Malaysia - Country assistance strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No: 18812-MA MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR MALAYSIA March 5, 1999 Southeast Asia and Mongolia Country Unit East Asia and Pacific Regional Office This document has a restricted distribution and may be used by recipients only in the perforrnance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (Exchange Rate Effective December 30, 1998) Currency Unit = Malaysian ringgit (RM) RM1 = US$0.26 US$1 RM3.80 FISCAL YEAR January 1-December 31 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS ADB - Asian Development Bank AMC - Asset Management Company APEC - Asia Pacific Economic Community ASEAN - Association of Southeast Asian Nations ASEM - Asia Europe Meeting (EU Financial Crisis Response Fund) BAFIA - Banking and Financial Institutions Act BNM - Bank Negara Malaysia (Central Bank) CAS - Country Assistance Strategy CDRC - Corporate Debt Restructuring Committee CEM - Country Economic Memorandum CPI - Consumer Price Index DOD - Debt Outstanding and Disbursed DOE - Department of Environment EDI - Economic Development Institute EPF - Employees Provident Fund EPU - Economic Planning Unit ERSL - Economic Recovery and Social Sector Loan EU - European Union FDI - Foreign Direct Investment FELDA - Federal Lands Development Authority GDP - Gross Domestic Product GNP - Gross National Product GEF - Global Environment Facility IDB - Islamic Development Bank IFC - International Finance Corporation IMF - Intemational Monetary Fund IT - Information Technology JEXIM - Japan Export-Import Bank MIGA - Multilateral Investment and Guarantee Agency MOF - Ministry of Finance NBFI - Nonbank Financial Institution NEAC - National Economic Action Council NERP - National Economic Recovery Plan NGO - Nongovernmental Organization NPL - Nonperforming Loan OECF - Overseas Economic Cooperation Fund (Japan) PHRD - Population and Human Resources Development Fund (Japan) PER - Public Expenditure Review PM - Prime Minister RISDA - Rubber Industries Smallholder Development Authority RSA - Rapid Social Assessment SMIs - Small and Medium Industries SOCSO - Social Security Organization SPR - Structural Policy Review SPV - Special Purpose Vehicle TA - Technical Assistance UMNO - United Malays National Organization UNDP - United Nations Development Program WDR - World Development Report Y2K - Year 2000 Regional Vice President: Mr. Jean-Michel Severino, EAPVP Country Director: Ms. Ngozi Okonjo-Iweala, EACSM Task Team Leader: Ms. Natasha Beschomer, EACSM Peer Reviewer Mr. Ishrat Husain, Director, ECCO 1  FOR OFFICIAL USE ONLY MALAYSIA COUNTRY ASSISTANCE STRATEGY Table of Contents EXECUTIVE SUMMARY ................... ..i 1. CONTEXT ............................................1 2. ECONOMIC, SOCIAL AND POLITICAL DEVELOPMENTS ............... .................................3 A. THE IMMEDIATE CRISIS ..............................................3 B. SOCIAL IMPACTS OF THE CRISIS ............................................5 C. SECTORAL ISSUES AND IMPACTS OF THE CRISIS ........7...................................7 D. POLITICAL AND GOVERNANCE ISSUES ............................................ 10 E. GOVERNMENT'S POLICY RESPONSE TO THE CRISIS ........................................... 11 3. ECONOMIC PROSPECTS AND KEY CHALLENGES ........................................... 14 A. ECONOMIC OUTLOOK ........................................... 14 B. THE DEVELOPMENT AGENDA: KEY CHALLENGES ........................................... 16 4. WORLD BANK GROUP ROLE AND STRATEGY ........................................... 18 A. LESSONS FROM PREVIOUS INVOLVEMENT .................. .. 1 8 B. CAS PREPARATION ..: 20 C. RATIONALE AND STRATEGIC APPROACH ............................ 20 D. PROPOSED ASSISTANCE PROGRAM: BASE CASE ............................... ................................... 2 1 E. ALTERNATE SCENARIOS/CONTINGENCIES .................................................................. 25 F. MONITORING AND EVALUATION .................................................................. 26 F. ROLE OF OTHER DEVELOPMENT PARTNERS ..................... ............................................ 27 G. MANAGING RISKS .................................................................. 28 ATTACHMENT 1: MACROECONOMIC INDICATORS IN MALAYSIA AND OTHER COUNTRIES ...... .................. 30 ATTACHMENT 2: MALAYSIA'S CHANGING POVERTY PROFILE ................................................................. 3 1 ATTACHMENT 3: GOVERNANCE AND TRANSPARENCY ISSUES ................................................................. 33 ATTACHMENT 4: SUMMARY OF CAPITAL CONTROL MEASURES, SEPTEMBER 1998 .................................. 34 ATTACHMENT 5: FINANCIAL AND CORPORATE SECTOR REFORMS ............................................................ 36 ATTACHMENT 6: FISCAL SUSTAINABILITY ANALYSIS .............................................. .................... 42 ATTACHMENT 7: SUMMARY OF GOVERNMENT BUDGET AND ESTIMATED FINANCING NEEDS .................. 45 ANNEXES ANNEX 1: MALAYSIA AT A GLANCE ................................................................. 46-47 ANNEX 2: SELECTED INDICATORS OF BANK PORTFOLIO PERFORMANCE AND MANAGEMENT .................. 48 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  ANNEXES (Continued) ANNEx 3: BANK GROUP PROGRAM SUMMARY: PROPOSED IBRD CASE LENDING PROGRAM, FY99-01 ....... 49 BANK GROUP FACT SHEET: IBRD LENDING PROGRAM ............................................................... 50 BANK GROUP FACT SHEET: MALAYSIA - IFC AND MIGA PROGRAM, FY96-99 ........................... 51 ANNEX 4: SUMMARY OF NONLENDING SERVICES ............................................................... 52 ANNEX 5: MALAYSIA SOCIAL INDICATORS ............................................................... 53 ANNEX 6: MALAYSIA - KEY ECONOMIC INDICATORS .......................... ..................................... 54-56 ANNEX 7: MALAYSIA - KEY EXPOSURE INDICATORS ............................................................... 57 ANNEX 8: BANK GROUP FACT SHEET: STATUS OF BANK GROUP OPERATIONS IN MALAYSIA ......................... 58 BANK GROUP FACT SHEET: STATEMENT OF IFC'S COMMITTED AND DISBURSED PORTFOLIO ........ 59 ANNEX 9: COUNTRY PROGRAM MATRIX ............................................................... 60-64 ANNEX 10: CAS SUMMARY OF DEVELOPMENT PRIORITIES .65 MAP: IBRD NO. 30075  Malaysia Country Assistance Strategy Executive Summary i. Economic, Social and Political Context. Malaysia has had an excellent track record of economic performance and social progress over the past three decades, bolstered by political stability and strong policies. Progress in the health and education sectors has been particularly impressive, reflecting the high priority given to human resources development in public policy. Malaysia has formulated a long-term development strategy, Vision 2020, under which it aims to achieve developed nation status by the year 2020 by increasing its competitiveness in high value-added export-oriented manufacturing and services sectors, notably in information technology; fostering an open trade regime; enhancing the financial sector; and sharing the benefits of growth equitably among the population. ii. In late 1997, Malaysia was hit by an unprecedented economic crisis, triggered largely by regional contagion, that threatens to undermine many of the country's achievements and derail Vision 2020. Malaysia survived the early impact of the crisis because of its relatively strong initial macroeconomic conditions and sound institutions, compared to the other East Asian crisis countries, but the situation has since deteriorated. The regional crisis led to a slump in investor confidence; external and domestic demand shocks and depreciation of the currency pushed Malaysia into recession by early 1998. The crisis also exposed underlying structural weaknesses in the economy, notably in the financial and corporate sectors. Banks are troubled by rising levels of nonperforming loans (NPLs), attributable largely to their overexposure to the broad property sector and the stock market; corporate distress has increased in the property, construction, infrastructure and stockbroking sectors. Business and consumer confidence have declined, and international market perceptions have deteriorated, as reflected in sovereign credit rating downgrades. Foreign direct investment (FDI) and portfolio flows have slowed, and the ratings downgrades curtailed access to international financial markets. iii. GDP is projected to contract 6.8 percent in 1998, and recovery will take time. Poverty and unemployment have increased, particularly in urban areas, and up to half a million Malaysians could fall below the poverty line. Pressure on public services, notably in health and education, has intensified following a shift in demand from the private to the public sector and, in the case of education, to domestic institutions which face capacity constraints. The crisis threatens to set back the Government's plans to improve the quality of social services, as well as its program of rural development over the medium term, particularly in some of the less-developed states such as Kelantan, Terengganu and Sabah. This poses a significant risk to development of human capital, the cornerstone of Vision 2020. The economic contraction is also affecting Malaysia's ability to provide employment and social services for migrant workers (about 2 million, out of a population of 21 million), which may have important regional repercussions. Recent political events, linked partly to the crisis, have attracted international attention, and prompted some short-term uncertainty and changes in the top leadership. However, there has been a consolidation, and Cabinet changes in January 1999 resulted in the appointment of a new Deputy Prime Minister/Minister for Home Affairs and a new Minister of Finance. This move was welcomed by the business community and reduced the political uncertainty. General elections are due in 2000. iv. Government's Response to the Crisis. The Government has taken preemptive measures, culminating in a comprehensive National Economic Recovery Plan (NERP). This focuses on restoring growth by reviving domestic demand, preventing the erosion of gains in the social sectors, and protecting the poor and near- poor. The Govermnent has also stated its commitment to maintain expenditures on the social sectors so that previous gains are not eroded. To stimulate demand, fiscal and monetary policy have been eased. Malaysia ran a budget deficit equivalent to 3.4 percent of GDP in 1998 and has announced a deficit of 6 percent of GDP for 1999. Despite strong moral suasion from the central bank, banking credit contracted by nearly 1 percent in 1998; it grew 27 percent in 1997. The decline in loans mainly reflected the contraction in economic activity, although the number of loans approved increased in the second half of 1998. Selective