The main issues facing the economy

By Samantha Joseph

In the first article we look at some of the key issues facing the Malaysian economy such as excessive subsidies, high government expenditure and rising debt. We examine the potential consequences of inaction and what is expected of Malaysia to avoid a sovereign credit downgrade.

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One of the major problems that faces Prime Minister Najib Abdul Razak’s government is how to rationalise, read cut, subsidies without too much of a burden to those in the lower amd middle income groups.

The government’s first step in revising subsidies has caused quite a backlash among the hoi polloi who protest the need for increased fuel prices when the money will flow out in the form of BR1M (1Malaysia cash assistance scheme) vouchers for the needy, putting the middle class in the unenviable spot of bearing the brunt of the increase.

While a good many Malaysians consider the subsidy revision a drastic step, Fitch, the rating agency that originally sent the authorities into a flutter of denial, rebuttal and calls of foreign oppression, is less than impressed with this attempt at improving the government’s financial situation: “The corrective fiscal measures, announced yesterday, are too small to alter the Negative Outlook on Malaysia’s ‘A-‘ sovereign rating.”

And indeed they are. Subsidy rationalisation, essentially the restructuring of subsidies to ensure that they only benefit deserving groups, is but just one of the problems facing the government.

Aside from the subsidy rationalisation, the Prime Minister has also announced a phasing out or sequencing of public projects in a bid to reach the fiscal deficit target of 4% of GDP (gross domestic product – sum of goods and services produced) by the end of the year.

Sequencing mega projects

The sequencing or rescheduling of mega projects, especially those which have a high import content and have little add-on impact to the rest of the economy will help to reduce government expenditure in the near term and thereby cut the budget deficit as a percentage of GDP.

“This includes a delay of building projects with high import content and low multiplier effects,” CIMB Chief Economist Lee Heng Guie observed. “While the government has yet to finalise the list of affected projects, the PM has indicated that the MRT lines 1, 2 and 3 will continue as scheduled but the high speed rail project is still under discussion.”

The other challenge for the government is to broaden the tax base as only a small proportion of the workforce – only an estimated 1.7 million workers against a workforce of about 12 million pay tax.

The general consensus is that the government will at least announce a date for the implementation of goods and services tax (GST) during the Budget in October, which is basically a value-added tax on consumption.

If a RM 0.20 sen increase to fuel prices is seen as the next worst thing to trampling kittens in the eyes of the rakyat, it will be interesting to see how our government will pull off the implementation of the GST. This will result in a one-off increase in the price of many goods and services except those which already carry a sales tax and those which will be given exemptions by setting the rate to zero at least for now.

Petaling Jaya Utara MP Tony Pua takes to task the idea that an added tax can fix the problem, likening it to a ‘panadol’ that provides only temporary relief.

Will GST solve deficit problems?

“Will GST help resolve the Federal Government’s deficit crisis? In the short term, of course it would. If GST is a cure, then Greece would never have gone bankrupt,” said Pua.

“The GST will only postpone a crisis by boosting the revenue of the government. However, if the government continues to spend wastefully, runs inefficiently and is embroiled in the cancer of cronyism and corruption, then no amount of taxes raised from the man-in-the-street will be able to prevent Malaysia from plunging into a crisis sooner or later.”

While international credit rating agency (ICRA) reports have are not yet forecasting a crisis should reforms be delayed once again, Fitch does point out risk factors that could negatively affect the economy should it be allowed to run its current course uninterrupted.

This includes further accumulation of contingent or other off-balance-sheet liabilities which are basically debt guaranteed by the government to various govert companies and agencies but not classified directly as government debt.

Also it includes further erosion of the current account surplus, which is the surplus in the net trade in goods and services. This can give rise to a “twin deficit” situation where failure to consolidate the budget is associated with the emergence of a sustained current account deficit, a shock to interest rates and/or employment sufficient to impair household debt servicing ability, and significantly slower GDP growth.

The rise and rise of Malaysia’s debt

RAM Holdings Group Chief Economist Yeah Kim Leng traces Malaysia’s rising debt to a sharp increase in indebtedness between the years 2008 to 2009, during the global financial crisis when GDP growth slowed down to 0.1% in the last quarter of 2008, and hit negative points in the first two quarters of 2009.

The Asian economic crisis provided us with a bitter lesson, and, in that case at least, we learned from it. The government plowed through the 2008 crisis, offering rescue packages that totalled RM67 billion, in an effort to avoid the mass retrenchment and cushion the fall in export demand.

