PRIME Minister Datuk Seri Najib Razak was clear in his revised Budget 2015 address last week: “We are neither in a recession nor a crisis [like that] experienced in 1997/98.” This message, which is meant to reassure the people, came together with a host of lowered economic indicators brought on mainly by circumstances that are beyond the government’s control.

To drive home the point that all is well with the country, Najib left for Davos, Switzerland, to attend the World Economic Forum a day after the announcement.

But is all really well with the economy?

The ripple effect of plummeting global crude oil prices over the last six months has exposed the vulnerability of the Malaysian economy. In June last year, oil prices were hovering at US$115 per barrel and now, they are more than halved to US$49.  

The perception of Malaysia being a large oil producer was debunked by the prime minister, given that the country is actually a net importer of petroleum after taking into account all petroleum products. But it is undeniable that the plunge in crude oil prices will hurt oil exports, which in turn will impact oil-related revenue.

As stated in the 2014/15 Economic Report, crude oil contributed 4.4% of total exports, but it is understood that oil-related revenue made up about 30% of the total in 2013.

Based on a more realistic crude oil price assumption of US$55 per barrel for the year compared with US$100 previously, oil revenue is expected to shrink to 21% of the total for 2015.

Falling oil prices are not the only problem for the country. Globally, commodity prices are also on a downward trend. In 2013, Malaysia’s palm oil made up 6.4% of total exports and liquefied natural gas, 8.2%.

The decline in commodity prices has raised concerns of a twin deficit where both the current and fiscal accounts fall into negative territory. The national budget has been in deficit since the 1997/98 Asian Financial Crisis and was widest at -7% of gross domestic product (GDP) in 2009. While Najib has assured that a twin deficit will not arise, it is far from comforting to see the current account surplus shrink to 2% to 3% of gross national income from an estimated 5.1% a year ago.

The current account is made up of the trade balance and net income from abroad, as well as net current transfers.

Further, the slump in oil prices means that the fiscal deficit target of 3% of GDP for 2015 is now unachievable, and this was subsequently revised to 3.2%. It is worth noting that if the budget were not revised, the deficit would hit 3.9%.

The government also revised downwards the projected GDP growth forecast to 4.5% to 5.5% from 5% to 6% previously.

“These revisions underscore the vulnerability of Malaysia’s economy and credit profile to sharp movements in commodity prices. The high share of revenue linked to oil and gas is a structural weakness for the sovereign,” notes Fitch Ratings in a statement made after the budget revision. The rating agency is maintaining a negative outlook for Malaysia’s long-term issuer default rating, “which means that we are more likely than not to downgrade the rating within the next 12 to 18 months”.  

It states that while the prime minister said he expects the current account to remain in surplus, the risks are “on the downside”, given the sharp decline in energy prices.

“The emergence of a twin deficit will remain a rating sensitivity for Malaysia,” it adds.

Could the country’s current account fall into a deficit? A deficit in the current account is the result of falling exports and/or rising imports along with outflows of income.

Maybank economist Suhaimi Ilias expects export growth to slow to 5.5% this year from 6.8% in 2014. However, he sees no reason to expect a deficit in the current account, although a smaller surplus is a certainty. He concurs that the country is, after all, a net importer of petroleum.   

Foreign investors who are jittery over Malaysia’s reliance on oil revenue were blamed for the sharp depreciation of the ringgit against the US dollar. However, the full blame should not be placed on these investors as the greenback also strengthened against most currencies on the back of economic recovery in the US.  

The ringgit has depreciated 11.83% against the US dollar since June 30, 2014, to 3.5938 last Friday. The bad news for Malaysia is that the weak ringgit is likely to persist for the rest of the year, with economists expecting it to average between the 3.50 and 3.60 levels.

Malaysia’s foreign exchange reserves are also on a decline. Based on data released by Bank Negara Malaysia, they were down 4% from two weeks ago to US$111.2 billion as at Jan 15 — the lowest level since March 2011.

