Bank Negara Malaysia’s recent cut in the overnight policy rate (OPR) has renewed the investment fraternity’s interest in the benchmark interest rate. Different questions were raised, for example, will the downward trend in the policy rate continue?
And if we assume the answer to be “yes”, then a more pertinent question would be: Will it be due to the fact that the OPR has been above the level generally seen as “appropriate” by economists given the current economic conditions, or, perhaps more importantly, is Malaysia, like many other countries in the world, slowly entering a period of the so-called “new normal” and “new neutral”, phrases popularised by Pacific Investment Management Co (Pimco), the well-known bond fund manager?
Essentially, the new normal thesis popularised by Pimco argues that world economic growth will remain muted post-global financial crisis (GFC). There will also be a shift in growth drivers from G3 economies to emerging economies, and from the private to the public sector. The public sector will tend to overstay (as a growth driver) to offset the lethargic private sector. At the same time, in the financial markets, central banks will find it difficult to smoothly undo some of the emergency responses undertaken to revive growth, with short-term policy imperatives materially conflicting with medium-term ones.
Given the less-than-optimistic scenario painted by Pimco, it is not surprising for the new normal thesis to slowly morph into a new phase commonly called the new neutral, which will see global interest rates remain below equilibrium for an extended period, given the sombre medium-term outlook. Essentially, the new neutral story is about policymakers having a predilection for an accommodative monetary policy stance to address the problem of weak economies that are not recovering meaningfully, or economies that are converging to trend rates of growth that will be decidedly sluggish.
Of course, this thesis sounds generally logical, given that the global economy is still struggling to find its footing despite the mild recovery of the US economy. In fact, of late, the US economy is losing some of its momentum, although labour market indicators seem to be more positive than before. Similarly, emerging markets’ nascent growth was mitigated by China’s decelerating economic strength as well as troubles brought on by domestic imbalances like high household debt and slowing investments.
Indonesia’s gross domestic product growth has weakened to below 5%, while Malaysia’s economic expansion slipped to 4.2% in the first quarter of 2016. On top of that, the plunging global crude oil price has compounded fiscal problems in oil-related economies, Malaysia included. All these have induced countries to rely heavily on monetary policy, given their already high government debt burdens arising from fiscal stimulus measures undertaken during the GFC.
Putting Pimco’s scenario into the Malaysian context, one can start to imagine how macroeconomic conditions would change in the medium term. Generally speaking, lower global growth and weaker world trade in the three to five-year horizon will mean lacklustre trade performance, which, in turn, would lower real and nominal growth for the Malaysian economy. Assuming Malaysia’s real GDP growth potential of about 5%, the new normal scenario may possibly result in a 0.5 to 1.0 percentage point (ppt) reduction in real growth in the next few years. This will bring the economy to another level where real growth comes down from 5% to 6% per annum to 4% to 5%.
Secondly, implications for nominal growth should not be ignored. In the years post-GFC, the median growth rate for Malaysia’s nominal GDP has been around 6.5% per annum (from 2011 to 2015), down from 10.2% posted prior to the GFC (between 2002 and 2008). In 2015, nominal GDP growth decelerated to 4.6%, more than 4ppts lower than the Ministry of Finance’s initial forecast done in late 2014.
Going forward, if weaker nominal GDP growth persists as a result of the new normal, then the ratios of government budget deficit, government debt, external debt and household debt to GDP will be affected, even if their absolute amounts do not change materially. Thus, budget deficits and debt growth, both at the government and household levels, have to be contained more aggressively just to achieve the same targets that the government has put in place, that is 3.1% for budget deficits and 55% for government debt.
The challenge in meeting these targets, however, comes from the fact that real growth itself is needed to sustain business and consumer confidence. Admittedly, given the pace of investments in various projects and relatively stable labour market, Malaysia will likely be able to sustain its commendable real growth of 4% to 5% in the near term. This is evidently positive for businesses and consumers. However, the government would also likely be compelled to implement selected fiscal measures to bolster the domestic economy’s resilience against headwinds in the global economy.
These measures could come in the form of income transfers, tax relief, bonuses for civil servants and so on, which would likely exert some pressure on government operating expenditure and revenue. Again, this would have some repercussions for the government’s balance sheet going forward. But again, as seen in the 2016 Budget Recalibration, the government has maintained the budget deficit target of about 3% of GDP to ensure that Malaysia’s sovereign rating is not compromised.
Therefore, to avoid exerting too much pressure on the government’s fiscal position, monetary policy measures may form a more viable alternative to support the economy. And this is logical, considering that there is still some policy space to manoeuvre within — the OPR remains well above its level during the GFC while the statutory reserve requirement level is 250 basis points above its lowest during the crisis. Hence, theoretically, more reductions can be undertaken if liquidity in the economy dries up.
Of course, one must also consider the opposing argument, which states that there are limitations to how much monetary policy can achieve. In particular, lowering interest rates may lead to undesirable outcomes like higher household debt and possibly deteriorating business sentiment due to investors’ negative perception of the economy’s strength.
However, assuming that policy response leans towards the monetary side in this new normal scenario, the thesis of new neutral would thus fit well with the Malaysian economy for the next few years. With this scenario, one can imagine that the OPR may be lower than it is at present and may remain relatively low for a few years. Bond yields may follow suit. At the same time, asset managers would have to settle for a period of lower returns.
The question now is: If such a scenario emerges, what are the implications for asset prices in Malaysia, especially housing prices, which may remain elevated if low mortgage rates were to prevail under the new neutral?
Let us ponder on this.
Nor Zahidi Alias is chief economist at Malaysian Rating Corp Bhd. The views expressed here are his own.
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