danamodel continues to hold excess funding. The RWCR stood at 12.8% by the end of June 2000 up from 12.3% at end 1999 and 11.8% at end 1998. In addition the banking system showed pre-tax profits of RM5.3 billion in 1999 as compared with losses of RM 5.7 billion in 1998. 31. A couple of qualifications are needed to the generally positive picture of financial sector stabilization and restructuring that emerges from the above discussion. Some firms going though the CDRC “London Rules” process have restructured debt by issuing zero coupon bonds. This reduces the amount of NPLs although the interest payments are simply postponed until the bonds become due. To some extent such forbearance has been allowed in other Southeast and East Asian countries and may even have been necessary to overcome the substantial loss of confidence that triggered the crisis (Table 5). 32. The ringgit was fixed to the US dollar as part of the stabilization measures. The volatility of the exchange rate had been making corporate valuations difficult especially given the highly open nature of the Malaysian economy and was frustrating corporate restructuring. More than 80% of trade and 70% of external debt is denominated in dollars. A modest undervaluation also gave a boost to exports and helped sustain aggregate demand and build reserves. However, the relative movements of dollar vis-a- vis the yen and the deutsche mark have become much more volatile recently. A reversal of the dollar’s sharp appreciation against these currencies in light of the massive US trade deficit would tend to introduce greater instability especially if speculative capital inflows mount in anticipation of at revaluation as was the case in 1994. Alternative exchange rate mechanisms might help to insulate the economy from such disturbances. However the authorities are also in the midst of financial sector reforms some of which center on cross 5 S&P rating sovereign credit rating as reported in IMF, Malaysia: Selected Issues IMF Staff Country Report No. 99/86, August 1999. - 15 - border flows and management of exchange risk. There may be some reluctance to alter the exchange regime before this process is further advanced. Table 5: Regional Comparison of Financial Sector Restructuring Strategies Indonesia Korea Malaysia Thailand Non-performing loans (% of total loans) NPLs at peak* 70.0 25.0 25.8 46.8 Transfers to AMCs 47.0 13.2 8.9 0.0 Latest NPL estimate 30.0(4/00) 11.3 (12/99) 16.7(3/00) ** 37.2(3/00) Financial Distress Resolutions Bank closures 66 out of 237 None None 1 of 15 Closure of other financial Not applicable 117 None 59 of 91 institutions Mergers of financial institutions 4 of 7 state banks 11 of 26 absorbed 10 finance 3 banks and 13 to merge by other banks companies finance companies merged in 1998. merged 2 banks merged in 1999 Further mergers by end 2000 Bank Recapitalization Public funds for recapitalization $27.6bn Government Danamodal Government injected $36bn injected $1.6bn injected $1.5bn into 9 CBs; 5 out into 10 into private of 6 major banks institutions institutions under now 90% the capital controlled by support program state and $12.2bn into public banks. Majority foreign ownership of Allowed, 1 Allowed, 2 No expansion Allowed, 4 banks pending announced and 1 of foreign bank completed and 1 pending branches is allowed pending However the 13 wholly foreign owned banks hold 30% of total CB assets. Source: Claessens et al., 1999a, country sources, Goldman Sachs and JP Morgan, * Includes loans transferred to AMCs ** NPLs: 3-month classification, BNM Monthly Statistical Bulletin table III.15; Total loans: BNM Monthly Statistical Bulletin tables III.12, III.13 and III14 Structural Reform Restructuring Financial Institutions 33. A key part of the financial sector program covers mergers and consolidation of banking sector institutions. At the time of writing the (June 1999) SPR several important steps had already been taken. Ten finance companies were merged or absorbed into their parent banks and plans were laid for further consolidation. BNM took over the control of four banking institutions (Kewangan Bersatu Berhad, MBf Finance Berhad, Sabah Finance Berhad and Sime Merchant Bankers Berhad). In addition, two large banks, Bank - 16 - Bumiputra Malaysia Berhad and Sime Bank Berhad, which had sustained large losses, were merged with larger banks in June and September 1999 respectively, after distressed assets were sold to Danaharta. These initial mergers and acquisitions effectively removed the largest problem banks from the system and formed an integral part of the stabilization effort. 34. However, in the longer run BNM recognizes that as the financial sector is liberalized, domestic institutions will be exposed to greater competition. To be successful Malaysia will need a smaller set of larger and well-capitalized banking institutions that are focused on return to equity and have adopted more efficient and modern lending practices backed by investment in information technology. Further mergers and consolidation must build strategic advantages and economies of scale and scope, rather than simply absorbing distressed institutions However, progress has been slow. The authorities announced in 1998 that mergers would be organized into groups defined around 10 anchor banks. There were objections to this from the banking community which wanted greater freedom to define the groupings themselves. The government responded to this and in February 2000 BNM approved alternative merger groupings proposed by the banks. The banks have until the end of 2000 to devise and implement the consolidation plans around these groupings. BNM has not issued formal instructions to the individual groups regarding execution of the mergers. However, it has issued directives regarding the process that the groups will be expected to follow. Accordingly, qualified external experts have been hired to advise on human resource needs and operational restructuring, and financial institutions are formulating restructuring plans without resort to forced retrenchments. 35. To ensure that the merger exercise is completed by end-December 2000, each banking group has been required to form a Joint Steering Committee headed by the Chief Executive Officer of the anchor bank with members from all the merger partners. This Committee will, among others, oversee the progress of mergers, deliberate on issues relating to the commitment of major capital expenditure, upgrading of existing systems, recruitment of additional staff and implementation of any salary revision or voluntary separation schemes by the merger partners. In addition, the anchor banks must ensure that there is a clear separation between shareholders and management so as to minimise conflict of interest between the parties and that the merger exercise does not result in the holding company or the banking institutions themselves to be highly geared. 36. Upon completion of the merger exercise, each of the banking groups would have minimum shareholders’ funds of RM2 billion and an asset base of at least RM25 billion. With the merger, the number of domestic banking institutions would reduce substantially from the current 53 to 29 banking institutions. It is expected that the formal mergers will be accomplished as planned by the end of 2000. But integration of operating and IT systems as well as rationalizing the human resource needs will take much longer. - 17 - Financial Sector Regulation and Supervision 37. In assessing progress in regulation and supervision practices it is important to distinguish between those measures which are temporary or transitional and related to management of the crisis, from those which are more fundamental and longer term. From a broader perspective it is clear that Malaysia has sought for some time to establish a modern regulatory system and is more advanced in this respect than many of its neighbors. However, the crisis resulted in some temporary reversals. For instance, in line with the longer term trend, classification conditions for NPLs had been shortened from 6 months to 3 months in October 1997, and provisioning requirements were tightened. But the classification condition was then loosened to again to 6 months in September 1998. A number of other conditions were softened at this time as well. The disclosure intervals for bank reporting were lengthened to 6 months (although KLSE listed firms are still required to publish quarterly statements). The ceiling of 15% on bank financing of shares and real estate was eased. These measures were introduced largely because of concerns over the level of bank lending and the desire to avoid a credit crunch. However, despite the return of banks to profitability and the resurgence of GDP growth, none of these temporary measures has been reversed. 