QUANTITATIVE EASING (QE) has unleashed a flood of cheap money in search of hosts throughout the world in the past few years. Many emerging markets have benefitted from this liquidity. As QE came to an end in the US last month, jitters spread across the globe, just like what happened during the “taper tantrum” in 2013.
The Malaysian federal government’s fiscal deficit, which is structural in nature, has benefitted from the effects of QE. Approximately 30% of Malaysian Government Securities are owned by foreigners, and ample liquidity has kept the yield low at around 4%. This low interest rate effect has also filtered through the country and might have contributed to the households’ appetite for debt. Household debt has risen to 87% of gross domestic product in 2013 from 57% in 2002.
The household debt ratio is high, but what is more significant is the type of debt and where it is concentrated. According to Bank Negara Malaysia, from a small percentage of household debt, loans for personal use have increased to be close to that of motor vehicle loans.
Since the proceeds from personal loans are likely to be consumed and the collateral for motor vehicle loans is based on depreciating assets, the future income of borrowers is not being enhanced by these types of loans. Besides, households earning below RM3,000 per month have higher leverage positions than those in other income groups.
Therefore, the fiscal position of Malaysia and its households is highly sensitive to interest rates and vulnerable to withdrawal of foreign capital that might be triggered by the end of QE. Although Malaysia appears strong on several metrics (for example, the amount of foreign currency reserves), the contagion effect is likely to bring Malaysia’s indebtedness into focus. So, the federal government should consider the following three suggestions to improve the country’s fiscal situation.
Firstly, the fiscal position can be improved by plugging leakages. One proven method that has been practised internationally (and in Penang) is the use of an open tender system in government procurement.
Secondly, Malaysia should lay out a credible and transparent road map to achieving a balanced budget. To be credible and be able to inspire the financial market’s confidence, the government needs to set clear targets and milestones. Off-balance sheet financing, state guarantees and other contingent liabilities need to be minimised as these might be overlooked during good times, but not necessarily when financial indebtedness becomes an issue.
Thirdly, to increase tax revenue, the tax system needs to be strengthened such that it is fair, simple, robust and accountable to the taxpayers. Using the Goods and Services Tax (GST) as an example, our research (www.penanginstitute.org/gst) shows that GST itself is a regressive tax (where low and middle-income households bear a higher burden compared with high-income households), consistent with international findings.
However, when GST is combined with the government’s cash handout exercise (BR1M) and income tax cuts, middle-income households will be worse off with less cash to spare. While it is impossible for everyone to end up having more cash, since it is a tax-raising exercise after all, what is more important is an improvement in the quality of public service and the provision of a conducive environment for households to increase income.
To increase revenue, the tax system also needs to be simple and robust. By opting for a multi-tier GST (exempt, zero and standard rates), the GST system has a certain degree of complexity to start off with. Myriad and vague rules will offer opportunities for loose interpretation and tax arbitrage. With tax evasion, fraud and corruption being certainties in the real world, GST might yield less than the anticipated amount.
Besides, since GST administration will increase the cost of business, and monitoring costs will reduce net tax revenue, there is a need to focus on clear and transparent rules. Instead of convoluted rules with multiple opt-outs, tax simplification should be the objective in the longer run. Experiences from countries with a flat tax system and the Laffer curve effect indicate that tax simplification might even result in higher tax revenue.
In addition, in order to raise more tax politically, there is a need to increase the accountability of those elected by the taxpayers. With higher accountability, the tax compliance rate is also likely to increase. These objectives can be achieved through tax-sharing arrangements between the federal and state governments.
Tax sharing will no doubt incentivise the states to increase the amount of tax by enhancing their local environment to generate higher income and consumption taxes — a win-win situation. It will also induce a healthy dose of competition among the states. Such an arrangement has been applied successfully in Switzerland and Canada.
Although the connotation attached to the impact of the end of QE to Malaysia has been negative thus far, the end of QE might actually be indicative of a sustained US recovery and a better growth outlook for Malaysia.
However, while previous US recoveries were driven by US consumerism, it might be different this time around. This is because US baby boomers are reaching 65 years old at a rate of 10,000 per day. With lower disposable income and low annuities due to low interest rates, these baby boomers are unlikely to generate strong consumption patterns compared with previous recoveries.
Besides, commodities prices (for example, oil and copper — leading indicators of economic health) have been falling lately, signalling that the global economy is weak. This will likely translate into slower growth in Malaysia.
Even if the US recovers, the recovery might not necessarily benefit Malaysia’s growth and improve its fiscal position. This is because the shale gas success in the US might suppress the rise in oil prices (a major contributor to the Malaysian budget), encourage re-shoring of US manufacturing and dampen foreign direct investments.
This analysis might lead one to conclude that with the US economy unlikely to recover strongly, the end of QE is unlikely to lead to higher US interest rates and cause significant capital outflow. Therefore, Malaysia’s debt vulnerability is unlikely to be tested in the immediate future.
This might well be the case because the Bank of Japan and the European Central Bank might take up the baton in providing cheap liquidity to the world. In this case, Malaysia would have more time to put its fiscal condition in order, such as implementing the aforementioned suggestions.
While narratives by the central banks have successfully guided and managed market expectations, there is always a risk that the market sentiment or confidence might suddenly change, resulting in drastic capital flows. Malaysia should seize this window of opportunity to reform.
Dr Lim Kim-Hwa is CEO and head of economics at the Penang Institute. He is also a Fellow in Finance and Financial Reporting at the University of Cambridge and associate chartered accountant of the Institute of Chartered Accountants in England and Wales.
This article first appeared in Forum, The Edge Malaysia Weekly, on November 10 - 16, 2014.