This article first appeared in Forum, The Edge Malaysia Weekly on January 31, 2022 - February 6, 2022

Malaysia faces a period of delicate transition towards recovery in 2022. Although we do not see the high growth scenario forecast by Bank Negara Malaysia or international agencies like the World Bank and the Asian Development Bank, we do see the possibility of a return to modest growth during the year.

We also do not see a risk of high inflation as predicted by many commentators. On the contrary, we believe that inflation will continue to moderate and must be kept low using price controls to support economic recovery rather than tighter fiscal and monetary policy, which will damage growth.

As we have recently argued, controlling inflation is an essential precondition to a solid recovery phase. Although we expect price pressure to ease gradually as supply constraints ease, the addition of utility bill subsidies such as those we saw last year can push inflation down to 1.5%-1.6% immediately in January. Inflation could then remain below 1.5% until June, fluctuating around 2% for the remaining part of the year. Overall, 2022 inflation would be close to 2% by the end of the year.

This low inflation scenario is a precondition for a solid recovery and is essential to support consumer purchasing power and to allow the low interest rate environment to remain in place to support new investment.

If economic policy in 2022 is successful in relaunching the economy, we forecast economic growth could be around 3.5% for the year. The momentum can build through 2023, when we see the economy reaching full speed potential.

However, even in this positive event, we expect underlying potential growth to be lower due to the structural damage caused by two years of lockdowns and recession. We estimate that underlying potential growth will fall to around 4.25%, compared to 4.75% in the pre-crisis period.

This is the tangible structural cost left over from the crisis. The loss of growth potential has to be added to the lost income in the last two years. We estimate that something around 15.4% of potential gross domestic product (GDP) has been lost since pre-crisis levels.

The fall in Malaysia’s underlying growth potential is due to the impact of the Covid-19 lockdown policies on business activity, which has caused many businesses to close permanently. It is also affected by the massive contraction in investment during the crisis, continuing the negative trend already in place for some years. The reduction in potential growth after a major economic shock is not new for Malaysia and happened after the 1997/98 Asian financial crisis as well as after the global financial crisis of 2008/09.

Lower potential growth will create a structural mismatch in the labour market because the working population and labour force will keep increasing at the same rate as before the crisis, while the rate of job creation will be constrained by the lower growth. This will cause structural unemployment and underemployment, which will be further complicated by the ongoing process of automation, which is a new problem that Malaysia has to tackle urgently.

In our view, Malaysia has to rely mainly on domestic demand from consumption and investment in order to achieve stable growth during 2022. While net external demand is often seen as the external locomotive relaunching the Malaysian economy, we cannot expect such a strong external push this time due to the slowdown in growth and inflationary risks emerging in the US, Europe and China.

Furthermore, the international scenario is exposed to two big uncertainties. First, the geopolitical situation poses serious risks of instability and second, there is a considerable risk of a severe financial contraction due to counter-inflationary policies in developed economies.

In Malaysia, consumption is likely to move faster and create more growth this year than investment. We expect consumption to increase 5.8% in 2022, compared to basically zero growth in investment.

Consumption will rise as the economy begins to reopen fully but this may be limited and transitory. A solid and systematic increase in disposable income will also be necessary but will not in itself be sufficient for a robust recovery in consumption if there is an increase in the savings rate to rebuild depleted wealth due to Employees Provident Fund (EPF) withdrawals or to pay down debt.

Since employment and real wages are the two main drivers of disposable income, these too must be a focus of concern. Employment is expected to increase in the recovery phase but this increase will be modest. During the latest recessionary periods of 2020 and 2021, there was a considerable increase in unemployment but a greater shift to part-time employment and underemployment in the labour market.

Real wages can only increase through an immediate reduction in inflation below the growth in wages. Wage growth will only be possible if there is an increase in productivity, which is unlikely to be very consistent given the shift to low-value adding forms of work. Reducing inflation immediately through price controls and the electricity discount, for example, will raise real wages more quickly and support the recovery of consumption.

This, in turn, will stimulate sales and profits, especially in the wholesale and retail sectors, which have been hit hard during the crisis. In an environment of expansion, this will cause inventories to rebound and later an increase in private investment, which will become more robust and systematic in the second half of the year. Investment will also play a key role in catching up with the Fourth Industrial Revolution (IR4.0) agenda, which is necessary to innovate and incorporate new technologies to boost economic development.

Investment will gradually pick up but may only grow to around 5% by 2023. The gradual recovery in investment takes time and will pass through two phases. First, in 2022, the investment to GDP ratio will stabilise after the great setback of the crisis and second, the ratio will start to slowly grow again in 2023. In our view, this is the main indicator to target for a robust and solid new season of growth ahead.

So, price stability first, followed by an increase in the investment to GDP ratio are the most important elements to change the overall macroeconomic scenario in Malaysia into a new cycle of growth.

Taking everything together, we see 2022 as a year of transition towards a robust growth path if price stability can be achieved through price controls coordinated with an accommodating monetary policy. Overstating the inflation risk may lead to higher interest rates, which would be disastrous at this nascent stage of the recovery cycle.

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