This article first appeared in Forum, The Edge Malaysia Weekly on May 6, 2019 - May 12, 2019

Malaysia’s equity market experienced an outflow of foreign capital to the tune of RM1.3 billion in the first quarter of the year. The bond market, however, was spared during this period, registering net foreign inflow for the first time since December last year.

But continuous news reports on the possible exclusion of Malaysia from the FTSE-Russell World Government Bond Index could limit the inflow in the near term. The pressure was reflected in the benchmark 10-year Malaysian Government Securities (MGS) yield, which spiked 12 basis points in the third week of April. All of a sudden, there is renewed interest in the country’s pertinent macroeconomic issues.

Adding to the strain on the ringgit is the possibility of Bank Negara Malaysia adjusting the policy rate downwards, judging from the dovish tone of its recent Monetary Policy Committee statement. The market has, to a certain extent, priced in this likely reduction. Analysts’ comments on the government’s fiscal position and current account (of the balance of payments) have also raised some anxiety in the financial market over Malaysia’s macro landscape. This is hardly surprising, as investors continue to focus on the government’s financial health and the country’s shrinking savings-investment gap (or current account).

While a bumpy ride looks imminent, we would do well to step back and examine the broader picture. In general, economists are aware of the possible repercussions if the two economic evils — budget and current account deficits — were to emerge simultaneously (by the way, Malaysia registered a still-healthy current account surplus equivalent to 2.4% of gross national income [GNI] last year, although this is lower than in the past few years). The so-called twin deficits tend to induce sudden capital outflow and weigh on countries’ currencies. A case in point: Both the Indonesian rupiah and Indian rupee have been on investors’ watch list for some time now. Whenever these countries’ budgetary and current account positions deteriorate, their currencies get hammered.

One point is worth mentioning. From a theoretical point of view, there is a connection between budgetary and current account gaps. Those familiar with the national accounting identity can easily prove this relationship mathematically. But a simple explanation for the man in the street would be as follows: budget deficits, normally the result of higher government spending, push up a country’s aggregate demand. This, in turn, leads to rising interest rates. Under a flexible exchange rate regime, a positive interest rate differential vis-à-vis the rest of the world would induce capital inflow into the country. This strengthens its exchange rate but leads to a deterioration in its current account balance, as the country’s exports become more expensive and thus less competitive on the international market (this is basically the Mundell-Fleming model, a standard economic model in the study of international economics).

However, many countries experiencing budget deficits do not incur current account deficits. For example, Malaysia’s budget deficits, incurred since 1998, have been accompanied by current account surpluses. However, the recent concern of investors is the declining trend of Malaysia’s current account surpluses as a percentage of GNI in the past few years.

It is also worth noting that from a theoretical perspective, a budget deficit on its own is not the real economic evil. The deficit only represents an excess of spending over revenue. More important are the reasons for this: Was the spending for the meaningful generation of economic activity or merely for the sake of spending (for example, white elephant projects)? Or has the country failed to generate sufficient revenue?

Of greater importance is the way the deficit is financed. In some parts of the world, deficits are financed by money printing. In such cases, inflationary pressure builds up and when prices get out of control, capital flight occurs. This is what investors fear the most. In contrast, financing the deficit through bond issuance is not inflationary. However, it tends to exert upward pressure on interest rates, which, if too excessive, will impact investments.

That said, a few points are worth mentioning about Malaysia’s budget deficits. One of the concerns is that the negative budget gap has been around for two decades — since the 1997/98 Asian financial crisis. Therefore, it is quite normal for the investor fraternity to wonder when it will cease to exist, and whether it will be a real drag on the economy going forward.

A look at Malaysia’s budgetary history shows that the country has experienced many deficit years since 1970. The only years that Malaysia experienced budgetary surpluses were between 1993 and 1997 (only five years). At least in Malaysia’s case, the deficits have not resulted in material macroeconomic disasters. Of course, moving to a balanced budget as envisioned by the government would be a plus point for the economy.

Second, raising funds to finance fiscal deficits has never been a real issue in this country. Malaysian government bonds are in demand, as evidenced by decent bid-to-cover ratios (essentially how many times the bonds are oversubscribed) over the years. Past records show that MGS and Government Investment Issues (GII) were comfortably absorbed by the market.

On another note, Malaysia’s shrinking current account surpluses are a concern, especially when global trade activity is softening. Lower trade surpluses exert pressure on the current account balance. Indeed, the surplus had shrunk to 2.4% of GNI last year from 11.2% in 2011. But slower investment growth will also ease some of the pressure on the current account balance because the latter also reflects the country’s savings-investment gap. A slightly lower investment (relative to savings) will be positive for the current account balance in the near term. Hence, rationalising (or spacing out) some of the mega projects will ease concerns over the shrinking current account surpluses for Malaysia. Of course, this has to be balanced by the overall benefits of these investments.

Malaysia experienced a brief period of twin deficits in the 1990s. However, that was when the country’s investment ratio was way above 40% of gross domestic product. Even then, the country managed to wheel out of it by spacing out its projects. This time around, the economic landscape is different. Investment ratios are nowhere around that level while a more diversified export market provides an important buffer for Malaysia’s trade performance.

Nor Zahidi Alias is chief economist at Malaysian Rating Corp Bhd. The views expressed here are his own.

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