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Executive Summary

Malaysia is on track to achieve the goals of high income and developed nation status by the year 2020. While macroeconomic targets, especially GNI per capita at USD15,000 and 3.3 million new jobs are expected to be within reach, the graduation process to be a fully developed and inclusive nation would take a while longer than envisaged, if corrective actions are not vigorously pursued. The latter involves a lot more key metrics, encompassing changes in economic landscape, sovereign rating and creditworthiness, development of economic and social institutions and also "soft" infrastructures. These metrics cover both quantitative and qualitative measurements, encompassing social policy and environmental concerns. Achieving high income target at national level is not a stumbling block, especially for resource-rich developing economies, whereby the competent and prudent ones have already surpassed their GNI per capita thresholds. However, these "blessed countries" are still struggling with market imperfections and inequalities, under-developed and incomplete financial markets and of greater important, weak institutions and poor governance. In general, market microstructures, social and ecosystem services need to be strengthened, key institutions for economic and social development improved, and good governance, which is a hallmark of most developed economies, need to be fully incorporated and given a top priority. Most importantly, access to economic opportunities and social protection, especially for the poor and disadvantaged groups needs to be widened, so that they can really protect themselves. Core labour standards also need to be improved, covering those in the informal sector, including migrant workers. At the macroeconomic policy level, well-established rules and procedures need to be observed, while "discretions" constrained, especially those that invite greater public scrutiny, such as wasteful government spending, directed development projects, corporate sector tax avoidance and discounts, among others. Development projects need intensive project appraisals, identifying both costs and benefits to the society as well as who are the gainers and losers, and enhanced with rigorous risk analysis. Cost-benefit analyses (CBA) are mandated legislative requirements in most developed economies, while ironically Malaysia has almost abandoned it long time ago. Without fail, rakyat are asking about development project beneficiaries, substantial cost escalation and environmental degradation.

The current development model, based on neoclassical welfare economics, is largely geared towards attaining macroeconomic aggregate targets, especially GNI per capita and the role of private investment. Excessive investment in structures and equipment, especially in luxurious real estate development and infrastructure projects skewed in certain areas, as seen in recent years will ultimately lead to "overcapacity", lowering the efficiency and quality of investment, raising private sector debt level and if not properly monitored, lead to financial instability, as seen in some "investment-driven economies" in the past as well as in recent years. Infrastructure projects that reduce bottlenecks and benefit the rakyat on a wider scale, especially water supply and sanitation and electricity and public spending on education and health will surely go a long way in improving long-term productivity and nation's competitiveness. Trickle down policy (a rising tide lifts all boats) is grossly inadequate in meeting the basic needs of the rakyat, ensuring the quality of life, living standards and welfare of the society as a whole. Greater focus needs to be given on sustainable development and good governance, whereby specific measures are undertaken to enhance natural and social capital and minimize social costs and negative externalities, associated normally with free market activities and reduced role of government. Special considerations should be given on emerging social policy issues, addressing distributional conflicts across ethnic and income class, environmental degradation, intergenerational equity, social cohesion and justice, and the welfare of future generations. Pursuit of growth and economic efficiency need to be enhanced with strong ethical and moral standards, exemplified with less wasteful spending and less rampant corruption, thereby ensuring true allocative efficiency of nation's scare resources. Apart from achieving the ultimate goal of national unity and harmony in all angles, we need to ensure that the society and rakyat as a whole derive maximum benefits in terms of economic and social development. More importantly, rights in whatever forms need to be balanced with strong responsibilities, a prerequisite in ensuring tolerance and harmony in the society, which seemed to be eroding in recent years.

This year continues to be a challenging year for Malaysia, especially with the El Nino phenomenon, which is expected to not only drive food prices higher, but also result in a lot of economic, health and environmental costs. On the external front, there is a crisis brewing in Ukraine, affecting trade and investment as well as security in Europe, while surging Islamic militancy and continued fighting in Iraq and Syria could potentially push crude oil prices to higher levels, as last seen in 2008. Most worryingly, inflation remained elevated in the first five months of 2014, hovering well above the minimum of official forecast (BNM, 2014: 3 to 4%). "Cost of living" is undeniably on the rise, especially with the planned implementation of goods and services tax (GST) in April 2015 and an impending review of minimum wage policy in January next year. While household purchasing power is clearly shrinking, following mark up in prices by both firms and traders, there are unfortunately other social costs and potential welfare losses that should not be taken for granted by the authorities. These include continued softening in global commodity prices (affecting rubber and oil palm smallholders) and tightening of domestic credit conditions (business owners and borrowers). As for long-term savers, real interest rate is already in a negative territory, while macro-prudential and administrative tightening has to a large extent affected the corporate sector. Business owners are now coping hard with higher operating costs, especially production costs, as seen by elevated producer price index, particularly for local production, continued exchange rate volatility and heighthened business uncertainty.

