Country Intelligence: Report

Malaysia

REPORT PRINTED ON 01 MAY 2013

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This information was last updated on 18 APR 2013, 12:29 AM EDT (4:29 GMT)

Outlook and Assumptions: Outlook

Robust domestic demand will ensure strong GDP growth in 2013. Malaysia's economy had proved quite resilient to global headwinds in recent quarters, managing to grow by 5.6% in 2012 thanks to persistent strength in domestic consumption and extraordinary investment growth. Some moderation is expected in 2013 partly on account of base effects and partly because of still weak net exports, but the economy should manage to grow by close to 5.0%. Inflation is inching higher again but is a nonissue. Headline consumer price inflation steadily retreated in 2012 but looks to have now bottomed. Nonetheless, weak external demand and soft commodity prices suggest there will be little upward pressure on prices in coming months. We anticipate average inflation of 2.0% in 2013, up slightly from 1.7% in 2012. There is no need for additional monetary easing. Bank Negara Malaysia is well sensitized to persistent external risks, but the domestic economy's robust performance so far suggests there is little need for monetary stimulus in the near term. Therefore, absent major adverse shocks, we see Bank Negara Malaysia remaining on hold throughout 2013, before initiating a moderate tightening cycle in 2014.

Outlook and Assumptions: Domestic Assumptions

We anticipate Greece will leave the Eurozone in 2014. With plenty of time to prepare for an exit, though, the impact on the global economy and financial markets will be limited. Elections take place as scheduled on 5 May, with no serious incidents of destabilizing violence. Outside of India and Japan, there will be very limited additional policy easing (monetary or fiscal) in Asia in 2013. Social tensions intensify over the medium term as a result of the growing influence of Islamist militancy and deteriorating inter-ethnic relations. Although an outbreak of violence is likely to be avoided, increased polarization of the three main ethnic groups is a strong possibility, and this will lead to modest capital flight.

Outlook and Assumptions: Alternative Scenarios

A full-year sequester in the United States would reduce 2013 growth there by about half a percentage point. We think this has a roughly 20% probability of occurring. A messy Greek exit from the Eurozone could trigger another global financial crisis with major negative impact on global growth and emerging market currencies. Malaysia's public finances could deteriorate sharply under the weight of public investment spending, continued heavy subsidy costs, and low non-oil tax intake. The weak state of public finances is a negative for the country's sovereign creditworthiness in the medium to long term. Social tensions and ethnic and religious polarization could deteriorate to a point whereby they undermine the investment climate and political stability. An outbreak of violence targeted towards ethnic minorities would greatly damage Malaysia's reputation among foreign investors and could also lead to domestic capital flight.

Economic Growth: Outlook

Some growth moderation is expected in 2013, but the outlook remains bright overall. Robust investment growth, driven by a combination of private-sector capacity expansion and government-financed infrastructure investment, and strong private consumption anchored in stable incomes, low inflation, and election-year government handouts, are two main support pillars for the Malaysian economy. Net exports, whose contribution to growth has been traditionally large, have lost some luster in recent quarters amid sluggish external demand and do not look yet poised for meaningful

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recovery. Nonetheless, growth of almost 5.0% in 2013 is widely anticipated; our recently upgraded forecast remains on the lower end of consensus. Policy settings are expected to remain largely unchanged, as fiscal largesse remains a feature of the policy landscape and particularly so in an electoral year. On the monetary policy side, the thriving economy suggests there is little need for further rate cuts, even though the inflation environment remains benign. We see Bank Negara Malaysia on hold through the rest of this year. Economic Growth Indicators 2010 Real GDP (% change) Real Consumer Spending (% change) Real Government Consumption (% change) Real Fixed Capital Formation (% change) Real Exports of Goods and Services (% change) Real Imports of Goods and Services (% change) Nominal GDP (US$ bil.) Nominal GDP Per Capita (US$) 7.2 6.6 2.9 10.4 11.3 15.6 2011 5.1 7.1 16.1 6.5 4.2 6.2 2012 5.6 7.7 5.0 19.9 0.1 4.5 303.5 2013 4.9 6.6 4.5 5.7 3.6 4.4 325.4 2014 5.2 6.2 3.9 4.1 6.2 5.8 350.3 2015 5.8 6.7 3.9 4.6 6.5 6.2 383.7 2016 4.6 5.5 4.0 5.8 4.2 5.0 416.0 2017 4.8 5.3 3.8 4.5 3.9 4.5 452.1

