Malaysia: Under severe stress, but not frail yet Asia Pacific Economic Outlook, Q4 2015

Economic growth lost momentum in the second quarter, driven by the introduction of the goods and sales tax and low LNG prices, but the economy is expected to maintain a robust growth track.

Malaysia_interior-imageDecades of strong growth have put Malaysia within sight of achieving high-income status. In 2014, the economy enjoyed 6 percent annual growth. However, lately, the economy has been experiencing strong headwinds. Economic growth lost momentum in Q2 2015 and grew 4.9 percent year over year,1 marking the slowest growth since 2013. The introduction of the goods and sales tax (GST) in April 2015 and low prices of liquefied natural gas (LNG), one of Malaysia’s key exports, due to sluggish external demand were the primary reasons for slower growth.

Underlying weakness in economic fundamentals, too, contributed to the slowdown. Private consumption expenditure growth, which was at its lowest in four years, grew 6.4 percent in Q2, down from 8.9 percent growth in Q1. A weak labor market and high inflation resulted in lower private consumption expenditure, which was primarily driven by spending on food and beverages, transportation, and communication in Q2.

Gross fixed capital investment growth fell sharply in Q2 from 7.9 percent in Q1 to 0.5 percent, marking a record low for the series. The fall was partly due to contraction in spending on machinery and new equipment. Public investment also contracted by 8 percent as projects in the oil and gas sector were either scaled back or canceled due to falling oil prices. In general, high interest rates, low business confidence, and poor economic reforms led to weaker private sector investment in the economy.

Impact of falling oil prices

Lower global oil and LNG prices in 2015 have impacted both Malaysia’s fiscal and current account balances. The government’s oil and gas income, which accounted for 31 percent of total government revenue in 2014, has been suppressed by lower oil prices, which have partly offset the benefits to public finances due to the recent removal of fuel subsidies and the introduction of the GST. Most likely, lower revenues will also impede the government’s fiscal consolidation efforts, and the fiscal deficit may widen to over 3 percent of the GDP in the next few years.

The government’s oil and gas income, which accounted for 31 percent of total government revenue in 2014, has been suppressed by lower oil prices, which have partly offset the benefits to public finances due to the recent removal of fuel subsidies and the introduction of the GST.

Lower oil prices have also weighed on export receipts of energy producers. The prices of LNG, which constituted 8.4 percent of Malaysian exports by value in 2014, have also fallen significantly. Consequently, lower exports have partly offset reduced energy import bills because of lower global oil prices. The merchandise trade balance, and, thereby, the current account surplus is expected to shrink in the coming years.

However, lower oil prices have eased inflation pressures. The economy has been experiencing a steady rise in prices since the beginning of 2015. Inflation jumped from 2.5 percent in June to 3.3 percent in July, marking a six-month high. Falling oil prices are likely to bring down the producer price index, and consumer price inflation may ease in 2015–16.

Currency in trouble

Lately, Malaysia’s currency has come under immense pressure due to poor economic performance, fiscal challenges, and volatility in capital outflows. In addition, political scandal around the alleged mismanagement of funds and the suspected involvement of the prime minister have weakened the government’s position and added to political uncertainties. External factors, such as China’s economic slowdown and devaluation of the Chinese renminbi, have resulted in faster depreciation of the Malaysian ringgit. The anticipated policy rate hike in the United States this year and soft energy prices have also aided the fall.

Recently, the ringgit depreciated to levels not seen since the Asian financial crisis of the late 1990s. Foreign reserves have fallen by more than 25 percent over the past year, indicating that the central bank has continually intervened in the foreign exchange market to limit further depreciation of the ringgit, currently Asia’s worst-performing currency.

Malaysia_Figure1_Sharp-depreciation

The central bank has promised to refrain from capital controls, which implies that domestic concerns and global uncertainties may accelerate capital outflows in the near term. This will likely put further downward pressure on the ringgit. However, it is highly unlikely that the central bank will hold itself back when faced with a sharp depreciation in the ringgit. As a matter of fact, there are rising market expectations that the central bank may raise interest rates in the upcoming monetary policy meetings to check further depreciation in the currency.

However, increasing interest rates may stifle capital investment and consumer demand, and may pose a threat to already slowing growth. A tighter monetary policy may not bode well for a highly indebted Malaysian economy. Key sectors of the economy are knee-deep in debt. Household debt stabilized in 2014, but continues to remain high at around 88 percent of GDP. Corporate debt is also high, and since most of it is dollar-denominated, a depreciating currency may weaken corporate balance sheets, as well as add stress on banks that lent money to these corporates.

Despite challenges, the economy is expected to maintain a robust growth track in the long term. The government’s upcoming 11th Malaysia Plan 2016–2020 is crucial to ensure Malaysia remains competitive in a rapidly evolving region. In addition, the government is aiming to achieve the status of a developed nation by 2020 through rapid investment in infrastructure. All these will likely help the economy sail through challenging times.