My Say: Managing headwinds and leakages

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


If the Malaysian economy were a ship, it is right now caught in a storm, battered by powerful headwinds and walls of water and the hull is beginning to take water because there are leakages. This provides the context for Budget 2016.

In the scheme of things, the annual budget of the federal government is just one of the many short-term policy tools that can influence the economy, but it is important because it signals the immediate and longer-term steps that are being taken to address the structural weaknesses of the economy and the external headwinds it faces. The budget partly captures the thinking and priorities in managing the economy.

China, after three decades of unbridled growth, the scale of which is unprecedented in global economic history, is slowing down and the Chinese are figuring out how to manage the rather normal growth rate.

Though the US economy has been showing strong signs of recovery, American consumers are still not where they were before the 2008/09 global financial crisis (GFC), when the world economy was churned by China’s production and American consumption saw world trade grow spectacularly.

Emerging economies, even BRICS, grew, fuelled essentially by the demand for commodities. While China is a manufacturing economy, major emerging economies, such as Brazil and Russia, and countries like Indonesia, Malaysia and Australia rode the commodity boom that started around 2001.

The bursting of the financial bubble that started in the US saw American consumers, overdosed on credit, retreating to repair their balance sheets. This contraction in demand, in turn, saw the Chinese slow down investments in new capacity, which then dampened global demand for commodities and pushed prices down after over a decade-long bull run. China’s switching to domestic sources of growth as a result of a slowdown in trade saw the country consume quite a bit of what it produced, slowing trade even further.

The reasoning is clear and it has been anticipated for some time now. The massive quantitative easing implemented in the aftermath of GFC has to be reversed. The extremely loose monetary policy has to be tightened. When that happens, liquidity will flow back to developed economies, weakening currencies and deflating asset prices in emerging economies that had benefited from the inflows earlier, feeding their appetite for credit and inflating asset prices.

Thus, the headwinds faced by the Malaysian economy are many and they are converging. Falling commodity prices, from oil and gas to palm oil, have affected the profitability of companies and their valuations, thereby affecting tax revenue and asset prices. The Federal Treasury still depends heavily on revenue from the oil and gas sector generally and from Petronas in particular.

Investments, which were primarily driven by the oil and gas sector, have dried up. Malaysia’s trade, which has been more resource-based than manufacturing-based, has also been affected and the economy has largely become domesticated — a small, open economy increasingly reliant on domestic sources for growth.

Beyond these external headwinds are issues such as the credibility of the government in managing its finances — its inability to effect fiscal discipline for almost two decades now. Malaysian fiscal policy literally rode the global commodity boom — it remained pro-cyclical from 1998, obsessed, as it were, with the need to attain growth targets instead of using the budget as a tool to affect relative prices and therefore as an incentive to achieve policy goals. Of course, there is the perception of budgets as “projects” and there is reason to believe that these projects are not achieving the purposes of fiscal policy.

Research has shown that government fiscal multipliers are getting smaller and that their effects dissipate quite quickly. Fiscal spending is also more meaningful — higher multiplier effects — when done counter-cyclically. Much of Malaysia’s fiscal policy is, however, pro-cyclical and it has been too much about spending. One suspects that too many of these projects are laden with excesses without really building new productive capacity for the economy or improving its technical efficiency. This explains the shrinking fiscal multipliers and is confirmed by the fact that there is quick dissipation of fiscal effects.

If one were to plot the GDP growth trajectory in the following three periods — 1988-1997, 1998-2007 and 2008-2015 — one can see three declining trend lines, which are suggestive of an economy losing steam. The average growth rate declined during these three successive periods. This was despite continuous pump-priming since 1998 and the economy benefiting — until very recently — from an unprecedented commodity bull run. The lesson is clear: the budget as a fiscal tool needs to be seen and used in a different light. Evidently, the way it is being used now has reached the point of diminishing returns. It would, therefore, be folly to do more of the same.

It is the issue of credibility in fiscal management that has accentuated the weakening of the ringgit. Yes, the currencies of major commodity-exporting economies have depreciated in value but the ringgit has also suffered from concerns about fiscal management — a credibility discount of sorts.

The implementation of the Goods and Services Tax, a necessary step to not only broaden the government’s tax base but also to formalise the economy, was poorly communicated and executed. Taxation will never be publicly lauded but it can be better explained or perhaps better received if there were greater credibility in fiscal management.

The government would do well if it admitted that the economic fundamentals, while still good, have deteriorated. The fiscal deficits are stubborn, thereby contributing to an accumulation of public debt, which will likely see higher debt servicing costs. The current account surplus is now razor thin and net trade has not been contributing much to growth.

The budget should therefore strive to impose fiscal discipline that would entail a total re-examination of existing projects and planned major spending, some prioritisation and possibly the delay of some projects. An admission of reality and a serious commitment to impose discipline will go a long way towards building credibility.

The exercise of fiscal policy is not just about achieving growth targets, which has been the case for many years now. Growth has slowed but growth is not what is important now. What is required right now is a display of fiscal discipline and the establishment of credibility. It must be understood that without fiscal discipline, there will be no fiscal flexibility in the future and the annual budgets of the future will be just plans to pay already committed expenses.

Finally, completeness and honesty demand the mention of the integrity overhang of the government. More than anything else, it is this integrity of public institutions that is important in the short term as well as the longer term. This integrity is at the heart of confidence — of owners of capital, in the pricing of risks and generally determines transaction costs, and thereby the efficiency, of the economy.

The capital market will exact a high price for government borrowings and the cost of servicing its substantial debts. Failure to address this integrity issue swiftly — it has dragged on for too long — suggests a systemic failure of institutions in the country. That would be a fatal blow to the economic prospects of the country.

The credibility and integrity gaps are more damaging than the external headwinds. Such headwinds will abate and a new normal will emerge, whatever it is. How well the economy can be managed during the storm and what can be done afterwards depend crucially on institutional strength, which rests on capability and integrity. Quite a bit of credibility and integrity is based on perception but most of it is based on actions.

Dr Nungsari A Radhi is an economist and managing director of Prokhas Sdn Bhd, a Ministry of Finance advisory company. The views expressed here are his own.