246.8 287.9

8,691 9,977 10,352 10,924 11,579 12,492 13,345 14,293

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

Economic Growth: Recent Developments

Strong finish to a better-than-expected 2012. The Malaysian economy grew 6.4% year-on-year (y/y) during OctoberDecember 2012, beating expectations and bringing the 2012 average to 5.6%. The fourth-quarter growth was the best since the second quarter of 2010 and was facilitated by a surprising drop in imports, which boosted the net trade contribution to GDP. The outright contraction in imports is somewhat at odds with continued robust growth in private consumption (6.1% y/y in the fourth quarter) and investment (15.0%). Although the pace of advance for each of these sub-components had slowed at the end of 2012, investment growth was actually almost twice as rapid as at the end of 2011. Assuming a steady propensity to import for consumer and investment demand, the implication is that it was a drop in consumer goods imports that caused the contraction in overall imports in the fourth quarter. If so, this has positive implications beyond the boost to net trade during the quarter. If decelerating consumer spending disproportionately affects imports, any such deceleration would have a lesser impact on overall GDP than would otherwise be the case. Given that Malaysian consumers are rather heavily indebted, it would not be altogether undesirable to see households rein in expenditures slightly in coming quarters. This scenario would be all the better, as this can be accomplished without a corresponding hit to the overall economy. An investment expansion of the magnitude witnessed in 2012 (an annual growth of 19.9%) has not been seen since 2000 and is unlikely to be repeated in the near term. With elections due within months, the government is bound to continue pursuit of heavy public infrastructure spending as part of the medium-term development plan. Nonetheless, with an already much larger base, the rate of further expansion is bound to slow. Similarly, foreign direct investment inflowswhich have staged a revival since 2010 and are a big driver for private investmentshould remain strong, but are unlikely to continue to scale new records. For these reasons, we anticipate fixed investment spending growth to moderate to the high single digits in 2013.

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Export demand moderated in 2011, but domestic demand remained resilient. The economy grew 5.1% in 2011, driven primarily by domestic consumption and investment. Most impressively, private consumption rose 6.9%somewhat surprising given elevated levels of consumer credit as well as disruptions to car imports as a result of natural disasters in Japan and Thailand. Other indicators, however, such as employment, income, and prices, were supportive of consumer confidence and spending. Government spending surged 23.6% y/y in the fourth quarter, reaching a new record high. Although public spending is relatively low in relation to overall GDP, this extremely high growth rate turned the sector into a sizeable contributor to GDP growth during the period. Investment spending rose a respectable 6.0%. The 2010 recovery exceeded early expectations. GDP grew an impressive 7.2% in 2010, marking the best performance in a decade. Although exports did recover handsomely, growing by 9.8%, robust import growth meant that net exports were not as powerful a growth driver as domestic demand. Indeed, private consumption gained 6.6%a far cry from the meager 0.7% expansion in 2009. Real fixed investment rose 9.4% in 2010, more than offsetting the 5.6% contraction recorded in 2009. Both public and private investments contributed to this good performance. Inventories, however, were truly central to the 2010 growth picturejust as we had predicted. Having experienced unprecedented inventory shedding in 2009, Malaysia's economic performance was lifted handsomely by inventory rebuilding in 2010.

Economic Growth: Consumer Demand - Outlook

Consumer spending is a key driver for the economy. Prospects for consumer spending growth over the medium term remain solid. Despite some dissipation of earlier pent-up demand, the fundamental factors driving consumer spending (high and rising incomes, a well-developed financial system that facilitates access to credit, low unemployment, and price stability) remain in place. One moderately restraining influence over the medium term may come from the policy angle. Currently, Malaysia has one of the highest ratios of household credit to GDP in Asia, and the central bank has recently hinted that more careful monitoring of private credit expansion is required. In addition, tax and subsidy reforms, if implemented, would likely mark a negative shock to household finances (at least temporarily). It is for this reason that we do believe that the pace of expansion in household spending should moderate to the 5.05.5% range over the next few years. Without such adjustments likely to occur in the near term, real private consumption should manage to grow by at least 6.6% this year and 6.4% on average in 201415.

Economic Growth: Consumer Demand - Recent Developments

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Consumers spend happily despite high debt levels. Although not a particularly large country in absolute population, Malaysia's relatively high per-capita income makes it an attractive target for retailers. Its per-capita income is more than six times higher than India's, three times higher than Indonesia's, and about twice as high as that of Thailand and China. In addition, those consumers have a relatively high propensity to consume, as evidenced by the fact that with one exception in 2010, the rate of growth in private consumption has exceeded total GDP growth each and every year over the past decade. This has resulted in a gradual rise in household consumptions share in GDP from 45% in 2003 to 49% in 2012.

