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Strengthening Economic Fundamentals

National Economic Recovery Plan
Chapter 5

Contents



The previous chapter discusses issues and measures to stabilise the currency and financial system, as well as to restore market confidence. These are largely short-term stabilisation issues that have to be urgently addressed.

This chapter addresses the fourth objective of the Recovery Plan, namely, strengthening economic fundamentals. The issues are structural in nature, and the measures recommended are aimed at instituting structural reforms that would set in place a more dynamic and resilient economy.

The actions to strengthen the economic fundamentals are as follows:

Actions

  1. Increase the quality of investments
  2. Improve the balance of payments
  3. Maintain a balanced public sector financial position
  4. Maintain an appropriate monetary policy
  5. Maintain price stability
  6. Increase labour competitiveness

  • Action 1: Increase the Quality of Investments

One of the areas of concern before the currency attack is the persistence of current account deficit in the balance of payments. During the 1990s, the current account deficit was around 5 per cent of GNP, except for 1991, 1994 and 1995 when the deficit rose to 8-10 per cent. This means that Malaysia has a savings-investment gap that has to be financed with foreign savings. The nature of foreign funds, whether in the form of short-term portfolio funds or foreign direct investments, can affect the countryís vulnerability to a sudden withdrawal of funds. The sharp increase of short-term private capital inflow during 1995-96 exposed Malaysia to such a risk.

Public sector investment in Malaysia was concentrated on physical and social infrastructure. Private sector investments, on the other hand, went into building industrial capacity, privatised infrastructural projects, and the construction of non-industrial real estate. There are two risks associated with the increase large investment in real estate and privatised infrastructure projects.

First, the investment in real estate was in response to inflated property prices caused by speculation and easy credit. Since real estate was used as collateral to secure loans, the banking system's loan portfolio became dependent on the maintenance of property prices.

Second, so long as the privatised infrastructure projects are not yet completed and operational, they do not bring in revenue to repay the investments. For some privatised projects (such as telecommunication, power, toll roads, and light rail transit), too many entrants into the industry have seriously affected their economic viability.

The high level of investment in Malaysia means that capital formation is a very important contributor to growth. In addition, the large demand for manpower required for sustaining the country's rapid growth rate since 1987 was partly met by the inflow of immigrants to take up jobs in plantations, construction, manufacturing, and services.

It would have been desirable for Malaysia to exhibit high total factor productivity (TFP), which means that productivity improvement is an important driver of economic growth. However, this does not seem the case with Malaysia because inputs of labour and, particularly, capital had been the main contributors to economic growth. Given the rapid growth of labour and capital, it is hardly surprising that the countryís TFP had been negligible in recent years.

The negligible contribution of productivity to growth is consistent with the finding that Malaysiaís incremental capital output ratio (ICOR) has been rising in recent years, which means that capital is used less efficiently in the country. A high and rising ICOR also suggests that there may be increasing wastage and leakage in terms of padded costs and ësurplus economic rentí paid to middlemen or commission agents.

  • Recommendations
  1. There is an urgent need for the authorities to prioritise large-scale investments requiring high import content since this would require a significant amount of capital and place the external balance under pressure.

  2. Care should be taken to reduce low priority infrastructure facilities.

  3. There is also the need to improve the productivity of investment by cutting wastage and cost.

  4. Bank Negara Malaysia should continue moderating the amount of bank credit channelled to consumption credit, property sector, and the purchase of stocks and shares.

Table 6: Balance of Payments, 1 9 8 5 - 1 9 9 7 (RM Million)

 

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997 e

Merchandise Balance

8,883

8,378

14,703

14,524

11,871

7,093

1,449

8,609

8,231

4,460

97

10,154

11,087

Export (f.o.b)

37,576

34,970

44,733

54,607

66,727

77,458

92,220

100,910

118,383

148,506

179,491

193,127

221,413

Import (f.o.b)

28,693

26,592

30,030

40,083

54,856

70,365

90,771

92,301

110,152

144,046

179,394

182,973

210,326

Balance on Services -10391 -8790 -8409 -10180 -11392 -9723 -13195 -14568 -16670 -17005 -19407 -19470 -20790
Freight & Insurance

