David Pilling
Financial Times
September 2, 2015

The country is facing comparisons with the 1997 Asian financial crisis

Malaysia is in the middle of a political maelstrom. But the country’s worries do not stop with the scandal affecting Najib Razak, the prime minister. Weak oil prices, a creaking Chinese economy and the prospect of higher US interest rates have all hit Southeast Asia’s third-biggest economy simultaneously. Could this be a re-run of the 1997 financial crisis?

Critics will call such a scenario alarmist. In many ways, Malaysia appears to be in better shape than it did before the last Asian financial crisis. It has had consistent current account surpluses, as opposed to deficits in the run-up to 1997. Its foreign exchange reserves, though depleted, are nearly double the four months’ export cover it had in 1996, the year before the precipitous fall of the Thai baht triggered capital flight all over Asia. Malaysia was not the worst affected back then. That honour went to Indonesia. Even so, Malaysia’s economy shrank more than 6 per cent in 1998.

What about now? Of all the Asian economies, Malaysia looks most vulnerable. “Comparisons with 18 years ago are not completely wide of the mark,” says consultancy Capital Economics in a note. Much of the problem is down to oil. Most Asian economies are net importers. They benefit when oil prices fall. Not so Malaysia. Although more diversified than it once was, it is still adversely affected by soft commodity prices. Oil and gas, together with palm oil, make up 30 per cent of exports. Last year, the oil and gas industry supplied a third of government revenue. Although Malaysia runs a current account surplus — of about 2.7 per cent of gross domestic product in the year to June — it has been coming down fast. Back in 2008, it was a heady 17 per cent of GDP.

“Malaysia is in a tight spot,” says Fred Neumann, chief Asia economist at HSBC. “It is sitting on the wrong side of the commodity downturn and is very reliant on credit.” Two years ago, reserves were 3.7 times short-term external debt. Today, that has sunk to 1.0 times. Reserves are falling faster than you can say 1MDB (the acronym of the sovereign development fund at the centre of the alleged corruption scandal). By mid-August they were $94.5bn compared with $106.4bn at the end of May. That reflects the central bank’s clumsy attempts to halt the ringgit’s slide. Those efforts failed; the Malaysian currency has dropped to a 17-year low of 4.17 to the dollar, not far from the 4.57 it hit in 1997 — after which the government introduced drastic capital controls. “They’ve spent $12bn of foreign exchange reserves in six weeks and achieved nothing,” says one alarmed banker. “That’s clearly unsustainable.”

Malaysia has relied on credit to sustain growth. According to HSBC, total debt, including household, corporate and public, is proportionally higher than in China and has risen faster. Household debt alone is at 80 per cent of GDP. In these circumstances, it would be nice if the central bank could cut rates. It is more likely to raise them to defend the ringgit and stem capital flight. For many years, Malaysian government bonds have been a favoured instrument of fund managers. Fitch recently maintained its A- rating on sovereign bonds and surprised some by upgrading its outlook from negative to stable. But if bondholders get skittish, they could quickly precipitate a downward spiral.

It is vital at such times to be focused. The government, fighting for its political life, is anything but. Mr Najib, who is facing questions about nearly $700m found in his private bank account, doubles up as finance minister. He denies any wrongdoing, but who could blame him if he were a little distracted?

It is also important to have trusted institutions. Malaysia does not do too badly on international rankings. On Transparency International’s Corruption Perception Index for 2014, it came in at 50 out of 175. Still, the 1MDB scandal has revealed some flaws. The auditor-general investigating the prime minister was shunted aside. A task force co-ordinating the probe was halted when Mr Najib promoted four of its members. Even the normally respected central bank has faced questions about its oversight of a system through which vast funds, of mysterious provenance, are alleged to have slipped like ships in the night.

Doubts about Malaysia’s institutional integrity will not help if it comes under speculative attack. Longer term, institutional weakness makes it less likely the country will achieve the high-income status it wants by 2020. That is why it needs to bolster the independence and integrity of its institutions. Even assuming it avoids a crisis, predicts Krystal Tan of Capital Economics, the perception of deep-seated institutional problems will persist. She cannot see the economy growing much above 4 per cent over the next decade. If she is right, it will be a long time before Malaysia extricates itself from the middle-income trap.