Malaysia hopes Ninth Five Year Plan will insulate it from global downturn

Institutional Investor – Malaysia special report, March 2008

Malaysia, like all major Asian countries, faces a vital question in 2008. Today, business is booming. But will it stay this way with a US slowdown?

“There are two points of view on the extent to which the US slowdown will affect Asian economies,” says Sanjeev Nanavati, chief executive officer for Citi in Malaysia. “One believes that regardless of whether the slowdown is strong or not, Asia would be relatively unaffected. The other says Asia cannot escape unscathed from what happens in the US.” For its part, Citi believes there will be a knock-on effect from a US slowdown, with a lag effect, but not a crippling one.

Within that broader framework, though, there are several things distinctive to Malaysia. The positive view is that domestic demand will insulate Malaysia from external shocks. It is true that exports are highly important in Malaysia; it is a big component of GDP and the US accounts for 15% of the value of Malaysian exports, according to Citi. But the advantage the government has is being able to launch grand national projects that should become a domestic spur to growth in order to counteract any drop in exports. “Obviously the companies that are affected by slowing exports aren’t the ones who are going to benefit at a domestic level, but at a macro level one should offset the other,” says Nanavati. On balance, he says, Malaysia should come out with a more than healthy 6% GDP growth rate.

At the heart of this theory is the Ninth Malaysian Plan. This vast plan, governing spending and national direction between 2006 and 2010, envisions RM220 billion of spending over that period, including RM20 billion of private finance initiatives.

While the effects of such pump-priming should be immense on the national economy, there hasn’t yet been much physical development. “There have been some projects announced, and some money is flowing, but the full effects have not yet been felt,” says Nanavati. But in the circumstances, that’s not a bad thing. “While some people look at that as a mild criticism, the flip side is that there are all these projects yet to be funded which the government can fast track to offset the effects of a slowdown.” So if the US economy starts to bite Malaysian exports, the government can speed up some projects, start awarding contracts and dispersing money, and watch the economy start to grow, starting with the construction sector.

At Goldman Sachs, Michael Buchanan, the chief Asia ex-Japan economist and co-head of pan-Asian economic research, observes similar themes, but with a slightly less positive overall effect. “The 9^th Malaysian plan is, if not fully coming to fruition, at least accelerating after a slow start, which is often the case with these things,” he says. “It’s due to come on at a good time, because Malaysia is one of the countries most sensitive to a US slowdown.” He sees this vulnerability both in terms of the export mix in commodities and manufactured goods, and also because of Goldman’s own quantitative studies. The Goldman view is of 5.2% GDP growth in 2008 and 5.6% for 2009, below consensus forecasts of 5.6% and 5.9% respectively.

The stock markets are proving to be reasonably resilient. By February 21, whereas the US S&P 500 index was down 8.7% year to date, Europe’s DJ Stoxx 50 down 13.1% and Hong Kong’s Hang Seng index down 15.2%, The Kuala Lumpur Composite had fallen only 2.1%. Of 35 major markets worldwide tracked by Reuters and printed daily in the Asian Wall Street Journal, only Pakistan has done better.

“Our market is holding up quite well,” says Dato’ Yusli Mohamed Yusoff, chief executive officer of Bursa Malaysia. “I believe that is down to the fundamentals of our market. Investors are seeing us as a safe haven at the moment, given that all of our companies are involved in industries which are quite solid prospects.”

Indeed, many of Malaysia’s leading companies are in sectors which look well-placed. See the box below for the plantation and palm oil sector; on top of that, Malaysia has oil and gas companies, well positioned for expected continuing strength in oil prices; and its banking system is robust, apparently untouched by sub-prime problems. “The Malaysian economy generally is still performing quite well,” Yusoff says. “Consumer spending is still quite strong, so if you look at any of our companies and the results they have been announcing it gives you a lot of confidence.”