capital controls were introduced in September 1998, and subsequently modified. The currency has been pegged at RM3.80 to the US dollar. The Government is implementing structural reforms in the financial and  -ii - corporate sectors, in particular to recover NPLs, recapitalize troubled banks, facilitate corporate debt workout and, where appropriate, encourage corporate restructuring on a voluntary basis in cooperation with the private sector. Malaysia's foreign exchange reserves have increased since the introduction of capital controls, and consumer confidence appears to be returning gradually. Yet it is too early to determine whether the Government's policy actions will succeed in restoring growth and reducing structural vulnerability of the financial and corporate sectors over the medium-term. Much depends on how the real economy and investor confidence continue to evolve. The CAS acknowledges this uncertain environment. v. Economic Outlook and Risks. Malaysia's recovery hinges on the scope and speed of structural reforms, the pace of recovery in the region and the rest of the world, and the restoration of market confidence. Given the high level of uncertainty in the region and unsettled market confidence, the Bank's base case projection assumes that GDP will continue to contract, by -I to -2 percent, in 1999, with growth unlikely to resume until 2000, in contrast to the Government's more optimistic projection of 1 percent growth in 1999. The easing of fiscal and credit policy will begin to stimulate domestic demand, but private consumption and investment will likely remain depressed over the short term because of the high level of uncertainty, and excess capacity. There may be little growth in exports, given sluggish regional demand. FDI may recover gradually. The surplus on the current account balance will fall from the high levels reached in 1998. If there are no further shocks the external balance will improve, and inflation will remain moderate. The greatest risk is further deterioration in the external environment, as Malaysia is a highly open economy. Although the ringgit is not overvalued in terms of the real effective exchange rate, the combination of a fixed exchange rate regime and looser monetary policy increases Malaysia's external vulnerability.Other risks are: lack of clarity on the details of financial and corporate sector restructuring; insufficient contingency planning in structural reforms; and a possible domestic backlash against globalization, resulting in the introduction of more restrictive policies. Inflation is not a major risk given the decline in aggregate demand and the emergence of excess capacity in the economy. vi. Short- and Medium-Term Challenges. The main short-term challenges facing Malaysia are clearly to overcome the immediate crisis and revive growth, and to maintain the country's human capital. Protecting investments in the social sectors, and softening the impact of the crisis on the poor and vulnerable, particularly in urban areas and the poorest states, are high priorities. Rekindling growth will, however, provide the main impetus for social sector development and poverty alleviation over the medium-term. The authorities will therefore need to maintain flexible macroeconomic policies, and accelerate and implement coherent reforms in the financial and corporate sectors in order to restore growth and confidence. A further challenge is increasing transparency and accountability in public policy. Adhering to clear criteria for the use of public funds in financial and corporate restructuring, and shifting to more open bidding procedures for privatization and public procurement, would increase transparency and efficiency. The way in which these immediate challenges are tackled will also affect Malaysia's ability to increase its competitiveness, enhance the business environment, and further develop the financial sector over the medium-term. Additional medium-term challenges include building appropriate technical skills for a technology- and knowledge-based economy, enforcing environmental legislation and regulations more rigorously, and exploring new approaches to social and welfare policy as society matures. vii. Renewed Client Relations. Malaysia has had a long and productive relationship with the Bank. One hundred loans totaling $3 billion, of which $2 billion have been repaid, have been approved since 1958. A country strategy note was presented to the Board in 1993, outlining a $1.2 billion lending program for FY92- 97. However, after running a series of budget surpluses in the 1990s, Malaysia unilaterally stopped borrowing. Some nonlending activity continued, but on a limited scale. The Bank's involvement also waned with the advent of new borrowing countries, and with administrative budget cuts. In mid-1997, just before the crisis hit, the Bank started to renew relations with Malaysia to deepen country knowledge, identify and disseminate best practices in development, and offer selective nonlending services. Preparation of a new Country Economic Memorandum (CEM) started. When the crisis spread to Malaysia in early 1998 the Government requested fast-disbursing assistance to mitigate the adverse social consequences of the crisis, and to finance a preemptive reform program. The Bank approved a $300 million Economic Recovery and Social Sector Loan (ERSL) in June 1998. As the recession deepened, the Government requested additional  -111- support, and preparation of the CAS and an initial pipeline of operations in the social sectors began. This CAS thus heralds a new phase in Bank-country relations. viii. Bank Group Strategy and Program. The Bank's primary objective in the CAS is to mitigate the social consequences of the crisis and prevent the erosion of social sector achievements in the short to medium-term, whilst also looking at instruments to restore growth and confidence, and enhance Malaysia's competitiveness. This rationale and strategic approach have been discussed with the Government and key stakeholders in the country. The Bank proposes a base case lending program of $1.0-1.5 billion over three years in investment loans in the social and related sectors. Three operations are being presented to the Board together with the CAS: the Education Sector Support Project, the Social Sector Support Project and the Y2K Technical Assistance Project. The underlying assumptions for base case lending are that progress in financial and corporate reforms will be steady, based on currently-established targets, with increased transparency and disclosure; and public expenditure on social services will be maintained in real terms.The risks to the Bank under this base case are considered manageable: Malaysia's exposure in the Bank's portfolio is 0.9 percent of the total. Moreover, no fast-disbursing loans are envisaged under the base case. The decision to focus exclusively on investment loans will also offset potential risks to the Bank, should Malaysia's external vulnerability increase significantly. ix. A high-case lending scenario could be envisaged if Malaysia develops and implements an exit strategy from capital controls, including modification; implements an accelerated and transparent financial and corporate sector restructuring program, consistent with international best practices; moves towards greater openness of the financial services industry to foreign equity participation to bring in fresh capital, knowledge and management; and commits to greater openness in privatization and public procurement. The recent modification of capital controls is a step in the right direction, but more needs to be done to move towards a comprehensive exit strategy. A high-case scenario could include (regular) fast-disbursing loans. The Government is aware that IMF endorsement of the macroeconomic framework would be a prerequisite for processing fast-disbursing loans. Under a low-case scenario, in which political and economic conditions deteriorate substantially, no lending would be recommended. If Malaysia's economic performance improves beyond current expectations, the Government may decide to scale down borrowing or exit completely. Under any scenario, the Bank proposes a solid program of nonlending services-policy dialogue with the Government and civil society, analytical work, policy notes and capacity-building-to assist Malaysia in managing the crisis and tackling medium-term development challenges. The Bank is also seeking to develop strategic partnerships with other donors active in Malaysia, notably the United Nations Development Programme (IJNDP), the Asian Development Bank (ADB), the European Union (EU) and Japan. x. Country and Bank Performance Monitoring. The Bank and the Government are developing a new framework for monitoring Malaysia's economic performance over the CAS period to evaluate the impact of current policies and mitigate downside risks. This is based primarily on preliminary indicators developed under the forthcoming Malaysia Structural Policy Review (SPR) and Public Expenditure Review (PER), as well as in economic and sector work and policy notes. Discussions with the Government on the monitoring framework are ongoing. Malaysia has no formal IMF program, but the Fund will also continue to monitor the economy under the Article IV arrangement, and to work with the authorities in ensuring consistency in the macroeconomic framework, in collaboration with the Bank. xi. Agenda for Board Consideration. The following issues are suggested for Board discussion: * Macroeconomic context and medium-term outlook for Malaysia in light of the regional economic crisis and global outlook; * Strategic thrusts of the CAS and the balance between short-term, crisis-related interventions and assistance with addressing medium-term development challenges; * Downside risks and flexibility of the proposed program to respond to them; * Proposed CAS monitoring framework  MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR MALAYSIA 1. CONTEXT 1. The Bank's principal justification for re-engaging in Malaysia is to support a country with an acknowledged track record of social and economic development that had voluntarily stopped borrowing, given its good economic performance, but was hit by an unprecedented economic crisis. Malaysia has one of the most remarkable growth records in modem history, a reflection of strong macroeconomic management and stability. This impressive track record, evidenced by 9 percent annual GDP growth in real terms from the late 1980s to the mid-1990s, contributed to a substantial reduction in poverty and enhancement of the quality of people's lives. Improvements in life expectancy and infant mortality are particularly impressive. In a quarter-century, real average per capita income increased 2.5 times and the poverty rate shrank from slightly over half of the population in the early 1970s to 5.1 percent of households in 1997. Substantial gains were made in education and health indicators; these are now comparable to those of many upper middle-income countries. Malaysia had a succession of budget surpluses in the 1990s which helped lower public debt, contain inflation and boost savings, while encouraging private sector-led growth. Malaysia also attracted large capital inflows, including portfolio flows but particularly foreign direct investment (FDI), of about $10 billion/year, or about 10 percent of GDP, drawn by expectations of high growth and its history of low external debt. Malaysia's development strategy, as described in well-articulated five-year development plans, has consistently given high priority to human resources development, high-quality social services and public institutions, and to achieving growth with equity. Malaysia's long-term goal is to achieve developed nation status by the year 2020 (Vision 2020). 