asian development outlook 2004: foreign direct investment in developing asia

8/7/2019 Asian Development Outlook 2004: Foreign Direct Investment in Developing Asia

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East Asia Taipei,China 65

spending was made in the second half of the year.Also in the second half, public investment pickedup, having declined for several years. e weak rst-half economic performance and expansionary scal policies pushed the central governmentbudget de cit to over 3.0% of GDP and publicdebt to more than 30% of GDP.

As a result of subdued domestic demand inrecent years, plus lower import prices and intensecompetition in local markets, the economy hasfaced de ationary pressures. e CPI remainedunchanged in 2001, declined by 0.2% in 2002, andfell by a further 0.3% in 2003. In the second half of that year, de ationary pressures abated as theeconomy strengthened and import prices of rawmaterials rose. Monetary policy, eased since 2000,remained accommodative: the offi cial discountrate and money market rates fell to historicallows. e M2 monetary aggregate grew moder-ately in 2003, in line with the economys perfor-mance. Stock market prices rallied in the secondhalf, with the Taiwan Stock Exchange WeightedPrice Index gaining 20.3%.

e trade surplus widened in 2003, re ectinga near 14% rise in exports in the second half. isand the expansion of net income receipts led toa marked improvement in the current accountsurplus. Direct investment recorded a net out ow,but the in ow of portfolio investment posted

record gures in 2003, re ecting the large-scaleportfolio allocation of international funds intoAsia. Large current account surpluses, as well asthe net in ow on the nancial account, resultedin continued accumulation of substantial foreignexchange reserves, totaling US$206.6 billion by year-end, or the third largest in the world a erJapan and the PRC.

Policy Developments

e authorities raised public spending moder-ately as a result of SARS. In April and May, they announced spending of NT$50 billion (US$1.4 bil-lion) to help cover business losses and bonuses todoctors and nurses required to take care of SARS

patients. In addition to the Expansion of Employ-ment Plan, the authorities launched an Infra-structure Expansion and Economic RevitalizationProgram to boost domestic demand and employ-ment; the combined budget was US$2 billion. By December 2003, 104,000 jobs had been createdthrough the plan and 100 public projects had beenselected for implementation under the program.

Various tax reductions and incentives havebeen introduced in recent years in an eff ort tostimulate output. However, these reductions andthe slow economy have eroded tax revenues,

which amount to less than 9% of gross nationalproduct (GNP), as against central governmentexpenditures of about 16% of GNP. Furthermore,about 70% of the expenditures are stipulated by law, which leaves little room for reductions. As aresult, the ratio of the central government de citto GDP widened from 2.5% in 2002 to 3.1% in2003; over a longer perspective, the ratio of publicdebt to GDP has risen from 14.8% in 1994 to31.7% in 2003. Although the debt ratio is stillmoderate by international standards, the upwardtrend has caused some concern to policy makers.

e Central Bank of China (CBC) cut thediscount rate on 15 occasions between December2000 and June 2003 for a total of 337.5 basispoints, to a historical low of 1.375% in an eff ortto boost domestic demand and alleviate de a-tionary pressures. Commercial bank lendingrates, however, remained in exible for some timeas banks took advantage of higher interest ratespreads. To make the monetary transmissionmechanism more responsive, CBC introduced

Figure 2.5 Growth Rates of GDP and Its DemandComponents, Taipei,China, 19992003

Source: Directorate-General of Budget, Accounting, andStatistics.


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66 Asian Development Outlook 2004

adjustable rate mortgages and a base rate system,which move in line with market rates and havemade the rates system more exible. Interestrates are likely to remain low for some time, eventhough the economy has rebounded. In December,CBC le key interest rates unchanged, but themoney supply target for 2004 has been increasedin response to rmer economic conditions.

Economic weakness has prompted the inten-sication of reforms in several Asian economies,and in this context, the authorities in Taipei,Chinahave identied nancial reform as a major focus.

is is partly to answer the calls for nancialreform that were triggered by an increase inNPLs, which stemmed from a period of substan-tial property-backed lending by banks prior to1997 and the subsequent downturn of the realestate market.

Various measures were adopted to resolvethe NPLs. e Financial Restructuring Fund,established in July 2001 with a capitalization of US$4 billion, has liquidated 44 insolvent commu-nity nancial institutions. Under the revisedstatute for this fund, which is being reviewed by the Legislative Yuan, the fund will be replenishedso that it can be used to facilitate the acquisitionof nancially troubled banks and other lendinginstitutions by healthy ones. Asset managementcompanies are encouraged, through incentivessuch as tax breaks, to help dispose of the NPLs.

e nancial reforms are indeed yielding results:the average NPL ratio of domestic banks at end-2003 was 4.3%, down from a peak of 8.0% inMarch 2002.

Financial reforms have been extended to covercorporate governance and prudential regulation.

e Financial Institution Merger Act and Finan-cial Holding Company Law were passed in 2000and 2001, respectively, to provide incentives fornancial institutions to consolidate and so reducethe number of banks. A new agency, the FinancialSupervisory and Management Committee, will beestablished on 1 July 2004 to bring the supervisionof banks, securities and futures houses, and insur-ance companies under one roof, although CBCwill retain the power to conduct examinations to

monitor nancial activities relevant to monetary policy. Other nancial reform measures includethe privatization of SOCBs and moves towardallowing universal banking. ese reforms areexpected to improve the efficiency and stability of the nancial sector.

Reforms have also been spurred by increasedcompetition with the PRC for labor-intensiveindustries. e relocation of some produc-tion to the PRC (and elsewhere) has promptedthe authorities and the business community in Taipei,China to encourage the upgrading of technology and generally to make industriesmore efficient. e economys early years of highgrowth were characterized by a rapid move toindustrialize; the latest phase is to develop high-technology and services-oriented industries. Atransition like this involves adjustment costs, suchas unemployment, as older industries move away.

ese costs fall unevenly on different industriesand members of society, and require official poli-cies to mitigate the social and economic impact.

Table 2.5 Major Economic Indicators, Taipei,China, 20012005, %

Item 2001 2002 2003 2004 2005

GDP growth -2.2 3.6 3.2 5.4 4.7Gross domestic investment/GDP 17.7 16.9 17.2 17.8 18.5

Ination rate (consumer price index) 0.0 -0.2 -0.3 0.8 1.2

Money supply (M2) growth 4.4 2.6 5.9 5.5 5.0

Fiscal balance/GDP -1.5 -2.5 -3.1 -3.0 -2.9

Merchandise expor t growth -17.3 6.4 10.5 8.0 7.4

Merchandise impor t growth -23.7 3.4 12.2 8.7 7.6

Current account balance/GDP 6.4 9.1 10.0 6.9 6.0

Sources: Central Bank of China; Directorate-General of Budget, Accounting, and Statistics; staff estimates.


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East Asia Taipei,China 67

Outlook for 20042005

GDP growth is expected to strengthen to 5.4% in2004 on the back of surging exports, a continuedrise in domestic demand, and structural changesin the economy, though this rate is forecast tothen slow to 4.7% in 2005. Buoyant externaldemand, especially for IT products, will be aboost to economic growth in 2004. Exports of goods and services are likely to strengthen by 8.0% in 2004 and by 7.4% in 2005. Higher levelsof exports and capacity utilization have promptedmajor exporters to increase capital spending,and still further investment is likely. Some majorcompanies, such as Taiwan Semiconductor Manu-facturing Co., the worlds largest semiconductor

foundry, have indicated that they will raise theirinvestment in 2004. Bank loans to the privatesector are increasing to meet this demand. Tech-nological upgrades in the IT industry will alsorequire greater capital investment. Indeed, asurge in investment by 8.5% in 2004 and 7.5%in 2005 is expected to be a major factor in therobust overall economic performance.

e gains in exports and capital investment,in turn, should revive the labor market. Higheremployment and rmer asset prices will likely bolster private consumption, which is expected

to expand by 4.0% in 2004 and by 3.8% in 2005.Ination is projected to rise, but to remain lowat 0.8% in 2004 and 1.2% in 2005, reecting thecompetitive pressures in the domestic market.Strong economic and revenue expansion willnarrow the budget decit. Public debt, however, isforecast to rise because of the upturn in govern-ment borrowing to nance new projects. Interestrates may rise in 20042005, but will likely remain moderate, partly because of low domesticinationary pressures. Strengthening domesticdemand will see growth of imports at 8.7% and7.6% over the forecast period, outpacing that of exports, leading to smaller trade and currentaccount surpluses.

e economy depends heavily on the perfor-

mance of its key trading partners, so this gener-ally upbeat outlook assumes that the globaleconomy will strengthen in 20042005.

