Malaysia
2010 Budget - Fiscal Policy Unwinding
October 27, 2009

By Deyi Tan, Chetan Ahya & Shweta Singh | Singapore

What's New?

The 2010 Budget was announced last Friday. Investors were not pricing in high expectations, in our view. Prior to the Budget, policy measures already announced by PM Najib in his first 100 days in office and comments made by government officials have already pointed to a rough picture of what might pan out. Indeed, as we highlighted in ASEAN MacroScope - Malaysia 2010 Budget Watch, October 13, 2009, we had three watch-factors: (1) cyclical growth support; (2) longer-term structural reforms; and (3) fiscal exit strategy. Below, we outline the three key points in the 2010 Budget on these fronts as well as our thoughts:

Point #1: Fiscal Policy Unwinding and a Less Expansionary Budget

With a global macro turnaround underway, markets have shifted attention from the extent of easing required to the policy exit strategies which should be undertaken. Similarly in Malaysia, the announced 2010 Budget shows an unwinding of fiscal responses. Contrary to what some quarters were expecting, a third stimulus package (one which would provide a strong temporary boost) was not incorporated into the Budget. However, a loose fiscal policy stance, although one less expansionary than 2009, is being adopted. The federal government expects a fiscal deficit of 5.6% of GDP in 2010 (versus -7.4% of GDP in 2009).

Specifically, government revenue is expected to decline by 8.4%Y in 2010 (versus +1.4%Y in 2009). As a result, government revenue (as a percentage of GDP) will fall from 23.5% of GDP in 2009 to 20.5% of GDP in 2010. On the other hand, government expenditure is also expected to decline 11.4%Y (versus +9.1%Y in 2009; 26.1% of GDP versus 30.9% of GDP in 2009). The contraction is bigger in operating expenditure (-13.7%Y versus +4.3%Y in 2009; 19.1% of GDP versus 23.2% of GDP in 2009) versus development expenditure (-4.5%Y versus +26.6%Y in 2009; 7.0% of GDP versus 7.7% of GDP in 2009). 

Our Thoughts

As highlighted in ASEAN MacroScope: Malaysia - 2010 Budget Watch, we did not think that a third stimulus package was necessary as policy measures from the second stimulus package were likely to spill over to 2010. In this regard, the absence of a third stimulus package is not a negative, in our view. Yet, given that the global recovery was unlikely to return to the vigor seen in 2004-07, and with Malaysia having one of the largest public sector economies within Asia and the public sector being one of the three growth legs (the others being manufactured exports and commodities), we believed that the pace of policy unwinding had to be gradual. In our view, the 2010 fiscal stance remains supportive, given that a deficit position is maintained and the wind-down of the federal government fiscal deficit looks reasonably gradual. 

The mix of shifts in revenue and expenditure (as a percentage of GDP) was quite interesting though, and it matters in terms of the macro impact. One thing to point out is that, as with all fiscal policies, embedded automatic stabilizers mean that revenue growth (and as a percentage of GDP) should typically pick up in a growth upturn, given the progressive taxation structure and higher incomes.  This would help to narrow the fiscal deficit in an anti-cyclical fashion. In the case of Malaysia, the smaller fiscal deficit has not been on the back revenue growth outpacing expenditure growth. Rather, it has been on the back of expenditure contractions outpacing revenue declines. Tax-related measures typically have a lower multiplier effect compared to expenditure measures. In this regard, we think that the support to the economy would be lesser for the same level of fiscal deficit as compared to a scenario where expenditure is growing but at a lesser pace compared to revenue.

Point #2: Macro Restructuring Efforts Underway

In terms of macro restructuring, steps will be taken to attract FDI and strengthen research and development activities. Specific niche areas in the services industry such as tourism, information technology & communication, finance and Islamic banking, halal, green technology and creative industries will also be further developed to enhance value-add and generate higher returns via measures such as upgrade of infrastructure facilities, tax incentives and funds to provide soft loans (for more details, please see pages 5-7 of ASEAN MacroScope - Malaysia: 2010 Budget: Fiscal Policy Unwinding, October 26, 2009).

