UNVEILING his "Prospering the Rakyat" budget (translated as "Prospering the People"), PM Najib proposed a deficit of 3.1% of GDP for 2016 (RM38.8 billion), versus a projected 3.2% this year (RM37.2 billion).

While this is not far off the government's long-held deficit target of 3% of GDP, we were somewhat disappointed, considering that the target was supposed to have been met this year, but was postponed in January owing to the slump in global oil prices.

Highly conservative revenue and expenditure projections …

To be sure, both revenue and expenditure projections remained extremely conservative, as has been the case in the last few budgets. Revenues are projected to rise just 1.4% to RM225.7 billion, from a mere 0.8% rise this year. Meanwhile total expenditure is forecast to rise 1.7% to RM265.2 billion, following a 0.6% gain in 2015.

In our view, it is likely that both revenues and expenditures will overshoot government projections, in both 2015 and 2016.

Although the (real) economy is currently losing momentum, the last time revenue growth fell below 2% (to just 0.6%) was in 2010 — when the economy was just emerging from the aftermath of the Global Financial Crisis. Meanwhile, on the expenditure side spending last saw significant compression in 2013 (rising just 0.8%), when Malaysia's sovereign credit ratings first began to come under pressure from rating agencies as the public debt-to-GDP ratio looked in danger of breaching the 55% statutory limit. By 2014, spending had risen 2.4%.

Based on our expectations for nominal GDP growth to pick up in 2016, and the view that public spending — particularly on the operational side — will be challenging to curb, we think revenue growth could rise to 4.9% this year and 6.6% in 2016 (from 3.4% in 2014), while expenditure could rise to 5.0% and 5.7%, respectively (from 2.4% in 2014).

In net terms, however, our estimates still leave the overall budget deficit larger than what the government expects, at RM39.5 billion for 2015 and RM39.6 billion for 2016, or 3.4% and 3.2% of GDP, respectively.

… but very optimistic macro assumptions

Oddly enough, despite the government's highly conservative revenue and expenditure projections, the underlying macroeconomic assumptions for 2016 appeared rather sanguine. Real GDP growth is projected to decelerate only a touch, from 4.5%–5.5% this year to 4%–5% next year. While our growth projection of 4.6% for this year sits within the official forecast range, for 2016 we think real activity could slow to 3.6%.

By industry, agricultural output is expected to remain unchanged at 1.3%, while mining/quarrying activity is forecast to accelerate to 4.0%, from a projected 3.5% this year. Manufacturing is expected to slow only a touch, to 4.3% for 4.5%. Construction is forecast to slow to 8.4% from 8.8%, while services growth is expected to moderate to 5.4% from 5.7%.

On the expenditure side, the expectations are similarly moderate. Private consumption growth is pencilled in at 6.4% for 2016, versus 6.8% this year. The slowdown in private investment is expected to be a bit more material, at 6.7% versus 7.3% this year. Meanwhile, exports are predicted to bounce 0.9%, versus -0.8% in 2015, while imports are expected to accelerate to 1.5% from 0.8% this year.

Little bang for the buck

Risks are that Malaysia's slowdown next year turns out to be more significant than what the government currently assumes. Amid the weakness and volatility in the Malaysia ringgit, rate cuts to prop up the economy are unlikely to be forthcoming from Bank Negara Malaysia (BNM).

But today's budget — quite predictably — also underscored the fact the government, too, is limited in what it can do to boost the economy via fiscal policy, as it remains constrained by fiscal and debt ratios. Following a 20% increase this year (the first increment in five years), development expenditure — the part of the budget where the boost to economic growth really comes from — is set to slow to a mere 5.4% in 2016, as the government slows the tap on economic and social services across the board. In fact, transport as well as education services will see cuts in spending, of 3.4% and 16.7%, respectively.

This casts a bit of a shadow over infrastructure plans laid out by PM Najib, such as a RM900 million effort to reduce congestion in the capital city of Kuala Lumpur through a public-private partnership, RM1.4 billion to build and upgrade 700km of rural roads nationwide, and a continuation of negotiations with Singapore regarding a high-speed rail between the two countries. To be sure, a number of other LRT and MRT projects also appear to be on track and will start operating in various phases next year. However, the outlays for these projects would already have been made in prior years.

Meanwhile, it remains to be seen if on the operational side the government can indeed stick to its projection for a modest 0.9% rise, following a 2.9% reduction this year. Although subsidy spending will remain fairly flat following reforms this year (-0.5% versus -34% in 2015), civil service salaries and pensions will rise a further 2% (from 3.2% this year), while debt service charges will pick up to 9.3% from 7.9%.

Revenues relying heavily on the GST

With real activity set to slow in the absence of monetary easing, not much additional new fiscal stimulus, and oil likely remaining in a slump (the official assumption is that crude will average USD50/bbl over 2016, versus USD55 this year), where revenues are concerned the government now appears significantly more reliant on the GST.

