Malaysia: Staff Report for the 2013 Article IV Consultation

The IMF staff report for the 2013 Article IV Consultation focuses on Malaysia’s economic developments and policies. The IMF report discusses that continued growth in domestic demand, especially investment, and a pickup in external demand should help maintain robust growth going forward despite the fiscal tightening. Amidst concerns about Malaysia’s public finances and sharp narrowing of the external surplus in spring–summer of 2013, authorities have taken timely action to secure fiscal sustainability and assure markets. It suggests that authorities’ decisions in 2013 are close to a fiscal policy breakthrough aiming to contain federal debt and related fiscal risks.

Abstract

The IMF staff report for the 2013 Article IV Consultation focuses on Malaysia’s economic developments and policies. The IMF report discusses that continued growth in domestic demand, especially investment, and a pickup in external demand should help maintain robust growth going forward despite the fiscal tightening. Amidst concerns about Malaysia’s public finances and sharp narrowing of the external surplus in spring–summer of 2013, authorities have taken timely action to secure fiscal sustainability and assure markets. It suggests that authorities’ decisions in 2013 are close to a fiscal policy breakthrough aiming to contain federal debt and related fiscal risks.

Recent Developments, Outlook, and Risks

1. Context. General elections were held on May 5, 2013. Prime Minister Najib’s incumbent coalition won narrow election, thus ensuring smooth policy transition. Amidst a difficult external environment for Emerging Market Economies (EMEs) last spring-summer, the administration has taken actions that signal its resolve to respond decisively to domestic and external challenges. A High-Level Fiscal Policy Committee (FPC) was created to improve management of the public finances, food and fuel subsidies and electricity tariffs are being rationalized, and a Goods and Services Tax (GST) will be introduced in 2015. These measures are key steps towards rebuilding fiscal buffers lost on account of expansionary policies during the global financial crisis.

2. Economic developments. Growth slowed to 4.7 percent in 2013, compared with 5.6 percent in 2012, but remained healthy. Weak external demand, especially in the first half of the year, weighed on activity, and a small negative output gap opened up. Domestic demand remained robust, supported by healthy labor markets, accommodative financial conditions and, during the first half, expansionary fiscal policies (Figure 1). Inflation remained subdued through the spring and summer despite the introduction of a minimum wage in 2013 but picked up recently. Headline inflation rose to 3.2 percent year-on-year in December, reflecting subsidy cuts. Core inflation has also increased but is still very low, less than 2 percent in December (Figure 2).

Figure 1.
Figure 1.

Malaysia: Growth and Exports

Citation: IMF Staff Country Reports 2014, 080; 10.5089/9781475557404.002.A001

Figure 2.
Figure 2.

Malaysia: Inflation and Domestic Resource Constraints

Citation: IMF Staff Country Reports 2014, 080; 10.5089/9781475557404.002.A001

A01ufig01

Inflation Rates

(In percentage change)

Citation: IMF Staff Country Reports 2014, 080; 10.5089/9781475557404.002.A001

Sources: Haver Analytics; and IMF staff calculations.

3. Financial Market Developments. Like many other EMEs, Malaysia has been experiencing capital outflows during periods of market turbulence, including spring-summer and early this year. Between end-May and end-2013, the yield curve for Malaysian Government Securities (MGS) has steepened: 10-year yields have increased by 70 bps, and the spread against the U.S. dollar has widened by about 20 bps. During summer turbulence, the ringgit weakened by about 11 percent against the dollar (peak-to-trough) and after a brief period of strengthening is now back below the September trough. Deep financial markets and a flexible exchange rate have helped facilitate financial adjustment, and the economy has been able to absorb the shocks without appreciable harm to date.

A01ufig02

Domestic Government Securities and US Treasury Yields

(In percent, 10-year bonds)

Citation: IMF Staff Country Reports 2014, 080; 10.5089/9781475557404.002.A001

Source: Bloomberg LP.

