Why isn’t Malaysia hurting?

Emerging Markets, World Bank editions, October 2012

Malaysia ought to be hurting. It is among the most exposed countries in southeast Asia to external demand. With grave concerns both east and west, developed and emerging, American and European and Chinese, one would expect it to be flirting with recession.

In fact, it’s doing much better than that: not shooting the lights out, by any means, but not going backwards either. Deutsche Bank forecasts GDP growth of 4.5% for Malaysia this year, recovering to 5.3% in 2013. “Malaysia is holding up slightly better than we had originally expected for an economy that is so exposed to external demand from G3 countries,” says Michael Spencer, chief economist for Asia Pacific at Deutsche Bank. “Two things have surprised us: one is the strength of domestic demand, and the other is that government spending has picked up quite a bit. It is not just infrastructure spending, but across the board and trickling down to the man on the street.”

Lee Heng Guie, regional head of economics at CIMB Investment Bank says that while “Malaysia’s highly open economy is not immune to a global slowdown,” it is looking respectable compared to its peers in the region thanks to a bright domestic picture. Household spending is steady and boosted by cash handouts to low and middle-income household groups, inflation is benign and unemployment was just 2.9% in the first five months of the year, he says. “Malaysia’s vulnerabilities are lower than in 2007-8, backed by a strong war chest of foreign reserves, healthy external balances and a more robust financial system,” he says. “We reckon that Malaysia’s fundamentals should provide some cushion to external headwinds, unless external conditions worsen sharply, which will then weaken domestic buffers.”

While FDI  doesn’t look particularly special (see Bank Negara interview for more on this), private sector spending domestically is up and state spending is gathering pace as the government’s Economic Transformation Programme is implemented, with a focus on big-ticket fixed investments in infrastructure. The ETP isn’t going to please everyone, nor is it going to achieve everything it aspires to, but as a kick-start to consumption and domestic growth, it seems to be working. “We feel it is a strong plan, well thought out, but to expect the government to push ahead with every element of it with equal success is probably unrealistic,” Spencer says. “It has drawn mixed views from various stakeholders but in my opinion it is a good job focusing on the right areas.”

Additionally, Malaysia is being helped by the rising tide of the broader Asean region, and greater trade between these states. Lee at CIMB says intra-regional trade in ex-Japan Asia accounts for 59.2% of overall Malaysian trade, reducing the impact of slower export demand from the US and Europe; those two accounted for just 18.7% of Malaysian exports in 2011. “As growth in Asia, including Asean, is expected to remain strong – albeit slower in 2012 – this bodes well for Malaysia via trade, investment and financial transmissions,” Lee says. “Southeast Asia is becoming an extremely important host of FDI.” This is true, although Malaysia is not the shining star in terms of regional FDI – that is clearly Indonesia, followed by Thailand and Vietnam. Nevertheless, Malaysia is certainly part of a regional growth story in which inflows to southeast Asia jumped 26% between 2010 and 2011, according to Lee, citing the World Investment Report.

Received wisdom has it that commodity prices dominate Malaysia’s economy, but this divides opinion. “One weaker point is on the commodity side: they are at the mercy of global prices,” says Tai Hui at Standard Chartered. This can work two ways; he notes that in Malaysia, palm oil exports went up 35% in value terms last year, but that 80% of that growth came from the increase in palm oil prices, and only 20% from actual volume increases. “This time it’s the other way around, as the value of exports has come down.”

The other view is that people have the wrong perceptions of Malaysia as a commodity economy. Commodities are clearly important, and their prices are beyond the country’s control, but Spencer argues it is not as exposed as one might think. “Commodities in totality, whether palm or crude oil, range between 10 to 25% of total exports depending on where prices are,” he says.

The flip-side to increasing regional engagement is: what of a slowing China? “China has become a very important export market for Malaysia,” says Spencer. “It is the biggest growth market for exports, both electronic and commodity-related. The slowdown in China is having an impact on Malaysia.”