The worry is that the weak ringgit could spiral downwards, given the high level of foreign bond holdings in the country. In addition, there are concerns about the government’s off-budget financing in the form of guarantees for debts issued by government-linked entities. One such entity is 1Malaysia Development Bhd (1MDB), which has debts amounting to RM41.87 billion, of which RM5.8 billion has explicit sovereign guarantee.    

Economists opine that the measures the Najib administration plans to undertake in the revised budget are as much as can be done under the current circumstances, implying that there isn’t much room for the government to manoeuvre.  

Interest rates, which can be used as a tool to prevent the ringgit from weakening further, appear to be an unlikely option for the central bank, given the high level of household debts in Malaysia, say economists.

They are not expecting Bank Negara to raise interest rates this year. “A rise in interest rates would put a strain on households’ ability to service their loans, and this could trigger defaults,” says an analyst.  

“They really cannot afford to take any drastic measures now. The after-effect would mean that people could lose jobs, then you could see defaults pick up, which will lead to slower growth. This could increase capital outflow,” says an economist.

As at June 2014, household debts reached a staggering 86.7% of GDP and public debt, 52.8% — near its self-imposed debt ceiling of 55%.

Maybank’s Suhaimi says the government will need to review the long-term impact of the situation should weak crude oil prices persist. “Otherwise, there will be a question mark on the sustainability of policies and on whether we can achieve the goal of a balanced budget in 2020.

“The government has implemented some fiscal reforms that many would not have thought it would, like the removal of the fuel subsidy. The upcoming Goods and Services Tax could prove to be a good source of revenue a few years down the road and the removal of the fuel subsidy was timely, given the decline in oil prices.”

Nevertheless, he says it is crucial for the government to look at reducing the operating expenditure. He adds that it will need to have discipline when it comes to spending.

The government’s operating expenditure has been rising every year in absolute terms, from RM211.2 billion in 2013 to RM223.4 billion in 2015. However, as a percentage of GDP, it was down from 21.4% to 19% during the same period.

In the revised budget, Najib announced a cut in operating expenditure of RM5.5 billion, through the deferment of this year’s National Service programme, the review of supplies, services, grants and transfers and the rescheduling of purchases of non-critical assets.  

“There was a cut in the operating expenditure, but who knows if the government will table a supplementary budget a few months down the line, as it has been doing in the last few years,” says an observer.

Much to the relief of investors in the construction sector, the government’s budgeted development expenditure of RM48.5 billion has been left untouched. However, Credit Suisse notes in a report on Jan 20 that a cut in development spending could happen eventually.

It reasons that this is because the government has historically found it hard to cut operating expenditure that comprises mainly civil servants’ salaries. But Credit Suisse believes the option remains attractive for two other reasons. “The prime minister’s comment that the current account ‘must be in surplus’ implies that the government could cut, or at least spread out, investment projects to lower the country’s import demand if it finds the current account flirting in deficit territory. Secondly, there is increasing scrutiny on off-budget financing vehicles (for example, 1MDB), and the government could find it more difficult to shift investment spending off-budget,” it explains.

Suhaimi opines that a development expenditure cut could come at the cost of the country’s economic growth. Furthermore, any delay in the ongoing infrastructure projects will only result in higher costs.

He says projects, like the mass rapid transit, are important with the removal of fuel subsidies. “Eventually, oil prices will go up again and the managed float mechanism price will rise too. These infrastructure projects need to be ready when this happens.”  

Maybank Investment highlights in a report that the budgeted and actual development expenditures between 2011 and 2014 have been below the originally budgeted amounts by RM2 billion to RM6 billion.

The market did not respond too well to the revised budget with the ringgit sliding further to hit a six-year low of 3.61 to the US dollar last Tuesday. The FBM KLCI closed three points lower on the same day.

While many describe the revised budget as “more realistic” and praise the government’s commitment towards fiscal consolidation, sceptics remain, with some saying the measures to boost exports are vague and the new fiscal deficit target being “a tad optimistic”. One thing both sides agree on is that 2015 will be a challenging year.

This article first appeared in The Edge Malaysia Weekly, on January 26 - February 1, 2015.

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