4. Outlook. Growth is projected to accelerate to 5.0 percent in 2014. Consumption and investment growth are expected to moderate somewhat but should generally hold up amidst conditions of full employment and the long pipeline of large, multiyear investment projects. In addition, the pickup of export growth since the second half of 2013 should be sustained as the global economy continues to improve, and offset headwinds from fiscal consolidation (a fiscal impulse of about minus 1 percent of GDP in 2014, although staff views the fiscal multipliers as low). Over the medium term, growth is expected to average 5 percent, reflecting higher investment, including infrastructure upgrades, which should help boost productivity. The gradual removal of subsidies is expected to result in a modest increase in inflation during 2014. Second round price effects are, however, expected to be limited in light of the low initial level of inflation, and BNM’s considerable monetary policy credibility. Inflation will likely reach about 4.0 percent in 2015 following the introduction of GST, but in staff’s baseline scenario, is expected to gradually moderate to below 3.0 percent in the medium term.

5. Risks. The risks to the staff’s baseline scenario are primarily on the downside and stem from both external and domestic sources (Appendix 2).

  • External risks. A key risk is a potentially bumpy exit from unconventional monetary policies (UMP) in advanced economies (AEs), which could trigger bouts of financial market turbulence and dampen external demand. With foreign investors still holding sizeable positions in the domestic bond and equity markets, Malaysia is vulnerable to capital outflows during periods of heightened global financial stress, as evidenced during spring-summer 2013. Other risks include a further slowdown in China, a protracted period of slow growth in Europe, and commodity price shocks.

  • Domestic risks. The relatively high level of federal debt (close to the government’s self-imposed ceiling of 55 percent of GDP) and large contingent federal liabilities limit the room for countercyclical fiscal policy. And while recent fiscal actions are welcomed, there remain implementation risks associated with these comprehensive reforms. In particular, setbacks in the implementation of fiscal reforms could undermine investor sentiments and trigger outflows from the bond market and a jump in yields which, in the context of the government’s high financing needs, could have a significant macro-fiscal impact. In staff’s view, however, implementation risks are low—the authorities have demonstrated the political will and possess the technical expertise to carry reforms out. In addition, high house prices, rising household debt, and banks’ large exposure to real estate remain a concern, particularly in light of UMP unwinding and a likely tightening in domestic financial conditions and higher interest rates. Other domestic risks include a higher and more persistent increase in inflation and inflation expectations, triggered by higher fuel and electricity prices as subsidies are being rationalized. Adjustments in fuel prices are expected to add about 0.5 percentage point to annual inflation in 2014–15, while the GST could add about 0.9 percentage point in 2015. The low starting level of inflation and the substantial policy credibility of the monetary authorities, circumscribe, in staff’s view, the risk of second round effects.

6. Policy advice. The authorities are taking decisive and proactive steps to reinforce Malaysia’s macroeconomic and structural policies (Appendix 1). While specific measures are consistent with Fund policy advice, they are home grown and driven by the authorities’ own multiyear adjustment and reform programs. Specifically, the authorities took action to strengthen Malaysia’s public finances during the second half of 2013. These measures are framed in the context of a medium term fiscal adjustment program and are consistent with past Fund technical assistance and staff policy advice. The authorities are carefully monitoring financial sector risks and are implementing additional macro prudential measures; they are also in the process of strengthening their information base through the collection of granular data on household assets and liabilities. The authorities are allowing two-way exchange rate flexibility. They are also implementing wide ranging structural reforms, and their specific programs benefit from extensive technical and policy support from the IMF and other international organizations.

7. Authorities’ views. The authorities were in broad agreement with staff’s assessment of the economic outlook and balance of risks.

  • They anticipate growth to increase in 2014 with the improvement in the external environment, although the fiscal consolidation can be expected to be a drag on growth. Private investment growth should remain robust at about 13 percent but some moderation in private consumption growth is likely.

  • The authorities also see the main risks to the outlook are being primarily on the downside and they highlighted risks from external sources, with a slowdown in global growth a key concern. In addition, uncertainty surrounding the unwinding of UMPs and the potential for policy missteps along the way and heightened volatility are also key risks for Malaysia.

  • On the domestic front, the authorities reiterated their commitment to steadfast implementation of fiscal reforms. The authorities acknowledged the risk of spillover to prices of other nonfuel goods and services from subsidy rationalization, which will raise headline inflation (albeit from low starting levels). They assess the risk of second-round effect at this point to be limited.