While the economy is well on the road torecovery, longer-term policies need to addressseveral challenges, three of which stand out. erst is rising income inequalities. Income percapita in Taipei,China is at a relatively high levelof about US$12,000. However, according to officialstatistics, the ratio between the incomes of thehighest and lowest quintiles widened from 5.4 in1996 to 6.2 in 2002. Whereas the economy grewbriskly in the 1970s and 1980s, with low unem-ployment and relatively even income distribution,since the early 1990s the development of elec-tronics and other high-tech industries has seen

incomes of skilled workers increase rapidly, whileincomes for the unskilled have crept up moreslowly or even declined, widening the income gap.Higher unemployment has also contributed tothese income disparities.

e second challenge is how best to managethe relationship between deepening economicintegration on the one hand and potential politicaluncertainties on the other, between Taipei,Chinaand the PRC. e PRC is now Taipei,Chinaslargest export market and largest investmentdestination, and economic integration between the

two economies benets both of them in the longrun. However, any uncertainties could hamperinvestment and growth on both sides of the strait.

e signicant impact of the bursting of the IT bubble on the economy highlights theincreased effect of external shocks. e economy now is more open and the IT industry plays amore signicant part, making Taipei,China morevulnerable to a weakening in global demandfor IT products. e third challenge is thereforefor economic policies to take into considerationsuch volatility. For example, more prudent scalpolicies are required, so that budgets in goodeconomic years make allowance for periods whenthe economy turns down and requires policy stimulation.


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Outlook2004

ASIAN DEVELOPMENT

Economic Trends and Prospects in Developing AsiaSoutheast Asia

T. Takahara


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Cambodia

Growth slowed in 2003, but is set to pick up in 2004. The Government has made advances inrebuilding institutions and creating conditions for economic stability, though further progress isneeded to reduce poverty. The private sector could play a much bigger role if infrastructure, nancial,and governance weaknesses are overcome.

Economic Assessment

Growth in GDP eased to 5.0% in 2003from 5.5% in 2002, the fourth consecutiveyear of slowdown (Figure 2.6). Domesticpolitical uncertainties including anti- ai distur-bances and the fact that Cambodian electionsheld in July 2003 have, as of early April 2004, yetto result in the formation of a new governmenthurt investment and consumption, and delayed

official transfers. Tourism was hit by the domesticpolitical uncertainties and SARS.Underpinning growth in 2003 was a recovery

in agriculture following a drought-induced declinein 2002, and robust growth in the export-orientedgarment sector. However, services sector activity weakened due to declines in the hotels, restau-rants, and real estate subsectors as a result of lower tourist arrivals and the political deadlocka er the elections.

Preliminary data for 2003 indicate that thescal decit narrowed to 6.1% of GDP from 6.6%in 2002. Although revenues came in below target,so did overall spending because current expen-ditures fell short of budgeted levels. Spending oneconomic and social transfers was higher thanbudgeted, while defense-related outlays werelower. e scal decit was nanced mainly by grants and concessional loans.

Ination subsided from 3.3% in 2002 to1.2% in 2003, reecting the scal stance, rela-

tive exchange rate stability, and stable food pricesfollowing a rise in rice production a er thedrought of 2002. e riel depreciated by 1.6%against the dollar to KR3,973/$1, and the spreadbetween the official and market exchange ratesremained at 1%.

During 2003, merchandise exports are esti-mated to have increased by 14.4% to $2.0 billion,with strong growth in garments and naturalrubber. e countrys garment exports were

granted special access privileges by the US andEU in the late 1990s, resulting in rapid growththat continued into 2003, especially to the US. egarment industry currently employs about 230,000workers and generates more than 10% of GDP andover 80% of total exports.

Imports also increased, by a robust 12.5% to$2.6 billion, with a particularly large rise in trans-port equipment and, to a lesser extent, machinery and other equipment. Reecting a higher base,the growth in imports offset the increase inexports, and led to a widening of the trade decitto $599 million from $563 million in 2002. ecurrent account decit also widened, to 3.9% of GDP in 2003 from 1.6% in 2002, due to the widertrade decit and a narrower services surplus asreceipts from tourism moderated. e decit wasnanced through official transfers and capitalinows, including about $130 million of FDI.Foreign exchange reserves at $737 million weresufficient to cover 3.4 months of imports.


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Policy Developments

Given nearly three decades of con ict and a vola-tile political environment, most institutions werebarely functioning when the Government beganits rst mandate in 1993. Since then, Cambodiahas made important progress in rebuilding insti-tutions, ensuring peace and security, and creatinga stable macroeconomic environment. e country is now at a crossroads in its governance agendaand further progress in strengthening institu-tions is needed to guarantee sustainable economicgrowth and poverty reduction.

Central to strengthening governance is

improving public administration at the centraland local levels. A rst phase that involved regis-tration of civil servants and new career path andremuneration systems was completed in 2003;a second phase was started, under which theremuneration and classi cation systems are beingoverhauled and performance-based allowances arebeing introduced in priority sectors (i.e., educa-tion, health, agriculture, and rural development).

Public sector nancial management is animportant priority in governance, particularly given the need to increase revenues and improvethe impact of government expenditures. ealignment of scal resources with developmentobjectives in the past 2 years has resulted in anincrease in budget allocations for the priority sectors and a reduction in defense spending. erevenue-to-GDP ratio, however, remains very low, and constrains spending on development.Increased revenue mobilization through tax andnontax collection and customs reforms is crucial.

Corruption has been a concern and is a

serious impediment to private sector develop-ment. e Government adopted the Anticorrup-tion Action Plan for Asia-Paci c a programto combat corruption and bribery launchedin 2001 by several countries and supported by international organizations and submitted anAnticorruption Law to the National Assembly. Inaddition, both the National Audit Authority andthe National Assemblys Finance and BankingCommittee are being strengthened. ese devel-opments are expected to enhance accountability and thereby reduce the duciary risk of publicfunds. e challenge, however, is to implement thereform measures eff ectively.

In the agriculture sector, while donors aresupporting privatization of SOEs as well as

commercialization and diversi cation of thesector, there is a need to expedite the implemen-tation of existing policy reforms, including theland titling system and social land concessionpolicies, which will provide formal land rightsto the poor. Natural resource management isanother key area of governance. More equitableaccess and sustainable natural resource manage-ment are essential for sustainable economicgrowth and poverty reduction.

Notwithstanding eff orts to improve gover-nance, the outstanding reform agenda is still very

long. Cambodias incidence of poverty remainshigh, with 3540% of the population living belowthe poverty line, and social indicators are amongthe lowest in the world. A reduction in the inci-dence of poverty requires a signi cant increasein economic growth, employment creation, andan increase in real wages. ere is then a needfor signi cantly higher rates of productivity and investment, and to nurture new sources of growth, particularly in the tradable goods andservices sectors. e existing sources of growthremain narrowly based on garments and tourism,and prospects for the garment industry are uncer-tain with the phaseout of the Multi bre Arrange-ment (MFA) in 2005.

While there is a continued requirement forpublic investment, given increased scal pressuresthe private sector should be encouraged to play a considerably larger role in economic develop-ment. Private investment is, however, constrainedby infrastructure bottlenecks, a weak nancialsystem, shortage of skilled labor, and governance

Figure 2.6 GDP Growth, Cambodia, 19992005

Source: National Institute of Statistics; staff estimates.


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East Asia Cambodia 71

issues. ese aspects need to be addressed if thecountry is to maximize benets from its accessionto WTO in September 2003.