“The purpose of these packages was to absorb retrenchment and the destabilisation shocks faced by the people and to accelerate development expenditure to offset a fall in aggregate demand because of significantly reduced exports,” a United Nations Development Programme report on The Global Financial Crisis and the Malaysian Economy said.

“In weathering the crisis, most macroeconomic fundamentals have remained strong but the recession has further widened the gap between actual GDP growth and the rate targeted for the achievement of Vision 2020,” the report said.

While the injection of fiscal stimulus did help greatly in allowing Malaysia to avoid the brunt of the crisis impact, the Eurozone crisis emerged to further complicate matters in terms of growth and recovery.

Bank Negara Malaysia’s Annual Report 2011 had pointed out that Malaysia would be mainly affected through trade channels. Both direct and indirect exports to Europe were calculated to make up approximately 14.2% of Malaysia’s total exports, limiting the impact on the economy.

Nevertheless, the trickle-down effect of the European foreign debt crisis did have some impact on private investment, and from there, domestic GDP.

“What we have noticed here is that through the spending since 2009 by the government, our debt level has increased by 10 percentage points,” Yeah observed.

“This was because of the so-called easy monetary policies which is also part of the monetary easing to stimulate the economy in response to the recession. For example, we lowered the interest rate to 2%, and the government also encouraged more lending. As a result, because of the low interest rate and easy credit conditions we saw that the household lending also spiked up.”

The initial costs of implementing the economic transformation programmes have also added to the burden, with projects ranging from private healthcare to oil and gas, and financial services. The majority of the tab for these projects are expected to be picked up by private sector investors.

Government operating expenditure is high

Government operating expenditure is also a contributing factor. One of the reasons is the bloated civil service, numbering some 1.2 million people. Malaysia has one of the highest civil servant ratio to population in the world, and the highest in Asia Pacific at 4.68%. The hike in salary benefits for 2013 is expected to cost the government an estimated RM2 billion. The previous civil servant salary hike in 2012 cost the government a cool RM6 billion.

The recent elections, touted as the most expensive in our history, cost the government RM400 million, not including costs specifically accrued by the Barisan National.  The BR1M voucher handout in February 2013 reportedly cost RM2.6 billion, and it is understood that the next Budget will announce an even larger handout to the lower-income groups to sweeten the bitter taste of rising petrol prices.

Possible rating downgrade is worrying

While Lee of CIMB says that government debt is not a new issue and that it’s been analysed for years, it took an international rating agency – in this case Fitch – and the threat of a ratings downgrade for action to be taken.

In the Fitch report, reliance on petroleum-derived revenues and the high and rising weight of subsidies in expenditure were observed as budgetary vulnerabilities. Diversifying revenue bases would help to ease the 33.7% (in 2012) that oil and gas contributes to the federal revenue.

“Malaysia’s credit fundamentals are weak by ‘A’ range standards. Its average income level of US$10,400 in 2012 was closer to the ‘BBB’ range median of US$11,300 than the ‘A’ median of US$18,600,” Fitch says.

Its overall level of development and standards of governance are also considered weak for its ‘A-‘ rating. Malaysia’s high level of private sector leverage is a risk from a credit perspective. Credit to the private sector reached 118% of GDP at end-2012, above the ‘A’ median 94%. Fitch projects the divergence from the ‘A’ median will widen out to 2015.”

While it may be easy to dismiss Fitch’s revision as an over-reaction, similar points had been brought up in an earlier report by S&P: “Malaysia’s slow fiscal consolidation to date stems from an inability to substantially reduce high subsidies and its relatively weak revenue structure; the government has a strong dependence on petroleum-related revenues.”

Reform measures that had been called out by the ICRAs had been put on the backburner until after the elections were over. It seems that only now the government is acting, and it remains to be seen if the intended and existing steps will be sufficient to lessen public debt and stave off a downgrade.

Fitch foretells that efforts for fiscal consolidation will not be an easy road, on the back of terms-of-trade shock and the weakened political position of the ruling coalition following the recent elections, making it that much more difficult to move forward with implementation.

“The government must draw up a  timeline of actions to execute the fiscal consolidation measures so as to assure investors that it has the political resolve to address the country’s fiscal issues without delay,” Lee points out.

“Faced with the risk of  a  sovereign ratings downgrade and investors’ focus on the  domestic and external sectors’ vulnerabilities at a time of a retrenchment of foreign capital, it is crucial that Malaysia fine-tunes its macroeconomic policy mix for growth and financial stability over the medium term,” he added.

That 20 sen increase looks like the government is prepared to bite the bullet but one hopes that it won’t relent in the face of a barrage of opposition to the move or be side-tracked again by political considerations, this time from the upcoming Umno general elections in October this year.