Reuters - Jan 05, 2000 Eastern

By Sabyasachi Mitra

KUALA LUMPUR, Jan 5 (Reuters) - Malaysia's economic indicators paint a rosy recovery picture but slack bank lending, a fixed exchange rate and dependence on electronics exports stand as possible roadblocks to sustainable growth.

Malaysia, which drew international criticism after it imposed controls on capital in September 1998, has staged a convincing turnaround on the back of a manufacturing boom spurred by foreign demand for electronic and electrical goods.

Gross domestic product, which shrank by 7.5 percent in 1998, is thought to have expanded by five percent in 1999 and is forecast to grow by 5.7 percent this year, according to a Reuters poll last month.

The country has piled up hefty trade surpluses, padded its foreign exchange reserves and removed non-performing loans from banks' balance sheets – all without fanning inflation.

But economists said the recovery had been export-led and highly dependent on electronics goods, including semiconductors, which accounted for 58 percent of total overseas sales in the first 11 months of 1999.

If, as many expect, foreign demand for electronics products tapers off in the first half of 2000 as worries over the millennium bug subside, Malaysia's engine of growth could be starved of fuel.

``The biggest risk is a slump in the global electronics sector,'' said Bhanu Baweja, economist at IDEAglobal.com.

Another worry is bank lending. The government has prodded banks to pick up lending to stimulate domestic investment, setting an annual loans growth target of eight percent in 1999.

But total loans outstanding at the end of November were up only one percent year-on-year, well below the target.

Banks are still reluctant to lend, fearing they could end up with more sour loans as they clean up from the country's worst recession since independence in 1957.

``Financial institutions are keen to repair their balance sheets and to boost their capital bases,'' Barclays Capital said in a recent research report.

``However, a perpetuation of such conservatism is starting to put a lid on real growth unless banks are ready to assume more corporate and household risks again.''

Analysts said that as domestic demand picked up, banks needed to step up lending to finance new investment. Stagnant lending could choke investment and put a brake on economic growth.

``Banks are becoming risk averse. The government has to take steps to break the vicious cycle,'' said Eddie Lee, regional economist at Vickers Ballas.

The ringgit's fixed exchange rate has so far been a blessing, shielding investors and trading firms from currency volatility and, because the ringgit has been undervalued, giving a major fillip to exports.

SG Securities said the ringgit currently had a fair value of about 3.30 per dollar, implying an undervaluation of at least 15 percent.

Inflation has been kept in check, but the undervalued ringgit could spur speculative inflows, eventually producing excess liquidity and upward pressures on prices, probably in 2001, SG said.

In the long term, the undervalued ringgit could undermine productivity growth by subsidising industries which would not be competitive in the absence of a fixed exchange rate.

Some experts expect Malaysia to shift to a managed float in late 2000. Prime Minister Mahathir Mohamad has said he will wait until the international financial architecture is overhauled.

That could take years.

``One of the greatest risks facing the Malaysian economy today is that PM Mahathir may retain the peg long after its usefulness to the economy has expired,'' Political and Economic Risk Consultancy Ltd said in a report last month.

The consultancy said the labour situation was becoming tight in some sectors, with manufacturing wages rising much faster than they did during the last recovery in the mid-1980s.

If manufacturing wages continue to rise, the ability of the ringgit peg to stimulate exports will be eroded, it said.

``If that happens, then policymakers will find it difficult to let the currency rise in order to relieve the pressure on inflation,'' the consultancy said.

In that case, Malaysia would have to grapple with rising prices and declining productivity -- a recipe for trouble.