Assuming a speedy resolution of the political dead-lock over forming a new government, economicgrowth is expected to improve to 5.4% in 2004,led by export-oriented manufacturing (primarily garments) and an upturn in tourism and construc-

tion. e garment industry and tourism willbenet from a stronger global economy.A forecast increase in global rice prices is likely

to lead to relatively robust agricultural growth,which will increase rural incomes and domesticconsumption demand. Given the Governmentscommitment to improving the effectiveness of its expenditures, spending on the priority sectorsis expected to rise, while spending for military purposes is projected to decline further.

Overall, the budget decit should narrowbecause of a stronger revenue mobilization effort.Improved public nancial management andrenewed emphasis on structural reforms will helpthe investment climate, as will membership of WTO. Efforts to integrate more closely with othercountries in the Mekong region are also likely topromote trade and tourism.

GDP growth is expected to remain at 5.4%in 2005. Although the phasing out of the MFAis likely to dampen growth, tourism is forecastto pick up further, as long as peace and orderare maintained. Agriculture is also expected togrow faster with new irrigation projects cominginto operation and as implementation of landownership reforms gathers pace. Overall privateeconomic activity will also be helped by progressin implementing structural reforms.

Ination is likely to rise moderately over

20042005, due to a recovery in domesticdemand, an expected upturn in global rice prices,and a likely modest depreciation of the riel as thecurrent account decit widens. is decit is esti-mated at 4.3% of GDP in 2004, pushed by a widertrade gap. Exports are likely to rise on the backof stronger world trade growth and a US decisionto increase its quota for Cambodian garmentsin 2004, but imports will likely rise even fasterin absolute term because of the import-depen-dent nature of manufactured exports and a likely increase in capital goods as investment picks up.

In 2005, the current account decit is expectedto widen further when garment exports areaffected by the phasing out of the MFA. Grossinternational reserves, however, are likely toremain at over 3 months of imports because of increased inows of official transfers and FDI.

Table 2.6 Major Economic Indicators, Cambodia, 20012005, %

Item 2001 2002 2003 2004 2005

GDP growth 5.7 5.5 5.0 5.4 5.4Gross domestic investment/GDP 21.2 22.2 20.3 21.1 21.3

Ination rate (consumer price index) 0.3 3.3 1.2 2.9 3.3


Fiscal balance a/GDP -6.8 -6.6 -6.1 -5.8 -5.6

Merchandise export growth b 12.1 11.4 14.4 17.0 12.0

Merchandise import growth 8.0 10.5 12.5 16.0 14.5

Current account balance/GDP -2.3 -1.6 -3.9 -4.3 -5.6

a Excluding grants. b Domestic exports.Sources: National Institute of Statistics; National Bank of Cambodia; International Monetary Fund; staff estimates.


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Indonesia

GDP growth improved modestly in 2003. Private and government consumption provided the impetus,but investment remained weak. The Government outlined a series of reforms to follow on from itsIMF program exit. Although slightly faster GDP growth is expected in the next 2 years, to achievehigher growth rates and create employment over the longer term, the Government needs to improvethe investment climate, strengthen its judicial and regulatory institutions, overcome infrastructureconstraints, and resolve outstanding decentralization issues.

Economic Assessment

GDP growth picked up to 4.1% in 2003,a modest improvement over 3.7% theprevious year, even though the country was hit by another terrorist attack (in Jakarta),and faced the regional problems caused by SARSand the conict in Iraq. Ination slowed to a year-

end 5.1%, the reference interest rate fell, and therupiah rmed against the dollar.Private and government consumption

remained the principal drivers of growth in 2003,as they have been since the 199798 Asian nan-cial crisis. In particular, private consumptionaccounted for 2.8 percentage points of the GDPexpansion in 2003, supported by declining interestrates and increasing bank credit for consumptionspending. Such credit rose to one third of totallending from one quarter in 2002. e lendingfacilitated a 25% jump in purchases of cars andmotorcycles during 2003. Government consump-tion accounted for 0.8 percentage point of theGDP expansion, while net exports added 0.7percentage point, and net investments subtracted0.2 percentage point.

Investment spending, measured by grossdomestic xed capital formation, has stayed at2025% of GDP over the past 5 years, downsignicantly from above 30% before the crisis. eNational Development Planning Agency estimates

that the efficiency of investments has declined, too,in that a given amount of investment producesa smaller increase in GDP now than before thecrisis. e composition of investment has also beenchanging, with the share of investment in prop-erty rising over the past 3 years to over 80% of thetotal, while investment in capital goods declinedto less than 18% in 2003. Although robust invest-

ment in construction may provide short-termgains in growth and employment, it is not likely to generate jobs in the longer term.

Net FDI continued to slide in 2003, by $2.1 billion, a er falling by $7.1 billion in 2002.

e Capital Investments Coordinating Boardapproved $13.2 billion of foreign investmentprojects in 2003, up from $9.8 billion in 2002,although only 38% of these investments were real-ized. In the rst 2 months of 2004, FDI approvalsfell by 66% from the year-earlier period, possibly aresult of investors holding off ahead of Indonesianelections in 2004.

In terms of sector performance, the industry and services sectors together accelerated to 4.4%growth in 2003 from 4.0% the previous year.Manufacturing grew by 3.5%, continuing theslow trend seen since 2000. Growth in agricul-ture picked up to 2.5%, its best rate for severalyears. e overall modest expansion, especially in manufacturing, resulted in about 1 millionnew jobs, though this was not enough to stop the


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Southeast Asia Indonesia 73

unemployment rate rising to 9.8% from 9.3% in2002. Agriculture, which accounts for 15.8% of GDP, provides jobs for about 44% of the workforce, and manufacturing 13.2%.

e incidence of poverty fell in 2002 to nearprecrisis levels of 18.2%, and declined further

to 17.4% in 2003, with low in ation supportingthis trend. ese gures are based on a measureof income needed for a person to meet a daily minimum food requirement of 2,100 calories andon other locally accepted requirements for shelterand clothing. Poverty has pockets of concentra-tion, and varies widely within and across regions,with 57% of the poor living in Java and Bali, and66% in rural areas. Changes in real wages, as anindicator of improvements in welfare, have beenmodest. Manufacturing wages have picked up toprecrisis levels, but agricultural wages stand atonly three quarters of the 1996 levels.

Growth challenges notwithstanding, theGovernment has made advances in terms of scalconsolidation, through revenue as well as expen-diture reforms. It aims to balance the budget by 2006. e overall scal de cit widened to 2.1% of GDP in 2003 from 1.7% in 2002, slightly greaterthan the planned target of 2%, largely as a resultof higher spending and lower than anticipated taxrevenues. In terms of resources, domestic bank

nancing and privatization resulted in budgetary in ows equivalent to about 2% of GDP, with thepartial divestment of stakes in four companiesproviding a record Rp7.5 trillion. e stock of total external debt at end-2003 leveled off at about65% of GDP, at around $135 billion, with publicexternal debt equivalent to 38.5% of GDP. elevel of debt is well below that reached duringthe crisis and is scheduled to gradually decline tosustainable levels over 20052007.

On the monetary side, Bank Indonesias policy stance has helped contain in ationary pressures(Figure 2.7). e appreciating rupiah and lowerin ationary pressures enabled the central bank toreduce the interest rates on its 1-month certi cates(SBI) by more than 4.5 percentage points over

the course of 2003 to 8.4% at year-end. e ratereductions, in turn, helped the Jakarta share priceindex rise by 62% over the year.

e impact of the lower offi cia l interest rateon lending rates for investment and workingcapital, however, was limited. Banks give priority attention to consumer and small and mediumenterprise nancing, considering lending tothe corporate sector too risky. Further, some of the bigger banks hold in their portfolios largeamounts of tradable restructuring bonds issuedin 1998 as part of the banking sector reform

initiatives, which have provided a source of risk-free returns.Progress was made in 2003 to restructure and

privatize banks. eir overall capital structure hasimproved, with capital adequacy ratios exceeding20% as against the minimum 8% requirement.Gross NPLs appear to have stabilized at around8%, and average net NPLs were reported at1.8% as of December 2003, although a relatively large share of restructured loans in the portfo-lios of some of the largest banks may mean thatthis gure will be revised upward as such loansmature. e Government sold 20% of its stakein Bank Mandiri in July 2003 and 40% in BankRakyat Indonesia in November 2003.

