Malaysia's flexible currency and strong financials provide a safety net

Resource rich and export-oriented, Malaysia’s economy has endured another major test in resilience, with a global slump in commodities and China’s slowdown reducing revenues from the key sectors of energy, palm oil and manufacturing. In 2015 the local currency, the ringgit, saw the biggest sell-off since the 1997 Asian financial crisis. Yet economic data continued to suggest business as usual. With a flexible currency regime, ample liquidity in domestic banks and alternative sources of growth, the country was able to absorb the external shocks.

Even for resource-based sectors, this stress test may prove to be a blessing in disguise as a more efficient industry is expected to emerge once commodity markets stabilise. At the same time, the portion of state revenues coming from oil and gas is shifting dramatically, falling from 41.3% in 2009 to an expected 14.1% in 2017. The traditionally dominant revenues from Malaysia’s state-owned energy firm, Petronas, are gradually being replaced by a bold move to introduce the goods and services tax (GST) and phase out fuel and food subsidies. The move seems to be paying off and has been endorsed by the IMF, though some argue it has transferred some cost pressures onto middle-class consumers, who remain the engine of growth in 2016.

Flexible Response

The strength of domestic demand was clear proof that diversification efforts undertaken during the last 10 years have put Malaysia in a better position to withstand both debt- and commodity-driven global downturns. Structural strength is reflected in Malaysia’s “A-” sovereign credit rating. Though under some pressure because of heightened risks, it remains a notch above Standard & Poor’s rating for China, “AA-”, and several notches above Indonesia’s “BB+”. “Malaysia is able to weather current economic uncertainties and low commodity prices as its economic fundamentals are still strong,” Abdul Wahid Omar, a minister in the Prime Minister’s Department, told OBG. “Its economy is well diversified, both in terms of economic structure and exports, as it is not over-exposed to any one industry or commodity. While commodities make up 23% of Malaysia’s total exports, more than three-quarters of its exports are comprised of manufactured products.”

Growth In Perspective

Malaysia’s GDP expanded by 5% in 2015, compared to 6% in 2014, beating the initial forecast of 4.9% for the year. This is in stark contrast to former emerging market growth stars such as Brazil and Russia, which posted output declines of 3.8% and 3.7%, respectively. The overall global economy expanded at a modest 2.4% in 2015, characterised by lower commodity prices and diminished flows of trade and capital.

Malaysia’s neighbour Thailand expanded by 2.8% whilst Singapore posted a 2.1% increase that year. Of similar nearly countries, only the Philippines grew faster, posting 5.8% growth, due to the country’s larger population, consumption-driven economy and lower per capita base. Meanwhile, Malaysia’s number one trading partner in Asia, China, recorded 6.9% GDP expansion, a 25-year low for a country that is used to double-digit performance. Malaysia’s other significant trade partner, India, became the fastest-growing economy, posting 7.4% in 2015. At the same time, Japan and South Korea continued to experience a soft growth patch, expanding by 0.53% and 2.61%, respectively.

On the whole these regional comparisons suggest Malaysia’s economy still has the necessary momentum to outperform at least a number of its Asian peers. This may allay some concerns that the economy has already peaked and entered the proverbial middle-income trap experienced by economies with GDP per capita of around $11,000.

Medium- & Long-Term Prospects

The medium- and long-term trajectory for Malaysia still looks promising. The country has now managed to deliver a steady expansion for seven uninterrupted years with average GDP performance of 5.3% since 2011, according to World Bank data. As a result, Malaysia’s ultimate aspiration of becoming an advanced economy by 2020 remains in sights, though the going is likely to get much tougher over the next four years as consumption support is likely to weaken. The country is also expected to face significant headwinds in finding alternative sources of economic activity due to high demand for skilled labour and new technologies that take time to acquire. The rate of unemployment in Malaysia remains one of the lowest in the region, hovering around 3.1% since 2013.

Workforce

Another strategic priority for Malaysia is to increase women’s participation in the labour force. This rose steadily from 45.7% in 2008 to 52.4% in 2013, according to UN Development Programme data, with the government aiming to reach 55%. However, it is still at a relatively low level compared to 80.7% male participation. Economists cite this as one obvious source of new productivity moving forward. “Moving up the value chain, especially for small- and medium-sized enterprises, can only be done through upskilling workers and improving productivity. But it is a costly process, which is why the government is providing financial support to enhance the ability of companies to achieve this goal,” CM Vignaesvaran, CEO of the Human Resources Development Fund, told OBG.

Over-reliance on construction, manufacturing, retail consumption and commodity sectors remains a key concern as banks are forced to limit their exposure to these domestic sectors. Meanwhile, rising household and sovereign debt means there is little margin for error should there be another significant external shock in the future. The government is committed to keeping sovereign debt around 50% of GDP – a big challenge given so much expectation from the public to have national agenda development underwritten by the government.