The banking system is now exposed to significant systemic risk, especially with continuing high household debt, tightening of domestic credit conditions and large exposure to property and real estate development. The bulk of the household debt are in the housing loans, of which the majority is exposed to floating mortgage rates. In terms of GDP per capita in USD, Malaysia's household debt at 86.8% of GDP at end-December 2013 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%. On the external account, international reserves remained more or less stagnant at about USD131.1 billion in the second quarter of 2014, following strong foreign exchange interventions by BNM to support depreciating ringgit (leaning against the wind), while net international investment position continued to be in a negative territory in 2013 at -RM47.2 billion (2012: -RM17.8 billion), affected by net outflows of direct investment abroad (DIA) and portfolio investment, especially for sovereign debt securities. The intensified reversal in the last two years is reminiscence of the situation in the year 2000, in which international reserves were sharply lower. Foreign investors have been retreating from government bond markets, reallocating their global portfolio either to equity market or government bonds in the US and their home countries.

Real GDP growth of the Malaysian economy grew markedly higher by 6.2% in the first quarter of 2013 (Q42013: 5.1%, Q12013: 4.2%), supported by continued robust domestic demand, especially private consumption and investment. There was also a sharp turnaround in the external demand in the first quarter of 2014, registering positive year-on-year growth of almost 15% (Q42013: -6.8%, Q12013: -12.9%). Domestic demand (excluding change in stocks) expanded by 7.4% in the first quarter of 2014 (Q42013: 6.7%, Q12013: 7.5%), with private consumption remained the key driver of growth, growing steadily by 7.1% (Q42013: 7.4%, Q12013: 6.4%) and contributing 3.7 percentage points to real GDP growth (Q42013: 3.7 percentage points, Q12013: 3.2 percentage points). As mentioned in the previous reports, consumption-driven growth for a prolonged period is not sustainable, as it is associated with rising consumer inflation and consequently demand for higher wages. More importantly, there is an accumulation of household debt, which at end-December 2013 stood at 86.8%, and is one of the highest for developing countries. Private investment, however, remained strong registering double digit growth of 14.1% (Q42013: 16.6%, Q12013: 10.0%), supported by capital outlays in the manufacturing and services sectors. Total investment approvals by MIDA in the manufacturing sector registered RM17.1 billion in the first quarter of 2014, of which the share of foreign investment amounted to 76.7% of the total investment approvals. There is a new wave of foreign investment, especially from Japan and Germany, which augurs well for the Malaysian economy, as external demand is on the uptrend, supported by a recovery in key advanced economies.

While the inflation rate in the first six months of 2014 increased by more than double the rate registered in the same period last year (January-June 2014: 3.4%, January-June 2013: 1.6%), growth in domestic liquidity, as measured by the broad money supply (M3), continues with its decelerating trend, attributed to a large extent by sharply lower net foreign assets, although domestic credit extension to the private sector remained supportive of economic activities. Net claims on Government, which is on an expansionary mode provided a welcome relief to an otherwise slower M3 growth. Growth in narrow monetary aggregate (M1) is moderating, registering a single digit growth of 9.6% in May 2014, the first since November 2012, indicating that domestic economic activities are currently being financed using internal resources by households and businesses, arising from increasingly limited access to credit markets. Growth in loans disbursed, the key metric for availability of financing in the banking system, decelerated markedly to 4.8% in May 2014 (December 2013: 24.7%), while loans approved registered sharper negative growth at -8.9% (December 2013: 20.4%), with the banking system reordering their financial priorities, especially with extremely tight liquidity conditions. As for firms and businesses, real balances now become input to the production process, affecting marginal cost and ultimately will be passed through consumers with a mark-up in prices. As mentioned in the previous reports, the dynamics of monetary aggregates should be given greater attention, especially with the hike in OPR by 25 basis points on 10 July 2014. With tighter domestic liquidity conditions, average 3-month interbank rate is trending up to reach 3.43% in May 2014, representing 37 basis points (bps) higher than the prevailing 1-month interbank rate and also 32 bps higher than its lowest at 3.11%, recorded in April 2013.

