SUNS4370 Tuesday 9 February 1999

Malaysia: Exit tax on short-term capital

Penang, Malaysia, Feb 5 (IPS/Anil Netto) -- Malaysia's imposition of an 'exit tax' to ease capital controls is designed to lure foreign funds back into the economy, but it seems unlikely to produce an instant response from investors.

But beyond its immediate effects, the move is significant as yet another step taken by a recession-hit economy.
Under the exit tax formula, foreign investors who want to withdraw funds bound under capital controls to be kept in Malaysia can now take them out, by paying a tax of up to 30% of the principal amount.

This aims to address worries by foreign investors about funds that were trapped in Malaysia since the government in September 1998 required that they be kept in the country for at least a year.

An exodus of foreign funds had been expected after the one-year period ends in September this year -- hence the new tax after a series of dialogues with fund managers in recent months.

Announcing the tax Thursday, Finance Minister Daim Zainuddin said the one-year holding period would also be lifted for funds brought into the country from Feb 15 but investors would now have to pay a tax. From Feb
15 onwards, investors in the stock market would need to pay a capital gains tax and profit on funds invested less than a year will be taxed at 30 percent.

"These new measures are aimed at encouraging existing foreign investments in Malaysia, and to attract new funds into the country while at the same time discourage destabilising short-term flows," he said.

Analysts put the value of portfolio investments stand at $10 billion, or nearly 40% of the country's foreign exchange reserves.

Foreign funds account for 23% of the current $80 billion market capitalization of the Kuala Lumpur Stock Exchange. Investors from the United States make up the largest group of foreign funds in Malaysia.

Malaysia can ill afford further capital flight, reeling from negative growth in the wake of Asia's economic crisis.

Daim said that foreign fund managers had shown interest in investing in Malaysia but with the freeze on repatriation of capital, their trustees had not allowed them to invest here.

The exit tax, he said, were made after discussions with fund managers on ways to replace the 12-month holding period. "This is their proposal," he said. "We do not want to destabilise the market again."

But Daim would not say if the new exit taxes would be permanent or temporary.

"It's (exit tax) not going to attract new investors straight away," says the research head of the Kuala Lumpur office of a foreign securities firm. "We are the only market with a tax on capital gains now."

"It's still much, much better than the 12-month holding period," he conceded, "but the tax on profits is still an obstacle. I think they will have to get rid of it in the next 12 to 18 months."

He also predicted that funds would start flowing out of the country between now and September, with very little new capital coming in.

"I was never sure why they introduced the 12-month holding period," said economist Subramaniam Pillay. "I think there will be quite a bit of outflow now but there will also be some inflow."

Other financial analysts however said that the exit tax is the most workable formula given Malaysia's desire to be more selective about the type of capital it takes in.

Still, the exit tax does indicate a realisation by the Malaysian government that the sentiment of the markets -- irrational it may be -- cannot be ignored.

At the same time, the government is keen to hold on to some form of controls it believes has stabilised the economy and stopped speculation on its currency and stock markets.
The Malaysian ringgit is now 3.80 to the dollar while the KLSE's composite index has almost doubled since the imposition of controls. Malaysia has been able to bring down interest rates to affordable levels, say officials in justifying the controls. Buoyed by falling imports, the current account has shot to a surplus
while foreign reserves have topped $27 billion from $21 billion.

"But the crucial factor is whether Malaysia gets reinstated on the (Morgan Stanley) index," Subramaniam said.

Morgan Stanley dropped Malaysia from its Emerging Market Free Series and All Country Free Indices on Dec 1 last year, three months after capital controls were imposed, making it the first country to be so
removed.

Reacting to the easing of controls, the firm said it would wait to see the impact of the new measures before deciding whether to reinstate Malaysia in its key market indices.

"It would help if Malaysia is on the index, but still, without that, people will still invest in the market," said Daim.

But there are other problems, such as bad loans of Malaysian banks that are weighing down on the economy. The government estimates that it will take $16.3 billion to recapitalise the nation's banks and boost public
infrastructure spending.

Analysts say that if investors are discouraged by the tax imposed on profits, the Malaysian government could be forced to print more money, adding downward pressure on the ringgit.

Sceptics are now saying that if the ringgit comes under new pressure, Malaysia can no longer blame speculators and would have to admit they reacted as they did because of fundamental problems in the economy and refusal to undertake reforms.

But "we are implementing serious reforms especially in the financial sector which had been badly affected by the global financial crisis," said Elena Shamsudin of the communication's team of the National Economic Action Council.

Apart from financial and economic factors, there are political matters, like the trial of former deputy premier Anwar Ibrahim, that cloud the country's near-term outlook.

A general election looms within 18 months, adding to uncertainty about Malaysia's fate.