38. While some standards were relaxed, BNM also introduced a number of measures to strengthen the regulation and supervision of the financial system. One of these was the decision in April 1999 to abolish the two-tier banking system. Under this system tier one banks which met more stringent prudential and capital requirements were allowed to conduct a broader range of activities than the tier-two banks. The idea was to bring about consolidation and strengthening of the banking sector by inducing tier two financial institutions to merge in order to meet the higher capital requirements and qualify as tier one banks. Instead, however, the effect was to induce expansion of capital through shareholder loans in order to achieve the minimum capital requirement to qualify as a tier-one institution. The banks then aggressively expanded lending to cover the costs of debt servicing and this lead to a deterioration of asset quality. BNM therefore abandoned the two-tier system and introduced rules requiring that controlling shareholders capitalize their financial institutions using use equity, retained earnings, or very long term debt or bonds. 39. In August 1999 BNMs guidelines were expanded to prohibit granting of credit to shareholders with controlling or influential interest in a banking institution and to any firms in which the shareholder has a significant interest. 40. BNM is now in the final stages of preparing a financial sector master plan that will guide developments in the sector over the next 10 years. A new liquidity framework will replace the fixed 15% liquid asset requirement. It will be based on each banks’ own one year projection of liquidity requirements based on the profile of maturity of assets and liabilities. The deadline for this has been pushed back to the end of 2000. However, 30 financial institutions have already adopted the framework as of September 2, 2000 and the rest are on track to do so by year end. - 18 - 41. The BNM has also taken steps to improve capital adequacy of the banking sector. Since March 1998 banks have been required to undertake stress tests that judge capital adequacy against a range of contingencies and the results are reported to BNM quarterly. The risk–weighted capital ratio of the banking system has increased slowly but steadily from 10.5 % at end 1997 to 12.3% at end 1999, and stood at 13.1% at the end August 2000. In April 1999 BNM announced that it would issue a set of “Minimum Standards in Credit Risk Management” although these were not yet available as of the June 2000 mission. 42. BNM is moving towards the consolidated reporting and supervision of bank groups. This is a positive development that will help to prevent over leveraging of banks and will give BNM better scope to assess systemic risk. Such reporting helps identify the potential communication of financial stress originating in one segment of the financial system to other parts via bank groups and their holding companies. It does however give rise to jurisdictional issues since the alternative, which is a reporting system based on functional classification, lends itself more readily to a clear designation of the regulatory authority responsible for each institution. BNM has indicated that it will issue provisions for the establishment of bank holding companies that clearly separate institutions falling under BNM’s direct regulatory control from those which do not, and that will allow separate assessment of performance at both the holding company and the subsidiary levels. Details of the new system are not fully settled but it is likely that BNM will have responsibility for supervising banks and finance companies and for holding companies of all financial institutions. Certain other financial institutions will be directly supervised by other authorities (securities dealers for instance may be supervised by the Securities Commission). Where a holding company includes a subsidiary that is not directly supervised by BNM, BNM will restrict its supervisory functions to the impact that the subsidiary has on the balance sheet and performance of the holding company. It must assess the risks to the holding company due to its holdings in the sub but it does not supervise the sub per se. Thus the move to consolidated reporting of bank groups is consistent with the formation of bank groups and it is in the interests financial system stability, but it will take some time to be fully articulated. 43. The 100% government guarantee of deposits currently remains in place. This represents a large contingent liability for the government but one which was necessary to provide financial stability during the crisis. However, now that stability is being restored, BNM has undertaken, with assistance from the ASEM grant managed by the World Bank, to replace the blanket guarantee with a deposit insurance scheme. The shift from blanket deposit protection to one with limited coverage would have to be implemented over a period of time and need to be properly sequenced so as to ward off any potential adverse implications to the economy. In the interim, appropriate transitional arrangements would be introduced, including measures to address moral hazard issues that persist under the blanket protection and consumer education and awareness pending full implementation of the deposit insurance scheme. In addition, the on-going merger involving the domestic banking institutions would result in a change in the risk profile of the banking institutions. Hence, the lack of historical data further complicates the assessment and formulation of a risk-based framework. - 19 - 44. The World Bank in collaboration with the IMF is undertaking a multi-country Financial Sector Assessment Program (FSAP). The G-20 formally endorsed and pledged support for this program in late 1999. In each participating country the program undertakes to provide an assessment of the level of compliance with international standards and codes as well as providing an analysis of the capacities and practices of the supervisory and regulatory system and those of the financial institutions themselves. The Bank would welcome Malaysian participation in this program. To date however, the authorities have indicated that they would prefer to concentrate resources on execution of their own financial sector reform program. Malaysia has agreed to participate in the parallel program for corporate governance (including accounting and bankruptcy) which is discussed further in Section F. Reform of the Capital Markets 45. Again there is a longer term effort to improve the regulation and supervision of the markets. Although much remains to be done a number of important steps were taken since the SPR was released. 46. In May 1999 capital adequacy requirements were introduced to ensure sufficient liquid capital in stockbroking companies. 47. The Central Limit Order Book (CLOB) share problem was resolved in early 2000. CLOB shares were KLSE-listed shares, traded in the over-the-counter market in Singapore. When BNM moved to shut down the offshore currency market they also froze trading in CLOB shares since these represented an alternative channel for speculation against the ringgit. Singapore investors were unable to dispose of an estimated $US4.9 billion worth of CLOB shares and this remained a source of uncertainty until February 2000 when the Singapore and Kuala Lumpur exchanges came to agreement on the registration and phased release of the CLOB shares through the Malaysian Central Depository. 48. A number of steps were taken to enhance the share trading infrastructure. The Institutional Settlement Service launched in July 1999 will now allow institutional investors and banks to participate directly in the clearing and settlement process. A new integrated electronic system of share applications was set up in August and KLSE trading suspension rules have been modified. 