Malaysia - Social and structural review update

Report No. 20813-MA Malaysia Social and Structural Review Update January 17, 2001 Poverty Reduction and Economic Management Unit East Asia and Pacific Region Document of the World Bank  CURRENCY EQUIVALENTS (as of January 2001) Currency unit = Ringgit (RM) RM I = US$0.26 US$I = RM 3.8 MALAYSIA FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS AGM - Annual Shareholder Meeting AMC - Asset Management Companies BNM - Bank Negara Malaysia CLOB - Central Limit Order Book DBR - Disclosure Based Regulation. EPF - Employee Provident Fund Fl - Financial Institutions FSAP - Financial Sector Assessment Program FSF - Financial Stability Forum HLC - High Level Finance Committee on Corporate Governance IAS - International Accounting Standards KLSE - Kuala Lumpur Stock Exchange MGS - Malaysia Government Securities NPL - Non-Performing Loan PDS - Private Debt Securities RM - Malaysian Ringgit RWCR - Risk Weighted Capital Requirement SC - Securities Commission SPR - Structural Policy Review Regional Vice President Mr. Jemal-ud-din Kassum, EAPVP Acting Country Director Mr. Zafar Ahmed, EACSM Chief Economist Mr. Masahiro Kawai, EAPVP Sector Director Mr. Homi Kharas, EASPR Country Manager Mr. Ijaz Nabi Task Team Leader Mr. Ron Hood, EASPR  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 Jeffley 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 receivedfrom 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' 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 firtnly 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 ' 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% (QI-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  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 Figurel: Quarterly GDP Growth (% yoy) 5. In Malaysia the sharp drop in domestic demand in 1998 was offset s 15