Monday, May 31, 2010

Were Ministers Briefed On The Subsidy Rationalisation Proposals?

Or are they just dim? Or did I completely misunderstand the specific proposals for education?

Don’t cut subsidies for students, says deputy minister

The Government has been urged to continue with subsidies under the Higher Education Ministry’s education programmes for students from poor families.

Deputy Higher Education Minister Datuk Saifuddin Abdullah said the ministry provided education subsidies which most parents relied on to send their children for higher studies.

He said many students would not be able to pursue higher studies if the facility was to be withdrawn.

“Many parents in the rural areas whose children study at public institutions of higher learning rely on government aid and loans,” he told reporters after closing a Moh Desa Perwira programme at the National Defence University in Kampung Bangau Parit near here yesterday.

He said the loans provided by the National Higher Education Fund Corporation had helped ease the parents’ burden.

“As such, it would not be right for the Government to reduce or withdraw the education subsidy.”

Principle 2 of the Subsidy Rationalisation Plan says:

Education is a human capital investment and subsidy should continue but we must reduce wastage / abuse.

From the specific proposals:

    • Remove subsidies for foreign students
    • Re-target subsidies for poor families

What on earth is the Deputy Minister talking about? Nowhere is the Government  contemplating cutting support for poor students.


It’s even worse than I thought – apparently ministers aren’t even talking to their deputies.

Thursday, May 27, 2010

Subsidy Rationalisation Lab Open Day

I attended the Open Day this morning on invitation from PEMANDU (or rather my company got invited and I was one of the truckload that got picked to go).

You can find Dato’ Sri Idris Jala’s presentation on the PEMANDU website (warning: pdf link).

Now we know where this RM74 billion figure being bandied about comes from. It includes not just officially designated subsidies, but also Petronas’ spending on the gas subsidy (which isn’t carried on the government accounts), as well as spending on education, healthcare and social services, which aren’t necessarily subsidies as the term is commonly used.

The rest of my thoughts on the subject:

  1. I think for the most part the rationalisation plan is sensible – in the political sense, though not necessarily in the economic sense. Spreading the pain over 3-5 years means less citizen anger, and gives the government time to formulate and implement a better social welfare policy – I’m not sure the mitigation proposals contained in the rationalisation plan go far enough to ensure that the subsidies that remain or newly introduced will offset the impact on the poor and lower income groups.
  2. There was a lot of general support for getting rid of consumer subsidies, especially on sugar (the stats on obesity and diabetes in the open day exhibition were truly frightening) where there were a few proposals from the floor in favour of immediate abolishment rather than phased in over 3-5 years. In this case, I think we have to take the next logical step – if sugar consumption has negative social welfare impact, then removing subsidies only partly compensates for the social costs (treatment of diabetics, healthcare for the obese and overweight). That means there’s actually a strong argument for taxing sugar as well as removing the subsidy on it.
  3. And if you buy that argument, then it goes ten-fold for petrol and other use of carbon fuels, because the environmental and social impact is so much greater. If you consume too much sugar, the costs are largely borne yourself, and partly on society through higher healthcare costs. Pollution from carbon fuel burning affects the air we all breathe, not just ourselves. That health costs are less visible, but no less powerful – check the incidence of asthma and bronchitis, not to mention lost work days from illness resulting from pollution (check this post for the basis of my argument).
  4. On the time span for rationalisation, I’m in favour of a shorter rather than a longer period. BNM apparently ran some simulations and came up with a figure of 4% in 2011-12, and back to 3% from 2013-2015 if all the proposals were implemented. To me the problem with a longer period is that you risk unanchoring inflationary expectations – i.e. people will start expecting higher inflation as a matter of course, and that means continuously higher wage demands which feed into higher inflation.  There was one proposal from the floor for the period to be shortened to 24 months – I think that strikes the right balance between spreading the pain and getting it over with as fast as possible. Five years is a long time, especially in politics, and there’s no guarantee that the political will for getting rid of subsidies will last that long. Understand that I’m not arguing against cost of living adjustments to existing wage levels – but rather a self-perpetuating cycle of price increases, which would necessitate a monetary policy response. As it is, I’m already thinking that OPR might go back to 3.5% next year, and even higher in 2012, just to mitigate higher nominal demand.
  5. There was also a lot of talk on education, although I think even the panel discussion missed some basic points. Dato’ Sri Idris mentioned that Malaysia ranks 7th in the world in spending on education per capita. If that’s the case, then the declining standards in maths and science in Malaysia suggests that money isn’t being used as effectively as it should, nor does it explain why tertiary enrollment (<30%) is so low compared to high-income economies (>60%). That’s a qualitative and quantitative issue that has to be addressed.
  6. Apart from a remark by Tan Sri Azman Mokhtar and an observation by YB Tony Pua that the fall in global oil prices meant that there is effectively no subsidy on petrol, there was little to no discussion on what to do if market prices fell below government mandated prices during the rationalisation phase – shall we go to market prices directly? Or some form of adjustment mechanism? Details here would be welcome.
  7. I’m still against the idea of providing substantive support to smallholders and small-scale fishermen. They are not productive, and no amount of technology or incentives are going to make them so. Better to provide living support (just give them cash), until the pace of development overtakes them. I know that sounds callous, but our food and agricultural production will never improve if we only look to perpetuating an existing moribund market structure that cannot survive without government support, instead of rationalising land use and capital into units that can be competitive and productive. This is of course more a political issue rather than an economic one, which is why I doubt there will be much change here.
  8. The panel discussion very nearly turned into an IPP-bashing session, and here’s hoping that there will be some movement in the direction of renegotiating the contracts.
  9. YB Tony also brought up the issue of toll highways, again. Check out his blog for details.