49. In December of 1999 the Securities Commission issued guidelines in support of the move towards disclosure-based regulation (DBR). Under the old system securities issues were subject to the approval of the Securities Commission under a merit system that basically controlled the issue price. When the DBR system is fully implemented, securities pricing will be free for market participants to determine and issuance will be regulated only by disclosure requirements. - 20 - Figure 10: Outstanding Ringgit Bonds 50. A key challenge for the financial sector is to reduce the current high level of dependence on RM b. 250 other debt bank lending finance which exposes 200 private debt the economy to excessive liquidity and systemic risk (Figure 10). The 150 cagamus SPR highlighted the fact that the 100 danamodal during the period 1995-97 the danaharta 50 khazana domestic debt market provided only malaysia gov 11-15% of net financial flows as 0 compared with 58% from the 1998 1999 banking system. In the immediate aftermath of the crisis the concern Source: BNM. was that there be sufficient bank lending to avoid a credit crunch and the authorities have been actively encouraging banks to maintain credit flows. But the medium term challenge is to stimulate financing through the private debt securities market (PDS) as an alternative to bank lending. Recently there have been signs of progress as the PDS market expanded strongly in 1999. This was partly attributable to the increase in Danaharta bonds related to corporate restructuring. But the main cause was a sharp increase in net debt issuance by private firms other than Danaharta, Danamodal and Cagamas. The share of the total ringgit bond market accounted for by truly private bonds rose from 29.7% in 1998 to 38.4% in 1999. This reflects the upturn in economic activity and the disappearance of excess capacity in several sectors. 6 In tandem with the increase in private bond activity several measures have been taken to improve regulation of the bond market. The National Bond Market Committee was established and a clearer division of regulatory authority has been made with the Securities Commission now given sole responsibility for supervising the corporate bond market. Steps have been taken to simplify the issuance of corporate bonds by allowing shelf registration which will sharply cut the six month period previously required to take an issue to market. Nevertheless bank debt still dominates as a source of finance. The debt to GDP ratio and the end of 1999 was 126%, down from 139% in 1998. The ratio of bank loans to net funds raised in the capital market was 263% in 1997. 51. Management of the EPF will affect development of the capital market. As indicated in the SPR, there is a strong case for promoting externally managed accounts within the EPF to overcome the over centralization of fund management. The EPF remains bound by a statutory requirement to invest a portion of its portfolio in Malaysia Government Securities (MGS). The slowdown in issuance of MGS as the need for fiscal stimulus abates has required ad hoc exemption from this requirement. A more durable solution would facilitate better fund management. The EPF is restricted in diversifying its holdings internationally. While it is necessary to adopt adequate precautions in respect of 6 Another factor was the reduction in the minimum grade of corporate bonds banks may hold introduced to accommodate the downgrading of bonds in bank portfolios and avoid mandatory disposals that would further depress prices. This change, as well as the one lengthening the time banks are given to dispose of shares acquired in debt-equity swaps from 6 months to 5 years were introduced to facilitate corporate restructuring. - 21 - foreign currency exposure, a ban on foreign holdings may compromise fund returns and the scope for efficient risk management. Liabilities of the EPF have three distinct liquidity risk patterns associated with pension, medical and housing withdrawals. At present these are not fully reflected in the management of the liquidity structure of assets. There were well advanced plans to undertake a comprehensive reform of EPF management which were derailed by the crisis. Now that the crisis has largely passed it may be time to revisit this issue. 52. The MGS should provide a benchmark yield that can be used for pricing PDS. The risk of default on MGS is very low, so the spread between MGS and the debt of a private borrower should be a good measure of individual borrower risk. Clear measures of such risk are important for the efficient functioning of capital markets. However, the market for MGS is distorted by the fact that MGS are used to meet liquid reserve requirements of the banks. In addition there is a captive market for MGS stemming from the statutory requirements of the EPF.7 As a result, the demand for MGS is artificially increased, depressing yields, and undermining the value of the MGS as a benchmark. In other countries alternative benchmark yields are derived from the market for US treasuries which are close to riskless. This requires that there be an efficient market in foreign exchange so that US yields can be translated in to local currency yields. In Malaysia in the past, this need was met by the currency swap market. The yield on US treasuries could be translated into ringgit yields via swaps, and the resulting yield curve used to price PDS. However, with the imposition of currency controls, the swap market was closed from September 8, 1998. Liberalization of this market could be expected to increase the issuance and trade of PDS and to narrow the bid-ask spreads. 53. Steps are needed to promote securitization of assets and the government has offered some limited tax incentives for this purpose. Unit trusts could play an important role in mobilizing domestic savings. Again the government has offered some tax incentives to promote trusts, and the net asset value of private unit trusts rose by more than 70 percent in 1999. But much of the growth is simply a reflection of the sharp recovery of the stock market in 1999. Moreover, at RM 11.1 billion, the private funds are only a quarter the size of the government sponsored funds of which the Employee Provident Fund is the largest. Financial Stability Forum 54. The Financial Stability Forum (FSF) was established in February 1999 by the G-7 Finance Ministers and Central Bank Governors. Its purpose is to promote international financial stability through information exchange and international co-operation in financial supervision and surveillance, to promote international financial stability, and improve the functioning of markets and reduce systemic risk. The membership includes the G-10 countries, financial centers such as Hong Kong and Singapore, international financial institutions, and international regulatory and supervisory bodies and supervisors, and committees of central bank experts. Working groups were established in May 1999 to study highly leveraged financial institutions, capital flows, and offshore financial institutions. 7 Because of these demands the government has from time to time found it necessary to issue MGS beyond what is need for financing the deficit and it has had to consolidated MGS in to fewer and larger issues. - 22 - 55. Malaysia was particularly active in the Working Group on Capital Flows. The Deputy Governor of BNM is a member of this group which produced its report in April 2000. Malaysia emphasized the potential role of capital controls as a prudential measure in preserving international financial stability as well as the importance of considering both debt and non-debt flows. Malaysian views were also reflected in the Working Group acknowledgement of the responsibility of both foreign and domestic banks in managing cross-border credit risk. Malaysia has fulfilled a number of recommendations of the Working Group including the following items. • Reduce the stock of short term debt (which was smaller than in other countries of the region to begin with) • Build foreign exchange reserves • Deepen the domestic bond market • Develop national risk management systems • Develop liquidity and credit risk management systems in banking sector • Establish capital adequacy standards for Banks; • Produce timely and high quality data. E. CORPORATE RESTRUCTURING Malaysian Performance in the Regional Context 56. Malaysia, Korea, Thailand and Indonesia all pursued both in-court and out-of-court processes for corporate restructuring, and all four countries established voluntary out-of- court settlement procedures generally following the “London Rules” approach. In broad terms, Korea and Thailand put the greatest reliance on out-of-court settlements. In Thailand the accord governing the activities of its Corporate Debt Restructuring Advisory Committee was signed by most financial institutions, obliging all creditors to abide by agreements reached by a majority. The Thai accord also provides for formal arbitration and with deadlines and penalties for noncompliance. The Malaysian arrangements were similar although no penalties were imposed for non-compliance. In Malaysia as in Korea a strong threat of foreclosure and receivership supported the corporate restructuring process. Significant revisions to Malaysia’s 1973 bankruptcy law rendered it much more clear and credible. Between 1973 and 1998 the law was applied to only 2 cases and resolution depended on conciliation services provided by government agencies. The revisions, implemented in July of 1999, provided for the establishment of special bankruptcy courts and explicit bankruptcy procedures. By the end of March 2000 more than 192 companies had filed for reorganization under Section 176 of the Companies Act. Company liquidations have risen rapidly from 681 in 1996 to 1898 in 1997, 4800 in 1998 and 3778 in the first nine months of 1999. The Indonesian arrangements were the weakest. 