However, niche areas cannot be further developed without corresponding soft infrastructure. In this regard, measures will also be taken to raise the quality of human capital. Specifically in the education sector, measures such as school infrastructure investment, training programmes, the creation of high-performance schools and an incentive-based system to attain performance targets will be undertaken to improve education quality. Separately, the quality of workforce will also be improved via education funds, training programmes and upgrading of existing learning facilities (for more details, please see page 8 of ASEAN MacroScope - Malaysia: 2010 Budget: Fiscal Policy Unwinding). 

Our Thoughts

In our view, human capital remains the key to the macro strategy of moving up the value-add chain in the identified niche areas. We think that the deteriorating net FDI trends and declining global manufactured export share in Malaysia are symptomatic of existing soft infrastructure gaps in terms of skills shortage and skills mismatch. In this regard, although we see the previous measure to change the teaching medium for science and maths from English to Bahasa as a step backwards, we see the current budget emphasis on education measures as a step in the right direction.

Some measures are more important than others. In our view, the more critical measures are ones such as the creation of high-performance schools which will help in generating pockets of excellence necessary to spearhead growth in niche areas. An incentive-based system to encourage schools to meet performance targets and training programmes for teachers will also help to raise the quality of educators, which is at the forefront of driving the improvement in the quality of human capital. Indeed, the reason why previous education measures such as the use of the English language as a teaching medium for science and mathematics had not reaped the desired results was due to lapses in implementation as the educators themselves were not incentivized to pick up the language. Overall, the education measures will be long-gestation ones and continual and effective execution will remain key to watch.

Point #3: Fiscal Consolidation Underway

The budget highlighted several measures for fiscal consolidation via an improvement in revenue base and a decrease in expenditure. The revenue measures include potential implementation of a goods and services tax to replace the current sales and service tax once the social study has been completed, a 5% tax on gains from disposal of real property, credit card charges, asset sales and rental fees from government premises and training equipment. Separately on the expenditure side, the government plans to restructure the fuel subsidy scheme to benefit only targeted groups. Indeed, we calculate that subsidized retail fuel prices are likely implying an underlying crude oil price of around US$40-45/bbl

Our Thoughts

In terms of the urgency for fiscal consolidation, we think that both the initial existing stock (outstanding public debt) and flow (fiscal balance) matter. With the globally acceptable benchmark for public debt standing at around 60% of GDP,  the low starting point for the existing stock of debt (at 48.6% of GDP in 2Q09) actually helped to offer some buffer for policymakers, despite the aggressive fiscal expansion in 2009. The fact that most of the public debt is being funded domestically and the ample domestic liquidity conditions for public debt funding also helped somewhat. We calculate that a fiscal deficit of less than 4% of GDP will keep public debt ratios from rising. With the fiscal deficit expected at 5.6% of GDP in 2010, public debt ratios will likely rise in 2010, but at a slower pace. However, we believe that this gradual narrowing of the fiscal deficit is acceptable when viewed in light of the need to accommodate current macro conditions.

Bottom Line

On cyclical growth support, with the federal government fiscal deficit going down from 7.4% of GDP in 2009 to 5.6% of GDP in 2010, we think that fiscal policy, though less expansionary, still remains accommodative. On longer-term reforms, measures were taken to improve the quality of human capital, which we see as crucial for moving up the value-add chain. Continued and effective execution will remain key. On fiscal exit strategy, we think that the public debt ratio is likely to rise in the near term, given the need to accommodate current macro conditions. However, the government appears to be moving in the right direction of fiscal consolidation.

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Mexico
Zipping Up the Fiscal Straightjacket
October 27, 2009

By Luis Arcentales & Daniel Volberg | New York

In a closely watched vote last week, the lower house of Congress decided to amend the administration's budget and tax reform proposals.  Among the key changes was a rejection of the proposed 2% ‘anti-poverty' tax on all consumption, which was instead replaced by a 1% hike in the value-added tax, excluding food and medicine.  A lot can change in the Senate between now and the deadline for approval at the end of October, but with mounting questions regarding the medium-term sustainability of Mexico's fiscal accounts, the results of the revised proposals may have inordinately strong implications, given the growing pressure on government receipts derived from the steady decline in oil output and exports.  We review the evidence.

