The Asian Wall Street Journal
September 2, 1999

Malaysia's Dubious Recovery

Policy makers in Malaysia are proclaiming victory this week as quarterly GDP figures register the first period of growth since the Asian crisis struck more than two years ago. To top it off, the anniversary of the imposition of capital controls came and went yesterday without event, putting to rest any fears of a mass exodus of capital on the day that the exit tax was lifted on investments made before Sept. 1, 1998.

While Prime Minister Mahathir Mohamad argues that the controls, and the fixed exchange rate, have allowed his government to "kick start" the economy into recovery, there is a broad consensus among Malaysia watchers that the controls had little to do with the recent growth, one way or the other. Even economist and one-time capital-controls cheerleader Paul Krugman acknowledges this, saying "[t]he controls turned out to be irrelevant because the pain was already subsiding when they were introduced."

However, while most analysts are quick to agree that the controls had little to do with Malaysia's recovery, the fact that the measures have not wreaked immediate havoc with that country's economy seems to have put a damper on any serious criticism of them.

That's too bad. Because serious criticism of the restrictions has never claimed that they would lead to immediate economic disaster. All along, critics have argued that, while capital controls might provide some short-term relief from the harsh judgments of the global economy, the long-term damage would more than wipe away these gains. These criticisms still stand. Indeed, the imposition of capital controls has only worsened the problems that led foreign investors to judge the Malaysian economy so harshly two years ago.

Apart from the obvious consequence of discouraging foreign investment, Malaysia's capital controls are having other, more serious effects. By cutting itself off from the judgments of the international marketplace, the government of Malaysia has shielded itself from the consequences of bad policymaking. Not surprisingly, a raft of ill-advised policies followed on the heels of capital controls, beginning with Dr. Mahathir's 65.1 billion ringgit ($12 billion) "stimulus" package, dramatic cuts in interest rates, instructions to banks to raise lending by 8%, and the 1998 bail-out of the ruling party's investment vehicle, Renong.

More recently, the government has taken the opportunity to further consolidate the financial sector, with the forced merger of the country's 58 financial institutions into six banking groups. Along with this consolidation, no doubt, will come a consolidation of government influence in that sector. In other words, stay tuned for further selective rescue packages.

The Malaysian government knows that these policies would have had the effect of inciting further capital flight had capital remained free to flee, which is why it claims the controls have been a success. Without them, there could have been no massive public works spending, no monetary expansion, and no impressive GDP figures within only a year.

But GDP figures alone are not proof of a healthy economy, any more than artificial stimulus can lead to real recovery. Real reform needs to happen before we can call this recovery solid. And that means allowing bad companies to fail, and bad lending and investment decisions to be punished by the marketplace. As long as capital controls remain in place, that remains highly unlikely.

Copyright Dow Jones & Co. 1999