WE started this column on Feb 3, 2014, with the intention of highlighting critical economic and capital market issues. In particular, we were concerned with short-term funds inflow to Malaysia, high household and Government debts, rising inflation and falling disposable income, stagnating private investments, weak productivity and unbalanced economic growth. Rising political, racial and religious polarization added to the gloom. We predicted 2014 would be a “wounded horse” back in February.

Without changing course, we are heading towards the storm. The weaknesses unravelled. What policy options are likely and what are the consequences?

The ringgit has fallen sharply since end August against the US dollar, to a four year low. While it is true the US dollar has strengthened against almost every currency, it is also true that the ringgit has fallen against most major currencies, even the euro and certainly the Singapore dollar. (See Charts 1 to 3)

Among the reasons for the weakening ringgit are:

1. Capital outflow as US dollar strengthens (See Charts 4 and 5)

This outflow could accelerate if foreign funds close their US dollar carry trades.

2. Current account surplus

Since 2008, Malaysia’s current account is clearly on a downtrend. (See Chart 6)

There is not enough space here to fully articulate the reasons. In summary, the causes are falling competitiveness, over spending by the public sector and the crowding out of the private sector, unbalance growth, poor ROI and low investment multiplier. (See Chart 7)

With the petroleum and natural gas sector accounting for 8% of the GDP and 28% of the revenue of the federal government, the current oil prices will severely dent both the current account and the fiscal deficit. Palm oil prices, as with most commodity prices, are also falling. The net effect is we could see the current account turning into a deficit, which has not happened since 1997.

3. Rising inflation and low nominal interest rates (See Chart 8)

Despite a large percentage of the basket of goods and services under the Consumer Price Index (CPI) are price-controlled items, the CPI is on an uptrend. Weakening of the ringgit and the introduction of the Goods and Services Tax in April 2015 will push up inflation rates substantially.  Meanwhile, nominal interest rates are likely to remain low, as a policy decision, with both the public sector and the household being heavily indebted.

The expectation of prolonged negative real interest rates will drive down the ringgit and further distort the economy. Borrowers and highly-leveraged entities are subsidised while savers are penalised, raising long-term risk and volatility.

What policy options will the government pursue if the economy slows further?

Fiscal policy options are limited without risking a de-rating of the government’s debts. Government debt to GDP is already near its self-imposed limits of 55%. And the government has been increasingly resorting to “off balance sheet” funding using guarantee debts.

Traditional monetary policy options are also limited. Lowering nominal interest rates will cause an even faster outflow of capital and risk the ringgit collapsing.

It is likely that Malaysia will also attempt the same strategy as the US and Japan, by bloating the balance sheet of the central bank (BNM). BNM then buys the bonds from banks and Employees Provident Fund (EPF). This frees the banks and EPF to go into the market and lend, stimulating investments and consumption.

Indeed, foreigners hold some RM147 billion of Malaysian Government Securities (MGS). If they withdraw, either BNM or EPF will need to step in. EPF has total assets of RM612 billion. Of this, RM265 billion is invested into equities, RM156 billion in MGS and RM156 billion in loans and bonds. It will be impossible for EPF to absorb the MGS without causing major upheavals in the capital markets.

With the lower velocity of money and a highly leveraged household, the new liquidity injection may not result in substantial consumption growth. It is likely that loosening of prudential measures on asset lending may follow.

Internalising public debts through BNM will also protect the financial institutions and the EPF from losses of its bond portfolio when interest rates eventually rise.  

This article first appeared in The Edge Malaysia Weekly, on November 24 - 30, 2014.

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