Wednesday, May 26, 2010

Is Ability In English Important?

You betcha. The debate on English education in Malaysian schools has from my perspective largely been conducted on the basis of “he said, she said”, with very little in the way of compelling research to back up either of the two opposing positions. While I’m firmly in the “English is important” camp (it’s certainly helped boost my career), I’ve never been comfortable without the backing of solid data. So I was quite happy to see this in my RSS feed yesterday (excerpts):

English skills raise wages for some, not all, in India

It is widely believed that there are sizable economic returns to English-language skills in India. Due to India’s British colonial past, English remains an official language of the federal government, and is still used in government and education. Moreover, due to the rapid expansion of international trade and outsourcing in recent decades, English has become even more important. Despite this, there are surprisingly no estimates of the wage returns to English skills in India. The impediment appears to have been the lack of a microdata containing measures of both earnings and English ability. In our study (Azam et al. 2010), we quantify the English premium using data from the newly available 2005 India Human Development Survey (IHDS)...

Estimates from Table 1 suggest that for men, hourly wages are on average 34% higher for workers who speak fluent English and 13% higher for workers who speak a little English relative to workers who speak no English. These effects are not only statistically significantly different from zero, but also economically meaningful. For example, the return to being fluent is as large as the return to completing secondary school, and half as large as the return to completing an undergraduate degree. For women, the average return is 22% for fluent English and 10% for a little English...

A striking finding is that older workers earn high returns to English regardless of their educational attainment while younger workers earn high returns only when they are highly educated. For example, older men without an undergraduate degree receive a 53% wage premium for being fluent in English, compared to 28% for older men with an undergraduate degree. In contrast, younger men without a degree receive a 13% wage premium for being fluent in English, compared to 40% for younger men with a degree. Among younger men, the returns to English are increasing in educational attainment. Furthermore, we find that English skills do not raise wages at all for younger men who have not completed their secondary school education...

Quantifying the returns to English-language skills in India is of interest for several reasons. First and foremost, a deeper understanding of the returns to learning English will help individuals and policymakers in India make decisions about how much to invest in English skills... But the amount to invest is the subject of active debate. In India, as well as many other developing countries, there are those who favour promoting the local language as a way to make primary schooling more accessible and to strengthen national identity. At the same time there are those who argue that learning English leads to economic prosperity given the role of English in the global economy and many Indians are willing to spend extra money on schools and tutors to gain English proficiency. Given that English skills are costly to acquire – it takes time, effort, and often money, to learn English – choosing the optimal amount to invest in English-language skills involves comparing expected costs to expected benefits. This study provides the first estimates of these expected benefits.

‘Nuff said.

Tuesday, May 25, 2010

Subsidies? How About Raising Petrol Taxes Instead?

One of the key aspects of the NEM, and a vital part of regularising government finance, is reducing and eventually phasing out entirely subsidies, particularly on food and fuel. Some of the figures bandied about, not least by the Prime Minister, are a little too much in la-la land, but the gist of it is clear – the cost of subsidies are too high, they’re not benefiting the target groups as much as they should, and they’re creating perverse economic incentives.

There’s a nice piece on the subject of petrol subsidies in yesterday’s The Star (excerpt):

Malaysians consume more fuel

As Malaysia practises a blanket subsidy on fuel, data made available to the Performance Management and Delivery Unit (Pemandu) subsidy rationalisation lab showed that 71% of fuel subsidy was enjoyed by the middle to high-income level groups.

Some 28% of those enjoying fuel subsidy earn more than RM5,000 per month, while 43% earned between RM2,500 and RM5,000.

Abuse of liquid petroleum gas (LPG), or cooking gas, has also contributed to an inflated subsidy bill. Some RM1.71bil was spent on subsidising LPG, to which only RM397mil or 30% are used by households.

In addition, there’s the rather telling datum that fuel consumption rose 8% in 2008, despite pump prices doubling in that year.

What are the actual subsidy numbers? Officially, based on MOF’s functional classification of expenditure, the government spent RM18.6 billion on subsidies in 2009 and RM35.2 billion in 2008. The historical data is illuminating (RM billions, inflation adjusted; 2000=100):

01_subs Subsidies started climbing in the wake of the 2000 recession, and haven’t stopped since. The killer blow was the climb in commodity prices and the concurrent upswing in food prices in 2008 (remember the rice “shortage”?).

Of course the official figure isn’t the whole story – there’s the hidden gas subsidy at Petronas which ends up as reduced government income from petroleum royalties and corporate taxes; the difference in pricing between what TNB charges against what it has to pay the IPPs; controlled prices on basic food items; as well as whether development spending as a whole can be considered as subsidies, as implied by the PM’s figures. I don’t think any of these are on the table for abolishment just yet.

In any case, the cabinet is meeting tomorrow to discuss the issue, and there will be an open day at KLCC on Thursday to gain public feedback.

The key problem in my view is that the subsidies are directed at consumer prices, rather than targeted at a particular group. This is easier to administer, but from the numbers in the article quoted above, it’s fairly obvious that the actual benefits accrue to everybody, rich and poor alike, corporations as well as individuals. That’s a rather inefficient and expensive way to handle welfare transfers – it’s actually highly regressive i.e. those that benefit the most need it the least.

