This article first appeared as 'Time to exorcise the ghosts of 97/98​' in The Edge Malaysia Weekly, on August 19, 2019 - August 25, 2019.

MALAYSIA’s economy has grown at a compound rate of 4.7% in the past 10 years. It is a decent figure. But behind the headline number, the picture is not so pretty. Much of that growth came from a debt-funded consumer binge and government spending, which is not healthy. The key to sustainable growth is private investment but, today, it is half of what it was as a percentage of GDP before the 1997/98 Asian financial crisis.

Our Cover Story explains that this is due to fears about exposing our corporate sector to debt, especially foreign borrowings. We argue why Malaysia needs to exorcise the ghosts from 20 years ago to give the private sector access to more and cheaper credit. This will incentivise the sector to invest, make money and create jobs that lead to higher incomes for both Malaysian workers and the country.

No one will argue that investment is the best solution to long-term sustainable and quality economic growth. Investments in productive assets will support output growth — for both domestic consumption and exports — and push up productivity. It will create employment and raise wages-incomes for the people and, at the same time, increase corporate profits.

Similarly, few would dispute the urgent need for Malaysia to reinvigorate investment as the main engine for future economic growth. So why is this not happening?

We see two major issues that are holding us back as a country — political uncertainty and structural economic issues. Both are legacies from the Asian financial crisis (AFC) in 1997/98.

Events during and after the AFC were traumatising, so much so that we are still being haunted, to this day, by the ghosts of 1997/98.

The crisis, as we all know, was first triggered by the collapse of the Thai baht, which very quickly expanded into a full-blown currency and financial crisis engulfing the entire region. Countries including South Korea, Thailand and Indonesia turned to the International Monetary Fund (IMF) for bailouts — at a high cost to their economies and population. Malaysia was not spared.

On the political front, a serious clash on how to tackle the raging crisis developed between Prime Minister Mahathir Mohamad and his deputy Anwar Ibrahim, which eventually led to the sacking of the latter. The rift sowed seeds of discontent and spurred the Reformasi movement and political distrust that still persists today.

Hardly a day passes when we do not read about speculations on political succession. Surely this will cause further misunderstanding besides distracting the government from achieving its various promises.

The prime minister has promised that he will hand over power after the economy has been set right. But incessantly talking about it must affect the mindset and psyche of investors, the general public and administrators. And the issue may well be moot if the economy fails to recover. If people’s lives do not improve, we may likely see yet another change in government. 1Malaysia Development Bhd (1MDB) and the introduction of the Goods and Services Tax (GST) brought down Barisan Nasional in GE14. The same will not deliver a victory to Pakatan Harapan in GE15.

Therefore, it would seem obvious that Pakatan Harapan’s focus should be on how to improve the economy. Indeed, improving the lives of the citizens should be the commonality that unites all component parties in the new coalition, rather than to be beset with issues of race, religion or succession. It is time for all Pakatan Harapan politicians to stop talking about succession, falling into the opposition’s trap of creating mistrust.

Pakatan Harapan was elected on the promise to root out corruption and implement deep political and institutional reforms. It needs to maintain this momentum and deliver on its promises.

Malaysia must strengthen the independence of institutions, rule of law and system of checks and balances so that future changes in government and who becomes the prime minister are less about individuals and more about policies.

Economically, Malaysia opted to implement the unorthodox measure of capital controls instead of seeking a bailout from the IMF.  The decision was heavily criticised but shielded our economy from the worst of the crisis.

Still, in the aftermath, overleveraged companies were forced into austerity to repair their balance sheets. There were mergers and acquisitions and some companies had to be bailed out. The banking sector saw a spate of consolidation and recapitalisation to strengthen the financial system. Foreign direct investments fell sharply and capital inflows dried up.

Capital control measures have since been relaxed though some remain. For instance, the ringgit can no longer trade abroad and there is tight control on raising foreign currency debt.

Investment had been the driving force behind Malaysia’s rapid economic development for four decades, right up till the AFC. Since then, however, investments have declined sharply. Chart 1 shows the downtrend in the country’s gross capital formation as a percentage of GDP.

Between 2000 and 2018, the compound annual growth rate (CAGR) in investments slowed to 4.1% on average — below GDP growth of 4.9%.

