« January 2014


 July 2014 »




Executive Summary

The MH370 tragedy unexpectedly provides an avenue for Malaysians to strengthen increasingly fragmented social capital in the country. Societal risks, such as radical religion and interfaith disharmony, which seemed to be on the rise before the tragedy become almost subdued and muted, as if it was a warning from the Almighty. The tragedy force us to pray together, regardless of religions of the victims and of greater significance, mobilizing productive military and commercial assets from many countries, reflecting a truly global operation. But, more importantly, we are now valuing so preciously the lives of those onboard and praying for their souls in heaven, again without questioning their citizenship and religious beliefs. In fact, this rare tragedy proved to be a rallying point for Malaysians moving forward. On the international front, there is joint search and rescue (SAR) operations and of most importance military cooperation, involving superpowers and friendly nations. These positive externalities augur well for the ASEAN economic community (AEC) and Asian century as a whole. There are clearly many lessons that can be learned, looking from economic and public policy perspectives. We need to put in place or beef up an early detection system with adequate warning signals, conduct stress tests and implement pre-emptive measures. Apart from having good supervisory oversight, we have to strictly enforce rules and regulations and follow standard procedures, as stipulated by the Government and relevant international agencies and organizations. These lessons seem almost parallel to an early warning signals, macro-prudential measures, stress tests and supervisory oversight that need to be put in place and implemented to avoid economic and financial crisis, without which social costs would be far higher, affecting welfare and wellbeing of millions of households and consumers.

Of greater significance, the Government needs to be always on top and ready to ensure that the wellbeing of the society is fully protected, and not to let non-market forces and incompetence run wild, especially in the fiercely competitive airline industry. The goals of economic efficiency and development progress, associated with lower cost of airline travel need to also include social policy concerns, extending beyond maximising shareholders' value or commercial-entity financial consideration. Apart from providing travelling comfort and convenience at lower cost through fair competition, we also need to be concerned with non-market aspects and social policy issues, such as public safety, accidents to be avoided or deaths averted, value of life, family stress and happiness, fairness, social justice, equity and distributional concerns, associated normally with national project, program or policy. Society and the nation as a whole, and more importantly other nations must not be burdened with social costs or negative externalities due to extreme airline competition, resulting in cost-cutting measures that affect crew performance, passenger comfort and flight safety. The avoided social costs will far outweigh the mitigation costs or defensive expenditure to prevent the tragedy. This is akin to landslide mitigation measures, although the probability of the occurrence of the landslide is very much higher, in comparison to MAS's only third airline tragedy in its entire history of operation.

But, Murphy's law phenomenon is quite difficult to avoid, striking at the worst possible time. MAS has incurred significant losses, amounting to RM1.17 billion for its financial year 2013 (2012: RM432.6 million), and reportedly had adopted a strategy to sell as many seats as possible. Management-labour relations were also reported as uncomfortable and most important of all, 2014 is the Visit Malaysia Year, whereby significant number of tourists from China are expected to visit Malaysia.