-1852

-1306

-1185

-2072

-3027

-3837

-4847

-4265

-4890

-7367

-9028

-8522

-8949

Other Transportation

64

149

45

-44

-5

-25

-10

-355

-196

441

737

1492

2408

Travel

-1332

-1368

-1327

-1403

-891

632

547

657

906

3603

4143

4786

3826

Investment Income

-5434

-4597

-4824

-5019

-5935

-5072

-6735

-7920

-8174

-9448

-10516

-11685

-13524

Government Transaction

-31

-190

-193

-217

-261

-3

-55

54

-72

-36

-23

-36

-65

Other Services

-1806

-1478

-925

-1425

-1273

-1418

-2095

-2739

-4244

-4198

-4720

-5505

-4486

Balance on goods & services

-1508

-412

6294

4344

479

-2630

-11746

-5959

-8439

-12545

-19310

-9316

-9703

Transfers

-14

96

348

395

219

147

102

337

513

-2225

-2515

-2936

-3697

Current Account

-1522

-316

6642

4739

698

-2483

-11644

-5622

-7926

-14770

-21825

-12252

-13400

Long Term Capital

4229

3386

-1405

-3218

2060

3473

10331

10328

13864

11659

16610

13527

18705

Official Long-Term Capital

2504

2124

-2470

-5102

-2458

-2836

-665

-2876

979

861

6146

750

4805

Private Long-Term Capital

1725

1262

1065

1884

4518

6309

10996

13204

12885

10798

10464

12777

13900

Basic Balance

2707

3070

5237

1521

2758

990

-1313

4706

5938

-3111

-5215

1275

5305

Short-Term Capital

870

-47

-2491

-1962

1562

1356

5135

11957

13931

-8484

2529

10317

-14229

Errors and Omissions

-368

1322

147

-663

-988

3019

-395

81

9370

3333

-1717

-5347

-1968

Overall Balance

3209

4345

2893

-1104

3332

5365

3427

16744

29239

-8262

-4403

6245

-10892

Net Change in BN Reserve

-2827

-4082

-2893

1104

-3332

-5365

-3427

-16744

-29239

8262

4403

-6245

10892

Net BN reserve

12457

16539

19432

18328

21660

27025

30452

47195

76435

68173

63770

70015

59123

Months of retained import

5.0

7.2

7.4

5.1

4.3

4.1

3.8

6.0

7.8

5.5

4.1

4.4

3.4

% cur. account balance to GNP

-2.9

-0.5

8.9

5.5

0.7

-2.2

-9.3

-4.0

-5.1

-8.2

-10.5

-5.1

-0.5

Note: e estimate

Source: Economic Report, Bank Negara Annual Report

  • Action 2: Improve the Balance of Payments

The current account of the balance of payments is an indicator of economic resilience, which influences investor confidence. A persistent current account deficit implies that the investment and consumption of a country have consistently been above its available resources, thereby making it increasingly dependent on foreign capital. If foreign capital inflows are insufficient to finance the current account deficit, the volume of external reserves will fall, which raises the concern about the long-term strength and stability of the economy.

In the 1990s, Malaysiaís current account has remained in the deficit. In 1995, the current account deficits peaked at RM21.8 billion or 10.5 per cent of GNP. It subsequently fell to 5.1 per cent of GNP in 1996 and 1997. The main cause of the current account deficits is the widening deficit in the services account. Although the merchandise account has generally recorded surpluses, they were insufficient to offset the deficits in the services account. In recent years, the deficit has also been affected by a smaller merchandise surplus because of the large and increasing value of imports of intermediate and capital goods. It is noted that Malaysiaís exports have high import content, especially electrical and electronic goods, which constitute a major share of Malaysiaís manufactured exports.

The deficit in the services account is mainly due to large outflows in the form of repatriation of profits, payments for freight and insurance and for professional and consultancy services. In addition, there is growing outflow of transfer payments due to the increase in foreign workers remittances. The components in the services account that record some surplus include air transportation, arising from increased capacity in MAS, and travel receipts, as a result of increasing tourist arrivals.

