South-Western College Publishing - Economics  
Malaysian Economy Out of Control
Subject Capital Controls, Currency Trading
Topic International Finance
Key Words Exchange rates, Capital Controls, Current Account, Economic Growth
News Story

When the Asian financial crisis hit Malaysia last year, Prime Minister Mahathir Mohamad responded by banning the removal of foreign money and making Malaysia's currency, the ringgit, nonconvertible outside of the country. The Prime Minister blamed his country's financial problems on foreign currency traders. In February, Malaysia replaced the ban on the removal of foreign capital with an exit tax that provided investors with a steep penalty for the withdrawal of funds held less than one year. Malaysia just announced that it has removed the exit tax on foreign investment. The government does not believe that the removal of the tax will result in a mass exodus of capital from the country.

Malaysia still imposes a capital gains tax on profitable investments. The capital gains tax, like the exit tax, is graduated to encourage investors to leave their capital within the country. The capital gains tax raises the cost of investment in Malaysia and could still be a deterrent to investment. Possibly as a result of Malaysia's position on capital controls, it has attracted less foreign investment than other Asia countries, like South Korea or Thailand, whose economies have also rebounded.

Malaysia's economic recovery has been aided by setting the ringitt to the dollar at a low rate. Exports became very competitive as a result and economic growth was 4.1 percent in the second quarter. Whether Malaysia's economy will continue this growth depends very much on the reaction of investors to the relaxation of controls. A significant capital outflow could damage the recovery. Dr. Mahathir believes that the outflow of capital will not be significant. Malysia has accumulated $32 billion in reserves and has a current account surplus; it could withstand the expected level of outflow.

(Updated October 1, 1999)

1. Define capital gains. Explain how a graduated capital gains tax based upon the length of time the investment was held would deter new investors from investing in Malaysia. How would it provide an incentive for foreign investors to keep their capital in Malaysia?
2. How would the inflow of foreign capital in the form of foreign investment aid the economic development of Malaysia? What would happen to the Malaysian economy if there were a sudden, significant outflow of capital?
3. The article mentions that the Malaysia's currency has been pegged to the dollar. How is this fixed exchange rate maintained in the face of changes in the demand and supply for foreign exchange.
Source Mark Landler, "Malaysia Ends Most Controls on Investment," The New York Times, September 2, 1999.

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