Commentary
by Observer

Background
The IMF, under Article IV of its Articles of Agreement, holds bilateral discussions annually with its Member countries. These discussions are in the nature of a review of member country economic policies, recent economic developments, IMF staff assessments of prospects and the presentation of policy recommendations. A report is then prepared for presentation to the Fund’s Executive Board of Directors. At the conclusion of the Board Discussion, a Public Information Notice (PIN) is released together with the full report. The Article IV consultation with Malaysia for 2010 took place in May/June of this year and following Board consideration, the PIN and the Report were released on August 13th 2010.

In its customary approach, these IMF documents are highly nuanced and attempt to convey the Fund’s views in measured and balanced tones in order to minimize possible disagreements with the country in question. They err on the side of caution and down play differences and criticisms of policies. The 2010 Malaysia report needs to be read in that context. It is remarkable that the report questions past policies, takes a somewhat critical and skeptical view of many current government policies and expresses open disagreement in certain instances. The report also exposes the dithering and inability of the Government to take firm measures in pursuit of its own announced policy reforms. This brief analysis attempts to highlight and bring to the fore a number of issues that in the view of the Fund reflect on the Government’s capacity to take on the task of implementing its modest reform agenda.

Key Issues
The report begins by observing that there has been broad agreement in the past between the authorities and the Fund on desirable policies—a prudent fiscal stance, reforms of government linked companies, measures to improve the investment climate, flexibility in monetary and exchange rate management, and further steps to strengthen Malaysia’s financial system. The report goes to note: “Views have differed, however, on the pace of reform. The authorities have favored a more gradual approach, perhaps better attuned to political realities and implementation constraints.” These statements represent a fairly open criticism of the Government and its credibility in pursuing reforms. They also seem to question the commitment of the Government to follow through on the policy agenda contained in the NEM issued in March of this year.

As the report indicates, the key focus of the consultations were on the policy requirements to support the recovery and the priorities for structural reforms over the medium term. On the issue of Fiscal Policy, the Fund argued that “budgetary gains would prove transitory, however, if the broader agenda of fiscal reforms remains unfinished. In particular, subsidy reform and the introduction of the goods and service tax should not be delayed.” It is worthy of note that the Government acknowledged that these were high priorities but that a broad consensus on implementation modalities was still being forged. This stance reveals that the Government has a weak hand and is divided.

A similar divide between the Government and the Fund was discernable concerning Structural Reforms. While the Fund saw signs of a renewed political commitment to push reforms, the Report expressed the view that molding the necessary social consensus would require time.

On Exchange rate policies, the Fund took the view that the Ringgit was in real effective terms weaker than its estimated equilibrium level. The report openly points out that the “authorities disagree with this assessment”. The Fund for its part argues “……..a stronger ringgit in real effective terms could facilitate over time the implementation of the economic transformation program by contributing to higher real incomes for households, greater capital deepening, faster productivity gains, and demand shifts in favor of services.” It should be observed that this represents a rather stark and open disagreement between the two parties.

The report points to a rethinking of the development strategy as Malaysia stands at the crossroads with the old economic model having lost the ability to drive the country forward and to free Malaysia from the middle-income trap where it is now stuck. The report notes the recent steps announced by the Government – the 1Malaysia program, the Government Transformation Program, the Economic Transformation Program built on the New Economic Model, (NEM) and the Tenth Malaysia Plan, (10MP). It is most significant that the report goes on to state: “Development policies have been dressed in rhetoric before but the sense of urgency seems higher now than in the past.” This is a rather remarkable and blunt statement and points to a question about the credibility of the Government.

Recent Performance
While acknowledging the recovery in growth terms in the last three quarters, the Fund projects a rate of growth of about 7 percent for the current year but a tapering off in 2011. The report is pessimistic about a pronounced recovery in private investment, given still unused capacity. Capital expenditure of public enterprises is expected to pick up. Thus, the prognosis is for government induced investment rather than the private sector providing the impetus for growth. These trends are indicative of the fact that public investment is likely to be the dominant factor as in the past.

