MONETARY POLICY IN 2010

MONETARY POLICY IN 2010

81 Monetary Policy
84 Monetary Operations
87 White Box: Financial Imbalances and the Role of Monetary Policy

ANNUAL REPORT 2010

79
MONETARY POLICY IN 2010 ANNUAL REPORT 2010 80
MONETARY POLICY IN 2010

MONETARY POLICY In the domestic economy, economic indicators

suggested that the economy had started to
The Malaysian economy experienced a strong grow again since the fourth quarter of 2009.
resumption of growth in 2010, driven by a Positive developments in manufacturing
robust expansion in private consumption and a production, financing activity, external trade
rebound in private investment. In tandem with the and labour market conditions reaffirmed the
improvement in the domestic economy, the focus assessment that the economic recovery was
of monetary policy in 2010 shifted away from the gaining strength. The economy was expected
need to avert a fundamental economic downturn, to expand further during the course of 2010,
and turned towards balancing the risks to inflation with growth being supported by strengthening
and growth, while ensuring that monetary domestic demand, particularly private
conditions were appropriate to prevent the build- consumption, and further improvements in
up of financial imbalances. external demand.

At the beginning of the year, economic indicators

were signalling that the global recession was With the improvement in economic
receding. Global growth was being led by a
rebound in manufacturing and an upturn in outlook, the need to normalise the
the inventory cycle. Signs of improvement were
evident from retail sales, consumer confidence, extraordinary monetary stimulus
and the housing markets. World trade was also became the focus of the MPC
beginning to pick up. The change in outlook
was reflected by the significant upward revision during the early part of the year
to the 2010 global growth forecast by the
IMF in its January 2010 update of the World
Economic Outlook (WEO). Meanwhile, economic Meanwhile, inflation was expected to rise
performance of the emerging market economies, gradually but remain low throughout the year.
including Malaysia, was expected to improve more Measures of core inflation and demand indicators
significantly than the advanced economies given suggested the potential emergence of demand
the more resilient fundamentals relating to their induced inflation later in the year, in line with the
economies and financial systems. recovery in demand conditions. Demand related
pressures on inflation, however, were expected to
Chart 3.1 remain relatively modest. The risk to inflation was
more likely to originate from supply-side factors,
Outlook for Real GDP Growth in 2010 namely the increase in global commodity prices
as global demand improved and the expected
Annual growth (%)
10 adjustments to administered prices that were
8 undertaken under the subsidy rationalisation
6 programme. These supply-side factors, however,
4
would not warrant tighter monetary conditions
2
unless they led to signs of persistent and wide
ANNUAL REPORT 2010

0
-2 US Japan Euro Asean 5* NIEs** World spread second-round effects.
Area
-4
-6 Against this backdrop, the need to normalise
-8 the extraordinary monetary stimulus undertaken
Oct ‘09 Jan ‘10 Apr ‘10 Jul ‘10 Oct ‘10 in 2009 became the focus of the Monetary
*Indonesia, Malaysia, Philippines, Thailand and Vietnam
Policy Committee (MPC) during the early
**Newly Industrialised Economies part of the year. Leaving the Overnight Policy
Source: IMF, WEO October 2009, January, April, July and October 2010 Rate (OPR) at such a low level could give rise
to financial imbalances and create distorted
81
 incentives for economic agents, leading to the when combined with unchecked financial
mispricing of risks, financial disintermediation innovation, led to large investments in risky
MONETARY POLICY IN 2010