Weak governance in state-owned commer-cial banks continues, though, to be a source of concern. Fraudulent loan transactions at BankNegara Indonesia and Bank Rakyat Indonesia in2003 prompted Bank Indonesia to demand tighterinternal controls in all banks, and the Govern-ment, as the major shareholder in Bank Negara

Figure 2.7 Exchange, In ation, and Interest Rates,Indonesia, December 2001December 2003

SBI = Serti kat Bank Indonesia.Sources: Bank Indonesia; Central Bureau of Statistics;International Monetary Fund.


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Indonesia, reconstituted that banks boards of directors and commissioners.

On the external front, the overall trade surplusrose by 3.9% to $24.4 billion in 2003. Relatively strong international oil prices contributed to 7.2%growth in merchandise exports. However, importsof oil and gas rose by 19.9%. Imports of capitalgoods increased by 7.6%, indicating a pickup inthe machinery replacement rate. Indonesia, aswith some other countries in the region, facesincreasing competition in labor-intensive exportproducts from countries such as the PRC and Viet

Nam. On the other hand, the rapid developmentof the PRC and its role as a regional productionhub in many sectors also provide Indonesia witha new export market non-oil and gas exports tothat country in 2003 rose by an estimated 25%from a year earlier.

Trade in services produced a decit esti-mated at $16.7 billion, wider than the 2002 levelof $15.9 billion. Earnings from tourism fell asa result of security-related concerns and of theimpact of SARS on regional travel. Internationalreserves grew by $4.2 billion to reach $36.2 billionat year-end.

Policy Developments

Indonesia was the last of the Asian crisis-affectedcountries to exit an IMF extended fund facility, inDecember 2003. In order to bridge the likely cred-ibility gap that may emerge, in September 2003 theGovernment unveiled an economic policy package,better known as the White Paper, to consolidate

and monitor ongoing and planned reforms underthree planks: prudent macroeconomic manage-ment; nancial sector restructuring; and realsector reforms aimed at increasing investment,exports, and employment. e White Papersbroad thrust has generally been well received by domestic and foreign investors, although its depthand breadth will require signicant human andnancial resources to ensure satisfactory imple-mentation. While about three quarters of themeasures have been completed, according to theGovernment, the content of the initiatives as well

as their likely impacts are being debated.With regard to macroeconomic management,measures are under way to achieve scal consoli-dation, particularly in expanding the revenue base.Delinquent taxpayers, especially those owing largeamounts, are being pursued, customs operationsare being strengthened, and a program to curbevasion of excise taxes is operational. Signicantprogress was made with the adoption of the StateFinance Law in March 2003 and the State Treasury Law in December 2003. ese two laws, togetherwith proposed laws governing state audits,contain general principles aimed at strengtheningbudgetary processes, improving public expenditureand nancial management, and enhancing publicsector accountability. e new legal frameworkalso paves the way for the separation of budgetand treasury administration and consolidation of public debt management functions.

e Ministry of Finance also proposed amend-ments to the Tax Law, which have generatedan intense debate in the business community

Table 2.7 Major Economic Indicators, Indonesia, 20012005, %

Item 2001 2002 2003 2004 2005








Sources: Bank Indonesia; Central Bureau of Statistics; Ministry of Finance; staff estimates.


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because some of the proposals are seen as coer-cive. Further public consultations are expected onthese amendments. Fiscal decentralization is beingstrengthened through revisions to laws on regionalautonomy, scal balances, and regional revenues.

e revised laws will aim to clarify the role of the provinces and gradually achieve scal equal-ization. However, there have been concerns overinadequate consultation with local governments.

With regard to the nancial sector restruc-turing plank of the White Paper, the Governmentclosed the Indonesian Bank Restructuring Agency (IBRA) at end-February 2004. IBRA recoveredabout 28% of the $60 billion of assets it inher-ited, comparing favorably to similar agencies inthe region. An asset management company will

be established to manage and recover the corpo-rate assets unsold by IBRA, which are valued atRp43 trillion.

At the broader sector level, Bank Indonesialaunched a study on the banking system in 2003,to formulate a new banking structure for thefuture. e study envisages consolidation of banksover the next 5 years, leading to two or three largenancial institutions with a regional and inter-national presence, three to ve nationwide bankswith a broad scope of business, and 3050 special-ized banks operating in different market segments

and areas of Indonesia.A dra law on a deposit insurance plan isunder consideration by Parliament and a nan-cial safety net framework is being formulated tosupport nancial stability, particularly in times of systemic crisis. Amendments in December 2003to the Central Bank Law will lead to the establish-ment of a new supervisory board to enhance theaccountability of the central bank. e Govern-ment has also strengthened the regulatory frame-work for pension, insurance, and capital marketinstitutions, which will enable the regulatory authorities to impose sanctions for noncompli-ance. In other signicant nancial sector develop-ments, Indonesia adopted an amended Antimoney Laundering Law, established a Center for Finan-cial Transaction Analysis and Reporting, and setup a National Committee on Antimoney Laun-dering to formulate policies in this area.

e third component of the White Paperreforms aimed at increasing investment, exports,and employment faces signicant implementa-

tion challenges given its complexity. Progress insome areas is evident through the adoption of new labor laws, a State-Owned Enterprises Law,an amended Water Resources Law paving the way for the commercialization of the water sector, anda new regulatory framework for the telecommu-nications sector. A policy to issue land certicatesthrough the conversion of informal titles has beenstepped up to facilitate access to bank credits. eSupreme Court has nalized a blueprint on judi-cial reform, and the Government has establishedan Anticorruption Commission. e Governmentalso completed the rst stage of a Poverty Reduc-tion Strategy Paper, which outlines measuresto achieve the Millennium Development Goals.However, it is unlikely that the strategy paper will

be nalized by May 2004, the date to which theWhite Paper committed.

Investment promotion is a key priority of the Government under the third plank of theWhite Paper. e Government labeled 2003 as theYear of Investments, but there was little tangibleheadway in facilitating direct investment. A erconsiderable delay, a revised Law on Investmentswith provisions for equal treatment of foreign anddomestic investment, simplied licensing, andclearer investment incentives is being nalized.

e Government established a high-level National

Team on Investment and Exports Promotionto resolve interministerial issues and addressinvestor concerns. Proposals are being nalizedfor a one-stop facility for investment approvalsand a revised, narrower list of sectors reservedfor domestic investment. Despite these measuresthough, domestic and foreign investors alikeremain concerned about regulatory uncertainties,lack of transparency in tax and customs proce-dures, and multiple layers of bureaucracy thathave expanded the scope for corruption.

e decentralization program adopted by theGovernment in 1999 represents another concernfor investors, because the regions are failing tocoordinate with regard to investment incentivesand regulations. Most important, investors viewthe Government as having adopted a culture of approvals and controls, rather than as havingmade a coordinated attempt to promote Indo-nesia as a regional investment destination. Whileextractive industries may retain their competitive-ness because of the countrys natural resources,


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traditional industry sectors have seen productivity and efficiency eroded due to lack of investment.


With macroeconomic stability restored a er thecrisis, the key challenge facing policy makers isto achieve and sustain higher levels of economicgrowth, especially through greater domestic andforeign direct investment. at there is long-terminvestor interest in portfolio investments in Indo-nesia was evident when the country returned tothe international debt markets early in 2004, forthe rst time in 8 years. On the back of strongglobal demand estimated at over $4 billion, the$1.0 billion 10-year bond was priced at a yield of

6.85%, or 227 basis points over the US Treasury rate. is compares favorably with a recent debtissue by the Philippines at a yield of 8.8%.

e 2004 budget approved by Parliament inNovember 2003 targets a decit of 1.3% of GDP,narrower than the planned 2003 decit of 2.0%.

e budget assumes GDP growth of 4.8%, averageination of 6.5%, and a steady exchange rate. eGovernment plans to reduce primary spendingby 0.9% of GDP, partly by cutting nonfuel subsi-dies and transfers to the regions. is, togetherwith lower interest payments, would reduce

total expenditures by 1.6% of GDP. (However, itseems unlikely that subsidies and transfers can bereduced signicantly in an election year.) ParisClub debt rescheduling provided annual relief equivalent to about $3 billion in debt servicepayments, but exit from the IMF loan programmeans that the country is no longer eligible forsuch rescheduling. Without this debt relief, the2004 budget projects a gross nancing need of 4.7% of GDP, the same level as in 2003, but witha greater amortization of debt, at 3.4% of GDPagainst 2.8% in 2003. Gross external nancing isprojected at 1.4% of GDP in 2004 (equivalent to$3.3 billion), compared with 0.9% of GDP in 2003.

