Malaysia’s equity market experienced an outflow of foreign capital to the tune of RM1.3 billion in the first quarter of 2019. The bond market was spared during this period, however, registering net foreign inflows for the first time since December 2018.
But a spate of news relating to the possible exclusion of Malaysia from the FTSE-Russell World Government Bond Index could limit the inflows in the near term. The pressure was reflected in the benchmark 10-year Malaysian Government Securities (MGS) yield, which spiked by 12 basis points in the third week of April. All of a sudden, there is renewed interest in the country’s pertinent macroeconomic issues.
Adding to the pressure on the ringgit is the possibility of Bank Negara adjusting the policy rate downwards, judging from the dovishness of its recent Monetary Policy Committee statement. The market has to a certain extent priced in this possible reduction. Analysts’ comments on the government’s fiscal position and current account (of the balance of payments) have also raised some anxiety in the financial market over Malaysia’s macro landscape. This is hardly surprising, as investors continue to focus on the government’s financial health and the country’s shrinking savings-investment gap (or current account).
While a bumpy ride looks imminent, we would do well to step back and examine the broader picture. In general, economists are aware of the possible repercussions if the two economic evils, i.e. budget and current account deficits, were to emerge simultaneously (by the way, Malaysia registered a still-healthy current account surplus equivalent to 2.4 percent of gross national income (GNI) in 2018, although this is lower than the past few years). The so-called ‘twin deficit’ tends to induce sudden capital outflows and weigh on countries’ currencies. A case in point: both the Indonesian rupiah and Indian rupee have been on investors’ watchlist for some time. Whenever these countries’ budgetary and current account positions deteriorate, their currencies will get hammered.
One point is worth mentioning. From a theoretical point of view, there is a connection between budgetary and current account gaps. Those familiar with the national accounting identity (i.e. Economics 101) can easily prove this relationship mathematically. But a simple explanation for the man on-the-street would be as follows: budget deficits, normally the result of higher government spending, pushes up a country’s aggregate demand. This, in turn, leads to rising interest rates. Under a flexible exchange rate regime, a positive interest rate differential vis-à-vis the rest of the world would induce capital inflows into the country. This strengthens its exchange rate but would lead to a deterioration in its current account balance, as the country’s exports become more expensive and thus less competitive on the international market (this is basically the story of the Mundell-Fleming model, a standard economic model in the study of international economics).
Having said this, however, many countries experiencing budget deficits do not incur current account deficits. In the case of Malaysia, for example, budget deficits incurred since 1998 were accompanied by current account surpluses instead. However, the recent concern of investors is the declining trend of Malaysia’s current account surpluses as a percentage of GNI in the past few years.
It is also worth noting that from a theoretical perspective, a budget deficit on its own is not the real economic evil. The deficit only represents an excess of spending over revenue. More important are the reasons for this, i.e. was the spending for the meaningful generation of economic activity, or merely for the sake of spending (i.e. white-elephant projects)? Or has the country failed to generate sufficient revenue?
Of greater importance is the way the deficit is financed. In some parts of the world, deficits are financed through money printing. In such cases, inflationary pressure builds up and when prices get out of control, capital flight will occur. This is what investors fear the most. On the other hand, financing the deficit through bond issuances is not inflationary. However, it tends to exert upward pressure on interest rates, which, if too excessive, will impact investments.
That said, there are a few points worth mentioning about Malaysia’s budget deficits. One of the concerns is derived from the fact that the negative budget gap has been around for two decades since the Asian Financial Crisis in the late-1990s. Therefore, it is quite normal for the investor fraternity to wonder when it will cease to exist, and whether it will be a real drag on the economy going forward.
A look at Malaysia’s budgetary history shows that the country has experienced many deficit years since 1970. The only years that Malaysia experienced budgetary surpluses were between 1993 and 1997 (only five years). At least in the Malaysian case, the deficits had not resulted in material macroeconomic disasters. Of course, moving to a balanced budget as envisioned by the government would be a plus point for the economy.
Second, raising funds to finance fiscal deficits in Malaysia has never been a real issue. Malaysian government bonds are in demand, as evidenced by decent bid-to-cover ratios (essentially how many times the bonds are oversubscribed) over the years. Past records show that MGS and Government Investment Issue (GII) issuances were comfortably absorbed by the market.
On another note, Malaysia’s shrinking current account surpluses are a concern, especially when global trade activity is softening. Lower trade surpluses exert pressure on the current account balance, causing the surpluses to shrink to 2.4% of GNI in 2018 from 11.2% in 2011. But slower investment growth will also ease some of the pressure on the current account balance. This is because the current account balance also reflects the country’s savings-investment gap. A slightly lower investment (relative to savings) will be positive for the current account balance in the near term. Hence, rationalising (or spacing out) some of the mega projects will ease concerns over the shrinking current account surpluses for Malaysia. Of course, this has to be balanced by the overall benefits of these investments.
Malaysia had experienced a brief period of twin deficits in the 1990s. However, that was when the country’s investment ratio was way above 40 per cent of gross domestic product. Even then, the country managed to wheel out of it by spacing out its projects. This time around, the economic landscape is different. Investment ratios are nowhere around that level, whilst a more diversified export market provides an important buffer for Malaysia’s trade performance.
This article was published in The Edge Malaysia Weekly dated May 6, 2019 – May 12, 2019.