Malaysia stands at an economic crossroads, and prime minister Najib Razak’s newly reinstated government could easily send it down the wrong path.
The government is overspending, and more is to come. It is in the midst of introducing a US$444 billion stimulus package that will be 92% funded from the private sector and the rest from the national budget until 2020 for revamping infrastructure, education and boosting the services industries to transform the country into a high-income nation within the next seven years.
The cost of this programme has so far inflated the public debt-to-gross domestic product (GDP) ratio to 53.8% as of last year, according to ratings agency Standard & Poor’s (S&P), the highest rate in Asia ex-Japan after India.
Added to this, the government has also made project-finance guarantees worth 15.6% of GDP as of March 2013. Combined, these promises could take Malaysia’s debt-to-GDP ratio well above the country’s statutory limit of 55%, according to economists and opposition politicians.
Its debts could balloon even further. Najib said in a victory press conference on May 6 that he would fulfil his election pledges, which include providing financial aid to lower-income households, discounts on cars and the construction of one million low-cost houses. The estimated bill? About MYR43 billion (US$13.8 billion) over the next five years.
Najib may well feel he needs to stick to such pledges, particularly given that the Barisan Nasional (BN) coalition, which is led by his United Malay National Organisation (UMNO) party, lost the popular vote in the election. But the country simply cannot afford them.
Malaysia’s GDP growth rate slowed to less than 5% between January and March, the first time it had dropped so low in seven quarters despite robust investment spending by the government. Exports, which account for roughly 60% of the economy, are slipping, and the country’s current account surplus nosedived by almost half in the first quarter of this year compared to the same period in 2012. Tax revenues are dropping too, courtesy of depletion of oil reserves that ratings agency Fitch says account for a third of Malaysia’s total revenue.
“If you look at the debt-to-GDP level itself, it’s not alarming and still manageable,” says Devendran Mahendran, a credit analyst at HSBC. “What a lot of people miss is that the underlying economic structure has become very dependent on debt and the allocation of capital in the economy has been going into real estate and infrastructure-related projects that are riskier in the long term. This becomes less productive. They need to show that they can bring the fiscal deficit under control.”
Fitch and S&P warn of possible ratings action if the government doesn’t address its public finances. In its latest sovereign credit report, Fitch said it was concerned that authorities would try to raise the debt ceiling as they did in 2009 rather than implement austerity measures. Doing so could jeopardise the country’s ‘A-’ rating by Fitch and Standard & Poor’s and ‘A3’ rating by Moody’s.
“We may lower the rating if the government can’t deliver the reform measures to reduce its fiscal deficits and increase the country’s growth prospects,” said an Asia-Pacific sovereign credit report published by S&P on March 13. “These reforms may include, but are not limited to, the GST [goods and services tax] and subsidy reforms on the fiscal side, and private investment and economic diversification reforms on the economic growth agenda.”
Look to Malaysia’s financial markets, however, and it would seem that its outlook has never been brighter. The benchmark FTSE Bursa Malaysia Kuala Lumpur Composite Index reached a record high on May 14, bolstered by domestic and foreign investors buying local instruments on the back of expected momentum from the stimulus programe and after their concerns of regime change proved ill-founded. Meanwhile, yields on the 10-year government bond have returned to pre-election levels after tumbling 30 basis points (bp) immediately after BN’s victory.
This disconnect cannot last. Investors may love Malaysia now, but it won’t take too long for them to realise how costly the ruling coalition’s spendthrift governance is to the nation’s long-term health. Some warn that the selloff is already happening in the bond markets and will continue. The country’s stocks and bonds could be set for a long slide.
Debt for the greater good
Malaysia’s rulers know the country risks falling into the middle-income trap, too developed to offer cheap production and rapid growth yet not wealthy enough to offer a top standard of living.
The country’s stated goal is to join the ranks of developed nations by 2020, but its per-capita income was US$6,700 in 2012, according to the economic transformation programme’s website administered by the Performance Management & Delivery Unit (Permandu), part of the prime minister’s department. The World Bank’s definition of high-income status is US$15,000.
The fact is that Malaysia’s economy simply isn’t growing fast enough. Its GDP growth rate has slowed from the highs of 10.3% it reported in the first quarter of 2010 to 4.1% in the same period this year, largely due to its export-led manufacturing sector losing out to cheaper rivals in China and Vietnam. This disappointing growth has led to a narrowing revenue base of 22% of GDP, which Fitch says is lower than the ‘A’ and ‘BBB’ range medians of 34% and 32%, respectively.
To revive economic momentum, Najib announced the US$444 billion economic transformation programme in 2010. The stimulus spending is intended to create 3.3 million jobs in 12 key areas, 60% with middle or high salaries.
The logic is that improving rural infrastructure and public transport, investing in education and broadening sources of tax revenue will help Malaysia achieve 6% GDP growth per year to reach developed-nation status.
