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Statutory Requirements In accordance with section 48 of the Central Bank of Malaysia Act 1958, Bank Negara Malaysia hereby publishes and has transmitted to the Minister of Finance a copy of this Annual Report together with a copy of its Financial Statements for the year ended 31 December 2006, which have been examined and certified by the Auditor-General. The Financial Statements will also be published in the Gazette. For the purposes of section 115 of the Development Financial Institutions Act 2002, the annual report on the administration of the Development Financial Institutions Act 2002 and other related matters for the year ended 2006 is incorporated in Bank Negara Malaysia’s Financial Stability and Payment Systems Report 2006 which forms an integral part of this Annual Report 2006. Zeti Akhtar Aziz Chairman 21 March 2007 Board of Directors Board of Directors Dr. Zeti Akhtar Aziz D.K. (Johor), P.S.M., S.S.A.P., D.P.M.J. Governor and Chairman Dato’ Ooi Sang Kuang D.M.P.N. Deputy Governor Datuk Zamani bin Abdul Ghani D.M.S.M., D.S.M., K.M.N. Deputy Governor Dato’ Mohd Razif Abd Kadir D.P.M.P., D.I.M.P. Deputy Governor Dato’ Dr. Wan Abdul Aziz bin Wan Abdullah D.P.S.K., A.M.N. Datuk Oh Siew Nam P.J.N. Tan Sri Datuk Amar Haji Bujang bin Mohd. Nor P.S.M., D.A., P.N.B.S., J.S.M., J.B.S., A.M.N., P.B.J., P.P.D.(Emas) Dato’ N. Sadasivan D.P.M.P., J.S.M., K.M.N. Tan Sri Dato Sri Mohd. Hassan Marican P.S.M., S.P.M.T., D.S.M.T., P.N.B.S., A.M.K. Dato’ Mohd Razif Abd Kadir was appointed as Deputy Governor with effect from 1 June 2006. Datuk Oh Siew Nam, Tan Sri Datuk Amar Haji Bujang bin Mohd. Nor and Dato’ N. Sadasivan were reappointed as members of the Board effective 1 March 2007. Dato’ Dr. Wan Abdul Aziz bin Wan Abdullah was appointed as a member of the Board with effect from 28 February 2007. Tan Sri Dato’ Sri Izzuddin bin Dali resigned from the Board with effect from 27 February 2007 on completion of his term as Secretary General to the Treasury. Governor Dr. Zeti Akhtar Aziz Deputy Governor Dato’ Ooi Sang Kuang Deputy Governor Datuk Zamani bin Abdul Ghani Deputy Governor Dato’ Mohd Razif bin Abd. Kadir Assistant Governor Dato’ Mohamad Daud bin Hj. Dol Moin Assistant Governor Muhammad bin Ibrahim Assistant Governor Nor Shamsiah binti Mohd Yunus Assistant Governor Dato’ Mohd Nor bin Mashor Assistant Governor Gopala Krishnan Sundaram Assistant Governor Lillian Leong Bee Lian Secretary to the Board Dato’ Mohd Nor bin Mashor Director Corporate Communications Abu Hassan Alshari bin Yahaya Internal Audit Hor Weng Keng Special Investigation Johar bin Mokhtar Financial Intelligence Jeremy Lee Eng Huat Economics Monetary Assessment and Strategy Dr. Sukhdave Singh Economics V. Vijayaledchumy International Ismail bin Alowi Regulation Financial Sector Development Ahmad Hizzad bin Baharuddin Financial Surveillance Donald Joshua Jaganathan Prudential Financial Policy S. Abd. Rasheed bin S. Abd Ghafur Consumer and Market Conduct Koid Swee Lian Islamic Banking and Takaful Bakarudin bin Ishak Development Finance and Enterprise Marzunisham bin Omar Supervision Financial Conglomerates Supervision Che Zakiah binti Che Din Banking Supervision Chung Chee Leong Insurance and Takaful Supervision Yap Lai Kuen IT and DFI Supervision Mahdi bin Mohd. Ariffin Payment Systems Policy Cheah Kim Ling Investment and Operations Investment Operations and Financial Market Norzila binti Abdul Aziz Foreign Exchange Administration Wan Hanisah binti Wan Ibrahim Currency Management and Operation Ramli bin Saad Organisation Support Human Resource Development Centre Lim Lai Hong Statistical Services Chew Siew Kheam Strategic Management A. Kanagalingam Risk Management Santhini a/p Chandrapal Human Resource Management Kamari Zaman bin Juhari Corporate Services Dato’ Mohd Nor bin Mashor Property and Services Zulkifli bin Abd Rahman Security Mior Mohd Zain bin Mior Mohd Tahir Legal Gopala Krishnan Sundaram IT Services Alizah binti Ali Finance Abdul Aziz bin Abdul Manaf Financial Services Resource Centre Lim Foo Thai Head of U nit Regulation and Supervision Support Siti Ramlah binti Ahmad Chief Representative London Representative Office Azman bin Mat Ali New York Representative Office Mahendran a/l Kanagaratnam Branch Manager Pulau Pinang Raman a/l Krishnan Johor Bahru Abdul Aziz bin Ahmad Kota Kinabalu Ahmad bin Abd Rahim Kuching Ishak bin Musa Kuala Terengganu Azizan bin Mohd Ali Shah Alam Mohd. Khir bin Hashim Contents Governor’s Statement The Malaysian Economy in 2006 3 The International Economic Environment in 2006 5 Overview 8 Domestic Demand Conditions 10 White Box: Development of Small and Medium Enterprises 18 Sectoral Review 31 Prices and Employment 40 External Sector Monetary and Financial Conditions 57 Overview of International Monetary and Financial Conditions 58 White Box: Openness of the Malaysian Economy 62 Ringgit Enchange Rate Developments 64 Liquidity and Money Supply 67 Financial Market Conditions 70 White Box: Movements of Islamic Rate of Returns and Conventional Interest Rates 73 White Box: Increased Cooperation in the Development of the Regional Bond