Fiscal Realities

A couple of things were raised last week that I want to address:

Issue 1: The Difference between Operating and Developing Expenditure

I’ve had to explain this at least twice over the last few days, so I thought I might as well spell it out. Malaysia is one of the very few countries that actually subdivides spending between operating and development expenditure – actually, I think Singapore is the only other country that does this. MOF keeps these accounts entirely separate (I’ll touch on how they intersect in a bit), whereas most other countries consolidate the two.

Explaining External Debt

Yesterday, the media (social, online, offline) were agog at Malaysia’s external debt numbers. They shouldn’t have been – the inflated numbers were due to a redefinition of external debt made last year (see here, especially the last four pages), which was announced, though nobody appeared to have caught on.

So what’s the deal?

Hafiz Noor Shams has a nice graph showing the difference between the old definition and the new one. I agree with him, the reporting on this has been deplorable, and not just from the local media (sorry guys, it has been pretty bad), but from the foreign media as well. One joker speculated that with external debt so high, Malaysia might have trouble “servicing” it, because the foreign exchange reserve cover was low. Hah!

1Q2012 Government Debt Update

With the fiscal deficit still with us, government debt continued to increase in 1Q2012 (RM millions):

Gross issuance reached RM24.7 billion, with redemptions totalling RM9.3 billion. As a result, net government debt increased by RM15.5 billion in 1Q2012, a marginal increase over 4Q2011, and total debt reached RM470.8 billion.

IMF’s Article IV Consultation With Malaysia: Points To Ponder

This is for policy wonks only! OK, it’s mainly for policy wonks, as there’s some interesting stuff for the layman to look at, if you have the patience to get through some of the jargon.

Starting with the summary page:

Malaysia: Staff Report for the 2011 Article IV Consultation

KEY ISSUES

Near-term outlook. Economic activity is expected to moderate as the weaker external environment tempers exports, private investment and consumption growth. This is expected to lower inflation, but will make the 2012 budget deficit target difficult to achieve. General elections, expected by analysts in early 2012, may add to market volatility.

Debt and Subsidies Clarified

What with the brouhaha over the actual amount of subsidies being paid, and the actual amount and definition of “national debt” as reported yesterday, PEMANDU felt it had to step in with clarification (in full from The Star):

Subsidy figures are correct, says Pemandu

PUTRAJAYA: Both sets of subsidy figures released by the Treasury and the Performance and Delivery Unit (Pemandu) are correct, the unit said in a statement.

It said the Treasury had only focused on direct subsidies because it took a public finance management approach in defining subsidy while the Pemandu lab had taken a macro-economic approach.

“The approach includes both direct and indirect subsidies as a necessary measure to increase competitiveness and remove market distortions,” it said here yesterday.

The Treasury had on Tuesday in a briefing to backbenchers announced total subsidies at RM18.6bil last year while Pemandu’s lab findings put the figure at RM74bil.

The unit said the definition of subsidy by Pemandu’s lab was based on that provided by the Organisation of Economic Co-operation and Development (OECD) in 1996.

“Some of these subsidies include contract obligations, financial support and rebates, assistance to Ministry of Finance Incorporated companies, and cost-based financial assistance which includes emolument for education and health.

“The substantial items under indirect subsidies which are not covered by the Treasury include cost-based financial assistance, assistance to MoF Incorporated companies and gas subsidy. “The subsidies defined by the Treasury are those which affect the Federal Government balance sheet directly,” it said.

The unit reiterated that as a gross domestic product (GDP) percentage, Malaysia continued to be one of the highest subsidised countries in the world, even higher than Indonesia and the Philippines.

“On average, the OECD subsidy level is 1.5% of the country’s GDP. Both the Treasury and Pemandu agree that Malaysia should increase its revenue or GDP and at the same time, reduce government expenditure in the next 10 years in order to stay competitive,” it said.

The unit said the Government would also continue to fight corruption, reduce wastages and leakages based on the Auditor-General’s report to reduce overall expenditure besides removing subsidies.

It said it also wished to clarify that the country’s national debt stood at RM234bil, which is defined as external debt and inclusive of both public and private debt.

“Our government debt stands at RM362bil, comprising domestic debt (96%) and foreign debt (4%).”

A Matter of Definition

When this report first came out yesterday afternoon, I thought it was a typo. But it turned up on the front page of the NST today in big bold letters, so someone has a very different idea of what “national debt” means than I do (excerpt, emphasis added):

Debt under control

KUALA LUMPUR: Malaysia’s debt is under control and steps are being taken to reduce it to prevent the country from suffering the same fate as Greece and Iceland.

