This article first appeared in Corporate, The Edge Malaysia Weekly, on June 20 - 26, 2016.

The textbook rule for stimulating economic growth is to lower interest rates. It is not surprising then that a growing number of central banks, spooked by the worsening global economic outlook, are easing their monetary policy.

Last week, South Korea’s central bank surprised the markets by slashing its key policy rate to a record low of 1.25%. Earlier, on March 17, Indonesia’s central bank cut its reference interest rate for the third straight month to 6.75% from 7.5% at the start of the year, amid falling commodity prices and a weak rupiah. Lest it be forgotten, there is a growing number of enthusiasts in the negative interest rate club too.

With Malaysia’s growth having slowed for four consecutive quarters as at March 2016, all eyes are on Bank Negara Malaysia. At the current overnight policy rate (OPR) of 3.25%, which is slightly off the decade’s high of 3.5%, economists are of the view that Malaysia still has room to relax its monetary policy, although not all agree on when the cut should be made.

History suggests that it takes more than a blip in economic growth to reduce the interest rates. The last time Malaysia’s OPR was lowered was in response to the 2008/09 global financial crisis. For the most part of 2008, Bank Negara had maintained the OPR at 3.5%. This had much to do with rising inflation, driven by an increase in food and energy prices. Fear of negative implications and the adverse impact of long-term distortion of borrowing costs on the Malaysian economy was also a determining factor.

A cut in OPR did not occur until early 2009 when the central bank saw a severe threat of fundamental slowdown due a deterioration in global conditions. A collapse of Malaysian exports despite domestic demand holding up moved Bank Negara to cut the OPR by 150 basis points (bps) to 2% between November 2008 and February 2009. It also implemented complementary measures to ensure the transmission of the policy rate to retail lending rates.

The question now is whether economic conditions have deteriorated to a comparable level that compels an OPR cut. On the surface, a moderate 4.2% gross domestic product (GDP) growth in 1Q2016 is nowhere near the kind of recession that spurred the central bank to make the last rate cut, but there are arguments in favour of the move.

Firstly, it is the distressing state of private investment in the country, which grew a mere 2.2% in 1Q2016, as opposed to 11.7% a year ago. And the outlook is no better. According to the Department of Statistics, business performance is likely to slow down further in 2Q2016 for all sectors (construction, wholesale and retail trade, services and industry).

Bank Negara data also shows that the propensity for businesses to invest remains weak. Loan applications in April declined 6% year on year with demand for business loans slipping 15% y-o-y. A month earlier, business loan applications declined 4.9%. Compounding the slowdown in loan demand was a further decline in approvals by 17.2% in April after falling 23.4% in March. The approval rate for business loan fell 13.3% and 30.1% y-o-y in April and March respectively. Lowering the OPR, which, in turn, reduces borrowing costs, should help boost demand for loans and investment.

Then, there is the glaring weakness in Malaysia’s trade performance. A economist with Malaysian Industrial Development Finance Bhd, who expects Bank Negara to cut interest rates by 25bps at its September meeting, says slowing global trade can hurt a small open economy like Malaysia. A fall in exports can precipitate a drop in production, investment, employment and consumer spending. So, easing the monetary policy can seem timely when Malaysia’s net trade contracted 12.4% y-o-y, slicing 1.2% off the country’s GDP growth. Exports in 1Q2016, in particular, fell 8.1% quarter on quarter and 0.5% y-o-y. This is in line with subdued trade performance globally.

Global trade saw a decline in volume and value by 1.7% and 2.9% q-o-q respectively due to weak demand in 1Q2016. Asia suffered the largest drop in exports at 2.7%, with all countries except Thailand recording a decline. The expectation among world trade bodies is that global trade growth will continue to remain subdued. The World Trade Organization, in its latest forecast in April, says growth in trade volume will remain flat at 2.8%. Worryingly, Malaysia’s largest customers — China, Japan, Singapore and the US — are all struggling to sustain their economic growth.

That Malaysia’s inflation seems under control, growing at its slowest pace in 13 months in May at 2%, suggests that an interest rate cut is not unthinkable.

Still, Bank Negara has not found these developments persuasive enough to adjust the OPR. This has partly to do with the central bank’s belief that the economy will turn for the better in 2H2016.

This optimism is premised on several factors. The strengthening of prices of commodities such as crude oil and palm oil should boost trade figures while the government’s infrastructure projects will support investment growth. At the same time, domestic consumption will be supported by the implementation of direct income transfer initiatives — reduction in compulsory contributions to the Employees Provident Fund, upward revision of the civil service salary scale, a higher minimum wage and various cash handouts.

“There is a sense that a direct income transfer to the low-income group is more effective than cutting the OPR because this group is more likely to spend the additional disposable income,” says Lim Chee Sing, group chief economist and executive chairman of RHB Research Institute.

Easing the monetary policy is not without risks. Lower borrowing costs can increase disposable income and encourage spending. However, it also allows for excessive risk-taking in an economy that considers its high household debt level of 89% to GDP a macroeconomic risk. Given the volatility experienced by the ringgit since the start of the year, economists say a monetary policy change can put further downward pressure on the currency.

In fact, these risks may not be worth taking at all. The Malaysian economy is still expanding and both consumers and businesses have shown great restraint in spending. Rajiv Biswas, IHS Global Insight’s chief economist for Asia-Pacific, is mindful of the experience of other central banks like the European Central Bank and the Bank of Japan, which have seen little result after implementing monetary policy stimulus when demand was weak.

Bank Negara’s caution on reducing the OPR will be defensible as long as Malaysia’s economic growth does not underperform the central bank’s assumptions. If growth disappoints, the country may need more than a change in its monetary policy to heat up the economy. 

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.