Academic journal article Journal of Southeast Asian Economies

Current Account Reversal during a Currency Crisis: The Malaysian Experience

Academic journal article Journal of Southeast Asian Economies

Current Account Reversal during a Currency Crisis: The Malaysian Experience

Article excerpt

I. Introduction

During the 1997-98 East Asian financial crisis, the affected economies experienced a massive outflow of portfolio capital. To effect the transfer of such financial resources, the current account of the balance of payments underwent a dramatic reversal within a relatively compressed time period accompanied by massive reduction in domestic spending, sharp depreciation in the real exchange rate, and upward pressure on the real interest rate. This paper studies Malaysia's experience with current account reversal following the outbreak of the financial crisis. During the period 1997-98, the economy experienced a net short-term capital outflow of RM34.6 billion, representing 6.5 per cent of nominal gross national product (GNP). In response, the current account reversed itself from a deficit that averaged 6.2 per cent of GNP during the period 1990-97 to a surplus of 13.7 per cent in 1998.

The magnitude of the current account reversal in Malaysia was the largest among the four East Asian economies that were most severely affected by the currency crisis. As Table 1 indicates, the current account in Indonesia reversed from an average deficit of 2.5 per cent of nominal gross domestic product (GDP) from 1993-97 to an average surplus of 4.6 per cent from 1998-2000, representing a reversal of 7.1 per cent. For Thailand, the switch-around in the current account amounted to 15.7 per cent of GDP. In contrast, Malaysia's external balance reversal during the same period amounted to 19.3 per cent of GDP. Such a massive turnaround in the current account, however, was accomplished with relatively less severe contraction in domestic demand. In 1998, economic activity in Malaysia contracted by 7.4 per cent compared with 13.1 per cent in Indonesia and 10.5 per cent in Thailand. Malaysia's current account reversal therefore appears to have been less painful in terms of the contraction necessary to achieve the reduction in domestic absorption to effect the transfer of resources abroad.

Malaysia stood out among the crisis-hit countries as the only one that did not follow the conventional restrictive macroeconomic policy to stabilize the exchange rate and bring about improvement in the external balance. Instead the authorities chose to fix the exchange rate and impose capital controls, and pursued a moderate expansionary policy. Malaysia therefore presents an interesting case study of current account reversal, and this paper represents an attempt to provide a better understanding of the events following the outbreak of crisis and the adjustment process during the critical years of recovery.

Section II of the paper analyses the dynamics of the external balance adjustment and how key macroeconomic variables shifted to facilitate the required real transfer employing an event-study approach. To complement the descriptive event-study findings, we estimate a structural vector autogression (SVAR) model in Section III to provide an econometric evaluation on the dynamics of the current account adjustment in response to shocks in relative prices and domestic income. Section IV summarizes the overall findings and draws some implications from the Malaysian experience on how the large current account deficit was reversed within a short period of time.

II. Current Account Adjustment and Macroeconomic Performance

An event-study approach to characterizing the dynamics of current account reversal would require an identification of the period before the external balance turned itself from a deficit to a surplus position and an analysis of the behaviour of the economy during the periods before and after the event. (1) The objective of such an analysis is to appraise the duration and the sustainability of the current account reversal and to evaluate how costly the adjustment process was in terms of macroeconomic performance. Using the criteria set out by Milesti-Ferretti and Razin (1998) for a significant and sustained turnaround in the external balance, (2) we identified the fourth quarter of 1997 as the period before the current account reversed into a surplus position (Figure 1). …

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