Like other economies in ASEAN such as Singapore and Thailand, 1Q09 marked the bottom in terms of percentage year-on-year GDP trajectory for Malaysia. 2Q09 data show that the economy declined at a slower pace of 3.9%Y (versus -6.2%Y in 1Q09). Seasonally adjusted sequential data are not published. However, our calculation shows that Malaysia emerged from a two-quarter-long recession in 2Q09. A few cross-currents are at work in terms of GDP components. The slower pace of decline in 2Q09 was predominantly driven by an inventory snapback. Destocking shaved only 1.9pp from headline GDP in 2Q09, while it shaved off a massive 9.7pp in 1Q09. Meanwhile, domestic demand (excluding inventories) also showed a slightly slower pace of decline at -2.3%Y (versus -2.9%Y in 1Q). However, external demand still saw further deterioration at -17.3%Y (versus -15.2%Y in 1Q09).
Taking Stock of Trends at the Margin
A restocking rebound would ultimately have to give way to a firmer turnaround in real demand for the uptick to sustain. The macro framework that we have when looking at the Malaysian economy is that it is essentially a three-legged growth model: first, it is dependent on manufacturing exports; second, it is dependent on commodity exports, given that Malaysia is the largest net commodity exporter within Asia; and third, it is dependent on fiscal pump-priming, as Malaysia possibly has the largest public sector economy in Asia and commodity revenue is recycled back into the economy via the political machinery. In this regard, we look at high-frequency macro indicators from a C+I+G+X-M framework to assess how each of these growth legs as well as the broader economy is faring at the margin, heading into 3Q09.
Private Consumption: Sentiment Picked Up Much More than Actual Spending
The reaction on the consumer side this time round has been worse than in the 2001 cycle (low of +2.1%Y in 3Q01 and no contractions) but not as bad compared to 1998 (low of -12.3%Y in 3Q98 and six quarters of negative percentage year-on-year growth) when the slowdown was relatively more home-grown. Indeed, GDP data on consumption show only one quarter of a shallow decline in 1Q09 (-0.7%Y) in this cycle. In terms of how strong the recovery in consumer spending will be, recent retail spending proxies still look like a mixed bag in terms of direction, suggesting that the near-term spending recovery could still be somewhat hesitant. Specifically, declines in passenger car sales (-11.1%Y, 3MMA in June 2009) and motorcycle sales (-17.7%Y) are holding somewhat steady while contractions in consumption imports have deepened (-8.2%Y). On the other hand, sentiment has rebounded strongly in 2Q09, attesting to reflexivity from asset markets, which could translate into incremental spending willingness in 2H09. Quality of labor market data for Malaysia is less than ideal, but retrenchment figures have tapered off recently. Anecdotally, we have heard of manufacturers who over-fired during the downturn and are now rehiring at the margin.
Fixed Capex: No Excesses Mean a Lesser Adjustment Period
The capacity utilization rate rebounded somewhat in 2Q09 to 78.2 from 72.0 in 1Q09. With capacity utilization mapping fixed capex trends fairly well, we believe that the trajectory turnaround for the latter will continue into 2H09 amid the tepid global recovery. Indeed, unlike in Singapore where corporates were aggressively undertaking capacity expansion plans right up until the Lehman episode, Malaysia's capex cycle post the Asian currency crisis has been fairly moderate. The fixed capex share of the economy has remained steady at around 20%. To the extent to which there were no excesses in this cycle, we believe that the adjustment period for capacity normalization will also be correspondingly shorter.
Fiscal Pump-Priming: Execution Underway
June data showed that fiscal execution is underway, with fiscal expenditure (12-month trailing sum, percentage of GDP) continuing to trend up, reaching a high of 28.5% of GDP from a recent low of 23.3% (February 2008). Consequently, the budget deficit widened to 5.3% of GDP (12-month trailing sum) from 2.8% in February 2008. Going forward, we believe that government expenditure is likely to pick up further on a sequential basis, as spending tends to be back-loaded in the second half of the fiscal year in the case of Malaysia. Initial comments by government officials suggest that fiscal policy from a deficit perspective, while still accommodative, could be less expansionary in 2010 compared to 2009. Yet, we note that, among the ASEAN economies, Malaysian policymakers have generally been among the more accommodative ones.