But getting rid of subsidies isn’t the whole answer, as you still have the negative welfare impact on the poor and lower income groups from higher food and fuel prices. They’d still need some form of support to replace the expenditure lost through higher outlays. Royal Professor Ungku Aziz has suggested a debit card scheme for the hard-core poor, with a monthly token of RM300 for basic food items. Or you can follow some Western practices like food stamps, or outright cash giveaways. Whichever the route we end up following, there’s going to be a call on Government finances and there’s going to have to be some form of administrative framework to manage the scheme i.e. the Government’s going to get bigger.

Now, from the financial perspective funding a social safety net can be derived from savings gained from the abolishment of subsidies. I don’t think that’s going to be a big issue, unless the scheme itself becomes too complex, or the government goes overboard in terms of benefits. You could also argue for an income tax cut, but that would be pretty regressive too as the tax base is so narrow. Alternatively, the reduction in subsidies could be predicated on a lower GST, if and when that comes into play.

However, there’s a hidden aspect particular to petrol and gas that isn’t being addressed – pollution and the concomitant need for healthcare (need I say that the services offered by public hospitals and clinics are also highly subsidised?), known in the economic terminology as negative externalities. Abolishing subsidies on these items would go a long way toward matching supply and demand, but the market price does not address their true economic costs. These become another form of hidden subsidy – increased healthcare costs, pollution cleanup costs, infrastructure delivery costs and more, that are borne not by the users of petroleum products but by everyone.

So I’m firmly of the belief that we ought to tax petrol and gas, not just lift subsidies. That achieves three things – one is to impose the true costs of using petrol and gas on users; secondly, it reduces fuel consumption, the impact on the environment, and encourages conservation; and third the proceeds can be used to help offset the costs of both the social safety net as well as the ancillary costs of the negative externalities arising from the use of petroleum products. It also helps that a Pigovian tax and transfer mechanism of this form will also be far more efficient in terms of raising social welfare and rebalancing incomes. There’s also the secondary effect of increasing pressure to raise pay packets – which is the direction we want to head in anyway.

I’m not blind to the difficulties here. There’s an obvious corollary that the government’s social welfare capabilities needs to be beefed up (it’s awful right now) in terms of manpower, organisation, data collection and funding – which increases the opportunities for waste, mismanagement and corruption. There’s also going to be an outcry from the middle classes, as they have the most to lose (no increase in benefits, but with all the cost).

This isn’t a vote winning proposition, but it is the right and economically correct thing to do.

For Further Reading (from Prof N. Gregory Mankiw):

  1. The Pigou Club Manifesto
  2. Alternatives to the Pigou Club
  3. Smart Taxes: An Open Invitation to Join the Pigou Club (pdf link)

Monday, May 24, 2010

April 2010 CPI: Tightening The Screws

April’s consumer price report shows the overall price level has been flat for the fourth month running, while the core price level (ex-food, ex-transport) is barely budging (log annual and monthly changes; 2000=100):


On the surface, that’s not a particularly good sign – if in fact the economy was growing, you would expect prices to be rising as the economy returns closer to full capacity. There’s a couple of reasons why there hasn’t been much movement, and the big one is the appreciation of the MYR (trade-weighted nominal index; 2000=100):


The MYR is up 7.1% in log terms for the year measured by the trade-weighted index, and is up against the currencies of every one of Malaysia’s major trade partners (my definition: >1% share in exports or imports). The big shifts are against the Euro (19.8%) and the GBP (15.1%), but we’re also up against Japan (8.3%), Australia (7.7%) and China (5.4%). Against our regional peers, the MYR hasn’t moved as much, which explains why food prices especially have held steady, as opposed to actually falling.

The other rather (marginally) less important reason is that there actually isn’t much momentum in terms of domestic demand in the economy, notwithstanding the 10.1% GDP growth in 1Q 2010. What we’re seeing over the last few months has really been a trade-driven recovery predicated on a commodity price upswing, which obviously isn’t having much impact on taking up the slack left by the recession much less the existing spare factory capacity which we already had pre-crisis. That in turn means that there’s very little pricing power that can be leveraged to improve business margins, hence the subdued inflation outlook this year.

The problem for the Malaysian consumer going forward is that I think the MYR uptrend has run its course for now – the MYR has risen nearly 8% in log terms in the space of 9 months, which is pretty abnormal even for a highly volatile international forex market. If BNM’s normalisation of interest rates continues pulling in portfolio capital, then I’d start to consider MYR to be overvalued again, much like it was at the end of 2007. The long term structural story for MYR is still intact, but I’m looking for a breather so that the fundamentals can catch up with market prices.

On that basis I’m still looking for higher inflation in the second half and a consolidating exchange rate, but we’re likely to average under 2% CPI growth for the year.

On a side note, subdued inflation and a stronger Ringgit both mean that BNM’s tightening shift is being magnified i.e. monetary policy is tightening faster than implied by the two 25bp hikes already made. My view remains that BNM should’ve let held fast at the last MPC meeting, with the next hike in July. If they do hike one more time in July, I think that will be it for the year.

Thursday, May 20, 2010

OPR Trajectory Subject To Prevailing Conditions

The Governor is keeping her options open:

Zeti: Further hikes in OPR will depend on economic performance

Governor Tan Sri Dr Zeti Akhtar Aziz said the normalisation process for the overnight policy rate (OPR) was a “dynamic one” and depended on how the economy performed.

“The process of normalisation is a dynamic one, if there's a slowdown in the economy then we'll pause but if there's growth then we'll continue,” she told reporters on Wednesday.

The next Monetary Policy Committee meeting is scheduled for July, which means at best they’ll be deciding on the level of the OPR based on April and May economic numbers.

