Authorities are cautiously optimistic.

"It looks as if the worst is over," Bank Negara governor Ali Abul Hassan Sulaiman said on Saturday as he announced an 8.6 per cent year-on-year contraction in gross domestic product in the July-September quarter.

Private economists agree the worst may be over but say the 1999 outlook has many potential pitfalls, including Malaysia's strong dependence on exports to the United States and Japan.

"I think Bank Negara is quite on the DOT by saying the worst is over," Daniel Lian of ANZ Investment Bank in Singapore told Reuters Television. "I think by the first quarter of next year we're going to see positive growth."

Gross domestic product shrank by 6.1 per cent over the first nine months of 1998, year-on-year.

The Malaysian Institute of Economic Research (MIER) said on Tuesdayit expects GDP to shrink by 6.2 per cent in 1998.

Striking an upbeat note, the central bank said recent international developments, including strong growth in the United States, had supported Asia's recovery.

It cited rebounds in regional stock markets, the appreciation of regional currencies against the US dollar and the resumption of capital flows into South Korea and Thailand.

Ali pointed to export growth in September, increased car sales in the third quarter over the second, higher loan approvals and a drop in retrenchments.

But the bank noted that consumption demand remained lacklustre with imports of consumer goods falling by 36 per cent in the third quarter against the second.

Private economists said money supply remained sluggish, the volume of loans was stagnant and car sales, while higher on a month-by-month basis, lagged behind last year's performance.

MIER said interest rate reductions and the fiscal deficit would boost aggregate demand in 1999, and forecast a 0.7 per cent year-on-yearrise in GDP.

But the think tank said any gains would be constrained by high domestic debt, tentative business and consumer sentiment and the sluggish property market.

It also cited the possibility of weaker-than-expected external demand and insufficient domestic funds to help ailing banks and finance the budget deficit.

After such a sharp contraction in economic activity, even a small expansion in GDP in 1999 would come as a relief to many businesses and give prime minister Mahathir Mohamad the chance to claim currency controls, imposed on September 1, worked.

Already, authorities point to the near doubling of the Kuala Lumpur Stock Exchange's blue chip index since September 1 as proof that the exchange curbs have helped.

No matter that the gains have been driven largely by state-controlled funds as foreigners, unable to withdraw the principal of investments before next September 1, stay out.

Second finance minister Mustapa Mohamed shrugged off a warning by MIER that foreigners might pull outlarge sums of money next September.

"If there is an outflow, I don't think the figure will be big," he told a business conference on Tuesday.

Song Seng Wun, regional economist at GK Goh Research in Singapore, said it was not clear if the more stable outlook was a product of capital controls or part of a regional rebound.

The International Monetary Fund said the currency controls had insulated the economy from short-term volatility but could magnify the impact of adverse developments in export markets.

In a paper presented on Tuesday to a conference organised by MIER, the IMF said the capital controls restricted Malaysia's options in responding to a possible drop in export demand.

With exports representing some 95 per cent of GDP and concentrated in electronics and electrical equipment, Malaysia is especially vulnerable to external shocks, it said.

More generally, the currency controls have given foreign investors reason to think twice about returning to Malaysia and run the risk of delayingcorporate restructuring, it said.

"Sweeping changes at the highest level of political and technocratic leadership also have contributed to perceptions of policy unpredictability and high country risk," it said, referring to the sacking of former finance minister Anwar Ibrahim.

Anwar's corruption and sex trial is expected to last at least until mid-1999, increasing the probability that civil unrest triggered by his sacking and arrest will keep simmering.

"It is a temporary recovery at best," University of Malaya professor Chandra Muzaffar said. "There are tough times ahead."