The Fund observes that equity prices (stock market) have show an increase of 5 percent in the current year, a performance far below other regional markets, reflecting Malaysia’s weaker capital inflows and shallower correction in the sell-off. The Fund report points to net capital outflows throughout the year. Portfolio inflows picked up in the second half of 2009, but outward FDI and ?other investments swamped the uptick. The Report also refers to the fact that both FDI and portfolio flows have been negative in net terms for many years reflecting underlying trends—the expansion abroad of Malaysian businesses, trade financing flows, and the recycling of current account surpluses. The report makes the point that over the last few years net FDI outflows have grown, as a result of limited opportunities for domestic investment by, as well as growing investment abroad by Malaysian companies seeking economies of scale, a regional exposure (e.g., in telecom), or supplies of natural resources (oil and gas field or land for plantations). The main drivers were sustained current account surpluses, a revival of trade credit from Malaysian exporters to importers overseas, and an increased willingness of the private sector to place funds abroad. In brief, these observations point to the emergence of a weak domestic investment climate. While the report does not detail the causes for this weakening, it is clear that much of it can be linked to policy failures. The term “capital flight” is not used in the report but it is not hard to draw conclusions from the report that this indeed has taken place on a significant scale.

The report goes on to mention the fact that the nation’s external reserves fell from RM 126 billion in mid 2008 to RM 88 billion in March of 2008. By June of this year, reserves at recovered to RM 95 billion. By way of elaboration the report alludes to the fact that these gyrations in reserve levels could be attributed to interventions in the foreign exchange markets by Bank Negara and the capital flight that has taken place.

Looking ahead, the report makes the following comment: “The outlook for the medium term depends on the scope and speed of the government’s own economic transformation program”. Further comments in the report suggest that the Fund does not have much confidence in full and speedy implementation of reform measures. This interpretation is supported by the fact that the Fund sees the external imbalance reflecting impediments to investment and high precautionary savings, which current policies address only partially.

The report suggests that achieving the Government’s target of doubling per capita income over the decade will depend on private domestic demand. A revival of private investment should compensate for a roll back of public projects, an enhancement in social welfare and new domestic business opportunities to curb capital flight. The report indicates that Government officials countered by suggesting that they saw encouraging signs of a renewed political commitment to drive the reform agenda but hedged this by cautioning that grass-root support was still being harnessed. These reservations indicate that there is still no full commitment to embark on a reform agenda.

The Fund’s report deals with the current fiscal situation at some length. While acknowledging that the 2010 Budget took steps to push back the deficit from 7 percent in 2009 to 5.5 percent in 2010, the Report is critical of the scope of the measures taken. These are skewed to the expenditure side, with economies expected from improved procurement as well as cuts in discretionary spending and transfers. From the tone of the report, the Fund appears to be skeptical that these measures will be adequate. The report notes that the long?delayed goods and service tax (GST) announced several years ago has yet to be enacted. Rather pointedly the report notes that the GST is intended to broaden—and stabilize—the tax base by replacing two existing taxes in a revenue neutral fashion. The report also refers to the fact that tax holidays represent a very large drain on the budget, estimated at about half of total tax revenues.

The report makes the following pointed criticisms of Government fiscal policies:

• “Fiscal risks in Malaysia have grown over the years. Policy has been pro-cyclical in good times, setting the stage for unprecedented deficits when budget support was necessary during the crisis. Increased dependence on oil revenue further undermines the public finances.”

• “Consolidation is needed to reconstitute room for maneuver and forestall market concerns”.

• “Budgetary gains will prove transitory, however, if the broader agenda of fiscal reforms remains unfinished.”

• “Savings can be achieved by rationalizing subsidies and tax structures. Political realities suggest that subsidy reform needs to be gradual but sustained. The sooner it starts the better. The broad approach under consideration—centered on periodic reductions of key subsidies with compensatory cash transfers to the most vulnerable groups—seems broadly appropriate, provided that reform fatigue does not set in.”