Economic Growth: Capital Investment - Outlook

The medium-term investment forecast incorporates annual growth rates in the mid-single digits, with upside from government-financed infrastructure expansion. Hugely ambitious public investment plans are a major positive factor for Malaysias investment prospects over the near term. Beyond this horizon, though, the investment outlook is somewhat clouded by high labor costs relative to many of its neighbors, although Malaysia's superior business operational environment partly compensates for this. One factor that could boost our longer-term forecast would be a change in government policy towards a more aggressive pursuit of establishing higher value-added industries such as biotech and a renewed commitment to further improving the business and investment environment. An interesting trend that appears to be taking hold in recent years has been the surge in outward FDI from Malaysia, which seems to suggest that Malaysian companies might be looking to relocate production offshore to take advantage of cheaper labor costs elsewhere.

Economic Growth: Capital Investment - Recent Developments

Investment surged in 2012. Investment spending jumped 16.1% year-on-year (y/y) in the first quarter and accelerated further afterwards, bringing the annual expansion to 19.9%. This revival in investment validates Malaysia's continuing appeal as an investment destination thanks to its good infrastructure, relatively low corruption, and solid rule of law. The upbeat investment picture described by national accounts data has been mirrored by rising foreign direct investment (FDI) inflows in the balance-of-payments. Additionally, fiscal spending on infrastructure upgrades offered a tremendous boost to total investment spending. Thanks to the 2012 surge, the share of fixed investment in GDP has now reached 25% againthe level where it last stood in 2001 prior to the high-tech bust and the global financial crisis, which had brought the sectors share in GDP to a low of 21%.

Labor Markets: Outlook

The unemployment rate will remain stable in the near-to-medium term unless exports collapse. Absent dramatic swings in the real economyinduced, for instance, by a collapse in exportsMalaysia's labor market should remain fairly stable over the next year or so. The unemployment rate is expected to remain stable over the next year as slower industrial output growth is offset by sustained employment in the service sectors.

Labor Markets: Recent Developments

Labor-market improvements solidified in 201112. Labor-market conditions continued to improve over the course of 2010 thanks to sustained export demand that had propelled industrial production growth. These improvements solidified further in 2011, with the unemployment rate easing to 3.0% by the end of 2011, a level at which it remained through September 2012. The unemployment rate then ticked up incrementally to 3.1% during the last three months of 2012.

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Unemployment peaked in the first quarter of 2009. The sharp decline in export demand at the end of 2008 has forced companies to aggressively cut costs and inevitably pushed unemployment rates higher. The impact was not really seen until early 2009, when the unemployment rate jumped to 4.0% from 3.1% in the fourth quarter of 2008, mostly because the speed of the downturn took many firms by surprise. In addition, regulatory requirements also slowed the implementation of planned personnel cuts, as companies operating in Malaysia must inform the government of any planned layoffs one month in advance. Nevertheless, the unemployment rate fell back to 3.5% by end-2009. Labor shortages represent a long-term growth constraint. The quality of available labor is generally high, relative to the current manufacturing base, centered on labor-intensive light manufacturing. However, Malaysia's labor costs have risen relatively sharply, undermining cost competitiveness in labor-intensive industries in relation to major emerging markets, notably China. The market remains relatively rigid, bound by a significant level of regulation supporting positive discrimination towards bumiputras and high welfare commitments. Malaysia's relatively small workforceabout 10.5 million workersis evenly distributed across sectors, with 37% engaged in manufacturing and construction, 28% in local trade and tourism, 16% in agriculture, 10% in services, and the remainder in government. Nevertheless, Malaysia suffers from a relatively serious shortage of domestic labor in various sectors, including electronics, but also agriculture, which has been exacerbated by official campaigns to rid the country of thousands of illegal foreign workers. The government has thus sought to address the problem through a variety of policies in the education sector (see below), as well as diversifying the workforce by relying on some sources of foreign labor. As a result of fairly tight labor-market conditions, unemployment rates have historically been very low.

Inflation: Outlook
Inflation has bottomed but remains a nonissue. Headline consumer price inflation has steadily retreated in 2012 but looks to have now bottomed. Nonetheless, weak external demand and soft commodity prices suggest there will be little upward pressure on prices in coming months. We anticipate average inflation of 2.0% in 2013, up slightly from 1.7% in 2012. Inflation Indicators 2010 Consumer Price Index (% change) Wholesale-Producer Price Index (% change) 1.7 5.6 2011 3.2 9.0 2012 1.7 0.0 2013 2.0 -1.6 2014 2.9 4.2 2015 3.6 5.6 2016 3.6 5.1 2017 3.5 4.7

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

Inflation: Recent Developments

Headline inflation rose slightly in early 2013 on account of higher food prices. Food prices rose to a year high in February 2013, bringing the headline consumer price inflation to a multi-month high of 1.5%. The increase is not troublesome, however, as even with a doubling of the current inflation rate Malaysia would still compare favorably with most other countries. Besides, the latest uptick in prices seems (so far at least) to be contained to volatile food prices; durable and nondurable goods are still experiencing outright price declines.