and excessive credit growth (See white box on financial products. In essence, the following
‘Financial Imbalances and the Role of Monetary are the main considerations with regard
Policy’). Ignoring such risks could lead to to the normalisation of monetary policy.
undesirable effects on the broader economy First, monetary policy must be adjusted
when such financial imbalances unravel in a pre-emptively to avoid the build-up of
disorderly manner. The policy focus, hence, was financial imbalances. Raising interest rates
to assess the appropriate timing and pace for when financial imbalances have already
the process of monetary policy normalisation. permeated into the economy would not be
With the economy still at a nascent stage of effective. Second, the monetary policy stance
recovery, the challenge was in ensuring that needed to be recalibrated given that the
raising interest rates would not disrupt the threat of a fundamental recession was no
sustainability of private sector demand in driving longer present. The extraordinary amount
economic growth. of monetary stimulus provided in 2009 was
no longer warranted as indicators showed
Incipient signs of the economic recovery growth becoming more entrenched led by
being firmly entrenched allayed this concern. the strong growth of private sector demand.
Compared to 2009, it was clear that the Notwithstanding this need to normalise
extraordinary conditions under which interest interest rates, it was recognised that monetary
rates were reduced no longer prevailed. policy needed to remain accommodative
Forward looking indicators suggested stronger to support the ongoing economic recovery.
economic recovery ahead, while engagements Policy adjustments would also be gradual to
with key industry players revealed more facilitate an orderly transition by financial
confident sentiments toward the economy. This institutions and market participants. Taking
assessment was affirmed in February 2010 when into account these considerations, the MPC
the numbers for 4Q 2009 showed a stronger normalised the OPR gradually by 25 basis
growth performance of 4.4%. points at each of the MPC meetings on 4
March, 13 May and 8 July 2010. The money
The MPC was mindful that if interest rates market responded to the OPR increases in an
continued to be held at very low levels for a orderly manner, with adjustments to money
sustained period, they could lead to financial market rates, which were then transmitted to
imbalances. This was a key lesson from the retail lending rates.
the experience of the industrial countries
at the heart of the recent global financial Retail lending rates adjusted quickly, with all
crisis. A prolonged period of low interest banks raising their base lending rates (BLR)
rates discouraged savings, led to excessive within 6 days of the announcement of each
borrowing, overinvestment in housing, and OPR increase. Nevertheless, with borrowing

Chart 3.2 Table 3.1

GDP and Inflation MPC Meeting Dates and OPR Decisions

Annual growth (%)
MPS Publication Dates OPR
12
10
8 26 Jan 2010 2.00
6
GDP
ANNUAL REPORT 2010

4
Inflation
4 Mar 2010 2.25 (+ 25 bps)
2
0
-2
13 May 2010 2.50 (+ 25 bps)
-4
-6 8 Jul 2010 2.75 (+ 25 bps)
-8
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2 Sep 2010 2.75
2009 2010
Source: Bank Negara Malaysia
12 Nov 2010 2.75
82
 Chart 3.3 points below pre-crisis levels1. Lending rates to
households were 38 basis points lower than pre-

MONETARY POLICY IN 2010

Base Lending Rate and Average crisis levels over the same period.
Lending Rate of Commercial Banks

% With the borrowing costs still

14

13
below pre-crisis levels, financing
12 conditions remained supportive of
11

10
economic activity
9

8
BLR 6.27% Reflecting the reasonable borrowing cost
7
and ample liquidity in the financial system,
6
private sector financing remained robust
5
ALR 5.05% throughout 2010. Loans extended to businesses
4
‘90 ‘91 ‘92 ‘93 ‘94 ‘95 ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10
during the year improved as retail sales and
investment activity improved. Household
Source: Bank Negara Malaysia
loans also expanded in line with the strong
growth in consumption expenditure following
costs still below pre-crisis levels, financing stable labour market conditions and positive
conditions remained supportive of economic sentiments. Notwithstanding the strong trends in
activity. Specifically, as at end-December 2010, financing, credit growth was judged to be in line
nominal retail lending rates on new loans with fundamentals and the overall level of household
to businesses remained on average 61 basis indebtedness remained at a prudent level.

Chart 3.4 Following the cumulative increase of 75 basis

points, the MPC considered the OPR level of
Average Nominal Lending Rates 2.75% to be appropriate and consistent with
on New Loans for Various Periods its assessment of the medium-term economic
growth and inflation prospects. In the second
%
half of the year, the Malaysian economy
7.5
continued to expand in spite of the slower
performance in the external sector. Domestic
7.0
45bps
economic growth continued to be supported
by domestic demand following favourable
6.5
labour market conditions, positive sentiments,
61bps
low inflation and conducive credit conditions.
6.0
50bps There were, nevertheless, downside risks to
38bps global growth arising from several factors. The
5.5 escalation of the sovereign debt crisis in the
euro area as well as the announcements of
5.0 impending fiscal austerity measures in several
advanced economies raised uncertainties on the
4.5 sustainability of the global economic recovery.
BLR Businesses Households Overall In addition, growth in the advanced economies
ANNUAL REPORT 2010