Public investment has carried Malaysia through global economic shocks in recent years, and Najib’s vision to improve the economy is admirable. But government spending already accounts for 10% of GDP, and Najib’s plans rely on the government borrowing a lot more. This could prove too costly for a country that is already more leveraged than similarly rated peers.
His plans also have a more self-serving motive: political survival. The BN coalition has steered the government since Malaysia’s independence from Britain in 1957, yet in the latest election it won less than 50% of the popular vote for the first time in 44 years.
This drop in popularity leaves the BN with a strong incentive to keep its election promises, to regain (or at least avoid losing more) support. But sticking to such pledges will only add to the government’s debt bill.
Costly guarantees
The government is also backing a set of expensive infrastructure projects, including the MYR50 billion Klang Valley Mass Rapid Transit (MRT) project. The projects are being funded with bonds issued by state entities and guaranteed by the government. These guarantees are only realised if the bonds default, so they are not added into the public-debt balance sheet.
Economists such as Hak Bin Chua from Bank of America-Merrill Lynch think it’s a false saving. He believes the return on public-transport projects will not cover the huge capital outlay, so much of the project cost will end up with the government. Public debt reaches 68% of GDP if the guarantees are included.
“The sharp increase in government guarantees raises questions [as to] whether this has been a convenient route to avoid reaching the 55% debt ceiling, defeating the spirit and purpose of such a threshold,” says Chua.
Government guarantees lower funding costs. Syarikat Prasarana Negara, a wholly owned subsidiary of Malaysia’s finance ministry that owns public-transport assets, and other government entities were able to issue bonds with single-‘A’ ratings from all three credit agencies. But the guarantees risk breeding complacency.
The fact that guarantees don’t immediately impact public debt means that public officials have little incentive to control how many projects they sign up to financially support. Less urgency over signing such deals means that officials could end up supporting debt issued with terms that are not particularly favourable. Meanwhile investors who might normally be diligent about the instruments into which they invest are likely to be less worried about scrutinising these deals because they will get paid whether the projects succeed or not.
These entities have run into debt trouble in the past, but continue to take on more. Prasarana announced on January 4 that it will be restructured due to the failed Star LRT, KL Monorail, the Putra LRT, as well as privatised bus operators.
Previous maturities were redeemed through capital injections from the government, says Lim Jin Aun, executive vice president of group communications and strategic marketing for Prasarana. “Nevertheless, Prasarana has taken steps to reduce its dependency on government support by exploring and tapping on opportunities on its land banks and real estate,” she added.
Still, Prasarana’s outstanding debt stood at MYR10.59 billion as of the end of November 2012 due to low fares, huge operating costs and unprofitable routes, according to a May 3 report from RAM Ratings. But this total, which includes government-guaranteed debt, could rise to MYR14 billion as Prasarana plans to issue another MYR6 billion of Islamic debt-like instruments called sukuk this year, although it will receive a MYR2 billion capital injection from the government, said the ratings agency.
Despite this lesson, the BN coalition’s costly promises mean that government-guarantee schemes are likely to continue flourishing.
The price of populism
Najib’s government has not entirely ignored the looming debt issue. In June 2010 it said that it intended to narrow the fiscal deficit to 2.8% by 2015.
The government plans to reduce subsidies on items ranging from fuel to flour from MYR42.4 billion in 2012 to MYR37.6 billion this year, and also cut housing and education spending. The annual subsidy bill is about MYR73 billion, or 4.7% of GDP, Najib was cited as saying in April according to a June 10, 2012 Bloomberg report.
But eliminating the deficit is a tall order, particularly given the BN’s election largesse, with revenues not rising fast enough to counterbalance growing debt levels.
Government revenue as a percentage of GDP grew to 22.1% at the end of last year compared with revenue ratios of 19.6% during the same period in 2005, according to BNP Paribas and data provider CEIC.
Najib needs to find new revenue flows and cut costs if he is to prevent Malaysia’s debt-to-GDP ratio from rising – neither of which will be easy. BoA-Merrill’s Chua notes that there are few specifics as to how the government will cut subsidies, and argues that such cuts won’t count for much even if they do take place.
Credit Suisse economist Santitarn Sathirathai adds that the government should at least focus on stabilising public debt at current levels by reducing the primary fiscal deficit by 1% of GDP. It could do this by raising subsidised retail fuel prices by 10 sen and introducing the much-discussed 4% GST.
But the proposed GST is wildly unpopular, making it hard to implement. The government’s claims about balancing its fiscal position look optimistic, to say the least.
Credit Suisse forecasts that the fiscal deficit will actually be just under 5% this year. Fitch estimates that without material fiscal reform, federal government debt will continue to rise through 2016, which could be viewed as a credit negative if authorities try to raise the debt ceiling.
Ratings reassessment
If public debt does increase without revenues rising to counterbalance it, the credit agencies could act.