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Disinflation intensified in 2012. Favorable base effects, tame global commodity prices, and easing food prices allowed Malaysia's consumer price inflation to decelerate notably in 2012. Having started the year at 2.7% year-on-year (y/y), the CPI rate declined to 1.4% y/y by July and to 1.2% y/y by December 2012, for an annual average of 1.7%. Food prices in particular played a key role in facilitating this trend: having started 2012 at 4.8% y/y, food inflation had eased to 2.0% y/y during NovemberDecember. Malaysia has a long tradition of price stability. It has historically enjoyed a benign inflation environment, thanks in part to its stable exchange-rate regime and good macroeconomic policies. Indeed, inflation rates have historically been more typical of a developed economy than of a developing one, having averaged just 2.9% during 19882007. Over the span of these two decades, inflation surpassed 5.0% only oncein 1998following a substantial depreciation of the ringgit. Between 2000 and 2007, annual inflation rates moderated further to an average of just 2.0% a year.

Exchange Rates: Outlook

Amid occasional bouts of weakness, the long-term outlook for the ringgit is one of moderate appreciation against the US dollar. The Malaysian ringgit enjoys strong fundamental support from large (although narrowing) current-account surpluses. Risks of speculative attacks on the currency are low relative to other regional markets, thanks to a lighter external debt burden and a large foreign-exchange reserve cushion. Depreciation episodes should therefore be mild and sporadic, with pressures more likely to intensify in the opposite direction, leading to currency appreciation. That said, acute spikes in global risk aversion can easily lead to temporary currency depreciation, as happened in May 2012, when the ringgit lost nearly 5.0% of its value against the dollar. Exchange Rate Indicators 2010 Exchange Rate (LCU/US$, end of period) Exchange Rate (LCU/US$, period avg) Exchange Rate (LCU/Euro, end of period) Exchange Rate (LCU/Euro, period avg) 3.08 3.22 4.12 4.27 2011 3.18 3.06 4.11 4.25 2012 3.06 3.09 4.04 3.97 2013 3.08 3.08 3.97 3.93 2014 3.07 3.08 3.90 3.84 2015 3.05 3.06 4.18 4.06 2016 3.01 3.04 4.31 4.25 2017 3.00 3.02 4.41 4.38

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank.

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Download this table in Microsoft Excel format

Exchange Rates: Recent Developments

The last few months of 2011 and MayJuly 2012 were unusually volatile periods, but the currency has swiftly recovered each time. The underperformance of Asian currencies over the course of SeptemberDecember 2011 was somewhat surprising given the region's robust economic growth and favorable external balances. In the case of some currencies, including the Malaysian ringgit, the last three months of the year proved to be as grueling as any month during the 200809 global financial crisis. In September 2011 alone, the ringgit lost more than 6.0% of its value relative to the US dollarthe worst monthly performance since the Asia crisis period. This panic-driven decline, linked to worries over the Eurozone debt saga, was short-lived, though, with the ringgit fully recovering its losses by February 2012. This improvement was once again disturbed in May 2012, when worries about the Eurozone led to generalized weakness in emerging market currencies and caused the ringgit to lose nearly 5.0% of its value relative to the US dollar. By midyear, though, the ringgit began appreciating anew, ending 2012 at MYR3.07/USD1.0. It traded at MYR3.09/USD1.0 at the end of March 2013.

Economic Policy: Monetary Policy and Outlook

No interest-rate changes expected in 2013. Bank Negara Malaysia is well sensitized to ongoing external risks but the domestic economy's robust performance suggests there is little need for monetary stimulus right now. In fact, with real private consumption growth hitting a four-year high in 2012, there has even been some talk of possible overheating. Therefore, absent some major adverse shock to the economy, we see Bank Negara Malaysia remaining on hold through early 2014, when a gentle tightening cycle will be initiated.

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Monetary Policy Indicators 2010 Policy Interest Rate (%, end of period) Short-term Interest Rate (%, end of period) Long-term Interest Rate (%, end of period) 2.75 2.60 3.98 2011 3.00 2.92 3.88 2012 3.00 3.04 3.52 2013 3.00 3.10 3.46 2014 3.25 3.27 3.67 2015 3.50 3.50 4.00 2016 3.72 3.88 3.82 2017 3.91 4.20 4.38

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

Economic Policy: Monetary Policy - Recent Developments

Monetary tightening in early 2011 gave way to a "hold" stance during the second half that continued through early 2013. The three rate hikes delivered in 2010 were followed by one more in May 2011 and by several increases in reserve requirement ratios over the course of 2011. However, as the previously sharp post-recession recovery gave way to more moderate rates of expansion in late 2011 and 2012, no further rate increases have been announced since then. The policy rate has now stood at the 3.0% level for 23 consecutive months. As the economy recovered in the post-recession phase, the interest-rate normalization cycle kicked off early 2010. The 25-basis point rate hike in March 2010 ended a 13-month-long "hold" stance and marked the beginning of a gradual move toward monetary policy normalization in the post-recession period. Additional rate hikes (of similar magnitude) followed in May and July 2010.

