Executive Summary

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Political Stability: War Of Words Threatens Confidence
Two issues currently dominate Malaysia’s political scene and present possible threats to stability. The first is an ongoing war of words between Abdullah and the former primeminister Mahathir Mohamad. Mahathir has been critical of Abdullah’s style of leadership and his abandonment of major infrastructure projects, and had gone as far as to accuse him of nepotism. Abdullah has the backing of his party and the risk of an imminent change in leadership is minimal, but confidence in the government has been damaged. The second issue is race. Sentiment at November’s annual assembly of the ruling United Malays National Organisation (UMNO) party was heavily pro-Malay – sometimes threateningly – and this has damaged the government’s moderate reputation.

Economic Outlook: Exports Confront Global Slowdown
Malaysia is highly externally dependent, with exports contributing over 120% to overall GDP, and as the global economy slows in 2007, Malaysian growth will drop to 5.5%, from an estimated 5.9% in 2006. Little support is likely to come from the domestic economy, which is feeling the effects of monetary tightening in late 2005 and early 2006. Inflation, however, is easing and will drop below 2% when the effects of fuel price hikes last March drop out of the base. This will create room for the central bank to cut rates in the second quarter, which will help to support the economy later in the year.

The Commercial Banking Sector
The government is committed to improvements across the banking sector and ensuring that it is as internationally competitive as possible. This, combined with Malaysia’s large Muslim population, means the country is rapidly developing as an Islamic banking leader. As at December 31 2006, total assets, loans and deposits amounted to US$227.6bn, US$130.9bn and US$172.3bn, respectively. By all three measures, Malaysia is home to a relatively large banking sector compared to those in most countries in Central and Eastern Europe and, of course, in the Middle East and Africa. In local currency terms, asset growth was 17% over the preceding year. Loan growth was lower at 11%. Deposit growth was larger than loan growth, at 20% Deposits per capita currently amount to around US$6,680.

At December 31 2006, the loan/deposit, loan/asset and loan/GDP ratios were 76.0%, 57.5% and 87.5%, respectively. Of the 59 countries for which BMI has compiled information, Malaysia has the 43nd highest loan/deposit ratio, the 22nd highest loan/asset ratio and the 15th highest loan/GDP ratio. The fact that these ratios are relatively high indicates that the banks are confident about future economic prospects in Malaysia.

Malaysia’s banks appear, collectively, to hold bonds worth US$17.8bn, and the banks’ bond holdings rose 15.3% over the year to December 31 2006. The banks’ bond holdings now amount to around 7.8% of total assets. Bond portfolios are small across the banking sector, and they are falling in absolute terms and as a portion of total bank assets. While there is no indication of future financial trouble for the government, the low ratio or bonds to total assets means that the banks’ exposure in such a situation would be minimal.

Press Reports
Malaysia’s central bank is preparing to throw open the banking sector to foreign participation and wants its banks to fortify themselves ahead of the event by either consolidating among themselves or by finding strong foreign partners. That has led to a rash of reports of interest from foreign lenders and speculation of other ne participants. Bank Negara Malaysia (BNM), the central bank, says that the country’s banks and financial institutions, given their enhanced capacity, are in a strong position to withstand greater competition arising from the more open market. Its governor, Tan Sri Dr Zeti Akhtar Aziz, said in a recent report that the banks were generating new activities such as in the investment banking, insurance and Islamic finance sectors. Nevertheless, Zeti cautions that for Malaysia as a small open economy, ‘the global dimension has assumed greater significance with the increased international inter-linkages’.

Hong Kong-listed Bank of East Asia (BEA) will reportedly pay as much as HK$1.86bn (US$230mn) for 25% of Affin Holdings following a provisional agreement between the two parties that was announced by Malaysia’s third-smallest lender to the stock exchange. Singapore state-owned Affin Holdings owns 100% of Affin Bank and the deal had been anticipated after the parties began negotiations last November. Some analysts are puzzled by BEA’s choice of Malaysian partner. Affin is by far the weakest bank among the nine Malaysian anchor banks where asset quality is concerned.

Malaysia’s Employees Provident Fund, meanwhile, is expected to approach Barclays and the Royal Bank of Scotland (RBS), along with other international banks, to buy a 20% stake in Rashid Hussain, a local bank that the state pension fund recently acquired. Neither Barclays nor RBS would comment, but it is unclear whether either bank would be interested. In the past Barclays has steered away from buying minority stakes and, while RBS has a small shareholding in Bank of China, it generally prefers to take control of banks in which it invests. Both banks have expressed interest in Asia, but neither has identified Malaysia as a key priority for expansion.

Apart from foreign banks, Texas Pacific Group (TPG), the US private equity fund, has expressed strong interest in buying a stake in a Malaysian bank. TPG is seeking to take a 20% stake in EON Capital, a Malaysian bank that has launched a bid for Rashid Hussain. It is the second attempt in recent months by TPG to gain a stake in a Malaysian bank after its bid for AMMB, the fourth-largest financial group, was trumped byAustralia’s ANZ Bank. Newbridge Capital also wants to buy the EON stake from DRBHicom, a local automotive manufacturer.