Malaysia — 2010 Budget Watch

Written by A report by Morgan Stanley
Wednesday, 14 October 2009 11:05

A gauge of policy tone
The 2010 Budget, to be released on Oct 23, will be Prime Minister (Datuk Seri) Najib Razak’s first budget announcement and should be a useful gauge of the policy tone. Malaysian equities have continued the typical trend of underperforming other emerging markets as asset markets in the developed world (S&P 500) trended up since the first quarter of 2009 (1Q09).

We believe this is likely reflective of the fact that investors are not building in high expectations for the 2010 Budget despite the reform measures Najib announced in his first 100 days in office. Indeed, recall that (Tun Abdullah Ahmad) Badawi’s term in office started off with high expectations on the back of reform rhetoric although the actual delivery subsequently fell short.

This time around, the market will likely need more convincing beyond policy rhetoric before belief in a turnaround in Malaysia’s structural story can be built. In our view, investors are likely to be watching out for three areas in the budget: (1) cyclical growth support; (2) a fiscal exit strategy; and (3) longer-term structural reforms.


Watch-factor #1: Cyclical growth support
Corporates seem to have some expectation of a third stimulus package in this upcoming budget. We think cyclical growth support from an accommodative fiscal policy will be needed as GDP (seasonally adjusted levels) remained 4.2% below the pre-crisis peak levels and as the macro recovery firms in 2010.

However, given that the economy has already emerged from recession, further stimulus measures, which by definition are aimed at providing a strong, temporary but immediate boost to the economy, are not required, in our view.

To be sure, in most Asean economies (with the exception of Thailand), policy responses are likely to wind down in 2010. Indeed, in Indonesia, the 2010 Budget recently announced shows stimulus measures being reduced from 73.3 trillion rupiah (RM26.58 billion) in 2009 to 61.2 trillion rupiah in 2010. The Singapore government is also evaluating the necessity of extending the Jobs Credit Scheme, a key part of its S$20.5 billion (RM49.92 billion) stimulus package, which will expire this year.

In Malaysia, the government announced two stimulus packages after the subprime crisis began in 2008. Whilst the first stimulus package (RM7 billion announced in November 2008) has been almost fully disbursed, only 25% of the second stimulus package (RM60 billion announced in March 2009) has been disbursed.

Government expenditure is typically back-end loaded in Malaysia, with ~60% of the current expenditure and ~70% of development expenditure disbursed in the second half of the fiscal year.

The low disbursement rate and the long-gestation nature of some measures in the second stimulus package mean that spillover into 2010 is likely, which also reduces the necessity of a third stimulus package, in our view, and provide some cyclical growth protection.


Watch-factor #2: The fiscal exit strategy
Beyond the cyclical fiscal protection to support the recovery in 2010, investors are also likely to be on the lookout for commitment by the government with regard to a fiscal exit strategy. Fitch had downgraded Malaysia’s local currency long-term debt in June 2009 from A+ to A. In our view, we think both the stock (existing level of public debt) and flow (fiscal deficit) matter for fiscal sustainability.

To begin with, Malaysia comes from a favourable starting point. From a flow (delta) perspective, government fiscal deficit (4Q trailing sum, ending 2Q09) (% of GDP) has risen to -6.5% of GDP from a low of -1.3% in 2Q06 and is expected to end 2009 at around -8% (government estimates put it at -7.6% of GDP). As a result, from a stock perspective, public debt has also risen from 43.6% of GDP to 48.6% of GDP in the same period.

This is still below the globally acceptable benchmark of 60% for public debt levels. Moreover, its public debt is mostly domestic-funded (46.5% of GDP vs 2.1% of GDP in external debt), which means funding needs are less vulnerable to foreign investor appetites.

Domestic demand liquidity conditions also look ample as foreign reserves are rising. This is why we are not overly concerned about fiscal conditions at this stage. Yet having said that, we note that aggressive fiscal expansion in 2009 has to be counterbalanced by fiscal consolidation going forward, failing which public debt ratios look set to rise further and pose fiscal sustainability concerns in the longer term.