2. In late 1997 Malaysia began to feel the impact of the regional economic crisis. Contagion that spread from Thailand in July 1997 triggered the crisis by contributing to a loss in market confidence, capital outflows and falling asset prices, and resulted in a 40 percent depreciation of theringgit (July 1997-August 1998). These effects were compounded by massive regional and domestic demand shocks. However, internal distortions which were beginning to emerge prior to the crisis also made the economy vulnerable to contagion. For example, total factor productivity growth fell in the 1990s reflectingless efficient use of capital. Construction and infrastructure sectors faced over-capacity and over-extension. Banks were becoming heavily exposed to the property sector and to the stock market, both of which are potentially volatile. Companies were becoming highly leveraged and increasingly illiquid. Despite its relatively low external debt (40 percent of GDP in 1996), Malaysia's domestic debt to GDP ratio had soared to over 160 percent, the highest in the region, mostly reflecting the increase in private debt. The efficiency of financial intermediation was hampered by Government guarantees provided to several projects. Malaysia's vulnerabilities reflect structural rigidities in the economy. 3. Malaysia at first survived the impact of the regional shocks better than the other East Asia crisis countries (Indonesia, Korea, Thailand) because of its relatively strong macroeconomic conditions and sound institutions, notably a strong central bank. However, as the regional crisis worsened, Malaysia's structural vulnerabilities, like those of the other countries, exposed the potential for large downside risks. The financial and corporate sectors have become increasingly vulnerable. Non-performing loans (NPLs) in the banking system have increased. Corporate problems in the property, construction, infrastructure and stockbroking sectors have also intensified. With the deepening economic and social impacts of the crisis in 1998 Malaysia entered into a recession. GDP is estimated to contract 6.8 percent in 1998, compared with 7.8 percent growth in 1997, and 8.6 percent growth in 1996. Investor and consumer confidence diminished. Although the recession appears to have bottomed out and there are some signs of recovery, sustained growth is likely to take time.  -2- 4. A particular concern is that the crisis will undermine many of Malaysia's impressive achievements in quality of life and social services. The impact of the crisis on the social sectors is already apparent as growth and poverty reduction trends have been abruptly reversed. Poverty is increasing, particularly in urban areas; up to half a million people could fall below the poverty line. Unemployment has increased from 2.7 percent in 1997 to a projected 4-5 percent in 1998, particularly in the construction and export-oriented manufacturing sectors. Pressure on public expenditure has intensified following a shift in demand from private to public services primarily by the poor and vulnerable, including migrant workers, and the gains made in health and education services are under threat. These adverse developments in the social sectors are not only important to address in the short term, but also have medium-term consequences because they are jeopardizing Malaysia's human capital, the cornerstone of Vision 2020. The economic and social impacts of the crisis on Malaysia will also have important spillover effects on the rest of the region. Malaysia is an important player in East Asia: over 50 percent of its external trade is intra-regional, in particular with Singapore and Japan; it employs a substantial number of migrant workers, largely from Indonesia and the Philippines. There are about 2 million migrants in Malaysia at present, out of a population of 21 million. About 800,000 are legal (October 1998 official figures), and the rest illegal. Given the porous borders with Indonesia, the pressure of immigration and its consequent burden on public services, is continuous. 5. The Government's initial approach to managing the crisis was similar to that used by the other East Asian crisis countries. In the early stages, the Government tightened both fiscal and monetary policies to stabilize the economy. However, as the crisis deepened, concerns increased over the continuing slump in domestic demand, growing distress in the financial and corporate sectors, and sluggish regional demand that these policies did not seem to be adequately addressing. Consequently, the Government changed course and developed a National Economic Recovery Plan (NERP) which focuses on restoring growth by reviving domestic demand, thereby tackling transitional poverty, and also on preventing further deterioration in the social sectors. Fiscal and monetary policy were eased to stimulate demand. In addition, the Government introduced some unorthodox measures in the form of selective capital controls which were designed to reduce the pressure on the exchange rate from the offshore ringgit market and to manage short-term volatile flows more effectively. The Government saw the controls as providing a breathing space for the economy, enabling policymakers to focus on reviving growth and tackling structural problems in the financial and corporate sectors. Capital controls have recently been modified with levies on portfolio flows replacing administrative controls. While some progress has been made on structural reforms, much remains to be done. 6. It is too soon to assess whether the Government's program will be adequate in scale and implementation over the medium term. Much depends on how the real economy and investor confidence evolve over the next year. Malaysia is a latecomer to the crisis, and there are downside risks. The principal risks of the Government's policy approach are that the scope of the crisis and vulnerabilities is being underestimated; and that details on financing and implementation are lacking in some instances, as these are still being elaborated. The Government has to be continuously vigilant to avoid potential inconsistencies in the policy package, particularly since Malaysia does not have a formal IMF program. The IMF is involved in economic monitoring under the Article IV arrangement, and the Government has shown some willingness to look at its policy package to maintain a flexible approach and achieve an appropriate balance. Some economic uncertainties persist, however, aggravated by recent political developments. The unsettled regional and global economic environment adds to this uncertain mix. 7. Against this background and acknowledging the risks, but also Malaysia's request and need for assistance, this CAS proposes to focus Bank support on helping to mitigate the social consequences of the crisis in the short term, and to prevent the erosion of social sector achievements in the short to medium term, whilst also looking at instruments to help restore growth and confidence. Malaysia has had a long relationship and a good track record with the Bank. One hundred loans have been approved since 1958, mostly in agriculture and rural development, for a total of $3 billion. Of that, $2 billion has been repaid. Malaysia's present exposure in the Bank's portfolio is 0.9 percent (1998). Following the Board's  -3- approval of a $300 million fast-disbursing Economic Recovery and Social Sector Loan (ERSL)l in June 1998, the CAS base case envisages investment loans mainly in the social and related sectors. In addition to the ERSL, the Bank's current portfolio comprises two operations in the health and education (polytechnic) sectors, approved in 1993. The Bank therefore has some knowledge and comparative advantage in these sectors, although this knowledge has had to be updated. A robust program of policy advice and selective technical assistance (TA) is also proposed to support the authorities in managing the present economic crisis as well as tackling some of the underlying structural weaknesses in the economy. 8. The rationale and strategic approach of the CAS have been discussed with the Government and other stakeholders in the country, notably parliamentarians, private business representatives, academics and nongovernmental organizations (NGOs) in a series of consultations undertaken in November- December 1998. Further details on participatory CAS preparation are given in Section 4B below. One issue in the discussions has been that the Bank's growth forecasts and assumptions for 1999 (-1 to -2 percent contraction in GDP) are more pessimistic than those of the Government (1 percent GDP growth). 2. ECONOMIC, SOCIAL AND POLITICAL DEVELOPMENTS A. THE IMMEDIATE CRISIS 9. Malaysia's economy is in recession. Despite relatively strong initial conditions and implementation of a preemptive reform program, the economic downturn in Malaysia has been much steeper than most analysts had expected in early 1998. There are several reasons for this. First, there has been an enormous wealth loss. Before the crisis Malaysia had the largest stock market in the world relative to its GDP (a stock market capitalization of 300 percent of GDP). The regional contagion burst the financial bubble, with stock prices plunging nearly 70 percent and stock market capitalization falling by more than 200 percent of GDP at one stage. This loss, combined with rising unemployment, contributed to the harsh contraction in consumption growth. Because of the fall in asset prices, weak demand, and the uncertain financial environment, investment has contracted. Second, Malaysia is a highly open economy, with foreign trade at nearly 200 percent of GDP. Early during the crisis there was some hope that the large depreciation of the exchange rate would enable net exports to become an engine of growth. Devaluations of similar magnitudes in neighboring countries were a relatively lesser concern since Malaysian exports are at a higher end of the technology ladder than those of Indonesia and Thailand. But exports have been disappointing, their expansion dampened by weak regional demand (at least 50 percent of Malaysian exports go to East Asia, particularly Singapore and Japan). Also, Malaysia's narrow and specialized export base (50 percent of exports are electronic goods, which have suffered large price declines) has added to its vulnerability. 