We are growing increasingly worried about Malaysia’s fiscal position. The government’s operating balance will fall into a deficit this year, for the first time since 1987 — unless Petroliam Nasional Bhd (Petronas) makes yet another bumper dividend payout. In fact, the call for special dividends from the national company has increasingly been the go-to solution for the government — instead of addressing its deteriorating fiscal health. Petronas has coughed up special dividends in three of the last four years (see Chart 1)
Without these special dividends, Malaysia would have fallen into an operating deficit — that means the government will have to borrow not only to fund capital development but also to pay for debt servicing charges (see Diagram).
Malaysia has always had enough revenue to cover all operating expenses, including interest, save for two short years — 1986 and 1987 — when the deep recession shrank tax income. This shortfall was rectified in the immediate following years. In fact, operating surplus increased strongly and remained at healthy levels — until about 2008. That was a major turning point — when expenses began growing faster than revenue, resulting in significantly smaller surpluses thereafter. Handouts became increasingly prevalent to win over voters … as cash became king. It set the country on the path of deteriorating financial health (see Chart 2).
Narrowing operating surplus led to rising government debt, higher debt servicing payments and even more debts — in other words, a debt spiral. Clearly, this situation is untenable. As Malaysia’s financial health deteriorates, our sovereign debt ratings will face an increasing risk of a downgrade by global credit rating agencies. When that happens, borrowing costs will rise — and the value of the ringgit will surely fall.
Yes, we are aware there are some who hold contrarian views, believing that we can spend ourselves out of debts. That is, fiscal spending expands GDP, which, in turn, generates tax and other revenue as well as expanding the denominator, causing debt-toGDP to fall. It is theoretically possible, but almost never happens — and especially not when the country falls into operating deficit.
What are operating and fiscal deficits?
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Yes, Malaysia has run a fiscal deficit — where operating expenses (including debt servicing) plus development expenditure exceed revenue — every year since the 1997/98 Asian financial crisis. What is worrying now is the fact that the operating balance is also in danger of falling into a deficit. As we explained, this is when revenue is insufficient to cover all operating expenses (see Diagram).
The annual operating surplus has shrunk sharply over the past decade, as government expenses grew consistently faster than revenue. It means less money left over to fund development expenditure. As a result, the government has had to borrow more to fund the widening gap, leading to steadily rising debts — and interest expenses. Case in point: Debt servicing now takes up 15.9% of total operating expenses, up from 9.5% just 10 years ago. In other words, more government revenue must now go towards servicing its debts — instead of spending on projects that could improve the people’s well-being. In corporate market parlance, “narrowing operating surplus” means the company is making lower profits and therefore has less internally generated funds for capital expenditure. It will have to borrow or cut back on capital spending, which will hurt future growth. An operating deficit means that if Malaysia is a corporate body, then Federal Government Bhd is making net losses.
The operating balance came perilously close to falling into deficit in 2020, when corporate income tax fell sharply at the onset of the Covid-19 pandemic and subsequent lockdowns. Petronas came to the rescue, with a special dividend of RM10 billion. The government’s finances improved in 2021, thanks to higher oil prices, bumper tax payments from glove and plantation companies and, to a lesser extent, electrical and electronics (E&E) companies. In 2022, the government again needed help to pay operating expenses — there was yet another special dividend of RM25 billion from Petronas plus a one-off Cukai Makmur imposed on large corporates.
Owing to the abnormal profits for glove and plantation companies, and Cukai Makmur, corporate income tax collected by the government increased sharply to RM79.8 billion and RM82.1 billion in 2021 and 2022 respectively, up from the average of RM65 billion from 2017 to 2019.
Tax revenue likely to fall short of Budget 2023 forecast
Corporate income tax, however, is set to fall short of the government’s estimated collection of RM96.4 billion for 2023, in the absence of these abnormally high tax payments and because of a global slowdown in demand for goods, which hurt manufacturing exports and earnings.
We tallied the tax expenses for all listed companies on Bursa Malaysia for the past six years, which made up roughly 46% of the total corporate income tax revenue (pre-pandemic) and a slightly higher 49% from 2020 to 2022, owing to the abovementioned abnormally high tax payments from glove and plantation companies and Cukai Makmur (see Table 1).
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In 1Q2023, listed companies’ tax expenses totalled RM7.7 billion, down a whopping 26.7% from 1Q2022. If we were to annualise the 1Q2023 tax expenses for listed companies, corporate tax income for the government would end up far, far short of the RM96.4 billion estimated in Budget 2023. Incidentally, RM7.7 billion is roughly similar to the average quarterly tax expenses from 2017 to 2019, without the pandemic distortions.
