Buckling down: Efforts are under way to balance the budget

With hotly contested elections behind it and favourable conditions in global markets, Malaysia’s government is on a drive to rein in traditionally large fiscal deficits. Having already brought down the federal deficit from a peak of 6.7% of GDP in 2009 to 3.9% in 2013, the government is aiming for a further reduction to 3% by 2015 and a balanced budget by 2020. The consolidation is expected to contribute to a cooling of the rapid growth in consumption that Malaysia has enjoyed in recent years, as both of the main tightening measures for 2013-15 increase consumer prices. The first was a reduction of fuel, electricity and sugar subsidies, implemented between September 2013 and January 2014. The next big step will be a 6% value-added tax (VAT), called the goods and services tax (GST), which is scheduled to be introduced in April 2015.

Showing Mettle

Deficit reduction has been a top goal for Prime Minister Najib Razak since he came to power in 2009. It is one of the central planks of the Economic Transformation Programme (ETP) he launched in 2010. However, the effort lost steam during campaigning for May 2013 elections in which Prime Minister Najib was narrowly re-elected. Fears that he and his party would not pursue fiscal reforms led credit rating agency Fitch Ratings to put a negative outlook on its Malaysia sovereign rating in July 2013.

Prime Minister Najib fought back by announcing the subsidy cuts and schedule for the GST. In its February 2014 annual review of Malaysia’s policies, the IMF said the fiscal reforms announced in late 2013 were “a fiscal policy breakthrough”. The measures also led Moody’s Investor Services to put a positive outlook on its Malaysia sovereign rating in November 2013, and Fitch was dissuaded from downgrading, although as of June 2014 its negative outlook remained.

Although government deficits have been on the big side, thanks to relatively quick growth, Malaysia’s public debts are not especially large. Federal debt totalled RM540bn ($168.5bn) at the end of 2013, equal to 54.7% of GDP, and up from RM502bn ($156.67bn), or 53.3% of GDP, at the end of 2012, according to the central bank, Bank Negara Malaysia (BNM). Federal debt service costs were a moderate 2.1% of GDP in 2013, and the term structure of debt is fairly well balanced, with 12% of debt due within a year and 34% due within three. Less than 30% of federal debt was owed to foreigners and only $5bn, or 3%, was owed in foreign currencies as of the end of 2013.

But markets treat Malaysia’s sovereign debt with extra caution due to the country’s large and volatile export revenues, which in a regional or global crisis can lead to sudden fiscal deterioration. For example, in 2009 the federal debt-to-GDP ratio rose suddenly to 50.8% from 40% in 2008 as weak exports led to a 7.4% contraction in nominal GDP and stimulus drove the deficit up to 6.7% of GDP. The consolidation is also about prestige, as the government is keen to improve its rankings in international comparisons and avoid having to raise a legislated debt limit that caps federal debt at 55% of GDP. Among emerging and developing East Asian economies tracked by the IMF, Malaysia’s 2013 government deficit was the largest besides Vietnam and Myanmar, while Malaysia’s gross debt-to-GDP ratio was the highest after Bhutan and Laos.

Weaning Off Subsidies

The Malaysian government has traditionally subsidised petrol, diesel, natural gas and electric energy, aiming to boost growth by reducing production costs. The government also uses subsidies of staple foods and staple-crop farming as a means of assisting the poor. As commodity prices skyrocketed in 2007-08, those subsidies suddenly became a heavy burden. Direct subsidies reached RM35bn ($10.92bn) in 2008, equal to 18% of federal spending or 4.7% of GDP, according to BNM data. When Prime Minister Najib came to power in 2009 he vowed to tackle the problem, making subsidy rationalisation a core component of his ETP. But while credit ratings agencies and international development organisations cheered, ordinary Malaysians were less thrilled. Prime Minister Najib’s political opponents made his cuts to subsidies a major rallying issue, and little in the way of actual cuts materialised. Meanwhile, commodity prices stayed high, despite weaker global economic conditions. Instead of shrinking, the government’s subsidy bill grew to RM44bn ($13.7bn) in 2012, equal to 4.5% of GDP.

