Fiscal drive: A thorough overhaul of sovereign finances takes place

The year 2015 will be remembered as the moment when the Malaysian government embarked on an ambitious and uncharted course to replace oil revenues with a consumption tax known as the goods and services tax (GST), which is set at 6%. According to the 11th Malaysia Plan (11MP), the introduction of the GST is expected to bring in a revenue stream of RM30bn ($7.4bn), the equivalent of RM1000 ($248) for every person residing in Malaysia and amounting to some 13.7% of government revenue.

Acknowledging Challenges

A risky but necessary move seems to be paying off, with the government claiming the GST has entirely replaced oil revenue, at least from an accounting point of view. However, for many the jury is still out. There was some evident pressure on government finances in 2016, with the administrative burden of setting up a new system resulting in revenue fluctuations. Foo Su Yin, CEO of RAM Ratings, spoke with OBG and cited delays in payments and a sudden increase in bureaucratic burdens to comply with. “One of the main concerns we had was whether the tax would be successfully monitored and implemented,” she told OBG. “But businesses have adapted quite smoothly, resulting in a broadening of the tax base and significant increase in revenue in light of the oil slump.”

Although expected, the move was socially and politically unpopular. Yet the fact is that fiscal adjustment was well overdue. Credit rating agencies Fitch, Moody’s and Standard & Poor’s (S&P) have all long been issuing warning signals to the Malaysian government that it is relying too heavily on royalties and dividends paid by the state-owned oil company Petronas to fund ambitious national development programmes. Only few years ago, in 2009, the Malaysian government used to receive RM65.5bn ($16.2bn) in petroleum-related income that constituted as much as 41.3% of its budget. Meanwhile, the sales and services tax that was in place before the GST replaced it was contributing only 7.5% of total budget revenue. In a middle-income economy with a strong consumption profile, this situation was becoming unsustainable, according to ratings agencies. Though at the time, these agencies noted that Malaysia historically has had fiscal financing flexibility because of its deep capital markets supported by a large national pension fund, there was a concern that an external oil shock could seriously damage the sovereign financial strength.

This was at a time when the federal government continued to explicitly guarantee a slew of infrastructure, housing and development projects with contingent liabilities reaching 16% of GDP in 2015. Rating agencies such as S&P issued warnings that in the absence of fiscal reform Malaysia was set to lose its coveted “A-” credit rating that it put on par with France in terms of its sovereign risk profile.

Taking Action

Thus measures introduced to broaden government revenue were a relief for investors and the financial community. Preliminary fiscal results showed that the performance of government finances in 2015 returned to acceptable levels. According to the Ministry of Finance (MoF), the fiscal deficit in 2015 stood at RM37.2bn ($9.2bn), equivalent to 3.2% of GDP. This compares to RM37.4bn ($9.3bn) and 3.4% in 2014, and even more favourably to RM42.5bn ($10.5bn) and 4.7% in 2011. The overall picture is that Malaysia has started to travel in the right direction in this regard.

Even with oil prices assumed to be as low as $30 per barrel, the MoF projects it can achieve a fiscal deficit of 3.1% in 2016. On the revenue side, the government projects that non-oil revenue will bring in at least RM216bn ($53.5bn) in 2016, a slight decrease of 1.3% on 2015. In operating expenditure, the 2016 budget forecast a 2.9% drop of RM7bn ($1.7bn), while development spending is set to rise by 10.4%, or RM5bn ($1.2bn). Credit rating agencies were quick to reward the government, affirming Malaysia’s currency rating outlook as “stable”. In March 2016 S&P issued a statement, telling investors “Malaysia’s fiscal performance has consolidated after weakening to accommodate the shock of the global financial crisis.” It added, “The annual increase in general government debt had averaged 6% of GDP over 2009-12. Deficits have since narrowed, and we project the average annual increase in debt at 2.8% of GDP over 2016-19.”

Calibrating Spending Priorities

While the Malaysian government is in search of alternative revenue streams, seeking to reduce dependency on oil revenues, it continues to recognise its central role in fuelling domestic demand and supporting national development goals. The release of the 2016 budget was therefore greatly anticipated by private sector players who expected a shift in priorities.

Already in the run-up to the budget, the Malaysian government made the timely move of removing the fuel subsidy. Introduced at a time of low oil prices, it had a fairly muted fiscal impact. However, in the future when prices recover it could lead to savings of around RM30bn ($7.4bn), large enough to finance 65% of total development expenditure in 2016.

Fiscal benefits aside, the removal of fuel subsidies will encourage energy savings in a country that for many years has enjoyed some of the lowest fuel prices in the world. Fast-growing domestic demand has meant that over time Malaysia has lost its favourable position as a net exporter of oil. The government also introduced more targeted assistance for lower-income groups. For instance, it was decided that a monthly school assistance payment of RM100 ($25) will only be provided for households earning less than RM3000 ($743) per month. This led to annual savings of RM190m ($47.03m).

Also, starting in January 2016 the government decided to impose full medical charges on non-residents, which is expected to free up funding for six new hospitals and rural clinics. This is a significant shift given that Malaysia’s health care is one of the more expensive in the region, accounting for 10% of the total operating budget. Another big winner has been the affordable housing segment. In the 2016 budget the government planned a total of 5000 units of affordable houses for 10 locations in Kuala Lumpur close to new transport networks.

Supporting Businesses

In terms of direct support for businesses, the most important new measure was the reintroduction of investment allowances for machinery and equipment, an incentive which had expired in 2000. Available from 2006 until 2008, the new incentive is targeted at private sector players in the manufacturing and agriculture sectors that invest in new technology. The intention is to reduce Malaysia’s dependence on imported foreign labour and create more highly skilled technical jobs for local technicians and engineers. Automation of production lines and packaging is likely to be in high demand in sectors such as rubber, electronics and food processing. In terms of sheer numbers the biggest winner is the infrastructure development sector. In the 2016 budget the government continues to prioritise completion of the Klang Valley Mass Rapid Transit System to improve links in Malaysia’s most concentrated urban area, home to 5m people.

As part of 11MP, a new emphasis has been placed on rural development. Rural electrification projects covering around 10,000 houses were allocated RM876m ($216.8m), while upgrades of rural roads received a total of RM1.4bn ($346.5m) in the budget. The biggest new development has been the launch of the Pan-Borneo Highway project, which is expected to cost as much as RM16bn ($4bn) and will transform the logistics in the eastern Malaysian states of Sarawak and Sabah.

New measures for tourism also amounted to an impressive sum of RM1.2bn ($297.04m) in the 2016 budget. As part of the overall drive to promote non-oil economy sectors, the Malaysian government is targeting 30.5m arrivals in 2016 to boost spending on retail and hospitality. The government will likely be able to recoup at least a share of this investment from the GST, with foreigners also contributing to Malaysian fiscal revenues through spending.

Eye On The Ball 

Despite scoring high marks for implementing bold fiscal moves, the Malaysian government has little margin for error. The flipside of introducing the GST has been a negative impact on business profits and higher prices. Coinciding with a weak ringgit, the move has put a lot of pressure on the Malaysian middle class, which was already impacted by retrenchments in the energy and banking sector. In the short term the government cannot take the foot off the accelerator if it wants domestic demand and private sector to maintain its fragile confidence. Hence a strong adherence to fiscal targets is required to convince markets and investors that Malaysia’s public finances are on solid ground.