The other big unknown in Malaysia concerns the next general election, which must take place by early 2013. The precise date remains elusive, but it has been a topic of keen conversation for months. “I think we should be looking at it in two ways,” says Spencer.” First, there is a lot of noise; there’s been a lot of noise for more than 12 months now. And while there is some uncertainty, corporate Malaysia has got on with life and remains very robust, with increasing confidence in investing offshore.” Examples include Sime Darby acquiring Battersea Power Station in London, CIMB buying a stake in a bank in the Philippines, and Genting developing a greenfield coal-fired plant in Indonesia.

But the other side of it is the impact on investment. “In 2008, there was a shock to everyone when the incumbent party lost the two-thirds position, and there is therefore greater concern about what would happen this time,” Spencer says. “The jury is out and investors are sitting on the sidelines for higher-beta companies in the stock market.”

Tai Hui, an economist at Standard Chartered, agrees. “2008 was a surprise, and investors will approach the next election with some caution,” he says. “If you look at the Singapore dollar against the ringgit, the Sing dollar is at an incredibly strong level, and maybe that’s a proxy for local sentiment. But after the election, once we’ve got clarification on whether Najib has earned a strong mandate for reform, and we have a clearer runway on policy implementation, that will bring investor interest back into Malaysia.”

Still, Edward Teather, senior Asean economist at UBS Investment Bank, sees some reasons for optimism. “What we have seen in other countries is that as you approach an election, the drive to liberalization fades, and you get a more politically acceptable protectionist veneer overcoming policymakers: don’t take risks,” he says. “But in Malaysia, you’re seeing some liberal steps taking place.”

“Given the policy momentum we are seeing now, we’re hopeful that if the current government remains in place, that momentum will continue.”

BOX: The banking sector

The bedrock of Malaysia’s resilience to external shocks, and in particular to volatile fund flows, is the vast improvement in the health of its financial services industry in the years since the Asian financial crisis. In May, the net impaired ratio of the Malaysian banking sector was just 1.6%, despite years of global turmoil. There is little exposure to European or US banks. “The Malaysian banking sector is on solid ground, backed by a strong capital base and healthy balance sheet,” says Lee at CIMB.

This is, in some measure, an extension of the domestic demand story: domestic liquidity is sufficient to insulate the system from external shocks, and to keep funds available. “The deleveraging pressure from locally incorporated foreign banks will be mitigated by the still-ample domestic liquidity in the banking system, while the slack or pullback in lending by foreign banks will be offset by domestic banks, which boast strong capital base,” Lee says.  “Moreover, a large part of foreign banks’ claims are funded by local customer deposits and hence, the pressure to retrench these claims is considerably reduced.”

Spencer at Deutsche makes a similar point. “There is still ample liquidity onshore,” he says. “The fund-raising requirements for infrastructure plans are essentially quasi-government backed, and we don’t see any red flags there. Savings rates in Malaysia are among the highest in Asia, corporate Malaysia is healthy, and the capital markets are relatively active, so funding is not a major issue.

Be that as it may, and as Governor Zeti says in the attached interview, Malaysia does remain vulnerable to capital reversals, even if it has got far better at dealing with them over the years. “Malaysia still needs to contend with the adverse impact of capital reversals, which will induce volatility in the domestic stock and foreign-exchange markets as investors exit risky assets in emerging markets and flee to safe havens,” says Lee

And while Malaysia’s domestic capital story is all well and good, there is still an inescapable pressure to engage with the rest of the world, and that pressure will continue to grow as assets require homes for investment. The Employee Provident Fund, by far the most powerful and significant institutional investor in Malaysia, illustrates the point. “The fact that the EPF today has 13 to 14% of its FUM outside Malaysia, when it was negligible six years ago, has really broadened the fund management industry in Malaysia,” Spencer says.

There are both good and bad consequences of that. “Malaysia has carved itself the nice position of being seen as the Asean investor hub,” says Spencer. One third of stock market earnings now come from outside Malaysia, he says, compared to a number in the teens in 2005. “Asean matters a lot to Malaysian companies: they have been very early investing overseas.” But at the same time, integration with capital markets mainstreams do bring with them inevitable volatility.

