Aggregate demand
On the demand side, private consumption will remain the key driver of growth in 2000/01. The counter-cyclical measures implemented by the government have effectively raised disposable income and consumer confidence.
Apart from the fiscal stimulus, the wealth effect created by the strong performance of the local stock market is likely to boost private spending further. Most consumption indicators confirm the uptrend.
Private investment was a drag since the outbreak of the financial crisis. Last year, private investment declined further to RM33 billion from 1998’s RM44 billion in nominal terms. In contrast, private investment was a key contributor of pre-crisis growth, when massive investment was poured into the economy to expand production capacity as well as to improve infrastructure.
Private investment is expected to remain weak this year, but pick up in 2001. The evidence of excess capacity is still apparent in many basic industries. However, the transformation towards a knowledge-based economy is likely to accelerate demand for new investment. Lack of skilled labour in meeting the demand of the New Economy may result in a strong and more concentrated human resource investment.
Last year, the funding of counter-cyclical programmes to promote economic recovery amid moderate increases in revenues resulted in an overall balance deficit of RM9.5 billion or 3.4 per cent of gross national product (GNP). The deficit spending is estimated to increase further this year to RM13 billion or 4.5 per cent of GNP. Though the rate of deficit is not alarming, it is definitely outside the comfort zone. Comparatively, Malaysia’s budgetary position is less favourable than that of its counterparts in the region. This trend seems to indicate the limited capacity of the government to contribute to growth in 2001.
Malaysia’s rapid recovery last year was owed largely to a favourable external environment. In 1999, net exports accounted for 23 per cent of GDP, the highest in history, and we expect this ratio to stay above 20 per cent this year on the back of a brighter global outlook. Higher export earnings are expected to be supported by the acceleration in semiconductor billings (25 per cent vs 17 per cent last year), the single largest export item of Malaysia.
Economic activities are expected to gain momentum in every region, but moderate in the US. World growth is estimated to increase to 4.0 per cent in 2000 (1999: 2.8 per cent). It is now approaching a full-blown synchronous recovery, the first since 1994. Such an event tends to have very cyclical implications for inflation and interest rates. Consequently, we have priced in the risk of monetary policy-makers around the world raising short-term rates before inflation become visible, to keep growth and inflation in equilibrium.
Among the emerging markets, Asia will probably remain the world’s fastest-growing region, on the back of current account surplus and low interest rates. Most, if not all, East Asian countries hit by the financial crisis have recovered. Strong domestic demand is gradually taking over from exports for growth.

Supply side
Last year, the manufacturing sector, underpinned by favourable domestic and external demand, led sectoral growth. Value-adding by other major sectors, except construction and mining, increased. The export-oriented industries were led by electronics (12.9 per cent) and the domestic-oriented industries, by transportation equipment (13.1 per cent).
The construction sector, which declined 23 per cent in 1998, finally turned around in the second half of last year (1.8 per cent). This reflected substantial fiscal stimulus by the government in roads, utilities and housing. The mining sector contracted as crude oil production was l4.4 per cent lower at 693,000 barrels a day, in line with recommendations of the National Depletion Policy. Meanwhile, improvement in the overall economy should lead to decent gains in the services sector.
The potential output gap is expected to narrow further this year as demonstrated by Bank Negara. Essentially, this indicates further growth in 2000 (and perhaps going into 2001) would not be subjected to cyclical constraints. We forecast that supply growth will continue to be led by the manufacturing sector. A more visible recovery of activities in the construction and services sectors is expected.

External front
The strength of the Malaysian balance of payments has clearly shifted from the capital account (mainly foreign direct investments or FDIs) to the current account following the financial crisis. This implies that the economy has attenuated substantial future economic rents. Last year, the overall balance of payments position continued to record a surplus of RM17.8 billion.
The current account achieved a surplus of RM47.4 billion or 16.9 per cent of GNP, the highest in Malaysian history. Favourable external demand, an undervalued currency and smaller capital imports have contributed to the superb performance.
Long-term capital recorded net inflows of RM11.7 billion during the year. Contrary to market expectations, FDI was higher but partially counterbalanced by higher Malaysian investments abroad. The overall balance of payments increased RM17.8 billion last year after netting significant outflows of short-term investments and errors and omissions of RM40.2 billion during the year. Consequently, Bank Negara’s total external reserves increased to RM117.2 billion, sufficient to cover 5.9 months of retained imports.
In 2000, the balance of payments is estimated to record net inflows of RM50 billion on the back of a current account surplus and zero outflows in the capital account. Given that the Kuala Lumpur Stock Exchange will be re-instated into the Morgan Stanley Capital International indices in May, positive inflows of short-term funds are expected.
While this trend appears highly desirable, it adds complexity and difficulty to the sterilising of inflows by Bank Negara.

