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Executive Summary

Looking back, we were very fortunate that external shocks occurred mainly in the fourth quarter of 2014. Commodity export prices were falling, especially crude oil, while the ringgit exchange rate depreciated across- the-board against currencies of Malaysia's major trading partners, most notably against the US dollar, Chinese Yuan, Thai Baht and Singapore dollar as well. While short-term demand imbalances (weak demand and excess supply) in the world oil market explained to a large extent the plunging crude oil prices, portfolio re-allocation by foreign investors and acquisition of foreign portfolio assets by local institutional investors, taking advantage the strengthening of the US economy and expectations of higher real interest rates were seen as the major contributory factors to depreciating ringgit. As a matter of fact, foreign investors were reallocating their portfolio towards dollar-denominated assets, shifting out of commodity-based contracts, while local firms were adjusting to a higher interest rate environment. In the oil industry, oil firms are pumping more today, revising downward their outlays for investment, while traders are cutting down on their inventories, as carrying costs are expected to rise with anticipated higher interest rate environment. Apart from these sudden economic clouds, heavy rains and severe flooding also occurred in late December 2014, affecting many states in both Peninsular Malaysia and in Sabah as well. Fortunately, Malaysia has more or less escaped the El- Nino phenomenon, which was predicted to happen in 2014.

If not managed properly and in a timely manner, the external shocks and traumatic events like severe flooding could affect productivity and potentially lower the potential output of the economy. Moving forward, these events could also possibly affect the projected growth trajectory of the Malaysian economy. Fortunately, growth is estimated to be exceptionally strong at 5.9% in 2014 (2013: 4.7%), which is very much close to the required growth of 6.0% per annum for Malaysia to escape the prevailing "middle-income trap". Moreover, actual growth remained well above the "socially efficient level of output" growth, estimated at 5.5% per annum, and output gap remained positive, supported largely by robust aggregate domestic demand. Additionally, there was a strong contribution from external sector in 2014, although moderating aggregate domestic demand continued to be the key engine of economic growth. Of greater significance, overall unemployment rate remained below the threshold of 4%, suggesting full employment situation in the country, while consumer inflation rate increased moderately by 3.2% last year. As such, moving forward, initial economic conditions are strong, as domestic economic fundamentals remain generally good and most importantly, confident and belief function about good management of macro economy still intact, especially among domestic households and firms and other economic agents as well as society at large. Fickle-minded and short-term portfolio investors, who are almost always acting in concert and following herd behaviour seem to be retreating, reallocating their portfolio to dollar-denominated assets and also searching for safe haven, especially in presently uncertain global economic and political developments.

This year will be a very challenging year for the Malaysian economy. Real GDP growth is projected to moderate, depending on the magnitude of fluctuations in crude oil prices and also movements of the ringgit exchange rate against currencies of Malaysia major trading partners. Commodity terms of trade (CTOT) shock, ringgit depreciation and anticipated higher interest rates environment are expected to adversely affect Malaysia's domestic macroeconomic fundamentals, particularly in the short-term. Looking from macro perspective, there are clearly less risks, but in fact more opportunities, especially with lower energy prices, which is quite a rare phenomenon, moving forward. These shocks can be considered transitory and as always are expected to dissipate in the medium and long-term, as part of business cycle dynamics and also global economic and political developments. In contrast to spikes in oil prices in the previous episodes, there will undoubtedly be expansionary effects in the medium-term, in the forms of lower energy and production costs, boosting not only growth in oil-importing countries, but also encouraging consumer spending worldwide. On the domestic front, ringgit depreciation will definitely help in improving export competitiveness, encouraging wider import substitution activities and most importantly facilitating greater number of tourist arrivals into the country. Of significance, trade balance is expected to improve, albeit with a time lag and foreign direct investment (FDI) could possibly accelerate further, taking advantage of lower costs of doing business in the country. However, these so-called expected opportunities need to be complemented with good governance, greater transparency as well as enhanced public accountability. There are social costs and in fact welfare losses, associated with lack of openness and transparency, gap in policy credibility and weak reputation. These "soft" attributes need to be nurtured and strengthened, providing good signalling, forward guidance and better public communication strategies.

Real GDP grew 6.1% in the first three quarters of 2014, driven mainly by robust private consumption, which grew by 6.8% (January-September 2013: 7.1%), underpinned by favourable labour market conditions. Public consumption remained strong, registering growth of 5.3% (January-September 2013: 6.9%), while public investment contracted by 6.3% (January-September 2013: 4.1%). Meanwhile, private investment has moderated, growing by only 10.9% during January to September 2014 (January - September 2013: 12.2%). External demand rebounded by 32.2% during January to September 2014 (January-September 2013: -14.8%), pushing real GDP growth markedly higher.