The measures recommended to improve the balance of payments include:

  • Strengthening the Merchandise Account
  1. Accord greater importance to the development of resource-based industries in order to encourage activities with low import content.

  2. Accelerate the development of backward linkages for the non-resource based industries in order to encourage local sourcing of inputs.

  3. Enhance technological advancement through research and development to encourage innovation and invention of capital goods for the manufacturing sector. The structure of incentives needs to be reviewed to promote this effort.

  4. Initiate a study on export competitiveness of the manufacturing sector.

  5. Initiate a study on the cost and benefit of electronic and electrical sector, which was started 30 years ago for creating employment. The import content for electronic and electrical industry is about 60-80 per cent.
  • Reducing the Services Account Deficit
  1. Reduce outflow of investment income by expanding the scope of reinvestment allowances to cover all retained profits regardless of the sector or nature of project in which the capital is accrued. Currently, the reinvestment allowance, which amounts to 60 per cent of the qualifying capital expenditure for expansion, modernisation, diversification and automation projects, is applicable to the manufacturing and agricultural sectors.

  2. Carry out a cost-benefit analysis on foreign direct investment.

  3. Increase the national shipping capacity. Currently, Malaysian ships represent only 0.54 per cent of total world merchant ships, while Malaysian trade forms about 2 per cent of total world trade. The ships could be leased. The purchase of ships has to be carefully scheduled so as not to burden the trade account.

  4. Reduce the outflow in insurance payments by increasing the capacity of the domestic insurance industry as well as by improving their image in order to be on par with foreign insurance firms. Steps have to be taken to bring on some foreign insurance agents to accelerate the development of the countryís insurance and re-insurance industry.

  5. Local exporters and importers should be encouraged to pool their shipping consignment in order to benefit from scale economies in the utilisation of freight and insurance.

  6. Encourage the export of Malaysian consultancy services. Assistance has to be given for the establishment of a Malaysian consultancy firm in areas where Malaysians have expertise. For example, local engineers involved in the construction of the Kuala Lumpur International Airport (KLIA) have gained substantial expertise and could provide consultancy services for construction projects abroad.

  7. Reduce the outflow of payments on professional and consultancy services by giving priority to local consultants. Impose more stringent conditions on the employment of foreign consultants. The payment of fees to foreign consultants should be in ringgit.

  8. Encourage in-bound tourism and lengthen their stay through attractive package offers by the hotel industry. It is noted that expenditure on accommodation accounts for 30 per cent of total tourist expenditure. To encourage tourists to stay longer, new tourism products have to be developed to appeal to the in-bound traveller, such as value-for-money bargain shopping for a wide range of quality products, eco-tourism, adventure-based tours or total immersion in cultural diversity.

  9. Negotiate with Japanese exporters to make Malaysia a destination for their holidays, meetings and conferences. This has to be implemented as a package along with their exports to Malaysia.

  10. Strive towards making Malaysia a regional centre for airfreight services, particularly with the completion of KLIA.

  11. Strive towards making Malaysia a regional centre of educational excellence. Maximise the opportunities that have arisen from the economic crisis, particularly the increased demand for local tertiary educational places.
  • Reduce the Deficit in Transfers
  1. Foreign workers in the country are to make compulsory contributions to the Employees Provident Fund (EPF). The relevant legislation has to be amended accordingly.

  2. Utilise foreign workersí contribution as an additional source of funds for domestic borrowing to help reduce the savings-investment gap.

Action 3: Maintain a Balanced Public Sector Financial Position

Malaysiaís public sector resource position is strong with budgetary surpluses since 1993, while the Federal Government external debt has declined from RM28.3 billion in 1986 to RM12.9 billion in 1997. Unlike the early 1980s which is characterised by a large Government, since the mid-eighties government budgets have become trimmer. The Government undertook the downsizing of the public sector through corporatisation and privatisation of public utilities and infrastructure. In fact, the current financial problems are partly contributed by the private sector channelling investments in speculative and unproductive sectors.