Labour market conditions remained favourable, especially with an acceleration in external demand and a strong pick up in growth of the manufacturing sector. Unemployment rate improved slightly to 2.9% in April 2014 (December 2013: 3.0%, April 2013: 3.0%), while seasonally adjusted figure was also at 2.9%. Overall labour force participation rate has also improved to 67.3% in April 2014, up by 0.4 percentage point from the previous month, but remained below the average of 69%, registered during the period August to November 2013. There were new entrants to the labour markets, comprising of mostly young workforce aged between 20-24 years, while senior workforce participation rate has been declining, discouraged by longer duration of unemployment and de-skilling effects. The number of employed persons increased markedly by 75,300 persons to 13.50 million persons in April 2014 (March 2014: 13.43 million persons), while the number of unemployed has declined by 8,500 persons to 407,200 during the same period. Latest available data in May 2014 showed that total number of retrenchments has increased to 949 persons, while total number of vacancies declined to 71,837 persons, pointing to increasingly competitive labour market.

Bank Negara Malaysia (BNM) in its Monetary Policy Statement, released on 10 July 2014, raised the Overnight Policy Rate (OPR) by 25 basis points (bps) to 3.25% from 3.00% previously. While the hike is minimal and somewhat anticipated, bearing in mind that it has been in place for more than three years (since May 2011), there will definitely be wider economic implications. Upward adjustment in lending rates will obviously push up debt servicing costs for borrowers, leading potentially to an increase in non-performing loans (NPLs) and required provisions. Household budgets will be squeezed by additional interest expenses on their loans. Moreover, with an ongoing Ramadan and forthcoming Hari Raya festivities, household expenditures are already bursting at the seams for many households, especially with reported increases in prices of durable and non-durable goods. These will be further exacerbated by pass-through effects of higher import prices as well as enhanced demand-driven inflation, following continued robust aggregate domestic demand and generally favourable labour market conditions.

While BNM has taken the so-called anticipatory and pre-emptive approach (ahead of the game), it has inadvertently succumbed to market speculation, bets and nerves. The appreciation of ringgit, as seen before and after the hike in OPR will not last long and further hikes are needed to satisfy FX market players, while the society as a whole bore the brunt of higher interest rates through sharply lower private consumption and output, and also real wages, resulting in welfare losses. The next move is surely critical, as the ringgit remains exposed to strong exchange market pressures, either way depending on market expectations, news and sentiments. Apart from continued confidence in the economy, sound domestic macroeconomic fundamentals and strong commitment to fiscal consolidation process are the key determinants to long-term nation's competitiveness and not through changes in short-term real interest rate differentials. The relatively low interest rates (after the hike) allow both the public and private sector to really adjust, and we must not lose that opportunity, with 'business as usual" approach. The most preferred option is putting domestic macroeconomic fundamentals in a sound manner, instead of purely monetary tightening and letting market mechanisms to sort it out. By throwing two stones simultaneously, positive interest rate shock and allowing monetary aggregates to decelerate sharply, the domestic real sector will be very much affected, further aggravating deterioration in domestic financial conditions. Moreover, external demand remains susceptible to adverse developments and anticipated switch in the sources of growth to external sector could prove very risky.

Nonetheless, a relatively tight monetary policy is timely, not only helping to anchor inflation expectations in the medium and long-term, but also complementing the ongoing fiscal consolidation process. With output gap turning positive in the first quarter of 2014, terms of trade continued to register losses and real exchange rate remained to be undervalued, allowing market interest rates to reflect tight domestic liquidity conditions could be the best option. While in the current scenario, domestic cost-push factors far outweigh demand-induced inflation, the latter is clearly gaining momentum, especially with continued robust aggregate domestic demand and favourable labour market conditions. For greater transparency and better communication, "forward guidance" should be used to guide the public about the likelihood of higher interest rates in the coming quarters and in the years ahead, especially with likely earlier-than-expected unwinding of the US Federal Reserves (US Fed) quantitative easing (QE) scheme and the turning of global negative real interest rates to a positive territory. Higher interest rates overseas could come much earlier than expected, as wages are on the rise, especially with declining unemployment rate. While Government's commitment to fiscal consolidation process remains firm, Federal Government spending programs need to focus more on social policy concerns, such as inclusiveness, intergenerational equity and distributional issues of the society or rakyat as a whole. In fact, 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. Government spending that provide wider benefits to the rakyat would also help to enhance public confidence and eliminate resentments.