Trade Trends: A Mixture of Price Effects and Cyclicality
Commodity-related exports are still reflecting price changes, with exports of mineral fuels and edible oils still showing unabated declines at -42.4%Y, 3MMA in June (versus -37.8%Y in May), given the peak of the oil price cycle in mid-2008. However, declines in other non-commodity exports have somewhat stabilized at -20.3%Y (versus -18.9%Y in May). Going forward, the US ISM New Orders index (which leads ASEAN exports by roughly four months) points to a more evident turnaround in 2H09, and we believe that such a turnaround is in the pipeline. More specifically, trade would likely be dominated by two trends. Commodity exports would be buoyed by the bounce-back in commodity prices and such positive base effects would be most pronounced in 1H10. On the other hand, manufactured exports would receive cyclical support from the tepid global recovery. Yet, to the extent to which Malaysia's manufactured exports have been gradually losing market share over the years, the tailwind on this front could be correspondingly weaker.
Deflation and a Dovish Central Bank
On CPI, deflation in Malaysia (-2.4%Y in July versus -1.4%Y in June) is still primarily driven by the transport segment rather than demand destruction per se. Retail fuel constitutes about 7.3% of the CPI basket, and administered fuel prices have been revised downwards by 33-35% since mid-2008. We believe that Malaysia will come out of deflation territory by end-2009 or early 2010 as base effects get washed out. Yet, whether Malaysia would see cost-push pressures from commodities in 2010 depends a lot on whether policymakers are likely to change the fuel subsidy system. Our base case assumption using the oil futures curve is for oil to average about US$75/bbl in 2010. If the current subsidy system is maintained, we suspect that policymakers will be unlikely to hike retail fuel prices. In this case, inflation will likely rise from 0.2%Y this year to only 1.5%Y in 2010.
On policy response, further easing is unlikely as the central bank (BNM) is keen to keep a balance between reducing the cost of capital for debtors and maintaining the interest income for saving households. Malaysia is after all a net saving economy. On exit strategy, we think BNM will be closely watching for second-round inflation pressures instead of ‘first-round' policy-induced inflation from base effects. In this regard, we believe that BNM is unlikely to be anxious with the initial uptick in headline inflation simply on fuel price base effects, and monetary policy normalization is likely to start only in 2H10, which would bring policy rates from 2% to 3%.
Bottom Line
The percentage year-on-year GDP trajectory bottomed out in 1Q09, primarily on the back of an inventory snapback. Beyond the inventory-led rebound, a firmer turnaround in real demand is required for an uptick to sustain. Structural weaknesses not withstanding (see Malaysia Economics: Where Are the Structural Gaps? April 23, 2009), looking at Malaysia via the three-legged growth framework of manufacturing exports, commodity exports and fiscal pump-priming suggests that the economy is likely to receive cyclical support going forward, with GDP growth expected to go from -3.5%Y in 2009 to +3.8%Y in 2010. Meanwhile on the policy front, deflation is likely to persist until late 2009 or early 2010, and we believe that monetary policy renormalization will take place in 2H10.
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Jackson Hole 0, Jerusalem 1
August 27, 2009
By Joachim Fels | London
Shekeling the tree: Until very recently, central banks around the globe stood united in their quest for easing monetary conditions through interest rate cuts or, where the lower bound for rates had been reached, unconventional policies. Moreover, at their annual gathering in Jackson Hole this past weekend, most central bankers signalled that an early tightening in the major economies is not on the cards. However, at least one central bank chose to differ this week: the Bank of Israel in a surprise move broke ranks and raised rates by 25bp on August 24, thus becoming the first central bank in the EM and non-EM space to tighten policy in this cycle. While we do not believe that this move alters the outlook for the big central banks, it does have two important ramifications. First, markets will increasingly focus on who's next to raise rates (Norway, we think). Second, with policies starting to diverge as some central banks, especially in Central and Eastern Europe, are still cutting rates, differentiation between countries is likely to become a bigger theme again for markets.