Prime Minister Datuk Seri Najib Razak said last year, the country’s debt fell almost one per cent to RM233.92 billion from RM236.18 billion in 2008. This is because of the repayment of some loans and the stronger ringgit against the US dollar.

The budget deficit is also expected to drop and is under control in the medium and long term.

“These measures will ensure that the federal government’s deficit does not rise to the extent that we will be unable to settle our debt,” he told the Dewan Rakyat yesterday.

The government will reduce its external debt by tapping domestic loans because local investors are flush with money and the cost of borrowing is also cheaper. Malaysia also has a comprehensive system that detects financial risks and weaknesses early.

Here’s the coverage from The Star, in case NST changes the link.

I’ve always taken “national debt” to mean the total outstanding borrowing of the national government, which are the collective liability of all the country’s citizens. It appears in Malaysia’s case, “national debt” is something completely different – it’s the aggregate external debt of the country, comprising government, semi-government and private sector (source: 4Q 2009 Treasury quarterly economic report, pg 14-16).

The trouble is partly the way the news was reported (it appears to conflate “national debt” with government debt), and partly from the PM’s further comments on the subject – if you check the actual breakdown, direct external government debt is just RM13.8b, or 5.9% of the total. The bulk of this “national debt” comprises RM71.6b from Non-Financial Public Enterprises (NFPEs), RM70.0b from the private sector, and RM69.0b from the banking system. Of these amounts, only the NFPEs (e.g Petronas) could be said to fall under direct government influence. So talking about consolidating the federal government deficit is more than a little disingenuous, because it has almost no bearing over reducing the “national debt” as it is curiously defined here.

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.

Government Debt and the Potential For Crowding Out

Hoisted from comments:

Wenger J Khairy said...

Dear Hisham H,

I for one have not a clue what the NEM is neither is worthwhile even spending an iota even discussing it. Actually what business activity can the Government directly influence without incurring additional debt. That itself is going to be a self defeating point of view.

Lets put some facts on the table.

Nos 1 the myth that the Government somehow is responsible for some huge subsidy. 1MPM6 mentioned that the "subsidy" is RM 70 billion budgeted for 2010.

RM 70 billion subsidy? Who is he kidding. The actual subsidy to consumeres [sic] was 2 major items, the subsidy for fuel - RM 10 billion, to be shared with the glorious IPPs,allocation for MARA RM 2 billion and the subsidy for interest on the PTPN fund - about RM 1 billion.

The big ticket items lumped together in this transfer payments mistaken by the PM for subsidy was

RM 15 billion - interest on debt
RM 10 billion - Pensions
RM 6 billion - to the Unis (wonder why our students need to pay fees on top of this, and this is only the Op Budget)
RM 1 billion – KLIAB

The balance RM 15 billion was a hodge podge of various accounts with corpratization being a chief culprit.

So essentially the domestic economy is like a merry go round. Spend today like theres no tomorrow.

Unfortunately for the gomen, is that short term rates are now starting to spike up. Our debt duration which used to be very much in the long term during DSAI is now 50% in the short - medium term with massive refinancing of debt over the next 3 yes. The gomens weighted interest rate is 3.4ish %, imagine what the "subsidy" for Gomen debt will be in 2012 if interest rates were to spike to 5%, (of course triggered by some currency crisis / short term money flow out.)

Key thing is BNM's forex reserves. Thanks to the wisdom of Pak Lah we have a sizable cushion. However, for all our supposed current account surplus, the end inc in BNM foreign reserve position has been 0 for the last couple of months owing to the massive "reinvestment in overseas" phenomenon.

So where JPM fears to tread let I Wenger J Khairy put it succinctly.

A massive public deficit will reduce the cost of capital which means more and more of bank loanable funds will be used to prop up MGS and GII. 0 credit growth in all sectors except the household sector.

Any decision by Uncle Sam to start to raise interest rates would put a pressure on BNM to do the same or else pummel the Ringgit.

Option A- Raise Interest rates
Public deficit continues to swell touching past RM 500 billion in 2012. This puts the soverign rating of the country at risk, not that local banks have a choice. In the end banks prop up the gomen and no new investment in the industry, which means declining international trade which means a potential decline in the BNM reserves which mean a downward bias on the ringgit (PPP fanboys be forewarned).