10. Third, there has been a major reversal in capital flows. The uncertain environment in the region and domestic problems in Japan have slowed inward FDI from around 7 percent of GDP in 1997 to a projected 3-4 percent in 1998. Short-term portfolio flows have turned sharply negative, from an inflow of 4 percent of GDP in 1997 to a projected outflow of 6 percent in 1998. Fourth, the Government's initial policy response, though proactive, was based on over-optimistic assumptions, in particular positive, albeit low growth in 1998. The downside risk of the regional crisis, that a shortfall in demand can push a weak economy into a deep recession through a vicious cycle of bankruptcy, financial market collapse, and greater contraction in demand, was probably not recognized early enough. Basing initial policy responses on optimistic scenarios may have made it difficult to protect against the worst outcomes, thus exacerbating the downturn. 11. Financial and corporate sectors are vulnerable. Although the condition of Malaysia's financial sector in mid-1997 was sounder than that of the other crisis countries, with a stronger capital IDesigned to support implementation of the Government's measures in early 1998 to minimize the downturn in economic activity, undertake structural policy reforms, and maintain expenditures on antipoverty programs; see Section 2E below.  -4- position, a lower level of NPLs and a higher level of provisioning for bad loans, the situation has since deteriorated. During the credit boom of 1995-97 when lending by financial institutions grew at about 28 percent per year, and foreign capital inflows averaged around 10 percent of GDP annually, banks and finance companies built up large exposures to property (35 percent of loans outstanding) and equity markets (10 percent of loans outstanding) without considering the impact of a possible downturn. Since mid-1997, severe internal and external demand shocks, initially high interest rates, and the slump in property and stock markets, in particular the 40-50 percent fall in property prices (especially for commercial property), have severely affected the portfolio quality of these financial institutions. At the end of September 1998, NPLs of commercial banks amounted to 15.5 percent of total loans (based on a 3-month classification), while those of finance companies and merchant banks reached 23.8 percent and 23 percent respectively. The manufacturing sector, which has traditionally relied on FDI and internal financing, accounts for just 16 percent of bank lending. However, at 14 percent, the sector's NPLs are also considerable. 12. Following the rapid credit expansion in 1995-97 the corporate sector became increasingly illiquid and highly leveraged (with a debt:equity ratio rising more than 20 percent annually during 1990- 97), and thus more vulnerable to external shocks. Outstanding bank loans to the private sector exceeded 160 percent of GDP. Interest expenses began to consume a large proportion of corporate income; about half of outstanding debt is short term, with maturities of less than two years. The interest burden on this debt doubled from 10 percent of GDP equivalent in 1994 to 19 percent in 1997. This problem has been compounded by a bunching of maturities, with a large proportion of debt falling due in the next two years. Because of the heavy reliance on bank financing, the corporate sector was hit hard by the rise in interest rates following the onset of the crisis. Corporations were also adversely affected by the contraction in demand, and from the decline in the value of assets used as collateral. Profits had been generated mainly by high growth and not from efficiency improvements in asset use. These underlying problems compounded the impact of the regional crisis, and have made it difficult for many corporations to service their liabilities. The crisis highlighted some weaknesses in corporate governance- in particular inadequate safeguards of minority shareholder rights in relation to connected party transactions; inadequate requirements for financial disclosure; and lack of independent oversight at the board level. Corporate problems are particularly apparent in the diversified holdings, property and construction sub- sectors; manufacturing, plantation and consumer sectors are in reasonable good financial condition. 13. A further source of market uncertainty is the Government's fiscal exposure through contingent liabilities associated not only with the fiscal costs of recapitalization of the banking sectors, but also with its legal liabilities in privatized infrastructure projects, mainly in the transport and power sectors. These include explicit and implicit Government guarantees, equity investments by Government-owned trusts and the Employees Provident Fund (EPF), the largest national savings institution/pension fund. The Federal budget does not recognize the magnitude of current and full build-out contingent liabilities, but total exposure is in the order of 10 percent of GDP. Many of the projects are partially completed with substantial sunk costs, and merit completion. Some projects may not be viable. In particular, the urban rail projects in Kuala Lumpur (KL) are facing financial difficulties and need restructuring. The estimated current level of Government exposure for four KL transport projects alone is around $2 billion, and the full build-out exposure is about $3.5 billion. Moreover, Government exposure costs may rise as deficits mount due to low ridership and competing concessionsi. In addition, other privatized urban infrastructure and utilities, particularly in water supply and sanitation and solid waste management, are strapped for funds, in the absence of agreed frameworks for private-public participation, notably on tariff issues. The Govemment is fully aware and concerned about these issues, and has begun to quantify these contingent liabilities. The Bank has assisted in estimating the magnitude of liabilities in certain sectors. 2 World Bank Kuala Lumpur Transport Sector Review (FY99)  -5- B. SOCIAL IMPACTS OF THE CRISIS 14. Legacy of social progress. Prior to the crisis rapid growth served as Malaysia's primary social safety net, and eradication of hardcore poverty was a priority for public policy. Substantial resources were allocated to health and education, and to developing rural infrastructure, achieving levels of service surpassing the East Asian norm (see Box 1 and Annex 1). Federal Government development expenditure on poverty alleviation was almost 21 percent of the total in 1991-95. Improvements were not uniform, however, as progress in the states of Kelantan, Terengganu and Sabah lagged behind, with a higher incidence of structural poverty. Moreover, the social safety net is narrowly targeted, and the poor have traditionally relied largely on private transfers. 15. The crisis has resulted in increased poverty and unemployment and the emergence of new vulnerable groups (see Attachment 2). Up to half a million Malaysians could fall below the poverty line Box 1: MALAYSIA's SOCIAL ACHIEVEMENTS ARE IMPRESSIVE... * The incidence of poverty in 1997 was 5.1 percent of households. Less than 1 percent of the population was classified as hardcore poor, (with incomes 50 percent below the poverty line of RM 104 per capita per month). * Life expectancy at birth (1996) was 72: 69.3 (male); 74.1 (female). The average for upper middle income countries is 70 years (World Development Report, 1998). * Infant mortality in 1996 was 9.1/1,000, down 88 percent since 1957; maternal mortality 0.2/1,000, down 94 percent since 1957. Infant mortality compares favorably with rates in Argentina (22/1,000), Chile (12/1,000), Thailand (34/1,000) and the average for upper middle income countries (30/1,000) (World Development Report, 1998). * Gross primary enrollment is 93 percent. Secondary school enrollment for both girls and boys have increased rapidly: lower secondary enrollment increased from 17.9 percent in 1960 to 82.5 percent in 1995, upper secondary from 10.2 percent to 55.8 percent. The enrolment rate for postsecondary education increased from 0.1 percent to 23.2 percent, while that for the university level rose from 0.04 percent to 3.7 percent. If students in private and foreign universities are included, the tertiary rate could be as high as double this figure (Ministry of Education: Education Statistics of Malaysia, various issues). * Rural infrastructure has improved substantially: 97 percent of rural households have access to paved roads, 76 percent have piped water in their houses, 80 percent have access to electricity, 94 percent have access to at least one primary school, and village health teams have provided rural health services. Eighty-nine percent of the total population has access to clean water. Federal Government development expenditure on poverty alleviation was almost 21 percent of the total in 1991-95. ...ALTHOUGH THE FORMAL SAFETY NET IS LIMITED * Over the past three decades, when the economy grew rapidly, relatively few formal mechanisms were put in place to help the poor in case growth sputtered. The publicly-financed social safety net in Malaysia is modest, particularly for a country whose GDP per capita was $4,800 in 1996, and whose GNP per capita in PPP (purchasing power parity) termis was $10,000 a year. * The fonnal safety net is narrowly targeted: in 1997 only one poor person in ten reported receiving a public transfer. Even for those who received them, public transfers accounted for only 1.4 percent of total income. Private transfers are more important to the poor: almost 90 percent receive private transfers, and 75 percent of them give them. Received private transfers accounted for almost 30 percent of poor people's income. Since the poor tend to give fewer transfers, net private transfers (received transfers minus given transfers), account for 28 percent of poor people's income * Some targeted assistance programs are in place under the Ministries of Rural Development, Education, Health, and National Unity/Social Development. These have hitherto amounted to about 0.3 percent of GDP. Invalidity and disablement benefits are administered by the Social Security Organization (SOCSO), and accounted for 0.12 percent of GDP in 1996. Most of these programs are directed at the hardcore poor. However, follow-up of the programs' effects (outcomes, as opposed to inputs) has so far been relatively limited. The Government is modestly expanding these programs in light of the crisis; the Bank and UNDP are working with the Government to strengthen program evaluation. * Malaysia has three main pension schemes and a few smnaller programs. The Employees Provident Fund (EPF) covers ahnost the entire labor force of 8 million througlia 23 percent wage deduction; the Pension Trust Fund covers