I’d originally thought that BNM would stand pat in May and raise in July, as 1Q 2010 numbers were good, but not so good as to justify a rapid tightening in policy. Certainly the developments of the last couple of weeks stemming from the dramatic fallout from the bailout of Greece, where there’s been a reassessment of Europe’s chances of a sustained recovery, argue for some caution.

Sharp falls in commodity prices also augur badly for sustained trade growth, since that has been the main driver for Malaysia’s export performance since at least 2006. And 1Q 2010 GDP growth had mixed numbers on a quarter to quarter basis.

But the rest of the region is still being pulled along by the China’s economic dynamo (Singapore has just revised 1Q 2010 GDP 2% higher – pdf link), and prospects in the US and Japan appear to be brighter.

On that basis, I think BNM will add another 25bp to the OPR in July as I originally thought, even if I think the pace of tightening is a little too quick for my taste.

Tuesday, May 18, 2010

ADB Thinks Emerging Asia Should Think About Capital Controls

Seems we're getting an outbreak of sanity here, especially after the IMF's change of heart (excerpt of press release):

Emerging Asia Should Be Ready to Act on Potentially Destabilizing Capital Inflows - ADB Report

The report said recent surges in capital inflows have been driven by portfolio equity flows as investors take advantage of widening earnings potential between emerging Asian and mature markets.

The use of capital controls may be appropriate in circumstances where capital inflows are transitory and are adding undue pressure on exchange rates and where effectiveness of macroeconomic policy measures to counter the inflows and the exchange rate movements is uncertain.

"Managing capital flows requires a wide array of policy measures; sound macroeconomic management, a flexible exchange rate regime, a resilient financial system and sometimes the use of temporary and targeted capital controls," Mr. Madhur said.

How and why do capital flows cause problems? There are a number of dimensions to this question, and most of the answers are bad.

First, on an overall basis, there’s little evidence that an open capital account, where portfolio capital is allowed to freely move into or out of a country, has any beneficial effect on economic growth or development (as opposed to capital market growth and development). In fact the opposite effect is more prevalent – liberalisation of the capital account in developing countries has a distressing tendency to turn into a full-fledged currency/financial crisis.

There may be an argument that inflows of foreign capital can lower the cost of capital, and thus increase real investment, but I find this line of thought unpersuasive. As I pointed out once, investment in the stock market is not investment in an economic sense, and does not contribute to a nation’s stock of real wealth – unless shares and bonds are bought at source via the primary market i.e. IPOs or auctions.

More to the point, the real problem with foreign portfolio inflows is twofold – they can just as easily leave as they come in; and they have a destabilising impact on nominal (but not real) valuations. The first problem is well-known, and complicates everything in macro-economic management, from volatility in exchange rates, money supply, and market interest rates, to the increased financial fragility of the financial system through cheap short-term foreign funding recycled through the banking system into long-term illiquid assets such as loans. This is exactly the problem that underlay the vulnerability of Malaysia and other East Asian economies in the run-up to the 1997-98 crisis.

The valuation issue essentially arises from this – nominal asset prices on the capital markets are determined by demand and supply of those assets. There’s nothing here to relate these prices to the underlying intrinsic value of any asset. If an asset was already correctly priced, then incoming money flows would inflate the price of that asset beyond its fundamentals – you have an asset price bubble.

The problem is further complicated by portfolio asset allocation, where foreign fund managers follow certain allocation rules – they generally go for highly liquid stocks and bonds (the better to sell in case of trouble), which in our case would be KLCI component stocks, and MGS or AAA corporate bonds. That means that incoming hot money flows tend to overinflate prices of highly liquid assets, and disproportionately reduce them when they leave. So what you get is much higher volatility in highly visible capital market securities.

The problem is much worse if capital inflows stick around for too long, and get recycled through the banking system. Since capital inflows in the presence of a flexible exchange rate cause an appreciation of the currency, that makes foreign funding cheaper for domestic companies. This is even more apposite since BNM is ahead of the curve in raising official interest rates. Foreign money inflows also have the impact of increasing the money supply and reducing market interest rates, potentially opening the door for inflation.

But the flip side is also true – a sudden outflow of portfolio funds will cause the exchange rate to depreciate, which while it won’t affect your funding cost would certainly affect the principal you have to pay back (not to mention creating a constricted monetary environment just when you need it the least). That in essence was Thailand’s and Indonesia’s bugbear in 1997-98, as their private companies had borrowed in USD but had their income streams in Baht and Rupiah. The downfall of the US dollar pegs in those countries caused a massive private debt crisis, to go along with recession and the loss of international purchasing power.

In short, portfolio capital flows tend to exacerbate changes in the business cycle, which has obvious costs in terms of misallocation of real investment.

So are capital controls the answer?

Only an imperfect one, as in it’s really hard to make them truly effective – where there’s profit to be made, there’s bound to be someone willing to take a risk on both sides of the border (China and its “A” shares are a good example). On the other hand, there is evidence to suggest that capital controls on portfolio capital flows does not harm foreign direct investment at all, so that is a positive.

Second is the issue of whether the capital controls imposed are transitory or permanent – the former can make your policymakers look wishy-washy (low credibility), while the latter would hamper development of the domestic capital markets. You have to pick your poison here.

Third, there’s little precedent for designing effective capital controls in the floating exchange rate era. We have very few case studies of effective implementation of capital controls in the last 40 years, and ironically Malaysia’s two flirtations with capital controls (1993-94, 1998-2005) are among the better known and most studied. Chile in the 1990s is another good example, targeting very specifically short term capital flows. The IMF is now advocating more research into policy design in this area, so we might have some hypotheses to test out soon.