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Economic Policy: Fiscal Policy and Outlook

Structural constraints will keep fiscal deficits elevated over the medium term. Malaysia's policymakers favor countercyclical fiscal policies, with public spending on infrastructure and other development programs greatly boosted when the economy faces headwinds. This fiscal largesse is nevertheless posing sustainability problems. Structural reforms in the fiscal area are very much needed, particularly through expansion of non-resource tax revenues in order to meet ever-rising spending. Subsidy reductions constitute another critical although politically unpalatable element of reform; subsidies account for close to 15% (and, during periods of high oil prices, as much as 25%) of current expenditures, resulting in perennial fiscal deficits in the range of 35% of GDP. Recurrent promises by politicians to "balance the budget" remain nothing more than political rhetoric for the time being.

Economic Policy: Fiscal Situation - Recent Developments

Economic recovery facilitated a modest improvement in public finances in 2011. The budget deficit narrowed slightly to 5.4% of GDP in 2010 and further to 4.8% in 2011. It is fair to say, however, that the extent of Malaysia's fiscal consolidation has failed to impress. Ambitious investment programs, coupled with perennial delays in subsidy removals weigh on Malaysia's fiscal health. Non-oil tax revenues have been in a steady decline for years, limiting authorities' ability to meaningfully reduce the fiscal shortfalls. Fiscal spending stepped up to prevent deep recession. The Malaysian government announced a huge fiscal stimulus package on 10 March 2009, as it warned of an outright contraction in the economy for the first time in a decade. The 60-billion-ringgit (USD16.3 billion) package was the government's second supplementary budget, but it dwarfed the initial MYR7-billion round of stimulus. The package's total spending is equivalent to 9.0% of GDP. The second round of spending brought the total level of pledged fiscal stimulus to 10.0% of GDP. The fiscal package aimed to bolster the corporate sector and consumers. Job creation schemes featured heavily in the program aimed at bolstering consumer spending. Some of the infrastructure projects already scheduled under the government's existing five-year plan were to be brought forward, with MYR5.00 billion (USD1.35 billion) allocated in the stimulus package. Targeted projects include construction of a high-speed broadband network and expansion of existing airport facilities. An additional MYR2 billion was set aside for skills training and employment creation, with the aim of creating 163,000 apprentice and permanent positions in the public and private sectors. Employers who hire workers that have been made redundant were eligible for

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tax breaks. Finally, the package aims to support household disposable income through tax relief on interest payments on mortgages, up to MYR10,000 per year over three years, while farmers and fishermen are eligible for subsidized loans. The stimulus package, coupled with declining tax revenues, pushed the fiscal deficit to 7.0% of GDP in 2009.

External Sector: Outlook

Nominal goods exports will resume modest growth in 2013. The rapid expansion of foreign trade during 2010 brought exports and imports roughly back to where they stood prior to the global crisis. Since then, however, and even going forward, the magnitude of further advances will be hamstrung by complex adjustments in global saving and consumption patterns. The medium-term outlook envisions much more muted growth rates in the high single digits and low double digits. The forces of deleveraging, with consumers in key markets (United States and Europe) working through their debt burdens and raising their savings rates, and insufficient compensatory demand from China and other emerging markets suggest that demand for Malaysia's exports will be less buoyant over the medium term. We expect Malaysian exports to resume modest single-digit growth this year, having been flat in 2012. Trade and External Accounts Indicators 2010 Exports of Goods (US$ bil.) Imports of Goods (US$ bil.) Trade Balance (US$ bil.) Trade Balance (% of GDP) Current Account Balance (US$ bil.) Current Account Balance (% of GDP) 199.0 157.3 41.7 16.9 27.3 11.1 2011 227.5 178.6 48.8 17.0 32.0 11.1 2012 226.8 187.3 39.4 13.0 27.5 9.0 2013 235.2 202.4 32.8 10.1 19.0 5.8 2014 254.6 221.4 33.2 9.5 22.6 6.4 2015 277.1 243.9 33.1 8.6 18.8 4.9 2016 299.1 265.7 33.4 8.0 15.9 3.8 2017 321.1 287.8 33.3 7.4 11.8 2.6