retired civil servants, and the Armed forces covers the retired military. Only a third of those who are over 60 years report receiving pensions. There is no unemployment insurance, nor universal family benefits. (1998 estimate), and poverty could increase further in 1999. The problem is not confined to the poorest states mentioned above; poverty has also increased in urban areas of western Peninsular Malaysia, in particular in the Klang Valley and Kuala Lumpur. The worst-affected groups are retrenched low-paid and  -6- low-skilled workers, hawkers and petty traders. Moreover, as private transfers diminished in the wake of the crisis, the condition of existing vulnerable or marginal groups, such as the disabled, squatters and indigenous people, is also deteriorating. Repatriation of wages from urban workers to rural dependents has reportedly diminished, for example. The poor are disproportionately impacted by rising prices: although inflation has been moderate (5.2 percent, year on year in December 1998), food accounts for the greater proportion of the consumer price index (CPI), and food prices have risen faster than other components of the CPI. The costs to households of health and education, for example of school textbooks and pharmaceuticals, have increased. A new Household Income Survey is being prepared to assess the impacts of the crisis in greater detail in early 1999. A Rapid Social Assessment (RSA-see Attachment 2 which summarizes the methodologies used), was prepared for the CAS by UNDP in association with Universiti Kebangsaan Malaysia, and gives a preliminary qualitative indication of the social impact of the crisis.3 16. Unemployment has increased from pre-crisis levels (2.7 percent in 1997-technically this is full employment) and is likely to reach 4-5 percent by end-1998. Most of the retrenchments (officially 76,000) have been in the construction sector (53 percent). Forty-three percent of retrenched workers across the board are women. Women account for 90 Box 2: GENDER PROFILE percent of retrenchments in textiles and electronics, and *In the past, Malaysian women benefited relatively 60 percent in manufacturing; male retrenchments are equitably from rapid economic growth, through increased incomes and improved access to social higher in the construction sectors where male labor is services. predominant. Many retrenched workers are being re- * Indicators of women's health, welfare and educational empr oyedomiat. Mtny rn hwerpd work arte bein re- opportunities exceed those of other East Asian employed, but often i lower-paid or part-tme position countries. with reduced benefits, for example in plantations or Life199- Malaysia a3.9Asia domestic service. The informal sector is absorbing some Infantmortity 11.4 39.1 retrenched workers, but this has increased competition for Maternal mortaity 34.0 Y female primary 48.7 47.1 existing petty traders and hawkers and reduced incomes: Femaleilliteracy 21.9 24.1 many have reported a drop in earnings of 30-50 percent in Univetsity intake 49.5 the latter half of 1998. There are emerging indications of *Female labor force participation (37 %) was below the wage erosion in the formal sector, particularly in the regional average (44%/o) in 1994. Male-female wage electrical, electronic and machinery sub-sectors. Focus differentials are significant, although Malaysia has ratified the Intemational Labor Organization (ILO) group interviews revealed that many employers are convention on equal pay for equal work. reportedly cutting wages and benefits, such as overtime * Women have been targeted by a series of Govemment initiatives, including poverty reduction programs (e.g., pay, rather than shedding workers. Amanah Ikhtiar Malaysia, a rural microcredit program). 1 T About 600,000 female heads of households are included 17. The crisis has also affected Malaysia's large in the Ministry of National Unity and Social migrant labor force, many of whom contribute positively Development's targeted assistance program. to the Malaysian economy. Malaysia provides a home for * The principal impact of the crisis is that women account for a high proportion of layoffs; they may also about 2 million migrants, including about 800,000 legal be affected by policies to repatiate migrant workers workers (official figures, August 1998) under well- (especially female domestic workers). defined work agreements, and at least 1 million illegal workers. By providing employment, Malaysia is supporting repatriation of funds to neighboring countries. The migrants work mostly in plantations, construction and domestic service, where many Malaysians are no longer willing to work. They were hard hit by the downturn in construction, and have also experienced delays in wage payments. About 100,000 foreign workers have been repatriated since the onset of the crisis, but they continue to fill certain skill shortages. Moreover, illegal migration is continuing, particularly in view of the downturn in Indonesia, and is difficult to halt, given Malaysia's porous borders. Migrant workers are also contributing to increased demand for public social services-for which they are eligible-in the wake of the crisis. In the state of Sabah, for example, about 70 percent of public hospital patients are migrants. The issue of migrants is therefore important with regard to crisis remediation and assistance measures. 3The Govemment has expressed reservations about the findings of the Rapid Social Assessment given its qualitative nature.  -7- 18. Income inequality had been increasing before the crisis. It FIGURE 1: TRENDS IN INCOME INEQUALITY decreased in the 1970s and 1980s, but 51 the trend gradually began to reverse itself in the late 1990s. The Gini 19 coefficient was an estimated 50 percent 49 in 1997. The trend could be attributable 48 to underlying structural problems, but the crisis may not have helped. The 46 influx of migrant workers may haveG contributed to wage differentials. 45 Regional inequality has also been 44 increasing. The tunaround from falling 1973 1984 1987 1989 1992 1995 to rising inequality is important and Note: The Gini coefficient vares between 0 and 1, with 0 being perfect inevitably a concer for the short- and equality and I perfect inequalitY. medium-term social agenda. Source: Ahuja, 1998. 19. In the wake of increasing poverty and unemployment, the demand for public social assistance has grown, and the Govermment has responded to this. In mid-1998, following initial budget cuts, the Government increased allocations to targeted assistance programs, including hardcore antipoverty programs, rural and urban microcredit, and a "fund for food" to support increased food crop production and raise rural incomes. These were supported by the Bank's ERSL in FY98. For the 1999 budget, development expenditure on social sectors was increased to 2.1 percent of GDP, from an average of 1.6 percent during the pre-crisis years, to provide essential services to the poor and near-poor. Operating expenditures are to be maintained at pre-crisis levels, around 5.8 percent of GDP, to meet the increased demand for public services. The Governmnent has also established a RM7 billion social assistance fund and a RM1 .5 billion fund to support small and medium industries (SMIs). C. SECTORAL ISSUES AND IMPACTS OF THE CRISIS 20. The crisis could jeopardize some of Malaysia's achievements in health and education, following years of systematic planning and implementation widely recognized as exemplary. It is also exposing structural weaknesses in these sectors. Budget constraints have forced the Government to postpone some of the reforms proposed to address these weaknesses. Public expenditures were cut in late 1997/early 1998. However, the Government has stated its commitment to preserving past achievements and restored some of these funds under the 1999 budget, particularly for programs that affect low-income groups. 21. In education, the Government had invested heavily, under successive five-years plans, in programs to put development of skills at the forefront of the national agenda. The objective was to produce an adequate number of skilled and qualified workers to meet the country's human resources requirements for the 21 " century (see Box 1 for the results). There have been impressive improvements in the enrollment ratios of relevant age groups at all levels of education over the past 35 years. Increased investment in education has been an important means of equalizing opportunities through affirmative action to allow the poorest segments of the population, mainlyBumiputera (Malays and other indigenous people), increased access. The Government had also set up large-scale overseas scholarship and teacher training programs. Public expenditure on education in 1996 was 20 percent of the total. The main issues facing the education sector now are summarized below; the Government had identified many of these before the crisis hit, under the Seventh Malaysia Plan (1996-2000): (a) further improving access to and quality of basic education, especially in the states of Sabah and Sarawak. This entails construction of physical infrastructure, increasing the professional competence of teachers and revising curricula; (b) rationalizing investments in secondary, technical and vocational education, updating curricula to take account of evolving market demand and the need for specific technical skills, and collaborating more extensively with private sector employers; (c) increasing access to high-quality postsecondary education, in particular increasing the capacity of polytechnics to meet a near doubling in demand; (d) improving the  -8- quality, capacity and funding mechanisms for higher education; and (e) strengthening managerial capacity throughout the education sector, in terms of planning, policymaking, monitoring, and greater use of information technology (IT) for project management and evaluation. 22. The current economic downturn has necessitated some adjustment in the Government's efforts towards sustaining and improving the quality of education as planned. These include reducing the number of sponsored students and teachers pursuing graduate and postgraduate studies overseas, as the costs have risen substantially following the ringgit devaluation; accelerating the development of local higher education institutions now that demand has shifted from overseas; reducing fund allocations for staff development training programs; and cutting the school construction program under the Seventh Malaysia Plan, thus exacerbating the shortage of classrooms, and hostels and housing for students and teachers in the rural areas. Moreover, with increasing poverty, demand for school nutrition programs and textbook loans, key elements of increasing access to education for low-income groups, has increased. These programs were cut at the onset of the crisis. For example, the number of beneficiaries under the nutrition program in 1998 was maintained at 1997 levels, and income testing was introduced to determine eligibility for textbook loan programs. However, given the long-term nature of human capital development, and the detrimental effects of a lapse in the ongoing programs, the Government has since reinstated several programs, and is committed to preserving their integrity to the extent possible. In particular, funds for nutritional and textbook programs have been restored. Under the 1999 budget, the Government has increased expenditure on education from 18.7 percent of the total in 1998 to 22.8 percent in 1999. 