57. All the countries but Thailand set up centralized asset management companies (AMC) to absorb banking system NPLs. While operational restructuring as opposed to - 23 - simple rescheduling has been a challenge for all of them, the Malaysian AMC (Danaharta) which was armed with special legal powers described in more detail below, has been the most aggressive, while Indonesia’s AMC has lagged seriously. All the countries besides Indonesia set up specialized bankruptcy courts to facilitate in-court settlements (Box 2). Box 2: Regional Comparison of Asset Resolution Strategies Indonesia Korea Malaysia Thailand Central AMCs Yes. Asset Yes. Kamco has Yes. Danaharta No. Decentralized management unit accumulated has acquired or approach on loan has accumulated $37bn of assets is managing workout. 3 private $31.6bn of assets $12.3 bn of assets AMCs set up, 2 planned; 3 public AMCs set up, and 1 planned / FRA set up to dispose failed financial company assets Transfer pricing at Yes Initially assets Purchased assets Not applicable subsidized prices were purchased are valued by above market independent clearing prices outside auditors with recourse. Since February'98, purchases have been attempted at market prices Nature of agency: Financial Not clearly Restructuring FRA is a restructuring or Not applicable defined. Mostly and disposition liquidation agent disposition restructuring and engaged in disposal disposing of assets Type of transferred assets Worst assets No particular Loans > RM5m. Not applicable strategy and mostly loans All assets of failed secured by finance companies property or shares Source: Claessens et al., 1999a; country sources - 24 - Table 6: Corporate Restructuring, August 1999 Indonesia Korea Malaysia Thailand Out-of-court restructurings Number of registered cases 234 92 (a) 53 825 Number of cases started 157 83 27 430 Number of restructured cases 22 46 10 167 Restructured debt/total debt (%) 13 40 32 22 In-court restructurings Number of registered cases 88 48 52 30 Number of cases started 78 27 34 22 Number of restructured cases 8 19 12 8 Restructured debt/total debt (%) 4 8 na 7 Source: Claessens, Djankov, Klingebiel, 1999 (a) Excludes restructurings of the 6th to 64th largest chaebol. Many restructurings have been done for small and medium sized enterprises. Table 7: Operational Performance of Publicly Traded Corporations and Share of Distressed Corporations Country 1995 1996 1997 1998 1999 * Net profit margin percent Indonesia 12.4 13.9 -3.6 -13.3 -8.9 Republic of Korea 2.7 0.4 -0.3 -2.6 2.7 Malaysia 12.2 12 6.9 -2.8 1.3 Thailand 7.1 5.1 -3.6 2.2 4.8 Firms that cannot cover interest expenses from operational cash flow percent Indonesia 12.6 17.9 40.3 58.2 63.8 Republic of Korea 8.5 11.2 24.3 33.8 26.7 Malaysia 3.4 5.6 17.1 34.3 26.3 Thailand 6.7 10.4 32.6 30.4 28.3 Source: Claessens, Djankov, Klingebiel, 1999 * first half 58. Overall Korea has made the most progress in restructuring, followed closely by Malaysia. Thailand and especially Indonesia trail behind (Tables 6 and 7). Out-of-court settlements have accounted for a majority of the restructured debt in all countries as bankruptcy proceedings in the courts have been slow, and the debt restructuring agencies operating outside the courts have tended to focus on getting quick resolution of larger cases first. The Corporate Debt Restructuring Committee Process 59. The CDRC process in Malaysia applies to multiple creditor cases with debts exceeding RM50 million and has been making steady progress (Table 8). As of August 31, 2000 CDRC had resolved 38 out of the 75 cases referred to it, representing RM 25.7 billion out of a total of RM 45.9 billion. This is up from 10 cases and RM 10 billion as of - 25 - August 20 1999. Most of the outstanding cases are at an advanced stage of discussions. It is anticipated that CDRC will wind up its operations by the end of the year. Table 8: Corporate Debt Restructuring Committee as of August 31, 2000 No. of cases Amount RM b. Application 75 46 Withdrawn/rejected 17 4 Resolved 38 26 referred to Danaharta 9 2 completed or in progress 29 24 Outstanding 20 16 Source: BNM Danaharta 60. Danaharta, which was launched in the third quarter of 1998, has legal powers that have had an important bearing on its success. First, special vesting powers insulate it, and subsequent purchasers, from undisclosed claims made after acquisition of the asset from the creditor. Second, Danaharta has the power to appoint special administrators without having to go to court. Finally, Danaharta can assume ownership of the assets and foreclose on collateral just as if it were the original creditor (Table 9). Table 9: Asset Tenders Held by Danaharta (June 1999 to present) Indicative/principal amounts Amount Recovery total withdrawn * net offered received rate * 1 2 3 (=1-2) 4 4/3 RM million RM million RM million RM million % First property tender 123 107 16 18 108 Second property tender 276 172 104 106 102 Third property tender 808 593 216 209 97 First foreign loan tender 541 181 361 199 55 Second foreign loan tender 957 27 930 658 71 Third foreign loan tender 642 216 425 289 68 TOTAL 3347 1295 2052 1480 72 * Assets that did not get Danaharta's reservation price were withdrawn. Recovery rates apply only to assets sold. Source: Danaharta 61. Danaharta completed its first asset carve out by June 1999. It finished its second, and most likely final, carve out in October 1999. Since then Danaharta has begun the more difficult task of asset sales and operational restructuring. Here the progress has been slow but steady. Six asset tenders were held including two property tenders held in November 1999 and April 2000, as well as two foreign loan tenders. Procedures for selecting and valuing assets for are clearly defined and executed. Independent expert advisors are contracted for valuing assets. Those that do not attract offers close to the independent valuations are withdrawn from the auction and transferred to Danaharta Hartanah a property management subsidiary of Danaharta. All 17 of the properties left - 26 - over from the first property tender were re-entered in the second tender and eight of them were sold, accounting for roughly a third of the proceeds of the second auction. 62. Danaharta is making solid progress on its portion of the NPLs. As of June 30, 2000 RM31.5 billion of the total of RM45.9 billion in its portfolio was been resolved. This is a significant jump from the RM18 billion resolved as of December 1999. However, Danaharta focussed first on the largest 20% of borrowers, and on the relatively easy cases involving sales of foreign loans and residential property. The pace will likely slow as they have to deal with smaller debtors, with commercial real estate and with enterprises requiring deeper operational restructuring. Moreover, a significant portion of cases have been resolved by simple rescheduling. This may postpone a problems rather than ensuring the necessary operational restructuring is undertaken. 8 Trends in Corporate Sector Performance 63. In aggregate, the corporate sector returned to profitability in 1999 with the net profit margin for the first half increasing to 1.3% compared with. -2.6% in 1998. Preliminary data collected based on a limited set of listed company returns indicate that net profit of non-financial firms increased to 6.2% in 1999 as compared with –3.3% in 1998 (Table 10). Table 10: Malaysia: Financial Ratios for Listed Companies Year 1994 1995 1996 1997 1998 1999 * Non-financial Companies Profit margin after tax (%) 11.0 10.5 10.1 7.5 -3.3 6.2 Price earnings ratio (%) 28.0 23.2 25.8 24.0 -25.4 24.5 Return on shareholders' funds (%) 11.3 11.0 10.8 7.6 -4.4 6.2 Return on assets (%) 5.6 5.3 4.6 2.9 -1.7 2.5 Current ratio (%) 1.26 1.21 1.14 1.12 1.02 0.84 Debt equity ratio 0.45 0.50 0.71 0.88 0.98 0.97 No. of companies 428 473 541 627 657 58 Financial Companies Profit margin after tax (%) 7.4 7.8 7.0 7.8 -33.2 -21.0 Price earnings ratio (%) 18.4 17.4 19.4 18.9 -5.0 -5.9 Return on shareholders' funds (%) 17.5 16.6 15.5 10.2 -21.0 -23.1 Return on assets (%) 1.40 1.50 1.43 0.95 -1.73 -3.14 Debt equity ratio 1.37 1.37 1.37 1.47 1.66 1.23 No. of companies 41 48 55 59 63 4 * Based on Annual Reports Received To Date. 64. These data suggest that there was a deterioration of corporate performance in Malaysia prior to the onset of the crisis. The return on assets fell from 5.3% in 1995 to 4.6% in 1996 and 2.9% in 1997 before turning negative in 1998. The profiles of other indices of profitability are similar. The pre-crisis declines are small however, which 8 As of December 1999 plain loan rescheduling accounted for quarter of the RM18 billion of loans considered “resolved”. Some 17 % were performing. Those foreclosed, under scheme of arrangement, fully settled or pending full settlement accounted for about 10% each. - 27 - would tend to indicate that while underlying structural problems were partly responsible for the decline, changes in external demand conditions and regional contagion were important contemporaneous factors. 