Cautious consensus at Jackson Hole: The main message that our colleague Richard Berner brought back from this past weekend's gathering of central bankers at Jackson Hole is that an early policy tightening in the major countries is definitely not on the cards, in line with our global team's forecasts. In Dick's own words (see The Message from Jackson Hole, August 24):
"Risky asset markets are celebrating early signs of economic recovery, but policymakers at Jackson Hole were far more cautious about the outlook...Most agreed that ‘tapering' some policy supports - for example, winding down and possibly extending the termination of the Fed's asset purchase programs - is now appropriate to signal the end of easing. There is also consensus that commitments to maintain the current highly accommodative policy stance should be conditional on the outlook for inflation. Whether expressed in terms of the calendar, like the Bank of Canada's pledge to maintain the policy rate at 0.25% until 2Q10, or the Fed's "extended period", the goal of policy is to prevent deflation. Indeed, US policymakers were quick to emphasize that there is no inconsistency between currently low interest rates and stable inflation. With US markets apparently pricing in the first tightening around the turn of the year, officials clearly wanted to express a more cautious stance, and their caution was echoed by many others".
In fact, the Fed, The Bank of Japan, the ECB and the Bank of England are all still engaged in their various unconventional easing programmes and are all forecasting inflation to remain below their respective targets in the foreseeable future. An early policy reversal thus remains unlikely for now - in this sense, there was nothing new from Jackson Hole (for more detail on other issues discussed, please refer to Dick Berner's piece).
From the trumpets of Jerusalem: Notwithstanding the cautious Jackson Hole consensus, the Bank of Israel became the first central bank to tighten policy in this cycle by nudging up its policy rate by 25bp to 0.75%. As justification, the policy statement points out that headline inflation is currently above the target range and that, even excluding non-recurring factors (increased tax rates, including VAT, and water prices), inflation is close to the upper limit of the target range. Also, the Bank of Israel notes a "turnaround" in real activity, even though there is "great uncertainty regarding the expected rate of growth". Looking ahead, our Israel watcher Tevfik Aksoy writes:
"While the current statement gives limited guidance on what the next move could be, we would be surprised if the bank kept the tightening at merely 25bp this year. This might not only prove ineffective (from an inflation perspective) but could also result in confusion in the market. Prior to the interest rate decision, we had pencilled in a 150bp hike for 2010, and we maintain our view, albeit with different timing. The minutes of the BoI rate-setting meeting are expected to be made public on September 7, after which we will revisit our rates outlook. The next rate-setting meeting will be held on September 24."
Why the Israeli situation is different: In a global context, the important thing to note about the Bank of Israel rate hike is that Israeli inflation has recently been uncomfortably high while interest rates have been extremely low. This differs from the situation in most other countries, which fall into two broad groups: First, as our Inflation Target Monitor on page 4 of The Global Monetary Analyst (August 26) illustrates, countries where policy rates are very low typically have inflation at or below target at this stage. Second, in countries where inflation is above target (mostly in Central and Eastern Europe and parts of Latin America), policy rates are typically much higher than in Israel. Thus, Israel looks like an outlier on the interest rate/inflation map and is thus unlikely to find many followers in hiking rates in the near future.
Next? Norges Bank? The most likely candidate for the next rate hike after the Bank of Israel is the Norwegian central bank, in our view. In its August policy statement, Norges Bank noted that "New information may also suggest that production and employment may slow less sharply than expected. These tendencies are still uncertain and new figures may change the picture, but should these developments continue, it may be appropriate to increase the interest rate earlier than projected in the previous Monetary Policy Report (our italics)". Thus, our Norway watcher Spyros Andreopoulos writes:
"Our central case is for the first rate increase to come in the December meeting. We think the urgency with which Norges Bank communicated a change in posture - effectively shredding the Monetary Policy Report which forecast rates on hold until the 2Q10 only one meeting after its publication - is telling. 2Q09 GDP data, published recently, show that the consumption-led recovery Norges Bank was forecasting is underway: household consumption posted the first sequential increase since 1Q08 at a 0.6% quarterly rate. With government spending also increasing strongly, all indications are that the substantial monetary and fiscal policy stimulus is succeeding in buoying the Norwegian economy. That said, we think Norges Bank will want to proceed at a measured pace, given the risks to the outlook and for fear of generating too strong an exchange rate. After the opening salvo in December, we have pencilled in a 25bp hike in every other meeting from then on, with the pace picking up in 4Q10 where we expect a hike in both meetings for that quarter. This would leave rates at 2.75% for 4Q10 in our estimates."