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

External Sector: Recent Developments

Trade activity weakened in 2012. Reflecting weaker external demand and attrition in commodity prices, the dollar value of Malaysia's merchandise exports contracted by 0.3% last year, having expanded by 14.8% in 2011. Imports still managed a 4.9% gain, although the pace of advances has softened markedly from 13.9% the year before. Moreover, the uninspiring growth in capital goods imports and the outright declines in intermediate goods imports (which make up over 60% of total imports) suggest that businesses do not anticipate an imminent revival in export orders. On the other hand, the surge in consumer goods imports highlights continued resilience on the domestic demand side, particularly in consumption. Recovery gained momentum in 2010, but that momentum withered in late 2011. Thanks to shifting base effects and a major surge in trade activity in October, annual comparisons turned positive in OctoberNovember. By end-2009, even though imports and exports each fell 21% for the year as a whole, nominal trade was growing in double-digit rates. Indeed, exports were up 23.6% y/y in December 2009, while imports rose 28.3% (y/y). The trend accelerated further, and in March

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2010another strong month for industrial production and tradeexports and imports were up 50.7% and 60.5% from a year earlier, respectively. Nevertheless, March marked the cyclical peak as far as annual growth rates were concerned. With base effects becoming less favorable, the rate of expansion in exports slowed considerably over the second half of 2010. For the year as a whole, nominal merchandise exports grew 26.3%, while imports rose 33.0%. Foreign trade activity continued to expand steadily over the course of 2011, but more difficult base comparisons and a loss of momentum in external demand meant that by the end of 2011, annual growth rates for both exports and imports were down to single digits.

Economic Structure and Context: Development and Strategy

From commodity exporter to Asian tiger. Thanks to an aggressive export-oriented policy, Malaysia transformed itself from a primary commodity producer to a newly industrialized country (NIC) over a span of 20 years. Robust growth was interrupted by the 199798 Asian financial crisis, although its effects were contained by the imposition of capital controls and highly expansionary fiscal policies. Ongoing restructuring has since greatly strengthened the financial sector. Nevertheless, some long-term challenges to growth exist: the economy needs to move up the value-added chain to preserve its competitiveness against fast-growing markets such as China. Deeper deregulation and increased openness of the labor market are required to strengthen the investment climate, promote innovation, and foster entrepreneurship. The New Economic Policy (NEP) and the Look East strategy have shaped Malaysia's economic development. The NEP was formulated in response to the race riots of 1969, and aimed at a more equal distribution of wealth through economic growth. Specifically, the program was focused on boosting the economic position of the Malay community, which, despite being the country's largest ethnic group had little to no economic clout. In 1971, the ownership of capital was 63% foreign, 34% non-Malay, and less than 3% Malay. The aim was to raise the Malay share of capital ownership to 30% and that of the Chinese community to 40% by reducing the foreign proportion to 30% in a 20-year timeframe. In tandem, the Look East framework emphasized an Asian model of development, promoting intra-regional trade. Within that framework, growth was fostered by the adoption of the classic Asian model: export sectors were liberalized while the development of domestic industry was centrally directed and shielded by protective regulation. These policies have brought about significant economic gains, although the downside of the positive discrimination policies favoring Malays (deepening resentment among non-Malay population, slower rate of innovation) have become more obvious over time, and have weighed on the country's international competitiveness recently. In early 2009, the government has announced steps to relax the NEP. Along with other measures aimed at encouraging foreign investor participation in the economy, these adjustments are hoped to lead to a more efficient and competitive business environment in coming years.

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Despite significant success, challenges remain. The country's developmental strategies were very successful at attracting foreign investment and boosting growth. In the 1990s, GDP growth averaged 8.3%one of the highest rates in the world. Nevertheless, some aspects of the programs were less successful, particularly the government's effort to lift the economic status of the Malay community. Former Prime Minister Mahathir, a long-term supporter of the idea, expressed disappointment over the program's performance when leaving power several years ago. He suggested that the program had had unintended consequences, one of which was to foster an attitude of dependency on government support, rather than a true entrepreneurial spirit among the Malays. Decades of positive discrimination have also bolstered an attitude of ethnic superiority among the Malay population, which has, at times, resulted in policy decisions that were, in fact, detrimental to growth.