Ms. Christine Lagarde, Managing Director of the International Monetary Fund (IMF) in her speech in France on 6 July 2014 provides a brief overview of the global economy, pointing that global activity is expected to gain momentum in the second half of the year, and to accelerate further in 2015. This is after unexpectedly weak performance in the first quarter of the year, especially inthe US. While advanced economies are strengthening, emerging market and developing economies (EMEs) are experiencing slower growth, but continue to provide the bulk of global growth. In its World Economic Outlook (WEO) 2014, released earlier on 8 April 2014, the IMF forecasts global growth at 3.6% this year and 3.9% in 2015, a significant improvement compared to 3.0% for 2013. The IMF cautions that EMEs are expected to face difficult external financial environment, arising largely from monetary policy normalization in key advanced economies. The World Bank in its "Global Economic Prospects: Shifting priorities, building for the future", released in June 2014 predicts that growth is expected to strengthen, while recent set-backs in the global economy were taken as only temporary. These include severe winter in the US and geo-political tensions in Eastern Europe and in the Middle East. Global risks have generally declined, but financial markets will continue to remain volatile, especially with tightening global financial conditions, restructuring in China and declining commodity prices.

The results of MIER's second quarter 2014 Consumer Sentiments Survey and Business Conditions Survey show that consumer and business confidence indices continue to move in tandem for fourth consecutive quarters, reflecting synchronization in both consumer and business sentiments. The second quarter 2014 Consumer Sentiments Index (CSI) is up by 3.3 points quarter-on-quarter to settle at 100.1 points (1Q2014: 96.8 points), pointing to neutral consumer sentiments. While consumers appeared passive about their current financial situation and outlook for jobs, their income expectation for the near term is slightly better than the previous quarter. Meanwhile, the Business Conditions Index (BCI), which turned around, registering 11.1 points on quarter-to-quarter basis to 103.1 points in the first quarter, firmed up by another 9.9 points to reach 113.0 points in the second quarter 2014, well above the 100.0 point threshold, indicating that that business conditions have generally improved. The key factors behind this quarter's momentum are the very favourable current index. The Current Index (CI) increased by 17.7 points to read 111.3 points in the second quarter of 2014, compared with 93.6 points in the previous quarter. All six sub-indices that make up the CI, namely sales, production output, new local and export orders, investment as well as capacity utilization increased quarter-on quarter. Meanwhile, the survey results indicate that manufacturers expect business conditions to deteriorate, as the Expectation Index (EI) loss 13.7 points to stay at 117.8 points in the second quarter of 2014. Both expected sub-indices that comprise the EI namely expected production and expected export sales drop by 8.6 points and 5.1 points, respectively.

These sentiments are generally echoed in the latest second quarter 2014 Vistage-MIER CEO Confidence Index, which showed the CEO Confidence Index turned around to register 92.2 points (Q12014: 85.6 points), adding 6.6 points on quarterly basis, but remained significantly lower than the corresponding quarter last year (Q22013: 104.4 points). Generally, chief executive officers (CEOs) were more optimistic going forward. Those who believe that the economy will worsen soon fell to 34%, down from 52% in the previous quarter, but up from 16% a year ago. There were also expectations of higher profitability in the second quarter 2014, with more than half of CEOs (58%) anticipating an increase in sales revenue. Additionally, 45% of respondents will increase their work force, while 44% planned on expanding their capital investment. Their major concerns include tough challenges of GST implementation, especially with higher costs and pricing, systems compliance, and an increase documentation, among others. Higher medical fees is also a major concern for CEOs, especially with Putrajaya allowing medical and dental practitioners to hike their professional fees by up to 14.4%. Findings from FMM-MIER Business Conditions Survey, released on 25 June 2014 showed that local manufacturers continued to think that current business conditions (compared to 6 months ago) are still unfavourable, but they are more upbeat in their assessment for the second half of 2014. Local and export sales and number of employees are expected to improve, while both production volume and capital investment are trending up. About 67% of respondents experienced higher production costs in the current first half of 2014, up from 64% in the second half of 2013.

With generally improving domestic economic fundamentals and broadly positive sentiments, as reflected in both MIER's CSI and BCI surveys as well as Vistage-MIER CEO Confidence Index and FMM-MIER Business Conditions Survey, domestic demand is expected to continue powering growth of the Malaysian economy. Strong external demand as experienced in the first quarter of 2014, together with continuing high private investment growth will see that BNM's recent growth forecast at 4.5% - 5.5% for 2014 will be achieved. We are maintaining our growth forecast of 5.3% for 2014, taking into account growth dividend to be derived from stronger than expected fiscal consolidation process, tighter monetary policy stance, as seen in the recent hike in OPR and better-than-expected global market environment. As for the year 2015, real GDP growth is projected to move nicely along the potential output growth trajectory of 5.5% - 6.0%, driven by better allocation of nation's scarce resources, enhanced economic efficiency and innovation and continued strong social protection.

Posted by suzy at 12:42 PM