Although few observers are prepared to make unconditional predictions of collapse in Malaysia, prognoses are far less optimistic than six months ago, and deteriorating by the week. “Given the pace of the economic slowdown that we are seeing from the most recent numbers, the risk is all on the downside,” says Gan Chin Lee, Singapore-based senior economist at Nikko Research. “I’m just in the middle of revising down my GDP forecasts for 1998 from plus 2% to minus 1%.” Growth in 1997 was around 7% and just weeks ago the government was forecasting 4.5% growth this year.
With Indonesia suffering riots and near collapse of the government, Korea facing the restructuring of much of its industrial base and Thailand feeling the strain of the IMF austerity package, a pessimistic view of Malaysia is understandable. Yet in the middle of last year, when events in Thailand prompted the financial rout that spread across Asia, Malaysia was reckoned to be very different from its neighbours.
Its property sector was much less speculative than that in Thailand, the arguments ran, and its banking system was better capitalized. If the ringgit weakened, exports would boom, rapidly improving the current account and stabilizing the exchange rate. Most important, unlike Thailand and Indonesia where the private sector had borrowed heavily offshore in foreign currencies, Malaysian debt was largely domestic. As exports picked up, interest rates would therefore be able to fall back fairly quickly to more normal levels, giving the economy the power it needed to pull out of a crash path.
In one respect these arguments have been proved correct: Malaysia has had more room for manoeuvre than other countries in the region and prime minister Mahathir Mohamad has not had to go to the IMF for a bail-out. The economy, which had reached the top of its cycle in 1996, still turned in “healthy” 7.8% growth last year. Property prices held up. The banks’ average non-performing loans were reported to be a very manageable 5%.
But now the pressures that led to a 33% devaluation of the ringgit and a 40% fall in share prices on the Kuala Lumpur Stock Exchange are starting to have a widespread effect. “The economy is contracting sharply,” says Samir Mehta, investment analyst at Lloyd George Asset Management in Hong Kong. “Manufacturing has held out so far because of electronic components. But heavy industry, construction, banking and finance are all grinding to a halt.” And exports have failed to boom. The high import content of most manufactured exports means companies are struggling to afford inputs, let alone invest in more capacity. “We are looking for minus 2% or minus 3% growth this year,” says Mehta. “By the third or fourth quarter of this year, people on the street will really be able to feel it.”
The real-estate market, so far spared the corrections suffered elsewhere, is about to crash. “There have been very few transactions recently, so economic reality is not reflected in the published prices,” says an analyst. “But with no-one expecting to make gains from capital appreciation any more, investors have to look at yield. This in turn is compared with the returns on deposits or fixed income. With three-month interbank rates now around 11%, there will be few takers unless capital values fall substantially, thereby raising rental yields from the 6% they achieved in 1996.”
Asset wipe-out
Most observers are forecasting a fall in capital values of between 30% and 40%. Even this may not be enough to cope with supply. Just under 640,000 square metres of new office and retail space came on stream in the Klang valley area around Kuala Lumpur alone last year. A further 1.3 million square metres will be completed this year, and there will be little if any demand for it.
A sharply deteriorating economy and an imminent fall in property prices will put further strain on a banking system already hurt by excessive short-term foreign-currency borrowing. “The banks are clearly in bad shape because they overextended loans during the boom of the past three or four years,” Mehta says. Loan growth in Malaysia, which had virtually tracked economic growth after the crash in 1985, suddenly took off in the second half of 1993. Between 1993 and 1996, total loan growth expanded by about 21% a year, more than twice GDP growth. That this abundant liquidity largely found its way into speculative ventures rather than productive assets is now becoming clear. Real estate and also stocks were bid to ridiculous levels. Lending for share purchases during this heady period rose at an annual rate of 46%.
Some estimates suggest that half of new bank lending over the past four years went into equity and property speculation. Much of the collateral that backed it has been wiped out already: the prices of high-flying stocks such as second-liner Quality Concrete have fallen by over 90%, even in local currency terms. More collateral will evaporate when the property slump begins in earnest. Ironically, that looks likely to be exacerbated by banks’ attempts to clean up their balance sheets. Late last year, for example, many began to refuse to accept property as collateral, a move that will have the opposite effect to that intended.
“The rush by bankers to shun property collateral will itself produce the collapse in value that will devour bank capital,” says number-one-ranked Asia strategist Russell Napier, an analyst at CLSA Global Emerging Markets.
At the moment, the Malaysian banking and finance system still looks quite healthy compared with Thailand’s or Korea’s, with non-performing loans (NPLs) officially at 8.7% as of February, even under the tighter definition of three-months overdue introduced late last year. “So far, the bulk of the problem has been in the finance companies, as the main defaults have come on vehicle loans and stock financing,” says Mehdee Reza, banking analyst at Credit Suisse First Boston in Hong Kong. “NPLs in this sector range from the low single digits to the high 30s. But we have yet to see the big correction in property prices. When this happens, later this year, the impact on the banks will be substantial.”
How high can average NPLs go? “Historically, capital destruction has been significantly higher in the Malaysian business cycle than in the US business cycle,” Napier points out. “While system-wide non-performing loans peaked at 6.7% in the US in 1991, Malaysian non-performing loans totalled 30% of assets at the nadir of the last business cycle.” Most analysts are now predicting NPLs to peak at about 25% of total loans, some 35% of GDP. This being the case, Malaysia may need to find more than $10 billion to recapitalize its financial system.