Or perhaps the RBA? Another country where the central bankers sound more hawkish recently is Australia. Helped by significant rate cuts, fiscal stimulus, exchange rate depreciation and Chinese recovery, the economy has avoided recession and the Reserve Bank of Australia (RBA) raised its outlook for growth and inflation in the early August policy statement. While the statement noted that "the present accommodative setting of monetary policy is appropriate", it also indicated that "with the cash rate at an unusually low level and the global economy stabilising, movement towards a more normal setting of monetary policy could be expected at some point if further signs of a durable recovery emerge". While our Australia watcher Gerard Minack's central base is that the cash rate will remain on hold until 2Q10, he acknowledges the clear risk of an earlier move.
Bottom line: Notwithstanding the surprise rate hike by the Bank of Israel this week, we continue to believe that the major central banks will keep rates on hold until well into 2010, a view that we feel was confirmed by central bankers at Jackson Hole. Israel is in a special situation, given that it has an unusual combination of extremely low policy rates and uncomfortably high inflation. We think that the next central bank to hike rates is Norges Bank (in December), with the RBA being another candidate to watch (though this is not our main case). In any case, with some countries now embarking on monetary tightening while others are still easing, differentiation between countries is likely to become a bigger theme for markets again.
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The Message from Jackson Hole
August 27, 2009
By Richard Berner | New York
The Grand Tetons' timeless beauty once again provided a relaxed backdrop in which to debate and reflect on the state of the global economy and financial markets at the Kansas City Federal Reserve's annual Monetary Policy Symposium this weekend in Jackson Hole, Wyoming. Gone were last year's gloomy acceptance by policymakers and market participants that continued downside risks for the global economy and financial markets would persist, along with the huddled meetings to deal with the gathering storm. In their place was relief that the worst of the crisis was now past and that economies were stabilizing or showing early signs of recovery, and hope that the outlook for recovery was good.
Sunny markets, cautious policymakers. Nonetheless, there is a significant disconnect between market sentiment and policymakers' moods. Risky asset markets are celebrating early signs of economic recovery, but policymakers at Jackson Hole were far more cautious about the outlook. While we continue to think that the recovery will ultimately be sustainable, we agree with most policymakers that it is still reliant on forceful policy support; that a self-sustaining recovery is far from a sure thing; and that downside risks to inflation persist. Ironically, continued caution from policymakers is a key ingredient encouraging investors to take on more risk, as low rates help to finance carry and other risky asset trades.
Against this backdrop, debate at the symposium focused on four areas of uncertainty: the success of policies to jump-start recovery, what comes next, when and how to exit from extraordinary policy support, and how to reform the policymaking and regulatory structure.
Aggressive monetary policy support for financial markets and economic activity has clearly contributed to healing in both, but there is still uncertainty about policy effectiveness and thus the outlook. Most agree that aggressive use of monetary policy's broader tool kit has mitigated the financial crisis and stabilized economic activity. While this is not the same thing as jump-starting recovery, most agreed that ‘tapering' some policy supports - for example, winding down and possibly extending the termination of the Fed's asset purchase programs - is now appropriate to signal the end of easing. There is also consensus that commitments to maintain the current highly accommodative policy stance should be conditional on the outlook for inflation. Whether expressed in terms of the calendar, like the Bank of Canada's pledge to maintain the policy rate at 0.25% until 2Q10, or the Fed's ‘extended period', the goal of policy is to prevent deflation. Indeed, US policymakers were quick to emphasize that there is no inconsistency between currently low interest rates and stable inflation. With US markets apparently pricing in the first tightening around the turn of the year, officials clearly wanted to express a more cautious stance, and their caution was echoed by many others.
Little consensus on exit strategy. There was little consensus at Jackson Hole about how to prosecute exit strategies even when they become appropriate: Should uncertainty dictate a gradual Brainard/Kohn approach, one that allows officials to correct small mistakes? Or should exiting from accommodation and moving to renormalize rates mirror the aggressive stance of easing in the crisis? 20 years ago this month, then-Secretary to the FOMC Don Kohn articulated the logic behind the gradualist approach: Small but frequent adjustments to the funds rate in the context of a larger policy strategy may be optimal. Two decades later, Vice-Chairman Kohn gave no hint that today's circumstances warranted a departure from gradualism. Yet the logic for adopting a more aggressive exit strategy is not without merit: Policy is extremely accommodative, so just to normalize rates will require sizeable moves. And while even normalization seems a distant prospect, no policymaker wants to overstay his or her welcome.