Looking ahead, Malaysians can expect this year to be really a challenging year, not only sharing the grief and sadness with the families of the victims of the MH370 tragedy, but also continue to feel the pinch and face economic miseries, especially with persistently high inflation rate and rising cost of living in the country. The worsening inflation situation is silently affecting millions of low-income households, who are currently struggling with deterioration in their real income and also living standards. While the weakening in the household/consumer purchasing power is a real economic challenge that needs to be overcome in the immediate-term, there are unfortunately other economic and social costs and potential welfare losses that can be expected in the near-term. These are real phenomena, especially with the recent softening in global commodity prices (affecting rubber smallholders and farmers); depreciating value of ringgit (consumers and importers, among others); rising unemployment rate, especially among youth and fresh graduates; and tightening of domestic credit conditions (business owners and borrowers). Meanwhile, the corporate sector is also bracing for credit spread shock with the expected higher borrowing costs and continued exchange rate volatility, while the banking system is currently being exposed to risks from high household debt, especially with the tightening of domestic credit conditions and large exposure of property and real estate. The bulk of the household debt are in the housing loans, of which the majority is exposed to floating mortgage rates. Defaults on consumer credit, especially automobile and personal loans are also on the rise, as seen in the number of reported bankruptcies, affecting not the young age group, but mostly those in the prime working age, that is 35 to 55 age bracket. In terms of GDP per capita in USD, Malaysia's household debt at 86.8% of GDP is one of the highest in the region, in comparison to Singapore and Korea which recorded substantially high GDP per capita, but each registering household debt of less than 80%. As such, Malaysia and also Thailand are particularly vulnerable to rising interest rates, in which debt servicing capacity is expected to deteriorate, resulting in correction in an already overvalued housing prices. Looking on the external side, international reserves are clearly depleting fast, especially with continued strong foreign exchange interventions, while net international investment position is estimated to be in a negative territory again in 2013 (2012: -RM14.7 billion), affected by net outflows of portfolio investment, especially debt securities.

Taking into account weakening in domestic economic conditions, the ongoing subsidy rationalization (the relevant factor contributing to domestic cost-push inflation observed since September 2013) needs to be carefully reviewed, properly sequenced and definitely not to be aggressively pursued. The subsidy rationalization, while undisputedly is necessary, should be implemented judiciously and sequenced through a gradual process, taking into account changing economic circumstances. Most importantly, these measures must be implemented in a credible manner with strong public support, coupled with genuine awareness and real understanding. On a parallel basis, the authorities need to be tough on previously untouched areas, particularly discretionary policies, such as "procurements" and "direct negotiations" and social injustices that result in wasteful spending and public resentments. This essentially require "intelligent communications", greater fiscal transparency and openness and, most important of all, intensive stakeholders' consultations. With regard to the key economic issue facing the country, that is "rising cost of living", we need a credible disinflation strategy, focussing more at the root causes of inflation and not stopping with just one-off direct cash transfers, which is in actual fact, fuelling the so-called demand-induced inflation.

While BR1M helps to a certain extent to lessen the financial burden on consumers, at least on a temporary basis, direct unrequited cash transfers with no conditions attached, distributed to millions of targeted household heads and consumers on economy-wide basis, is in fact direct injection of liquidity into the economy. Although it is well-received and very popular, this populist measure is akin to macro textbook's "helicopter rain of money", fuelling further inflation phenomena with the so-called demand-induced inflation, as traders and firms were taking advantage, marking-up their prices and workers continue demanding higher wages and allowances, as seen in recent months. Most worryingly, these direct cash transfers come from Federal coffers, obtained from taxpayers money, and expended as current expenditure or Government consumption which empirically provides minimal economic multiplier effects on the real side of the economy, except pushing consumer prices to higher levels. We clearly need to examine and review this approach and start looking at an inflation-targeting framework and having a monetary policy stance that is credible and dominant, focussing on price stability while allowing real GDP growth to be endogenously determined and having greater flexibility in exchange rate movements. Malaysia's real GDP growth is tracking closely the US real GDP growth, as seen in recent years, despite the fact that Malaysia's trade and financial openness, measured as a percentage to GDP are actually the highest among developing countries. Moreover, trade exposure to advanced economies (US and Euro area) is also moderating, indicating the need to decouple the tight bilateral output growth relationship by allowing greater adjustment on the real side of the economy, especially with the expected slower growth in China, Malaysia's largest trading partner.

In this respect, fiscal policy needs to take a backseat, at least in the near-term, focussing more on its earlier commitment to fiscal consolidation process, thereby helping to achieve the objective of fiscal sustainability in the medium and long-term. Meanwhile, monetary policy must take a dominant role in the immediate-term, placing more weight on curbing rising inflation by anchoring fully inflation expectations, protecting the country's hard-earned international reserves from fast depleting, and reversing current undervaluation in the real exchange rate. This is necessary and timely, especially in the expansion phase of business cycle dynamics, and more importantly when the Government debt limit is nearing the threshold of 55%, and sovereign rating position is more or less at stake. The current high-debt state (based on GDP per capita USD), under business-as-usual scenario (BAU) or "do-nothing" policy will affect sovereign risk premium and investors' confidence, especially when portfolio investors are disposing their large overseas holdings of debt securities and, more importantly declining trend in capital inflows into emerging market economies, Malaysia included.