While the revised budget and tax reform proposals seem fairly successful in stabilizing the fiscal deficit in the next couple of years, they still leave the fiscal accounts quite vulnerable over the medium term.  The revised budget and tax reform proposals don't seem to go far enough in reversing the deteriorating medium-term fiscal trend unless the Mexican economy starts growing at 4% after 2010 - as assumed in the government's economic agenda for 2010-15. However, 4% growth is a pace well above anything experienced in Mexico's recent history - whether one considers the past five (3.4%), ten (2.9%), fifteen (2.9%) or twenty years (3.1%).  Indeed, it is important to note that our conclusions hold almost irrespective of whether oil prices continue to rise steadily from current levels, in great part because at prices above those originally proposed for the 2010 budget by the administration (US$53.9 per barrel for the Mexican basket), a meaningful portion of the extra revenues derived from higher crude is offset by mounting domestic fuel subsidies (see "Mexico: Oiling the Fiscal Coffers", EM Economist, June 6, 2008). (Fuel subsidies depend on several factors - including international crude quotes, the exchange rate and domestic fuel prices - in addition to the budget's oil assumption. The amount budgeted for fuel subsidies rose by nearly 0.25% of GDP in the revised proposal versus the original version.)

The legislative process not over yet - the deadline for approval of the ‘revenue law' is at the end of October, and November 15 for the full budget - and the revised proposal may still be modified, but we suspect that any further revisions that weaken the ability to generate extra fiscal revenue may have further negative implications for the medium-term fiscal outlook.  Indeed, opposition groups in the Senate have gone as far as suggesting alternative fiscal plans that would be tantamount to rejecting most of the new taxes, an event that, in our view, would likely force the hand of the rating agencies that already have Mexico on negative credit watch.  

Watering Down the Fiscal Reform

When the administration unveiled the 2010 budget draft on September 8, we found it to be an ambitious effort to put the fiscal accounts on the right path (see "Mexico: Loosening the Fiscal Straightjacket", EM Economist, September 18, 2009).  At the time, we warned that even if the tax reform was approved without major modifications, Mexico would continue to face a fine fiscal balancing act in the coming years that required firm efforts to contain spending in order to avoid medium-term fiscal deterioration.  Since then, the budget proposal experienced several changes in Congress which have weakened its reach, in our view.  

At the heart of the original reform was a 2% ‘anti-poverty' tax on all consumption, which was rejected in Congress, and which would have generated as much as 0.6% of GDP in additional resources while achieving the important goal - also stressed by the rating agencies - of broadening the tax base by including food and medicine. Instead of the ‘anti-poverty' tax, the lower house approved an increase in VAT to 16% from 15% (11% from 10% in bordering states), which not only keeps the tax base intact by excluding food and medicine, but also generates only about 42% of the original amount.  In addition to the consumption tax, the administration's plan also called for a series of excise tax hikes on alcoholic beverages and cigarettes, a new 4% tax on telecom services and a higher burden on gaming as well.  Of course, the overall revenues from these items were never too material, amounting to less than 0.2% of GDP.  Still, in the October 20 proposal, the tax on telecom was lowered to 3% and beer taxes slashed at a combined cost of around 0.04% of GDP.

The gap generated by the rejection of part of the proposed taxes will be filled by a wider deficit and higher oil, both of which represent steps in the wrong direction, in our view.  Indeed, the revised taxes would lift revenues next year by just over 1.0% of GDP - a third less than the originally proposed amount of near 1.5% of GDP.  To make up for this shortfall, the new macro outlook assumes oil prices at US$59 per barrel for the Mexican basket (up from US$53.9 per barrel previously) while the deficit widens to 0.75% of GDP from 0.50% (excluding Pemex's capital expenditures).  It is important to note that the reliance on oil in 2010 goes beyond the revised higher price assumption. The projected 2010 revenue increase uses all of the M$72 billion (0.6% of GDP) expected from the tax for the Oil Stabilization Fund (DSHFE) - which applies when crude prices exceed US$22 per barrel.  Thus, the 2010 budget is expected to drain the Oil Stabilization Fund and divert any expected inflows into the Fund towards spending, leaving the fiscal coffers more vulnerable to swings in crude prices. 