Among the austerity measures recently adopted by the Government in December 5 1997 is the 18 percent cut in Federal spending, in addition to the 2 percent cutbacks announced in the October budget. The cutback involves an immediate 10 per cent across-the-board cutback in both operating and development expenditure and an 8 per cent cut on a more selective basis, where ministries and departments determine their own expenditure priorities.

The downturn in the economy will also mean that Federal Government revenue may be adversely affected. Although there was an overall surplus of RM4.2 billion in the first quarter of 1998, however, the increase in public expenditure would mean that the budget would be in deficit. The Federal Government is expected to achieve an overall deficit of RM7.9 billion or 2.9 per cent of GNP in 1998.

The Government has agreed to take some loans from multilateral institutions such as the World Bank and the Asian Development Bank to fund programmes aimed at alleviating the economic hardship of those hit by the economic slowdown. The areas that will receive the funding include health, education, and anti-poverty programmes.

In order to make up for the slack in private sector activities, as well as to continue making investments in physical and social infrastructure, the Federal Government would have to continue to adopt an accommodative stance to help generate economic activities. The country should go for a budgetary deficit in the Federal Government finance for 1998.

  • Action 4: Maintain an Appropriate Monetary Policy

There has been a tightening of monetary policy to moderate the rate of loans growth (Figure 8). The policy of reducing the rate of loans growth from a high to a moderate level is bound to cause some painful adjustments in some industries. However, lowering the interest rates sharply could cause the exchange rate to weaken further, which could lead to an outflow of funds and push up interest rates.

However, the present monetary policy is tight enough. In 1998, there has been negative growth of M1, while M3 growth has been declining sharply since January. The benchmark 3-month interbank rate is around 11-plus per cent and the average base lending rate (BLR) of commercial banks is around 12 per cent in mid-March 1998. The average BLR for finance companies is 14.4 per cent. In January 1998, average lending rates for commercial banks and finance companies are around 11.7 per cent and 12.3 per cent; by March, lending rates of financial institutions are in the range of 14-16 per cent.

With declining rates of return because of the economic slowdown and higher cost of imported materials, lending rates are already sufficiently high to moderate loans growth. If interest rates were raised higher, this would adversely affect corporate cash flow and cause more companies to experience insolvency problems.

The fact that there was very little credit growth in December 1997, and since January 1998 the amount of total outstanding loans recorded for each month has fallen. This suggests that this issue should be handled with care. While it is important to keep the credit growth in line with the macroeconomic outlook, productive activities should continue to receive financing support and working capital. The availability of finance is essential for the businesses to continue generating economic activities as well as to avoid unnecessary business failures due to the lack of access to funds.

  • Action 5: Maintain Price Stability

Maintaining low inflation is critical for ensuring Malaysia's competitiveness, stability of the ringgit, and improvement in the standard of living. In this regard, the Government is strongly committed to non-inflationary policies. To control inflation in the short run, appropriate monetary policy would be adopted together with stricter enforcement and price checks by relevant authorities to ensure regular supply of goods.

In the medium- and long-run, measures to increase supply and reduce distribution and marketing costs would be introduced to ease constraints and bottlenecks. In addition, reducing further the taxes on essential goods could help to moderate price increases and compensate for income loss among households. In view of rising inflation and income loss, especially for retrenched workers, the Government should consider reducing sales and service taxes and individual income tax in next yearís budget.

Currently, a total of 21 goods are classified as controlled items and another 25 goods are classified only during the festive seasons, such as Hari Raya and Chinese New Year. These controlled items account for about 10.5 per cent of the total weights in the consumer price index. The Ministry of Domestic Trade and Consumer Affairs is also monitoring weekly the prices of 231 essential goods and reports the results to the Cabinet. This is to reduce the incidence of hoarding, excessive buying and profiteering by traders. The following measures are recommended:

  1. The policy on price control should be reviewed regularly.

  2. New price adjustments or announcements must be carefully planned and implemented with minimum delays.

  3. Taxes are imposed at exit points for controlled items that leave the country.

The employment situation weakened considerably following the economic crisis. Employment growth has slowed down markedly, while retrenchments and unemployment have risen. As such, the pressure for wage increases is not expected to be strong in 1998 and 1999. The system of wage agreements in the private sector has been institutionalised and rigid. Because of past collective agreements, employers do not have the opportunity to adjust wages downwards when the economy slows down.

