Mahathir's Economic Policies Could Bring His Downfall 
International Herald Tribune
December 15, 1998
David Roche

Prime Minister Mahathir bin Mohamad of Malaysia's policy of capital controls, for what used to be Asia's most internationalized manufacturing economy, is nothing short of disaster.

His decision to force Malaysia's central bank, Bank Negara, to inject a huge expansion of money into the economy will only generate inflation and destroy the currency.

In a country that now has no means of financing a current account deficit, the gap will have to be closed by shrinking domestic purchasing power. Mr. Mahathir will then be unable to placate the masses, especially majority Malays on whose support his party, the dominant partner in the governing coalition, depends. Social tensions will mount and opposition to his regime will grow. Eventually he will be forced to go.

After sacking Bank Negara's governor and imposing capital controls in September, Mr. Mahathir forced the central bank to make substantial cuts in interest rates and the mandatory reserves of commercial banks. This has released more than 43 billion ringgit ($11.35 billion) into the banking system, or nearly 20 percent of gross domestic product.

The government is now instructing banks to increase lending. In effect, it is trying to accelerate economic growth by giving more money to already bankrupt creditors rather than to productive investment. Many of the biggest creditors are companies that have close ties to the government.

The strategy will not work, because the cause of Malaysia's economic crisis is similar to the causes of the crises buffeting other Asian states. It is based on a huge overhang of domestic debt. Bank credit amounts to more than 160 percent of gross domestic product, and has been plowed mainly into unproductive sectors like real estate and finance. These sectors account for more than half of all bank lending.

Overinvestment is also reflected in massive excess capacity in property and manufacturing. As a result, the credit used to finance this investment bubble will never be serviced.

Malaysia's banks are in big trouble. Their nonperforming loans, on which no interest is being paid, will peak at around 40 percent of total lending. Even after assuming a recovery rate of 50 percent on the assets backing those loans, and after taking into account existing bank equity and reserves, the government will still have to find 56 billion ringgit, or 22 percent of gross domestic product, to restore the banking sector to something like a state of health.

That is not the end of the state's need for funds. The government is trying to shore up the economy with 15 billion ringgit in fiscal stimulus and infrastructure packages. Malaysia's deep recession will create a deficit on the federal budget account of 27 billion ringgit, or 10 percent of gross domestic product, between now and the end of 1999. Altogether, this adds up to a resource requirement of more than 98 billion ringgit, or a stunning 37 percent of gross domestic product.

Can the Malaysian government raise such a large amount without printing money and fueling inflation?

To deal with the banks' bad debt problem, Bank Negara was ordered to redefine nonperforming loans. Bad debts are now defined as loans that are not serviced after six months, rather than the normal three. And they are no longer bad debts once repayments are made for six consecutive months, rather than 12 as before. So, in a stroke, the government has "solved" that problem.

To finance part of the resource gap, the government is hoping to get about 17.5 billion ringgit from foreign official sources. Japan and Taiwan are reportedly prepared to provide some aid. Perhaps the Asian Development Bank and the World Bank will also contribute. But the bulk of the financing must come from domestic savings because the effective closing of Malaysia's capital markets to foreign participation cuts off other sources.

Government and institutional cash cows in Malaysia could bring in a further 30 billion ringgit. Malaysians contribute to a state-run Employee Provident Fund that runs a sizable surplus of receipts over payments every year.

Also, the state-owned oil company, Petronas, can be prevailed upon to buy new issues of government bonds with its cash surpluses, as can Malaysian life assurance companies. But that will still leave the government with a net shortfall of more than 51 billion ringgit.

The gap will have to be closed by the government's printing presses.

The huge increase in ringgit put into circulation will not remain locked in the country by the government's exchange controls. Companies and individuals will find a way to convert their ringgit into foreign currency and move it out of the country.

As a result, the ringgit's fixed exchange rate will be undermined by an "offshore" collapse. Malaysian living standards will plummet as unemployment rises and inflation squeezes real incomes. Industry will starve to death on a dearth of imports of capital goods and a lack of domestic demand.

The scene will be set for social upheaval that will force Mr. Mahathir to go. Luckily for Malaysia, there is an alternative leadership in the wings — or, to be more exact, languishing in jail — in the shape of former Deputy Prime Minister and Finance Minister Anwar Ibrahim. Under new leadership, Malaysia can reconnect with the world, but not before its people pay a heavy price.

The writer is managing director of Independent Strategy Ltd., a global investment research consultancy based in London. He contributed this comment to the International Herald Tribune.

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