Monday, June 4, 2018

RM1 trillion debt? Don’t Panic

I realise in writing this that I’ll probably be a very lonely voice in the wilderness, but I think this needs to be said and intellectual honesty forbids doing anything else. I also promised years ago that I would defend a Pakatan government when keeping an elevated level of government debt. I’m going to keep that promise now.

As the news of the Malaysian government’s real debt position has been slowly been revealed over the past two weeks, the reactions have predictably ranged from horrified to furious. Unfortunately, the prevailing thought is mostly about how this debt is to be paid back, and the burden on taxpayers as this is being done.

Let me flip my usual practice, and begin with my conclusion, before going into the reasons why.

Except under very specific circumstances, on no account should the Malaysian government:

  1. Shift from a budget deficit to a budget surplus; or
  2. Make any attempt to reduce the absolute level of government debt.

This is of course, completely at odds with the “conventional wisdom”. However, the conventional wisdom is in this case, mostly wrong. There are two strands of thought I have in mind in making the above recommendations:

  1. Historically, successful sovereign debt rationalisations have almost never involved actually reducing the absolute level of debt, with most of the heavy lifting done by growth and inflation (in roughly equal proportions);
  2. Most schools of economic thought outline the unintended and unwanted consequences of public debt reduction, even if implicitly.

The clearest most recent example of point 1 is Indonesia, where debt to GDP dropped from 87% in 2000 to just 23% in 2012. This was despite the absolute amount of government debt actually doubling during this period; it currently stands at 3x the level in 2000.

How was this done? Again, growth and inflation. Indonesia saw inflation mostly hovering between 5% and 15% for most of the 2000s, and averaging about 5% for most of the past decade. Nominal GDP growth was similarly high, at between 10% to 25%(!), which made the size of the economy 5x-6x larger:

Under those conditions, it’s not hard to reduce the debt burden to something more manageable. Other successful debt rationalisations followed similar modalities (offhand, the one I remember best is the sharp reduction in the US debt to GDP ratio following WWII).

The lesson here is that it is not necessary or even optimal to pay down debt to reduce the debt to GDP ratio. The other lesson here is that the best debt reduction strategy is to deploy fiscal policy to maximise growth and potential growth, rather than to pursue fiscal austerity. The latter route is filled with cautionary tales of failure e.g. Europe since 2011.

On the theory front, what happens when you try to actively reduce government debt? I won’t go into the reasons why a certain level of government debt is always desirable – I’ll save that for some future post.

In a New Classical paradigm (and Austrian thought), a negative fiscal shock results in an expansion of the private sector (the opposite of “crowding out”). New Keynesians would indicate a temporary slowdown in growth, but with the economy moving towards a new equilibrium with, again, the private sector leading the way. Post Keynesians (and I daresay MMT) would say a permanent slowdown would occur. Monetarists would point to an independent central bank responding to the fiscally induced slowdown, with a resulting expansion of private economic activity.

The mechanisms underlying these analyses would be similar – a reduction in public debt reduces market interest rates, which induces the private sector to borrow and spend more. Monetary theorists would suggest this comes from monetary policy (interest rate cuts) taking over from fiscal policy expansion. Others could point out the effect on the yield curve from public debt reduction. Others still would place their bets on a depreciation of the real exchange rate. Loanable funds theorists would think its a release of real resources from an inefficient public sector to a more efficient private sector.

Fundamentally however, the end result is roughly the same – a reduction in public debt results in an increase in private debt. The alternative is slower growth, and one unfortunate empirical finding of the Great Recession is that once lost, potential growth is never regained and the economy shifts down to a lower growth path.

So in any move towards absolute debt reduction, some thought must therefore be given to whether the Malaysian private sector has the wherewithal to take on more debt. And the answer to that question is mostly…no.

The corporate sector has been repairing its balance sheets since the Asian Financial Crisis, and while gearing ratios have risen in the past decade, there is little appetite for increasing leverage even more. In the slow growth world we are living in today, private investment in industrial capacity has been lukewarm and haphazard. Much of investment over the past decade has actually ended up in structures (aka office buildings and retail malls), of which we’re seeing a glut. What’s happening in the West today is corporates borrowing money to fund share buybacks – not exactly improving economic growth potential.