After the fuel subsidy cut in September 2013, total direct subsidies for that year fell slightly to RM43bn ($13.4bn), equal to 17% of federal spending or 4.4% of GDP. Fuel subsidies were estimated by the government to total RM24.8bn ($7.74bn) in 2013. The IMF forecast the subsidy cuts would save about 0.5% of GDP in 2014-15. The government raised petrol and diesel pump prices by RM0.20 ($0.06) per litre. Fuel subsidies paid to state oil and gas company Petroliam Nasional (Petronas) are calculated as the difference between fixed retail prices and the company’s costs plus margins. Production costs are pegged to international oil prices, rather than actual costs, which avoids incentivising cost bloat, but exposes the fiscal position to fluctuations in global oil prices.

At the same time, the government collects handsomely from Petronas, seeing a total of RM80bn ($24.97bn) in 2012, equal to 38.5% of federal revenues or 8.5% of GDP. That included RM38.3bn ($11.95bn) in taxes, RM12.5bn ($3.9bn) in petroleum proceeds, RM1.2bn ($374.5bn) in export duties and an RM28bn ($8.74bn) dividend, according to the company’s 2012 annual report. In addition, Petronas subsidises domestic natural gas supplies, which in turn supports low energy prices. The government reduced those subsidies in 2014 with a 15% increase in electricity tariffs in January 2014 and a 20% increase in gas prices in May 2014. As the IMF wrote in a March 2014 report, “While these subsidies are mainly implicit subsidies (i.e. not fully reflected on the government’s fiscal accounts), reducing them would have a positive impact on revenues through improved profitability of Petronas.”

The government also ended long-standing subsidies of sugar in January 2014, using the funds for targeted aid to the poor. The government was expected to pause to gauge the subsidy cuts’ impact on demand before announcing the next major round of cuts.

Quasi-Fiscal Substitute

The fuel price increases had a noticeable impact on inflation, which rose to 3.5% year-on-year (y-o-y) in February 2014, cooling slightly to 3.4% by April of the same year. But the higher prices and retrenchment of federal spending had little apparent impact on growth, which accelerated in the first quarter of 2014 to 6.2% y-o-y. One reason is that the overall public fiscal balance, including state-owned companies, has widened as the federal government’s fiscal balance has shrunk. According to the IMF, the consolidated public sector deficit widened from 3.4% of GDP in 2011 to 5.2% in 2012 and an estimated 6.8% in 2013. The IMF also forecasted a small consolidation to 6.5% of GDP in 2014.

Many large state companies play quasi-fiscal roles and are financed with government-guaranteed debt. One such firm is 1 Malaysia Development, a state-run investment vehicle set up by Prime Minister Najib that is developing two large areas of Kuala Lumpur and operating 15 power plants. In June 2014 Reuters reported that the company had run up $11bn in debts, mainly spent buying the plants. Another big quasi-fiscal spender is the Mass Rapid Transit Corporation, which has announced plans to raise a total of RM23bn ($7.18bn) to finance construction by 2017 of the first of three planned lines in a new Klang Valley Mass Rapid Transit (MRT) system. Stephen Hagger, managing director and head of equities at Credit Suisse Malaysia, said the MRT was a logical way to taper off fuel subsidies. He told OBG, “Fuel subsidies supported high car ownership, which partly explains the heavy traffic downtown. The alternative is of course public transport.”

Longer Term

The GST due in April 2015 will replace a patchier set of taxes on goods and services, with most of its revenue gains to come from fewer exemptions and enhanced collections thanks to the way VAT ropes businesses into ensuring their suppliers have paid. However, food and some other essential goods will be exempt, and as of June 2014 the government had not yet decided whether to exempt fuels. The IMF expects the GST’s net revenue to be about 0.3-0.5% of GDP. At the same time, the government announced a 1 percentage point cut to corporate tax rates, which accounted for about 41% of federal revenues in 2013, and a decrease of up to 3 percentage points in personal income tax rates, which accounted for 12%.

The government has not yet spelled out its strategy for balancing the budget by 2020. In a March 2014 study of Malaysia’s options, the IMF urged further subsidy cuts, which it said could be worth 3% of GDP and would hurt demand less than other consolidation measures. The IMF suggested instituting recurring property taxes, raising the personal income tax and better targeting social benefits. The IMF warned that oil prices would likely fall later this decade, while outlays on health care, retirement and quasi-fiscal debts would increase. As of June 2014 the IMF was forecasting that Malaysia’s general government deficit would continue to decline to 2.08% of GDP in 2016, but would rise to 3.26% of GDP in 2019.