Private consumption and government spending took over as the main growth drivers of the economy. But both consumption and government spending have reached their limits as future engines of growth.

Private consumption, in particular, has grown well above GDP growth rates since 2008 under the stewardship of former prime minister Najib Razak.

In the 10 years under his leadership, Malaysia’s economic growth was super-charged by private consumption and, to a lesser extent, government spending. Between 2008 and 2018, consumption grew at a CAGR of 7.3% on average, while government spending expanded at an average compound rate of 5.1%. As a result, consumption as a percentage of GDP rose from 44.7% to 57.3% over the same period.

Households went on a debt-fuelled spending binge. Household debt-to-GDP rose from 63.9% in 2008 to as high as 89.1% in 2015 before Bank Negara tightened credit requirements to contain indebtedness.

The economy grew at a CAGR of 4.7% on average in the past decade — pushed up by the consumption binge that was paid for with debt.

Without this spending surge, if we assume a constant consumption to GDP ratio of 44.7% (as it was in 2008), Malaysia’s GDP growth would have been only 2% on average (taking into account the actual government spending, investments and net exports) — instead of the reported 4.7%. (See Chart 2.)  

Najib was like the prodigal son. Instead of addressing the more difficult issues of how to stimulate investments to grow our economy, he took the easy way out. Effectively, his feel-good policies lulled Malaysians into spending away their savings and future incomes.

Savings rates fell sharply, with serious implications on bank deposits growth and funds available for investments. We will elaborate on this a little later. What is clear is that we now have to rebuild our savings by working harder and smarter.

Another negative side effect of the rapid growth in spending was surging imports of consumer goods. The country’s total imports grew at a CAGR of 2.5% between 2008 and 2018, well ahead of the 1% growth in exports — eroding Malaysia’s balance of trade as well as reserves. (See Chart 3.)

The current government cannot and must not follow a similar path.

While household debt-to-GDP has fallen off the peak to 83% currently, the average Malaysian remains among the most indebted in the region.

Yes, consumption remains a very important pillar of the economy. As a country develops, consumption and services tend to make up an increasingly larger percentage of GDP. Malaysia’s consumption currently tops 57% of GDP. By comparison, consumer spending in the US makes up some 70% of economic activities.

In other words, consumption has room to grow but that growth must be supported by rising disposable incomes, not borrowings. Technological innovations can help households repair their balance sheets, for instance, by shifting from ownership to subscription-sharing and new alternative financing models. Nevertheless, this will only happen with time.

More critically, the government must focus on rejuvenating investments, not only to raise future disposable incomes but also to create jobs for the younger generation.

Similarly, a continuous increase in government spending is no longer an option. Ballooning public debt — which now stands at over RM1 trillion — risks negative repercussions on the country’s credit ratings and currency stability.

The government must still invest in sectors such as education and healthcare to ensure accessibility for all, as well as social programmes and key infrastructure. And it can and should increase spending to boost growth in the short term — for instance, to make up for the slack in private spending during a cyclical downturn. But not as a sustainable long-term growth driver.

Malaysia needs to stimulate sustainable investments from the private sector, where empirical evidence has proven it to be more enterprising and, due to its profit focus, more efficient.

The government’s role is to promote investments — and not just any investment. It has to focus on investments in the right sectors, those with high multiplier effect, which create quality, high-paying jobs that will lift overall per capita income.

Too much of investments in the past decade have gone into the “wrong” sectors. That includes overbuilding in the property sector. Vacant office spaces and shop lots and empty shopping malls are all low productive assets, as are unsold and unoccupied homes.

Meanwhile, investments in low-valued-added, cookie cutter assembly manufacturing coupled with insufficient spending on R&D and proprietary intellectual properties have translated into limited pricing power and loss of competitiveness against other emerging countries where labour is even cheaper and more abundant.

The result is low returns on investments, which also means less profit for reinvestments — all contributing to the observed weakness in capital formation in the country. It becomes a vicious cycle.

The jobs that were created require low skills and pay low wages, often attractive only to foreign immigrants. There is a noticeable lack of jobs paying the US$4,000-US$8,000 range (or RM16,000-RM32,000). Not only does this mean the country is unable to attract the pool of foreign talents, it also pushes young, educated Malaysians to seek opportunities overseas, including in neighbouring Singapore.