Economic Structure and Context: Demographics and Labor Markets

Labor-market rigidity poses risks to economic growth. Malaysias labor force is relatively small, estimated at 12.5 million people as of 2011. Some industries such as the palm oil plantations rely on foreign workers, usually brought in from Indonesia. The workforce is broadly distributed across sectors, but is increasingly concentrated in services. In 2011, about 27% of workers were employed in manufacturing and construction, 12% in agriculture, and the rest in a variety of services ranging from retail to tourism to healthcare. Having steadily declined after the Asia crisis, the labor force participation rate has started to increase again in the last several years and currently stands at about 65%. Malaysia enjoys above-average demographics, with the overall population and the labor force expected to continue to grow through the forecast horizon; however, female labor force participation is somewhat constrained. The quality of labor is relatively good, especially when compared with other Southeast Asian countries such as Indonesia. Nevertheless, Malaysia's labor costs are also considerably higher, undermining cost competitiveness in labor-intensive industries vis--vis big emerging markets such as China and Vietnam. The introduction of the countrys first-ever minimum wage in 2012 is expected to further undermine labor competitiveness in low-end manufacturing industries. Additionally, the labor market remains relatively rigid, bound by a significant level of regulation supporting positive discrimination towards bumiputras (ethnic Malays and other indigenous groups) and high welfare commitments.

Economic Structure and Context: Monetary System

The central bank of Malaysia functions according to the revised Central Bank of Malaysia Act of 2009, which strengthened the bank's independence. Its powers of enforcement remain constrained, however. Bank Negara's main objective is to promote monetary and financial stability while encouraging economic growth. The monetary policy framework shifted from money-supply targeting to interest-rate targeting following the Asian Crisis because the former was rendered imprecise and difficult to manage by inflows of foreign moneys. The exchange-rate arrangement was changed from a peg to the US dollar to a managed float in July 2005, following a similar move by Chinese authorities. Generally speaking, the bank has good credentials and is credited with maintaining financial stability in the country.

Economic Structure and Context: Financial System

Consolidation has strengthened Malaysia's banking sector in the aftermath of Asia crisis. Following the Asia crisis, bank restructuring and recapitalization has been coordinated by Danaharta, an independent agency supported by over USD2.1 billion of government capital. Sister organization Danamodal issued bonds to provide funds for further recapitalization. As a result, Malaysia has made more progress in restructuring than many of its Asian neighbors. Following successful corporate restructuring, solvency and liquidity ratios have been drastically strengthened while profitability has increased. The country's 54 former banks have been forced by the government to merge into one of 10 core groups, boosting core financial ability and market presence. The focus of reform under the direction of the central Bank Negara Malaysia has now shifted to improving regulation and bolstering competition in the sector through deregulation.

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Gradual liberalization improves competitiveness. Restrictions that forced foreign banks to raise at least 50% of their credit from domestic banks have been lifted in a bid to boost overseas participation, while interest rates were liberalized in April 2004 to generate greater competition. Under the new system, banks are now allowed to set their own base lending rates (BLRs), guided by a new unified benchmark rate, the overnight policy rate (OPR).

Economic Structure and Context: Key Sectors

Malaysia: Top-10 Sectors Ranked by Value Added 2012 Level (Bil. US$) 1. Agriculture 2. Oil and Gas Mining 3. Public Admin. and Defense 4. Retail Trade - Total 5. Wholesale Trade 6. Banking and Related Financial 7. Construction 8. Communications 9. Refined Petroleum and Coke Prod. 10. Hotels and Restaurants Top-10 Total
Source: World Industry Service, IHS Global Insight, Inc. Updated: 16 Apr 2013

2013 Percent Change (Real terms) 2.1 1.5 5.3 4.4 4.4 6.8 4.4 6.0 1.8 5.0

Percent Share of GDP (Nominal terms) 12.1 9.2 8.1 6.9 6.8 4.8 3.7 3.1 2.9 2.7 60.2

36.4 27.6 24.4 20.7 20.6 14.5 11.1 9.2 8.7 8.1 181.3

Economic Structure and Context: Natural Resources

Natural resources support Malaysia's major industries and are an important source of foreign-exchange earnings through direct exports. Malaysia is fairly rich in natural resources. Indeed, much of its initial development was built on commodity exports. Timber, palm oil, and rubber are abundant, and the country is one of the largest palm oil producers in the world. Thanks to a good-sized maritime coast, fisheries are also an important resource. Mineral resources include petroleum and natural gas (the country is a small net oil exporter), but reserves are modest. Among metallurgical deposits tin, copper, iron ore, and bauxite are the most significant.

