In the first eight months of 1998, monetary policy was conducted in a difficult economic environment caused by the deflationary contagion effect of the region's financial crisis on domestic financial markets and the real economy. Priority continued to be accorded to restoring macroeconomic stability and thereby stability in the domestic financial markets. In responding to changes in the economic environment, monetary policy remained flexible. At the start of the year, a tight monetary policy stance was adopted with the view to strengthen further economic fundamentals and the financial system as well as to contain inflationary pressures due to ringgit depreciation. However, when it became evident that the prolonged crises and slow down in external demand had affected the economy adversely resulting in 4.8% contraction in real Gross Domestic Product (GDP) in the first half of the year, monetary policy was eased and new measures introduced to support the recovery process. At the same time, improving the efficiency and functioning of the money market and intermediation process of the banking system was given emphasis to ensure the availability of financing at reasonable costs.

In the first quarter of 1998, the annualized growth of the key monetary aggregates M1, M2 and M3 moderated significantly to - 11.3%, 15.7% and 13.7% respectively as at end of March 1998 (4.3%, 22.6% and 18.5% respectively at the end of 1997). The primary reason for the slowdown was the significant moderation in loan growth in the period due to weak business expectations, higher interest rates and more cautious lending by financial institution in credit growth among the banking institutions in an environment of slowing economic growth was a cause of concern as the effective allocation of resources to productive activities remained important in efforts to stimulate growth. Liquidity in the banking system was tight partly as a result of inefficiencies in the money market which resulted in smaller financial institutions facing difficulties in securing interbank funds. The competition for funds subsequently led to a significant increase in interest rates particularly for short-term money of a few institutions which became reflected in overall higher interest rates for the banking system.

money market, the average base lending rates (BLR) of commercial banks and finance companies was higher at 11.96% and 14.23% respectively at the end of March 1998 (10.33% and 12.22% at end-1997).

The moderation in monetary growth continued into the second quarter of 1998, with the annual growth in M3 slowing down to 7.3% as at end-June on account of continued slowdown in lending activities as financial institutions undertook adjustments to strengthen their balance sheets given rising non-performing loans (NPLs). Continued weak aggregate demand and negative expectations about near term economic prospectus in an environment of high interest rates also dampened demand for bank credit. Liquidity remained tight and interest rates firm with the 3-month interbank rates stable at around 11%. As part of efforts to enhance transparency and promote efficient liquidity management a new procedure for market operations was introduced by BNM on April 30, whereby forecasts of cash flows of the financial system were to be provided at regular intervals to assist market participants to assess the liquidity situation in the system. Meanwhile, the average BLR of commercial banks and finance companies increased to 12.27% and 14.70% as at end-June 1998 respectively from 11.96% and 14.23% respectively at end-March.

Given the sharp deterioration in growth of the real sectors of the economy and the banking system due to the sharper-then-anticipated decline in economic activities and aggregate demand, BNM continued to implement measures to address these concerns focussed on reducing the cost of funds to the banking sector in order to enable them to lower their lending rates. Effective May 1, 1998 the band for permissible daily variation in the average balances that was required to meet the SRR was widened to +2% of the prescribed SRR rate from the previous band of +0.5% to allow banking institutions greater flexibility in managing their daily liquidity operations and lower the cost of operations. On July 1, the SRR was again reduced by a further 2 percentage pints from 10% t 8% to improve liquidity in the system. BNM also relaxed the hire purchase guidelines for the financing of passenger cars effective July 28 to revitalize the motorcar industry. The margin financing for cars was raised from 70% to 85% and the restriction on maximum repayment period was removed. This was to address the sharp contraction in sales of passenger cars faced by the motor vehicle industry, as a result of stricter hire purchase lending guidelines imposed earlier.

In August, a deceleration in the rate of inflation, absence of demand pressures and relatively stable ringgit allowed BNM to adopt a cautious easing of monetary policy as part of overall efforts to support the economic recovery process. The 3-month intervention rate was reduced from 11% to 10.5% and further to 10% which resulted in lower lending rates. The average BLR of commercial banks declined from 12.27% at end-June to 9.05% as September 9, 1998. As part of the overall easing of the monetary stance, BNM also exercised flexibility in ensuring compliance with credit plans by allowing individual institutions with lending capacity to exceed their respective credit ceilings.

In late August, against a backdrop of a 6.8% contraction of real GDP growth in the second quarter of 1998, new measures were introduced to ease liquidity. They included a further reduction in the SRR to 6% from 8% effective September 1, 1998 and a reduction in the intervention rate from 10% to 9.5% effective August 28. In addition, as a move to enable faster transmission of changes in monetary policy on interest rate levels, the BLR framework was revised. The calculation of the BLR was subsequently based on the BNM 3-month intervention rate instead of Kuala Lumpur Interbank Offered Rate (KLIBOR), while the administrative margin of financial institutions that is allowed in BLR computation was reduced to 2.25% from 2.50%. in addition, the maximum margin over the quoted BLR was reduced from 4.0 percentage pints to 2.5 percentage pints effective October 1, to lower the cost of funds to borrowers.

In September, the Government adopted additional new measures to reduce interest rates and improve liquidity to expedite the economic recovery process. With effect from September 3, the BNM intervention rate was further reduced to 8.0% from 9.5%. This reduction aimed at effectively reducing the maximum BLR of the commercial banks and finance companies to 9.06% and 10.76% respectively. As a further measure to ease liquidity, commercial banks were no longer required to maintain vostro balances of foreign banking institutions with BNM. Greater flexibility was also accorded to banking institution in their asset-liability management. In line with measures announced to establish a new liquidity frame work in July, the liquid asset requirement for commercial banks was revised downwards to reduced from 17% to 15%, while the SRR was further reduced to 4%. However, the liquid asset requirements of finance companies and merchant banks were retained at 10% (12.5% if they issued negotiable instruments of deposit (NIDs).