Convincing the private sector to engage more in financing the real economy is still a challenge. Perhaps most worrying is the rise of political and social tensions in a country that was historically rewarded by investors for its long-term political stability. Addressing income inequality, economic inclusiveness and the rural-urban income gap will remain at the top of the state’s agenda, with most of Malaysia playing catch-up with the Klang Valley.

Safety Net

During the 2007-08 global financial crisis, the main safety net Malaysia had against dropping oil prices and weakening currency were high levels of foreign reserves, low debt servicing requirements outside of Malaysia and a strong banking system. Although on the rise, the country’s debt-to-GDP ratio of 54.5% leaves some breathing room, allowing the government the option to step up fiscal stimulus if needed to avert a crisis. This is especially the case given that most government bond issuance is in ringgit, meaning the government could fund itself through taxation and local savings rather than foreign income or borrowing.

This is a highly comforting fact that is often under-appreciated by big-picture investors, who note Malaysia’s high non-resident debt but overlook the detail that, unlike in other emerging markets, foreigners are actually taking local-currency positions. It also means that Malaysia, unlike during the 1997 Asian financial crisis when most external debt was in US dollars, is financially much less vulnerable to ringgit fluctuations as far as their debt servicing is concerned. In extremis the central bank, Bank Negara Malaysia (BNM), could engage in quantitative easing and, like the US Federal Reserve, European Central Bank or the Bank of Japan, could buy sovereign debt to avoid a sudden stop in liquidity. The same is true for local banks and corporations, which learned lessons from the past crisis and now generally avoid currency mismatch on their balance sheets. Meanwhile, BNM and the government had sufficient reserves to cushion the economy and provide some limited stimulus to sustain local demand. The IMF’s 2016 Article IV consultation for Malaysia noted that the monetary policy remains accommodative, “with cuts in the reserve requirements supporting domestic liquidity and growth.”

Fiscal Levers

Large infrastructure projects launched by the government, some targeted stimulus, coupled with ongoing fiscal consolidation and a steady hand in monetary policy helped to cushion domestic consumers and corporate players against a loss of confidence. At the same time, a substantial 23% depreciation in local currency in 2015 also played an important role in offsetting the drop in oil and gas revenues in dollar terms, according to the World Bank. While Malaysian exporters’ local-currency income was boosted by devaluation, there was limited pass-through of exchange rate changes to domestic prices, according to the IMF. That accounts for surprisingly strong domestic demand, which expanded by 5.8% in 2015, and private consumption held its own at 5.6%, compared to 6.4% in 2014. Although devaluation and introduction of the GST resulted in price pressures, the headline inflation rate published by BNM remained low at 2.1% in 2015, compared to 3.1% in 2014.

Despite decent growth performance in tough circumstances, the local business community and media reported a heightened sense of uncertainty amongst households and the private sector. Selangor-based daily The Star reported in December 2015 that the main factor cited was the rising cost of living for middle-class families due to the introduction of the GST, which coincided with the removal of fuel and food subsidies. Meanwhile, there has been much focus on the bitter political dispute surrounding investment losses incurred by 1 Malaysia Development (1MDB), a sovereign development fund. Though systemically the debt accumulated by the fund is relatively small, 1MDB has become synonymous with Malaysian political risk.

Addressing Foreign Concerns

Excessive sell-off of the Malaysian ringgit during 2015 forced an all-time low against neighbouring Singapore. This was a signal to Malaysian policymakers that the country’s economic performance was not properly priced in by foreign investors. According to BNM’s 2015 annual report, net outflows of non-resident funds reached RM19bn ($4.7bn), an 82.7% increase compared to RM10.4bn ($2.6bn) recorded in 2014.

This was seen as being firstly due to the broad sell-off in emerging markets that touched all currencies in that category, including Malaysia. The ringgit also suffered from the unwinding of speculative carry trades, which see investors borrow in other lower-yielding currencies, such as the yen, euro and US dollar, and then proceed to bet on an interest rate spread and currency appreciation.

Additional underperformance is due to a popular misconception that Malaysia, like some of the countries in the Middle East, is an oil- and commodities-based economy. However, overall commodities make up no more than 20% of Malaysia’s total exports. Recent data confirms this view. In 2015 Malaysia’s oil exports reached a total value of $33.1bn, or 16.5% of all exports, according to International Trade Centre data. At the same time, exports of electronic equipment, Malaysia’s top export, stood at 29.8% of the total. Some exports like rubber, plastics, wood and organic chemicals, which together amount to 10% of exports, actually benefitted from the devaluation of ringgit and saw sharp gains because of currency devaluation.

