Subsidy rationalisation, rents and inflation

It’s vital that business/commercial rents are constrained as these have knock-on effects on the cost of doing business and the cost of living.

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Published in MalayMail, BusinessToday & AstroAwani, image by AstroAwani.

There’s no justification whatsoever for any cost and price increases following the subsidy rationalisation of diesel on June 10. 

This is because the subsidy rationalisation – confined to Peninsular Malaysia only – isn’t a blanket one but coincides with the pre-existing managed floating diesel price mechanism. In effect, subsidy rationalisation here becomes a targeted and direct measure (i.e., for the B40 and M40 non-commercial users). Diesel price remains capped at RM2.15 per litre in Sabah, Sarawak and Labuan. 

The Madani government is right in decisively implementing this subsidy rationalisation move – given that we’re already a net importer of refined petroleum (see, “Higher oil prices a double-edged sword – Economists”, The Sun, April 16, 2024). 

According to the OEC (Observatory of Economic Complexity), in April 2024, Malaysia’s deficit for refined petroleum was at RM54.7 million. The OEC also stated that in 2022, we imported USD27.1 billion in refined petroleum (primarily from Singapore), becoming the 9th largest importer in the world. Refined petroleum was the 2nd most imported product in 2022.

What the government is doing is simply part of the broader (and long “drawn out”) process of subsidy reforms first initiated under the Najib administration since 2013/14 onwards. 

Recall that in September of 2013, then Prime Minister Najib Razak announced an overnight increase in diesel (and RON95) petrol prices by 10%.

And there’re the leakages resulting from the smuggling of our diesel across the border into Thailand. 

Finance Minister II Amir Hamzah Azizan said there had been a tenfold surge from RM1.4 billion in 2019 to RM14.3 billion last year in diesel subsidies alone. This corresponded to the rise in the consumption of subsidised diesel from 6.1 billion litres in 2019 to 10.8 billion litres in 2023 – a 70% increase.

Given that diesel consumption in Malaysia is much lower than petrol due to market dynamics of the automotive sector (both in terms of production and consumer demand/preference as measured by e.g., total industry volume/TIV – at less than 12% of total sales), the rise in consumption can only be attributed to illicit sales via cross-border smuggling (where diesel prices are higher). 

Following the subsidy rationalisation measure, diesel sales at the country’s borders showed a 40% decline.

As alluded to, targeted assistance in the form of cash is provided to B40 and M40 individuals/households who own diesel-engine vehicles to mitigate the impact of higher retail prices. This alone shows that the subsidy rationalisation isn’t a (retroactive) policy aimed at penalising the rest of the group (collective) for the abuses by the free riders (distributive) of the blanket subsidy situation back then.  

Cash assistance of RM200 per month (for the first 167 litres of diesel) or RM2,400 per year is based on usage data. The RM200 is estimated to cover the additional cost of travelling 75 km daily for typical diesel vehicles like pickup trucks. 

According to the Department of Statistics (DOSM), the subsidy level is sufficient for over 80 percent of private diesel vehicle users.

Under the Subsidised Diesel Control System 1.0 and 2.0 (SKDS 1.0 & 2.0), commercial vehicles that’re registered for the scheme will be able to use the fleet card to enjoy subsidised prices. This covers 10 types of public transportation vehicles (SKDS 1.0) and 23 categories of goods transport vehicles (under the logistics sector – SKDS 2.0). 

In effect, the subsidy rationalisation for diesel is limited in scope – the main policy aim being to reduce and/or pre-empt smuggling and leakages. 

That’s the horizontal and internal (i.e., domestic trade) aspects. 

In terms of the vertical and external (i.e., current account) dimensions, it makes no sense for us to be in a balance of payments (BOP) deficit with regards to (refined) oil/petroleum (being already a net importer) and then having to continue subsidising the domestic market. 

This means that Petronas will be operating at a much lower profit margin (foreign exchange impact – negative) since it can’t mark-up based on the international pricing in order to recover purchase costs (resulting in lower average realised prices and, by extension, revenue), especially when global oil prices are higher. 

Lower global oil prices will only translate into net “losses” due to the overall financial implication/position. This means reduced operating cash flows and retained earnings which also affects the dividends given out to the government as the shareholder. 

Subsidy rationalisation (of diesel via the production of diesel exhaust) is also in line with Petronas’s Energy Transition Strategy – to achieve net zero by 2050 as aligned with the National Energy Transition Roadmap (NTER). 

Even if, at the end of the day, there’s no actual subsidy (in monetary terms) as a hypothetical (but plausible scenario), it still means that Petronas has to suffer an “opportunity cost” in terms of the petroleum sharing contracts (PSCs) at the upstream end of the supply chain as well as the midstream when it sells to the retailers. 

Both subsidy (via dividends from Petronas to the government/State) and opportunity costs are possible under the Automatic Pricing Mechanism (APM) “spreadsheet” formula. 

Recall that the APM has been in place since 1983. It’s basically a form of price controls for pump petrol prices which back then encompassed the whole range of retail products (RON 97, RON95, diesel). 

As a fixed cost-pricing mechanism, if the global market petrol prices came down, the government would impose a sales tax on the retailer. 

Conversely should the global petrol prices go up, the subsidy mechanism would kick in. Prior to 2017, the retail prices for petrol and diesel were determined monthly (using a managed float system). Since then, the APM has been calculated on a weekly basis. 

The APM works by ensuring that at each stage of the supply chain, the wholesaler and retailer are “allotted” their respective profit margins (albeit thin – which is traded off against the sales by way of volume margins).  