Certainly, we cannot be sure whether corporate earnings and taxes paid will not surge strongly higher for the rest of the year. But we are highly doubtful, given the prevailing global economic outlook. (As shown in Table 1, actual annual growth in corporate tax expenses in the three years before the pandemic was flat to negative.)
In this case, we believe Petronas, once again, will be called upon to raise its dividend to the government to fill the gap. The national oil company has been asked to pay the government bumper dividends in three of the last four years. The government expects RM40 billion in dividends this year. But if we are right, and tax revenue does fall well short, Petronas may have to up its dividends to record levels. This is clearly not sustainable in the long run. If the national oil company cannot reinvest at a sustainable rate, it would be tantamount to the proverbial “killing the goose that lays the golden egg”.
For sustained improvement in the operating balance, the government needs to have a credible fiscal consolidation plan. It will have to significantly raise revenue — primarily taxes — and/or cut spending. Unfortunately, both will result in short-term pain for the people. Quite frankly, few democratically elected governments have the political will to inflict pain on voters.
And judging by recent announcements of more handouts, more spending, more pay, more everything to be popular, reducing expenditures will not happen anytime soon (see Collage of news headlines).
Case in point: In 2018, following the fall of the long-ruling Barisan Nasional coalition, the new government raised a red flag on the country’s nearly RM1.1 trillion in total borrowings, including government guarantees and off-balance-sheet liabilities. Much was made of the need for fiscal consolidation. Since then, however, the fiscal deficit has increased further, from 3.7% in 2018 to the estimated 5% in Budget 2023 (see Chart 3).
Direct government debt rose from RM686.8 million at end-2017 to RM1.08 trillion in 2022 and is forecast to hit RM1.17 trillion this year. Total debt and liabilities have now risen to RM1.45 trillion, equivalent to nearly 81% of GDP.
To quote Prime Minister Datuk Seri Anwar Ibrahim: “The country can no longer survive with a high [fiscal] deficit and [we] seek to reduce [the debts] and [with] reductions that do not burden our development programmes.” Underscoring the urgency for greater fiscal discipline, Economy Minister Rafizi Ramli stated that the fiscal deficit must be gradually lowered, to 3.5% by 2025, if there is to be any hope of reducing the RM1.45 trillion debt pile. We have heard similar rhetoric repeatedly since 2018. Clearly, it is easier said than done. Perhaps it is time to do it first, and only then announce.
The risk of serious repercussions …
A government’s fiscal position has a significant effect on the perception of risk and investor confidence in the country. The lack of fiscal discipline is often an indicator of weak policies and mismanagement of the economy. We cannot stress this enough. And if anyone needs a reminder, look no further than the UK’s mini budget (announced in September 2022) debacle. The plan for unfunded tax cuts, which would raise public deficit and borrowings, sent the UK government’s long-term borrowing costs sharply higher and the pound sterling tumbling. The government was forced to roll back all of its proposals and then prime minister Liz Truss resigned the month after.
Even the US is not invulnerable. Its stock and bond markets were buffeted — US Treasury yields rose to their highest for the year and stocks were sold off — in the immediate days after Fitch Ratings downgraded the country’s debt rating. The ratings downgrade was predicated on rising fiscal deficit and debt burden (weaker federal revenues, new spending initiatives and higher interest payments) as well as erosion of governance.
What more for emerging markets like Malaysia. We cannot expect to run persistent fiscal and operating deficits and rising debts — and not, eventually, be forced to face the consequences. As the government’s fiscal position deteriorates, lenders will demand higher and higher interest rates to compensate for rising risks. A credit rating downgrade affects not only the government’s borrowing cost but also the cost of borrowing for all domestic businesses, financial institutions and, ultimately, the people. And yes, especially young Malaysians who will eventually have to pay for the excesses of today and of the past. Why should they?
Tourism — the low-hanging fruit to turn the economy and ringgit around
There is no argument that Malaysia needs to reinvigorate investments to get the economy back on track. Investments, and in particular high-value investments, are the sustainable long-term economic growth driver that will boost government tax revenue and fiscal health, as well as create more and better-paying jobs, raise income levels and the standard of living for the people.