Friday, May 14, 2010

1Q 2010 GDP: Solid Growth, But Momentum Is Slowing

Yesterday’s GDP numbers included some revisions to previous data that changes the growth numbers somewhat, but doesn’t change the fact that the economy posted some pretty good numbers for 1Q 2010, beating the consensus estimate by 0.7% to reach 10.1% for real GDP growth (log annual changes; 2000=100):


While growth was across the board, the real driver was a strong upswing in trade over last year’s numbers. The rest of the components posted less than impressive growth numbers.

The supply side showed equally solid growth across sectors except for mining, with manufacturing leading the way (log annual changes; 2000=100):


I think these solid numbers prompted BNM to continue with their “normalisation” of interest rates, though it’s interesting that the market is talking about “better than expected” whereas BNM is saying “recovery is well entrenched”. That’s a nuanced view of things, and if you look at quarter on quarter growth, you’ll see why – although we still see growth, the magnitudes are less than comforting.

On the demand side, trade is still driving GDP up, but growth is well down from 4Q 2009 (log quarterly changes, seasonally adjusted and annualised; 2000=100):

03_demand _sa

Note that investment is nearly 10% down from the last quarter, and trade volume is falling. Private consumption is still weak (+4.4%), although there is some minor support from government spending (+8.4%).

On the supply side, it’s agriculture that’s showing negative growth (-3.0%) while mining in contrast has zoomed up (19.8%). Manufacturing growth has slowed though still high at 14.9%, but the construction (+3.2%) and services (+1.3%) sectors are almost flat (log quarterly changes, seasonally adjusted and annualised; 2000=100):


Under these circumstances, I’ve always found it useful to look at the levels, rather than growth numbers. There’s always a risk of a distorted picture using growth metrics alone when an economy is going into or coming out of a recession. The contrasting scenarios shown by the different growth measurement methodologies certainly suggest looking beyond mere growth numbers (real GDP; 2000=100):


On the demand side, it’s clear that trade caused the recession, and trade has largely brought the economy back. The levels are still below 2008 peaks however, and investment is lagging the other components. Private consumption is a little weaker than it should be, though it looks like its more or less back to its long term growth path.


On the supply side, manufacturing took the brunt of the recession (mining looks bad, but the numbers are approximately level). I’d discount the contribution of the construction sector because it’s so small, while agriculture and services are substantially unmoved off their long term growth paths.

For the rest of the year, the prognosis for growth depends really on whether there is a full recovery in trade and investment. I think that’s likely as the US economy is strengthening and Europe and Japan have bottomed out. The risk factor is primarily in my view a pullback in growth in China, which I think is unlikely over the near term – of course, I’m no China expert so take that with a bucket of salt.

But to return to the issue of “normalisation” of the OPR, from the look of things, there’s still a substantial positive output gap i.e. the difference between actual and potential output of the economy. That in turn suggests that there’s not much foundation for a structural rise in inflation, which in turn argues for a more moderate approach to increasing interest rates.

I’m not keen on the “asset price bubble” story, as I see little evidence that cheap domestic money is playing a role in driving up asset prices locally. It’s hot money from outside the country that is propping up the bond market and causing the Ringgit to rise, and an interest rate hike (while penalising existing bond holders), will attract further foreign portfolio interest.

Time for capital controls? Maybe, especially as the thinking on capital controls have turned 180 degrees in the last ten years.

Technical Notes:

1st quarter 2010 GDP report from the Department of Statistics

OPR @ 2.50%

Looks like the majority opinion got it right, and I was wrong – the Monetary Policy Committee raised the OPR 25bp to 2.50%, citing a stronger than expected recovery” in the global economy and the economic recovery is firmly established” in the domestic economy.

Note the difference in emphasis – I’ll talk about these differences in the following post on the GDP numbers that were released at the same time and why it has coloured my view on the direction BNM should have taken.

Click here for the full press release.

Wednesday, May 12, 2010

March 2010 IPI: Full Steam Ahead

It’s rare that I can be unequivocal about interpreting the data, whether it’s GDP, inflation or anything else. But yesterday’s industrial production report from DOS doesn’t pull punches.

Whichever way you look at it, growth has been positive and high (log annual and monthly changes;seasonally adjusted; 2000=100):


About the only sour note, if you can call it that, is that apart from electricity generation index levels are still below 2007/2008 peaks:


But since I’d consider 2007/2008 as a bit of a bubble period anyway, that’s no real cause for not considering the economy to have fully recovered, at least in terms of industrial production.

Now, what does this say about 1Q2010 GDP growth? My point estimate based on IPI alone as an explanatory variable suggests 11.0% in y-o-y percentage terms and 10.4% in log terms – the consensus estimate is 9.4% in percentage terms. The risk is all on the upside, as IPI does not incorporate services output.

The picture is slightly less rosy if we use the internationally accepted methodology of annualised, seasonally adjusted quarter on quarter growth, which yields just 6.7% in percentage terms and 6.6% in log terms. This is a factor of the rip-roaring growth of 14.6% in 4Q 2009, which obviously increases the base of the calculation.