Nanavati agrees that Malaysia has defensive characteristics. “It it still seen as a safe haven in a sea of volatility,” he says. “So there is money still flowing in here. People may not have made as much money here in the past as they have made in other markets, but the corollary is that they have not lost as much, or are not likely to lose as much. The risk return isn’t as severe, either on the upside or the downside.” So, if Asian markets are to follow a downward trend this year, “the feeling is the market may slide but it’s not likely to slide as much.”

Supporting that too is the strengthening Malaysian ringgit. “In dollar terms you have the currency buffer playing in your favour,” says Nanavati. Goldman has been forecasting substantial appreciation of the ringgit since last September, on the basis that inflationary pressure from global commodity prices and last year’s wage hikes, coupled with solid domestic demand and the fact that some traders use the ringgit as a proxy trade for Chinese yuan appreciation, would all lead to continuing inflows and a gradual acceptance of a strong currency from the authorities. While the ringgit has now gone through Goldman’s immediate forecasts, and a weakening in global risk appetite might offset the impact of further US rate cuts on the currency, Buchanan believes the underlying story for further strength in the ringgit remains strong, and will be supported by domestic demand and faster yuan appreciation.

Bursa Malaysia is in itself a very clear demonstration of the momentum in Malaysian financial markets. The average daily trading value (between on-market and direct business) in the Malaysian equity markets in 2006 was RM1.2 billion; in 2007 it was RM2.3 billion. Derivatives contracts grew by 50%. Nobody’s expecting things to be easy if world markets struggle. “As a market we find that sentiment will be affected quite significantly by what happens in other markets,” Yusoff says. “But for the first month [of 2008], volumes were not too bad. We are averaging more than RM2.5 billion a day, and that’s on the back of continuing interest from foreign investors.”

That, in turn, reflects an increasing willingness of foreign investors to engage with a market which, once known for its capital controls, is now about as easy to access as any in Asia. Foreigners account for 35 to 40% of daily stock market volumes, with the last real foreign exchange restrictions having been ditched last year.

Investor interest requires confidence about governance, and one of the most interesting developments to watch in this regard has been the progress Khazanah, the investment holding arm of the Malaysian government, has made in trying to restructure the GLCs, or government-linked companies. Khazanah holds stakes in 50 of these companies, including many of Malaysia’s biggest enterprises, and is entrusted with the GLC Transformation Programme, launched in 2004, to make them better-run, more profitable companies.

In hard financial terms, Khazanah has been doing well. It has submitted its Interim Progress Review to the Prime Minister which includes estimates for 2007 performance; it says that total aggregate profits for the 20 biggest GLCs (known as the G-20) are expected to be RM17.4 billion for 2007, compared to RM10.2 billion in 2006. Naturally, measures like this are only useful if they compare favourably to the broader market, but they certainty do: that 70% increase is three times faster than consensus earnings growth for the market as a whole. Between inception in May 2004 and November 20 2007, total shareholder return had outperformed the Kuala Lumpur Composite Index by 3.3%, according to Khazanah, with an 83% increase in market cap over that period. (A small technicality: The G-20 strictly speaking only contains 18 stocks. The reason for this curiosity is that three of them – the plantation groups Sime Darby, Kumpulan Guthrie and Golden Hope Plantations – have merged into a re-listed Sime Darby).

Khazanah and its managing director, Azman Mokhtar, are big supporters of key performance indicators for its companies and Khazanah itself. It offers a wealth of data on things like service levels (it claims they are improving in GLC companies, among them Tenaga, CIMB and Telekom Malaysia) and has also published a series of colour-coded books to improve governance practices.

The silver book, for example, is entitled: “Achieving Value Through Social Responsibility.” Khazanah says 70% of the G-20 companies (so 14 of them) have revamped or completed plans articulating how they can contribute to society while providing value to GLC shareholders. The red book, called “Reviewing and Revamping Procurement Practices”, has led to pledges by GLCs to generate procurement value creation of RM4.9 billion over the next four years – that is, cost reductions, cost avoidance and increased efficiency.