“There’s been a bit of complacency from foreign and institutional investors because Malaysia is rated single-A and has been a stable credit with less volatility. Against that we think ratings agencies are getting a bit more cautious,” says HSBC’s Mahendran. “In terms of fiscal slippage, one or two of the ratings agencies may put Malaysia on a negative outlook and this may cause people to wake up and reassess what’s going on in Malaysia.”
In such a case, foreign investors will also reassess their view of the equities market, according to Anand Pathmakanthan, head of Malaysia equity research at CLSA.
“It does have a bearing on a small country like Malaysia if ratings agencies put us on a negative outlook,” says Pathmakanthan. “It will be an important event. But our view is that the market will be strong this year primarily because we don’t see this action happening this year, neither do we see the government taking any policy action this year to tackle the deficit. That will happen at the earliest next year.”
S&P sovereign credit analyst Takahira Ogawa said pressure on Najib to cater to his constituents clouds the likelihood of him introducing GST and cutting subsidies.
“The BN came back to power, which is perhaps good for Najib’s drive to implement structural reform policy. But the bad news is that the majority is reduced. It’s still a little too early to assess the momentum inside the party,” says Ogawa. “There might be a certain group within UMNO that says the government shouldn’t implement these policies because it might not bode well for [the party’s] popularity.”
Financial market impact
Malaysia’s capital markets will not be able to ignore the danger of soaring national debt and the threat of a resulting credit downgrade forever.
The bond market is already feeling the pinch. Malaysia’s debt, especially its benchmark 10-year bond, rallied to 3.1% in the week following the elections, which was only 10bp above the interbank policy rate. It is now back at pre-election levels of 3.41%.
Credit Suisse says bond yields are still too tight and that the yields don’t look sustainable unless interest-rate cuts become likely. It expects yields to widen further to 3.75% by year-end. Credit default swaps could also jump 30bp-40bp from current trading levels of 85bp when Najib announces the budget near the end of the third quarter due to fiscal-slippage worries, says HSBC’s Mahendran.
A massive selloff of Malaysian bonds may not be imminent, but the government’s failure to improve its finances does pose a risk. Signs of fiscal weakness and a potential credit downgrade would quickly cause bond yields to spike.
And that’s assuming an otherwise benign external environment. If another global financial crisis were to descend, Malaysia’s vulnerability would quickly be made clear.
“The potential consequences for onshore borrowing costs in the event of a sudden-stop financing scenario are significant,” said Philip McNicholas, Asean (Association of Southeast Asian Nations) economist at BNP Paribas. “In light of this, it is possible that an external liquidity shock considerably smaller than the [2008] global financial crisis could have a material impact on Malaysia and its asset markets.”
Malaysia’s ammunition to battle such a crisis is already depleted. McNicholas noted that increases in the share of short-term external debt since 2008 have caused the country’s external liquidity indicators to deteriorate, making it increasingly challenging to service outstanding debt.
As things stand, the country is precariously poised. It wouldn’t take much bad news, either on its fiscal position or a worsening of external conditions, to cause a mass exit of foreign-investor money.
That would be damaging, given that foreign investors have nearly doubled their ownership of Malaysian government securities to a record 46.9% as of March 2013 from 23.5% in June 2010. The flight of even part of this money could well cause a major run on the country’s financial markets.
Managing growth expectations
For the sake of Malaysia’s economic and financial health, Najib needs to focus on untangling the country’s structural weaknesses. It will prove a daunting political endeavour.
He should begin by managing the public’s economic growth expectations. The government cannot continue to spend its way to developed-nation status without mapping out a responsible plan to rein in the fiscal deficit and finding a more credible way to fund infrastructure projects. Both will slow the pace of growth.
Najib also needs to press through unpopular but necessary tax increases in the form of a GST or increased fuel and consumer-goods prices. In addition, he should ensure far more scrutiny on the value of the country’s massive infrastructure projects and diversify the manner in which they are paid for. These projects should not be able to rely on never-ending government guarantees.
The government needs to broaden the economy too, so that it does not depend heavily on state spending and subsidies. This is particularly controversial because it requires scaling back its Bumiputera-preferential policies, which are pro-ethnic Malay, to ensure a more level playing field in Malaysia. The government particularly needs to offer incentives for small- and medium-sized enterprises to win bids for systemically important infrastructure projects, to broaden competition.
This will be extremely difficult, because it will upset some of Najib’s core corporate supporters and voters. But it’s necessary if business opportunities are to expand beyond the players that dominate the corporate landscape today. And by doing so, the BN may alleviate some of the concerns of the opposition and its constituents, potentially winning back some support from the more educated urban population.
Najib did well to secure his coalition’s re-election against an aggressive opposition bid, but he now faces an unpalatable choice. He can either risk his political career to build a more competitive, harmonious country on a healthier economic footing, or let Malaysia slide towards fiscal insolvency to the applause of his political base.