Technical Notes:

March 2010 Industrial Production report from the Department of Statistics

Euro Debt Crisis and Contagion Roundup At Morgan Stanley

Morgan Stanley’s Global Economic Forum has a fantastic roundup of developments in Europe and possible contagion effects around the globe, including East Asia as well as a piece on Malaysia (excerpt):

We think that the impact on Malaysia would be more significant from the perspective of trade linkage rather than capital flows. On the latter, Malaysia's FX reserves are about three times its short-term external debt. This is way above the global adequacy benchmark of one, reducing the currency's vulnerability should capital flows dry up. Moreover, the basic balance surplus (comprising more stable flows such as current account balance and FDI) had been the key contributor to the balance of payments position and FX reserves, rather than portfolio flows. This also further mitigates the impact on domestic liquidity conditions and currency amid a decline in risk appetite. Indeed, Malaysia's exposure to the fiscal debt concerns in Europe would come predominantly via the trade front. As a portion of total exports, ASEAN exporters' exposure levels to Europe demand look fairly similar. About 8.6-11.0% of total ASEAN exports are bound for the EU15. More specifically, 0.5-3.2% of ASEAN total exports are bound for Greece, Italy, Portugal and Spain. However, within ASEAN, we note the high export orientation of Malaysia's economy, with exports of goods standing at 82% of GDP (of which 10.3% is to the EU15). In this regard, Malaysia would thus be the second most exposed (after Singapore) to a slowdown in euro growth and the cascading effects of that on Europe's trade partners.

Note: Since the page link will change depending on updates to GEF, I’ll be updating the hyperlink to the MS page once it gets posted to the GEF archive.

About the only (technical) quibble I have is this line in the article analysing the compromising of the ECB’s independence:

Tonight the ECB decided to take one step further and - in addition to reinstating some of the measures it had already taken during the height of the financial crisis (term funding and USD swap lines) - also open the door to outright purchases of government bonds. These purchases will be sterilised and as such do not constitute quantitative easing, i.e., an expansion of the ECB's balance sheet.  So far, the size of the intervention programme and the details about which debt instruments the ECB is going to buy are not known.

They’re right that sterilised purchases of Eurozone government bonds would not constitute quantitative easing, but they’re wrong that it would not result in an expansion of the ECB’s balance sheet. My understanding of the process goes something like this:

1. Purchase of Euro government bonds through Euros created at the ECB (+ assets, +liabilities)

2. Sterilisation through issuance of ECB bills to drain the excess money created in step 1 (+ assets, + liabilities) – money supply stays constant

3. Offset of Euros created and bought back in step 1 and 2 (- assets, - liabilities)

This means the ECB’s balance sheet will still increase by whatever amount of government bonds it purchases, except that its liabilities will be interest bearing (ECB bills) rather than non-interest bearing (Euros).


Link to the archived page.

Your Deposits Are Safe

…from 1 January next year, at least if you have less than RM250,000. Perbadanan Insurans Deposit Malaysia is also working on a similar protection scheme for insurance and takaful policy holders.

There’s always a potential moral hazard issue with a deposit insurance scheme – since depositors are protected from bad management by banks, that might make banks more willing to take on more risks. On the whole however, the empirical evidence is mum on this issue in the nearly 80 years such schemes have been used.

Tuesday, May 11, 2010

Silly Reporting, Sillier Analysis

From Bloomberg a couple of days ago (excerpt, bold emphasis mine):

Inflation Fears May Slow Malaysia Subsidy Cuts, Economists Say

By Barry Porter

May 10 (Bloomberg) -- Malaysia may cut subsidies slowly to prevent triggering record inflation as it prepares to revamp a system that’s hampered efforts to reduce the budget deficit, Standard Chartered Plc and Citigroup Inc. said.

A taskforce is exploring ways to revamp the government’s entire portfolio of subsidies that keep the cost of essential items from flour to highway tolls low for consumers. An attempt to reduce the amount the state pays to cap fuel prices caused inflation to surge to a 26-year high in 2008 as gasoline became more expensive.

The government will learn from past experience and ensure its subsidy cuts will be a “very tempered, gradual process,” Alvin Liew, an economist at Standard Chartered in Singapore, said May 7. “They still have time on their hands. It’s not a Greek situation where they need a bailout, not yet anyway.”

Malaysia spends about 73 billion ringgit ($22 billion) a year on subsidies, Prime Minister Najib Razak said on April 6, calling the amount “not sustainable.” The government, which has said it is considering a global bond sale, aims to narrow its budget deficit to 5.6 percent of gross domestic product this year from a 22-year high of 7 percent in 2009.

What’s wrong with this picture?

First, take note that in July 2008 crude oil reached over USD140 per barrel on the world markets. That’s about double the level it’s at now. The level of price increase necessary to equilibrate domestic gasoline prices with world prices are far lower right now than it was in 2008. Since the outlook for crude oil prices are still up, that means the time to cut subsidies is now, not later.

Second, Alvin Liew’s comments are so off base that I’m wondering if we’re looking at the same country. Greece has a public debt to GDP ratio of 125%, an external debt to GDP ratio of 170% (public and private debt), a budget deficit of 13.6% (all 2009 numbers) and external reserves of just USD3.5 billion (2008). Malaysia’s corresponding numbers are 53.7%, 36.1% and 7.0% (2009 numbers) and USD96 billion (as of end-April 2010). Huge, huge difference in terms of national and external liabilities, and the financial resources to meet them.

Greece also has the problem of having its entire national debt denominated in Euros or other currencies, whereas Malaysia’s is mainly in MYR. That means that in extremis Malaysia can print Ringgit to meet its national obligations, while Greece has to beg the European Central Bank to pick up its debt (which after much arm twisting and teeth gnashing, the ECB has finally committed to do) and rely on the EU and the IMF to provide short and medium term financing. While printing money is not an ideal solution as it risks a run on the currency and rising inflationary pressure, it does mean that near term debt obligations can always be met by a country issuing its own currency.