  • The authorities are less concerned with risks to financial stability from high household debt and house prices. They pointed to the large cushions provided by high levels of household financial assets, healthy labor markets and low risk of unemployment. In addition, mortgage interest rates are largely tied to the policy rate (indirectly through the base lending rate), which has been relatively stable and makes sudden increases unlikely. Lastly, the authorities’ targeted and phased approach to macroprudential policies, along with efforts to increase financial literacy, has curtailed risks.

Near-term Economic Policies: Achieving a Smooth Transition

8. Policy mix. The authorities’ policy mix is appropriate in the present conjuncture, in which Malaysia’s priority is to address fiscal vulnerabilities against a backdrop of low inflation, and an improving external environment that is nevertheless still subject to large uncertainties and potential capital flow volatility. The decisive, yet gradual tightening of fiscal policy should help Malaysia maintain market access at low funding costs while avoiding undue damage to economic growth or igniting higher inflation. The slightly accommodative monetary policy stance has been appropriately supportive of growth in the context of low inflation, a small negative output gap and, until mid-May 2013, strong capital inflows. Going forward, however, monetary policy may need to be recalibrated as UMPs unwind and if inflation risks rise. The tightening of macroprudential policies to date appears to have helped to address potential financial stability risks, but continued monitoring is appropriate and additional measures may be needed.

9. Fiscal policy. Following the market turmoil in spring-summer, the federal government recalibrated fiscal policy in September-October and is on track to reach its fiscal deficit target of 4.0 percent of GDP in 2013.1 According to staff projections, fiscal adjustment in 2013 was significant (about 1 percent of GDP), driven by higher income taxes and lower development spending. Current spending, which has increased considerably in recent years, driven by wages and subsidies, was higher than budgeted in 2013 but is expected to remain stable relative to GDP. In particular, spending on subsidies, which increased by 0.6 percentage points of GDP in 2012, is expected to remain elevated in 2013 and would have been higher in the absence of the fuel price adjustments implemented in September. The 2014 federal deficit target of 3.5 percent of GDP seems feasible if, as assumed in the staff’s baseline projection, growth in current spending is contained within a tight envelope and fuel prices are increased further during the year (Figure 4). Oil revenues are projected to decline by 0.5 percent of GDP, in line with a projected decline in international oil prices. Under the staff’s baseline projection, fiscal adjustment in 2014 will be driven by subsidies (about 1 percent of GDP), the wage bill, while development spending as percent of GDP will also slow down.23 The fiscal impulse (based on staff’s definition of fiscal balance) is about minus 1 percentage point of GDP. 4 Its impact on growth is expected to be relatively small, given that a significant share of the adjustment comes from subsidy rationalization, whose fiscal multipliers are low. The public sector deficit has widened in recent years, reaching 5 percent of GDP in 2012, and is expected to be about 6½ percent of GDP during 2013–2014. The increase in the public sector deficit was driven in part by higher development spending by Nonfinancial Public Enterprises (NFPEs), which has offset the decline in development spending at the federal government level. Fiscal impulse at the broader public sector level was positive in 2013 but is expected to turn negative in 2014.

Figure 4.
Figure 4.

Malaysia: Fiscal Policy Developments

Citation: IMF Staff Country Reports 2014, 080; 10.5089/9781475557404.002.A001

A01ufig03

Fiscal Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 080; 10.5089/9781475557404.002.A001

Sources: Malaysian authorities; and IMF staff estimates.
A01ufig04

Development Spending

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 080; 10.5089/9781475557404.002.A001

Sources: Malaysian authorities; and IMF staff estimates.

10. Monetary policy. Bank Negara Malaysia (BNM) has kept its policy rate unchanged at 3 percent since May 2011 (Figure 3). This policy stance, reflecting BNM’s dual mandate of ensuring medium-term price stability and sustainable growth, kept real interest rates low and supported growth, against a backdrop of uncertain global growth prospects and low domestic inflation rates. Looking ahead, staff expects BNM to begin a gradual tightening cycle. The gradualist approach is warranted by the unusual degree of uncertainty around the external environment and is also consistent with the need to safeguard domestic financial stability in an environment of high household debt. Furthermore, while inflationary expectations are well anchored at present, the succession of price increases stemming from subsidy rationalization and the introduction of the GST could lead to a pickup in inflation expectations. BNM’s task in the near term is to allow pass-through of cost-related increases in prices (cost-push inflation) while detecting and preempting, in a timely and decisive fashion, any second round effects from becoming embedded in the wage-price structure.

