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Global Economic Outlook
Malaysia: 2011 Outlook
By Michael Manetta
- We have revised up our 2011 growth forecast and see consumption and investment poised to fill the demand gap left by weaker manufacturing exports in Q1.
- While sudden capital flight remains a risk, Malaysia’s financial vulnerabilities have moderated as firms and banks have deleveraged balance sheets away from external debt.
- Bank Negara Malaysia will resume interest rate normalization in Q2 2011 as both domestic and external demand pull the output gap into positive territory, stoking inflationary pressure.
Growth Dynamics: A Secular Rebalancing Toward Domestic Demand
Malaysia’s recovery from the 2008-09 recession turned decidedly square-root-shaped in 2010, with growth averaging a seasonally adjusted annualized rate (SAAR) of just 3.7% YTD through Q3, compared to 11.4% SAAR from Q2 to Q4 2009. By Q1 2010, the domestic inventory restocking cycle had largely run its course (though it continued to make positive y/y contributions to growth through Q3), as had the government’s stimulus package. In their absence, 2010 growth has been supported by private domestic consumption and investment expenditure, a dynamic that also has spurred imports and led to a negative net export contribution to growth. In 2011, we expect Malaysia’s real GDP growth rate to fall slightly below its 2003-07 average of 6.0% y/y, with the level of real output remaining below that which would have been reached had 2003-07 conditions persisted thereafter. Given high base effects and modest external demand, GDP growth will moderate to 4.9% y/y in H1 before accelerating to 6.2% in H2.
Figure 1: GDP Set to Return to Precrisis Growth Rates at a Lower Output Level (seasonally adjusted)
Source: Bank Negara Malaysia, RGE estimates, RGE forecasts
On the expenditure side, private consumption will drive y/y final demand growth in Q4 2010 and H1 2011. Government spending for FY2011 is back-loaded, and external demand remains likely to stay subdued until H2, given China’s plan to tighten monetary policy in late 2010/early 2011. Domestic demand remains healthy, with employment up 1.5% y/y in Q3 alone, including growth of more than 5% y/y in manufacturing employment despite that sector’s Q3 slowdown. Accordingly, recent consumer sentiment surveys point to extended optimism from the household sector, which bodes well for consumption.
Investment will also play a supporting role in the 2011 growth story. Government efforts to encourage private investment, particularly policies to facilitate foreign participation in the corporate sector, have already improved the nation’s ranking in annual ease-of-doing-business surveys. In addition, the number of applications for banking loans for capital purchases accelerated in H2 2010, suggesting a pickup in domestic investment demand despite three central bank rate hikes through July. Still, the pace of loan applications slowed heading into Q4, corroborating evidence of a drop in business sentiment in Q3 that may signal an impending pause in new capital investment. Indeed, we forecast sequential investment contractions in Q4 2010 and Q1 2011, due in part to a seasonal correction as well as hesitancy among Malaysian managers to expand capacity given a less certain external environment.
This is particularly true for the electronics and electrical products (E&E) industry, Malaysia’s largest manufacturing subsector, which has seen its global competitiveness steadily erode over the past 10 years. A pickup in U.S. consumer spending, spurred by the extension of the Bush tax cuts and a payroll tax reduction, may provide temporary support for E&E exports next year. However, commodity-related exports—including palm oil, liquefied natural gas (LNG), crude petroleum and petrochemicals—have risen in prominence and will likely be the main driver of export revenue growth in 2011 after milder external demand leads to a y/y export contraction in Q1.
Figure 2: E&E Exports to Continue the Secular Decline That Began Prior to 2008
As a result of this secular decline in E&E competitiveness, we see manufacturing contributing about half as much to y/y GDP growth in 2011 (averaging 1.1 percentage point per quarter) as in the precrisis boom (2 percentage points on average from 2003-07). Most of this contribution will come in H2 2011, after producers pare down inventories in H1. Meanwhile, service industries—including restaurants, hospitality, finance and business services and transportation—will continue to be major contributors to Malaysia’s growth, as they were precrisis, by catering to domestic demand.
Risks: A Once-Bleak External Environment Belies Potential Upsides
Downside risks remain rooted in weak demand from the G3, which still directly accounts for some 30% of gross export revenues. However, RGE’s revised U.S. forecast indicates that the chance of a severe contraction in external demand is much more remote than what we foresaw in September. Capital flow volatility remains the more potent risk, particularly in an era of EU periphery debt concerns. Though traded asset values would take a substantial hit if global capital were to seek safe havens, Malaysian firms would be unlikely to face severe capital constraints akin to late 2008 and early 2009. The Malaysian private sector has reduced outstanding external debt levels while drawing more on domestic savings channeled through the banking system, in which short-term external liabilities remain below precrisis peaks (though they have been trending higher).
Figure 3: Real Private Sector and Banking Sector Outstanding External Debt
Source: Bank Negara Malaysia
Upside risks in 2011 are most likely to come from commodities, led by palm oil and LNG. Growth in India and China is likely to push demand for palm oil considerably higher, while regional demand for LNG should also remain elevated. Recently announced tax incentives may also boost exploration of crude petroleum, although the impact is more likely to be felt several years out.
Policy Implications: Further Reforms Needed to Boost Private Investment
The government’s oil exploration tax incentive is among several policies that Prime Minister Najib Razak’s administration is pushing to boost private investment. The 2011 budget, which forecasts a slight reduction in the fiscal deficit to 5.4% of GDP (from 5.6% in 2010), earmarks about 6% of expenditure for infrastructure projects while also channeling funds into so-called “entry point projects” that the government hopes will ultimately “crowd in” private sector funds. Critics accuse the government of favoring these big ticket projects while ignoring critical structural issues, such as the need to reform the country’s outdated affirmative action policies that favor ethnic Malays and regulations on foreign investment in the services sector. Yet Najib has taken some piecemeal steps, such as liberalizing financial services ownership laws as well as rules governing M&A, which have helped fuel consolidation in Malaysia’s often fragmented industries. To enhance medium-term growth prospects, implementing tax reform (which has been postponed repeatedly), streamlining property registration procedures, privatizing certain government-linked companies (GLCs) and eventually addressing affirmative action should remain top priorities.
On the monetary front, we expect Bank Negara Malaysia (BNM) to resume normalization toward precrisis nominal overnight rates of 3.5% beginning in late Q1 2011. To keep the real policy rate above 1%, BNM will likely hike three times in 2011—in March, May and July, each time by 25 basis points—as credit expansion, marginal food and fuel subsidy cuts and higher global food prices push inflation to 2.6% for the year. BNM has already begun addressing the rise in home prices by lowering loan-to-value ratios on third mortgages, a move aimed at speculative purchasers. Thus far, BNM has shied away from hinting at capital controls, though the central bank governor, Zeti Akhtar Aziz, has suggested that the central bank’s foreign reserves will be used to smooth volatility in currency markets through partially sterilized FX interventions.