Pre-crisis period* slowed as the temporary boost to economic

activity from the build-up of inventories and
Crisis period**
the earlier policy stimulus had begun to fade.
December 2010 Furthermore, the policy-induced slowdown in
* January 2008-October 2008
1
** March 2009-February 2010 Over the period January 2008 to October 2008 when the
OPR was still at 3.5%, the lending rates on new loans for
Source: Bank Negara Malaysia businesses and households were on average 6.01% and
5.67% respectively.
83
 PR China to achieve a more sustainable growth financial flows. Sustained divergence in growth
over the medium term could affect intra- prospects between developed and emerging
MONETARY POLICY IN 2010

regional trade. economies led to continuous financial inflows

into the emerging market economies and
With regard to inflation, the consumer price created upward pressure on their currencies.
index (CPI) edged higher during the second half This was further compounded by further
of the year. This increase was moderate despite monetary easing in advanced economies.
the series of adjustments to administered prices, Differences on currency policy among the
and was mainly on account of supply factors. G20 nations also heightened tensions in the
At the same time, the lower imported inflation foreign exchange market. In response, several
from more modest growth in the advanced emerging market economies responded by
economies and the stronger ringgit helped to imposing measures to better manage the
mitigate some of the pressures on inflation. For significant increase in capital flows. Different
the year as a whole, inflation remained low at countries, however, had different threshold
an average of 1.7%. levels to capital flows and exchange rate
appreciation and varying capacity to manage
The risk of a build-up of financial imbalances them. The inflows into Malaysia have so far
continued to be evaluated throughout the year. been manageable and with no discernible
Assessments showed that growth in asset prices signs of the inflows creating imbalances in
and credit were generally not excessive and the domestic economy and financial system.
continued to be in line with the improvements in Amidst the large capital inflows, the ringgit
the economy. First, there were limited evidence exchange rate movements remained orderly,
of overvaluation in the equity market. The while sterilisation operations ensured that
magnitude of the KLCI increase did not deviate the impact of the excess liquidity on domestic
too far from its underlying trend. Moreover, monetary conditions was contained. Having
even though equities posted healthy gains, a broad range of instruments for monetary
equity purchases funded through borrowings operations helped increase the efficiency of
were low. Second, evidence of excessive credit domestic liquidity management. The depth
growth was also limited. The ratio of loan to and resilience of the financial system together
GDP relative to its trend was neither excessive with the healthy level of international reserves
nor persistently above trend. Third, property also served to mitigate the risks arising from
price inflation at the national level remained reversal of these flows.
modest with an annual increase of 1.5% in 2009,
compared to the 2000-2008 average of 3.6%2. MONETARY OPERATIONS
However, there were concerns of speculative
activity in the property market in selected Overall conditions in the domestic money
locations in the urban areas. The number of market were stable in 2010. Focus was
transactions and house prices in these locations accorded to ensuring that the normalisation of
experienced faster growth. There was also a rise monetary policy was being transmitted to the
in financing provided to individuals for multiple money market rates in an efficient and orderly
unit purchases. In this instance, targeted macro- manner. Money market conditions remained
prudential measures were judged to be more orderly as financial institutions adjusted
appropriate to address such concerns. The their interest rates to the increases in the
policy intent was to reduce speculative activity OPR in March, May and July 2010. The Bank
in the property market. To this end, the Bank in maintained the average overnight interbank
November 2010 announced the implementation rate (AOIR) within the corridor of ± 25 basis
of a maximum loan-to-value (LTV) ratio of 70% points of the OPR. During the period 2 – 4
ANNUAL REPORT 2010

applicable to the third and subsequent house March 2010, the AOIR traded lower, close to
financing facilities taken out by a borrower. the floor rate of the corridor. This reflected
market participants’ exceptional interest for
Another development that posed challenges to overnight placements with the Bank ahead of
the conduct of monetary policy during the year the March MPC meeting. Subsequent to this
was the larger and more volatile international episode, the AOIR traded within a wider range
up until the third quarter in line with market
2
Source: National Property Information Centre (NAPIC) expectations for further increases in the OPR.
84
 Chart 3.5 Chart 3.6

MONETARY POLICY IN 2010

Outstanding Liquidity Placed with
OPR and Interbank rates
Bank Negara Malaysia
% RM billion
3.1 Celing rate of the corridor for the OPR 350

2.9 300

2.7 250

2.5 200
Floor rate of the corridor for the OPR 150
2.3
2.1 100

1.9 50
1.7 0
J F M A M J J A S O N D
1.5
2010
J F M A M J J A S O N D

2010 Direct Money Market Repo Others

Borrowing
OPR 1 week Wadiah Acceptance BNMN

1 month Overnight Commodity Murabahah BNMN-i

Placement (CMP)

