Sustainable structural reforms the way forward

For Malaysia to be more resilient in dealing with any economic shocks, we have to be serious about structural reforms.

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Published in Astro Awani, and Malay Mail, image by Astro Awani.

The US Federal Reserve (Fed) raised its federal funds (FFR) rate for the fourth consecutive time – by 0.75% in July – bringing the target range to between 2.25% and 2.5%.

Prior to that, the US central bank had adjusted the policy interest rate in March this year by 0.25%, 0.5% in May and 0.75% in June.  

The FFR hikes – intended to be (a form of) monetary tightening (and) as measured by the dollar index (DXY) – has served to only replicate the (infamous) Volcker effect whereby the US is veering somewhat ominously to a (post-technical) recession despite a (so-called) “tight” labour market domestically and dollar “shortages” externally, i.e., as embodied by capital flight and outflow of funds in search of higher yields. 

The paradox of “low” unemployment (although not back to pre-pandemic levels) but with two consecutive quarters (i.e., Q1 & Q2 2022) of minor contraction (hence, technical recession) seems to indicate that sluggish wage growth alongside the desire by individuals and households to save more, i.e., given the high inflation already existed in 2021. 

This is demonstrated by the (gradual) slowing down of consumer spending by Q1 of 2022, according to the US government’s own Commerce Department (see e.g., “Consumer spending was weaker than reported, a bad sign for the economy”, New York Times, June 29, 2022) 

Q1 2022 only recorded a 0.5% increase in consumer spending – which could be attributed to the stimulus cash having been exhausted by Q4 2021. The Economic Impact Payments under the American Rescue Plan Act (2021) provided up to USD1,400 for eligible individuals or USD2,800 for married couples filing jointly, plus USD1,400 for each qualifying dependent, including adult dependents. 

Q2 2022 similarly recorded only a 0.2% increase in consumer spending – as people need more cash on hand to spend on food and fuel which are the highest contributors and drivers of inflation.

At the same time, US production and manufacturing activities also a show a slowing down even as logistical bottlenecks have more or less ease (with the sole exception of China on the back of intermittent lockdowns) and because inventories have been building up (see e.g., “US manufacturing sector slows modestly in July”, Al Jazeera, August 1, 2022). 

The S&P US Global Manufacturing PMI (Purchasing Managers’ Index) edged lower to 52.3 in July. The decline is set to continue – with the S&P Global US Composite PMI Output Index – serving as a leading indicator – having tumbled to 47.5 in July from 52.3 in June (see e.g., “U.S. business activity contracts in July for first time in 2 years, survey shows”, Reuters, July 22, 2022). 

A general PMI reading of under 50 will definitively suggest a contraction of industrial and business activities. 

Still the Fed is determined and set on the course of aggressive interest rate hikes to “slay the inflation dragon” – in what could well be an amnesiac application of the Volcker model – i.e., negating the “low” unemployment rate by rehashing the Nairu theory whereby there’s a trade-off between inflation and unemployment. But Nairu has not been shown to be conclusive at all as can be seen from the stagflation era in the US and UK of the 1970s. 

Back in Malaysia, the impact of a bullish DXY has meant a stronger USD relative to the RM. However, there doesn’t seem to be a danger for the RM to “veer off course” with a wild oscillation/fluctuation of a double-digit depreciation. 

Notwithstanding, it’ll mean that the gains from the easing of the inflationary pressures will be quickly neutralised by the exchange rate pass through (ERPT) effect. 

To mitigate that, EMIR Research (“Domino effect of the OPR hike”, May 27, 2022) has advised that our forex holdings, which has experienced significant depletion in recent months (as measured by a financing capacity of below 8-9 months of retained imports, see e.g., “Malaysia sees largest drop in foreign reserves in seven years”, The Edge Markets, June 24, 2022), been conserved from managing fluctuations (which minor gains would easily be negated and dissipated) towards building up our food security capacity. 

This will ensure that the impact of the ERPT would be minimised with localisation and enhancing the resilience of our supply-chains as well as reducing the import contents of our food production. 

Since the Fed approved the first interest rate hike on March 16, the RM has witnessed a depreciating trend. Then USD1 was equivalent to RM4.1967. However, the frequent interest rate adjustments from the US have resulted in a more expensive USD in relation to the RM. As of August 3, USD1 traded for USD4.455. 

As for capital outflow due to the stronger DXY, instead of (progressively) hiking the overnight policy rate (OPR), we should be progressively lowering it (and, therefore, creating the necessary anticipation for the financial markets). 

This would, among others, allow for bond traders/investors (overseas) to short-sell our Malaysian Government Securities (MGS). This would allow traders/investors to hedge against Fed interest rate hike which reduces the price of US Treasury securities that makes it unattractive to off-load in the secondary market (as highlighted in EMIR Research article, “Monetary policy need not be tied to interest rate manipulation”, February 17, 2022) and buy back the previously sold MGS at a lower price. 

It’d also ensure the promotion of market liquidity through Bank Negara’s Iscap (Institutional Securities Custodian Programme) where captive (bond) holdings (in the form of unrealised or accounting loss) such as the impact of lower bond price (and correspondingly rising yields) on bank’s FVOCI (fair value through other comprehensive income) securities can be avoided.