Option B- BNM continues to keep rates low, which means Ringgit gets pummelled on the forex market

So either way long term I see Soros prediction of 5 to the dollar becoming a reality and a massive inflation spike to hit the country in 2012.

SO says I Wenger J Khairy

Wenger paints a nightmare scenario, one I think has a low probability of happening, but he does have some highly pertinent points that bear examination.What he’s talking about is what’s called in economic terminology the “crowding out” of the private sector, as public sector demand on financial resources or the concomitant increase in the cost of capital reduces private consumption and investment. I don’t think that’s likely in Malaysia over the short term, though a failure to generate GDP growth over the next two years would certainly bring this factor potentially into play, as the government tries to pick up the slack in terms of deficient demand. It’s also a potential factor as we go through the latter half of the decade unless growth picks up, and the implementation of the NEM successfully shifts the burden of growth to the private sector.

In any case, my comments on Wenger’s post are as follows:

1. Subsidies – the breakdown of government operating and development expenditure by function is available in BNM’s Monthly Statistical Bulletin. Operating expenditure classified as subsidies were RM35.2 billion in 2008 and RM18.6 billion in 2009, nowhere near the RM70 billion quoted for 2010, so Wenger has a point – as far as it goes. It depends on whether you classify development expenditure as subsidies. If you do (and I’ll grant you it’s a bit of a stretch), then the RM70 billion figure is suddenly very plausible. Development expenditure was RM42.8 billion in 2008 and RM49.5 billion in 2009. (Technical Note: for those who are curious, the Malaysia Plans effectively lay out the government’s development expenditure over each 5yr Plan period).
   
2. Debt duration and interest burden – this is something I’ve noticed myself, as the bulk of issuance over the past couple of years has been in 3-year and 5-year maturities, rather than the 5-year and 10-year maturities that the Treasury usually favours. Effectively, that means the Treasury might have some trouble rolling over maturing debt in 2012-2014 when the bills come due, on top of the additional borrowing requirement for deficit financing over the next couple of years (Wenger’s estimate of RM500b sounds plausible to me, though I think it’s probably about 10% too high and one year too early).
   
   I honestly don’t think this will lead to crowding out of private investment or household financing over the medium term however, because Wenger missed one thing – the financial system is just sloshing with liquidity. Commercial bank holdings of MGS and GII are just 3.7% of their total assets, while loans comprise just 58.7%. As of February, commercial banks have RM187 billion on tap at the central bank – or nearly double the borrowing needs of the government for the next two years.
   
   But the spike in short term rates is real enough:
    
   I think this is a combination of a couple of things: BNM’s “normalisation” of interest rates which puts a floor under MGS yields, and (paradoxically) a reduction of investor uncertainty.
   
   The recession drove a big increase in demand for short term, risk-free securities against a relatively static supply in MGS maturing in less than one year, which drove down yields at the short end while widening the spread between maturities. Now that the recovery is well entrenched, the return of risk appetite should shift demand towards the longer end of the yield curve, while also converging yields across the maturity spectrum i.e. the yield curve is going to flatten.
   
   Note that under the current monetary regime which uses an interest rate target as the policy instrument, interest rate volatility should be relatively low compared to the volatility of the exchange rate or money supply (see the difference in MGS yield behaviour pre- and post-July 2005 in the chart above). If this thinking holds true then spreads over the past year or so were an aberration, and convergence should see spreads tightening again. In other words – don’t read too much into the spike in short term yields.
   
3. Forex reserves – I think you’re off base with this one, Wenger. If BNM is allowing the Ringgit to float and only intervening during periods of high volatility, as I believe they are, then changes in reserves will not reflect flows of capital at all. I suggest you use this instead:
   
   (Change in Reserves) + (Change in commercial bank net foreign assets) - (Change in trade balance) = (Estimated Capital Flows)
   
   This doesn’t capture reinvestment, but yields a more realistic estimate of inflows or outflows of capital:
   
   
   But I agree with Wenger’s assessment that money is leaving (or staying) outside of the country.
   
