The new prime minister also said jailed opposition leader and coalition partner Anwar Ibrahim would be freed on Wednesday.
"The king, with the advice of the pardons board of the federal territories of Kuala Lumpur, Labuan and Putrajaya, has allowed a full pardon and given an immediate release for".
"The pardon timing is fast, and this speaks to the recognition that his conviction was unjust", said Bridget Welsh, a political science professor at the John Cabot University in Rome.
Anwar still needs to be elected as a member of parliament, and it was assumed that his wife would stand down from the seat she won last week, says Weiss.
In the 1990s, Mahathir was prime minister, Anwar who worked under him was his deputy and clear heir-apparent.
Once seen as a potential future leader, he had been jailed on charges of sodomy and corruption after falling out with the government.
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The pardons board in Malaysia's capital will meet this week to discuss Anwar's release and Mahathir said he would be released the same day.
Swiss Attorney General Michael Lauber has been publicly critical of the lack of cooperation his team of prosecutors got from the government of former Malaysia premier Najib Razak, who himself has been accused of pocketing some of the diverted money.
Anwar was supposed to speak to the press outside the centre upon his release, but the sheer hubbub from supporters and media seems to have delayed this.
US investigators say Najib's associates stole $4.5 billion from the fund, some of which landed in Najib's bank account.
The agenda for the Mahathir government includes scrapping a goods-and-services tax, reviewing large infrastructure projects, reintroducing fuel subsidies and cutting spending.
A person described in the United States lawsuits as "Malaysian Official 1" was said to have received more than US$1 billion in 1MDB funds, some of which was used to buy jewellery for the person's wife.
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Anwar's freedom is expected to ease fears of a growing rift within the newly formed coalition government, after differences erupted between supporters of Mahathir and Anwar over cabinet positions and Anwar's role in the party. "But Mahathir may be reluctant to hand over to his former nemesis, and if he drags his feet other scenarios could come into play", said Peter Mumford of the Eurasia Group in a research note.
Mahathir had said he would stand aside for Anwar and told a Wall Street Journal conference on Tuesday via video that he would remain in office for now.
"The Anwar and Mahathir relationship will be a challenge to navigate as trust, ambition and priorities will be likely problem areas", said Welsh, a Southeast Asia expert who was in Malaysia to monitor the polls.
Without a deal to help recover the funds, Najib faces the likelihood of prosecution and possible criminal charges.
Mahathir has removed the Najib-era attorney general, treasury chief, and anti-corruption agency chief as he ordered officials to step up investigations.
"Just last week nobody would have thought that this posh boarding school boy would be rear ended by his old political headmaster", he said.
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