65. Increases in corporate risk are also evident prior to the crisis. The proportion of firms unable to service interest expenses from cashflow began rising in 1996. In addition, financial leverage began rising well in advance of the crisis. The debt equity ratio for non-financial firms increased from .45 1994 to .50 in 1995 and then to .71 in 1997. It currently remains stuck in the range of 1.0 – roughly double what it was in the pre-crisis period. This is an important reason why NPLs are still 16.7% of total loans (Q1 2000) - down only moderately down from the peak of 18.9% hit in Q4-1998. F. CORPORATE GOVERNANCE AND COMPETITION POLICY 9 66. The SPR noted that Malaysia has comprehensive laws related to corporate governance and creditor rights, and that accounting standards are good (Table 11). It suggested that enforcement and actual accounting practices were weaker, but that this was improving steadily since the Financial Reporting Act of 1997 gave the force of law to accounting standards approved by the Accounting Standards Board. The SPR also highlighted the importance of improving regulations and practices in the area of responsibilities of boards of directors, related and interested party transactions, protection of minority shareholders and disclosure of financial and non-financial information. 67. Malaysia has been moving to improve enforcement and to bring its laws and regulations more closely into alignment with international standards. A comprehensive report on corporate governance was approved in February, 1999. It was based on the recommendations of the High Level Finance Committee on Corporate Governance (HLC) which comprised members of the Securities Commission (SC) The KLSE and the Registrar of Companies. Some of the recommendations implemented or where implementation is imminent include the following: • Law reform – The Securities Commission (Amendment) Act 2000 was passed by both houses of parliament in April 2000. The act introduces enhanced disclosure obligations on issuers and stringent sanctions for false and misleading information in prospectuses10. It gives investors the right to pursue civil action against companies, directors and their advisers where there has been a contravention of the law11. The SC is also empowered to pursue civil action on behalf of investors where it is in the public interest to do so. 9 This section draws on some of the work done by the World Bank on Corporate Governance Assessments for the Financial Stability Forum. 10 Section 55 SCA - imprisonment for 10 years, fine of RM3 million (US$ 0.8 million) or both. 11 Section 57 and 153 Securities Commission Act 1993. - 28 - Table 11: Summary of Corporate Governance in Malaysia Market and Regulatory Overview Y/N Remarks Market Cap (percent of GDP) na As of 12/31/99: RM 553 billion (US$145.4 billion) or approximately 184% of 1999 GDP Turnover Ratio na 34% Number of Listed Companies na 757 as of 12/30/1999 Legal System (Origin) na Common Law system with a comprehensive legal framework (UK) Autonomy of Capital Markets Regulator na SC. Chairman and commission appointed by and report to the minister of finance (MOF). Accounts annually tabled in parliament. Self funded. Powers of the Capital Markets Regulator na Administrative, including powers to conduct investigations and to prosecute with consent of Attorney General. No judicial powers. Stock Exchange Governance na KLSE; 4 board members chosen by MOF and five by its members. Supervised by the Securities Commission. Corporate Ownership Structure na Concentrated. In half of the listed companies the five largest shareholders own more than 60% of shares. Shareholders' Rights Voting Rights na Each ordinary share carries one vote. Non-voting preferred shares are rare. Some (strategic) companies have “special shares” which entitle holder to exercise a veto or confer rights over directors’ appointments. Proxy Voting Yes No need for notarization. Deposited before meeting/no postal ballot. Cumulative Vote/Proportional Representation No Voluntary Code sets out best practice on proportional representation. Ownership % required to call Shareholder Two or more members holding =10% may call extraordinary meeting. Meeting Redress against Violations/ Minority Yes Personal actions, representative actions and derivative actions. Oppression Remedies Procedural difficulties with recovery of damages in representative action. Take-over Code Yes Mandatory Tender Offer in Change of Yes Required at =33% of share capital. The bidder must pay the highest price Control paid for the shares of the offeree in the preceding 12 months. Insider Trading & Self-Dealing Prohibition Yes “Insider” includes all persons w/material non-public info. Investors allowed to seek full compensation. One case pending in court. Preemptive Rights Yes KLSE listing requirements require preemptive rights to be worked into the articles of association. Oversight of Management Board Structure One tier board, combination of executive and non-executive Independent Directors Yes 1998 survey indicated most companies have good mix. Anecdotal evidence suggests controlling shareholders sometimes act as “shadow directors”, in which case the Companies Act imposes fiduciary duties. Getting prove and enforcing the law are difficult in practice. Committee Practices Yes Audit committee with at least 3 members – majority of independent directors. Disclosure and Transparency External Auditors Yes Appointed/removed at AGM. Consolidated Statements Yes Required by listing requirements of KLSE. Segment Reporting Yes Required, but not fully compliant with IAS standards. Disclosure of Price Sensitive Information Yes Must disclose material information to the public immediately; clarify and confirm rumors/reports; provide response to unusual market action. Accounting – Standards and Enforcement Not across the board compliance with IAS. Company Officers related Disclosures Yes Aggregate remuneration is disclosed. Related Party Transactions Yes Intl accounting standard (IAS24) on related party disclosures adopted; there are rules for both directors and related parties Disclosure of Ownership Yes Lowered from 5% to 2%, but ownership structure is difficult to capture. Risk Management and other Disclosures na Soon to be introduced KLSE listing requirements will require annual reporting on the state of internal controls in a company. ACRONYM KLSE: Kuala Lumpur Stock Exchange IAS: International Accounting Standards SC: Securities Commission AGM: Annual Shareholder Meeting - 29 - • Malaysian Code on Corporate Governance – Voluntary in nature, the code sets out broad principles of good governance and best practices for listed companies. The amendment to KLSE’s listing requirements12 will require companies to disclose in their annual reports a narrative account of how they applied the principles of the code to their structures and processes and the extent to which they have complied with it. • Mandatory accreditation of directors – The new listing requirements will require directors to attend compulsory training programs13. 68. There has been criticism about lack of autonomy and transparency of the regulatory authorities in Malaysia. The SC has enhanced its enforcement capacity by restructuring the enforcement department and putting greater emphasis on corporate compliance. Senior officials from the Attorney-General’s chambers are assisting SC’s enforcement efforts. In 1999 the SC investigated 54 cases and initiated 23 prosecutions for offences ranging from submission of false or misleading information, using schemes to defraud, engaging in acts to defraud and short-selling14. It is the responsibility of the Attorney General to initiate prosecution. The Securities Commission (SC) has wide administrative powers, but does not have the judicial power of a court. It reports to the minister of finance and its accounts are tabled in parliament annually. The chairman holds office for a period of up to three years. The finance minister has the right to remove any member of the commission from office, including the chairman. The SC is financially independent15. 