Finally, some foreign investors were frightened by a sudden decline in foreign exchange reserves, which dropped below the threshold of $100bn – compared to $133.6bn in 2011 – sufficient to finance 7.9 months of imports and 1.1 times its external debt, according to an August 2015 Bloomberg report. Even on this score, foreign investors may not have sufficiently detailed understanding of Malaysia’s vulnerability to foreigners selling off holdings in Malaysian currency. Most government securities are in fact held in ringgit, and thus Malaysian foreign reserves are meant to serve more as a cushion against excessive sell-off than as a source of funding current account deficits.

The economy as a whole has historically been able to post a moderate current account surplus, thus mitigating the need for foreign borrowing. According to the IMF, in terms of percentage of GDP the current account balance stood at 2.9% in 2015, compared to 4.3% in 2014. This decline was mostly due to portfolio outflows as opposed to a growing trade deficit. In terms of trade, Malaysia remains one of the most competitive economies in South-east Asia. The Ministry of International Trade and Industry reported that overall trade volumes in 2015 increased by 1.2%. At the same time, the trade surplus was 14.3% higher than in 2014, largely due to stagnant demand for imports and a surge in exports of non-oil manufacturing sectors.

Supportive Central Bank

Throughout this period the BNM often intervened to support a more orderly exchange rate market, although there was no effort to reverse the course of devaluation. In a “managed float” exchange rate system the Malaysian central bank does not have any explicit ringgit-to-dollar targets and enjoys significant autonomy despite political attempts to influence its policy in the past. Having suffered its biggest losses in 2015, the ringgit became the best-performing currency in Asia in 2016, rising by 9.5% in the first quarter of that year. Foreign funds returned en masse, reversing outflows.

Structure Of The Malaysian Economy

The return of volatility and sudden outflows of capital served as a reminder that Malaysia’s economy retains a high degree of openness and increased integration with the global financial system. The domestic economy is significantly affected by both global and regional developments, Zeti Akhtar Aziz, former governor of the BNM who was succeeded by Muhammad Ibrahim, told The Star in March 2016. She added that the resilience that underpins the Malaysian economy in facing the current difficult environment is derived from the continued strength of Malaysia’s economic fundamentals, as well as a reflection of the structural adjustments and reforms undertaken in the recent decades. A key aspect of this, according to Zeti, is diversification of the structure of the Malaysian economy from an over-dependence on exports to new domestic sources of growth. According to BNM data, there has been a shift away from the external sector in the last six years towards domestic consumption and private sector investment.

Dependency On Foreign Workers

Economists looking closely at trends within manufacturing have observed a shift towards higher value-added technology sectors such as solar modules. However, there is still high dependency on labour-intensive manufacturing, with Malaysia in a fortunate position to be able to import low-cost foreign labour. According to Ahmad Tajuddin Ali, chairman of UEM Group and of the Construction Industry Development Board, demand for foreign labour has been high particularly in the construction sector. “It is a double-edged sword,” he told OBG. “Without foreign workers there is not a large enough domestic labour pool willing to work in the sector, but by bringing in foreign workers we are solving a current problem by creating a future one.”

Household Debt

Fiscal sustainability and ringgit volatility aside, the most cited macroeconomic risk related to Malaysia is its high household debt. As a result of favourable credit and monetary policy, local consumers were able to enjoy loans for new vehicles and homes, as well as fund their consumption using credit cards. Household debt has doubled since the 1997-98 Asian financial crisis and stood at 89.1% of GDP in 2015. While still manageable, household debt is among the highest in the region – although relatively low compared to the mature economies of the US and Europe – and has authorities, credit analysts and bank supervisory authorities calling for a slowdown.

Although banks are well-capitalised, saving ratios, especially among lower-income groups, are so low that another external shock could result in a sudden spike in non-performing loans and result in weakening the banking sector. Should debt stabilise at these levels, BNM said in April 2016 that ability to service debt is sound. The BNM’s “Financial Stability and Payment Systems Report 2015” noted that higher debt levels are supported by a steady outlook for income and employment.

The bank also pointed out that the share of borrowing by households with monthly incomes of less than RM3000 ($743) has declined to 23.6% of total household debt in 2015, down from 24.3% in 2014. The consensus is that with credit conditions tightening and households having little room for further expansion, new consumption will have to come from higher incomes, which requires an acceleration of private investment and government expenditure in 2017 and 2018 if current levels are to be sustained.

Outlook

The cyclical pressures on the ringgit are likely to continue to ease throughout 2016, leading to appreciation and renewed confidence. GDP is expected to expand by 4.4% on the back of government investments and an uptick in foreign direct investment. Inflationary pressures are likely to ease towards the end of 2016. With plenty of domestic liquidity and flexible currency, Malaysia can continue to adjust in the face of volatile markets; however, it needs to implement its ambitious development strategy to achieve its goals by 2020.