Fiscal reforms for sustainable growth

Published: Saturday August 17, 2013 MYT 12:00:00 AM 

Updated: Saturday August 17, 2013 MYT 12:32:47 PM

BY CECILIA KOK CECILIA_KOK@THESTAR.COM.MY

Economists believe the existing subsidy scheme, especially that for petrol,
create economic distortion s, con tribute to excess consumption
and levy an unaccounted for and unacknowledged bur den on society.

THE call for Malaysia to expedite structural reforms to rebalance its economy and strengthen its public finances has grown increasingly louder in recent weeks following Fitch Ratings’ downgrade of the country’s credit outlook from “stable” to “negative”.

According to economists, addressing the country’s long-running deficit and high public debt is not a rocket science. The right approach, they point out, has to be two-pronged: one is by cutting down on expenditure through subsidy rationalisation and stemming of wastage and inefficiencies, while the other is by expanding revenue base through tax reforms to reduce the nation’s reliance on petroleum-derived revenue.

Still, such fiscal consolidation measures require strong political will on the part of policymakers to execute in order to bring about positive change for the country’s economy over the long term.

As Euben Paracuelles, a Singapore-based economist at Nomura Holdings Inc, points out, there are near-term political hurdles, especially in view of the upcoming Umno party elections, to overcome in order to implement the necessary fiscal consolidation measures to rein in deficits and burgeoning public debt.

Nomura is one of the few investment bankers that expect Malaysia to miss its fiscal deficit target for 2013. In its recent report, Nomura says it expects Malaysia’s fiscal deficit this year to remain unchanged from last year at 4.5% of gross domestic product (GDP) vis-à-vis the Government’s target to cut the deficit to 4% of GDP in 2013.

“For the first half of the year, Malaysia’s fiscal deficit is already tracking above 5% of GDP. While I believe the Government would likely pursue fiscal consolidation measures (particularly in light of Fitch’s outlook downgrade) for the remaining part of the year, I think those measures will be only implemented at a managed pace as opposed to doing it aggressively to achieve the full-year target,” Paracuelles explains to StarBizWeek.

While Paracuelles concedes that fiscal consolidation measures might present headwinds to Malaysia’s economic growth in the short term, he says they will eventually give the Government more fiscal flexibility to support implementation of more reforms.

Ratings under pressure

Over the week, a statement circulated from Moody’s Investors Services showed that its credit opinion on Malaysia for the time being was still with a “stable” outlook for the country’s A3 sovereign rating.

This is in contrast to Fitch’s recent downgrade of Malaysia’s sovereign credit rating outlook from “stable” to “negative”. The latter’s move was prompted by what it saw as deteriorating prospects for budgetary reform and fiscal consolidation to address weaknesses in public finances in view of the Government’s poor performance in the 13th general election in May.

Fitch, however, had reaffirmed the actual ratings for Malaysia’s long-term foreign and local currency at A- and A, respectively. The average lifespan for a rating outlook is about 18 to 24 months before a change in actual rating is enforced.

According to the international rating agency, Malaysia’s public finances are its key rating weakness.

For a start, the country’s national debt had grown significantly from 39.8% of GDP in 2008 to 53.3% of GDP as at the end of last year. This put it just slightly below the Government’s self-imposed debt ceiling of 55% of GDP.

While Malaysia’s budget deficit has notably improved from a high of 6.7% of GDP in 2009 to 4.5% of GDP last year, some analysts remain concerned over the Government’s ability to achieve the ultimate fiscal deficit target of 3% of GDP by 2015 without aggressive fiscal consolidation taking place.

Moody’s says Malaysia’s credit rating could move up the ranks if the Government undertook structural reforms to rebalance its economy so that the private sector could play a bigger role in driving growth. Needless to say, improving the debt dynamics would also be credit positive for the country, while deterioration in the Government’s financial strength, possibly arising from ineffective policies or the lack of fiscal reforms, will put the country’s credit rating under pressure.

In a recent note, Affin Investment Bank Bhd chief economist Alan Tan points out: “The risk of a downgrade in the country’s credit ratings will make it expensive for Malaysia to borrow money from abroad. A lower rating will also dampen investment flows into Malaysia’s equity and bond markets, as there will be negative perceptions of the country’s deteriorating credit quality.”

