After independence of Malaysia in 1957 from the British, Malaysia have changing the monetary system and established a new monetary policy. Since the established of the Central Bank in 1959, the objective of monetary policy in Malaysia has been adjusted. The financial infrastructure and control inflationary are the target of the management. Before that, the role of monetary policy just a complementarily to fiscal policy but today its roles are more demanding especially after monetary reforms were implemented and financial liberalization. Monetary policy's objective is to promote the exchange rate stability, highest sustainable rate of output growth and consisitent with domestic price.
So, after the independence of Malaysia, there have two parts of monetary to measure the monetary policy, which is the pre-liberalization and the post-liberalization.
Monetary Measure during the Pre-Liberalization Period
The first decade after Independence day of Malaysia saw a transformation in the monetary and banking system. Monetary policy was designed to enhance and develop a sound financial system. Various development policies were implemented during the early 1970, for example, the demand for banking services like demand for credit and demand for long-term loan from business began increasing.
The targets and Instruments of Monetary Policy, Pre-1978
Policy Instruments Indicator Intermediate target Final target
Reserve Requirement
Minimum Liquidity Requirement
MONETARY
BASE
MONEY SUPPLY
Volume and Direction of Credit
OUTPUT,
EMPLOYMENT,
PRICES,
BALANCE OF
PAYMENTS
BANK CREDIT
BANK ASSETS &
LIABILITIES
Discount
Operations
Interest rate
Ceilings
Moral
Suasion
The pre-liberalization's monetary framework can be explained using the chart above. At the administration of the central bank, there were five policy instruments which are reserve requirement (SRR), moral suasion, interest rate ceiling (IRC), discount operation (DO), volume and direction of credit (VDC) and minimum liquidity requirement (MLR). These five instruments were used to control the money supply in Malaysia and the bank credit creation process to achieve the final target.
SRR is a ratio of reserve to eligible liabilities and it can influence the level of deposits and loan extended by banking system. SRR proven to be an effective means of monetary regulation during pre-liberalization even SRR is less flexible. In January 1959, SRR was introduced by commercial banks and the Central Bank monitors the banking sector liquidity. For example, in late 1960s, Central Bank had changed the SRR three times due to the expansion of public sector expenditure and export boom. The period of changed the SRR is from 2.5% in 1959 to 3.5% in 1965 and to 5.0% at the end of 1969. Similarly, under the control of the monetary authority, the average lending rate changes from 7% to 8% in 1970. In 1984, the Central Banks' emphasis was on narrow money which is M1 comprises currency in circulation and private sector demand deposit. In banking system and reserve requirements, the monetary authority used to special deposit placement to influence the monetary base or high powered money. The MLR and VDC are the credit control instruments. MLR was established by Malaysia to protect the bank depositors, ensure that channel their funds and to safeguard the banks' liquidity.
The monetary and banking environment was transformed slowly between 1968 and 1973. This transformation result an improvement in the transmission mechanism of monetary policy. During this period, Central Bank of Malaysia allowed commercial bank accepts medium-term fixed deposit with maturities 36 months. The annual growth of monetary aggregates which is M1 and M2 rise from 7% to 18% between 1968 to 1973.
To control the credit creation process, 10% liquidity requirement was set by finance companies. Because of the boom in export prices with the first oil shock, the imported inflation was occur and the inflation rate was recorded at 17%. So, the commercial banks take action and had raised the SRR from 8.5% in 1972 to 10% in 1974.
Because of this economic environment, the Central Bank of Malaysia also take action to aimed at inflationary pressure and reducing the financial systems' liquidity. Beside the raising rate from the commercial bank, the lending rate of commercial bank also raised from 8% in 1973 to 10% in 1974. The inflation trend movement was under control from 1978 onward. In addition, the first introduced in early1974 of the quantitative control on credit was also withdrawn in February 1975. The measures taken above was effectively managed to contain the inflationary pressure.
Monetary Measures during the post-liberalization period
Monetary policy in post-1978 can be divided into two periods. First is the monetary policy stance during the period toward maturity which is from 1979 to 1988 and the second is during the challenging period which is from 1989 to 1995.
At the end of 1978, based on the cost of fund, the banking sector is allowed to determine the interest rate. After 1978, monetary policy reform was implemented and there were some changes in the instruments and target. The new monetary policy was included the open market operation (OMO) which is offered more impart on the monetary policy. The OMO used for three purpose, firstly, to influence the market interest rates. Second, to alter the structure of public debt without changing the monetary base and third is to change the size of the monetary base. The changing of monetary policy as below:
The targets and Instruments of Monetary Policy, Post-1978
Policy Instruments Indicator Intermediate target Final target
Reserve Requirement
Discount rate
OUTPUT,
EMPLOYMENT,
PRICES,
BALANCE OF
PAYMENTS
Open market operation
MONEY SUPPLY
MONETARY
BASE
BANK CREDIT
Minimum Liquidity Requirement
BANK ASSETS &
LIABILITIES
INTEREST RATE
Lending to priority sector
Hire-purchase guideline
Moral
Suasion
During this period, MLR had reduced many times as it was being replaced by OMO and credit rationing had also abolished. The lending to priority sectors like housing loan still under the protection of Central Bank. There was some information during the period 1979 until 1988.