69. The powers of KLSE were strengthened in 1999 through the amendments to the Securities Industry Act. KLSE can now take action against directors and any person involved with its listing rules; it is no longer confined to the listed entity. In addition, the Securities Commission has the power to apply to court for disqualification of chief executives and directors of listed companies where they have been convicted of offences under securities laws or have had an action taken against them for breach of listing rules or civil action for breach of the insider trading or market manipulation provisions. 70. In July 1999, the KLSE introduced a new memorandum on merger and acquisition rules directed at improving the transparency in the business conduct of stockbroking companies. This was followed by the announcement in April 2000 that the country's 63 brokerages must sign firm agreements to merge into no more than 15 firms before the end of the year. This deadline was subsequently removed but the SC is monitoring development sand may impose a further deadline if progress is not made by the industry. 12 Expected to go into effect in August 2000. 13 A recommendation expected to be implemented before the end of 2000 is the creation of a Minority Shareholder Watchdog Group. The Employees Provident Fund, the largest institutional shareholder in Malaysia, is coordinating this initiative. The EPF has called for other institutional funds to participate in this group. The plan is to form a non-profit company that will supply institutional funds with research and guidance and act as a catalyst for collective shareholder action against errant management. 14 SC’s Annual Report 1999 sets out details of enforcement action taken and key statistics including a breakdown of complaints received and their status, cases investigated by section and details including the names of persons charged. With respect to the KLSE, its website (www.klse.com.my) sets out details of reprimands issued and fines imposed for contravention of its listing requirements. 15 The sources are (i) 0.02% levy on securities transactions; (ii) fee income; (iii) interest earned. - 30 - 71. The process of corporate restructuring especially among the firms involved in large transportation and infrastructure projects present some special challenges. The role that the government and government controlled institutions play in resolving the financial difficulties of entities such as MRT (railways) and MAS (airlines) are highly visible and are as important in influencing foreign investors as are all the legislative and regulatory changes affecting corporate governance. Table 12: Compliance with OECD Corporate Governance Principles OECD PRINCIPLE Y/N REMARKS The Rights of Shareholders Shareholders Rights Yes Companies Act confers all basic rights to shareholders, including secure methods of ownership registration, free transfer of shares, the right to information, the right to requisition a general meeting. Shareholder participation in decision- Yes Shareholders have the right to vote on election of directors, amendments to the articles of making on fundamental corporate associations, on key corporate transactions, and mergers and acquisitions. changes Shareholder ability to participate Yes Shareholders can participate and vote in company meetings and shareholder ballots. A shareholder effectively and vote in general may appoint a proxy. A proxy has the right to speak at a meeting and may demand a poll. No postal shareholder meetings voting. Disclosure of structures enabling Some Threshold for reporting acquisition of shares has been lowered from 5 % to 2 %. However, ownership control disproportionate to equity structures are difficult to capture. ownership Market for corporate control Some Any acquirer who has obtained 33% of the voting rights must make a mandatory general offer for remaining shares in accordance with Take-over Code of Jan 99. However, concentration of shareholding imposes a constraint on the market for corporate control. Shareholder activism Some Growing activism, as shareholders become increasingly concerned with corporate governance issues, and use both legal processes and seeking regulatory redress. Equitable Treatment of Shareholders Provisions for equitable treatment of Yes Shareholders whose rights have been violated may invoke legal remedies, including personal, all shareholders and redress representative, and derivative actions. There are procedural difficulties with the recovery of damages mechanisms in representative action. Increasing use of arbitration and mediation. Insider trading Yes Criminal offence. Civil penalties allow investors to seek full compensation for loss from the offenders, but no successful prosecution of insider trading yet. One case pending. Disclosures by directors on matters Yes IAS 24 on related party disclosures has been adopted. KLSE’s listing rules specify that a company affecting the company and related must make a public announcement, send a circular and seek the approval of shareholders on all party transactions material related party transactions. Disclosure and Transparency Disclosure of material financial and Some PLC’s must publish annual audited accounts, auditors’ and directors’ reports and quarterly financial non-financial information statements, but there are no statutory provisions attaching civil liability to decisions as to the timing and content of disclosures and legislation does not provide for recovery of damages by investors against misleading or deceptive statements. Standards of accounting, disclosure, Some Not across the board compliance with IAS. and audit. Annual audit by independent auditor Yes Appointed/removed at AGM. Auditor is not required to give an opinion as to whether the information in the directors’ report is consistent with audited accounts. Channels for disseminating Yes Companies are required to make immediate public disclosure of all material information concerning information their affairs to KLSE. Responsibilities of the Board Duties and liabilities of the board Yes Directors owe their duties to the company, not the shareholders. They have “trustee-like” fiduciary duties in addition to the duty of care, skill and diligence. The board considers major policies and may appoint one of their own as manager. There is no statutory or judicial recognition of the board’s collective duty to oversee management. KLSE can take action against directors directly involved with its listing rules and the SC can apply to court for disqualification of CEOs/ directors where they have been convicted of offences or breach of rules. Equal treatment of shareholders Yes Each ordinary share carries one vote. No maximum number of votes per shareholder allowed. Non- voting preferred shares are rare. Key responsibilities of the Board Some Not clearly defined. All listed companies are to have an audit committee and most have other committees for overseeing key responsibilities of the board. Objectivity and commitment Some Anecdotal evidence that there are instances when controlling shareholders act as “shadow directors” without taking on the corresponding statutory duties and liabilities. - 31 - 72. Competition law. Malaysia has opted to split its competition legislation into two parts: consumer protection; and trade practices. There is ample precedent for this in other countries and the consumer protection law is regarded as of best practice standard. However, the trade practices legislation, which in most countries covers such matters as abuse of dominant position, price fixing, collusion, bid rigging and merger and acquisition notification and review procedures, remains in draft form. This leaves Malaysia behind most developed countries as well as a number of its regional colleagues such as Thailand and Korea which have recently passed such legislation and have made strong efforts to establish the institutional framework for its implementation through establishment of independent competition authorities. 