On the other side of the equation, Bank Negara’s Monetary Policy Committee (MPC) has always insisted that the OPR hikes are never meant to fight off inflation but for policy normalisation, but since the inevitable outcome remains that it only aggravates the cost of living, therefore, by implication, inflation isn’t reduced thereby. 

And this at a time when inflation isn’t demand-induced but supply-driven.

On the one hand it’d seem that the government is embarking on a so-called “semi-austerity” drive. On the other hand, deficit spending has, rather unintendedly to be sure, shifted to monetary policy whereby higher interest would translate into higher income directly and indirectly via share dividends. Given that our government-linked companies (GLCs)’ market capitalisation is somewhere between 25% to 40% of the Bursa, this means that the higher income will translate into State spending that will continue to bid up prices (including shares) for patronage purposes and therefore, contribute also in this regard to inflation.

The Department of Statistics Malaysia (DOSM) revealed sustained inflationary pressures in the food and non-alcoholic beverages category since April – from 4.1% to 5.2% in May and 6.1% in June. 

As a result, the Consumer Price Index (CPI) – which measures the rate of change in the cost of purchasing a constant basket of goods and services by households in a specific time period – rose from 2.3% year-on-year (y-o-y) in April to 2.8% and 3.4% in May and June, respectively. 

As producers have to bear the brunt of price increases from feed ingredients and labour shortages, the Producer Price Index (PPI) translated into a double-digit percentage rise since April – from 11.0% and 11.2% in April and May, respectively, to 10.9% in June. 

Although there’s a slight drop of PPI y-o-y by 0.3%, tomato, round cabbage, aubergines, hen’s eggs and chicken, for instance, are the essential food items that contribute to the highest increase in the index for the agriculture sectors. It rose by 1.4% y-o-y – from 16.7% in May to 18.1% in June, compared to the other sectors such as mining, manufacturing, electricity & gas supply and water supply.   

The government has deployed price controls as a key tool in combatting inflation. In fact, Malaysia is reputed by the World Bank to have one of the highest numbers of price controls in the East Asia Pacific (EAP) region, with the other being the Solomon Islands (“Temporary Price Controls as a Second-Best Option to Control Sudden Spikes in the Prices of Basic Necessities”, Undral Batmunkh and Tobias Pfutze, World Bank Malaysia Hub, May 24, 2022). 

However, price controls in the long-run aren’t sustainable as proven by events.

For Malaysia to be more resilient in dealing with any economic shocks (including inflation), the current administration has to be serious about structural reforms at the economic, social and governmental levels. 

Following are the policy recommendations from EMIR Research: 

  1. Create resilient supply chains
  • We need to build up our food security capacity by investing heavily in local/domestic feedstock and fertiliser production. 
  • At the same time, we need to reconfigure our supply-chain linkages by increasing our dependency and cooperation with our regional neighbours through strategic alliances for food, feedstock and fertiliser production and stockpiling under the common Asean framework.
  1. Synchronisation and closer coordination between monetary and fiscal policies
  • What constitutes policy normalisation by Bank Negara (with regards to the OPR) needs to be re-defined as to be closely aligned with inflationary dynamics – that in turn underpins fiscal policy (e.g., “automatic stabilisers” such as cash transfers and subsidies).
  • Monetary policy, therefore, should to be aligned with the need for sustained deficit spending and that means lower OPR (not higher). That is to say, monetary policy should be accommodative of fiscal policy and not just the general economic environment.
  1. Strengthen macro-prudential regulations 
  • It’s hoped that the Consumer Credit Act (2022) spearheaded by Bank Negara will strengthen macro-prudential regulations on consumer spending behaviour as part of the wider strategy to rein in our household debt which is among the top five in Asia. 
  • We call for monetary policy to be better focussed and geared towards credit creation to ensure it is procyclical and sectoral/sectional-specific in coordination and synchronisation with a counter-cyclical fiscal policy.
  1. Reduce the concentration of market power of cartels and monopolies – both GLCs and private sector
  • Market concentration is rampant in Malaysia – either through cartels/monopolies or oligopolies. Take rice, which is a staple, for example. Bernas, a private sector player, has the privilege of being the sole gatekeeper of rice imports (its concession has been extended in 2020 for another ten years) and the dominant mid-stream operator (including in joint-ventures/JVs with smaller players). While it doesn’t have the power to set the price of rice, this form of price control simply means that padi farmers and millers can sell at a loss to Bernas even as the buyer of last resort (BOLR).
  • And as food security expert Dr Fatimah Mohammed Arshad has said, GLCs as big capital may exert their market power and hence create a high barrier to entry for entrepreneurs and small- and medium-sized enterprises (SMEs). Instead, cooperatives should play the leading role as the “middleman”/distributor and wholesaler (as urged by EMIR Research in “Cooperative Movement – Vital Component In the Prihatin Approach to Addressing Economic Challenges”, February 15, 2021).

In conclusion, sustainable structural reforms that will ensure the nation continues to move forward is the only way, going forward. 

Jason Loh and Amanda Yeo are part of the research team of EMIR Research, an independent think tank focused on strategic policy recommendations based on rigorous research.

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