Market 78 Financing of the Economy Monetary Policy in 2006 91 Overview 91 The Policy Environment and Challenges 93 Monetary Policy in 2006 97 White Box: Selected Ongoing Central Bank Initiatives for Promoting Regional Cooperation 99 Monetary Operations in 2006 100 Communicating Monetary Policy Outlook and Policy 103 The International Economic Outlook 105 Malaysian Economy in 2007 114 Monetary Policy in 2007 114 White Box: Potential Output of the Malaysian Economy 116 White Box: Liberalisation of the Foreign Exchange Administration Policies 118 Fiscal Policy in 2007 Governance and Organisational Development 123 Overview 128 Risk Management in Bank Negara Malaysia 131 Organisation Structure Annual Financial Statements 138 Balance Sheet as at 31 December 2006 139 Income Statement for the Year Ended 31 December 2006 140 Notes to the Financial Statements Annex Governor’s Statement The Malaysian economy achieved a steady growth in 2006 amidst an environment of moderating inflation. We entered the year with rising inflationary pressures, arising from record-high oil prices. While the policy rate was raised three times during the course of six months, monetary policy decisions carefully balanced the need to deal with the risks of inflation and the need to sustain a steady pace of economic growth. With the increased flexibility of the economy, the more diversified economic structure, the improved macroeconomic fundamentals and the strengthened financial sector, the economy has emerged stronger and more resilient in 2006. While the external position remained strong, domestic private sector activity continued to drive the economic expansion. This trend was also reinforced by strong inflows of foreign direct investment. The manufacturing, services and the agriculture sectors continued to be the main engines of growth, while the mining and construction sectors experienced a recovery during the year. Inflationary expectations were well anchored during the year. Despite rising inflation in the first half of the year, demand-induced inflation remained low and there was limited evidence of second- round effects from the supply-driven price shocks to headline consumer prices. Hence, following the increase in interest rates in late 2005 and early 2006, monetary policy remained unchanged for the remaining part of the year. Malaysia continues to be a highly open economy in terms of the volume of trade and financial flows, and in terms of the foreign presence in our economy and financial system. In 2006, both exports and imports expanded at double-digit rates. Foreign direct investment in Malaysia also accounted for over one-quarter of investment. In addition, foreign financial institutions in the banking sector account for almost 30% of the market share while in the insurance, the foreign presence accounts for about 70%. Foreign participation in the capital market is also significant, with participation in the bond market now including non-residents who invest in papers as well as those issuing securities. As a result of the high degree of integration with the global economy and the international financial system, global developments have significant effects on the domestic financial markets and economy. In addition, with the highly liberal exchange control policies, there have been large and volatile capital flows. Malaysia is therefore not insulated from external developments and contagion. Malaysia’s ability to absorb this increased volatility has, however, been strengthened considerably. This increased resilience has been derived from the more diversified economic structure, the improved macroeconomic fundamentals, the strengthened financial system and the more developed financial markets. While this growing resilience means that the country has the enhanced capacity to deal with shocks arising from unexpected external developments, the private sector will also need to actively manage their risks so as to be better positioned to benefit from the increased opportunities that the new environment accords. Strengthened corporate governance and risk management practices, reinforced by increased efficiency and greater innovation, will contribute to enhanced competitiveness and resilience. The accelerated development of the financial system has led to the emergence of new financial intermediaries, new financial instruments, more developed financial markets, and more liberalized exchange control rules. These progressive developments are aimed at meeting the changing requirements of the environment, facilitating flexibility in managing financial transactions and enhancing risk management by the private sector. It has been almost two years since Malaysia transitioned to a more flexible exchange rate regime. The successful transition was the result of having in place a series of preconditions for its successful implementation. This includes a stronger and more dynamic banking sector; a deep and liquid bond market; strengthened macroeconomic fundamentals; sufficiently high level of reserves; and the liberalisation of the capital account commensurate with the capacity of the market to manage the risks.