The fiscal consolidation process, though painful and seemingly unpopular, will undoubtedly yield net benefits in the medium and long-term and in the final analysis helps to ensure the wellbeing of our future generations. We need to focus more on intergenerational equity and inclusiveness and also distributional concerns of the community. While stronger fiscal consolidation process is normally seen as counterproductive, especially with its negative effects on real GDP and higher prices in the short-term, as seen in the past six months, economic simulations show that stronger fiscal consolidation process helps to significantly lower Federal Government debt, reduce substantially sovereign risk premium and improve to a large extent sovereign rating position. As a small open developing economy, which is very susceptible to adverse external shocks, especially capital flow volatility, Malaysia's debt-to-GDP ratio must not be compared with those in advanced economies with their high USD GDP per capita and generally strong institutions, as our sovereign rating is clearly lower and somewhat different in terms of default probability. Therefore, it is incumbent upon the Government to take corrective fiscal actions seriously, rather than delaying it to a later date, by which time fiscal issues snowball and become much more difficult and painful to rectify, as evidenced in the euro zone's "stressed economies" in the last two years and more recently by a few "emerging market economies" in developing Asia. These countries have been experiencing twin-deficits, weak domestic economic fundamentals and continue to rely heavily on foreign financing for their economic and social development.

With the fiscal consolidation process underway and no reneging in the commitment thus far, monetary policy should be able to take a centre stage, focussing on short-term macro stabilization measures, tackling elevated inflation situation and ensuring stability of the financial system as a whole. This is so important because usually a period of rising inflation will be followed by a period of rising unemployment, as output growth slows down and domestic currency weakens. Moreover, inflation expectations are generally slow to disappear and therefore, relatively tight monetary policy is clearly needed to anchor inflation expectations in the medium and long-term. With narrowing output gap, terms of trade remain unfavourable and real exchange rate undervalued, allowing market interest rates to reflect tight domestic liquidity conditions while maintaining the OPR at 3.00% at least until the third quarter of 2014 could be the best option, as domestic interest rate margin remains well above 3% (BLR of commercial banks at 6.53% in February 2014). For greater transparency and better communication, "forward guidance" should be used to inform the public about the likelihood of higher interest rates in the coming years, especially with the tapering of the US Federal Reserves (US Fed) asset purchase program on staggered basis (scheduled to complete at end-December 2014) and the turning of global negative real interest rates to a positive territory.

While the inflation rate in the first three months of 2014 shot up by more than double the rate registered in the same period last year (January-March 2014: 3.4%, January-March 2013: 1.4%), growth in domestic liquidity, as measured by the broad money supply (M3), continues its decelerating trend attributed to a large extent by sharply lower net foreign assets, although domestic credit extension to the private sector remained generally supportive of economic activities. "Other influences", which include major items such as retained profits or losses of BNM and the banking institutions and provisions for bad and doubtful debts, continued to exert negative effects on the growth of M3 in February 2014. Growth in narrow monetary aggregate (M1) is also decelerating, but remained at double digit growth, indicating that economic activities are currently being financed using internal resources by economic agents, digging deeper into their own cash and demand deposits, especially in an environment of credit-constrained economy and increasingly limited access to credit markets. Growth in loans disbursed, the key metric for availability of financing, decelerated by more than half to 12.2% in February 2014 (December 2013: 24.7%), while loans repaid registering an uptrend in growth at 16.8%, as economic agents reordering their financial priorities, especially with rising market interest rates. Real balances now become input to the production process of firms, affecting marginal cost and ultimately will be passed through to consumers with higher prices (mark-up in prices). As mentioned in the previous reports, the dynamic of monetary aggregates should be given greater attention, especially with the OPR remaining unchanged, while monetary aggregates are taken as endogenously determined in recent years. With tighter domestic liquidity, average 3-month interbank rate is trending up to 3.29% in February 2014, about 22 bps higher than the prevailing
1-month interbank rate and 19 bps higher than its lowest at 3.11%, as recorded in April 2013.

