Malaysia: On the path of fiscal reform Asia Pacific Economic Outlook, Q1 2015
The Malaysian government has announced several actions to reform public finances, including stopping fuel subsidies and implementing a new goods and services tax.
In November 2014, Malaysia’s government announced that it will stop fuel subsidies from December. Domestic fuel prices will now track average international prices. The fuel subsidy removal was not the only move that the government has made in reforming public finances. From April 2015, a new goods and services tax (GST) is set to come into effect. While the GST is aimed at increasing revenues, it is also an attempt to diversify revenue sources, which are currently dominated by income tax and hydrocarbons.
Lower oil and gas prices will dent government revenues. Currently, 30 percent of government revenues come from oil royalties.
These measures have not come without criticism. For example, there are concerns that the government will reinstate fuel subsidies if global fuel prices rise sharply. Criticism around the GST includes the long list of exemptions and the tax’s impact on low-income households. Moreover, despite these measures, the government could miss its fiscal deficit target this year (3.0 percent of GDP). Such concerns notwithstanding, the government needs to continue on its fiscal reform path. Apart from greater fiscal legroom, the economy’s structural fundamentals will improve, thereby enhancing investor attractiveness.
Economy slowed in Q3
GDP expanded 5.6 percent year over year in Q3 2014, down from 6.5 percent in Q2 and 6.2 percent in Q1. This was its slowest pace of growth since Q4 2012. Growth would have been slower had it not been for resilient consumer spending during the quarter. Private consumption grew 6.7 percent in Q3, up from 6.5 percent in the previous quarter. Consumers are likely to have benefitted from high wages due to a tight labor market. A rise in inflation and high debt levels do not seem to have bothered consumers in Q3, although they are likely to weigh on the sector going forward.
Investments and exports were a drag on growth in Q3. While export growth slowed to 2.8 percent in Q3 from 8.8 percent in Q2, growth in gross fixed capital formation fell to a mere 1.1 percent from 7.2 percent over this period. Gross fixed capital formation recorded the weakest growth in five years, which could be a worry given the central role of investments in the government’s target to become a developed nation by 2020. The drag on investments came from public investments, which fell 8.9 percent in Q3 due to delayed infrastructure projects; private investments, on the other hand, grew 6.8 percent.
External demand may weigh on exports and investments
Public sector investments are likely to revive this year, as delayed infrastructure projects finally get off the ground. Although these projects will affect private sector investments as well, the impact is likely to be partially offset by weakening external demand. Of particular concern will be a weak Eurozone economy and slowing growth in China, due to which exports fell 3.1 percent year over year in October. Moreover, with the Chinese economy trying to shift away from investments to a domestic consumption–driven growth model, demand and thus also prices of commodities have been hit. For example, in October 2014, export volumes of natural rubber from Malaysia fell 30.6 percent, while the average unit value fell 31.4 percent.
Overall fixed investment will also have to contend with slowing residential investment activity, which faces headwinds from weakening house prices and a tight monetary stance by Bank Negara (BN). Consequently, fixed investment growth is not likely to rise above 4.0 percent in 2015, while exports growth is likely to slow down to 4.0–4.5 percent.
Government finances to improve
Lower oil and gas prices will dent government revenues. Currently, 30 percent of government revenues come from oil royalties. The budget for 2015 assumes an oil price of $105 per barrel. Current trends indicate that the prices might end up lower. Low hydrocarbon prices, however, will help Malaysia reduce its import bill. The country is a net importer of hydrocarbons, albeit a small one. The government has ended subsidies on petrol and diesel effective December 1, 2014, which will likely save the government $6 billion annually and aid public finance.
Revenues will also benefit from the new GST, set to come into force from April 1, 2015. At 6 percent, however, the GST rate is lower than desired, while the list of exemptions appears to be increasing. Nevertheless, the GST marks a positive beginning for better public finance management. In the medium term, the taxation regime will need more reforms. Income tax is one such area where the government will have to widen the tax base: Only 1.7 million workers pay income tax out of a workforce of 12 million.
Consumers face headwinds from inflation
Private consumption has been a key driver of economic growth in the last few years. However, a rise in leveraged spending has left households in debt. For example, household debt stood at about 87 percent of GDP in 2013, one of the highest ratios in Asia. This has strained household finances, especially in the wake of slowing house prices, a key component of household balance sheets. As households repay debt amid a hike in interest rates, consumption growth is likely to slow down in 2015.
While a tight labor market (unemployment rate of 2.7 percent in October 2014) has helped keep nominal wages high so far, real wages are likely to face pressure from rising inflation due to an easing of fuel subsidies and the introduction of the GST. In November 2014, inflation rose to 3.0 percent from 2.8 percent a month before. Price pressures could rise if sharp monetary tightening by the US Federal Reserve in 2015 leads to Malaysian ringgit depreciation, thereby pushing up imported inflation, which, in turn, could induce BN to hike rates by 25–50 basis points. In such a scenario, private consumption growth will likely grow 4.0–4.5 percent in 2015, down from 6.0–7.0 percent in 2014.
Not the expressway, but a good road ahead
As Malaysia’s economy enters 2015, fundamentals appear good enough to ensure medium-term growth of 4.0–5.0 percent. While it is likely to face headwinds from short-term inflation, high household debt, and slowing growth in China, the economy will benefit from a gradually improving fiscal situation and strong growth in the United States. Moreover, as stalled projects are cleared, the country is likely to witness more public investment in infrastructure. If the government couples this with efforts to reform education and the labor market, 2015 will indeed turn out to be a good year for Malaysia.