Malaysia did not turn to the International Monetary Fund for assistance when pressure from the 1997-1998 East Asian financial crisis hit the country. The country was less vulnerable than its neighbors, not least because it had earlier imposed limits on foreign borrowing and prudential regulations and supervision of the banking sector. Although Malaysia's pathway through the 1997-1998 crisis included an orthodox adjustment program of the type the IMF would have required, this program was soon reversed in favor of reflationary monetary policies and the imposition of a short-term capital control regime. These responses took place against a backdrop of political intrigue and drama, but they reflected an underlying pragmatism and recent history of using capital controls and of not turning to the IMF. KEYWORDS: Malaysia, Anwar Mahathir, capital controls, currency and financial crisis, Asian crisis.
The 1997-1998 East Asian crisis, triggered by the collapse of the Thai baht in July 1997, led to a currency crisis, a financial crisis, and then economic recession in most countries of the region. However, the Malaysian economy and population were not as adversely affected as their counterparts in Thailand, South Korea, and Indonesia. While the precrisis level of indebtedness in Malaysia was very high, the level of foreign exposure was much lower--as a share of gross domestic product (GDP) and, especially, as a share of the open economy's extraordinarily high export earnings. Unlike in other countries in the region, Malaysia's level of foreign liabilities did not exceed its foreign exchange reserves, so the country was not in need of emergency credit facilities, including from the International Monetary Fund (IMF). After the severe banking crisis of the late 1980s, Malaysian prudential regulation had been improved and had not been as badly undermined by liberalization pressures as in the other three economies. In brief, Malaysia was the one country involved in the East Asian crisis that did not involve the IMF.
In this article, I examine the political economy of the Malaysian crisis of 1997-1998. (1) I explain why Malaysia was less vulnerable to crisis than its neighbors--not least because a severe banking crisis in the late 1980s and reforms undertaken in its aftermath had led to preemptive reform, which limited foreign borrowing and ensured greater banking prudence. Nevertheless, in the 1990s, Malaysia was vulnerable to contagion because the authorities had encouraged massive, easily reversible portfolio investments, especially in its stock market. However, its vulnerability was mitigated by the use of capital controls applied in September 1998.
I also argue that Malaysian economic policy during the crisis went through four distinct phases: an early phase of "defensive" policies, led by the prime minister, Mahathir Mohamad; economic orthodoxy, led by then finance minister Anwar Ibrahim; reflationary fiscal policies, also led by Anwar; and, finally, reflationary monetary policies, with a capital control regime imposed by Mahathir. While these policy shifts have been portrayed as the result of an ideological struggle between a nationalist prime minister and his more market-oriented finance minister, I argue that the ideological differences between the two men have been overstated. Rather than given to ideological extremism, Malaysian crisis management was underpinned by considerable pragmatism and flexibility, which allowed for a speedy recovery. The high-profile clashes between Mahathir and Anwar had more to do with the former's fears of a palace coup by the latter than with fundamental disagreements about how to handle the financial crisis.
After the value of the Thai baht collapsed in mid-1997, currency speculators turned their sights on other economies in the region perceived to have maintained similarly unsustainable US dollar quasi-pegs for their currencies. The Malaysian ringgit (RM) had oscillated around RM2.5 against the US dollar during the first half of 1997, (2) with some arguing that it was slightly overvalued.3 After the Thai baht was floated on 2 July 1997, the ringgit, like other currencies in the region, came under strong pressure, especially because Malaysia, like Thailand, had maintained large current account deficits during the early and mid-1990s. The monetary authorities' efforts to defend the ringgit actually strengthened it against the greenback for a few days before the futile ringgit defense effort was abandoned by mid-July, having allegedly cost some RM9 billion (then over US$3.5 billion). The ringgit was then floated, following the Thai baht, Indonesian rupiah, and Filipino peso, and fell to its lowest level ever by January 1998--to almost half the value it had held against the US dollar in mid-July 1997.