In addition, membership of the Eurozone means that a de facto devaluation of the currency cannot in fact happen (relative to other Euro members), which means that Greece has no chance to improve its external competitive position, unlike what occurred in East Asia during the 1997-98 crisis.

In short, Malaysia doesn’t – and won’t – need a bailout.

Third, I think our Prime Minister is guilty of hyperbole when quoting that figure of RM73 billion in subsidies. I can’t actually reconcile this statement with the actual published figures, and the only way I can get near that number is to add development expenditure to operating expenditure that’s classified as subsidies. Otherwise, spending on subsidies in 2009 was only RM18.6 billion.

Also on Bloomberg (not on Malaysia, but just as silly):

Fed Restarts Currency-Swap Tool With ECB Amid Crisis (excerpt)

The Fed’s swaps come at a time of increasing political scrutiny. Congress could ask why the U.S. central bank is expanding the supply of dollars to help smooth disruptions caused by fiscal imbalances in Europe.

Senator Bernard Sanders, a Vermont independent, wants the Government Accountability Office to look into Fed lending facilities during the crisis, including swap lines with foreign central banks, such as the $20 billion facility the Fed opened with the ECB in December 2007.

A vote on the Sanders amendment could come as soon as May 11 as Congress proceeds on the most sweeping overhaul of financial regulations since the Great Depression.

“Many members of Congress are deeply suspicious of the Fed’s interventionist instincts,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. “Bailing out Wall Street caused enough resentment; appearing to bail out Greece would be even more problematic.”

“The Fed cannot afford to rile up its congressional critics while the financial reform bill is still in play,” Crandall said before tonight’s announcement.

I’ve commented on this before (read this post for details) – a swap line is not a loan in the conventional sense. And the Fed supplying USD to the ECB under the current circumstances simply means those Dollars go straight back to the US. Factual note: the Fed’s swap line with the ECB in 2007 was US$300 billion, not the paltry US$20 billion quoted in the article.

Views on the OPR

I’m in the minority:

Economists widely expect interest rate hike in M'sia

They see a 25 basis points rise at Thursday's meeting

PETALING JAYA: Bank Negara may raise the overnight policy rate (OPR) by 25 basis points (bps) to 2.50% at Thursday's monetary policy committee (MPC) meeting, economists said.

RAM Holdings Bhd is anticipating a 25 bps increase in the OPR as part of the central bank's interest rate normalisation process since early March following the country's strong fourth-quarter economic performance last year.

"The increase is likely to take place to pre-empt [sic] an overshooting of asset prices which can be a result of excessive speculative behaviour in the economy, shown by the recent increase in the disbursement of loans and the spike in the local bourse's turnover ratio in March," economist Jason Fong said.

It’s more of the same from most of the rest, though Peck Boon Soon of RHB Research Institute expects the next move to be in July, as I do.

March 2010 Monetary Policy Update

After all that has happened during the past week in Europe and in capital markets, it might seem a bit strange to focus on more mundane local happenings but with a possible rate hike coming on Thursday, reviewing the arguments for and against takes precedence as this will have a more immediate and direct impact on the Malaysian economy.

On the face of it, there’s little enough evidence to recommend a rate hike, save for the “normalisation” of interest rates that BNM is committed to. Money supply growth is hardly excessive (log annual and monthly changes; seasonally adjusted):


…although loan growth looks a little high, it isn’t excessive either (log annual and monthly changes; seasonally adjusted):


Inflation is tame, and while I expect it to go up it should remain below Malaysia’s long term average of around 2.5%-3.0% for the year (log annual and monthly changes; 2000=100):


Interest rates have of course responded to the last rate hike in early March:


…but MGS yields have turned down slightly due to increased foreign portfolio capital inflows, which have landed primarily on the government bond market as the most liquid “safe” asset to park in.

The big risks in BNM’s view is less on consumer price inflation, but rather asset price inflation and the risk of a setback externally. In that sense, the indicators I’ve outlined above are probably of less importance.

Unfortunately, there’s not many solid clues to look at here. MGS yields turning down is a sign of bullishness among investors, as is the (up to last week at least) rising MYR. The KLCI looks like its tapped out for the moment (though I’m no stock expert):

05_pe ratio

On the non-financial side, house prices seem to have recovered their upward trend, but all the action seems to be confined to high rises which have inherently volatile prices anyway (and for some strange reason, most of the price increases in Q4 2009 appears to have been driven by prices in Penang).

Household borrowing zoomed up on a y-o-y basis, but has generally moderated over the past couple of months – the base effect again (log annual and monthly changes):


The external front is less clear, with the US continuing on a rocky road to recovery, but Europe risking another downturn. Growth in East Asia is of course continuing at a fairly torrid pace, though few if any of the monetary authorities appear particularly eager to start tightening too rapidly, which should keep regional demand up.

On balance, there seems to be little argument for a rate hike *right now*, as opposed to waiting two more months to the next meeting in July. That GDP growth is going to be impressive in Q1 2010 is neither here nor there – with the bottom of the recession occurring in Q1 2009, this past quarter’s growth was going to be above average anyway.

Right now, I’m leaning towards BNM holding steady at this coming meeting, as much because there’ve been no comments from the Governor to prepare the ground so to speak, as anything else.

Thursday, May 6, 2010

Scott Sumner Takes A Shot At China Bears

…not for being wrong, but for being disingenuous (excerpt):

Plato would not be impressed

"I’m not impressed by predictions that assume the EMH is wrong. But I am willing to keep an open mind on the EMH. I am especially unimpressed with predictions that assume the EMH is wrong and that are based on false or misleading economic statistics. If those predictions turn out to be accurate, it would not make me think more highly of the person who made the prediction, I’d just assume he got lucky.