Government’s commitment

Prime Minister Datuk Seri Najib Tun Razak had early this month said the Government would unveil a detailed strategy on how to address growing concerns over the health of Malaysia’s public finances in Budget 2014, which would be tabled on Oct 25.

In stressing that the Government remained committed to strengthening the country’s macroeconomic and fiscal position, Najib pointed out that a fiscal policy committee (FPC) had been formed to address the challenges that the country faced.

“A key test of the Government’s budgetary resolve will come with its 2014 Budget announcement on Oct 25. No doubt, Fitch and the other rating agencies (Moody’s and Standard & Poor’s) will be looking for some credible tightening measures, including an increase in what seem to be extremely generous fuel subsidies, as well as a clear timetable for the introduction of the goods and services tax (GST),” Credit Suisse’s economists, led by Robert Prior-Wandesforde, argues.

According to economists who attended a pre-Budget 2014 dialogue held in June this year, Najib did display a strong resolve to cut Malaysia’s fiscal deficit to the official target level of 4% of GDP this year and to around 3% of GDP by 2015. Fiscal consolidation apparently would be achieved through prudent and productive spending and revenue enhancement through tax enforcement and compliance.

“It appears subsidy rationalisation will resume under Budget 2014 as the Prime Minister reinforced the Government’s desire to move towards targeted subsidies and direct financial aid to the poor and lower-income groups from the existing blanket subsidies,” Maybank Investment Bank Bhd economists, led by Suhaimi Ilias, highlights in their recent report.

They, however, think that GST would not be featured in Budget 2014, as the long-delayed tax reform was not specifically mentioned during the pre-Budget dialogue.

CIMB Investment Bank chief economist Lee Heng Guie, in an e-mail, explains toStarBizWeek: “Improving the nation’s fiscal position will be challenging without significant reforms to address the cost of fuel subsidies, broaden the fiscal revenue base or reduce dependence on oil-related revenues.

“We think reforms are more of a continuous process and the rakyat must be assured that populism will not come at the expense of fiscal sustainability. A clear and credible fiscal consolidation plan to return to fiscal sustainability over the medium term must be enacted to bolster investor confidence.”

Economist Tan Sri Ramon Navaratnam, also chairman of Asli Centre for Public Policy Studies, concurs, saying, “Greater reduction of the country’s fiscal deficit and debt should be a priority that goes alongside with efforts to build sustainable economic growth.”

“If we do not address the deficit and debt situation systematically, we may well set our economy on a slippery path,” Navaratnam argues.

Subsidy rationalisation

Economists believe resuming the subsidy rationalisation programme is an important measure to put Malaysia’s fiscal health back on track, as it could yield substantial savings into the national coffers. The measure, which has been shelved since mid-2011, was one of the key reforms highlighted under the country’s Economic Transformation Programme when it was launched in 2010.

“The existing subsidy scheme, especially that for petrol, create economic distortions, contribute to excess consumption and levy an unaccounted for and unacknowledged burden on society,” Malaysian Rating Corp Bhd chief economist Nor Zahidi Aliasexplains.

To put that into perspective, Zahidi argues that every litre of petrol consumed would cost the economy circa 50 sen in environmental damage, health costs and lost of productivity through traffic congestion.

“Subsidising petrol use encourages greater consumption. And the blanket approach under the current subsidy scheme should be reviewed as those who can afford higher prices often benefit more than those who can’t,” Zahidi explains.

Alliance Research Sdn Bhd chief economist Manokaran Mottain concurs, adding that it is high time that Malaysia revamp its existing subsidy scheme, which form a bulk of the country’s operational expenditure.

“We should have a targeted-approach scheme to ensure that the benefits are really going to the poor and low-income households, and not just to anybody, including the rich,” he explains.

Prudent spending

Besides resuming the subsidy rationalisation programme, economists say there are also other initiatives that should be implemented to promote efficiency and effectiveness in Government spending.