Devaluation lowered the foreign exchange value of Malaysian assets, including share prices. The stock market fell severely, with the main Kuala Lumpur Stock Exchange (KLSE) Composite Index (KLCI) dropping from over 1,300 in the first quarter of 1997 to less than 500 in January 1998, then to around 300 in August 1998 and to 262 on 2 September 1998, after the initial announcement of the capital control measures the day before. The stock market collapse, in turn, triggered a vicious cycle of asset price deflation involving the flight of foreign as well as domestic portfolio capital. Lower asset prices also caused lending institutions to make margin calls, requiring additional collateral. Foreign lenders became more reluctant to roll over their short-term loans. Interest rates also increased, for a variety of reasons, exacerbating the effects of reduced liquidity.
Like the currencies of other crisis-hit economies, the ringgit fluctuated wildly until mid-1998, weeks before it was fixed at RM3.8 against the US dollar on 2 September 1998. Much of the downward pressure on the ringgit was induced by regional developments as well as by adverse perceptions of the regional situation. Ill-advised political rhetoric and policy measures by the political leadership exacerbated the situation. (4)
Foreign and domestic speculators fueled the panic as investors scrambled to get out of positions in ringgit and other regional currencies. This caused currencies to fall yet further and with them the stock and other markets, constituting a rapid vicious circle. With financial liberalization, fund managers had an increasingly greater variety of investment options to choose from and could move their funds much more easily than ever before, especially with the minimal exit restrictions the Malaysian and other authorities in the region had prided themselves on. The nature and magnitude of hedge fund operations, as well as other currency speculation, undoubtedly exacerbated these phenomena, with disastrous cumulative consequences.
Malaysia's Management of the Crisis
The Malaysian government's response was characterized by three key decisions. First, there were ill-advised attempts to assert Malaysia's sovereignty over market forces and economic policy. Subsequently, Malaysia swung to orthodox macroeconomic policies (albeit without IMF assistance), but then retreated from that stance as its contractionary impact was felt. Finally, Malaysia decided to apply capital controls to support reflationary monetary policies.
The Reassertion of National Control over Economic Policymaking
The initial Malaysian government's response to the crisis was led by Prime Minister Mahathir, who portrayed the collapse of the ringgit as being due exclusively to speculative attacks on Southeast Asian currencies. (5) In September 1997, Mahathir declared that "currency trading is unnecessary, unproductive and immoral," and argued that it should be "stopped" and "made illegal." More damagingly, he threatened a unilateral ban on foreign exchange purchases unrelated to imports (which never happened). All this upset "market sentiment" and seemed to exacerbate the situation until he was finally reined in by regional government leaders and his cabinet colleagues. (6) The partial truth in his rhetoric was not enough to salvage his reputation as a maverick in the face of an increasingly hostile Western media, and Mahathir came to be demonized as the regional bad boy.
Mahathir's early policy responses to the crisis probably made things worse. In late August 1997, the authorities designated the top 100 indexed KLCI share counters. "Designation" required actual presentation of scrip at the moment of transaction (rather than later, as had been the practice), ostensibly to check short selling, which was said to be exacerbating the stock market collapse. However, this ill-conceived measure adversely affected liquidity, causing the stock market to fall further. The government's threat to use repressive measures against commentators making unfavorable reports about the Malaysian economy strengthened the impression that the government had a lot to hide from public scrutiny. Anwar's mid-October 1997 announcement of the 1998 Malaysian budget was perceived by "the market" as reflecting "denial" of the gravity of the crisis and its causes, ostensibly including "populist" fiscal deficits (which was not the case).
A post-cabinet meeting announcement, on 3 September 1997, of the creation of a special RM60 billion fund for "selected Malaysians" was understandably seen as a bailout facility designed to save "cronies." Although the fund was never institutionalized, government-controlled public funds--including the Employees Provident Fund and Petronas--were later deployed to bail out some of the most politically well-connected and influential individuals and organizations, including Mahathir's eldest son; the publicly listed corporation set up by Mahathir's party cooperative (KUB); and the country's largest conglomerate (Renong), previously controlled by the prime...