I understand that predictions are fun, and it’s only human to want to anticipate what will happen next. I’m all for making conditional predictions based on various public policy options. And I’m all for drawing inferences regarding the implied predictions embedded in asset prices. But the sort of unconditional predictions discussed in the Bloomberg article should be placed in the astrology section of the newspaper. Fun to talk about, but not to be taken seriously."

EMH by the way is the Efficient Markets Hypothesis. While I’m inclined to lean against the EMH being right, statistically speaking it’s not very easy to prove or disprove.

In any case I would not have structured an argument against China bears in terms of EMH anyway – I think it is less than useful to frame analysis of developing countries, particularly one as dynamic and as diverse as China’s economy is, in terms of the equilibrium conditions in developed economies. That is, the dynamics and interaction of money, debt, growth and asset markets are radically different between an economy on its production frontier, and one that is attempting to reach it.

For the same reason, I find it difficult to fault China’s management of its currency – you cannot directly take an economy with deep and broad financial and capital markets that are capable of withstanding volatility and massive capital flows, then make judgements on what monetary policy should be followed in a country with a relatively weak and unsophisticated banking system. Financial liberalisation in developing countries has almost always been followed by financial crises, not just in East Asia but pretty much across the globe (Mexico, Russia, Turkey to name a few). China’s heavy-handed approach to managing its currency and banking system may not be optimal in Western eyes, but it is governed by necessity.

Wednesday, May 5, 2010

March 2010 Trade: Busting Out

So much for looking at the upper range of last month’s interval forecast – the March numbers went well past (log annual and monthly changes; seasonally adjusted):


The post-CNY bounce was a lot stronger than I figured, and it also gives a big boost to expectations of a very strong Q12010 real GDP growth figure which should be due out at the end of this month. This also means that another 25bp hike in the Official Policy Rate is now definitely on the table for the next Monetary Policy Meeting, due next week.

Back on the trade front, most of the growth occurred in non-electronics exports:


…and I suspect the boost is mainly being driven by improvements in the terms of trade i.e. we’re benefiting from higher commodity prices:


The appreciation of the MYR over the last two quarters dampens the effect of higher prices somewhat, but not enough. Note that the global economy has recovered to its pre-recession income level, so growth from here on out is subject to output constraints which will have the effect of boosting commodity prices further.

The outlook over the 2Q2010 looks even better, with intermediate good imports climbing continuously since last August. For next month’s forecast though, I expect a bit of mean reversion to be going on, though realisation should still be in the upper range of the forecast:

Seasonally adjusted model


Point forecast:RM56,234m, Range forecast:RM63,284m-49,185m

Seasonal difference model


Point forecast:RM51,333m, Range forecast:RM58,566m-44,100m

Technical Notes:

Preliminary March 2010 External Trade Report from the MATRADE

Tuesday, May 4, 2010

Impressions of Dubai: Lessons for the NEM

I’m back after spending close to a week in Dubai and an interesting trip it was. The United Arab Emirates (of which Dubai is a part) has one of the highest per capita incomes in the world – ranked third in real terms after Qatar and Luxembourg in 2007 according to the latest Penn World Tables (Malaysia is ranked 53rd by comparison).

Dubai has an interesting economy and its development perhaps holds some lessons for Malaysia, never mind their recent debt crisis (stemming largely from an overheated property sector). You would think that a gulf nation like Dubai would be awash in oil, but oil revenues now comprise less than 10% of the economy. They’ve managed to nicely avoid being infected with Dutch disease and the economy has maintained its high income despite the lack of any other significant natural resources.


How was this done? Largely by going the services route – Dubai is intent on being the financial centre for the Gulf, as well as a prime tourist and shopping destination. Duties and taxes on goods is virtually nonexistent as is individual and corporate income tax, which is a strong draw for expatriates and multinationals. Dubai is also a centre for trade in the region, even if it produces next to nothing on its own.

This focus on non-tradables means labour incomes, being restricted to competition within the emirate, are continuously bid up – I read about low to mid-level executives earning at least AED10k a month (or about MYR9,000).

The flip-side to high labour incomes can also be seen – Dubai is an expensive city when you are talking about anything other than tangible goods. A smallish apartment costs around AED70k a year to rent (the hotel room I stayed was rated at AED2500 a night), transportation costs an arm and a leg, and it’s clear that a lot of that high labour income is being eaten up by higher (much higher) costs. No doubt “things” are cheap relative to labour income – from walking around some of Dubai’s many shopping malls, there’s little to choose from in terms of prices between Dubai and Kuala Lumpur. But in terms of other costs – housing, transportation, even fast food – Dubai has all the hallmarks of the Balassa-Samuelson effect.


That’s one of my main concerns with the New Economic Model and high-income status for Malaysia in that higher labour income necessarily means higher costs in everything except material goods. Which means if we’re not careful, we’ll still be dealing with the same issues of inequality and relative poverty as we have now, except your roti canai and nasi lemak will cost double what it does today.

Before I leave this topic, one last observation – Dubai’s fortunes are being built on the backs of immigrants. If it weren’t for the signage and the scorching desert heat, it’s pretty hard to tell you’re in the Middle East. English is the lingua franca and most people I met and spoke to were from as near as Kuwait and as far afield as the Philippines – 85% of the population come from somewhere else. I’m told that “locals” are slow and complacent – sound familiar?