Another key change is that income taxes will be higher for longer.  The original proposal called for a temporary increase in income taxes to 30% from 28% in 2010, declining to 29% in 2011 and returning to today's level of 28% by 2012.  By contrast, the revised schedule keeps the 30% rate until 2012, cutting it by one percentage point in 2013 and by the same amount in 2014.  In fact, the change to the income tax schedule between 2011 and 2013 - which would generate around 0.25% of GDP in revenues per year on average, according to our estimates - represents a key offset to the gap left by the rejection of the 2% ‘anti-poverty' tax.   

One positive aspect of both the original and revised proposals is that to generate additional revenues they rely in great part on increasing rates on taxes currently in place, thus providing credibility to the program by limiting execution risk.  Moreover, though the revised bill sets a precedent by setting a deficit of 0.75% of GDP - above the 0.5% called under exceptional circumstances by the Fiscal Responsibility Law - the wider 2010 shortfall comes with strings attached, as any deficit above M$40 billion approved for 2011 (around 0.3% of GDP) would require an adjustment in the 2010 deficit (proposed at M$90 billion) by an amount equal to the difference between the approved 2011 deficit and M$40 billion.  With expenditures back-loaded each year, the authorities should have enough room to trim expenditures between the expected approval of the 2011 budget in mid-November 2010 and the end of the year.  Last, the proposal incorporates only modest fuel price hikes - an important source of revenue which could be adjusted in a discretionary fashion by the finance ministry.  

Zipping Up the Fiscal Straightjacket

For all the setbacks the budget proposal has faced in Congress, the ultimate goal of the tax reform should be to ensure medium-term fiscal sustainability.  Looking at 2010, the authorities seem to have plenty of options at their disposal to plug the fiscal gap, ranging from more aggressive fuel price hikes to more borrowing, and even the higher oil assumption of US$59 per barrel leaves room for outperformance, based on current future prices (see "Mexico: Fueling Inflation?" EM Economist, August 21, 2009).  However, over the medium term we have warned that absent tax reform and/or meaningful efforts to curb expenditures, the fiscal accounts may be heading towards unsustainable deficits, as oil output continues to decline (see "Mexico: The Fiscal Straightjacket", EM Economist, July 17, 2009).

To determine whether the tax reform adequately addresses Mexico's challenge, we ran projections of Mexico's fiscal accounts. We focus on projections for both fiscal revenues and fiscal expenditures. We proceed by breaking down fiscal revenues into oil receipts and non-oil revenues. We then project both components of fiscal revenues out to 2015 to coincide with the mid-point of the next presidential term, since we think it gives a convenient estimate of the potential fiscal pressures that the next administration is likely to face.

Our revenue projections are made under two different scenarios: a low-growth scenario with real GDP growth of 1.5% - near the average growth of the Mexican economy during the ‘lost decade' of 1981-89 (1.6%) - or a trend-growth scenario with GDP growth of 3.0% - close to the average annual growth of the past decade (2.9%). Under these two scenarios, we also differentiate between low and trend growth in private consumption - 2.1% in the 1980s and 3.8% in the past decade - to better quantify the revenue potential of the excise taxes. We further assume that oil prices remain constant near US$80 per barrel starting 2011 - in line with current spot prices - throughout the forecast horizon and that Mexico's oil output continues to decline by 5% per year. 

To estimate the potential fiscal pressures in the coming years, and complement our revenue projections, we created two scenarios for expenditures. In the first, we use the average real growth in realized expenditures in the past five years (+7.2%). For the second, we assume half of the aforementioned growth pace - an expansion rate that we feel is consistent with inertial expenditure pressures derived from areas like pension liabilities, selected social programs and financing costs.  Last, we run a separate projection using the parameters from the administration's economic agenda for 2010-15, unveiled with the budget proposal on September 8, 2009. 