Given the growth in private and governmentconsumption, both of which are likely to risefurther in 2004 (due to the availability of credit forconsumption and government spending in an elec-tion year), GDP growth is forecast to rise to 4.5%in 2004 and in 2005. is higher rate will dependboth on Bank Indonesia keeping a rm hand onmonetary policy in the election period and on the

oil industrys ability to ramp up oil production,which is currently below its OPEC quota. A key impediment to li ing oil production has been thedelay in adopting satisfactory implementing regu-lations for the Oil and Gas Law enacted in 2001.

e Government also needs to prudently manageits foreign reserves, as the external liquidity posi-tion is expected to deteriorate in 2004 due tothe anticipated increase in the amortization of external debt to above $5 billion, in comparisonwith a net inow of $1.9 billion in 2003. Whilethe reserves position will still be adequate at about$33 billion, or equivalent to over 6 months of imports, it could become less comfortable if any unanticipated external events occur.

Looking at the risks to the outlook, in the

short term growth may exceed the 2004 estimate.Political parties are expected to spend upwardof Rp15 trillion ($1.8 billion) in campaigningduring the year, which will have multipliereffects through greater consumption. e Presi-dent signed a decree in March 2004 authorizingcentral and regional governments to access anddisburse emergency funds to support immediatepublic needs. us, private and public spendingmay be stronger than projected. On the otherhand, no signicant new investments are expectedin 2004 because of the election uncertainties,

which may dampen growth. For public nance,a planned increase in domestic bond issuanceby the Government may face investor resistanceand may make it more difficult for companies totap the bond market. In addition, the Govern-ment anticipates raising Rp10 trillion from priva-tization and asset recovery in 2004, but sellingstate assets might be difficult in an election year.

us, prudent debt management will be criticalas the Government has to redeem bonds worthRp28 trillion.

In the medium term, there are continuingconcerns that Indonesia may be trapped in a rela-tively low-level growth path, with the economy growing at less than 5%, unless certain key chal-lenges are addressed.

e rst key challenge is poor governance andinefficient and corrupt legal and regulatory envi-ronments. As the process of consensus buildinghas become more complex in the new democraticperiod, the Governments approach has been topropose simple laws to expedite approval, leaving


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critical issues to be addressed in implementingregulations. Lack of clarity and predictability insuch regulations has hampered progress in many key areas, including decentralization, invest-ment, and infrastructure, and has eroded overallinvestor and public condence. Poor governancewithin tax and customs administrations is amajor concern. Further, the public increasingly believes that corruption has become more perva-sive and less predictable following decentraliza-tion. e Government has adopted only a feworganizational measures toward improving theinvestment climate, without addressing theconstraints in an integrated manner. e trendsin 20022003 indicate that investment may recover only slowly over 20042005. In particular,

the FDI environment is very weak, even in sectorswhere the country has a comparative advantage,including energy and mining.

e second key challenge relates to decentral-ization. Five years a er the introduction of theambitious decentralization agenda, signicantissues and risks remain. Core concerns are theweak legal and regulatory framework governingdecentralization; an inefficient intergovernmentalscal system; and a lack of accountability at the

local level. e Governments focus at presentis on the political aspects of decentralization,while no major reforms to scal decentraliza-tion or equalization are yet envisaged. Given therevenue dependence of most local governmentson the center, the Government needs to articulatea sound implementation framework that balancesthe scal and political aspects. Other issues thatneed resolution include a clear assignment of functions to the local governments; a strength-ening of the nances of local governments and of accountability at the local levels; and increasingregional capacity to implement decentraliza-tion. A major issue is to ensure that developmentspending is increased from the current low levelof 3.2% of GDP, in order to reduce the serious

regional inequalities and address the state of disrepair and underprovision in infrastructure(Box 2.3).

Security presents the third key challenge.While the Government has been resolute indealing with terrorist attacks, investors still seelack of security as a major concern, which in turnplaces a risk premium on investments. In addi-tion, the Government needs to resolve the politi-cally sensitive problems in the troubled provinces.


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In the late 1990s, when thedepreciating rupiah pushed up

Indonesias debt burden, the Gov-ernment postponed several projectsplanned by independent powerproducers (IPPs) and directedthe state-owned power utility,Perusahaan Listrik Negara, to reim-burse only part of its obligationsto the IPPs. e Government alsopostponed 37 proposed toll-roadprojects and launched a review of another 18. Several water utilitieswent bankrupt.

Since then, the Government hasmade progress in several areas of infrastructure development, includ-ing (i) adoption of laws that havestrengthened the legal frameworkfor telecommunications, oil andnatural gas, electricity, and waterresources (although the implement-ing regulations are still lacking forsome of these laws); (ii) raising of tariffs for electricity from 2 cents/kilowatt-hour to 7 cents; (iii) re-negotiation of 27 IPP contracts

without disputes; and (iv) partprivatization of the telecommunica-tions sector.

However, the country may stillface an infrastructure crisis if itsinfrastructure networks are notrepaired and new investments arenot undertaken. While infrastruc-ture sectors received priority in the1970s and 1980s, total infrastruc-ture spending as a share of GDPfell from about 20% in 1992 toabout 14% in 2002. Of this, centralgovernment spending on infra-structure declined steeply fromabout 4% in the early 1990s to justover 0.5% of GDP by 2002.

Also, although the central Gov-

ernment has devolved considerablefunctional responsibilities to districtand provincial governments, infra-structure spending at these levelsof government has not increasedto compensate for the reduction incentral government spending.

e following are key problems: Road Transportation. Interur-

ban corridors are heavily con-gested and rural feeder networksare in poor condition. Progresson expanding toll-roads hasbeen slow, although a new regu-

latory framework is being for-mulated. Investment needs aresubstantial, estimated at $12 bil-lion over the next 5 years.

Water Supply and Sanitation. Only 16% of the population hasaccess to piped water, served by over 300 water utilities, most of which are in nancial difficul-ties. Self-provision and otherunregulated small-scale privateproviders cover the remainingneeds. Unlike the power sec-

tor, water tariffs have not beenraised to appropriate levels. Electric Power. e electrica-

tion rate of 53% is among thelowest in Southeast Asia. esector is highly centralized withdirection on investment comingfrom the Government, whichcauses problems for managersof IPPs.

Telecommunications. Fixed-linetelephone density of 36 linesper 1,000 people ranks amongthe lowest in Southeast Asia.Despite privatization, signi-cant investments are needed toaddress disparities in serviceprovision across the country.

Indonesias large size and diversegeography present unique chal-lenges in the provision of infra-structure. A er the Asian nancialcrisis, the Government in 2001established the National Committeeon Infrastructure Policy and Devel-opment to coordinate infrastruc-ture policy formulation and sectordevelopment. e committeesestimates show that $72 billion willbe needed over 20052009 if thecountry is to achieve 6% averageannual GDP growth, and more

than $150 billion if the planninghorizon is extended to 2014.Considering that the central

and local governments can allocateabout $41 billion over the next 5years, there is an urgent need toattract private sector investments of above $30 billion. e Governmentalso wants to develop domestic(between East and West Java) andregional (Trans-ASEAN) oil andgas pipelines.

ese investment plans need to

be supported by reforms in twoareas: rst, expediting the adoptionof a sound regulatory frameworkto accompany the recently adoptedlaws; second, strengthening theoverall investment climate to pro-vide for contract enforceability,legal and regulatory predictability and certainty, and exibility inlabor regulations.

Source: National Committee onInfrastructure Policy and Investment.2003. Policy Paper for the ConsultativeGroup on Indonesia . December.