Source: Bank Negara Malaysia Source : Bank Negara Malaysia

With the resumption of portfolio inflows into main instrument used (accounting for 62.7%
the domestic financial markets, a key challenge of outstanding monetary policy instruments),
for monetary operations was to manage the there was a sizable increase towards securities-
surplus liquidity in the interbank market. based monetary policy instruments (2010:
Malaysia, along with other emerging market 37.3%, 2009: 20.2%). Bank Negara Malaysia
economies, registered net portfolio inflows Monetary Notes (BNMN for conventional
in 2010. For the year as a whole, aggregate and BNMN-i for Islamic money markets)
surplus liquidity increased significantly to were increasingly used in 2010 as there had
RM299.2 billion as at end-December 2010 been strong demand for these securities by
(2009: RM251.8 billion). investors, particularly non-resident investors.
Hence, the frequency of issuances for the
The composition of monetary instruments BNMN and BNMN-i was increased from once
became more diversified in 2010. Although a week in 2009 to twice a week in 2010. The
uncollateralised borrowings remained the share of Islamic monetary instruments was

Chart 3.7

Breakdown of Outstanding Monetary Policy Instruments

Others
Others
10%
16%
BNMN-i
3%
BNMN
9% Direct Money
BNMN-i
Market Borrowing
Commodity Murabahah 10%
34%
Placement (CMP)
1%
Direct Money
ANNUAL REPORT 2010

Market Borrowing
Wadiah 54%
Acceptance BNMN
16% 23% Repo 5%

Repo Wadiah
7% Commodity Murabahah
Placement (CMP) Acceptance
1% 11%

2009 2010

Source : Bank Negara Malaysia

85
 23.9% of total monetary instruments as at maturity range for uncollateralised borrowings.
end-2010. Liquidity absorbed through Islamic The initiative made liquidity management more
MONETARY POLICY IN 2010

instruments increased in line with the growth efficient by providing financial institutions
of total liquidity in the system and stood at the option to offer their excess ringgit funds
RM71.6 billion (2009: RM58.9 billion). according to their liabilities’ profile. This would
enhance the Bank’s liquidity management by
In terms of the maturity profile of monetary matching the Bank’s liquidity forecast with the
instruments, the average maturity was extended financial institution’s liquidity requirements.
to 40 days in 2010 (2009: 27 days). This was Another enhancement of monetary operations
a change in strategy compared to the last few was the automation of Commodity Murabahah
years when the focus was on a shorter average Programme transactions in the Fully Automated
maturity structure to ensure that liquidity can System for Issuing/Tendering (FAST). This system
be swiftly unwound in the event of large and caters for both auction/tender and bilateral
sudden outflows given the significantly more transactions of the Commodity Murabahah. The
volatile environment in the financial markets. system configuration of FAST enables the purchase
In a period of rising interest rates, extending and sale of commodities, auto generation of
the maturity of borrowings allows for more murabahah contracts and digital signature.
cost effective sterilisation operations as surplus
liquidity is locked-in at a lower rate over a With respect to Islamic monetary instruments,
longer period. the Bank will introduce new instruments that
are structural variations of the BNMN-i issuances
During the year, the Bank introduced several in 2011, namely the Bai Bithaman Ajil (deferred
changes to the features of monetary instruments payment) and Istithmar (investment based on a
to increase operational efficiency. One of the combination of Murabahah and Ijarah). These
initiatives was the Range Maturity Auction (RMA), new structures would appeal to a wider base
a variation to the money market term tender3 of investors given the stricter compliance with
which would allow flexibility in determining the Shariah requirements of different jurisdictions. In
line with the vision of Malaysia being an Islamic
3
Money market term tender refers to uncollateralised
Financial Centre, the Bank would continue
borrowings with a predetermined maturity within 1 week to develop new and flexible Islamic monetary
to 2 months. Normal maturities for money market term instruments that are widely acceptable amongst
tenders are 1 week, 2 weeks, 3 weeks and 1 month. global investors.
ANNUAL REPORT 2010
86
 Financial Imbalances and the Role of Monetary Policy

MONETARY POLICY IN 2010

In 2010, the OPR was raised by a total of 75 basis points. Although inflation remained benign
and the economy was at an initial stage of recovery, the OPR was adjusted upwards to normalise
monetary conditions to manage the risk of financial imbalances. In the Bank’s assessment, if left
unchecked, the subsequent unwinding of financial imbalances could undermine the sustainability of
the economic recovery and have adverse consequences on price stability and economic growth.

Financial imbalances can manifest in the form of an unhealthy build-up of leverage, under-pricing
of risks, excessive yield seeking activities, over investment in certain markets, asset prices that depart
substantially from fundamentals and increased risks to the stability of the financial system. These
distortions tend to surface when interest rates are expected to remain very low for a prolonged
period. In this regard, the Bank is mindful of the need to ensure the stance of monetary policy is
appropriately aligned to mitigate the risks to inflation and growth.