Unemployment is well above the threshold of 3.0%, adding further to the current misery of the rakyat. Unemployment rate stood at 3.3% in January 2014 (December 2013: 3.0%), while seasonally adjusted figure was slightly lower at 3.1%. Overall labour force participation rate, which exceeded 69% (August to November 2013), has decelerated to 67.8% in January 2014, indicating that that eligible workers become discouraged and prefer to stay outside the labour force, especially with unfavourable labour market conditions and could also be dissatisfied with the weak implementation of minimum wage policy. Moreover, the duration of unemployment seemed to be getting longer and longer, while the working age population is expanding fast, especially with increasing number of new entrants to the labour market and also the influx of foreign workers. Number of employed persons decreased by 18,900 persons to 13.53 million persons in January 2014 (December 2013: 13.55 million persons), while the number of unemployed has increased by 32,700 person to reach 457,700 during the same period. Youth and graduate unemployment are emerging issues that need to be tackled fast, as unemployment rates among these categories are very much higher than the national average, which is masked by labour market imperfections and distortions and a higher share of informal sector.

Real GDP growth of the Malaysian economy moderated to 4.7% in 2013 (2012: 5.6%, 2011: 5.1%), supported by continued robust domestic demand, especially private consumption and investment. There was a turnaround in the external demand in the third quarter of 2013, representing first positive quarterly growth after seven consecutive quarter of declines. Domestic demand (excluding change in stocks) expanded by 7.6% in 2013 (2012: 10.6%, 2011: 7.9%), while external demand as measured by net exports of goods and services contracted by 22.9%, but clearly an improvement compared to -31.7% experienced in 2012 (2011: -4.6 %). The major contributory factor was the turnaround in exports of goods and services which grew by 1.7% in the third quarter of 2013, and expanded strongly by 2.9% in the last quarter of the year, after contracting for five consecutive quarters, indicating clearly an improvement in the external sector in the second half of 2013. Nonetheless, private consumption remained the key driver of growth in 2013, growing steadily by 7.6% (2012: 7.7%, 2011: 6.8%), and contributing 3.9 percentage points to real GDP growth of 4.7% in 2013 (2012: 3.9%, 2011: 3.4%). As mentioned in the previous report, consumption-driven growth for a prolonged period is not sustainable, as it is associated with rising consumer inflation and as a consequence demand for higher wages and living allowances. More importantly, there is an accumulation of household debt, which at end-2013 stood at 86.8%, and is one of the highest for developing countries. Private investment, however remained strong registering double digit growth of 13.6% in 2013 (2012: 21.9%), and its growth is again trending up, from the low of 10.8% in the first quarter to 16.5% in the fourth quarter of 2013, pointing to continued strong investor confidence in the country, especially among foreign investors. Total investment approvals by MIDA in the manufacturing sector has increased to RM52.1 billion in 2013, representing an increase of 26.7% from RM41.1 billion in 2012 (2011: RM 56.1 billion), of which the share of foreign investment amounted to 58.6% of the total investment approvals. This augurs well for the Malaysian economy, as external demand is clearly picking up, supported by strong recovery in key advanced economies, especially the US and euro area.

