Counting the cost of Malaysia’s public debt

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Malaysia’s 15th straight year of fiscal deficit and rising public debt beg the question whether the country can continue running up debt without risking macro stability. The federal government debt-to-GDP ratio is 53.5%, approaching the Finance Ministry’s internal fiscal rule of 55% and crimping the government’s ability to take on additional debt. The lack of strong political will to press ahead with fiscal reforms could undermine the country’s fiscal and debt position.

Persistent deficits lead to rising debtSince the 1997/98 Asian financial crisis (AFC), the federal government has run up fiscal deficits. As a result of the unbroken 15 years of deficits, federal government debt has expanded by 11.5% per year to RM456.1 billion or 53.5% of GDP as at end-December 2011. While one can argue that the federal government debt-to-GDP ratio is “safe and manageable” compared with the debt-laden eurozone economies, it does not mean that Malaysia’s policymakers can go slow on fiscal reforms. More room for fiscal manoeuvring is crucial to safeguard growth during these uncertain times.

Indicators of government debt sustainability Various indicators of debt burden suggest that while Malaysia’s debt level has not reached a tipping point, it warrants attention from policymakers as fiscal room is needed and long term fiscal risks need to be contained.

The debt-to-GDP ratio has been rising steadily and is moving closer to the prudent level of 55% to 60% of GDP. The 11.5% annual growth in debt outpaced the 8.4% annual nominal GDP growth during 1997 to 2011. The debt service charge (DSC) relative to revenue is rising. DSC is estimated to have taken up 10.1% of 2011’s total revenue.

Navigating the fiscal challengesThe high level of debt constrains the government’s ability to take on additional risk in its balance sheet. If the country does not commit to a credible fiscal reduction plan, it runs the risk of a downgrade of its credit rating in the event of a major change that pushes the fiscal deficit off track. Rising debt may lead to policy trade-offs between debt management, fiscal policy and monetary policy. Poor fiscal management and high levels of debt can jeopardise monetary policy objectives as they can increase inflationary expectations and cause real interest rates to rise and/or the currency to depreciate.

1. Persistent deficits lead to rising debt

Fiscal deficit for 15 years runningSince the 1997/98 Asian financial crisis, Malaysia has been incurring budget deficits in both good and bad times. While a fiscal deficit is needed to counteract a downturn, the country should not be running a deficit when things are back to normal. The government should aim to balance the books over the economic cycle. The deficit-to-GDP ratio was brought down from 5.3% in 2002 to 3.2% in 2007 before it hit a record 7% of GDP in 2009 during the global financial crisis. In the 2012 budget, the fiscal deficit is projected to come down to 4.7% of GDP from 5% of GDP in 2011. However, Malaysia has the highest fiscal deficit-to-GDP ratio in the region.

Diagnostic check on the fiscal positionThere are bad deficits and there are good deficits. What makes a fiscal deficit good or bad depends on both the context in which the deficit is run and the reason for the rise in the deficit. Our analysis of Malaysia’s fiscal position shows that:

(1) The country is still running operating surpluses but the surpluses have been narrowing due to rising operating expenditure (OE) growth (10% per year from 1997 to 2011) amid 8% annual growth in revenue. In 2011, operating surplus narrowed sharply to RM2.8 billion from RM8 billion in 2010. The questions are: (i) how sustainable is the operating surplus given the generally unrestrained OE? About 65% of total OE in 2012 is in the form of “locked-in” expenses comprising emoluments (28.6% of total OE), subsidies (18.3%), DSC (11.3%) as well as pensions and gratuities (6.7%); and (ii) how can the revenue base be expanded? The revenue base is narrow, depending on oil revenue (33% of total revenue) and income taxes (36.8% of total) in 2012.

(2) As the operating surplus (average of RM10.4 billion per year or -13.4% per year from 1998 to 2011) was not sufficient to cover the rapid growth in development expenditure (8% or an average of RM36.2 billion per year from 1998 to 2011), this resulted in an overall deficit of between 1.8% and 7% of GDP from 1998 to 2011.