Average annual inflation rate at 3.7%
Average annual growth of real GDP at 5.5%
Average lending rate at 11.6% by commercial bank
The average annual growth of monetary aggregates also decline due to the tight monetary policy by the Central Bank. In early 1980s, due to a lag effect of global recession, this action was in line with the unsettled condition of the international economic environment. This situation was take action by Central Bank with reducing rate in the money market and maintaining stability in the foreign exchange.
The rapid economic growth in Malaysia was continuing within six year during 1989 until 1994. During that period, the average inflation rate at 3.6%, average annual growth of real GDP at 8.6% and the unemployment rate at 3.0% in 1993 and 2.9% in 1994. This was created the pressure price and money demand, consequently, money supply also been increase. The monetary aggregate demand between 1992 and 1994 were reached the highest which at 35%, 27% and 24% for M1, M2 and M3. So, Central Bank was used the tight monetary policy to reduce excess demand and reduce the inflation pressure and maintaining price stability after 1989.
Money, Credit, and Interest Rates
The Monetary Aggregates
In Malaysia, there were three types of monetary aggregates which is narrow money (M1), M2 and M3. M2 and M3 is used to measures of board money. M1 is defined as currency and demand deposit held by private sector whereas M2 is defined as M1 plus the following financial assets of private sector:
repo transactions effected by the commercial banks
fixed deposits of all maturities of the private sector at commercial banks
savings deposits of the private sector at commercial banks
net issues of NCD to the private sector by the commercial banks
M3 has been constructed since 1978 and defined as M2 plus the following asset:
fixed deposits of the private sector at finance companies, merchant banks, discount houses and Bank Islam;
savings deposits of the private sector at finance companies, merchant banks, discount houses and Bank Islam;
net issues of NCD to the private sector by finance companies, merchant banks, discount houses and Bank Islam
repo transactions effected by finance companies, merchant banks, discount houses, and Bank Islam.
In past three decades, the monetary aggregates have expanded and some factors have contributed to the growth of economic, there factor are:
the expansion of financial networks
the widening of the range of banking instruments and services
an increase in the role of money in the economy
the acceleration of credit activities of the banking system
the rapid monetization process
The lending operations of the banking system to the non-bank private sector, the overall
position of the country's balance of payments and the financial operations of the government are three main sources which influence the level of money supply in Malaysia. Firstly, The expansionary or contractionary will have an impact money supply. The arising or declining on money supply will reflected between level of government deposits with the banking system and the bank lending to the government or bank holdings of government debt. If the bank holdings of government debt are smaller than the government deposit, then the public sector will have imparted a contractionary impact on the money supply, and vice versa.
Secondly, the banking system in Malaysia is the only institution which can creates money through its loans to private sector and as a major source of liquidity for the private sector. Depend on size of their statutory reserve, bank can determine the limit of loan to them. Thirdly, by receiving more inflow of fund from foreign exchange receipt, the domestic deposit in Central Bank will increase. Therefore, money supply increase.
Deposit-loan gap in banking system
Before 1985 and 1986, the total deposits always exceeded the total loans extended by the banking system. But, after the end of 1992, the banking system started has a loan-deposit gap. During this period, government Malaysia had to discourage the banking sector continues lending any loan for speculative purpose. Consequence, the banking sector only relies on non-deposit source of funds such as through borrowing from the interbank market and drawdown their excess liquid assets. So, in period 1988 until 1992, tight liquidity conditions were launch in banking system which is increasing the interest rate. Increasing interest rate can reduce investment so the aggregate demand will fall down. So the economic will recover back. For example, the average lending rate of the commercial banks was increase from 7% in 1989 to 10.26% in 1992. The commercial bank also raised the deposit rate to attract more saving, for example, deposit rates raised from 4.6% in 1989 to 7.65% in 1992.
Credit aggregate and operation
As we know from above, the credit extended by the banking sector went to the private sector. After the recession period of 1985 to 1986, the economy started recovers slowly and credit extend was rapidly increase to annual average of 13% which more than 80% credit is extended to private sector. The authority had changed the SRR on the commercial banks from 3.5% in 1990 to 9.5% in 1994 to monitor strong growth in credit operation. Furthermore, they were requested to observe the SRR and MLR based on the average daily amount of eligible liabilities held over a 2 weeks period.
Exchange rates and domestic interest rate trends
The Malayan dollar was pegged to sterling during the fixed exchange rate regime. In 21 June 1973, the fixed rate was abandoned then the floating of pound sterling in 1972 and the floating of Singapore in June 1973 also. This trend cause the value of Malaysia Ringgit has determined in term of a "composite" of the principal currencies. The Association of Banks was free to determine its own exchange rates based on the composite rate. This type of operate foreign exchange business only the license commercial banks can operate it. The performance of the Malaysia Ringgit has been one of mixed fortunes. Due to inflationary pressure from imported, the Ringgit was weakness between 1973 and 1978. From 1985 to 1991, the Ringgit Malaysia was proved to be depreciated against Malaysia's trading partners' currencies. In 1992 to 1993, the Ringgit appreciated slightly after the monetary authority took steps to rectify the interest rate differential problem and stop the short term capital outflows.