Monetary situation and interest rates
Last year, the inflows of funds and low new loan take-up increased liquidity in the financial system. Outstanding loans in the banking system grew by a mere 0.3 per cent while deposits expanded by 4.0 per cent. As a consequence, the loan-deposit ratio declined to 84.1 per cent, the lowest since 1994. In response to the excess supply of funds, the benchmark three-month Kuala Lumpur Inter-bank Offered Rate (Klibor) fell from 6.4 per cent in the beginning of the year to 3.2 per cent in June. The interest rates remained firm at this level.

Conclusion
The favourable economic conditions — current account surplus, subdued inflation, abundant liquidity and encouraging external demand — reinforce our optimism over the economic revival in Malaysia in 2000/01.
While there are no serious supply-side risks, a shortage of labour and particular/specialised skilled labour could pose minor supply constraints. Meanwhile, soft credit-demand and increasing liquidity would keep interest rates low. Going into 2001, the narrowing of the potential output gap and low interest rates should accelerate the momentum in private investment. The direction of interest rates would then depend on the discretion of the authorities, according to policy.

Policy responses
The contemporary policy target and impact
Over the past few years, the government’s macroeconomics have succeeded in dealing with the immediate requirements of the economic condition — reviving growth and consumer confidence.
Given the current state of the economy, we believe these policies will remain effective in the short term, but not for long.
The budget deficit spending and accommodative monetary stance will continue to spearhead growth this year. The main policy target remains centred on consumption.
Consequently, the promotional efforts focus on areas that have strong linkages in the economy, that is, small- and medium-sized projects, educational infrastructure and low-cost housing — thereby enhancing the multiplier effect on consumption.
Monetary policy is likely to be stable this year. There is no compelling reason for changing the policy despite the discomfort of some market critics. On the exchange rate, capital controls and the pegging of the ringgit will remain the core economic policy over the medium term.
This is still highly desirable. Unless new fundamentals emerge — the creeping up of imported inflation due to improved purchasing power, significant inflows of portfolio investment, or the rising need of a stronger currency for the import of investment goods — the policy-makers are likely to keep the peg and capital controls.
Bank Negara would keep interest rates low, in line with the expansionary fiscal policy and partly reflecting the equilibrium of the demand and supply of funds. However, if we take a closer look at the interest rate policy, it is actually being managed to serve three distinct micro functions over the last one year.
• First, the lending rate was kept low to ease borrowers’ interest burden, and to check the downward spiral of non-performing loans. It is also aimed at stimulating economic activities, as the investment hurdle rate is kept low.
• Second, the intervention rate was kept at 5.5 per cent, less than 200 basis points above the three-month Klibor of 3.2 per cent. This allows banks to still maintain a decent profit margin.
• Third, the deposit rate was kept above the inflation rate to prevent dissavings. However, as loans growth for investment purposes is still low, Bank Negara may be compelled to sacrifice banks’ margins by lowering the intervention rate, thereby reducing the lending rate without affecting the savings rate.
Bank Negara explicitly admits that while it is engaging an expansionary monetary policy, assets price is not a target. Rightly or wrongly, by pursuing policies that have a significant impact on asset prices, particularly equities, it would generate an effective short-term response to revive growth.
This is especially so, given the significant size of the KLSE market capitalisation of more than 100 per cent of GNP.

The flip-side of current pursuit
However, beneath the surface of a seemingly healthy re-charged economy, some disquieting signs are emerging:

Return to investment for growth?
Export growth appears to have limited potential for further upside. The growing dependence on electronic products increases risk. At the same time, it would be too dangerous to pursue consumption growth by using an extreme expansionary policy for too long, especially since the Federal Government budget deficit is stretching a little too far for comfort.
Given these constraints, the policy-makers have only one option at its disposal — investment. This may lead to a bias policy target moving towards investment sooner than expected. A key consideration would be to keep interest rates low.