KUALA LUMPUR, Malaysia - Drive another spike into the heart of one more bloodied Southeast Asia dream. Malaysia is in recession.

At the moment that Malaysia was to have showcased to the world a decade of glitzy development - as the host of the Commonwealth Games that start Friday - the sky seems to have fallen in, leaving the region's longest-serving prime minister, Mahathir Mohamad, stunned but hardly less combative.

While other regional leaders of his generation, such as Singapore's Lee Kuan Yew and Indonesia's Suharto, have ceded or been forced from power, Mahathir, 73, has responded to the crisis by broadening his authority and becoming the first Asian head of state to abandon previous support of the free-market economy espoused by the International Monetary Fund.

''The free market has failed and failed miserably,'' Mahathir said Sept. 1 in announcing foreign-exchange controls, ignoring the fact that until the Asian economic downturn began last year Malaysia had used the free market to create one of the region's great economic success stories.

Economists said the new restrictions are sure to spook foreign investors, whose capital Malaysia needs to recover. Mahathir replies that, orthodox economics aside, Malaysia can generate growth by lowering interest rates and increasing the money supply - in effect, spending its way back into prosperity.

Mahathir's policies represent an open challenge to the IMF and reflect the widespread frustration in Southeast Asia, where Western-styled economies have collapsed, wiping out a generation of growth.

The frustration has led to an ongoing debate, which has subtle anti-American undertones, over the merits of IMF bailout packages, the role of U.S. banks that encouraged now-broke governments and foreign companies to borrow heavily, and the activities of Western traders who can wreck a country's currency without regard for local consequences. Mahathir contends that the region's crisis is a Western conspiracy aimed at economic colonization.

The frustration is heightened by the apparent lack of success of IMF remedies, such as slashing government spending and raising interest rates. Even Thailand - which has followed the IMF prescription to the letter - expects its economy to contract 8 percent this year and has not seen a substantial return of capital. If Mahathir's formula works for Malaysia, the wisdom of the IMF's draconian rescue packages will come under question in other countries, Asian and European diplomats said.

Among Mahathir's new policies: In an attempt to draw back $8 billion that Malaysians have parked abroad and to undercut currency speculators, he has made the local currency, the ringgit, nonconvertible. This means the currency circulates only in Malaysia and the Central Bank can set it at a fixed rate, now at about 3.8 to the dollar.

The trading of Malaysian stocks outside the country has been banned and locals leaving the country can carry no more than the equivalent of $2,600. Any foreigner buying Malaysian stocks will have to hold them for at least a year before selling.

Massachusetts Institute of Technology economist Paul Krugman has suggested exchange controls as a risky but plausible step toward Asian recovery. But in an open letter on the Internet to Mahathir, he warned that the controls should be considered only temporary and should not be viewed as alternative to real economic reform.

Mahathir, who has ruled for 17 years, embraced IMF reforms when Southeast Asia was hit by recession in the mid-1980s. The result was a decade of growth and development - and a blueprint to turn Kuala Lumpur into one of Asia's most modern capitals by the start of the Commonwealth Games, which are attracting 6,000 athletes and thousands of visitors and journalists.

Although economic gloom and political uncertainty caused by Mahathir's sacking of his popular finance minister and heir apparent, Anwar Ibrahim - a staunch supporter of IMF reforms - have distracted Malaysians' attention from the games, Kuala Lumpur has indeed been transformed.

In the past two months, a $6-billion international airport opened, as did two rail lines. An expansive and beautiful downtown park was built in the shadow of the world's two tallest buildings. A $60-million, 885-seat concert hall was christened by the new Malaysian Philharmonic Orchestra, whose members were recruited from 22 countries (only four musicians are Malaysians) at salaries in the $45,000 range.

Anwar's sacking came Sept. 2, six days after Malaysia officially announced the economy was in recession, with the ringgit having lost 40 percent of its value, the stock market down 75 percent and new car sales off 70 percent, all over the past year. Mahathir, who took over Anwar's portfolio as finance minister, told reporters Tuesday that he had thought of retiring this year but had reconsidered in light of firing Anwar.

Highly regarded by global economists, Anwar, 51, who also was deputy prime minister, did not take his dismissal quietly. Saying he dared not leave his home for fear of arrest, he denounced a smear campaign accusing him of corruption, sexual improprieties and being a CIA agent and said he would lead a people's movement for political and economic reform.

His challenge to the very system that the autocratic Mahathir has built was unheard of in a country where debate is tantamount to dissent and dissent is generally considered treasonous. When critics, for instance, questioned government policies in 1987 during an inter-party squabble, Mahathir simply put about 100 of them in jail. He continues to exercise absolute control over the local media.

Although Mahathir is said to genuinely believe the West - its media, financial institutions and governments - are out to get Malaysia, and his relations with Washington are often testy, Malaysia itself remains open to the West and an important U.S. ally.

The United States is Malaysia's biggest trading partner and largest investor. The U.S. and Malaysian militaries routinely conduct joint exercises and U.S. ships regularly call at Malaysian ports. Fifteen thousand Malaysian students study in the United States.