For 2016, GST collections are projected to surge to RM39 billion, from RM27 billion this year (the tax was introduced only in April). Interestingly, this RM12 billion jump — a sizeable 1% of GDP — almost offsets the projected decline in oil-related revenues. According to PM Najib, the contribution from state oil agency Petronas (including its dividend) and other oil-related activities will come to RM31.7 billion in 2016, from RM44 billion this year — a RM12.3 billion drop.

Clearly, the GST has been a success in the context of fiscal reform, with collections this year having exceeded expectations (the original projection was RM21.7 billion). However, the downward pressure faced by oil-related revenues this year and the next means that the government has to lean all the more on the GST to pick up the slack. This is a potentially precarious dependency, considering that GST collections are also subject to the economic cycle. Furthermore, as part of its plans to ease the cost of living for Malaysians, in 2016 the government will increase the range of zero-rated goods. The brands of medicine that will be zero-rated will be doubled to 8,630 from 4,215; various food items such as soybean-based milk and organic-based milk for infants and children, dhal, and mustard seeds will also be zero-rated. Others who will be able to receive GST relief include oil and gas companies or those in the promotion, research, or exhibition industry that are re-importing certain types of equipment, as well as consumers purchasing prepaid mobile services.

Other key takeaways

As expected, an area that the budget attempted to address was the rising cost of living, which has been cited as the foremost concern among Malaysians. To that end, the government increased its cash handouts for low-income households (known as the 1Malaysia People's Aid, or BR1M) to RM1,000 from RM900. Families with incomes between RM3,001 and RM4,000 will also receive higher handouts, with the BR1M assistance in total benefiting 4.7 million households to the tune of RM5.9 billion.

Minimum wages will also be raised from 1 July 2016, to RM1,000 a month from RM900 currently in Peninsula Malaysia, and to RM920 in Sabah and Sarawak. For civil servants, the minimum starting salary will be raised to RM1,200.

Conversely, high-income earners will be taxed more. The taxable income band for the highest tax rate was increased to 26% from 25%, for those earning an income of between RM600,000 and RM1 million. For those earning above RM1 million, the tax rate will increase to 28% from 25%.

Some serious money will also be poured into various projects to boost investment, although we expect multiplier effects from these to be apparent only over the medium to long term. These include an RM18 billion allocation next year for the Refinery and Petrochemical Integrated Development Project (RAPID) Complex in Pengerang, Johor; the development of an airport township or KLIA Aeropolis over 1,300 acres, which is expected to attract an investment of RM7 billion; development of the Malaysian Vision Valley over 108,000 hectares between Nilai and Port Dickson as announced in the 11th Malaysia Plan, with an initial investment of RM5 billion next year; and implementation of Cyber City Centre in Cyberjaya with a development cost of almost RM11 billion over a period of five years.

Meanwhile, sovereign wealth fund, Khazanah, will also be investing RM6.7 billion in nine "high-impact" domestic projects, in sectors such as healthcare, education, tourism, communication software, and infrastructure.

Tourism clearly remained a key pillar of the economy, with PM Najib describing the sector as having "the highest potential to generate economic activities in the currency situation." For 2016, the government targets 30.5m tourists, which is expected to contribute RM103 billion to the economy. For this, a sum of RM1.2 billion will be allocated to the Ministry of Tourism and Culture. Online visa applications will also be implemented beginning with China, India, Myanmar, Nepal, Sri Lanka, the US and Canada; by mid-2016, and E-Visa will be implemented. To take advantage of the current level of the ringgit and in efforts to attract more tourists, the 100% income tax exemption on statutory income for tour operators will be extended from year of assessment 2016 until 2018.

Agriculture — and in particular food production — also received a leg-up, with the Ministry of Agriculture and Agro-based industry receiving a RM5.3 billion allocation for 2016. This will go towards programmes on cultivation, research, agricultural infrastructure and food subsidies. Furthermore, more companies in the food production business will receive various tax deductions and exemptions for investing in subsidiaries, undertaking new food production, or undertaking project expansion.

In conclusion

In the very near term, the budget may well provide a fillip to Malaysian markets, with factors such as the BR1M hand-outs, minimum wage hikes and the list of sizeable investment projects potentially seen as providing weakening domestic demand a much-needed boost.

But we have our doubts over how long any upturn in sentiment can last. Admittedly, cash hand-outs and wage hikes might provide some relief to households in the short term. But there currently exists a high level of precaution among consumers, particularly with regards to the labour market outlook — an area that the budget did not address. Consequently, it is difficult to see the hand-outs and wage hikes suddenly translating into sustainably stronger private consumption. Higher minimum wages will also be an additional burden on firms, many of whom are already grappling with excess capacity amid a fall-away in both external and domestic demand, as well as rising import costs (due to the ringgit's weakness).

Meanwhile, from the fiscal angle this budget does not "rock the boat" in any sense, and does just enough to keep the ratings agencies at bay for now. A 3.1% budget deficit to GDP ratio is not great, but not terrible either — assuming the government does indeed manage to achieve a narrower gap of 3.2% this year as well. Nevertheless, as we have highlighted, there continues to be risk of fiscal slippage both for 2015 and 2016, given ongoing pressures on both revenues and expenditure. Potentially overly optimistic projections on items such as GST collections and low operating expenditure leave the government little room for error.