Malaysia continues to try to develop its financial sector, and the latest example was the Capital Market Masterplan 2, launched by the Securities Commission in April 2011. Like previous landmark documents from the Securities Commission and Bank Negara, it takes a long-term ambition, setting targets for the capital markets to support economic growth over the next 10 years; the first masterplan concluded in 2010 and featured a compound annual growth rate of 11% in the local capital market despite the global financial crisis. The new plan calls for a doubling of total market capitalization from RM1.2 trillion in 2010 to RM2.4 trillion in 2020, fuelled by large domestic investment, new listing of government entities, and rapid growth in small and mid-cap stocks.

Alongside this will come continued development of the country’s Islamic finance industry – already the largest in the world by some measures, with Islamic banking assets of RM113.5 billion and takaful assets of RM6.2 billion, a RM125 billion Islamic private debt securities market, and such local entrenchment that sukuk account for 45.5% of domestic corporate bonds, according to CIMB. Islamic banks control almost one quarter of the broader Malaysian banking sector’s assets, loans and deposits.

BOX: GOVERNOR ZETI INTERVIEW

Emerging Markets met with Bank Negara Malaysia Governor Dr Zeti Akhtar Aziz in London in September.

EM: For a country heavily exposed to external forces, Malaysia appears to be holding up well. How do you feel about the country’s health and resilience?

Zeti: There has been a tremendous payoff for the strengthening of our economic and financial system in this environment. We have been affected – our export sector has been very affected for some time now – but our domestic demand has held up very well.

It’s not only consumption that’s important. Investment by the private sector has picked up this year. Foreign direct investment has moderated, but there are still inflows, which have strengthened this year in new areas of growth. Our financial sector – both the banking sector and the bond and sukuk markets – have been vibrant. There has been significant new issuance. And it’s not just existing investments that are expanding or being refinanced; there are new investments taking place, and IPOs in the stock market. All these have been very positive in ensuring the financial sector has not been disrupted by all this volatility.

So is Malaysia in the clear now?

Of course we are going to be affected if there is any further slowing down. Already, export market growth has slowed quite significantly, although we do have a diversified export base in terms of products and markets. 25% of our exports are to Asean, and 60% of our trade is with Greater Asia. Since these remain growth centres in the global economy, Malaysia has been able to benefit, because this trade is growing as trade with the US and Europe has slowed. Regional investment activity is also taking place, both inflows and outflows.

EM: But with that greater regional engagement, what is the impact of a slowing China?

Well, we have to monitor that very closely. I believe that of course China is also affected by global developments, but they have implemented many policies and measures to support growth, and we believe they will be able to generate sustainable growth in this environment.

Yes, we are a commodity producer and exporter. We also export manufactured goods and services and have other areas of growth: education, healthcare and tourism, which is growing immensely. Being in the centre of Asia, we grow as incomes rise in the region. We have something like two million tourists a month coming to Malaysia.

EM: There must be an election in the near future, and there has been a lot of noise about it for more than a year now; presumably the uncertainty doesn’t help FDI. What has the impact been?

It hasn’t been a disruptive force. In this kind of environment the focus is on where the opportunities are. As long as Malaysia presents opportunities – not just the areas of economic activity that are open to foreigners to participate, but more importantly the competitiveness, the cost of doing business, and the efficiency of the system in terms of approvals and red tape, which have improved tremendously – then we don’t anticipate the politics will be an important consideration for foreign participation in our economy.

There hasn’t really been a ‘wait and see’. It is more the external developments that cause investors to be on the sidelines, because they don’t know the outcome of policies taken in Europe or the US. I have mentioned many times that global policy spillovers have become more significant: not just global developments emanating from the banking sector, but global policies having implications on capital flows and making them more volatile, making the environment more uncertain for foreign exchange transactions.

To address that, we have liberalized very aggressively, since we moved to a flexible regime in 2005, to allow the private sector to better manage their foreign exchange exposure. We allow unlimited foreign currency accounts, with potential for hedging. Restrictions that increase cost have been removed, allowing investors and exporters to undertake foreign currency business between them. Now, our payment system can handle two international currencies, RMB as well as US dollars. This is another great advance for us.

EM : Do you feel Malaysia is now as open and liberalized as it needs to be?