That’s the numbers. Viewed from outside, Khazanah’s progress has been mainly, but not exclusively, positive. Typically the two success stories are seen as being CIMB – now merged with Bumiputra Commerce and several smaller financial businesses to become a strong, full service and to some degree pan-regional bank – and Malaysia Airlines. The airline remains one of the most remarkable turnarounds in recent Asian corporate history, moving from near bankruptcy in 2005 to record profits in 2007. Its third quarter net profit of RM364 million was up 52% year-on-year, creating the highest profit in the airline’s 60-year history in the first three quarters of the year alone. Operating profit was up 254% year on year.

On the debit side of the equation, at least for the last few years, has been Proton. As the manufacturer of the national car, a classic Mahathir project, the Proton has a symbolic value in Malaysia beyond just being a commercial enterprise, but for years it has been in terrible trouble, with declining market share, under-use of its production capacity, and consistent losses. For much of the last two years the company and government have been locked in talks with Volkswagen and General Motors about them taking a stake in the car company, although the prospect of an outright foreign takeover has proven highly controversial.

Then, in November, Khazanah announced it had ended discussions with Volkswagen and GM, saying: “The government of Malaysia has taken note of the recent positive developments at Proton, in particular the improvement of domestic sales and exports. The government is, therefore, of the view that Proton’s management should be allowed to continue with its plans to further strengthen the company.” The market didn’t believe a word of this, and hammered the stock, but it has since gained significantly following the announcement of a new model, to be launched early this year, with a focus on exports to Asean, Asian and Middle Eastern markets. CIMB Investment Bank now rates it a ‘trading buy’ in the hope of improving margins.

In between these two extremes are companies like Tenaga Nasional and Telekom Malaysia, where the feeling generally is that progress is made but more needs to be done. CLSA, for example, has an underperform on Telekom Malaysia, although that is mainly because it feels the stock has risen too far on speculation that a foreign partner may buy into the company. Nanavati says: “In terms of corporate efficiency, I think it’s fair to say that the numbers would show for almost all the GLCs that they are more efficient year-on-year. The question is, what are people’s expectations? How efficient did you expect them to be, and under what timeframe?”

Others share the same broadly positive view. “We’re in the camp where we have seen positive GLC reform momentum, translating to positive earnings,” says Mark Tan, associate economist within the Asia research department at Goldman Sachs. “But it’s difficult to measure how much of that has translated into concrete economic momentum.”

From an investor’s perspective, one interesting question is whether Khazanah will reduce its stakes in its 50 member companies in order to increase the float available for public investment. Timing suggests they would be unlikely to do this soon – “I would think that in a choppy equity market that is tending downwards, you’re unlikely to see the government selling, adding to supply and putting on downward pressure,” notes Nanavati – but it would certainly help institutional investors who complain about the thinness of available stock.

This is something Yusoff would like to see at Bursa Malaysia. “We are actively engaging with the government in terms of how they can increase the level of free float in the companies that they control,” he says. He thinks that a recent move by the government to set up a Shariah-compliant  exchange-traded fund, made up of holdings from government funds in Malaysian companies, was a step in the right direction. “We want to see more of these transactions in future. That would create not only new instruments for people to invest in, but increase the shares for public trading. We want to see some of our other entrepreneur-owned companies doing the same. While we have a good supply of interesting companies that investors are attracted to, they [investors] sometimes complain it is not easy for them to get shares, and they are tightly held by families or government-linked organisations.”

He adds: “We are always trying to encourage these majority shareholders to sell down their shares, because it’s only when investors can get hold of shares that they will be interested in the company. Otherwise they will move onto shares and other markets.”