Development expenditure is an important component of fiscal policy to expand the country’s productive capacity, which will lead to higher productivity, economic growth and investment. During severe economic downturns such as the 2008/09 global recession, an exceptional increase in development expenditure is warranted to ease the recession and aid the recovery.The arithmetic of fiscal sustainabilityThe arithmetic of sustainability is centred around the relationship between government budget balances and debt levels. Fiscal policy is defined to be sustainable if it leads to a stable or decreasing government debt ratio over time. A deficit ratio is judged sustainable as long as it does not exceed the product of the GDP growth rate and the debt ratio. We now apply the sustainability concept to Malaysia’s public finance position during 1998 to 2012. The table shows the evolution of both actual financial balances as well as “maximum stability balances” for Malaysia. The latter refers to the deficit ratio that would have been unsustainable indefinitely given the conditions prevalent in each period, that is the actual rates of nominal GDP growth and actual debt ratios. The difference between the actual financial balances and the maximum stability balances yields the “sustainability gap”. A positive (negative) sustainability gap implies a falling (rising) debt ratio on account of the interest burden. Our analysis showed that Malaysia had a positive sustainability gap during 2004 to 2011, except for 2009. The large negative gap in 2009 was due to the massive stimulus package of RM67 billion during the global financial crisis.

How effective are the fiscal operations?The question is how effective is fiscal spending and what is its multiplier impact on the domestic economy? Our analysis, using the Blanchard model, does suggest some positive implications from fiscal spending in 2002 to 2011, with the fiscal impulse being more apparent in 2005 to 2007 when the authorities took the automatic cyclical response of spending in a weak economy.

Using the expenditure approach, we decompose the contribution of public sector spending to GDP growth. This showed that the contributions of public consumption and investment to GDP growth were generally weak, reflecting the fiscal slippage due to “leakages” and ineffective implementation of projects. To some extent, the inflated project costs led to a sizeable budget gap without yielding the desired impact on the economy. The mismanagement of public projects and misappropriation of funds were revealed in the Auditor General’s Report.

Expansionary spending will not necessarily lead to a positive change in output and income growth if the multiplier effect is restrained by inefficiencies and low-impact projects. We calculated the net multiplier effect arising from a change in tax and government expenditure on output. The results showed that the overall net impact on gross output is less as the positive impact from public spending was offset by a negative tax multiplier. This means that the rationale of increased government spending premised on higher taxes collected is somewhat misguided. Higher taxes mean less net disposable income.

2. Rising debt is a source of concernFederal government debt (also known as public debt) is the debt owned by a central government. It comprises domestic borrowings and external loans. In managing debt, the federal government is guided by several rules and guidelines with regard to borrowings.

(i) Article 111 of the Federal Constitution allows state governments to borrow only from the federal government in order to keep a check on credit creation. (ii) Under the External Loans Act 1963, foreign debt is capped at RM35 billion to limit exposure to exchange rate risks. (iii) The combined outstanding borrowing domestically for development expenditure, through the Loan (Local) Act 1959 and the Government Funding Act 1983, is capped at 55% of GDP, while the Treasury Bill (Local Act) 1946 limits the current maximum amount of Treasury bills that can be issued and outstanding at any one time to RM10 billion (source: 2010/11 Economic Report, Ministry of Finance, Malaysia). Federal government debt rose by 11.6% per year from 1971 to 2011. Over the four decades, there were three episodes of debt growth.

(a) The debt ballooned during 1970s and mid-1980s, growing by 19.6% per year during 1971 to 1983 and 12.4% per year from 1984 to 1987 as the government embarked on expansionary fiscal policy and implemented major public projects/investments. As a result, the debt-to-GDP ratio rose progressively from an average of 46.5% in the 1970s to 78.6% in the 1980s. The ratio even surpassed 100% of GDP in 1986 and 1987. The government increased debt rapidly to bridge the structural budget gap. The deficit hovered between 3.3% and 16.6% of GDP in 1970s and 1980s. At its peak, it was 16.6% of GDP in 1982 (15.6% in 1981).

(b) Recognising the adverse consequences of unsustainable debt levels and fiscal deficits, the government undertook: (i) painful fiscal structural adjustment programmes, involving the reprioritising of public projects, rightsizing of the public sector and privatisation of government agencies; and (ii) prudent and active management of debt. In 1987, the government embarked on a policy to prepay the more expensive external loans to contain the external debt and reduce the debt servicing burden. This led to a progressive reduction of the debt-to-GDP ratio from 103.5% in 1987 to 31.9% in 1997, thanks partly to five successive years of fiscal surpluses between 1993 and 1997, supported by favourable economic growth, strong revenue growth and contained expenditure growth.

(c) Since the 1997/98 Asian financial crisis, federal government debt has been rising by 11.5% per year to RM456.1 billion or 53.5% of GDP in 2011 (0.1% per year during 1989 to 1997). The rise was associated with the funding needed to bridge the 15 straight years of deficits.

