Monday, July 19, 2010

The NEM In Numbers: Nominal Versus Real

I’ve been meaning to cover this issue for some time now, but haven’t had the time. It’s very late to be talking about this, but I suppose better late than never.

One of the things that has been bothering me about the New Economic Model is that the public discourse revolves around trying to reach over 6% real growth. That’s largely false, or to be more precise, largely misleading.

The goal of the NEM is for Malaysia to reach high income status, which is defined as between US$15,000-US$20,000 in per capita income by 2020, compared to our reported level of US$6,896 as of 2009 (source: IMF World Economic Outlook Database April 2010). Per capita income here is defined as nominal GDP as the numerator and the total population as the denominator.

Two problems immediately come to mind here, relative to what’s being bandied about. First the income target is in US$, not in local currency terms. Secondly, we’re talking about a real (inflation adjusted) target, when we’re actually aiming for a nominal (current Ringgit) target.

To see what I mean, let’s take a look at the NEM projections (click on the link for a bigger version):


If you look at the notes below the table, the critical assumptions are average population growth rate of 1.3% and an average exchange rate of RM3.2 to the USD.

I don’t have a problem with the population estimates – growth rates have been trending sharply downwards for the last two decades. Even if population growth exceeds this average for the next decade, the coming demographic transition (see this post) could add an extra 1%-2% output growth over the next couple of decades which should help offset the higher head count.

The exchange rate estimate on the other hand I’d consider overly conservative. One of the stylised facts about high income economies is that they have higher price levels and higher exchange rates (known as the Penn effect; see this post for the mechanism). Capping the RM/USD exchange rate at 3.2, which is where we are now, isn’t terribly realistic.

If we conservatively assume a 2% appreciation per annum (as we transform from a middle income to high income economy), than by 2020 we’ll have a RM/USD exchange rate of 2.615 and an average level across the decade of 2.87. That’s a more than 10.5% difference in calculated income levels – about 1% per annum extra growth in US Dollar terms. That’s a bit more realistic, but probably a little conservative as well, since the average appreciation rate of the exchange rate was well over 3% per annum over the past five years (July 2005-now).

Leaving that aside for the moment, let’s look at the different trends in nominal and real growth. The NEM projections are for 6.2% real growth for the first half-decade and 6.9% growth for the second (6.3% and 8.8% respectively in nominal terms). That averages out to about 6.6% real growth or 7.5% nominal over the whole ten years.

Many people are saying that’s hard – I don’t think so. In the last decade (2001-2010), including government forecasts for GDP this year which are acknowledged to be too low, we’re looking at an average of 4.0% real growth. That’s what people are assuming where the challenge of growing the economy will be – getting 6.5%+ real growth. But the target, as I pointed out above, is in nominal terms not real terms.

So the actual target we really ought to be discussing is the 7.5% projected nominal growth rate. And comparing that to the performance of the economy in the past decade it doesn’t look that hard – Malaysia averaged 7.6% between 2001-2010.

In other words, we’re talking about a nominal growth target for 2011-2020 that is slower than that of the past 10 years (which, by the way, included two recessions). Add currency appreciation to the mix, a dramatically slowing birth rate, a workforce cohort that is expanding more rapidly than the overall population, and I wouldn’t be surprised to see a nominal target rate of just 6% (or less) in local currency terms, to achieve high income status by 2020.

And if inflation returns to its long term trend, we’re probably then looking at needing just 3.5%-4.0% real growth over the next decade – not so hard after all. We’re back to the same growth trend we’ve had this past decade.

Or equivalently, if we do hit the NEM projections over the next few years, we’ll hit high income status early – I’m expecting in the 2017-2018 time frame. The government will probably then proclaim the NEM a success from a numbers standpoint (never mind how conservative the original projections are), when economic fundamentals and a changing demographic structure have probably played a bigger role in achieving that goal.

Don’t get me wrong – I believe the NEM is important, but not so much for reaching high income status which to me is a given. What’s more important is really the question of maintaining a high income economy which requires structural changes in education and infrastructure (soft and hard), as well as the more vexing question of what kind of economy and what kind of society we aspire to be. And that’s something the numbers will never show.


  1. Dear HishamH,

    I have a totally different view on the situation. First would relate to the Ringgit USD exchange rate. I do not think Malaysia can sustain a long term appreciation of the Ringgit against the USD as it will make our exports uncompetitive. So if the ringgit were to strengthen to lets say $:RM = 2.87, it will be followed by a reduction in exports. A reduction in exports would create more unemployment and put downward pressure on growth.

    The second has to do with the structural differences in the nation between 1980 - 1996 (DSAI was FM) and after that. During the earlier period, Malaysia could count on massive Yen denominated investment that boosted output and resulted in economic growth. Right now, private investment is at the lowest levels as a % of GDP as investors react with unhappiness at the appointment of the current Deputy at MITI. If private investment continues at this levels, it will be a far stretch to assume that growth can be sustained on a long term basis (2010 excluded due to the low base in 2009).

    Lastly will have to do with credit creation. Between 2003 and 2010, under the stewardship of the wise Pak Lah, Bank Negara's reserves grew from a paltry amount to at one time over RM 400 billion. Directly and indirectly, this growth in reserves stimulated credit creation in the private sector. Ever since Pak Lah stepped down, our net payments on the BOP has been decidedly negative.

    People do not see that the BOP is related to domestic credit creation. Its a second order effect, and trying to grow the country's credit base without an increase in reserves will in the end will put downward pressure on the ringgit once again.