The following measures are recommended to bring wages in the private sector to a more realistic level:

  1. Unions should exercise responsibility to ensure that collective wage agreements are in keeping with economic conditions, corporate profitability, industry competitiveness, and worker productivity.

  2. Persuade companies to retrain rather than retrench workers.

  3. Encourage companies to keep workers at reduced pay instead of retrenching them.

  4. Consider implementing productivity gain sharing between employers and workers in the plantation sector.

  5. Strengthen the employment insurance system and job placement agencies.

The purchase of houses is not covered in the computation of the Consumer Price Index (CPI). During 1990-97, house prices had more than doubled because of strong economic growth. It is recommended that the House Price Index (HPI) should be published regularly every quarter or at least twice a year.

Some measures to break down inflationary expectations should be adopted in order to keep inflation down. The recommended measures, which include competition policies and administrative measures, are as follows:

  1. Enhance domestic competition through further deregulation and privatisation.

  2. Phase out the remaining import and marketing monopolies.

  3. Phase out the remaining non-tariff barriers and allow competitive imports.

  4. Set up a special tribunal to deal with unpaid dismissal on a company by company basis.

The other measures to keep inflation down include the following:

  1. Malaysian manufacturers should give priority in using local raw materials where possible.

  2. Consumers and consumer associations should assist in restraining rising prices and reporting unethical practices and abuses by traders.

  3. Increase public awareness of the issues on inflation through the dissemination of information and news in order to break inflationary expectations.

  • Action 6: Increase Labour Competitiveness

Enhancing Malaysiaís international competitiveness is essential in the face of intense global competition and changing consumer markets. The country is currently endowed with a stable political climate, favourable economic environment, supportive regulatory and policy regime, and the availability of an educated, adaptable and trainable workforce. To take advantage of these favourable conditions, public and private sectors should work towards increasing productivity and efficiency, which would finally help to sustain higher wages and household income.

However, wage increases should reflect productivity gains for the country to maintain its competitive advantage. The tight labour market prior to 1998 had resulted in an upward pressure on wages not commensurate with the increase in productivity. To maintain competitiveness, it is critical that labour productivity growth is higher than wage increase. The current employment laws and the wage system, which is not pegged to productivity, restrict the adjustment of wages in relation to operating costs and productivity. The following measures are recommended to set in place a flexible wage system:

  1. Increase labour productivity and competitiveness through the implementation of a flexible wage system that is linked to productivity.

  2. Allow tax exemption on bonus payments not exceeding three months.

  3. Introduce a mandatory freeze on basic wage increases only in collective agreements until the economy recovers. Bonus and incentive payments should be allowed, especially in industries still enjoying profits.

The training of workers should continue in order to upgrade human capital and enable Malaysian workers to perform higher skilled jobs. A survey of enterprise training in 1994 indicated that only 32 per cent of firms in the manufacturing sector trained their workers. Among the reasons given for the low incidence of training was the availability of skilled workers ëpoachedí from other firms, fear of disrupting the production line and the use of mature technology. The slow take up rate of reimbursable training fund from the Human Resource Development Council also shows the unwillingness of firms to train their workers especially during the period of high economic growth.

Training will increase labour productivity and is useful as an alternative policy to the retrenchment of workers. The retraining of workers in new skills increases occupational mobility, and allows firms greater flexibility to restructure and readjust its workforce.

The following measures on training are recommended:

  1. Employers should be encouraged to send workers to be trained under this scheme but the HRDF needs to publicise this scheme widely to the industries.

  2. The CIDB and the Institute of Banks should intensify training and retraining of workers in their respective sectors.

  3. Channel the levy collected from foreign workers to a fund to be used for the retraining of retrenched workers.






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