Whether GLC or not, Malaysia has a lot going for it in terms of changes in corporate behaviour. Credit Suisse analyst Stephen Hagger refers to “Malaysia’s capital revolution” in a January report. “Free cash flow is surging in Malaysia thanks to steady earnings growth, little in the way of debt to service and minimal planned capex,” he says. Increases in free cash flow often coincide with strong stock market performance, he says. He ranks IOI, Bumiputra Commerce, DiGi, Resorts World, Telekom Malaysia, Public Bank and PLUS among his “capital management success stories,” and is positive on the Malaysian market.

An important consideration at the time of writing was Malaysia’s March 8 general elections. While there has never been any realistic possibility of the ruling Barisan Nasional party losing power, opposition candidates have targeted gaining one third of the seats, which would mean it would no longer be so easy for the incumbent party to push through policy without objection. “It would mean a significant downside risk, as it would provide barriers for progress on the 9MP initiatives,” says Buchanan.

Malaysia is considered a politically stable country, but it would be fair to say that over the last 12 months the tensions in this multi-racial country have occasionally bubbled to the surface. There have been street protests over matters such as discriminatory treatment of minorities. It may be that the certainty of results over the last several decades may dissipate in coming years.

In the meantime, though, an election and a new mandate should have some immediate impacts on spending, which brings us back to the Ninth Malaysian Plan. Colbert Nocom at UBS credits Malaysia’s solid comparative stock market performance to “expectations that a fresh mandate for the government will facilitate quicker implementation of its aggressive pump-priming plans.” On Nocom’s numbers, only RM58.2 billion of the projected RM220 billion in the 9MP has been spent so far; “We believe that we could see a major upward revision in the government’s programmed spending.”

BOX ONE: Debt markets

Just as the equity markets have proven more resilient to global shocks than many of Malaysia’s neighbours, the local debt markets too have remained highly effective. Sub-prime hasn’t hit it – the lending practices were different among Malaysia’s banks, and global volatility has not hit the top end of local currency markets in Asia, particularly Malaysia. Issuance in dollars has obviously tailed off, but the ringgit markets look solid.

“Deals are getting done,” says Nanavati. “The issue with Malaysia specifically is that the market is quite robust for locally AAA and AA rated credits; the market has always been less liquid for single A credits, and now is probably more illiquid than ever before.” At that top end – which, it should be stressed, refers to local ratings, which are considered more generous than those of Standard & Poor’s – then there has been little major difference to issuing conditions.

“The other phenomenon we see today,” adds Nanavati, “is that certain credits could issue in ringgit today, swap it into dollars, and their cost would be 40 basis points cheaper than if they issued in dollars directly. That’s a combination of credit spreads and local liquidity.” For high yield issuers, though, the market is pretty much shut in local currency.

BOX TWO: Palm oil

On February 25, the great and good of the world palm oil industry gathered in Kuala Lumpur for the annual Palm and Lauric Oils Conference & Exhibition, attracting 1500 delegates from 50 different countries.

If that seems an awful lot of attention for oils and fats, it’s because these products, and in particular palm oils, are among the world’s hottest commodities. Malaysia is well placed for it at both the physical and derivative level: it has some of the most powerful plantation companies in the world, and also the most widely traded crude palm oil futures contract.

Among the brokers who are highly positive on plantation stocks is Macquarie Research. “We believe the continuing tightness in world supply remains bullish for edible oil prices going forward,” says  plantations analyst Gerald Sheah in a recent note. “In the short term, world production is not likely to be able to keep up with demand.”

This is down to two key themes. If one takes edible oils’ traditional use as food, this is obviously growing with population and wealth, underpinned by developing countries such as China. On top of that, the promotion of biofuel as an alternative fuel is also creating great demand for palm oils and other edible oils.

On top of that, Sheah adds: “Ethanol production has also resulted in a fight for acreage among corn, soybean and wheat in 2008… the pace at which new land can be cultivated is trailing requirements, while marginal land with lower yields would nonetheless require higher prices before being planted.”