With growth moderating in 2013 and domestic economic fundamentals are now showing signs of weaknesses, Malaysia needs to be extra vigilant, implementing measures that can minimize downside risks to growth and employment and taking new measures and strategies to ensure stability in the financial system. Malaysia needs to avoid overly competitive (significantly undervalued) exchange rate and ensure the ringgit exchange rate is not too far distant from "fundamental equilibrium exchange rate". New measures need to be put in place to strengthen the long-term potential output growth through gains in productivity, advances in technology, R&D and innovation. While current inflation rate is clearly well above the minimum threshold of 2.0%, which is also the official target for both the ECB and the US Fed, the estimated output gap remains an issue in Malaysia. Additionally, the estimated "core inflation" takes into account only volatile food prices, while technically it should also exclude volatile energy prices from the headline inflation, as adopted in many inflation targeting countries.

In retrospect, Bank Negara Malaysia (BNM) kept the Overnight Policy Rate (OPR) unchanged at 3.00% at its Monetary Policy Committee Meeting on 6 March 2014 and the next monetary policy statement will be on 8 May 2014. With core inflation (adjusted CPI, excluding food and non-alcoholic beverages) has been edging upward in recent months, and new wave of price increases are expected in the coming months, especially with coming Ramadan and Hari Raya festivities, there is a need to curb demand-induced inflation and more importantly, anchor expectations of inflation in the medium and long-term. Monetary policy needs to take a tighter stance, if not real exchange rate continues to depreciate, due to narrowing of real interest rate differentials and increasing risk premium. Consequently, inflation situation could get out of control, as domestic cost factors continue to push consumer prices to higher levels. As suggested in the previous report, BNM should start adopting inflation targeting framework and gradually allow market interest rates to rise, as shown by sharp increases in the 3-month interbank rates and one bps monthly increase in the weighted ALR of commercial banks in recent months. This soft approach using signals akin to "forward guidance" seems reasonable and fair, especially with an improving external demand which will help to offset minimal interest rate shock on aggregate domestic demand, especially private consumption. In most cases, moderately high interest rates help to facilitate structural adjustment, although its effects on inflation take longer to materialize than its immediate negative impacts on output growth and employment. In this respect, BNM should not be rushing in terms of raising overnight policy rate (OPR), but by allowing market interest rates to adjust gradually upward provide strong signals that high inflation will not be tolerated and prospects for higher interest rates seem likely. Meanwhile, real GDP growth, which is on the expansion path, remains below potential output growth (5.5%) and "core inflation" is somewhat over-estimated (need to exclude volatile energy prices from headline inflation). Moreover, deflation remains a downside risk in key advanced economies, especially in the euro area while forecast of softening in global commodity prices will help to soften the impact of domestic cost push as well as demand-pull factors. In this respect, better public communication policy, firm commitment on the part of fiscal policy, forward guidance with firm signalling approach and allowing market interest rates to gradually increase are the best means to successful monetary policy stabilization measures. However, these need to be supported with "intelligent communications", greater openness and transparency. The real drawback is that the ringgit remains de-internationalized, and the "fear of floating" with heavily managed exchange rate system, resulted in depleting hard-earned foreign reserves and apparently slow and weak structural adjustment process. While ringgit exchange rate movements have been largely stable in 2011 and 2012, averaging about RM3.07 per USD, the volatility has since increased and ringgit value declined to an average of RM3.15 per USD in 2013 and RM3.29 per USD in the first four months of this year.

In its World Economic Outlook (WEO) 2014, released on 8 April 2014, the IMF indicates that global economic activity is expected to improve further in 2014 -2015, as global recovery is gaining momentum, but growth process remains at uneven speed. The IMF forecasts global growth at 3.6% this year and 3.9% in 2015, a significant improvement compared to 3.0% estimated for 2013 and moving closer to world potential output growth. However, these new forecasts point to a downward revision from earlier forecasts (January 2014, WEO Update) by 0.1 percentage point for 2014 and 2015, respectively. While strong recovery is expected in advanced economies as a group, especially in the United States (US), growth in emerging market and developing economies (EMEs) is expected to pick up only modestly, as reflected in 0.2 percentage point downward revision for 2014 and 0.1 percentage point in 2015. IMF cautions that EMEs are expected to face difficult external financial environment, arising largely from monetary policy normalization in key advanced economies. As such, these countries, Malaysia included need to be ready in weathering market turmoil and must be able to mitigate external vulnerabilities.