In addition to the above, the report recommends that Malaysia should strengthen its budget framework along three dimensions, namely a) an indicative consolidation path along which the deficit is brought back to more manageable levels. This approach could cast budget decisions in a starker multi-year perspective and provide discipline; b) budget documents incorporate a statement of fiscal risks to assess vulnerabilities surrounding budget outcomes and c) budget decisions could emphasize the evolution of the non?oil balance and be benchmarked against a framework that links spending to an equitable drawdown of oil wealth.

These recommendations are designed to provide greater transparency and accountability and also to move towards more prudent use of non-renewable national assets.

Fund Views on the NEM and the 10 Five Year Plan

The Fund’s report acknowledges that the NEM report suggests a sea-change in the attitude toward comprehensive structural reforms. That said, it goes on to state “It sets up a stark choice for Malaysians and their political leadership, a choice between muddling through in a business-as-usual mode and going for a historical transformation of the economy………. The agenda is daunting and will require difficult trade-offs, given the tight fiscal envelope”. This statement is unambiguous and expresses a degree of skepticism about the ability and willingness on the part of the Government to persist with the implementation of the reform agenda.

The Fund has also called for a stronger ringgit over the medium term as this will help achieve the objectives of the NEM and the 10MP. The Fund argues that an appreciated ringgit in real effective terms will over time facilitate the implementation of the authorities’ economic transformation program and contribute to higher real incomes for households, greater capital deepening, faster productivity gains, and demand shifts in favor of services. The Fund report also observes that structural rigidities have contributed to the imbalance between national savings over investment. The report goes on to note: “Moreover, there is no feasible reorientation of the policy mix in the near term (toward a more expansionary fiscal stance and a more restrictive monetary policy) that could speed up the external adjustment without compromising domestic stability—or potentially triggering speculative inflows.”

The report in the concluding section returns to the fiscal picture and warns that budgetary gains will prove transitory, if a broader agenda of fiscal reforms remains unfinished. It stresses that poorly targeted and distortionary fuel subsidies should be phased out sooner rather than later, and the introduction of a goods and service tax should not be unduly delayed.

The concluding part of the report states: “The structural reform agenda is daunting and will require difficult trade-offs, given the tight fiscal envelope. Yet, hard choices seem unavoidable to lift productivity growth and living standards. Accordingly, implementation will need to be calibrated to political realities. Acting at a measured pace on a broad front is probably the best way to exploit policy complementarities and harness the benefits of reform. However, careful communication will be needed to sustain the adjustment and pre-empt reform fatigue.”

Concluding Remarks

The IMF’s report on the Article IV consultations is a remarkable document in that it is not couched in the normal diplomatic niceties. The analysis and assessments are sharp and pointed. Furthermore, the tone of the report conveys a degree of skepticism about the seriousness with which the commitments contained in the NEM and the 10th Malaysia Five Year Plan are likely to be pursued. The report lays out in rather stark terms the underlying structural imbalances that exist and makes the case for addressing these daunting challenges in a systematic manner. It spells out in clear terms the needed policy changes in the fiscal field, exchange rate policies and monetary policy. It makes the case for reform of the subsidy program now in place. Although the report does not directly touch on the issue of affirmative action policies which have long driven Malaysian economic policies, the underlying message is clear. By endorsing the NEM, the report implicitly calls for a fresh start that rejects the distorting elements of the NEP.

The Executive Board of the IMF stressed that a sound and sustained fiscal adjustment is necessary to put the public debt ratio on a downward path and encouraged the authorities to follow the indicative deficit path proposed in the Tenth Malaysia Plan. Directors looked for a decisive effort and sustained momentum in implementing this agenda.

The IMF has flashed the yellow card and warned the Government on the need to remove imbalances and distortions. It is now up to the Government to act boldly and introduce reform measures that it has announced but which are being held back because of opposition from vested interest groups, PERKASA and its allies in particular. The 2011 Budget to be announced in October offers an opportunity. The issue is: will there be a new start or will the nation be subjected to the same old rhetoric?