This hollowing out of the middle class saps the country of the potential for stronger, income-driven domestic consumption.

Why have investments been so weak since the AFC? The fallout from the AFC has exacted a heavy psychological toll on all. We saw increased risk aversion in banks as well as on the part of regulators, as evidenced by rigid guidelines on provisions, risk weightage, coverage ratios, foreign funding, and so on.

The ensuing sector consolidation reduced the number of banks, leading to lesser diversity in terms of lending strategies and practices. All of the remaining big banks gravitated towards the safest segments, mortgage and hire purchase loans.

Currently, a significant portion of bank liquidity goes to mortgages (46.4% of total loans) with another 10.1% for hire purchase. This loan bias contributed to the drop in funds available for business investments.(See Chart 4.)

Big corporates are able to tap the bond market, which has grown rapidly. Nevertheless, the banking sector continues to hold an outsized role in funding investments, especially compared with countries such as Singapore and the US where the stock and bond markets are much larger and growing. (See Chart 5.)

Small and mid-sized enterprises (SME) with little financial track record and hard assets for security have limited funding options. The same goes for startups, thereby constricting entrepreneurship, innovation and potentially robbing the economy of growth with the highest productivity.

Over the past 10 years, corporate debt in Malaysia has expanded at a slower pace compared with that in China, Singapore, Indonesia and Thailand in US dollar terms (though slightly higher than Thailand in local currency terms). (See Table 1.) We will lag if investment growth does not catch up with others.

How do we get the banks to lend more to the critical SME and commercial segments?

The average loan-to-deposit ratio (LDR) for the banking industry has risen steadily since 2006, coinciding with the sharp increase in household debt. The ratio now stands at 87.3% on average, though still off the peak of 97.2% in 1997. LDR for the five biggest banks by market capitalisation ranges from 81% to 95%.

Current LDR ratios suggest there is still room to boost lending. But banks themselves as well as regulators appear very cognisant of systemic risk. Given the lessons from 1997/98, we suspect banks are unlikely to expand their LDR significantly, at least not without corresponding growth in the deposits base.

Deposit growth, however, has been weakening. Indeed, annual loans growth, driven by household credit, outpaced deposit growth in all but three of the last dozen years. This can be attributed, in part, to the country’s dwindling savings.

Gross national savings have been on a downtrend, falling from nearly 40% of gross national income (GNI) in 2008 to just 26.7% in 2018 — the result of rapid consumption growth as well as rising cost of living that outpaced sluggish income growth. (See Chart 6.)

Malaysia’s deposit rates are already relatively high, compared, for instance, with that in regional financial hubs Singapore and Hong Kong. To further raise this may not necessarily attract more capital inflows, but would certainly translate into higher cost of funds and lending rates. That would be counter-productive to promoting loans growth.

A better option would be a carrot and stick approach to rejig the banks’ current loan portfolios. Specifically, banks could be induced — through moral suasion or new rulings — to extend loans to the corporate and commercial sectors for investments.

We are not proposing a clampdown on mortgage and hire purchase loans. But these loans can be expanded via an alternative capital market structure or dedicated institutions.

Reducing mortgage and hire purchase loans would free up liquidity for banks to increase lending to businesses, without compromising LDR.

While this would increase the overall risks of their portfolios, it also means higher net interest margins (NIM) and profitability. Indeed, the heavy reliance on lower risk consumer loans (and hence, low margins) is one reason for banks’ narrowing NIM.

In short, banks must play a more active role in spurring the credit expansion cycle.

The SMEs, collectively, are the single largest employer in the country and arguably, the most innovative and productive. Banks are the best placed to finance this segment given their expertise and market reach across the country. But if they are unwilling, preferring to stay within the safer mortgage loans or lending only to large corporate borrowers, then the government must facilitate other forms of financial intermediation, new financial initiatives and instruments to ensure there are vibrant funding options for SMEs and startups.

Domestic institutions such as the Employees Provident Fund (EPF), Permodalan Nasional Bhd (PNB) and Kumpulan Wang Persaraan (KWAP) hold a substantial chunk of Malaysian savings through mandatory monthly deductions. We recognise the rationale and need for these institutions to diversify their portfolios, to include overseas investments, as a strategy to maximise stakeholder returns.