The household sector is in an even worse position. Debt levels remain elevated, despite 3-4 years of repair. Savings rates remain dismal at less than 2% of disposable income. Increasing household borrowing over present levels would be literally begging for a financial crisis, and one that would be even harder to resolve than a sovereign debt problem.

One last thing to add to my analysis here is that Malaysia still runs a current account surplus. That implies a continuing excess of savings over investment, and while there are a number of reasons for this, the inescapable conclusion is that running a fiscal deficit still remains a viable – indeed, in my view, obligatory – option. A fiscal deficit of less than 3% also meets the international standard for a “balanced” budget anyway.

Some people are bound to mention Malaysia’s last bout of debt reduction in the 1990s, which involved running a budget surplus. I’d argue the circumstances are different – at that point in time, the economy had a current account deficit, which implied that a budget surplus was not only useful, but necessary. Unless and until Malaysia’s current account falls into deficit, I will continue to advocate running a fiscal deficit.

So to repeat my conclusions, with the addition of the proviso mentioned above:

  1. As long as Malaysia has a current account surplus, the government should aim for a level of fiscal expenditure aimed at maximising potential growth, even if this means running a perpetual fiscal deficit;
  2. Ignore the level of debt – it’s not really important, and reducing it should not be a policy priority. Reducing it would place too great a burden on the private sector balance sheet.

Oh, and there’s no danger we’ll turn into Greece.


  1. Hi Hisham, I just want to ask regarding the ECRL debt. What you have described above regardless of whichever's school perspective in the end would lead to a potential crisis because of the increase in private sector debt, most likely household's. But with specific reference to the ECRL debt that's loaned from China, with the money not brought back here, and I think I could safely presume that most of that money would be spent on Chinese capital and labour, if that debt could be cancelled and is cancelled, would it have the same impact to the economy as to how you described above? As in, would the private sector be forced to take on more debt because the reduction of this particular debt? My hunch is that it doesn't because that money was not spent in Malaysia's domestic economy in the first place, but I'm not sure. Can you explain the changes in the components of the National Account with respect to the cancellation of this particular debt?

  2. Thanks Hisham, great piece as always.

    Few questions:
    1) While it has been a popular metric, I couldn't understand the first-principle reasoning of comparing debt to GDP. Do you mind to explain briefly?

    2) Since I couldn't understand the applicability of debt-to-GDP ratio, I often turn myself to looking at government's debt servicing ability (both interests and principal repayments, essentially the cashflow capacity). It seems to me that government's finance is not as sound as I thought, judging from its moves to redeem assets from Khazanah and selling lands to BNM, to service its debts. Notice that even Danainfra and Prasarana are on life support by MoF. Did I miss anything here?

    3) I guess the key question to ask on government's debts is not about how much, but what are they for. Though our transportation infra projects are good for the nation's productivity growth, but they are pathetically unprofitable. Our government can't be subsidizing productivity growth forever, sound very unsustainable to me. Would it be better if government begin to shift away slightly from transportation DevEx?

    1. The thing is, to operate the transportation system at a profit would entail massive cost increase on the part of the end user. Just look at the increase in LRT fares back in 2015 and the furore that came with it. Is the average Malaysian willing to pay more for their train ride?

      As for moving away from transporation DevEx, our transportation network isn't really fully developed so like it or not we need to continue to develop it lest we be left behind.

    2. Thx. I wasnt referring to having them be profitable, more on just hoping for them to ensure sustainability thru effecient operations, even at an appropriate level of deficit if necessary, but without burdening our fiscal position.

    3. Hi Fung,

      It is uncommon around the world that public transportation is unprofitable unless we are Hong Kong where 90% of their population will take public transportation.

  3. Wouldn't inflation and a depreciating currency cancel itself out, assuming that the debt is denominated in a foreign currency.


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