The results of MIER's first quarter 2014 Consumer Sentiments Survey and Business Conditions Survey show that consumer and business confidence indices continue to move in tandem for third consecutive quarters, reflecting synchronization in both consumer and business sentiments. The first quarter 2014 Consumer Sentiments Index (CSI) is up 14.4 points quarter-on-quarter to settle slightly higher at 96.8 points, after recording the lowest reading in almost five years in the fourth quarter of 2013. While consumers may be a notch higher in the recent quarter, the confidence level remains below the threshold of 100 points, indicating that confidence has yet to turn a corner for better outlook. Nonetheless, they are less perturbed by both the current economic conditions and expected conditions in the first half of this year. Meanwhile, the Business Conditions Index (BCI), which has been on the downtrend for two consecutive quarters, turned around registering 11.1 points on quarter-to-quarter basis to 103.1 points (10.1 points year-on-year), surpassing marginally the 100.0 point threshold, indicating that that business conditions have finally improved. Of significance, the sub-component of Expectation Index (EI) registered strong gains of 31.8 points to stay well above 100-point threshold at 131.6 points in the first quarter of 2014. On the contrary, Current Index (CI) component remained below the 100-point threshold at 93.6 points, up only by 4.2 points quarter-on-quarter, indicating that manufacturers remain cautious on current business conditions, as shown by lower capacity utilization. Nonetheless, with consumer sentiments and business conditions indices on the upside and hovering within 100-point threshold, we can generally conclude that both consumer and business confidence has improved in the first quarter of 2014, although consumers remain cautious, especially in their spending. These sentiments are generally echoed in the latest first quarter 2014 Vistage-MIER CEO Confidence Index, which showed the CEO Confidence Index dipped even further to 85.6 points, losing 14.1 points year-on-year, the lowest in the last three quarters. More than half (53%) of chief executive officers (CEO) out of 384 respondents were of the view that economic conditions have worsened in recent times, while only 9% thought otherwise, up slightly from only 7% in the fourth quarter 2013. In terms of outlook, a majority (52%) of the respondents are bracing for an economic downtrend in the coming months. Their major concerns include rising costs, weakening of the ringgit and impact of recent measures on local property market.

Taking into account weakening in domestic economic fundamentals, especially in recent months and also the continued weak sentiments as shown in both MIER's CSI and BCI surveys, as well as Vistage-MIER CEO Confidence Index, domestic demand is expected to moderate slightly in 2014. While domestic demand will continue to be the key driver of growth, improving external demand as seen in the last two quarters of 2013 and also in the early months of 2014, together with continued strong private investment will see that that BNM's recent growth forecast at 4.5 - 5.5% for 2014 will be achieved. We are revising our 2014 growth estimate to 5.3% for 2014, though a little bit optimistic, but taking into account growth dividend to be expected from stronger fiscal consolidation process, tighter monetary policy stance and better-than-expected global market environment. This forecast, however, hinges on the need for strong commitment by both fiscal and monetary authorities in dealing with recent economic weaknesses, which essentially require bold approach, searching for the optimal moves, but definitely no turning back. As for the year 2015, real GDP growth is projected to move nicely along the potential output growth path of 5.5%, driven by economic efficiency and innovation, especially with expected enhanced competition in both product and services markets, less market distortions and imperfections, greater labour market flexibility and more importantly productivity gains as well as more efficient allocation of scarce resources. The GST implementation is expected to provide a strong signal that reform is underway to strengthen public finance, especially on the revenue side. Despite its initial negative effects, especially on consumer prices, the expected economic benefits will definitely far outweigh the costs, and the wellbeing of the society as a whole will be better, especially in medium and long-term. These positive gains, associated normally with stabilization measures and economic reform programs require strong "political will" on the part of the Government and, more importantly, strong support and ownership by the all the stakeholders, especially the rakyat.

Posted by suzy at 04:17 PM