Activist fiscal policy: Uncertain effects, risky legacy. Most agreed that the depth of the crisis warranted aggressive use of fiscal policy, especially given concerns about monetary policy traction in the credit crunch. But there is widespread uncertainty about the bang-for-buck and fiscal policy multipliers from either the 2008 or 2009 stimulus packages, and little if any consensus about their current benefits. Some estimates of fiscal policy multipliers were significantly less than one. Moreover, participants at Jackson Hole unanimously wanted a credible commitment to reducing deficits to head off a potentially damaging rise in real interest rates. We couldn't agree more.
Expanding the policy mandate. Financial stability is now a key goal for monetary policy, but how to achieve that expanded policy mandate and whether it complements or conflicts with the traditional goals of price and economic stability are still open questions. As Bank of Canada Governor Carney noted, "a prolonged, benign macroeconomic environment can encourage ...complacency...as risk taking adapts to the perceived new equilibrium..." and changes the monetary transmission mechanism. "Indeed", Carney noted, "risk appears to be at its greatest when measures of it are at their lowest". In other words, achieving price stability can encourage excessive risk taking and leverage that will breed, Minsky-like, financial and ultimately economic instability. Policy ideally should not contribute to such instability; it should lean against it.
However, defining this expanded mandate and deciding how much would go to central banks, the scope, the techniques and how to communicate the objectives and strategy are still evolving. As the first line of defense, many central bankers recognize the need for better regulation, for example through improved macroprudential supervision and regulations that reduce procyclicality in financial markets and credit availability. Time-varying capital buffers, discussed at last year's symposium, and their funding-market cousins - through-the-cycle margins and haircuts - are on most policymakers' lists.
However robust, no regulatory framework will eliminate panics resulting from financial shocks. The debate extended to how to institutionalize liquidity provision to quell such panics in a way that fits Bagehot's dictum to "lend early and freely (i.e., without limit) to solvent firms, against good collateral, and at ‘high rates'" - especially when it comes to evaluating ‘good' collateral. When and where to draw the line between liquidity support for a solvent firm from the central bank and a rescue from the taxpayer for one requiring restructuring requires both principles and judgment.
And what if such improved regulation fails to prevent a credit or asset boom? In contrast with the US view of a few years ago, central bankers today increasingly believe that policy should lean against the wind of such booms. Critical to that judgment is work suggesting that small changes in funding costs (either through actual change in policy rates or in adjustments to margins or haircuts) can have a significant effect. Announcing their intentions to do so does not preclude flexibility in deciding whether exuberance is going too far and could reduce the now-infamous ‘put' that developed when central bankers took a hands-off approach. Whether institutionalized in the ECB's ‘two pillar' approach to policy or in some other credible fashion, policymakers must develop the right framework for allowing them to achieve financial stability, as well as the flexibility to accommodate deviations from it.
Spectacular weather no metaphor for investor uncertainty. The ever-changeable weather in the Tetons is often the proverbial pathetic fallacy, a metaphor for the conference. Not so last year or this: Last year's weather was ideal, but the cloudy litany of economic, financial and policy concerns was widespread. I shared those concerns, noting then, "With global growth slowing, there is reason to worry that the adverse feedback from the economy to credit quality will trigger more financial dislocations that will require tough choices - choices that involve trade-offs between moral hazard and real economic hazards, potentially setting lasting and uncomfortable precedents for the future".
This year, the spectacular weather seemed to fit investors' moods, contrasting with the still-cautious disposition of policymakers. An improving economic outlook and still-low interest rates are providing a sweet spot for investors. A scenario of rising earnings and sustainable growth now seems more plausible than at any time in the last two years. And low rates provide fuel for leveraging high-beta, cyclical investment opportunities. But there is a lot of good news in the price, and market participants will for now have to grapple with the uncertainty surrounding the outlook and the prospects for an eventual exit from policy support. Investors also face uncertainty about the ways that policies to achieve the goal of financial stability will reduce leverage, prospective returns and growth. Finally, they face uncertainty of how elected officials will respond to the financial crisis by reshaping the Fed.
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