For those in the industry, the interest in biofuels is merely a bonus; it’s really all about food consumption. “This is the key point: people hear about it but it doesn’t really sink in,” says Dato’ Yeo How, executive director at IOI Corp, which has almost 170,000 hectares of plantations in Malaysia alongside considerable downstream operations. “Take China, with affordability and the changes in lifestyle. It’s not just a question of in the past they could afford one bowl of plain white rice and now they can afford three. You have to consider diet changes, more protein, more chicken. To produce one kilo of chicken you need two kilos of animal feed.” So the effect is more widespread than it at first appears. On top of that, whereas people used to be able to, say, dig into land usually used for wheat in order to grow something else like corn or soya beans, today all crops are at capacity and land is at an immense premium. This all pushes prices up, and that’s before one even thinks about renewable fuels.

Prices in this area have soared. Crude palm oil futures were trading at around RM1900 per tonne in early 2007; in late February, May 08 futures were trading at around RM3700. To put that into context, Macquarie’s long term forecast for CPI prices is US$700, equivalent to about RM2250.

This has flowed through to Malaysia’s plantation companies. IOI, for example, recorded a 65% increase in pre-tax profit in the first half of its financial year. Kuala Lumpur Kepong, another plantations company, almost doubled its first quarter net profit year on year, as well as its earnings per share. And Sime Darby logged a 33% increase in profit in its 2006-7 financial year.

BOX: SHARIAH

Malaysia has long been the Asian market that has most whole-heartedly embraced Islamic finance. Most people consider there to be two world centres of Islamic finance, Bahrain for the Gulf and Kuala Lumpur for Asia; numerous other bidders for the crown, from London to Dubai to Singapore, have raised their heads but the fact is that every significant multinational body with relevance to Islamic finance is based on one of those two locations. In Malaysia, that includes the International Islamic Financial Market, the International Centre for Education in Islamic Finance, and the Malaysian International Islamic Finance Centre.

For one thing, Malaysia has the most comprehensive regulatory framework for Islamic finance in the region, even if some in the Gulf consider it excessively so (such as the requirement that Shariah scholars can only serve on the board of one Malaysian bank at a time).

Partly because of this clarity, Malaysian has managed to build a vibrant market in sukuk, the Islamic version of a bond. According to Bank Negara Malaysia, between 2001 and 2006 the Malaysian sukuk market grew at an annual average rate of 17%, and the issuance of sukuk has now surpassed the issuance of conventional bonds for three consecutive years. Issuers are widespread – 90% of them are corporate – and annual turnover in sukuk trading in the secondary market stands at around RM 135 million, according to Bank Negara. All told, there were US$56 billion of sukuk issued out of Malaysia as of January: that’s 62% of the world’s total.

Malaysia has managed this through a combination of building a suitable environment for a market to flourish, making the best of the natural advantage of a majority Muslim population, and increasingly because of an ability to attract some of the vast liquidity from the Middle East. Malaysia realised early on that it should look beyond the possibilities of domestic issuers, and has fostered the ability of issuers to launch multi-currency sukuk, or to swap ringgit funding into other currencies.

Malaysia actively encourages innovation in structure. In recent years products have been launched including residential mortgage backed securities, commodity-based financing, and investment and equity-linked products based on the Islamic approaches of musyaraka, mudaraba and ijara. It is little surprise to see that a new joint venture designed to provide a mortgage guarantee program for Islamic and conventional mortgages, which ought to boost the Islamic securitisation market, has strong Malaysian participation: the partners are Cagamas Berhad, the Malaysian Mortgage Corporation and the Hong Kong Mortgage Corporation.

Innovation is a tricky subject in a market whose principles are based on tradition; one challenge Malaysian sukuk issuers face is that some Middle East investors believe that Malaysian sukuk are not Shariah-compliant, since in some cases the underlying assets that underpin the sukuk are financial rather than physical.

But the truth is Malaysia offers the only liquid local-currency sukuk market in the world, and that will prove steadily more advantageous as Islamic finance grows worldwide.