73. Tariff Policy The 2000 budget introduced tariff reductions on 305 tariff line items covering yarns, textiles and footwear components. Rates on these items were generally lowered from 20% to 15%. Duties were also reduced on 46 tariff line items covering various goods in chapters 85 to 94. However the reductions were concentrated on raw materials and intermediates rather than finished goods which has the effect of increasing effective rates of protection. The higher duties introduced in 1998 on cars, consumer durables, construction material and machinery have not yet been lowered. Duties on 165 food items were reduced in the 2000 budget as a means of keeping food costs down during the crisis. These included some items such as dried fish, tinned mackerel and pasta that are important in the to lower income groups. The tariff changes will reduce on trade international trade tax revenue by an estimated RM 141 million or 4.6%. 74. Industrial Policy and Foreign Ownership Until January 1998 Malaysia maintained foreign ownership restrictions in manufacturing based on the share of production exported with no limitation for firms with 80% exports ranging down to a 30% ceiling for firms with less than 20% exports. These limitations (other than certain metal and plastic fabrication industries) were lifted in 1998, largely to encourage FDI during the crisis. The policy will be reviewed at the end of 2000. 75. All manufacturing enterprises above a certain minimum size remain subject to licensing which involves a combination of set qualification criteria and administrative judgement. The rules have the effect of favoring capital intensive, higher technology enterprises with export orientation, using licensing, tax concessions, (including duty drawbacks and exemptions for exports) and preferential government procurement. There have been some minor changes in the tax incentives in the last two budgets but essentially the system remains as it was before the crisis. 76. The Bumiputera policy introduced with the New Economic Policy of 1970 requires that a portion of new share issues, and the non-foreign share of equity in joint ventures, be reserved for the Bumiputera or ethnic Malaysians. These policies, which were intended to raise Bumiputera participation in ownership to a minimum of 30%, have not been significantly altered since the crisis. 77. There are 13 wholly foreign owned banks in Malaysia. The foreign banks account for 30% of assets in the banking system and have a large stake in the insurance industry. While the government is committed to building a financial sector capable of serving a - 32 - globalized economy, so far regulations continue to prevent foreign banks from expansion of their branch networks. The bank merger program to be completed by the end of 2000 will tend to increase industry concentration. Further liberalization of the banking industry through increased foreign participation should be allowed as the merger program progresses and the consolidation of the domestic industry is accomplished. H. PUBLIC SECTOR PERFORMANCE AND MANAGEMENT 78. The SPR emphasized that Malaysia has strong public sector institutions and that the civil administration is well regarded and has contributed to the private sector’s perception of the government as being friendly to business. This perception is reinforced by a legal system that is effective in enforcing contracts and protecting property rights. These factors underpin Malaysia’s remarkable growth and inflows of foreign direct investment which, in relation to GDP, are among the highest in the world. 79. The SPR made a number of specific recommendations including: (a) Conduct a comprehensive survey of Government financial exposure to privatized projects and implement risk management systems. (b) Renounce or provide explicit budgetary reserves for contingent liabilities. (c) Produce guidelines for the extension and management of future contingent liabilities. (d) Make public the contingent liability position. (e) Open a larger share of procurement to open bidding and do more audits. (f) Make performance audits and client surveys routine. 80. Some progress has been made in these areas. The government has recognized that weaknesses exist in the planning and budgetary process pertaining to contingent liabilities and privatization. As a result the Treasury is reorganizing the Finance Division and a unit dealing specifically with privatization and contingent liabilities is being created. The new unit is expected to provide better coordination of budgetary allocations for contingent liabilities and establish risk management procedures for government investments. As an initial step the Treasury has begun a study to identify and evaluate all contingent liabilities. In addition, a trust fund has been created so that the Government can make early provision for contingent liabilities expected to be realized in the future. 81. It has been acknowledged that performance evaluation needs to be improved to ensure that programs produce the desired outcomes, satisfy program needs and meet goals effectively and efficiently. Accordingly Treasury is: i) issuing a circular on the Guidelines for Evaluation Program; ii) providing training on evaluation for agencies commencing from October 1999; iii) appointing a consultant to assist with the implementation of Evaluation Program; and preparing a standard manual on Program Evaluation and Evaluation Audits. The extension of program performance agreements to - 33 - cover all statutory bodies irrespective of whether they are in receipt of allocations from the annual budget is under consideration, together with initiatives to ensure that reporting standards are more results oriented. 82. Public Procurement rules remain largely unchanged. In fact the regulations requiring public tender were relaxed in 1999 as a temporary measure to facilitate public spending during the crisis. Privatization sales are still conducted on a case-by-case basis by the EPU. 83. In the recent past the Government of Malaysia has encouraged private participation in infrastructure projects and has geared its privatization policy towards this end. During the crisis a number of these projects have run into financial difficulty. Heavy debt burdens arising among enterprises in telecoms, transportation and water sectors have given rise to the need for major capital injections and restructuring. As in other countries in the region the public sector has played a role in this process. It is critically important, however, that such public intervention: a) is transparent; and b) results in changes to management and operational structures that will cure the underlying problems. Simple cash injections alone will not ensure this. Exclusion of foreign participation may cut of access to valuable technology and management expertise. Reliance on publicly owned enterprises and publicly directed investment funds for these recapitalization needs, without real restructuring, sends the wrong signals and weakens longer run development potential. - 34 - TABLE 13: MACRO GROWTH AND RECOVERY Issue Steps needed Steps accomplished Remaining Steps Debt sustainability • Provide temporary fiscal • 4 percent of GDP • Measure and contain stimulus without creating increase in the contingent liabilities and unsustainable debt. Government deficit budgetary effects of • Measure and contain provided stimulus to NFPE activities. contingent liabilities buffer the effects of the crisis during 1998 and 1999 • Debt outlook is sustainable. Significant reduction in short term external debt Management of capital • Complete exit from • The temporary and pre- controls and exchange rate controls announced nature of • Removal of the 10 % peg. • Early warning system controls was a positive exit levy. feature • Orderly transition to • Phaseout of capital system of consistent controls on foreigners exchange and monetary using exit taxes and policies coordinated with avoidance of the the introduction of anticipated large capital financial sector reforms. flight. (September 1999) • Create environment for • Improve FDI flows • Limited recovery of • Renewed FDI flows investor confidence • Recovery of domestic domestic investment • Recovery of property investment • More sectorally balanced market, especially growth established commercial real estate. • Containment of • Continued price stability. inflationary pressures TABLE 14: SOCIAL PROTECTION AND POVERTY Issue Steps needed Steps accomplished Remaining Steps • Protect risk groups • Promote income earning • Significant set of short • Improve response time during contraction activities term ad hoc expenditure of program delivery • Promote employment programs in 1998, 1999 • Protect social assistance and 2000 budgets for spending Rural water and sanitation smallholder programs, micro credit, housing construction, health clinics, Fund for Food • Protection of education and health sector budgets during crisis • Create medium-term • Improve poverty • Sustained emphasis on • Eventual