With the revised tax reform, overall revenues as a share of GDP remain relatively constant under both scenarios, based on our calculations.  Over the forecast horizon, the tax reform yields around 0.8% of GDP in extra revenues per year, but the impact is uneven: after generating slightly above one full percentage point of GDP in 2010-12, the benefits plunge to near 0.6% of GDP through 2015 as the temporary income tax increases are rolled back starting 2013.  Meanwhile, after representing 8.0% of GDP in the past five years, we find that oil-related revenues could dip by around two full percentage points by 2015 on average, depending on the GDP growth scenario. 

While the new taxes go a long way towards offsetting the decline in oil-related receipts, the fiscal accounts still maintain a deteriorating trend over the forecast horizon.  In the most constructive of our scenarios - namely with 3.0% GDP growth on average and real expenditures rising at half the pace of the past five years (+3.6%) - after stabilizing between 2010 and 2012, the fiscal deficit resumes a modest yet steady deteriorating trend coinciding with the phasing out of the temporary income tax hike.  This result is discouraging considering that, under similar assumptions, the original proposal - which included a permanent source of revenue in the form of the 2% ‘anti-poverty' consumption tax - managed to successfully stabilize the deficit at manageable levels of around 2.5% of GDP (again see Mexico: Loosening the Fiscal Straightjacket).

Under our low GDP growth scenario (1.5%), by contrast, the fiscal shortfall would balloon to almost 5.0% of GDP by 2015, even if expenditure growth is limited to 3.6% per year - a pace that is not without risks, in our view, given mounting social and infrastructure spending needs and the election cycle.  By contrast, if expenditure growth were to revert starting 2011 to the rapid pace observed during 2004-08, even in the 3.0% growth scenario the fiscal deficit would widen to unsustainable levels.  In what we suspect is the most likely outcome - one of moderate GDP growth and expenditure growth at least a few percentage points above inflation - the results from our scenario analysis suggest that avoiding fiscal deterioration would require a firm effort to keep a lid on expenditures, even if the revised version of the tax reform were to be approved by the senate without any modifications.

Using the government's 2010-15 macro scenario, we find that medium-term fiscal sustainability is hostage to GDP growth.  The authorities assume in their macro outlook that, after posting 3.0% GDP growth in 2010, Mexico would make a discrete jump to higher growth rates of 4.0% in 2011 and 4.2% thereafter - a pace well above the annual pace of the period of global abundance of 2003-07 (3.5%), the 1990s (3.3%) or the average since 1980 (+2.9%).  Interestingly, fiscal sustainability does not hinge on persistently higher oil prices, given the drag from fuel subsidies after oil exceeds a certain threshold.  And though the authorities assume that oil output remains constant at 2.5mbpd in their projection towards an essentially balanced budget by 2012 and beyond (excluding Pemex's capital expenditures), even a modest decline in production is not nearly as important as the negative impact from GDP growth returning to its observed long-term trend of around 3.0%.  Note that the government's baseline scenario assumes that real growth in expenditures matches GDP growth, thus providing some room to maneuver. 

With fiscal sustainability heavily dependent on the GDP growth outlook, the burden shifts to the outlook for the structural reform agenda.  The announcement of the 2010 economic program showed that the Executive remains committed to advancing the structural reform agenda aimed at enhancing the country's competitiveness. Though the timing is yet to be determined, the authorities unveiled guidelines for a new ‘competitiveness agenda' that includes measures to add flexibility to labor markets, strengthen the anti-trust agency, strengthen financial regulation and rethink the law for private-public partnerships with the aim of facilitating investment in infrastructure projects.   Were Mexico to fail to make progress on the structural reform agenda that seeks to boost potential growth, the country should continue to face a fine fiscal balancing act in the coming years.

Bottom Line

With mounting questions regarding the sustainability of Mexico's fiscal accounts, the results of the revised fiscal proposals may have inordinately strong implications. Absent firm efforts to contain spending growth down the road, in its current form the revised tax proposal may not go far enough in reversing the deteriorating medium-term fiscal trend.  Looking beyond the immediate fiscal challenge, we believe that the best test of Mexico's success would be to continue advancing its structural reform agenda to boost competitiveness. Insofar as Mexico's growth performance remains subpar, the country should continue to face a fine fiscal balancing act in the coming years.

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