Figure 3.
Figure 3.

Malaysia: Monetary Developments

Citation: IMF Staff Country Reports 2014, 080; 10.5089/9781475557404.002.A001

A01ufig05

Malaysia: Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2014, 080; 10.5089/9781475557404.002.A001

Sources: CEIC Data Co. Ltd.

11. Macroprudential policies (MAPs). BNM’s current monetary policy stance is supported by macroprudential policies to curtail financial stability risks from rapid increases in household debt and house prices (see Box 3). Household debt reached 83 percent of GDP at end-September 2013, up from 55 percent five years earlier. Over half of the debt is on residential property, of which nearly 70 percent is contracted at variable rates tied to the Base Lending Rate (BLR), although lending rates have fallen recently even as the BLR has remained unchanged. Starting in November 2010 and continuing, most recently, with the 2014 budget in October 2013, the authorities have imposed a series of targeted, gradual, and escalating MAPs, which have been mainly directed at speculative purchases of homes and unsecured credit (see Table 8). The 2014 budget also addressed affordability issues through special financing schemes and measures to raise the supply of affordable housing.5 There are early signs that the more recent measures have slowed down the approval of new loans and begun to cool the housing market; however, some inertia in loan growth due to drawdowns of loans already committed can be expected. Should credit growth remain strong, additional MAPs should be introduced, and their scope and stringency should depend on the evolving stance of monetary policy, and they should be carefully designed to ensure effectiveness and avoid circumvention. Options for additional macroprudential measures include capping loan-to-value ratios (LTV) on second and first mortgages, explicit limits on debt service-to-income ratios, or additional capital charges on high LTV loans.

Table 1.

Malaysia: Selected Economic and Financial Indicators, 2009–14

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Sources: CEIC; Data provided by the authorities; and Fund staff estimates.

Based on staff’s estimate of the federal government fiscal balance using GFSM 2001, which differs from the authorities’ cash-based measure of the fiscal deficit.

Capital expenditure in the budget includes foreign fixed assets and other items, such as purchase of shares and land, which are excluded from public investment in the national accounts.

By remaining maturity.

Table 2.

Malaysia: Indicators of External Vulnerability, 2008–12

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Sources: Haver Analytics; data provided by the authorities; and Fund staff estimates.

Gross debt.

Discount rate on 3-month treasury bills.

Table 3.

Malaysia: Balance of Payments, 2009–14

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Sources: Data provided by the authorities; and Fund staff estimates.

By remaining maturity.

Table 4.

Malaysia: Illustrative Medium-Term Economic Framework, 2009–18 1/

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Sources: Data provided by the authorities; and Fund staff estimates.

Period ending December 31.

Capital expenditure in the budget includes foreign fixed assets and other items, such as purchases of shares and land, which are excluded from public investment in the national accounts.

By remaining maturity.

Table 5.

Malaysia: Summary of Federal Government Operations and Stock Positions, 2009–14

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Sources: Data provided by the Malaysian authorities; and Fund staff estimates.

Authorities’ measure of the overall fiscal balance and the IMF’s measure of fiscal balance (net lending/borrowing) are different due to differences in methodology/basis of recording (GFSM2001 versus authorities’ modified-cash based accounting) and differences in the treatment of certain items.

General government includes federal government, state and local governments and statutory bodies. Public sector includes general government and NFPEs.

Table 6.

Malaysia: Monetary Survey, 2009–13

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Sources: IMF, International Financial Statistics; and Bank Negara Malaysia.
Table 7.

Malaysia: Banks’; Financial Soundness Indicators, 2009–13

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Sources: CEIC Data Co. Ltd.; and IMF, Financial Soundness Indicators database.

Loans are classified as nonperforming if payments are overdue for three months or more. Total loans include housing loans sold to Cagamas Berhad. Net NPL exclude interest-in-suspense and specific provisions.

Deposits include repos and negotiable instruments of deposit. Loans exclude loans sold to Cagamas Berhad.