“In the immediate term, the Government could exercise more restraint in its supplementary budget expenditure, which has often resulted in Government spending exceeding the original budget estimates,” MARC’s Zahidi says.

According to Zahidi, MARC expects the Government’s revenue collection this year to be on track to come in at about 5% (or about RM10bil) higher than budget estimates.

“If the Government could cap over-budget expenditure, the excess revenue expected from this year’s collection could be used to pare down the fiscal deficit,” he points out.

The efficiency and effectiveness of expenditure is vital, CIMB’s Lee stresses, adding that the actual outcomes from fiscal monitoring and management tool have to be examined in depth to ensure that output/outcome budgeting could help weed out unnecessary and irrelevant concessions, and cut down on non-performing programmes, projects or entities.

“An ad-hoc cut in expenditure will not do. What is needed is optimum utilisation of scarce resources that have alternative uses,” Lee argues.

“This requires a fundamental review so as to weed out all non-developmental, non-priority and unproductive expenditures, while focusing on growth-oriented spending. The problem of overlapping spending schemes also has to be avoided,” he explains.

According to Lee, Malaysia should also include, among others, an effective monitoring system to track public-private partnership projects for cost control and outcomes, as well as a critical review and reform of the Government’s procurement system to combat wastage, leakages and corruption, in its fiscal roadmap.

“As supplies and services make up 15.6% of total operating expenditure, more cost-saving initiatives must be implemented (in this area) to control the bloat,” Lee explains.

On that note, Navaratnam argues that there should be stronger resolve to eliminate corruption to promote efficient spending. He points out that all project tenders should be conducted in an open, transparent and competitive manner to ensure minimum cost to the system.

“There is no point in cutting down on subsidies and raising some taxes if the savings thus incurred are frittered away in higher cost of tenders and contracts (and other form of leakages),” Navaratnam says.

Revenue enhancement

According to economists, Malaysia’s fiscal consolidation will not be complete without a proper plan to enhance the Government’s revenue base. They believe the Government should push ahead with tax reforms to strengthen its finances. These initiatives should include improving the tax administration and implementing GST to replace the existing Sales and Service Tax (SST).

“I don’t know why we are dragging our feet on GST. We are one of the few countries in South-East Asia still without GST,” Manokaran argues, adding that experiences of other countries have shown that there are merits to incorporating GST in the economy, as it is a more efficient and effective tax system.

While it is undeniable that implementing GST could result in slightly higher inflation over the short term, the system could be a positive factor in the long run.

Zahidi points out that the present SST system is both inefficient and distortionary; but the GST system could help ensure greater compliance, a bigger tax base and improved tax revenue.

Widening the tax base via GST, Navaratnam argues, can also help minimise the effects of tax evasion and avoidance by some segments of society who actually earn enough to be paying tax.

According to economists, GST implementation is expected to be compensated by a reduction in personal income tax and corporate tax rates, which should have positive effects on the country’s economy.

For one thing, a reduction in personal income tax will result in higher disposable income for households to spend, while lower corporate tax could help boost private investment. “But most importantly, the Government should get rid of the ‘having more funds means able to spend more’ mentality,” says an economist, who does not want to be quoted.

On concerns that GST could hurt the poor, Navaratnam argues there are ways and means to ensure that the underprivileged would not be negatively impacted. For instance, direct handouts such as stamps, vouchers and grants can be provided to assist the poor and low-income group. In addition, there is already a commitment that basic and essential goods and services will be exempted from GST.

“There are precedents all over the world, there’s no need to reinvent the wheel,” Navaratnam says.

With investors now eyeing Malaysia’s roadmap for fiscal reform, there should be no more delay in implementing bold measures to ensure that the health of the country’s public finances remain sound.

As CIMB’s Lee puts it: “We should not wait till the market pressure us to reform ... we should reform before the market tells us to do so; otherwise, it will be too late, and the country will have to suffer the wider negative consequences (of higher borrowing cost and the effects of poor investor sentiment, among others).”

Lee, however, stresses that the pace of fiscal adjustment should not be frontloaded as it could undermine economic momentum.

“The pacing of fiscal reforms will allow the economy to adjust without creating significant distortions for businesses and households,” he explains.