Central bank’s balancing act
One option that’s closed to the central bank, Bank Negara, is to print its way out of trouble. Malaysia’s low interest rate differentials against the US dollar meant that its foreign-currency debt situation was recently relatively healthy. Rating agency Moody’s Investors Service estimates total external debt at the end of 1997 at $3.5 billion with a ratio of debt to exports of about 46% – low by international standards. However, its overall debt position is now in many ways worse. Michael Baptista, CSFB’s regional banking analyst for Asia, estimates that Malaysia now has a loans-to-GDP ratio of 160%, the highest in the region. Furthermore, the fall in the value of the ringgit has worsened Malaysia’s external debt position more than many realize. It is estimated to be now well over 40% of GDP, and a further depreciation of the ringgit, which would inevitably occur were interest rates to be lowered, would put the country into risky territory. This means that the central bank will not run the risk of pumping money into the system to inflate away the debt.
At the same time, Bank Negara has been fighting to avoid a repeat of the credit crunch that hit the Malaysian markets late last year. Malaysia’s 36 finance companies were in March corralled into eight groups, to keep all of them “viable”. Even the bankrupt ones have been allowed to continue to accept deposits. Bank Negara has guaranteed all deposits in the financial system – a guarantee that bankers know it could not keep, but which has helped bolster public confidence. When the banks are pushed to the edge as the finance companies were before them, a “national service” arrangement whereby stronger banks are forced to take on board their weaker brethren will almost certainly be introduced, again with state support. The only bank to face collapse so far, Sime Bank, was rescued in April by broker Rashid Hussain and rival Tong Kooi Ong and his Phileo Allied Group, but only after guarantees from Bank Negara that Sime Bank was “clean”.
This still raises the question of where ultimately the billions in new capital will come from. Local observers believe that national oil and gas monopoly Petronas, which is thought to hold up to $25 billion in hidden reserves, might be called upon to perform a patriotic duty. Bank Negara might also like to allow larger foreign stakes in banks. Currently set at 30%, this restricts bank recapitalization.
“But the politicians will fight very, very hard to avoid this final ‘evil’,” says an analyst. “The anti-foreign rhetoric we have heard since the start of the Asian crisis emanating from Malaysia taps into a very deep seam.” The Institute of International Finance is predicting that private capital flows into Malaysia will be nil this year.
The most important foreign influence will be Japan. It will play a vital role in determining what options Malaysia has, and how quickly it might recover. “Japan’s the one,” says William Belchere, vice-president and senior fixed-income strategist for Merrill Lynch Asia. “If it goes down, everything follows suit.”
Less apocalyptic observers – for example Joseph Yam, head of Hong Kong’s Monetary Authority – are worried less by the prospect of collapse than the possibility that renewed yen volatility and lack of regional leadership from Japan will exert a long-term drag on prospects for growth. The retreat of Japanese banks is already hurting. In the case of Malaysia a Japanese withdrawal of any longevity will hurt more. It may have fewer foreign debts than many other countries in the region but a greater proportion are derived from Japan, currently about $10.5 billion in loans outstanding. More important, Japan has for years been the largest foreign direct investor in Malaysia. It also imports about 10% of Malaysia’s electrical and electronic products (half of the country’s exports), and 50% of its timber.
Malaysia is in the opposite position to Mexico, which could rely on credit and booming demand from the US economy to help it out of the mire after the peso devaluation. Japanese imports from Association of South East Asian Nations countries have been falling since 1995 and the latest numbers show a further weakening of demand. Lending and direct investments – which contributed to the bubble in the first place – are also slowing as the domestic credit crunch and the weak yen reduce the Japanese appetite. The resulting loss of liquidity is helping to tip companies Asia-wide – even in Hong Kong – towards bankruptcy. Malaysia must therefore be bracing itself for the knock-on effects of the continuing Japanese sclerosis.
The best that can be hoped for is a softer landing than that experienced by Korea or Thailand. There are signs the government is working hard to engineer one. Bank Negara has managed to resist any pressure to loosen monetary policy. It must have very high level backing. Deputy prime minister Anwar Ibrahim has consistently taken a noticeably softer line than Mahathir on the evils of foreign capital.
He has hinted that in order to solve the current difficulties, economic policies that favour the bumiputra (ethnic Malays) may have to be relaxed. These policies were developed to redress an unbalanced economic system in which most power lay in the hands of the sizeable but minority Chinese population. But they planted the seeds of what has been characterized as “crony capitalism” Malaysian-style. Government projects were handed out mainly to bumiputra-controlled companies. Chinese-controlled companies supported the government in order to ride the train of development, rather than stand in its path.
Anwar has also indicated that “if the government has to choose between saving the economy and one or two companies, we will save the economy”.
This could put Malaysia on the road to a solid recovery. “Bank Negara has tried very hard to encourage a proper market-style consolidation, which they are now forcing,” says Reza. “If the government allows in foreign capital, something which will raise the quality of the banking system and improve competitiveness, in two or three years you would have in Malaysia a very efficient financial system.”