Although the BOP’s position was weakened by capital outflows, the latest data show that this weakness has since reversed and together with the large current account surplus should ensure ample domestic liquidity for domestic debt funding. Moreover, Malaysia’s sovereign debt ratings are still several ranks above investment grade. Last, we calculate that even keeping the fiscal deficit at 10% for 2010 will keep public debt marginally below 60%, which is a globally acceptable benchmark.

A need for fiscal consolidation: The aforementioned factors are the reason why we are not overly concerned about Malaysia’s fiscal condition at this stage despite the ~-8% fiscal deficit for 2009. Yet, running persistently large fiscal deficits beyond the near-term need for cyclical fiscal protection would pose fiscal concerns over the longer term and in our view aggressive counter-cyclical fiscal response in 2009 needs to be balanced with fiscal consolidation going forward.

What level of fiscal deficit is sustainable? We calculate that a fiscal deficit of less than -4% will help keep public debt levels from rising in Malaysia. We think strict adherence to the -4% benchmark might not be necessary for 2010, but we would watch out for a clear commitment to bring fiscal deficit to below -4% in the next two years.

Fiscal consolidation can happen on two fronts: One way is through expenditure and the other is through revenue. The crux to fiscal consolidation lies in revenue momentum outpacing expenditure momentum. The current round of deficit widening has been due more to expenditure expansion than revenue reduction. Government expenditures rose from 23.4% of GDP (12-month trailing sum, % of GDP) in February 2008 to 29.3% in August 2009, primarily on the back of current expenditure.

Stimulus expenditure are relatively easy to roll back: On expenditure management, we believe the announced stimulus measures should be relatively easy to unwind as the majority of them are one-off allocations to funds, infrastructure spending, or have specific time lines, after which the measures automatically lapse.

Expenditure shifts could also raise efficiency: Expenditure streamlining by shifting away from operating expenditures towards developmental expenditures, which tend to have higher multiplier effect, and within development expenditure, from hard infrastructure spending towards soft infrastructure spending, should help enhance the efficiency of expenditures within a given amount of resources.

High dependence on commodity revenue: Expanding the government revenue base via tax and non-tax measures is another route towards fiscal deficit consolidation in the longer term. An expansion in revenue base is also likely to help correct what we see as heavy dependence of government revenue on the commodity sector. Although commodity-related primary industries constitute about 27% of GDP, commodity-related revenue constitutes a disproportionate 40% share of government revenue.

Automatic stabilising effect will mean a cyclical rise in revenue: In the near term for 2010, the automatic stabilisers (ie, progressive tax system and higher income growth) should ensure a cyclical rise in government revenue and provide some support to rein in the fiscal deficit. However, we believe that structural measures to raise government revenue, such as through the goods and services taxes, even if announced, might not be implemented until the macro recovery firms.


Watch-factor #3: Longer-term structural reforms
Reform measures and their implementation are another area to watch. Whilst commodity revenue and fiscal pump-priming have ensured growth momentum and raised hard infrastructure standards over the years, soft infrastructure in terms of policy direction and competitiveness has been neglected and the symptoms in terms of declining global manufactured export share and FDI trends are showing.

To this end, the PM has announced some reform measures such as liberalisation of the financial sector, removal of the bumiputera equity requirement rule, a switch in the teaching language medium and six National Key Results Areas with designated Key Performance Indicators in his first 100 days in office.

Some measures are positive, and others less so whilst some send mixed signals, in our view. For most of the positive measures, true execution remains the key. Critically, we believe skilled human capital is the most important aspect in helping Malaysia move up the value-added chain and stay competitive. In that regard, we would watch out for structural measures to raise education standards and labour market competitiveness and possibly a liberalised approach towards skilled foreign talent in the budget.

• Underperforming other EM markets: The S&P index has risen 54.7% since March 2009. MSCI Malaysia has risen 55.7% in the same period. However, MSCI Malaysia (US$ terms) has underperformed MSCI EM by 18.1% in the same period, continuing its typical trend of underperforming during market upturns and suggesting that investors are not building in high expectations in the lead-up to the budget announcement.

• Market trading patterns pre- and post-budget announcements: With financial markets behaving like a market of one, relative performance would provide a better gauge of Malaysia’s historical market trading patterns pre- and post-budget announcements in the past 10 years. Historically, budget announcements are typically not events that cause Malaysia equity markets to outperform EM markets.