Tuesday, June 22, 2010

Malaysian economic momentum persists

KUALA LUMPUR: After recording its strongest pace of quarterly year-on-year (y-o-y) gross domestic product (GDP) expansion in a decade, the Malaysian economy looks to have sustained this momentum, though with the favourable base effect fading, it is unlikely to eclipse the 10.1% expansion seen in 1Q10.

However, the stronger-than-expected cyclical upswing in the external sector, and the boost it affords export incomes, should complement consumer spending and ensure the domestic economy continues to strengthen.

Manufacturing, the sector most damaged by the global downturn, surged 16.9% y-o-y on the back of strong gains in the dominant electrical and electronic appliances (E&E) segment.

While the base effect will become less favourable over the remainder of the year, it should not prevent Malaysia registering full-year GDP growth of 7% in 2010. The service sector is expected to be a key driver, thanks to further liberalisation of financial services and resilient consumer spending.

Private consumption should return as an important pillar of economic growth as wages, employment and productivity numbers as well as manufactured product sales, especially for big ticket items such as motor vehicles and televisions, continue to strengthen.

This should help domestic-oriented production (up 17.6% y-o-y in 1Q10) to strengthen further, especially as capacity utilisation data for this segment suggests there is significant scope to increasing production.

Of great concern remains the sluggish rebound in investment which rose only 5.4% y-o-y despite a favourable base effect. For now, we expect government stimulus measures to offset this weakness, though such support is unlikely to last, increasing the need for a rebound in private investment.

Fortunately, with export engines picking up and labour market dynamics improving, household sector borrowing has begun to quicken, supporting consumer spending, which should eventually lead to a turnaround in capital expenditures, and higher pace of overall credit expansion.

The government's'' effort to reign in its largesse of recent years also presents some downside risks, should the external engine falter. The government plans to cut its fiscal deficit to 5.6% of GDP in 2010 (Macq: 4%) from 7% of GDP in 2009.

This target should be achieved by stronger economic growth boosting tax collections, firmer global oil prices, and fiscal consolidation efforts such as the projected 13.7% decrease in total government expenditures focused on cuts to targeted subsidies and bureaucracy.

In the light of the government's budgetary intentions, talk of reductions in retail fuel subsidies and weaker agricultural output, upside risk to consumer price inflation has increased.

However, as none of these risks to inflation is the result of demand factors, non-food inflation remains manageable. In March, the Bank Negara Malaysia (BNM) became the first central bank in emerging Asia to begin normalising policy rates. It continued this trend in May, raising the policy rate by a further 25 basis points (bps) to 2.5%.

BNM governor Tan Sri Dr Zeti Akhtar Aziz has repeatedly stressed the step was part of efforts to normalise policy rates and should not be interpreted as monetary tightening, as the broader policy was still accommodative.

The decision to leave the statutory reserve requirement (SRR) unchanged at 1%, which was slashed 300bps during the initial phases of the crisis, exemplifies this.

We would expect BNM to keep the SRR at this level until it feels the global economic recovery is more solid. Still, what is striking about BNM's move on the policy rate is that the pace of Malaysia's domestic economic recovery as well as gains in financial and non-financial assets are not significantly ahead of those in neighbouring countries.

BNM has also downplayed inflation as a reason for hiking the policy rate. Instead, it appears strong domestic demand growth, as well as the uptick in household borrowing growth, may have sparked the move toward policy normalisation.

We expect policymakers to move to raise rates by another 50bps by year-end with one 25bps hike in 3Q and one in 4Q, taking the policy rate to 3%. The market's anticipation of these hikes, however, should press for broad MYR strength in the coming months. Admittedly, the timing of the new fuel subsidy system is a risk to the policy rate trajectory.

Politics remains a crucial swing factor for both domestic and foreign investors, with events of the past month offering some hope that institutional reform may take place.

The thawing of relations with neighbouring Singapore and moves to further incentivise investment in the Iskandar Development Region (IDR) were particular highlights and should help to boost investment.

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