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Economics: Malaysia Economics – Markets – Strategy Bank Negara to hike the policy rate 50bps in 3Q08, to 4.0% Policy action needed Higher inflation will push real interest rates towards negative territory, if they are not already there (Chart 3). Adjusted for inflation, real deposit rates were at -1.63% in Apr08. Real policy rates and lending rates will most likely fall further if inflation spikes to 5.8% in June on the fuel price hike. A negative real interest rate scenario favours borrowers, and risks fuelling asset inflation. As general prices rise, so could inflation expectations, resulting in even higher inflation going forward. For example, if workers demand higher wages in anticipation of further price increases, it will inevitably set off a second round of price increase. Thus, policy action is needed now to anchor inflation expectations, and to prevent second-round inflationary effects. We expect Bank Negara to hike the policy rate by 50bps at the next policy meeting in July (Chart 2), taking the Overnight Policy Rate to 4%. In fact, while no policy meeting is planned for June, we do not discount the possibility of an inter-meeting hike. In addition, while the inflationary effects of the fuel price hikes are expected to be transient and will likely wear off after 12 months, the government has hinted that this may just be the first of a string of subsidy cuts. Overall, inflationary pressure will remain high amid risks of higher global commodity prices and further hikes in subsidized fuel prices. The central bank sounded hawkish in its most recent policy statement, and we believe the rhetoric will remain so in the next few quarters given the outlook on inflation. Chart 3: Real interest rates heading south %, % pa 6 5 4 Real policy rate Real deposit rate Real lending rate 3 2 1 0 -1 -2 -3 -4 Latest: Apr08 Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07 Chart 4: Growth likely to moderate %-pt contribution 20 15 10 5 0 -5 -10 Net exports Investment Govt expenditure Pvt consumption GDP growth Latest: 1Q08 Mar-05 Mar-06 Mar-07 Mar-08 Growth will be affected The impact on growth will be mixed. Although savings from the subsidies can be used to stimulate growth, we think that this is more likely to happen in the longer term than in the near term. In fact, the government has not publicly explained how the savings from the subsidy cuts will be used. While we assume that effort will be put into upgrading the existing transport network, work will probably start at a later stage and benefits will only be reaped in the longer term. In the near term, domestic demand will be most affected by the fuel price hike. In particular, private consumption, which registered robust growth of 11.6% YoY and contributed 3.6%-pts to overall GDP growth, is expected to moderate to an average of 7.3% for the full year (Charts 4 and 5). Government expenditure, which grew by a robust 10.5% YoY in 1Q08 (making a 0.7%-pt contribution to 110
Economics – Markets – Strategy Economics: Malaysia growth) will also be shaved. We reckon that growth in government spending could slow to an average of 5.5% for the year, as the government cuts down on its energy subsidies. Delays or postponements of some government projects due to political differences between the Federal and opposition state governments may further complicate matters and slow down the disbursement of government funding. Investment growth will likewise be affected. Capital investment rose 6.0% YoY and contributed 0.8%-pts to overall growth in 1Q08. Given ongoing political uncertainty, a moderation in the growth outlook as well as possibly higher interest rates going forward, investment growth will probably taper off to an average pace of 5.7% for the year. Domestic demand will be most affected The slowdown in domestic demand will be compounded by an anticipated decline on the external front. Although net export growth has been higher than expected at 26.4% YoY in 1Q08, it was underscored by a low base in the same period last year and helped by much slower import growth of 3.4%. Overall export growth in fact moderated to 6.0% YoY in 1Q08, down from 7.8% YoY in the previous quarter. Chart 5: Domestic demand set to moderate % YoY 16 Pvt consumption Govt expenditure 14 Investment DBSf 12 10 8 6 4 2 0 Mar-05 Mar-06 Mar-07 Mar-08 Chart 6: GDP growth forecast revised down to % YoY 8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 GDP GDP growth (previous) GDP growth (latest) Mar-05 Mar-06 Mar-07 Mar-08 MYR mn 150000 140000 130000 120000 110000 100000 90000 80000 70000 60000 While the underlying fundamentals of the Malaysian economy have been strong, near-term downside risk to growth remains high. The broader weakness in global demand is expected to continue weighing on export-oriented sectors. The domestic segment will be affected by higher inflation, monetary tightening as well as sentiment-dampening fuel subsidy cuts. With that, we expect overall GDP growth to moderate to 5.1% this year, down from our previous forecast of 5.8% (Chart 6). Growth next year is expected to register 5.8%, a tad below our previous forecast of 6.0% owing to spill-over effects. Growth is expected to moderate to 5.1% this year 111
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