4. A massive public deficit will reduce the cost of capital - I think this is a typo - shouldn't it be "raise" instead?
   
5. Any decision by Uncle Sam to start to raise interest rates would put a pressure on BNM to do the same or else pummel the Ringgit – I don’t think this will happen. US rate hikes might slow or halt the appreciation of the Ringgit, but on balance the fundamental story for the Ringgit will still be up. Even with the uncertainty over the trajectories of the two economies, this isn’t a tough call to make. It’s useful to think of it this way – what matters is the real interest rate differential, not just the interest rate difference (click on the pic for the larger version; shaded areas mark Ringgit appreciation relative to the USD): 
   
    
   It’s not a perfect match (note the initial drop in the real interest rate differential during the appreciation of the Ringgit post 2005), because the joker in the pack is the perceived risk premium, which is (i) unobservable, and (ii) time varying. In any case, we have a pretty long head start on tightening, and any US moves in that direction will have to cover a pretty significant gap in Malaysia’s favour. I find myself at odds with Soros – I think a sub RM3.00 to the USD rate a more likely outcome by 2012.
   
   Statistical Note: technically, because the exchange rate (I(1)) and the real interest rate (I(0)) are of different orders of integration, the relationship cannot be long term. Specifically, the real interest rate can only effect the rate of change in the exchange rate, but not its level.
   
6. This puts the soverign [sic] rating of the country at risk… – This is an interesting and valid point, and related to the risk premium I referred to in my previous point. Actual external debt is fairly low and dropping:
   
   
   But the real sensitivity of government debt to the sovereign risk rating, which on surface only directly affects non-Ringgit denominated government debt, is quite a bit higher than that. You have to add in foreign holders of domestic debt to the external debt numbers:
   
   
   …and probably take into account the external debt of NFPEs and the private sector as well, as these will also be affected by a rerating. On the other hand, I don’t think this will matter much at least over the near future because (i) the ratings agencies didn’t exactly get covered in glory the past couple of years, and (ii) the universe of alternative investments isn’t exactly that great. The thing is, while deficits matter for short term interest rates, long term it’s the debt to GDP ratio that investors look at. And on that score I think we’ll be fine:
   
   
   We’re still below the 60% level where investors start getting worried, and far below the 90% level where government borrowing starts impacting growth. Other countries in the region are on par or worse, and the advanced economics are far more at risk of seeing crowding out over the near term (many have damaged financial sectors as well). Malaysia’s total external debt position (public + private) isn’t all too bad either:
   
   
   Going forward, as long as the pace of government borrowing (i.e. the deficit) lags nominal GDP growth, as I expect it will this year, then the debt to GDP ratio should stabilise or retreat. Traditionally there are three ways for governments to reduce their debt burden. Higher taxation (works) or equivalently, reduced expenditure (which works even better – see this post) is what most people think of. The other two are inflation through monetary expansion or other means, and boosting economic growth directly which changes the denominator.
   
   I suspect all three are in play for Malaysia – the actual government debt level at the end of 2009 was a full RM18 billion below my estimate, suggesting that cuts in expenditure may have reduced the borrowing requirement below the projected range defined by the two stimulus packages and the original budget for 2009. In essence, the government traded off public consumption in favour of public investment.
   
   Second, inflation should return to its long term average later this year of around 2.5%-3.0%, which will have a small but measurable impact on the real debt burden (5% MGS yields notwithstanding – yes I think that’s distinctly possible as well, but primarily through higher inflation driven by faster growth).
   
   Third, trade growth is being driven by changes in the terms of trade through rising commodity prices, and not in volume of manufactured goods. The mining and agricultural sectors have never been big borrowers relative to the manufacturing industry, so would be less sensitive to crowding out by public borrowing (of course, their output and income are also more volatile). Another factor is that the manufacturing sector is suffering from massive over-capacity, so there is plenty of slack (and less financing required) to pick up output even in the absence of long term financing.
   

In short I don’t think the crowding out scenario is credible just yet, though a double-dip in the world economy will guarantee we’ll have trouble. Also there’s no doubt that higher interest rates will eventually impact the private sector, but given we’re starting from a below-optimum point, I’m uncertain how much that effect will be or at what point it will kick in. On the other hand, I don’t think at this stage government borrowing will exhaust or impinge the capability of banks to finance business, given the existing excess liquidity situation we’re in.

In passing, I actually like the NEM, less because I think it will have much of an impact on Malaysia reaching high-income status (I think demographic factors and the exchange rate will take care of that), but because it sets the foundation for sustaining higher income growth in the future - as in 20-30 years from now. But one effect that the NEM will have right now is it’s market-orientation. If the government holds to this principle, then there’s a good chance private investment will flow again. More pragmatically, the sale of government owned companies and assets will help offset the need to borrow.