There has always been a close link between monetary policy and financial stability. First, extremely
loose monetary policy for a prolonged period can be at the root of financial imbalances. Monetary
policy affects the inter-temporal allocation of resources which underlie the incentives for economic
agents to save and borrow. Interest rates that are kept too low for a prolonged period would
create incentives for savers and borrowers that are detrimental to the economy over the medium
term. For example, low or negative real returns on deposits could encourage shifts from low risk
deposits towards speculative investments in riskier assets in a search of higher yields. Substantially
low borrowing costs could also promote excessive leverage by households and businesses. Second,
a well functioning and resilient financial system is necessary for the effective transmission of
monetary policy. As the financial imbalances unravel, the balance sheets of financial institutions
that are exposed to bad assets and delinquent borrowers would be impaired. In turn, these weak
financial institutions will not be able to expand lending activity to support economic activity during
downturns even under such an easy monetary policy environment. Third, financial imbalances have
implications for macroeconomic stability, whereby a disorderly correction of imbalances may lead to
a contraction in economic activity. For example, in the event that asset bubbles burst, asset values
would deteriorate. Consumption and investment activities would be adversely affected as households
and businesses face difficulties in securing financing due to deterioration in the value of collateral.
Consequently, economic activity could slow or even contract.

The recent global financial crisis exemplifies clearly the close link between monetary policy and
financial stability. The crisis was a culmination of financial imbalances accumulated over a prolonged
period of very low interest rates. The unravelling of financial imbalances led to the collapse of
financial institutions and market disruptions globally. Failures of the financial intermediation process
and the contraction in private sector economic activity subsequently resulted in the worst global
recession since the Great Depression. While monetary policies in the advanced economies at the
centre of the crisis were substantially eased to support the economic activity, the dysfunctional
financial institutions and markets were not able to transmit the unprecedentedly large monetary
policy stimulus to the broader economy.

In formulating monetary policy, the Bank does not only focus narrowly on managing inflation and
growth over the typical monetary policy horizon of 6 - 8 quarters. The Bank takes into consideration
ANNUAL REPORT 2010

information on the developments in the credit and asset markets in its monetary policy decision
making, with the view of ensuring macroeconomic stability over the medium term. Monetary policy
takes into account the underlying cause of asset price inflation rather than the asset price inflation
itself. This approach has resulted in policy action when monetary policy adjustment was made even
in the absence of risks to inflation within the monetary policy horizon. The recent monetary policy
normalisation is an example of this approach.
87
 The use of interest rate policy to manage the risks of financial imbalances takes into account
MONETARY POLICY IN 2010

several important caveats. First, monetary policy must be pre-emptive in order to be effective.
Raising interest rates when asset prices are already significantly overvalued would not be effective
in deterring speculative activity as the expected gains from asset prices increases would have by
then far exceeded the borrowing costs. Second, monetary policy on its own would not be effective
in addressing such financial imbalances. To rely only on interest rates may in fact result in an over
adjustment. Macroeconomic policies need to be considered in a holistic manner. There may be a
need to complement monetary policy with more targeted macro-prudential measures1 if risks emerge
in specific sectors of the economy. Malaysia has a long history of relying on a broad array of policy
instruments in managing the risks of financial imbalances. During the episode of asset price bubbles in
the mid-1990s, in addition to monetary tightening, the Bank implemented prudential credit measures
such as lowering the loan-to-value ratio for the purchase of selected non-owner occupied properties.
These measures were also complemented by fiscal measures such as the upward revision of the
graduated real property gains tax to between 15-20%. Third, monetary policy is a blunt tool. Merely
raising interest rate aggressively to prevent financial imbalances could unnecessarily increase the cost
of borrowing at the expense of broader economic growth.

In conclusion, monetary policy is relevant in addressing financial imbalances due to its influence on the
behaviour of economic agents, and the need to obviate the consequences of financial imbalances on
the efficacy of monetary policy itself. Hence, in addition to balancing the risks to inflation and growth,
it is important to ensure that the stance of monetary policy is appropriate to prevent the build-up of
financial imbalances.
ANNUAL REPORT 2010

1
The Asian experience also suggests that macro-prudential tools are likely to be an integral part of the tightening in monetary
and credit conditions as the economic recovery continues. For example, PR China, Hong Kong SAR, Korea and Singapore
announced various measures to deflate housing prices in 2009 and 2010.
88