By HUGO RESTALL

(Editor's Note: This is an opinion piece from Wednesday's Asian Wall Street Journal. Mr. Restall is the editorial page editor of The Asian Wall Street Journal.)

Malaysia's shrinking foreign exchange reserves are a kind of economic Rorschach test -- you can interpret the figures in various ways, depending on how you view the country's economic policies. Prime Minister Mahathir Mohamad was relying on capital controls to shield his country from the unsettling ebb and flow of the world's money, and for a time it seemed to be working. Now, however, it appears many Malaysians themselves are eager to get their money out, and the control regime is too porous to stop them.

Malaysia's reserves have fallen by $4.2 billion in the last eight months, even as exports have surged. That's strange enough, since a favorable export situation should be boosting confidence that the economy will go on recovering and the country as a whole has the wherewithal to pay its debts and maintain its pegged currency. Instead, not only is confidence eroding,but the resulting outflow of capital is outstripping the earnings from exports. What's going on?

The short answer is that nobody knows, and it may be a combination of factors, some of them short term. One benign explanation would be that Malaysian firms are paying down some of their foreign debts. Another possibility is that Malaysia is moving out of its holding pattern, sustained by its massive export sector and capital controls, and entering a more difficult period when it will have to convince foreign and Malaysian investors of its long-term prospects. Foreign direct investment has been dropping and portfolio investors are pulling out. Dr. Mahathir's new willingness to contemplate sales of stakes in a couple of state firms to foreigners suggests that he understands this necessity of turning this around. But it will be a difficult sell.

The reason is a spate of recent decisions to maintain Malaysia's relationship-based economic system at the expense of minority shareholders and efficiency. A couple of years ago, there were still hopes that the country would use the breathing space afforded by capital controls to undertake reforms. Those hopes have now been dashed.

Take the plan hatched a few weeks ago by two companies with close ties to the ruling United Malays National Organization. United Engineers Malaysia agreed to purchase $1.8 billion in problematic assets from Renong in what amounted to a bailout of its parent. This was a replay of three years ago, when UEM also came to Renong's rescue, an incident which caused a big fall in the local stock market since it signalled a complete disregard for the interests of minority shareholders. This time the result was much the same -- UEM's shares have now fallen 27% since the announcement.

Left over from that old incident was a pledge by Renong's well-connected chairman Halim Saad to buy back Renong shares from UEM at the original purchase price, a guarantee in effect that UEM would not be too badly disadvantaged by the deal. Mr. Halim will still have to honor that promise, but UEM's agreement to buy Renong's assets has again freed him and Renong from pressing debt worries. The complex deal confirmed that, if anything, minority shareholders enjoy even less protection than they did before the Asian crisis. In other words, Malaysia hasn't taken to heart lessons on corporate governance that it should have learned from the crisis.

In addition, Dr. Mahathir has gone to the rescue of major companies whose failings could hurt national prestige. The government is preparing to buy back the 29% stake in Malaysian Airline Systems held by Tajudin Ramli. According to the Far Eastern Economic Review, the taxpayer will pay more than twice the market price so that Mr. Tajudin won't suffer significant losses from his investment seven years ago, even though under his leadership the airline has experienced major turbulence. We see the government preparing to bail out Tajudin Ramli, another UMNO favorite son, after his foray into aviation with Malaysian Airline Systems. And the ailing national car company Proton recently got a boost from the deep-pocketed state oil company Petronas in the form of new equity.

Sure, the picture isn't all gloomy. Kuala Lumpur did a pretty good job of cleaning up its financial sector, cleansing the banks of their bad loans. But it has done little to discipline the corporate sector with bankruptcies. It can't or won't get tough with the bumiputra tycoons, partly because of the divisions within the Malay elite since the arrest of former deputy Prime Minister Anwar Ibrahim. And the present economic recovery is based in large part on lower interest rates and fiscal stimulus spending, both of which have encouraged overinvestment that could prove disastrous in the event of a downturn.

There are also political jitters which could sour investors on Malaysia. Dr. Mahathir's succession is a big unknown. The rising power of Islam is another. The lack of a free media means even Malaysians have a hard time gauging how serious these problems might be, and how deeply the cronyism rot has spread through the economy.

Experience elsewhere has shown that capital controls are effective for only a short period before people find ways to circumvent them. That seems to be happening now in Malaysia. It may not herald the beginning of a massive capital flight that upsets the recovery, but it does mean that Dr. Mahathir will be under pressure to undertake reforms that should have begun two years ago. As everyone pores over the Rorschach test of Malaysia's balance of payments, some patterns are beginning to emerge.