Exports expanded by 6.4%, while imports grew slightly slower at 4.5% during the period. Consequently, balance of payments (BOP) current account surplus improved, registering RM43.4 billion (January-September 2013: RM25.1 billion), supported by substantial improvement in goods account, albeit continuing deficits in the services as well as in the primary and secondary accounts. Overall BOP registered a surplus of about RM25 billion in the first nine months of 2014 (January-September 2013: -RM17.32 billion), underpinned largely by a strong merchandise balance. Financial account has also improved in the recent quarter, but has been offset to a large extent by continued deficit in "net errors and omissions". Current account (CA) surplus of BOP is projected to remain in surplus, albeit at a smaller amount in 2015, on the back of J-Curve effects on trade balance and also improving services deficit. Falling commodity prices are expected to lower exports value, while RM depreciation is expected to increase import bills, but at the same time enhance export competitiveness in the medium-term and long-term. With generally improving financial account, overall BOP is expected to remain favourable this year. BOP CA surplus is projected to moderate further in 2016, escaping to a large extent the "twin-deficit" problem, as predicted by many analysts.

Inflationary pressures remained strong for the twelve months of 2014, averaging 3.2% (2013: 2.1%). Inflation rate moderated in September 2014 (2.6%), but edged up slightly to 2.7% in December 2014, after registering moderately high rate of 3.0% in November 2014 (October: 2.8%), on account of pass-through effect of a cut in fuel subsidy on 2 October 2014. Transport charges remained high at 4.0% in December 2014, barely move from 5% registered in November 2014. Moving forward, consumer headline inflation will be triggered by both domestic and external factors. The scheduled implementation of GST in April 2015, together with mandated review of the minimum wage policy and rising demand for higher wages and benefits will provide sparks for a new round of higher inflation expectations. Fortunately, falling crude oil prices and lower energy costs will help to offset domestic cost-push factors, especially for transport charges, but that depend on degree of pass-through effects and price stickiness. Additionally, low inflation environment in key advanced economies and less than full pass-through effects from ringgit depreciation will also see that inflation remains under control (Inflation 2015: 3.5%, 2016: 3.0%).

Monetary aggregates moderated in the first eleven months of 2014. M1 has been trending down since early 2014, while M3 bottomed-out in August 2014 and started to edge upward steadily, attributed to an uptrend in quasi money (M2). Growth in broad money (M3) were driven by continued credit, extended to the private sector and also higher net claims by the Government. The influence of net foreign assets remained contractionary during January to November 2014, and could possibly showing unfavourable position for the year as a whole. Tighter domestic liquidity conditions is reflected in the upward trends of key interest rates. Average interbank rates (3-month) increased significantly, reaching 3.86% (22 January 2015), indicating generally higher interest rates this year. BNM anchored the OPR at 3.25% in its latest MPC meeting on 6 November 2014, providing extra "comfort zone" to economic agents and adopting the so-called "gradual adjustment approach". With growth is expected to moderate and inflation remains under control, monetary policy will continue to be accommodative, at least until mid-2015. Nonetheless, net financing activity is expected to moderate, especially with tightening of domestic liquidity conditions and higher interest rates in the coming months.

The ringgit continued its depreciating trend in January 2015, which started in September 2014, as US dollar gained strength on the back of an improving US economy and expectation of US monetary policy normalization. Unfortunately, depreciating ringgit exchange rates, which are almost across-the-board will likely cause higher import bills and add sparks to domestic cost-push factors, especially with the oncoming GST implementation in April 2015. Portfolio outflows by non-residents are expected to continue, thereby reducing further foreign exchange reserves, especially with expectations of continuing flat OPR in coming months and weakening in domestic macroeconomic fundamentals. These include deterioration in commodity terms of trade (CTOT), declining share of Government expenditure to GDP, widening of real interest rate or yield differentials, and also rising risk premium. The shares of total trade and total private gross flows to GDP are expected to weaken, but only moderately, especially with offsetting effects and dynamic interactions, associated with negative external shocks. As such, ringgit will remain under strong exchange market pressures by traders, arbitragers, hedgers and to a large extent speculators, as crude oil prices continue to take a severe beating. While we have successfully diversified our economy away from commodity-based exports, our nominal effective exchange rate (NEER) tracks closely crude oil prices, as oil-related revenue account for close to 30% of Federal Government revenue in recent years. Oil and gas exports constitute only 13% of total exports, while the share of manufactured exports is significant at about two-third of total exports.