Economic Structure and Context: Trade Profile

An export-oriented growth strategy has made Malaysia one of the most trade dependent economies in the world. Exports and imports, cumulatively, account for over 200% of GDP. The United States is the largest export market, accounting for about a fifth of merchandise exportsa reflection of Malaysia's successful electronics industry. Otherwise, however, trade is highly concentrated within Asia. Singapore, Japan, and China are among the top trading partners by volume, and there are strong exchanges with Taiwan and Thailand as well. Electronics dominate both exports and imports, given Malaysia's strong focus on electronics and semiconductors industry, as well as large imports of intermediate goods that are

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re-exported following additional processing. Crude oil and natural gas exports are similarly matched by imports of refined petroleum products. Other major exports include various commodities such as wood and wood products, palm oil, and rubber. Malaysia: Major Trading Partners, 2011 EXPORTS Country China Singapore Japan United States Thailand Hong Kong India South Korea Australia Indonesia
Source: IMF, Direction of Trade

IMPORTS Billions of USD 29.9 28.8 26.1 18.9 11.7 10.2 9.2 8.4 8.2 6.8 Percent Share 13.1 12.7 11.5 8.3 5.2 4.5 4.1 3.7 3.6 3.0 Country China Singapore Japan United States Indonesia Thailand South Korea Germany Hong Kong Australia Billions of USD 24.7 24.1 21.4 18.1 11.5 11.3 7.6 7.2 4.4 4.2 Percent Share 13.2 12.8 11.4 9.7 6.1 6.0 4.0 3.8 2.4 2.2

Malaysia: Major Trading Partners, 2000 EXPORTS Country United States Singapore Japan Hong Kong Netherlands Thailand South Korea United Kingdom China Germany
Source: IMF, Direction of Trade

IMPORTS Billions of USD 20.2 18.1 12.8 4.4 4.1 3.6 3.2 3.0 3.0 2.5 Percent Share 20.5 18.4 13.0 4.5 4.2 3.6 3.3 3.1 3.1 2.5 Country Japan United States Singapore South Korea China Thailand Germany Indonesia Hong Kong Philippines Billions of USD 17.3 13.7 11.8 3.7 3.2 3.2 2.4 2.3 2.3 2.0 Percent Share 21.1 16.6 14.3 4.5 3.9 3.9 3.0 2.8 2.8 2.4

Medium- and Long-Term: Outlook

Competition from lower-cost producers poses a growing challenge. Because Malaysias economy is so highly dependent on exports, anything that affects world demandparticularly for electronic products, but also for commodities such as hydrocarbons and palm oilrisks hurting its economic growth. The economy does not suffer from serious imbalances, although fiscal policy remains too loose. Nevertheless, there is the risk of complacency and the related loss of competitiveness as new, rapidly reforming economies attract increasing foreign direct investment (FDI) inflows. Indeed, Malaysia must continue to reinvent and position itself more aggressively as a higher-end production platform, at the cutting

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edge of technological progress. An interesting development in recent years has been the rising value of outward FDI from Malaysia, suggesting that an increasing number of Malaysian businesses are themselves looking to outsource production elsewhere in Asia. At the moment, it appears that Malaysia's development strategy over the medium term will focus more on developing a world-class service industry, such as Islamic finance (in which it has already developed a world-class reputation) to offset its gradual loss of competitiveness in manufacturing. Ethnic and religious tensions are risks to internal stability. Political risk has been low for the past 20 years, but since the 2008 elections, which resulted in unprecedented gains for the opposition forces, we have seen more instability in the political arena. Although a more vibrant democracy is a positive factor in the long run, there are near-term concerns about the direction of macroeconomic policymaking. Indeed, a significant problem with Malaysia's investment environment, and one that poses risks to its long-term economic performance, relates to the sensitivity of ethnic relations. Malaysia has adopted an affirmative action policy in favor of the Malay majority. In practice, this policy has given rise to vested interests and has obscured the commercial rationale behind key economic transactions. The neglect of commercial considerations in favor of the political ideas of ethnic-Malay empowerment in business has reduced the overall efficiency of the Malaysian economy. The highly centralized government system has fostered unhealthily close relations between political and corporate circles, with charges of corruption, cronyism, and opacity commonly leveled at the operational environment.

Analyst Contact Details:

Simona Mocuta

Malaysia: Country Reports - Recent Analysis

Economic

1. Malaysian consumer price inflation inches slightly higher in March

18 APR 2013

Economic

2. Malaysian industrial output shrinks in February, weakness probably exacerbated by seasonal effects
12 APR 2013

Economic

3. Malaysian exports disappoint in February falling to two-year low

08 APR 2013

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Sovereign Risk - Economic

4. UN data show Malaysian FDI to Africa tops China in 2011

01 APR 2013

Economic

5. Malaysian inflation inches higher in February as food prices hit year high
21 MAR 2013

Sovereign Risk - Economic

6. Malaysia's January trade surplus lowest since mid-2002

12 MAR 2013

Economic

7. Malaysian IP growth improves slightly during January

12 MAR 2013

Economic

8. Bank Negara extends hold stance on Malaysia's monetary policy

08 MAR 2013

Economic - Country

9. Upside surprises continue across ASEAN with better-than-expected Malaysian Q4 GDP numbers
21 FEB 2013

Sovereign Risk - Economic

10. Malaysia's industrial production slows in December 2012, trade disappoints

11 FEB 2013

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