Of greater concern is the rising outstanding debt guaranteed by the federal government, which increased markedly by 8.7% per year. from RM11 billion at end-1985 to RM96.9 billion or 12.7% of GDP at end-2010. The increase has been quite rapid since 1997. If we include the outstanding federal government guaranteed loans, public debt would be RM504 billion or 65.8% of GDP in 2010, exceeding the 55% debt ceiling set by the government. Technically speaking, federal government guarantees are not included in the public debt total until there is a call on the guarantees. That said, for better control of total borrowings, the accrual basis (adding the contingent liabilities) would provide a full picture of the longer-term implications of the government’s debt obligations as the federal government would assume the contingent liabilities if the statutory bodies/companies defaulted their debt. We think the funding of the Mass Rapid Transit (MRT) project is expected to add to the contingent liabilities of the government.

3. Indicators of debt sustainabilityNot at tipping point but vigilance is neededVarious indicators of the debt burden suggest that while the country’s debt level has not reached a tipping point, it warrants attention from policymakers as fiscal room is needed and long-term fiscal risks need to be contained. The debt-to-GDP ratio has been rising steadily, moving closer to the prudent level of 55% to 60% of GDP. The 11.5% annual growth in debt outpaced the 8.4% annual nominal GDP growth from 1997 to 2011. The DSC relative to revenue is rising. DSC is estimated to have taken up 10.1% of 2011’s total revenue.

4. Implications of a fiscal deficit and rising debtHigh levels of government debt over a sustained period will have economic and financial ramifications over the longer term. Rising public debt could crowd out private capital formation and, therefore, productivity growth. This occurs through the competition for domestic liquidity, higher interest rates, a shifting of resources away from the private sector or investment in low-impact projects.

This situation is made worse if the government wastes borrowed money on unnecessary projects or tax incentives for the business associates of current politicians. The high level of debt constrains the government’s ability to take on additional risk in its balance sheet.

If the country does not commit to a credible fiscal reduction plan, it runs the risk of a downgrade of its credit rating in the event of a major change that pushes the fiscal deficit off track. Also, persistent fiscal deficits impair the ability of policymakers to response effectively to future economic shocks.

Rising debt levels may lead to policy trade-offs between debt management, fiscal policy and monetary policy. A growing share of Malaysia’s future income would be devoted to service the increasing debt. With domestic debt making up 96% of total debt, this minimises foreign currency risk but involves trade-offs between fiscal and monetary policy. Investors would perceive that the authorities have less incentive to raise interest rates to curb inflation as they may wish to keep rates low in order to contain the cost of borrowing.

Poor fiscal management and high levels of debt can jeopardise monetary policy objectives as they can increase inflationary expectations and cause real interest rates to rise and/or the currency to depreciate. Unsustainable deficits have a cost, as seen in a number of countries recently. Interest rates can soar if investors lose confidence in the ability of a government to manage its fiscal policy. It is difficult to determine the exact threshold level at which the perceived risks associated with the public debt increase markedly. However, without fiscal reform, the debt and deficits are unsustainable over the medium term.

5. Fiscal transformation is the way forward Walk the talkMuch has been said about the need for fiscal reform. The lack of strong political will to press ahead with reforms could undermine the country’s fiscal and debt position. We note that some progress has been achieved on subsidy rationalisation. We believe that a plan which clearly and credibly pushes fiscal consolidation on a sustainable path could help keep longer-term interest rates low and sustain investor confidence, thereby supporting strong economic growth.

The careful design of tax policies, spending programmes and subsidy rationalisation would increase the incentive to work and save, encourage investment in human capital by attracting talent and skilled workers, stimulate private capital formation, maximise resources and provide essential and “value for money” public projects.

We stress that the pace of fiscal adjustment should not be frontloaded as it could undermine recovery. The government should target a long-term decline in the public debt-to-GDP ratio, not just its stabilisation at post-crisis levels. In carrying out fiscal consolidation, the expenditure policy will require a bias towards reprioritising of projects or spending cuts, containing public sector wage bills and moving from universal to targeted social transfers while protecting the poor.

An overhaul of the current pension system should be considered since the current trend is unsustainable. On revenue reform, the design of tax policy should be fair and equitable in order to be sustainable. The government should maintain an adequate social safety net and provision of public services as well as contain tax evasion. The push for a wide and investment-friendly reform to boost potential growth should be expedited as strong growth has a huge effect on reducing public debt.

On budget planning and development, an oversight body needs to be set up to ensure better fiscal rules, budgetary processes and closer fiscal monitoring to ensure fiscal discipline.
This article appeared in The Edge Financial Daily, February 23, 2012.