In the short-term, continuing low crude oil prices, financial frictions, price stickiness and wage rigidities in the product and labour markets will cause ringgit to continue its undershooting. These are amplified by unverified news and rumours, herd behaviour and short-term fickle-minded portfolio investors. In terms of fair value or fundamental equilibrium exchange rate, the ringgit is presently being supported by strong domestic macroeconomic fundamentals, although good news have already been discounted and reflected in the spot price. The ringgit is now seemed to be below its fair value or undervalued, due to extreme undershooting, and it is expected to revert back to its equilibrium fair value of about RM3.50 per US dollar, as selling pressures subside. Portfolio flows have been very volatile, since the global economic and financial crisis in 2008, moving in and out of Malaysian equity and capital markets, dictated mainly by US monetary policy and its associated uncertainty, such as taper tantrum seen in May last year.

BNM's "leaning with the wind", constrained by trilemma, as explained in the international finance textbooks, saw that ringgit depreciated well above RM3.50 per US dollar, moving in tandem with regional and other emerging market currencies. Passive reserve management strategy could well see the ringgit continue to slide, as there is clearly "less fear on depreciation", since the situation is expected to help improve export competitiveness. While maintaining monetary policy independence under free flow of capital is considered important and letting exchange rate taking the brunt of adjustment (greater exchange rate flexibility), fiscal affairs need to be managed in a credible manner and prudently, as continued fiscal deficit, high Government debt and rising contingent liabilities are the topical concerns of portfolio investors, FX strategists and sovereign rating agencies. This is especially so with the expected sharp decline in oil-related revenue (2014est: 29% of total Federal revenue), moderating private spending and elevated borrowings to finance public infrastructure projects. About 40% of ringgit-denominated Malaysian Government securities (MGSs) are owed to non-residents, and borrowings by GLCs and private corporations are mostly in US currency. Although bilateral ringgit and US dollar exchange rate moves in tandem with crude oil prices, based on high frequency real time data, these transitory relationship is expected to weaken in the medium term. Exchange rates move with news and expectations, whereby market participants are mostly rational and forward looking, placing greater weight on unanticipated events. Moreover, external reserves position remained substantial (44% of nominal GDP), providing solid buffer and "insurance cover", depending on reserve management strategy of BNM and external developments. Speculators like to get their fair share of accumulated reserves, taking calculated risks and profiting from macroeconomic mismanagements, poor governance or pure mistakes. Net international reserves continued its downward trend, touching USD111.2 billion as at 15 January 2015 (end-December 2014: USD116.0 billion; end-Dec 2013: USD134.9 billion). Fortunately, the ratio of international reserves to short-term external debt remained at 1.1 times, marginally above the standard international threshold of 1.0 time, as short-term debt also changes with economic developments. Most worryingly, Malaysia international investment position continued to record deficit of RM47.2 billion in 2013 (2012: RM17.8 billion), indicating that Malaysia was again a net debtor in 2012 and 2013, and this position is expected to remain in 2014. Continued outflows in portfolio investment, particularly debt securities contributed to the existing situation.

On the international front, the World Bank in its latest publication on Global Economic Prospects (GEP) report, released on 13 January 2015 mentions that the global economy is still struggling, with economic activities in many large developing economies are less dynamic than in the past years. This assessment is in line with the International Monetary Fund (IMF) in its latest update of the World Economic Outlook (WEO Update), released on 20 January 2015. While the IMF maintained the 2014 annual growth estimate for the world economy at 3.3%, the global growth projections for 2015 and 2016 are revised downward to 3.5% and 3.7%, respectively. The reductions by 0.3 percentage point for 2015-2016 forecasts reflect a reassessment of prospects in China, Russia, the euro area, Japan and also weaker activities in oil-exporting countries. Recent economic developments, particularly lower oil prices and shifts in sentiments and enhanced volatility in global financial markets are the risks facing the global economy and opportunities as well. The IMF maintained the 2014 growth rate estimate for the advanced economies at 1.8%, but revised the 2015 growth projection up slightly by 0.1 percentage point to 2.4%, while maintaining the prediction for 2016 at 2.4%. Among the advanced economies, economic activities in the United States and the United Kingdom are expected to gain momentum this year, supported by improving labour market conditions, while their monetary policies remain generally accommodative.

Recovery in the US economy is clearly gaining momentum, supported by strong domestic economic fundamentals. However, the euro area is still grappling with low growth, low inflation, high unemployment and high Government debt. The recovery has been sputtering in the euro area, according to the World Bank's latest GEP (13 January 2015). The report mentions that there is a possibility of prolonged stagnation in the euro area, especially with growing tensions between Russia and Ukraine and the ensuing economic sanctions. Japan is also growing at a very slow pace, almost similar to the euro area, constrained largely by high public debt, which stood at 230% of GDP. Japan's growth forecasts for 2015-2016 have also been revised downward by the IMF (20 January 2015), projecting growth of 0.6% in 2015 and 0.8% in 2016. Meanwhile, China is struggling hard with the slowdown, especially with cooling property market and Russia is battling hard with an economic crisis, as the rubble took a severe beating. Expectations of rising interest rates in the US saw that commodity prices suddenly fall, especially crude oil and US dollar getting much stronger-than-expected. Crude oil prices declined by almost 50%, underpinned not only by excess supply and slowdown in demand, but also political economy considerations. Geopolitical risks have gained prominence, especially with continued fighting in the Middle East, sanctions against Russia and its retaliatory actions and also changes in the political landscape. The latter include political uncertainty and possibility that pendulum swing to the extreme left, throwing away tough austerity and reform measures in many "stressed economies" in the euro area.

