my Say: The fiscal conundrum

This article first appeared in Forum, The Edge Malaysia Weekly, on December 2, 2019 - December 08, 2019.
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The 2020 budget passed by parliament proposes an expenditure of RM297 billion, equivalent to 18.4% of gross domestic product, to be financed by RM244.5 billion of revenue and RM53 billion of borrowings to obtain a deficit of 3.2% of GDP.

Of the RM297 billion, only RM56 billion is for development expenditure, which represents public investments to build new capacities in the economy. This is only 3.4% of GDP, which is a small fiscal tail to wag the GDP dog. In other words, RM56 billion to spur an economy of more than RM1.6 trillion. As has been the case for some years now, almost all of the development expenditure will be financed by borrowings.

While public consumption, as measured by the government’s proposed operating expenditure of RM241 billion, is not insignificant as a single item, its transmission to aggregate demand is via consumption, which is immediate and does not have long tail effects. Public investments in the form of development expenditure, on the other hand, are supposed to build new capacities and therefore have multi-period effects on the future.

Since federal budgets have been in deficit since 1998, the absolute amount and share of development expenditure to GDP have been declining, which means the fiscal policy lever has been losing its efficacy. While budget deficits and their corresponding debts are accumulating, the size of public investments as a percentage of the economy is getting smaller. The trade-off is clear: higher development expenditure comes with bigger deficits and an even faster accumulation of total outstanding debt, which will then make operating expenditure larger because of debt-servicing expenses. As it is, debt-servicing costs already account for 14% of operating expenses.

Fiscal policy has not only lost its relative effectiveness — at the very least, its relative size and significance — but it is also getting costlier, even in this period of low interest rates. In aggregate, the public sector as an economic agent is becoming a smaller player in the economy. However, it is its well-being as an economic agent, both as a consumer and an investor in new capacities, that is worrying.

The obvious problem is the growth in operating expenditure. This is a reflection of the increase in the size of government itself to the point that emoluments and pensions alone now account for 45% of total operating expenditure. As revenue growth has not kept up with the increase in operating expenditure, total revenue is now just about sufficient to cover operating expenditure, which means that almost all of the development expenditure is being financed by borrowings, as is the case in the proposed budget.

The nature of fiscal deficits is perhaps more important than their size. If the deficits were spent on building new capacity — for example the right infrastructure projects or lowering the cost of doing business via the expenditure side or tax cuts — then the net impact of the deficits would likely be positive for the medium term as the multiplier effect would kick in over a longer period in the future.

Development projects, however, create future operating expenditure commitments — not just expenses to service the borrowings but also for maintenance. In the case of the so-called privately funded initiatives (PFIs) implemented in the past, there were long-term commitments for the government to pay the private parties for projects they delivered using their own financing. Thus, this avoidance of the need for development expenditure via PFIs simply translates into long-term operating expense commitments. This is a short-term cash flow management strategy that incurs long-term commitments that should only have been used extremely judiciously.

This is the same when projects were funded with financing raised by government guarantees. These were outside direct government borrowing and therefore more expensive. But the repayment and servicing of the borrowings were drawn from the budget via operating expenses. They are not contingent liabilities but represent actual obligations paid through the budget. These expenses have contributed significantly to the growth of operating expenditure as well. The MRT, LRT extension and Pan Borneo Highway are major projects financed in this manner.

One can also argue that there could have been better clarity in how publicly funded projects fit the big picture of achieving a national development outcome and certainly a better cost-benefit analysis in determining the priority of implementation. Maybe there needs to be a clear big picture first to properly locate the projects. The fiscal multiplier of public investments is known to be much higher than that for public consumption, but if the public projects are poorly prioritised or implemented, then the fiscal multiplier is low. If we add corruption to the equation, it gets worse.

How projects are implemented matters too as this should have an impact on the development of local firms. There has been massive expenditure on the earlier mentioned projects — LRT, MRT, Pan Borneo Highway and double-track railways. In the past, there have been similar projects such as KLCC, KLIA and Putrajaya. How have our firms benefited from these massive projects? What new capacities have they developed? How many domestic firms have successfully leveraged government procurement to be more competitive overseas and grow beyond the procurement?

It is not that public procurement cannot be used strategically to develop domestic firms. It has to do with how procurement is conducted. The examples of the US space and defence programmes and strategic procurements in many countries prove that government procurement can be used to build the capacity of domestic firms, which can be the platform for them to develop their competitiveness and therefore national competitiveness. The way government procurement was used under the guise of bumiputera agenda should be avoided. It achieved neither capability development of the target group nor the allocative efficiency of fiscal policy.

Judging from the number of construction projects — from highways, railways and utilities to oil and gas — there should have been many such Malaysian firms that, on their own or in collaboration with foreign firms, would have developed capabilities in these and associated industries. There are a few local companies that have done well enough to venture overseas but the linkage between public and private projects and local firm development has been disappointing. The spin-offs to local firms must be better and for this to happen, the way public investment projects are undertaken must change.

The fiscal challenges are enormous but the trade-offs should be clear. There are always trade-offs. Unfortunately, the pain can be immediate but the gains will take time to come through. Reforming the system, however, requires making these hard decisions, or else nothing will change. In the short to medium term, there will not be much leeway in using fiscal tools to manage aggregate demand. Thus, allocation efficiency is crucial — getting the most bang for each ringgit spent.

At the end of the day, the real issue of the sustainability of fiscal deficits has to do with the supply of liquidity in the economy and the pricing of sovereign risks. These determine the demand for, and the pricing of, government debt. As it is, most of the debts are denominated in ringgit, although there is substantial foreign ownership of the debt paper. While this removes the direct forex risks, substantial foreign holdings of public debt can affect exchange rates should flows be bunched up due to differentials in risks premium, which also depends on lenders and investors’ perception of risks.

There are uncertainties — politically related ones — that affect such perception, apart from issues on the supply side, especially in the labour market, that influence those risk assessments. It is managing these sorts of risks that will therefore affect consumer sentiment and investor confidence that sorely need boosting right now. Investments in new types of businesses require higher appetite for risks — something that is a mixture of sentiments and fundamentals. While investors are prepared to take business risks, they are put off by perceptions of uncertainties arising from policy and regulatory uncertainties.

While there will be a limited role for fiscal tools such as the budget in stimulating aggregate demand, it is important to learn lessons from the past in terms of how development expenditure was used. How fiscal policy is implemented is in fact a barometer for overall government policy: Is there clarity in policy direction, a change in priorities and, more importantly, a change in how things are done? While there may be differences in how investors and consumers perceive “what” should be the priorities, the change in “who” is supposed to manage the process via a change in government is driven by the desire to see changes in “how” things are done. That includes how fiscal policy is formulated, implemented and governed. These have to change.

Dr Nungsari A Radhi is an economist and the views expressed here are not related to any of his organisational affiliations

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