Box 2.3 Challenges in Meeting Infrastructure Needs


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Lao Peoples Democratic Republic

Macroeconomic conditions were relatively stable in 2003, although ination rose to nearly 18% at one stage and the scal position remained weak. The countrys major challenges include raisingadequate government revenues to fund social and economic development and dampening ination.Growth in 20042005 is expected to remain at around the 6% level.

Economic Assessment

The Government estimates that GDP growthin 2003 was 5.9%, or similar to rates of growth in the previous 2 years. Agricul-ture, which accounts for just over half of GDP,expanded by 8.3%, in part because rains in theupland areas a er a dry period li ed rice output.While industry grew by 14.6%, the services sectorcontracted by 4.9%, stemming from regional

weakness in tourism that followed the SARSoutbreak as well as from security concerns. Slowerprivate investment, due to more cautious banklending, also hindered growth.

e overall budget decit in FY2003 (ended30 September 2003) was 7.8% of GDP (5.7%including grants). is represented an improve-ment from the decit of 8.3% of GDP recorded inFY2002 (but a deterioration from 4.8% if grantsare included). Either way, the decit, mostly nanced by grants and external concessionalloans, was still above target. Revenue mobiliza-tion remains a major and worsening problem: asa share of GDP, revenues declined to 11.0% in2003 (Figure 2.8). Fortunately, better expenditurecontrols prevented a repeat of the overrun incapital spending that was seen in 2002.

Ination in the Lao Peoples DemocraticRepublic (Lao PDR) has been running at one of thehighest rates in the subregion and averaged 15.5%over 2003, up from 10.6% in 2002. Higher pricesfor food, water, electricity, and petroleum were

contributory factors, as was the lingering impact of a depreciation of the kip against the ai baht in2002. e authorities took steps to restrain credit,reducing by nearly half the growth in broad money supply to about 20% in 2003. e kip depreciatedby about 5% against the dollar over the year.

Merchandise imports and exports, a ercontracting in 2002, recovered. Exports rose by 23.0%, with the main contributors being hydro-power, timber, and garments, which together

account for about 80% of total exports. Importsgrew by 7.2% in 2003. e merchandise tradedecit narrowed to an estimated $135.6 millionfrom $170.1 million in 2002, continuing anarrowing trend evident for several years. ecurrent account decit is about $51 million, equiv-alent to 2.5% of GDP. Foreign exchange reservesincreased to $215.5 million, sufficient to covermore than 4 months of imports. FDI rose fromthe weak 2002 level to a still low $19.5 million,and approvals went up sharply, indicating thatFDI might head toward the much higher levelslast seen 5 years ago.

With an estimated per capita income of justabove $300, the country is one of the poorest inthe region. e Expenditure and ConsumptionSurvey conducted in FY1998 estimated that 39%of the population lived below the national poverty line of $1.50 a day. Preliminary results from arecent survey suggest that poverty incidence hasfallen to around 30%, representing quite a sharpreduction over 5 years.


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Policy Developments

e major challenge facing the Government is the scal weakness, because it seriously constrainsresources available for social and economicdevelopment. e revenue eff ort has been chroni-cally weak and it deteriorated again in 2003. eGovernment responded with increases in taxeson petroleum, beer, and tobacco, and committed

to introduce a VAT, although the timing has notbeen nalized. However, it also introduced taxincentives for private investment that have thepotential to erode revenues. Furthermore, theeconomy faces a reduction in customs revenues asit meets its commitments under the AFTA agree-ment to lower tariff s.

Concern over weak revenue collection andpoor scal administration was a major impedi-ment in 2003 to the IMF concluding a thirdreview of its PRGF loan to the country. ( esereviews are required by IMF before it disbursesloan installments.) IMF nally concluded itsreview, which had been delayed since January 2003, in August, having found improvements inthese areas, though it also indicated that furtheradvances in revenue collection and tax adminis-tration are crucial.

e Government plans to tighten expenditurecontrols, improve its scal information system,and give stricter nancial evaluations to proposedprojects in an eff ort to make sure that spending

does not again run out of control. In terms of the budget components, there has been a long-standing imbalance between capital and recur-rent expenditures, with capital items receivingpriority, though recent eff orts have recti ed thisimbalance somewhat, as seen in a declining shareof capital expenditures. Social sector spendingas a share of expenditures has also risen, inparticular on health and education, although inabsolute terms these areas are still seriously shortof funding.

Reforms of the state banking system aremoving forward, but further progress is neededto put it on a commercially sound basis. ebanks have strengthened their credit managementand four international banking advisors were

appointed to assist in various areas, includingcredit appraisal. Two small state-owned commer-cial banks were merged and the Governmentplans to seek strategic shareholders in anotherone. In contrast, few advances were made inreforming the debt-burdened SOEs, which need tobe restructured to reduce their NPLs, a move thatwould complement the banking reforms.

Total external debt currently stands at around$3 billion, or just around 150% of GDP. At facevalue, this appears to be a signi cant debt burden.However, more than half of the total debt is owed

to the Russian Federation and is currently notbeing serviced. A er extended negotiations, thetwo governments in June 2003 agreed in principleto write off 70% of the bilateral debt and servicethe remaining debt, valued at $380 million, over33 years at a preferential interest rate. is isconsistent with the terms of the Russian Federa-tions memorandum of understanding as a cred-itor in the Paris Club.

A speci c agreement relating to the interestrate, grace period, rescheduling, and paymentmodalities (cash, goods, investment) is stillpending. Nevertheless, this is a major policy development that has the potential to signi cantly improve the overall debt position of the country.Of the remaining debt in convertible currency,less than 5% is commercial and the rest consistsof long-term concessional loans with bilateral andmultilateral institutions. e debt service ratio isabout 7% of exports and will rise slightly whenthe Lao PDR starts servicing the renegotiated partof the debt to the Russian Federation.

Figure 2.8 Central Government Expenditures andRevenues and GDP Growth, Lao Peoples DemocraticRepublic, 19972003

Source: National Statistical Center.


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Southeast Asia Lao Peoples Democratic Republic 81


GDP growth is expected to edge higher to around6% in 20042005. Exports are likely to risebecause of the improvement in global economicactivity and the particularly rapid growth of thecountrys major trading partners ailand andViet Nam as well as the PRC. Furthermore, aspart of ailands Economic Cooperation Strategy,the Lao PDR has been granted zero tariff rates

on eight major agricultural products, while theLao PDR and the US have signed a bilateraltrade agreement that may pave the way to the USgranting Normal Trade Relations status in 2004,which would not only help exports but also assistthe country move toward membership of WTO.Receipts from tourism are also likely to increasein 2004 from the 2003 level, when they wereaffected by the regional SARS outbreak and secu-rity concerns. e lowering of tariffs in line withthe AFTA agreement will li imports.

e investment outlook is also improving. eGovernment is promoting FDI and is committedto support private sector development. Neverthe-less, ination needs to be curtailed and furtherprogress made in developing infrastructure andthe nancial system in order to make the invest-ment environment more attractive. e Govern-ment forecasts single-digit ination in 2004, butination rates of 1015% over the forecast periodlook more likely.

Among investment projects, the outlook forthe construction of the Nam eun 2 hydro-power project has improved with the Electricity Generating Authority of ailand agreeing tobuy electricity from the plant over 25 years, whilethe Sepon mine plans to expand output, havingproduced 165,000 ounces of gold in 2003. emine is also scheduled to start producing copperin early 2005.

Although it seems that the poverty inci-

dence has fallen over the past 5 years, reducingpoverty generally worse and more concentratedin northern areas remains a major challenge. eNational Poverty Eradication Program and thePoverty Reduction Strategy Paper include specicpolicies, though the program requires priori-tized action plans and effective follow-up to besuccessful. e expected growth in the economy will contribute to reducing the poverty incidencefurther, and, if the economic momentum is main-tained over the medium term, the poverty reduc-tion target of 25% or less by FY2006, as speciedin ADBs poverty reduction partnership agreementwith the Government, seems achievable.

ese outcomes are contingent on the main-tenance of macroeconomic stability, continuedimplementation of scal reforms, and relatively stable oil prices. e main risk to the outlook isthe weak scal system: any further deteriorationin revenue collection or sudden excessive expendi-tures would be particularly damaging.