Most worryingly, short-term risks are on the rise, following continued economic and financial imbalances. These include sharper-than expected financial market correction, arising from bubbles in asset markets, a spike in household debt and a faster-than-expected US monetary policy normalization. Fiscal imbalances in the euro area and in many emerging economies, misalignment of currencies and mismanagement of fiscal stimulus could also lead to increase in risks. Medium-term risks include low potential growth in advanced economies and consequently lower potential growth in emerging market and developing economies. Looking from longer-term perspective, aging population is expected to lower labour input in advanced economies, especially in Japan, while the possibility of "hard landing" in China remains on the horizon, despite its largely engineered slowdown.

Looking at medium-term economic and social development, the Eleventh Malaysia Plan (2016- 2020) is scheduled to be unveiled in the Parliament in May 2015. While Malaysia aspires to join the four Asian tigers, its country classification remains as one of the emerging market economies (EMEs) in Southeast Asia with an upper middle-income status. Malaysia is a small trade-oriented and financially integrated economy, not being able to influence commodity export prices, but largely a price-taker in the world export markets, and very much susceptible to the vagaries of global economic and financial developments. Nonetheless, we provide good example in terms of economic development experiences and also social engineering, where growth has been integrated with the goals of income distribution and growth is now increasingly becoming inclusive, while environmental protection is adopted as one of the key agendas of sustainable development in the New Economic Model, released in 2010.

Looking forward to 2020, Malaysia "catch-up" endeavour through economic transformation programs requires not only greater sophistication and technical skills in managing macro economy, but more importantly, support and ownership by all stakeholders, encompassing society or rakyat as a whole. While advances in technology, skilled labour force and strong entrepreneurial talents are often mentioned as the key factors in raising productivity and potential output of the economy; good governance, strong institutions, high moral values, deep-rooted social capital and wider "collective action" of the citizenry are also mentioned as prerequisites for the country's quest to be a high-income and developed nation status by the year 2020.

These so-called "soft attributes", especially strong "social capital and collective action" have been fully tested in recent months, following negative external shocks that came down like a perfect storm, almost simultaneously through a plunge in commodity prices and a sharp depreciation in ringgit exchange rate. Consequently, foreign reserves fell by almost USD23.7 billion to settle at USD111.2 as at 15 January 2015 (end-December 2013: USD134.9 billion). On top of that, there were heavy rains and severe flooding that occurred in many states in Peninsular Malaysia as well as in Sabah, affecting thousands of households and causing a lot of damages to crops, houses and infrastructure facilities. The estimated total costs of damages exceeded RM2 billion. There are clearly lessons to be learned here, especially from key advanced economies that we spare to emulate, like Japan and the US, which have managed successfully their worst natural disasters by focussing more on advanced warning systems, pre-emptive measures, strong enforcement of rules and regulations, especially for design of buildings and public infrastructure facilities. The hallmarks are their strong environmental protection and disaster or emergency management authorities. In addition, social capital and collective action have almost always played their parts, very much stronger than what we have seen recently in Malaysia.

These efforts seemed parallel to the macroeconomic management of the economy, whereby the relevant economic central agencies are trying hard to insulate the economy from adverse external shocks by adopting anticipatory and forward looking approach, implementing pre-emptive measures and having in place good macro-prudential rules and regulations, enhancing monetary policy credibility and ensuring fiscal sustainability, among others. Economic shocks come in a variety of forms, such as productivity slowdown, terms of trade and interest rate shocks and mark-up in prices and wages. As such, we need to be vigilant and most importantly, must be able to withstand and adjust successfully to these negative shocks with all available toolkits, especially with good modelling and forecasting capabilities. Mental models and using other people forecasts that have their own vested interests are not adequate and may also be counter productive. We need to be hands on, pay attention to details and have more intensive consultations, so that welfare of the society continues to protected and avoid welfare losses. We also need full confidence and possibly having strong emotional intelligence (EI), together with solid social capital and collective action to face these external challenges. Most importantly, we must work together, stay calm and maintain our much-needed patience, as we are not in an economic crisis yet, just a temporary setbacks.

Posted by suzy at 11:38 AM