broadening of safety net monitoring and evaluate access and quality of social safety net to meet antipoverty programs education and health the needs of all and • Sustain education and programs. especially groups with health programs special needs. • More timely production and release of socio- economic data particularly the household survey, and associated evaluation of social programs. - 35 - Table 15: FINANCIAL SECTOR STRENGTHENING AND CAPITAL MARKET DEVELOPMENT Issue Steps needed Steps accomplished Remaining Steps Stabilization of • Stop • The acceleration of NPL growth was arrested. • Stabilization phase is financial acceleration of (Q4-1998) complete institutions (FI) NPLs in • Closure/merger of most distressed FIs (1998- Banking system 99) • Recapitalize FIs • Recapitalization of remaining FIs (1999). • Provisioning for NPLs has been put through bank balance sheets, Capital adequacy is well above the 8 percent minimum and the banks returned to positive profits in 1999. • Danaharta’s second carve out completed and NPL purchases are now done (October 1999). Financial sector • Formation of • Merger groups approved by BNM. (Feb 2000) • Completion of legal mergers mergers and merger groups • Finance company mergers and closures (target December 2000) consolidation • Completion of completed. (1998/99) • Operational integration of mergers merged institutions Long term • Completion of Financial development of • Tightening of public disclosure requirements Sector Master Plan financial sector for FIs (March 98) 2 • Release credit risk regulation and • Abolition of Two Tier regulatory system (April management guidelines and supervision 1999) for banks. further deepen risk • Tightening of single customer exposure limits management systems in banks for banks. and assessment capacities at • Introduction of new liquidity framework to BNM replace fixed LAR (announced July 1998) • Implement bank holding • Connected lending rules tightened Aug 1999. company rules and reporting • Risk management requirements for derivative of bank groups on instruments consolidated basis. • Bring remaining banks into new liquidity management framework (Dec. 2000) • Adopt system of compulsory deposit insurance. • Reverse the crisis-related forbearance measures related to classification, provisioning and reporting standards • Exit of Danamodal • Raise 30% limit on foreign participation in banks. Capital market Deepen capital • Tax incentives for consolidation of SBCs • Complete Capital Market development markets by reducing (Budget 2000) Master Plan the reliance on bank • SC policies and guidelines issued to support • Completion of stages 2 and 3 credit, increasing the move towards disclosure-based regulation of the DBR program. volume and range of (DBR) rather than the existing merit-based • Promotion of asset backed financial instruments system. (Phase 2 of 3 - Dec. 1999) securities. traded and take the • Capital adequacy standards issued for stock • Introduce shelf registration of legal regulatory and broking companies (May 1999) securities supervisory steps • Clearing and settlement system improvements • Liberalize regulations to allow necessary to achieve through Institutional Settlement Service EPF to diversify assets and these ends. established (July 1999) adopt more decentralized fund • Electronic system for IPO applications. management. (August 1999) • In step with strengthening of • Introduction of Institutional Settlement financial markets and Services (July 1999) introduction of the liquidity • Resolution of CLOB share problem (February framework, liberalize swap 2000) transactions, refine statutory • Tax incentives for unit trusts and for requirements that create securitization of assets (Budget 2000) captive market for MGS and • Establishment of National Bond Market lay basis for establishment of Committee and clearer separation of regulatory benchmark yield curve. authority with SC given sole responsibility for • Relax the remaining capital corporate bond market. (1999) controls on residents. • Easing of restrictions on BB rated companies to issue bonds (July 1999) - 36 - TABLE 16: CORPORATE RESTRUCTURING Issue Steps needed Steps accomplished Remaining Steps Reduce the NPLs • Remove troubled • Danaharta established with • Reduce the NPLs in banking system of financial system debtors from FIs. broad powers to deal with which have peaked but remain and return • Establish resolution larger debtors and resolve substantial (16.7 % at end 1999 corporates to mechanisms cases with appropriate burden excluding Danaharta, 23.5 % profitability including, in-court sharing. Transactions are including Danaharta) settlements, market based. NPL • Press forward with operational voluntary out-of- acquisition phase is restructuring. court settlement and completed. • Strive for early windup of Danaharta asset management • Significant resolution through companies. rescheduling. • Establish effective, • Four rounds of asset sales and credible bankruptcy auctions completed. system • Establishment of bankruptcy law, bankruptcy courts and procedures. • CDRC launched and has resolved roughly half of the value of cases before it TABLE 17: CORPORATE GOVERNANCE AND COMPETITION POLICY Issue Steps needed Steps accomplished Remaining Steps Improve the legal • Tighten rules on • Appointment of High Level • Implement plans to tighten the framework for insider trading, Finance Committee on provisions of the Companies Act corporate minority Corporate Governance and relating to directors’ reports, governance and shareholder rights, release of detailed financial results and audited Competition related and recommendations (March accounts. policy. Improve interested party 1999) . • Refine KLSE share ownership the enforcement of transactions, rights • Beneficial interest disclosure classification to allow construction audit and and responsibilities for KLSE trade (Sept. 1998) share-ownership matrix in line with disclosure of boards of • Share buyback and transfer international best practice. standards. directors, and guidelines (Oct. 1998) • Pass Trade Practices portion of disclosure • Separation of control of Competition legislation and establish requirements of financial institutions and independent competition authority. PLCs stockbroking companies • Seek to broaden share distribution to (August 1999) counter the concentrated share • Share buyback and transfer ownership remains concentrated and guidelines (Oct. 1998) prevalence of pyramid structures and • Threshold for reporting share cross holdings in corporate groups acquisitions lowered from 5% to 2%. (1999) • Ongoing program of tariff rate reductions. (Budget 2000) • Quarterly financial reporting according to MASB with 2 month deadline (Mar, 1999) • Limits imposed on numbers of directorships (Mar. 1999) Competition • Pass competition • Consumer Protection • Complete review of foreign Policy law legislation passed. ownership regulations in • Refine trade and manufacturing and confirm industrial policies continuation of the temporary liberalization measures introduced in January 1998. • Further rationalization of tariff rates and elimination of NTBs to reduce protection . - 37 - TABLE 18: PUBLIC SECTOR MANAGEMENT Issue Steps needed Steps accomplished Remaining Steps Improve budgeting and • Identification and control • Initial steps for the • Completion inventory of planning system and establish of off-budget contingent establishment of contingent liabilities appropriate level of liabilities especially for contingent liability unit • Ongoing provisioning for government involvement in infrastructure and within Treasury contingent liabilities as private sector. privatized assets • Establishment of Trust part of the regular • Definition of public Fund for contingent budget. sector in National liabilities • Eliminate budgeting Accounts: inclusion of rigidities that require all subsidies, revenues to cover contributions to public operating expenditures enterprises and place less reliance on • Introduce greater capital programs that flexibility in budgeting have implementation to reflect cyclical lags for demand demand management management purposes. needs. • Further integration of off budget items into overall budget. Improve transparency and • Performance based • Initial steps taken to • Deepen audit procedures accountability in public recruitment and improve performance and widen coverage administration promotion in CS evaluation including • Introduce competitive • Performance audits on guidelines, training and bidding for privatization public programs preparation of a manual of infrastructure • Open bidding on public on Program Evaluation procurement and Evaluation Audits.