Table 2.8 Major Economic Indicators, Lao Peoples Democratic Republic, 20012005, %

Item 2001 2002 2003 2004 2005




Fiscal balance a/GDP -7.6 -8.3 -7.8 -5.4 -5.3

Merchandise export growth -3.3 -6.9 23.0 20.4 4.5

Merchandise impor t growth -4.7 -8.4 7.2 11.7 1.8

Current account balance b /GDP -4.6 -2.3 -2.5 -2.2 -1.9

Debt service ratio 7.2 8.3 6.8 - -

- = not available. a Excluding grants. b Excluding official transfers.Sources: Bank of the Lao PDR; Ministry of Finance; National Statistical Center; International Monetary Fund; staff estimates.


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Malaysia

GDP growth exceeded forecasts in 2003, supported by solid expansion in manufacturing and strongdemand for exports. With still faster growth expected in 2004, the economy should be able to reduceits reliance on government spending. The major concern is low rates of capital formation, as bothforeign and domestic investment are below levels needed to sustain strong economic expansion.

Economic Assessment

In 2003, the economy extended and deepenedthe recovery that took hold in 2002, withGDP growth picking up to 5.2%. Consump-tion continued to be the main driver of demandgrowth, contributing 3.5 percentage points to theoverall GDP strengthening. Private consumptionrose by 5.1% and public consumption by 7.9% asthe Government raised its spending. Net exports

contributed 2.0 percentage points to the expan-sion in GDP. Gross xed capital formation grewby 2.7% in the year, accounting for 0.8 percentagepoint of growth. Total investment actually declined by 0.9%, due to a drop in inventories.

On the production side, industrial output roseby 7.0% and accounted for 2.9 percentage pointsof GDP growth. Manufacturing increased by 8.2%as the global economic recovery accelerated in thesecond half of the year to li demand for elec-tronics goods, the countys major export. Agri-culture posted strong growth of 5.5%, of which4.1 percentage points were generated by a 12.1%rise in crude palm oil production. Given higherworld commodity prices in 2003, the nominalvalue of palm oil exports surged by 36.3% toRM20.2 billion, and agricultural products shareof exports rose from 6.5% in 2002 to 8.4% in2003. Services grew by 4.4%, as the damage doneby the regional SARS outbreak to the tourism andretail sectors faded in the second half.

e Government had aimed to reduce its

budget de cit in 2003, but the SARS-induced prob-lems and weak international demand in the rsthalf caused it to change course and adopt a policy of aggressive scal stimulus. A scal packageannounced in May included tax incentives forinvestment and consumption, directed lendingprograms, and extra public spending. e packagecost the Government $1.7 billion, or nearly 2.0%of GDP, but helped keep the recovery on track.

e 2003 budget de cit came in at 5.3% of GDP,

considerably wider than the original target of 4.0%.Economic growth was also li ed by anaccommodative monetary policy, as interest ratesremained low despite the wide budget de cit. emonetary policy of Bank Negara Malaysia (BNM)remained anchored to the ringgit-dollar peg.During 2003, the market began to see an upsiderisk for the ringgit, leading to large purchasesof dollars by the central bank and a buildup inforeign reserves. ough the resulting expansionin the ringgit money supply was partially steril-ized by BNM, narrow money (M1) still increasedby 14.6% and broad money (M2) by 11.1% overthe year. e accumulation of foreign reserves wasthe main source of money supply growth becausecredit from banks and other lending institutionsgrew by only 4.8%. Interest rates fell modestly in2003; in May, BNM cut its intervention rate by 50 basis points to 4.5%, and at year-end the rateon 1-year treasury bills was 2.8%, down slightly over 12 months. e banking sector continuedto strengthen its nancial position, with NPLs


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Southeast Asia Malaysia 83

at commercial banks declining to 6.4% from7.4% (de ning NPLs as loans that have beennonperforming for 6 months).

As a result of the ringgits peg to the weak-ening dollar, the domestic currency declined by 6.0% against a trade-weighted basket of curren-cies, improving the countrys export competitive-ness a er 2 years of ringgit appreciation. In ation

remained tame, despite the ringgits depreciationand the money supply growth. Consumer pricein ation slowed to 1.2%; the small rise was mainly due to a modest rise in food prices. e producerprice index rose by 5.7% because of increases inpetroleum products and other commodities.

On the external side, the improvement in theglobal economic environment in the second half of the year, coupled with the ringgits deprecia-tion, led to a doubling of growth in merchandiseexports to 12.4%. Shipments to most tradi-tional major markets grew in the 710% range,according to customs data, while exports to Indiajumped by 43.9% and to the PRC by 29.6%.

Imports rose modestly by 5.4%, with most of the growth attributable to a late surge in importsof capital and intermediate goods. Imports forconsumption rose by only 1.1% for the year,and made up only 5.9% of the total. e tradesurplus widened sharply to $25.7 billion from$18.1 billion in 2002. e current account surplussoared to $13.4 billion, or 13.0% of GDP, nearly

double the 2002 level, and was re ected in a sharpincrease in net offi cial foreign reserves to a record$44.9 billion. e buildup in reserves was rein-forced by a rise in portfolio investment resultingfrom renewed interest by international inves-tors in Asian equities, and the apparent under-valuation of the ringgit. External debt was littlechanged at $49.3 billion at end-2003, equivalent toless than 48% of GDP.

FDI approvals in 2003 rose by $1.1 billion to$4.1 billion, though the increase was entirely dueto two large planned investments by United ArabEmirates rms, including an aluminum smeltingfacility in Sarawak. Gross FDI in ows rose to$5.7 billion in 2003 from $5.4 billion in 2002. NetFDI declined slightly to $1.1 billion, primarily due

to a buyout by a Malaysian company of foreignstakes in an energy sector joint venture (Figure 2.9).

Policy Developments

Economic performance in 2003 was built uponexpansionary scal and monetary policies, as wellas strong demand for exports. A revival of invest-ment is required to provide a more sustainablefoundation for stronger economic growth, thoughthe Government did unveil some new measures inthis area in 2003, including a liberalization of FDI

regulations and a relaxation of previous ethnicity-based ownership restrictions (but full implemen-tation of that sensitive decision has been slow).

If the economy is to reach its estimatedpotential growth rate of 6.57%, the Governmentneeds to secure improvements in productivity and competitiveness, stimulate investment, andupgrade technology and work force skills. isis increasingly important as the PRC and Indiabecome greater competitors for FDI, and becausethey already off er much larger domestic marketsand considerably lower unit labor costs, particu-larly in labor-intensive manufacturing sectors.(At the same time, the rise of these large regionalneighbors presents signi cant opportunitiesfor Malaysian businesses.) Public investment isexpected to fall by 4.2% a year in 2004 and 2005as the Government trims its scal de cit. Sharpincreases in private investment are needed tomake up for this decline, given the dependence of the economy on government capital spending inthe past 5 years.

Figure 2.9 Net FDI, and Total and Private GFCF,Malaysia, 19972003

FDI = foreign direct investment, GFCF = gross xed capitalformation.Source: Bank Negara Malaysia.


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ere are two main challenges to overcome if investment is to reach the levels needed to supportsustained higher growth. First, considerableimprovement is needed in the investment climate,including a reduction and eventual elimination of regulatory barriers to business operations. Exam-ples include tariff and nontariff trade barriers,privileges that have been granted tobumiputras, and lingering restrictions on capital ows. Ashi to higher value-added sectors would alsorequire stricter enforcement of intellectual prop-erty rights. Although the legal foundation exists

for these rights, court enforcement of laws hasbeen inadequate. Improvement in the investmentclimate will also require further sustained actionto combat corruption.

Second, further progress in implementing key structural reforms will be essential. A privatiza-tion program review recently initiated by theGovernment under which sales of controllingstakes in state enterprises are being postponedwhile independent consultants review the proce-dures and plans for future sales could be apositive step if it results in a more transparent,competitive, and efficient process. If Malaysiancompanies are to continue growing into globalcompetitors, they need greater exposure to marketforces and competition, both domestic andforeign, and a more open privatization processwould contribute to achieving that goal. Openingmore sectors to foreign investment would alsohelp attract capital and technology.