The breakdown of the APM cost-profit margin formula is as follows: 

  • MOPS index (Mean of Platts Singapore) – benchmark refined (refinery cost) oil pricing – oil companies: denominated in USD
  • Alpha – price difference between MOPS with actual prices – oil companies: x sen per litre (fixed) +
  • Operational costs – oil companies: x RM per litre (fixed) +
  • Profit margin – oil companies: x RM/sen per litre (fixed) +
  • Profit margin – petrol dealers/retailers: x sen per litre (fixed) = retail price.

To be sure, the APM remains in place for petrol as well as diesel. The only difference is that diesel is now semi-equalised with RON 97 as having a targeted subsidy system/scheme in place (unlike the latter which doesn’t have one). 

As such, the government hasn’t abolished the managed float system for diesel (as with all retail petroleum products) under the APM.

This means that, by extension, the interplay between sales tax and profit margin of the retailers (as well as price control in the form of lowering prices at the discretion of the government of the day) remains in place minus a subsidy component for diesel (blanket) and RON97. 

Price stability remains guaranteed.

The sooner-rather-than-later or immediate instead of “gradual” implementation of the subsidy rationalisation saw a 56% jump in retail/pump diesel price (Euro 5 B10 and B20) under the APM. 

Diesel users represent the entire stream (upstream, midstream, downstream) of the supply chain.  

Immediately following this subsidy rationalisation, some businesses hiked up prices (see, “Businesses seen raising prices after partial rationalisation of diesel subsidy”, The Edge Markets, June 11, 2024; “Diesel subsidy rationalisation – 10 companies hauled-up for price gouging”, The Star, June 14, 2024). 

EMIR Research first highlighted the issue of “sellers’ inflation” in “A thorough revision is required to reflect the actual inflation rate” (June 30, 2022). This phenomenon refers to the pricing power of sellers (producers, service providers, retailers) due to market dominance or hold on a “captive market”. 

It’s both a vertical (business-to-consumer/B2C) as well as horizontal (business-to-business/B2B) phenomenon. 

The vertical dimension is more popularly understood. But what’s not often highlighted or even neglected is the advantage the wholesale seller has over the wholesale buyer (horizontal) in terms of the contractual terms which locks in the purchasing regardless of prices. 

For example, the supplier would include what’s a standard variation price clause in the contract. At times, the variation price clause would be operable/operative without prior notice given to the purchaser (e.g., the hypermarket).  

So, this (partly) explains why some of the costs and prices have gone and continue to go up despite the government’s comprehensive inflation mitigation measures (as also embodied by the extensive Payung Rahmah initiative). It also explains why costs and prices continue to go up despite the decrease in the overall Consumer Price Index (CPI) which includes the energy/fuel prices. 

Now, the sub-phenomenon of contractual advantage also applies to landlords too as they have price-setting/fixing power in the form of the rents

One of the critical drivers/levers of inflationary pressures in Malaysia with particular reference to urban centres such as the Klang Valley has been the “unremitting” (quote, unquote) increases in rents. 

As it is, rents represent an essential/regular fixed overhead costs for many businesses. 

Whilst there’s no equivalent variation price clause in the tenancy contract/agreement, it’s a standard practice for many landlords to increase the rent as part of the renewal terms – even if unwritten and purely by performance or conduct of the parties by “mutual consent”.

Landlords (sole and corporate) tend to raise rent regardless of the business cycle (“contango”, “backwardation”) at the macro-level. 

This also meant that landlords would tend to disregard the nature of business (e.g., no differentiation between a small and a medium-sized business) as well as the projected volume of sales of the business tenant – and focusing only on past performance and the location (including size of footfalls, market demographics, accessibility, proximity to public transportation facilities) at the micro-level.

These represent the justification/rationale for profit gouging enabled by market power (concentration/dominance – e.g., ownership of multiple premises in the same location) and/or collusion (“groupthink” in terms of the market price). 

In this, landlords (constrained by a myopic view) seek to protect and maximise their self-interests but at the expense of the rest of the economy by further eating into the costs of businesses and the purchasing power of consumers.  

For too long, successive administrations have overlooked this critical and fundamental issue of commercial (and residential) rents as a major contributory factor/variable to cost of living pressures.

EMIR Research, therefore, call on the government to set up a “Business Rent Council” to monitor and regulate business rents in the country. The body would also act to supervise the Association of Landlords Malaysia and related private sector bodies. Among the functions of the Business Rent Council’s supervisory powers is installing a ceiling on the levels of rent hikes/increases based on periodic reviews – after consultations and inputs from all stakeholders. 

This is to ensure that the interpretation of “market prices/forces” by the landlords are aligned and synchronised and coordinated with the actual economic (macro) and business (micro) dynamics.

Otherwise, the hike in rents will only be to the detriment of businesses and, by extension, consumers who will have to bear the ultimate costs. 

At the same time, the federal and state governments should collaborate on reintroducing what would be a revived but in modified, updated and targeted form of the Rent Control Act (1997) alongside the enactment of a Residential Tenancy Act to provide an added buffer against inflationary pressures for business and non-business tenants alike, respectively. 

This will serve to partly cushion and mitigate adverse impacts on the purchasing power of businesses (via costs) and consumers (via wages) in line with the principles of the Madani Economy Framework (MEF). 

To recapitulate, it’s vital that real estate/property prices in the form of business/commercial rents are constrained as these provide the basis and knock-on effects on the cost of doing business and the cost of living. 

Jason Loh Seong Wei is Head of Social, Law & Human Rights at EMIR Research, an independent think tank focussed on strategic policy recommendations based on rigorous research

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