TERRY McCARTHY Kuala LumpurPrime Minister Mahathir Mohamad loves the spotlight, and he thrives on bashing conventional wisdom. He achieved both on Sept. 1 when, in what he promised would be a shocking development, he announced capital controls on what had once been one of Asia's most open economies. For good measure he also banned foreigners from taking stock market earnings out of Malaysia for 12 months. A day later, he fired his deputy Anwar Ibrahim, who had opposed steps to shut the economy off from the rest of the world. And when Anwar led protest rallies warning, among other things, that the controls would be used to bail out Mahathir cronies, the Prime Minister had him arrested.The upshot? Malaysia has suddenly become politically shaky. And its international credibility is as low as its credit status, which the rating agencies Standard & Poor's and Moody's have both recently downgraded. Mahathir may be firmly in charge, but Malaysia has fallen off the radar screen of most foreign investors. Even the World Bank has announced that the capital controls have disrupted its plans to lend the country $1.7 billion. In Kuala Lumpur the black market rate for the dollar is already up to 4.2 ringgit, compared with the official rate of 3.8.Mahathir remains defiant. To boost the stock market, he began prodding local banks--already weighed down with huge levels of bad debt--to increase their lending for share purchases. The central bank, at Mahathir's behest, also pushed through a critical change in the banking system, declaring that a loan becomes non-performing only if no repayment is made on it for six months, instead of the previous three-month standard. The switch, introduced Wednesday with some confusion--the same announcement had been made on Tuesday and then retracted an hour later--was ostensibly meant to allow banks to lend more. But it also provides a neat way of reducing the overall amount of bad loans in the banking system and allowing property developers with empty new buildings to stay afloat--at least in a drawn-out, Japanese sort of way. (Japan has stagnated for eight years since its bubble burst.)So why did Malaysia do it? The country had achieved phenomenal growth in the past decade of openness. Malaysia is the only Southeast Asian country that permits foreigners to own land, for example. It was until recently the 13th largest trading nation in the world, with imports and exports more than one-and-a-half times GDP. Its 22 million people saw incomes shoot up as a result of foreign-investment inflows, often in big state-initiated infrastructure projects. So why suddenly turn away from the path of Asia's Miracle and veer instead toward a go-it-alone approach more akin to North Korea or Burma?Economists in the region say Malaysia's shift traces to what many refer to as the M factor. After 17 years in power, Mahathir was unable to stand back and watch as the wealth he thought would multiply to first-world levels by 2020 evaporated as quickly as the monsoon rain on Kuala Lumpur's hot asphalt. Insiders say that in recent months he has become obsessed with neighboring Indonesia, where the plunging currency wiped out economic advances of the last two decades. Determined not to suffer the same fate, Mahathir desperately cast around for a way of reasserting control over the economy, forcing out anyone--even his anointed successor Anwar--who dared to oppose him. Now the economy is firmly in the hands of one man, a 72-year-old veteran of open-heart surgery who concurrently holds the titles of Prime Minister, Home Minister and Finance Minister.PAGE 1 | Can Wan Azizah Ismail sustain her husband's reform movement? Should Anwar have been arrested as a threat to national security? Will the currency controls help Malaysia?Many economists are prepared to give Mahathir the benefit of the doubt--as long as the controls are limited in duration and not a substitute for much-needed reform of the financial system. There's no reason why it shouldn't work, says Simon Maughan, regional banking analyst for Indosuez W.I. Carr Securities in Hong Kong, provided they use the capital controls to restructure the economy and reform the banking system. As Mahathir predicted, interest rates have come down--from 15% to about 9%--the Kuala Lumpur stock market has seen a modest rally, ringgit deposited overseas (principally in Singapore) are returning, and spending on big-ticket items like cars is beginning to creep back up. Malaysia's experiment has been watched closely around the world in the run-up to this week's meetings in Washington of the International Monetary Fund and the World Bank, where plans for calming volatility on world financial markets top the agenda.The picture is still one of modified optimism, insists Zainal Aznam Yusof, deputy director-general for economics at Malaysia's Institute of Strategic and International Studies. Zainal is on the National Economic Action Council, a group of ministers, bureaucrats and academics convened by the Prime Minister to come up with emergency measures to save Malaysia's economy. The council had been secretly drawing up plans for currency controls since January, according to Zainal, who says the measures should be seen as a temporary firewall, part of the recovery plan, not something separate and not a substitute for actions that must be taken. He concedes, however, there is still some debate about how long is temporary.The question at the core of Malaysia's economic dilemma is whether to bail out the country's struggling conglomerates. Mahathir maintains that many of the biggest, most heavily indebted firms are fundamentally sound but have fallen victim to attacks on the currency from outside speculators. Some economists, however, argue that companies closely connected to Mahathir have long received preferential treatment and should be allowed to fail. Indiscriminate assistance will not be entertained, says Special Functions Minister Daim Zainuddin, whom Mahathir tapped to supervise the rescue plan. Daim also promises that Malaysia will continue to revamp the financial system.But many outsiders remain puzzled by the currency controls and skeptical that they will be accompanied by needed reforms. Paul Krugman, the M.I.T. economist whose FORTUNE article advocating currency controls started the debate, wrote an open letter to Mahathir Sept. 1 pointing out that imposing such restrictions is a risky step with no guarantees of success. He identified four principles to follow: the controls should disrupt ordinary business only minimally; they should be in place for a stated period of three years or less; they should be based on a highly competitive real exchange rate; they should not be viewed as an alternative to reform but as a means of giving a country breathing space to undertake what's needed to clean up the financial system.Four weeks into the new regime, Mahathir is not doing well by those principles. Importers and exporters desperately seeking guidance from the central bank on how new currency regulations affect their business are generally met with a slew of contradictory directives. Mahathir has said he sees no reason why currency controls shouldn't be permanent, contradicting some officials who say they won't be around for long. Mahathir has also said he might devalue the ringgit from its current rate of 3.8 to the dollar if necessary to maintain competitiveness in export markets. Moreover, there are signs--like last week's loosening of credit controls for banks--that the government is not serious about reforming the banking system and cleaning up the bad loan problem.At best, say many economists, the controversial controls have given Malaysia temporary relief. It has bought them six months to a year at most, says Sani Hamid, emerging markets analyst at Standard & Poor's MMS in Singapore. What we are afraid of is that you will see economic growth at the beginning, but behind those numbers will be unproductive investments and an exact replica of the bubble economy that caused the crisis in the first place. In that case, much of what Mahathir has worked for could be frittered away. | PAGE 2 Can Wan Azizah Ismail sustain her husband's reform movement? Should Anwar have been arrested as a threat to national security? Will the currency controls help Malaysia?