Some long-anticipated privatizations weredeferred in 2003. A decision to publicly list

Felda, a large state-owned palm oil producer, wasannounced in September, but then indenitely postponed when the Government said it neededmore time to assess the impact of such a move onplantation settlers who own more than half of theland managed by Felda. Other anticipated priva-tizations are still pending, such as those of waterutilities, most of which need additional capital.

An expected cut in the corporate incometax rate to stimulate investment was put on holdin 2003 because of the scal pressures, and theplan to reduce the budget decit in 2004 and

2005 makes it unlikely that this measure will beimplemented in the near future. In another policy change, the Government decided in November2003 to impose high excise taxes on imported carsto maintain protection of domestic manufacturers,even though AFTA-mandated cuts in automobiletariffs were implemented. is sent a signal thatprotection of some manufacturing sectors is goingto continue for some time. Proton, the majorbeneciary of that decision, has performed poorly in recent years, and any incentive for it to improveitself was harmed by this decision. e excise taxrates are effective for 1 year, so the decision onwhether to extend them beyond 2004 will providethe Government with another chance to considerits policy in this area.

In contrast to such protectionists efforts, BNMmoved to open the nancial system when it li edrestrictions that had forced foreign banks to raiseat least 50% of their banking credit from domesticbanks, so prompting some foreign banks toconsider expanding their Malaysian operations.

Table 2.9 Major Economic Indicators, Malaysia, 20012005, %

Item 2001 2002 2003 2004 2005








Sources: Bank Negara Malaysia; Department of Statistics, Malaysia; Ministry of Finance; staff estimates.


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Southeast Asia Malaysia 85

Corporate restructurings are entering a newphase, as the work of the state agencies establishedto manage problem assets is nearing completion.Danaharta, the Malaysian asset managementagency, achieved 75% of its key recovery targetof RM30 billion, and expects to complete thistask in 2005. e Corporate Debt RestructuringCommittee ended its operations in late 2002.Danamodal Nasional Berhad was closed at the endof December 2003, having strengthened commer-cial bank balance sheets through the injectionof RM7.6 billion during its 5 years of operations.Malaysia will now rely more on market-basedrestructurings, including mergers and acquisitionsand bankruptcy, which require a strong legal andcorporate governance framework. BNM issued

new regulations to improve such governance inthe banking sector, including guidelines governingthe functioning and composition of banks boardsof directors. A new deposit insurance plan is beingprepared and is expected to be implemented in 2004.

e changeover to a new prime ministeron 31 October was smooth and the new leadertook some decisive steps including canceling acontroversial RM14.5 billion railway proposal andcracking down on corruption which were gener-ally well received by the business community.


e improved economic performance of 2003,coupled with moves toward greater transparency in government decisions and a stronger anticor-ruption stance, has created favorable conditionsfor 2004. GDP growth is forecast to edge up to5.8%, with strong export demand and privateconsumption projected to counteract the planneddecline in government spending. In 2005, growthis forecast to slow slightly to 5.6%, due to furtherscal tightening.

e projections assume 1215% growth inprivate investment, including increases in FDI of about $1 billion a year, offsetting the planned cutsin public investment but not generating a signi-cant improvement in the ratio of gross capitalformation to GDP. Better investment outcomes,which would be possible if policy is focused oninvestment-promoting initiatives, offer the oppor-tunity for higher than projected economic growth.

e Government is targeting a reduction in

the scal decit to 3.3% of GDP in 2004, withrevenues projected to increase by 7.2%. A planned1.6% reduction in expenditures will be more diffi-cult to achieve, although the Governments deci-sion to hold elections early in the year, and avoidan extended period of politically driven budgetdecisions, is encouraging in this regard. Plannedcuts in the development budget are already deep,but further modest cuts may be possible if neces-sary. e Government aims to further narrow the2005 budget decit to 1.8% of GDP, and balancethe budget the following year. Under any plausiblegrowth projections this will require signicantfurther spending cuts.

In the past year, as the dollar fell against mostcurrencies with oating exchange rates, pressure

has gradually built on BNM to consider a moreexible exchange rate and allow the ringgit toappreciate against the dollar. e rise in port-folio investment inows into Malaysia, fueled by the market view that the ringgit is undervalued,is likely to reinforce this. Upward pressure onthe ringgit will be contained, though, by a likely accommodative monetary policy in the context of low ination and a narrowing scal decit.

Interest rates are expected to remain at theircurrent low levels, although a further reductionin the BNM intervention rate cannot be ruled out

if growth falters. Ination will probably not riseabove 2.0% in the coming 2 years, but moderateincreases are possible.

With world economic growth expected tostrengthen further in 2004, the outlook forexports is positive. ey are likely to expand by 810% in 2004, which would be a solid result a erthe strong improvement in 2003. Imports are alsoexpected to grow by 810%. As the US continuesto be the major export market, prospects wouldbe undermined if the US economy unexpectedly hit a at patch because no other market is yetpositioned to take up this slack. e Governmentseems determined to stimulate domestic demandto reduce the economys exposure to externalchanges, though this will be a difficult goal in aperiod of scal consolidation. With indicationsthat growth in the PRC may slow by 2005, andgiven the ripple effects that would be created inMalaysias other markets if the US and the PRCboth slowed, external risks pose the main threatto the economy in the coming 2 years.


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Myanmar

GDP growth was officially reported at 10% for FY2002, but other indicators suggest that it waswell below potential. Major problems, such as continuing budget decits caused by subsidies toweak state enterprises and underinvestment in social areas, are yet to be addressed. Medium-termprospects are limited, but solid gains could be made over the longer term once the macroeconomic imbalances and structural issues are resolved.

Economic Assessment

According to the official estimate, GDPgrew by 10.0% in FY2002 (ended 31 March2003); growth was estimated at slightly over 10% in FY2003. e stronger areas of expan-sion in FY2002 were energy, mining, construc-tion, and manufacturing. However, in FY2003

Myanmar faced several problems that constrainedgrowth, including a hardening of internationaltrade and investment sanctions that hurt exportsof textiles and other goods and led to the closureof some garment factories. Troubles in thebanking sector, shortages of certain imports andof power, and slower growth in xed investmentalso hindered the economy.

Weaknesses in the data make an objectiveassessment of the economy difficult. Informa-tion is o en incomplete, delayed, and difficult toreconcile. For example, GDP is officially estimatedto have grown by 10% or more in each of thepast 3 scal years, yet some essential factors of production, such as sown land area and the useof fertilizer, pesticides, crude oil, and natural gas,have been at or declined for at least part of thatperiod. Electricity generation in FY2002 was lowerthan in FY2000. A more modest growth scenariois also suggested by official gures on the growthof agricultural production, which slowed to 2.9%in FY2002 from 8.1% in FY2001.

e scal decit, which is largely nancedthrough central bank credit creation because of a low level of revenues, was targeted to narrowto 2.5% of GDP in FY2002 from 5.9% in FY2001,but provisional gures indicated that the targetwas not met, hitting 4.1% of GDP. More than 60%of the overall decit was caused by the decits of state economic enterprises. e current expen-

ditures of such enterprises were higher than theGovernments total spending. e capital expen-ditures of these enterprises in recent years havebeen less than 10% of their total expenditures,which helps explain a sharp slowdown in xedinvestment. e continuing need for governmentsubsidies stems from delays in the privatization of state enterprises, as well as repeated expenditureoverruns and supplementary budgets.

Myanmars ination rate slowed to a still-high24% in September 2003 from 57.0% at end-2002.Supply constraints contributed to price increasesfor items such as food, and some panic buyingof essential goods was seen in early 2003 whenthe Government imposed limits on cash with-drawals during a period of turmoil in the nan-cial system. e ability to use monetary policy tocontrol ination is constrained by the monetizingof the budget decit and a policy of keepingnominal interest rates fairly stable. With highination, this meant that real interest rates werenegative in 2003.

asian development outlook 2004: foreign direct investment in developing asia

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