To a large extent, yes. There are probably two or three other areas that can be [opened]. We always believe in sequencing this, especially for the major fundamental areas, and the most fundamental one is the internationalization of the currency.

We believe we remain vulnerable to speculative attacks; right now there is no restriction on inflows and outflows. Onshore you can trade as much as you want to do, in foreign exchange transactions, either to bring in funds or take them out. So we have a free flow of inflows and outflows of funds, but it is done onshore and in our time zone, which we believe reduces the prospects of speculative attacks on our currency from offshore. The most important thing is that we are able to better intermediate sudden inflows and outflows. So when there is a deleveraging taking place in Europe or the US, as happened in 2009, where huge amounts of outflows followed, we have been able to manage them despite the magnitude of these flows being so much larger than we saw in the Asian financial crisis.

Our financial system is much more developed now than then, not just in terms of the banking sector but the bond market, which is now the largest in southeast Asia. This has helped us intermediate flows because they are dispersed throughout the financial system. Other reforms include the transition to greater market orientation, such as a more market-determined interest rate framework, so the price discovery process is more efficient. So far, the economy and financial system have been able to cope with the volatility, and that is a great step forward.

EM: Malaysia has embraced the RMB. What is the opportunity there?

China has become our largest trading partner. We export commodities and manufactured goods to China, and they account for 13 to 14% of our total exports. It makes sense to settle that trade in a domestic currency, either RMB or ringgit. We engaged with the Chinese authorities to explore this, and I believe we were the first country outside Hong Kong to operationalize the settlement of trade in RMB. This has been growing as exporters and importers come to realize the benefit. The motivation is to reduce the cost of transactions, and to reduce the exposure to the volatility of other, third currencies. Now there is a RMB-ringgit exchange rate against which exporters and importers can make an assessment.

In recent years your hopes for Islamic finance have moved from the domestic industry, which is already mature, to Malaysia as a hub for international Islamic capital. Has that been achieved?

To a great extent. Beginning in 2003, we issued licences to other Islamic financial institutions from other parts of the world. Then we liberalized our bond and sukuk market to allow foreign businesses to raise financing in our market. Then there was an openness for investors to invest surplus funds in our market; there’s quite a high percentage of foreign participation. Our Islamic financial institutions are only now going abroad. This is what we look forward to: to expand activities in the international environment. We’ve already seen a Singapore dollar sukuk, an RMB sukuk issuance, and of course we’ve had dollar issuance, by corporates from the UK, Europe and Japan. Investors have participated, because all issuance is generally oversubscribed, and the investor base is dispersed throughout the world.

What happened to the Islamic megabank idea?

Well that’s still on the table.  It’s also a long process because those who are participating in it and who have been given a conditional licence, within a consortium, are not all banks, so the screening process and the conditions that will be applied to them are a long drawn-out process. When it has firmed up, an announcement will be made.

What is the impact of Asian and Asean financial integration?

That has made a lot of progress. We are not discouraged by developments in Europe. We believe it will unlock the economic potential of the region. Right now, the progress has essentially been in terms of trade and cross-border investment, while financial integration wasn’t so significant. That is what we have worked to achieve more recently. It will not only support economic integration, but will help the financial resources of our region to be channeled and recycled towards economic activity in our region. Asia needs massive investment in infrastructure, and savings can be mobilized for this. We believe the development of the regional bond markets in particular will facilitate this, because many of these investments will be long term, and we have the capacity to absorb the financing of those activities.

Another area of cooperation is to ensure, during these times, that we put in place the framework for crisis management, for surveillance, and for capacity building. This also aims to make us more inclusive: we don’t just want the core countries to press ahead, we want to bring with us Vietnam, Cambodia, Laos, Myanmar.

While we are looking at what is happening in Europe, we can draw many lessons about what we need to do so that should any market crisis occur with systemic implications for the rest of our region, we are already putting in place the mechanisms to deal with it. We can act pre-emptively to address it collaboratively. The region is becoming much more cohesive: when we managed the financial crisis each one of us managed it on our own, but now we have put in place the mechanisms to act together.