According to latest available statistics, the EPF has the highest exposure to foreign investments (some 27% of total assets), followed by Khazanah Nasional (about 15%), KWAP (11%) and PNB (4.9%). All have expressed intentions to raise their overseas investments.

At the same time though, they have a responsibility to further our national interests. The four institutions collectively control some RM1.44 trillion worth of funds, a significant amount compared with the total banking system’s deposits of RM1.92 trillion. Given the sheer size of these funds, their decisions to funnel money into overseas investments will have significant impact on domestic liquidity.

How these institutions invest to raise their returns, the extent of foreign diversification and their role, if any, as catalytic investors, or in achieving the “shared prosperity” objective of the government needs to be carefully and comprehensively decided.

As we wrote at the start of this piece, investment is the lifeblood of an economy — that will ensure long-term sustainable growth, create jobs, raise overall productivity and per capita income, which will, in turn, underpin domestic consumption growth and lift the living standards of the people.

Promoting investments must be a priority. Sometimes, solutions require thinking outside the box. Yes, an overleveraged corporate sector was one of the reasons we suffered during the AFC. And yes, our then high exposure to foreign currency-denominated debt was blamed for the double shorting of the ringgit and stock market.

We are still holding on to this two-decades-old aversion to foreign borrowings. Restricting companies from borrowing abroad may have inadvertently handicapped investments and growth.

While it is true that restricting foreign currency debt will better insulate the ringgit and prevent a repeat of the speculative bets against the currency, it also limited the availability of foreign capital as a source funding. That, in turn, played a part in keeping our interest costs higher than it could have been, especially at a time when domestic savings rate was falling rapidly.

Chart 7 shows the widening interest rate differential for 5-year government bonds between Malaysia and select emerging and developed countries, including Singapore, Indonesia, Thailand, the US, Japan and Germany. Spread differential with China remained more or less similar — despite the latter’s huge increase in investments and loans growth.

Higher cost of capital reduces investments, profits, wages and employment prospects for Malaysians. This cost is self-inflicted. It is one of the reasons foreign reserves stagnated, after falling well off the peak in 2012, despite our huge annual trade surpluses. The resulting perception of higher risks could have also encouraged domestic capital outflow, thereby worsening the reserve levels through a negative feedback loop. (See Chart 8.)

Lowering the cost of money will lead to greater demand for loans from entrepreneurs. We should allow the private sector to determine which projects and sectors to invest in, as opposed to a top-down directive. Businesses best understand current market dynamics, their comparative advantages and where they have the highest confidence of success.

Banks, in turn, must be encouraged, through moral suasion or otherwise, to meet this demand, and given the leeway to do so, including relaxing regulatory requirements, if necessary.

Leverage on its own is not taboo for businesses. Far from it. Businesses should take on debt to invest in productive assets, to expand and grow. It is not a coincidence that countries where corporate debt has risen more rapidly are also those that have grown their economies faster.

It is about how the money is used. The banks are the best financial intermediary to assess and determine the viability of each project, given their experience and expertise.

The point is that we must stimulate investments while ensuring the allocation of resources into the most productive assets.

All actions have consequences, benefits and costs. There is also a cost to inaction. We must learn from lessons of 1997/98 but they must also not cripple us.

To paraphrase Bank Negara Governor Nor Shamsiah Mohd Yunus, “Malaysia needs to urgently embark on a structural reform to rebuild the country’s strengths and prepare for the future. Reforms should not only address the immediate economic vulnerabilities, which include enhancing the fiscal position and strengthening household resilience, but also ensure the right kind of investments are attracted, that will yield high-value industries and jobs.”

The economic lesson of 1997/98 is not the rapid growth of investments funded by debt. Rather, the fault was that significant debt was built up for non-productive utilisation and the use of short-term debt to fund projects with long gestation.

There will be another political crisis and there will be another economic crisis. But it is not going to be a repeat of 1997/98. We must move forward. Stop looking at every corner and in every shadow for ghosts that do not exist.

It is time to unleash the animal spirits of the private sector.

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.