Attracting investments, both domestic and foreign, requires bold structural reforms, many of which we have articulated in recent articles. At its most fundamental, it is about restoring investor confidence — in the government and its policies, in the governance and integrity of public institutions — and al lowing a truly competitive business environment for greater efficiency, instead of protecting the business elite and rent-seekers. But rebuilding confidence, once it is eroded, takes a very long time. A shorter-term, “easier” fix is tourism. Boosting tourist arrival numbers will boost foreign currency in flows, Bank Negara Malaysia reserves, the current account surplus and — most likely — the ringgit.
Foreign currency inflows from tourism contracted steeply because of border closures and lockdowns during the Covid-19 pandemic. We highlight the relevant data, extracted from the current account inflows/outflows, in Table 2. Travel services have historically brought in more than RM30 billion a year. The huge reversal in travel services — from inflows of about RM30 billion to a negative figure (outflows) in 2020 to 2022 — led to a sharply wider services deficit in the current account over the last three years
While tourist arrival numbers started recovering in 2Q2022, they remain well below pre-pandemic levels (see Chart 4). The appetite for travel has been very strong around the world, particularly for international travel, which recovered later.
Malaysia must capitalise on this still-robust residual pent-up demand — by redoubling efforts to promote the country overseas and making tourists feel welcomed, instead of being stuck in immigration for hours. Notably, arrivals from non-Asean countries — they spend more and stay longer, on average — are lagging tourists from our closer neighbours (see Tables 3 and 4).
In fact, the tourism sector should be a main focus beyond the immediate urgency. Tourism is an invaluable source of foreign currency and reserves. The sector has low leakage and high value-added with low import content. It also has relatively deep linkages to the domestic economy, given the diversity of related activities, such as accommodation, food and beverage, entertainment and retail, including sales of local produce and locally made goods. Over the longer term, the development of tourist attractions could also stimulate domestic economic activities, including construction and infrastructure.
Tourism as a percentage of GDP for Malaysia is still low compared to many of our regional peers (see Table 5). Before the pandemic, in 2019, tourist arrivals in Malaysia totalled 26 million, compared to 40 million for our northern neighbour Thailand. In other words, there is room for tourism to grow as a sustainable driver of economic growth.
In summary, bolstering tourism and our current account balance is important, as narrowing surplus and foreign currency reserves — relative to the country’s value of imports and short-term external debt — add to the perception of growing risks.
A higher current account surplus, with more diversified (stable) sources — such as tourism and higher value-added manufacturing — will reduce the risks of economic-financial instability: for instance, owing to commodity price fluctuations, sudden currency crisis and capital flight. Maintaining a healthy current account surplus is all the more critical, given Malaysia’s persistent fiscal deficits and mounting debts.
Start planning to reduce heavy reliance on oil
Malaysia continues to rely heavily on oil export revenue, including dividends from Petronas. As a result, fluctuations in oil prices in the global market have an outsized impact on our current account, foreign currency reserves as well as government revenue, operating surplus and fiscal deficit. The value of the ringgit is also closely correlated to oil price movements.
Oil and gas-related products accounted for 17% of gross exports in 2022, but roughly one-third of net exports. This is due, in part, to the comparatively low-value-added manufacturing sector. Oil and gas, on the other hand, come from the ground — therefore, the net value is highly correlated to selling prices. Similarly, oil-related income comprised about 30% of total government revenue last year. In other words, in the years when oil prices are high, our current account surplus, foreign reserves and government operating balance tend to be higher, and vice versa.
Both current account surplus and government operating surplus have fallen sharply over the past decade. The current account surplus is being eroded by rapid growth in consumption goods imports and, to a lesser extent, imports of services and repatriation of income by foreign companies and migrant workers. And as we explained above, the government operating surplus has fallen sharply as expenses consistently grew at a much faster pace than revenue (see Charts 2 and 5).
The lower surpluses also mean the buffers against any unexpected oil revenue shortfall are now significantly less. This leaves Malaysia increasingly vulnerable to unpredictable oil price movements that are beyond our control — not to mention gradually declining oil production.
Our current probable and proven reserves (a more than 50% chance of being technically and economically possible to be produced) could last for only 15 years (although reserves can be expanded with successful exploration). The global transition to renewables is gaining traction by the day. It is, therefore, not at all too soon for Malaysia to start planning for this eventuality. Economic transformation takes time. To continue depending on oil to save the day for the government is foolish.
The Malaysian Portfolio fell 0.7% last week, paring total portfolio returns to 156.7% since inception. Insas (+2.4%) was the sole gainer for the week, while profit-taking sent Hartalega Holdings (-4.6%) and Star Media Group (-2.4%) lower. This portfolio is outperforming the benchmark FBM KLCI, which is down 20.1%, by a long, long way.
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