23. Malaysia's health sector has performed well in terms of equity, access and outcomes. Malaysia has achieved remarkable progress in reducing mortality and increasing life expectancy; its health indicators are among the best in the region, and exceed those of some upper middle-income countries (see Box 1). Significant progress has been made in the control of childhood and communicable diseases. The Government has invested extensively in infrastructure development, in particular in clean water supply and sanitation to increase access to safe drinking water, and provision of basic community and rural health services. Public expenditure on health in 1996 was 6 percent of the total budget, relatively low in comparison with similar income countries, but rising steadily. Private healthcare provision has increased significantly in the past decade (private expenditure on healthcare accounted for 1.5 percent of GDP in 1996). The key issues facing the public health sector, as recognized before the crisis hit, are: (a) the need to increase the efficiency and quality of health services while maintaining equity, in particular pro-poor considerations; (b) developing new specialist skills to tackle the emerging threat of non-communicable diseases (cancers, cardiovascular conditions); (c) reducing persistent regional disparities in service provision, particularly shortages of physicians and allied medical staff, especially in light of a continuing "brain drain" to the private sector; and (d) developing a new institutional framework for public healthcare management, including selective corporatization of facilities, outsourcing of nonmedical/ancillary services, and development of an appropriate healthcare financing or insurance scheme. 24. The crisis has set back the Government's plans to implement sectoral policy reforms. However, the immediate impact of the crisis has been the substantial increase in the price of pharmaceuticals, including essential drugs. Further, falling real household income, particularly among the growing numbers of unemployed and the poor, has reduced people's ability to pay for medical care, resulting in a shift from private to public facilities (where fees are relatively low); utilization of public health facilities has increased 9 percent since the onset of the crisis. The 1998 health budget was initially cut by around 12 percent. However, as in the case of education, the Government is committed to maintaining the quality of services, and programs affecting the poor. Accordingly, for 1999, core public health programs have been reinstated (with the support of the Bank's ERSL), in particular construction and maintenance of rural clinics, and rural water supply/sanitation systems, and supply of essential drugs to the poorest states  -9- and urban districts. The Government has increased expenditure on health from 5.7 percent of the total budget in 1998 to 7.1 percent in 19994. 25. Malaysia's agriculture sector comprises both large-scale commercial and export-oriented plantations (including oil palm and rubber), which account for most of the output, and smallholder cultivation which is mostly noncommercial and relies largely on traditional techniques. Under the Seventh Malaysia Plan, the National Agricultural Policy (1998-2010) and the Philosophy and Strategy of Rural Development, policymakers had been examining some of the emerging structural issues in the sector. In the plantation subsector, a key problem has been how to manage persistent labor shortages-most of the workers being migrants-by increasing technological efficiency. Before the crisis, the Government was also developing a strategy to increase national food production, explore other export potential such as poultry, halal meat, fisheries and aquaculture, and, accordingly, enhance research and development, and upgrade production, marketing and storage facilities. With regard to smallholders, the key problems are uncertain land tenure and land fragmentation, labor shortages and low level of technology, adversely affecting production and productivity. Smallholders are also adversely impacted by administrative price controls on selected crops, particularly food, which reduce their earning potential, and by inadequate access to rural credit: although an institutional framework for rural financial intermediation is in place, coordination and oversight are weak. The Government committed considerable resources in the past to raising smallholders' income, particularly under the RISDA and FELDA schemes5, including development of new lands, for example in the poorest states. The Ministry of Rural Development is trying to work with some local communities to develop alternative income-generating activities, such as village industries. Rural infrastructure, in particular roads, telecommunications and power supply, has been continuously upgraded, but some weaknesses remain, in particular in the area of storage and handling facilities. The crisis is delaying some of the proposed reforms and agricultural/rural development programs that the Government has envisaged. However, in general, the impact of the crisis has been less pronounced in rural areas, particularly on the plantation sector, as export-oriented crops with small imported inputs, such as oil palm, have enjoyed high prices in ringgit terms. 26. With regard to environmental issues which are cross-sectoral, the crisis, while perhaps not contributing to specific "brown" and "green" problems, may divert attention and reduce resources for tackling them. In the context of the crisis, continued enforcement of environmental regulations is a key concern, particularly as it relates to development of infrastructure and promotion of small and medium industries. Despite the interest generated, coincidentally, by the environmental disaster of forest burning in Indonesia, which seriously affected air quality in Malaysia in mid-1997, in general, environmental issues are more of medium-term concern. For over two decades, Malaysia has enjoyed significant environmental advantages while maintaining rapid growth: (a) abundant rainfall provided ample surface water for flushing rivers, even as industrial and urban wastewater discharges grew; (b) air quality remained relatively good in the rapidly industrializing Klang Valley, due in part to availability of clean domestic natural gas for power generation; (c) despite the loss of forest cover in some parts of Sabah and Sarawak, adjacent protected areas continued to harbor significant biodiversity; and (d) the Department of Environment (DOE) developed strong basic environmental management skills, disseminated through training for neighboring countries, offered in partnership with the Bank. Environmental regulations are extensive. However, Malaysia now risks losing these advantages. "Brown issues" are becoming particularly problematic. With emerging trends towards more severe and frequent drought episodes, water allocation and pollution control have become critical in the Peninsula. With the recent privatization of water supply and wastewater services and increasing pressure on water resources, DOE's and other agencies' environmental management capabilities are overtaxed, and the capacity gap with private contractors is widening. 4 Source: Economic Report, 1998/99. Government of Malaysia. 5 RISDA: Rubber Industries Smallholder Development Authority; FELDA: Federal Lands Development Authority  -10- D. POLITICAL AND GOVERNANCE ISSUES 27. Recent Political Developments. Malaysia is a federal constitutional monarchy with a parliamentary system of Government. It has enjoyed political stability for the past three decades. Malaysia's political dynamics are dominated by the ruling party, the United Malays National Organization (UMNO), which has also formed a coalition with Chinese and Indian political groups. UMNO's leader invariably serves as the country's Prime Minister (PM). The current PM, Dr. Mahathir Mohamed, has held this position since 1981. Principal opposition parties are the Democratic Action Party (DAP), backed mostly by the Chinese population, and the all-Malaysia Islamic Party (PAS) which controls the state of Kelantan. The constitution requires that general elections be held every five years. The next general elections are scheduled for 2000. 28. Recent political events, linked partly to the crisis, have attracted international attention, and prompted some short-term uncertainty. However, there has been a consolidation in the top leadership. Recent Cabinet changes in January 1999 resulted in the appointment of a new Deputy Prime Minister/Minister for Home Affairs and a new Minister of Finance to help manage the economy. Decision-making is more centralized. A more uniform policy approach is evident among agencies and ministries. The new appointments have been welcomed by the business community and should contribute to restoring confidence. 29. Malaysia has not experienced the kind of ethnic and religious strife as seen recently in Indonesia, for example. Malaysia did suffer ethnic riots in May 1969, and as a result initiated a public policy of affirmative action towards poorer Bumiputera. This provided the basis for a more solid relationship between ethnic groups that has served Malaysia well in these troubled times. The progress of Malaysia's economy and associated social changes have led to open debate, in particular on transparency and accountability of decision-making as well as social equity, issues that will remain on the medium-term political agenda. It is unlikely that this debate will degenerate into full-scale unrest. A hard-won, social cohesion prevails in Malaysia among the different ethnic groups, and there is an underlying bias in favor of pragmatism in the way the country is run. 30. Equity Issues. Malavsia has , . ,. , ~ ~~~~ T.ABLE 1: MALAYSIA'S STRONG AND implemented a consistent policy of WELL -PERFORMING PUBLIC SECTOR INSTITUTIONS social/ethnic equity in the interests of broad (ratings on scale of 1, low, to 6, high) societal goals. Malaysia is a multicultural __ - ., . ........ ~~~~~~~~~~~~~Institutional Malaysia Similar- High- Full society, comprising mainly Bumiputera, dimension income income sample Chinese and Indian ethnic groups, counties' countries" indigenous people and others. To avert Law and Order conflict between these groups, in particular Crime 3.4 4.7 3.5 4.5 between the more economically Judiciary unpredictability 2.9 4.0 3.0 4.2 disadvantaged Bumiputera and the Chinese Policy uncertainty 2.5 3.7 2.9 3.5 following the Kuala Lumpur riots of 1969, Corruption 2.4 2.9 1.9 3.2 the Government implemented an affirmative Regulatory obstacles action policy (New Economic Policy, NEP) Level 2.9 3.2 3.0 3.2 which focused on improving access to Time spent 1.4 2.0 1.5 2.2 education, public services and income- a) Costa Rica, Czech Republic, Estonia, Hungary, Mauritius, Mexico, Poland, Slovak Republic, South . . ~~~~~~~~~Africa, Turkey, and Venezuela (1995 GNP per capita = US$2600 to US$4100). generating opportunities for Bumiputera, b) Austria, Canada, France, Germany, Italy, Switzerland, United Kingdom, and United States. P lC Note: The mapping of survey questions to instituttional dimension is as follows: erisne, questions 9 and particularly in rural areas. The policy, 10; judiciary unpredictability, question 11; policy uncerainty questions 1, 2, and 12i; corruption, queston 14; level of regulatory obstacles, questions 12a-c, e, f, andj; time spent, question 21. When predicated on reducing income disparities more than one question is listed, the rating is the arithmetic average of the responses to the questions. and hence reducing social and political Source: WlorldDevelopmentResort, 1997. tensions and ethnic conflict, did contribute to social development and to political stability, increasing theBumiputera's share in the economy from 2.3 percent in 1970 to 20.6 percent in 1995. It was aided by sustained high growth rates. It continues to be an important focus of public policy, although recent trends in income inequality suggest that this may become a greater concern than ethnic equality over the medium term.  31. Public Institutions. Despite the recent deterioration in its image, Malaysia has a strong track record on governance and public sector integrity (see Table 1 and Attachment 3-Governance and Transparency Issues). Objective assessments-based on a number of private sector surveys- suggest that Malaysia has made substantial improvements in anticorruption policy and fostering transparency in the last five years. In 1998 Malaysia was ranked fourth by Transparency International among East Asian economies surveyed on corruption issues, behind Singapore, Hong Kong and Japan, alongside Taiwan (China) and 29th out of 85 economies worldwide.6 Malaysia compares favorably to high-income countries and its East Asian neighbors in terms of public sector accountability and efficiency, and the credibility of its laws, regulations and enforcement mechanisms. The regulatory burden on business is low, red tape has declined, and regulatory discretion is moderate. Business surveys (World Development Report 1997, View of the Firm 1997, Economist Intelligence Unit 1997, Enterprise View 1997, S&P Overview 1997) have rated Malaysia's business climate ahead of that prevailing in the region, with the exception of Hong Kong and Singapore. 32. The challenge to the Government is to deal with poor perceptions of governance, transparency, and the rule of law in Malaysia as well as to uphold past achievements. Priorities in this regard are transparent management of public resources for financial and corporate restructuring (see Section 2E below), particularly publicizing criteria for support of strategic industries, and instituting transparent privatization and procurement procedures. Several infrastructure projects were privatized withoutopen bidding. Other issues include increasing transparency/comprehensiveness of the budget, in particular to identify contingent liabilities; increasing accountability in public expenditure management, and strengthening monitoring of outputs and outcomes. Attachment 3 gives an overview of Malaysia's achievements and key issues in public administration, anticorruption measures and public expenditure management, and a preliminary assessment of the judicial system and checks and balances on Government. E. GOVERNMENT'S POLICY RESPONSE TO THE CRISIS 33. The Government has consistently taken a proactive approach to crisis management, beginning with an Emergency Financial Package in December 1997, and a preemptive reform package in March 1998, involving tightening of fiscal and monetary policy, broad-based financial and corporate sector reforms, and measures to protect the poor and vulnerable. The initial macroeconomic policy response was orthodox and similar to that in other crisis countries. Since then the crisis deepened: demand failed to pick up and a credit crunch emerged. A National Economic Action Council (NEAC), established to manage the crisis, elaborated a comprehensive National Economic Recovery Plan (NERP, July 1998). Its principal objectives are: stabilizing the ringgit, restoring market confidence, maintaining financial stability, strengthening economic fundamentals, and preserving equity. In accordance with this plan, fiscal and monetary policy have been eased. Selective capital controls were introduced in September 1998, but subsequently modified. The exchange rate was fixed at 3.8 ringgit to the US dollar. Appropriately, resumption of growth is the Government's first order of concern, but not at the expense of inflation. The Government has stated that it will be able to finance the recovery package (fiscal deficit, costs of financial and corporate restructuring) primarily from domestic but also from external resources. Questions remain on how this will be done, and important work on putting the financing package together is ongoing. 34. A fiscal stimulus package has been introduced to restore growth. The Government ran a deficit, equivalent to 3.4 percent of GDP in 1998, and has announced a deficit of 6 percent for 1999. It has also established special funds: a RM5 billion infrastructure development fund (which will also facilitate restructuring and completion of some privatized infrastructure projects), a RM7 billion social development fund, and a RM1.5 billion fund for Small and Medium Industries (SMIs) affected by the crisis. These measures are designed to avert the dangers of a worsening or longer recession for domestic demand. Over time, the Government will have to reassess the need for a fiscal stimulus. Moreover, an Only 85 economies are included in the 1998 Transparency Intemational index: a minimum of four surveys are required in each economy to qualify it for inclusion.  -12- increasing share of resources will need to be channeled to the social sectors, and to ensuring that the quality of public programs is maintained 7Fiscal stimulus should give priority to projects with large local content and strong multiplier effects, such as construction of low-cost housing, or rural infrastructure, that will help to create jobs, and bring about a recovery that is broadly shared by all, while reducing the pressure on the external balance. 35. Monetary policy has been eased. The Government's stated aim is to alleviate the credit crunch of the first six months of 1998, now that the balance of payments position has improved. During early 1998 Bank Negara Malaysia (BNM-the central bank) had tightened credit policy. Credit flows turned negative as markets overreacted to the central bank's initial regulatory tightening and falling demand. Banks also became increasingly reluctant to lend as their NPLs mounted. To ease the credit crunch and lower the cost of funds to banks, BNM progressively reduced the statutory reserve requirements from 10 percent in July to 4 percent in September 1998. The maximum spread over the base lending rate was narrowed from 4 percentage points to 2.5 percentage points. In order to correct the overreaction on the part of the banking institutions that resulted in a sharp pullback of credit, BNM established minimum credit growth targets of 8 percent for individual banks (with the exception of the weaker banks). However, actual credit growth in 1998 was marginally negative. In 1998 total loans outstanding extended by the banking system declined by 1.6 percent, mainly reflecting the economic contraction, even though, since June 1998, total loans approved have increased.8 Monetary expansion may not be effective in the current environment, when demand remains low despite monetary easing. An important issue is whether bank lending is sluggish because of demand or supply factors. If the problem is demand constraint, then increasing bank liquidity substantially can lead to another round of bad loans and protraction of the crisis. The narrowing of the spread over the base lending rate, imposed by BNM, may restrict banks' ability to price loans according to client risks. It can undermine profitability, slow the resumption of credit growth, and perpetuate the management of interest rates through direct rather than indirect means. Finally, care should be taken that any further expansionary interest rate policies take into account the need to maintain positive real returns for savers. 36. Capital controls have been modified. The Government introduced capital controls in September 1998 (see Attachment 4) with the objective of reducing the speculative pressure on the exchange rate, and the volatility of short-term capital flows, to avoid further internationalization of the ringgit and ensure that developments abroad would not destabilize domestic markets. In addition, the Government required that proceeds from stock sales be held for a year before they could be converted into foreign currency. In February 1999, the Government modified these controls. This change will affect both the existing stock of portfolio inflow that has been locked in as a result of the capital controls introduced on September 1, 1998, as well as new portfolio inflows in the future (details given in Attachment 4). The existing stock of portfolio investments, locked in as a result of the September 1998 announcement, can now be repatriated, upon payment of a levy on the principal amount. For funds brought in before February 15, 1999, the principal amount repatriated after one year from September 1, 1998, or one year from the actual date the principal amount came into the country, will not be subject to the levy. If the principal is repatriated within one year it will be subject to a graduated levy. Profits realized during this one-year period will not attract any levy, even if repatriated during this one-year period. Profits realized and repatriated on investments made after the one-year period will be subject to a 10 percent levy. For new portfolio inflows after February 15, 1999, the principal amount is not subject to levy on repatriation. Profits made and repatriated within 12 months after the investment will need to pay a 30 percent levy; after 12 months, the levy is 10 percent. These are steps in the right direction, but the measures need to be further strengthened with a package of consistent macroeconomic policies and structural reforms. A Public Expenditure Review is currently being prepared to assess these programs. Commercial banks recorded annual growth of 3.5 percent in 1998. Finance companies recorded a decline in loans of 14.7 percent, mainly due to ongoing mergers. Merchant banks recorded a 3.7 percent decline in loans. In 1998 about RM11.8 bn of NPLs were sold to Danaharta (see para 37), resulting in a further deterioration in the total loans outstanding. If these NPLs were included, total loans outstanding extended by the banking system would have increased by 1.3 percent in 1998. Loans approved increased significantly in the last quarter of 1998 (RM7.8 bn/month, compared to RM4.2 bn for the first three quarters of 1998).  -13- 37. Measures are under way to restore confidence in the financial and corporate sectors. Under the NERP, the Government has established a special institutional framework primarily to deal with NPLs and corporate debt, and at the same time address the liquidity needs of weaker financial institutions through selective recapitalization. This framework comprises Danaharta, an Asset Management Company (AMC) to purchase NPLs from the banking system; Danamodal, a Special Purpose vehicle (SPV) to recapitalize troubled banks; and a Corporate Debt Restructuring Committee(CDRC) to facilitate financial, operational and managerial restructuring of corporations through voluntary out-of-court debtor/creditor arrangements (London Rules approach). Broad operating policies and procedures have been established for these institutions and work on the more detailed operational aspects is ongoing with the help of international private sector advisors. The Government has recently introduced an over-arching committee to coordinate the objectives of each agency. Overall, these mechanisms, strategies and supporting legal environment for financial and corporate sector restructuring are appropriate and consistent with a market framework" The Government expects that NPL acquisition and selective bank recapitalization will be completed by mid-June 1999. The Government has shown some evidence that it is prepared to subject large corporations to the CDRC procedures; they would not receive preferential treatment. For a profile of Malaysia's financial and corporate sectors, current policies, actions taken and outstanding issues, see Attachment 5. 38. The Government has been taking additional actions in the corporate sector, in parallel with the CDRC initiative. These include tax incentives for corporate restructuring and measures to strengthen corporate governance. A recently-established High Level Finance Committee on Corporate Governance has drawn up a new Malaysian Code of Corporate Governance, Code of Ethics, to be published in early 1999, and recommended a series of measures to improve legal safeguards for shareholders and strengthen accounting standards and financial disclosure requirements. It also recommended training and education for key stakeholders. Amendments and changes to the Companies Act came into effect on January 1, 1999. 39. The Government's approach to financial and corporate restructuring is not dissimilar to those adopted by other countries in the region.10 Whilst implementation is ongoing, it would be premature to conclude whether the program will be adequate in scale and scope. Much depends on how the real economy and investor confidence evolve over the next 12 months. This uncertainty is inevitable and is best managed through contingency plans. The key risks associated with financial and corporate restructuring are that: (a) the Government may be underestimating the magnitude of the problem; (b) the crisis may be prolonged because of regulatory forbearance (e.g. changing the definition of NPLs from 3 to 6 months as occurred in mid-1998, see Attachment 5); and (c) information on implementation may be inadequate, giving rise to concerns about use of public funds and the extent of burden sharing. 40. Key issues in structural reform. The principal issue in the financial sector is the need to recover NPLs resulting from banks' over-exposure to the property sector and the stock market, and to recapitalize distressed banks now facing serious liquidity shortages. The challenge to Government is raising sufficient funds to finance the cost of NPL purchase and bank recapitalization in 1999-2000, in the order of $8 billion or 11.2 percent of GDP, although private sector estimates are higher. The financing need for Danaharta is $3.95 billion (5.3 percent of GDP) and has been met. The financing need for Danamodal, $4.21 billion (5.7 percent of GDP), has been largely met (see Attachment 5). 41. A second set of issues relates to continuing the process of consolidating institutions and restructuring the financial sector on the basis of a longer-term vision. Restructuring the financial sector will also entail further strengthening of prudential regulations and the supervisory framework to bring Malaysia in line with the highest international prudential standards and also to strengthen disclosure; improving credit management processes at the level of individual banks; intensifying surveillance of banks, including development of an early warning system; and introducing a depository safety net 9 NPLs purchased by Danaharta and Danamodal investments wiil be based on intemationally accepted principles of valuation. The Government has also amended Section 176 of the Companies Act, 1965 to prevent debtor abuse of provisions relating to forbearance from creditor action. 10 See the Structural Policy Review for cross-country comparisons of financial and corporate indicators and reform programs  -14- mechanism. Progress is being made, although there has been some regulatory forbearance with regard to classification of NPLs. In this regard, BNM's autonomy will need to be reinforced. Another issue is opening up the banking sector further to foreign equity participation. With regard tononbank financial institutions (NBFIs, see Attachment 5), the key issues are strengthening disclosure requirements and enhancing the regulatory framework. Some capital market regulations have been strengthened. For example, listing regulations have been amended to require listed companies to disclose debt immediately. A new and strengthened code for mergers and takeovers has been announced and regulations covering minority interests have been strengthened. Capital adequacy ratios and client asset protection rules have been introduced for stockbroking companies. 42. The priority in the corporate sector in the short-term is clearly to alleviate the problem of rising debt in vulnerable sub-sectors. Other problems are falling profits, declines in asset prices, and increasing liquidity constraints as a result of weakening demand. These are a direct consequence of the recession, and slackening external demand. Other issues in the corporate sector include over-dependence of companies on short-term loans from banks; and financial and managerial weaknesses in individual companies that existed irrespective of the crisis. Moreover, whilst there is a legal framework for corporate restructuring, it has proven inadequate in the current crisis. Problems and inconsistencies exist, for example, without clear guidelines on insolvency, winding up, reorganization of companies, and creditor protection and limited experience of courts in supervising reorganization. In particular Section 176 of the Companies Act, which provides temporary relief from creditors, was being used to roll over debt. It has since been amended, requiring courts to involve creditors in the decision-making process. The court- based insolvency procedures were also too protracted and the court system was not equipped to deal with the significant increase in corporate financial distress. Without fundamental restructuring, some of Malaysia's companies may face protracted difficulties, in light of the lower growth rates projected over the next few years. Banks, Danaharta Danamodal and CDRC are gaining experience in large-scale corporate restructuring and distressed debt management by working closely with international private sector advisors. 3. ECONOMIC PROSPECTS AND KEY CHALLENGES A. ECONOMIC OUTLOOK 43. Economic Outlook. There are some signs that the economy is stabilizing. Exports picked up in the last two months of 1998 in US dollar terms. If there is a global recovery in the electronics market, Malaysia will benefit from it as its exports are dominated by electronic products. The recent surveys on consumer and investor sentiments show that the downward trend in expectations has stabilized.The small increase recorded in the Malaysian Institute of Economic Research (MIER)'s Business Conditions Index in the fourth quarter of 1998 suggests that the downturn may have flattened. The recent modification in capital controls is also expected to improve investor confidence. It is, however, too early to conclude that a robust recovery has begun. As Malaysia is a highly open economy, much will depend on the pace of recovery in the region and in the rest of the world. There may be little growth in exports since the region- wide recession is expected to continue in 1999. The downside risks in the rest of the world have also increased with the crisis in Russia and Brazil. Initial indications are that a combination of external and internal factors could result in the recession continuing in the first half of 1999, with some recovery in the latter part of 1999. On balance, the economy could contract by 1-2 percent. 44. The increase in unemployment, uncertainties over job security, and the fall in real wages will continue to affect consumption adversely. Although there were some signs of improving consumer confidence in the third and fourth quarters of 1998, suggested by an increase in exports in US$ terms and an increase in passenger car sales, the outlook remains uncertain. Domestic consumption is likely to fall (especially for durable and other luxury items) because of the wealth loss and because consumers' perceptions of permanent income will remain more volatile than their perceptions of total income. Investments (both domestic and foreign) may not pick up because the high level of uncertainty in the  -15- region will delay new projects, imported machinery and equipment have become more expensive relative to producer price increases, and construction and infrastructure sectors in particular face problems of excess capacity. The easing of fiscal policy, lowering of interest rates, and the easing of access to credit will begin to stimulate domestic demand, but this may be insufficient to restore market confidence and cause positive growth in private consumption and investment. Progress in financial and corporate restructuring and building a track record on policy reforms will improve market sentiment. TABLE 2: SELECTED INDICATORS-BASE CASE (MOST LIKELY) PROJECTION ACTUAL ESTIMATE PROJECTION 1994 1995 1996 1997 1998 1999 2000 Part A: Main Macro Aggregates Annual growth rates, calculatedfrom constant 1978price data GDP at market prices (%) 9.2 9.5 8.6 7.8 -6.8 -1.7 3.0 Total consumption (%) 9.8 8.9 4.9 4.8 -12.4 -2.2 5.9 Private consumption (