    Lastly, a lot of the nominal growth in the past decade or so was due to the commodities boom, especially in the palm oil and crude oil sector. This deluge of money found its way into the banking sector which stimulated credit growth. So if the country were to meet the 2000 - 2010 benchmark, why not the jokers at Pemandu/NEM straight out put a target number on the price of oil and palm oil. Because it is precisely those 2 commodities which will dictate whether or not the numbers will be achieved in the end. This should be further taken into context considering that investment in the manufacturing sector has had double digit % declines for the past 2 years or so.

    So I cannot see how the NEM will work. The investment and the competitiveness is certainly not there.

  2. One by one:

    1. I see our export sector is partly low-cost manufacturing and partly commodities. For the former, the level of the exchange rate is irrelevant since domestic value added is relatively small. Costlier Ringgit value of end-products is largely offset by lower import input costs. There's very little domestic employment impact, because we're largely looking at our foreign work force, not Malaysians. Hence, despite the sharp drop in trade volumes last year, unemployment only rose less than 1% (and has since come back).

    For the commodity sector, empirically, causality runs from terms of trade to the exchange rate i.e. higher prices are putting upward pressure on the exchange rate (implication: inelastic demand curve). So no need to worry much here either.

    The impact of the Ringgit exchange rate on export competitiveness will only matter if exports are independent of imports - and they're not.

    2. I'm glad you mentioned this, as very few people seem to remember that it was Japan's outward investment that was the primary reason behind our investment growth in the last two decades of the 20th century.

    By the same token, our current low level of private investment is probably what we can expect going forward, as the rate that is endogenously generated by the economy (I don't think personalities have anything to do with it) in the presence of the significant excess capacity we have in manufacturing. You won't see investment growth rising until that excess capacity is deprecated/destroyed/redeployed.

    But I think you missed the whole thesis of my post - I don't think we need even moderately fast growth to achieve high income status, not even at the pace of the last decade.

    3. Now you've completely lost me. Reserves would only be relevant to domestic credit creation, if at all, under a fixed exchange rate regime. Under the current floating regime, the level of reserves that we have is both excessive and expensive, and completely divorced from domestic monetary conditions. It's just sitting there, losing us money.

    The only thing reserves are now useful for is basically as an insurance policy for hot money outflows.

    4. I agree that commodity prices will be pretty important for us going forward, especially with the stagnation in manufacturing over the last five years.

    I don't know if you're correct in regarding "a lot of the nominal growth" coming from that sector in the last ten years - CPO and crude prices only started climbing in 2007, and the implicit GDP deflator I've been working with only spiked in 2008. That suggests at best a 1-2 year time-frame where high commodity prices boosted nominal incomes.

  3. Dear HishamH,

    Appreciate your response. Perhaps would like to comment further on the link between reserves and the BOP. The argument was presented in the book the "Dollar Crisis".

    The author presented the case for the link between reserve build up and a growth in the money supply. He cited Thailand and Japan and as the example.

    The thrust of the story
    (a) From strict correlation point of view, reserve and credit growth was correlated for the case of Japan, Malaysia and Thailand. The lag maybe between 1-2 years.

    (b) Build up of reserves act as high powered money entering into the domestic banking system.

    (c) One can draw a simple flow chart how lets say surplus US dollars earned by Sime Darby gets deposited as Ringgit in Maybank, and at the same time increases Bank Negara reserves.
    In the case of Thailand, their reserve build up was due to surplus on the Capital and Financial account

    (d) Build up of reserves act as exogenous source of credit creation in the domestic banking system. If there was a build up of credit due to solely endogenous factors, wouldn't it be highly inflationary?

  4. Do you think we need a more liberal immigration policy. We are losing out to the BRIC because they have a bigger population, therefore bigger domestic market.

  5. Gundrohiker, I'd agree with a more liberal immigration policy, though not so much as a way of getting a bigger domestic market. After all, smaller countries such as Singapore do just fine with a smallish population.

    First let me say this is just my opinion, and isn't backed up by any theoretical considerations or empirical evidence, just my feelings on the matter.

    I think being open to immigration is important for a few reasons. First, it's a potential avenue for maintaining a supply of labour to fill low-cost, low-value jobs which Malaysians can't and won't fill. This will be important as the economy moves higher up the income scale.

    Second, immigration will help offset drastically declining population growth, thus reducing dependency ratios and maintaining potential income generating capacity. Immigrants would typically have higher birth rates than residents.

    Third, immigrants tend to be harder working and more entrepreneurial. It's often the risk takers who are more likely to immigrate. The US was a nation built by immigrants (and not necessarily the high income/highly educated ones either), and it maintains its higher growth rate, relative to the "older" advanced economies, largely due this continued influx. Note that among the advanced economies, the US despite all the angst over their "aging" still have the "youngest" demographic profile. I saw the same process at work on my visit to Dubai a couple of months back - immigrants feature at all levels of society and business, and its their efforts that have built Dubai's economy.

    I think the concern over brain drain in Malaysia is valid, but the thing is, I see these concerns mirrored virtually everywhere in the world. Trying to directly address the problem via incentives is unlikely to be successful as you're competing against everyone. It then boils down to the fundamentals - openness, equal opportunity, low taxation levels, and a society that welcomes and celebrates achievement irrespective of race, color, or creed.

    Whether Malaysia and Malaysians are ready for that is, of course, something else entirely.

  6. I will post your reply on Star online blog for bigger coverage and hope the policy makers see it.

    The DPM has made the right move to give education to stateless children since they would inevitably become future Malaysians.