GST: Tiptoeing into structural deficit

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In the Penang Monthly article published in September 2013 (“Asian financial crisis act II?”1 ), it was concluded that the similarities between the mid-1990s and today in Asia are eerily close, but a full blown financial crisis is pretty unlikely since economic stress has yet to develop to a critical state. A gradual and competitive devaluation of currencies in Asia, however, is more likely to occur. And with recent movements in the foreign exchange markets, it is time to revisit this topic

The factors behind the present volatility in the currency markets can be categorised into roughly three large themes. Firstly, after years of quantitative easing (QE) by the Federal Reserve, the US economy is showing signs of recovery. This, together with the end of QE, has ignited expectations of US interest rates rising and perhaps reverting to its long-term average. Consequently, on a trade weighted basis, the US Dollar has appreciated significantly – 20% since July 2014. A strong Dollar, no doubt, is helped by the start of the European Central Bank’s (ECB) version of QE.

Secondly, since the start of QE in 2009 US interest rates have fallen, with the three-month Treasury bill currently yielding about 0.02%. Consequently, a significant amount of capital has left the US in search of yield, and emerging markets have received trillions of US Dollar capital. With an influx of capital in these markets, firm leverage has increased. However, corporate nonbank borrowers appear to have learned from the 1997 Asian Financial Crisis and have structured their borrowings to be long term. According to the Bank of International Settlements, the weighted maturity of loans exceed eight years; a longer maturity will certainly mitigate roll over and short-term repayment risks.

Debt servicing in local currency will be higher if the loans are US Dollar denominated and the US Dollar appreciates. Lower free cash flow after financing cost might reduce corporate capital expenditure and ultimately lower the country’s growth prospect. This can spiral into a loop, prompting further withdrawal of foreign capital from emerging markets. Therefore, the best hope for emerging markets is for US inflation to remain muted and its recovery less uniform or robust enough to warrant interest rates hikes, buying emerging markets more time for reform and re-adjustments. However, with the end of the US QE and with other central banks engaging in their own versions of QE, the US is in a relatively tightening mode; the underlying trend might only be less potent.

In the case of Malaysia, as reported by Bank Negara recently, non-residents hold RM223.3bil (30%) of domestic debt securities in 2014, vs. RM70.4bil in 2009. While a sudden withdrawal of foreign capital would cause financial market disruption, high foreign participation in the local markets need not necessarily be bad. Since domestic fund managers have also been diversifying overseas, on an ownership basis in local currency, Malaysia need not necessarily be worse off. Therefore, foreign investments in domestic securities should be welcomed and an open policy will increase the maturity and sophistication of local markets. Ultimately, this should lead to lower cost of capital.

While a sudden withdrawal of foreign capital would cause financial market disruption, high foreign participation in the local markets need not necessarily be bad.

Thirdly, crude oil price has fallen significantly, largely due to a mightier US Dollar, the Organization of the Petroleum Exporting Countries (Opec) defending its market share, lower geopolitical risks, the success of shale oil in the US and a slowing global economy. Although the number of rigs in the US (the main source of additional new oil supply) has fallen precipitously since April 2011, according to the Energy Information Administration (EIA), production in the US is expected to rise 7.8% in 2015 as the remaining rigs are highly efficient. With many half-commissioned rigs being weeks from production, some believe that a sustained rise in oil price is unlikely as these will attract new shale oil supply from many producers who are highly levered and would need the additional cash for financing.

This leaves Malaysia as the only net exporter of oil in Asia to be negatively affected. In 2014, Malaysia’s net export value of oil was RM8.8bil, compared to LNG (RM60bil) and CPO (more than RM40bil). Hence, the bigger impact will happen when LNG prices are repriced. The re-pricing usually happens with a lag as LNG is sold on long-term contracts but benchmarked against oil price. On the other hand, lower oil price is likely to benefit oil importing countries. The additional boost in their growth should benefit Malaysia’s electronics and electrical exports, which contributed slightly less than RM40bil in 2014. Therefore, the combined trade impact is not so clear cut.

On a trade weighted basis, the US Dollar has appreciated significantly – 20% since July 2014. A strong Dollar, no doubt, is helped by the start of the European Central Bank’s (ECB) version of QE.

Nevertheless, these three large themes will continue to cause the Ringgit’s volatility and bring Malaysia’s fiscal deficit into focus. One of the methods to address the deficit is through levying GST. Malaysia needs to introduce GST out of necessity as it faces a structural deficit and too much is at stake for not following through with the implementation. There has been much debate on whether GST is a regressive tax (where the poor suffer a higher burden vs. the rich) or not. We stand by our research that GST on its own is regressive, but when GST is combined with cash handouts (BR1M) and income tax cuts, it is the middle income households who would benefit the least as they are ineligible for BR1M and do not benefit much from the income tax cuts. These households earn between approximately RM65,000 and RM103,000 per annum.

It's a Japanese dog's life. Due to an aggressive monetary policy adopted in Japan, the Yen has depreciated significantly against the Chinese Yuan, Korean Won and Taiwanese Dollar in the last two years.

Malaysia needs to introduce GST out of necessity as it faces a structural deficit and too much is at stake for not following through with the implementation.

Many are naturally worried about rising inflation post-GST. Using a mechanical calculation of the CPI basket, we expect inflation to increase by an additional 1.3%. The Australian experience has shown that prices will increase after GST is introduced in the short term. However, with strong external deflationary forces globally, falling inflation (or even negative inflation) is the longer-term threat. After two months of falling inflation, Thailand has recently cut interest rates, joining the growing list of countries easing monetary policies.

Therefore, the pressure to cut interest rates in Malaysia will soon rise after the jolt from higher prices postGST. If the interest rate is cut, new lending restrictions might need to be implemented as household debts have reached 87% of GDP in 2013 and has continued to grow 9.9% in 2014, with residential property loans rising by 13.2% in 2014 (2013: 12.9%).

Due to an aggressive monetary policy adopted in Japan, the Yen has depreciated significantly against the Chinese Yuan (up 25%), Korean Won (up 24%) and Taiwanese Dollar (up 19%) in the last two years. In this light, Malaysia has been relatively fortunate as the Ringgit has appreciated by only five per cent. With the Bank of Japan committed to hitting its two per cent inflation target and as Germany’s competitive position is boosted by the ECB’s QE equivalent, the Yen might continue to fall. Asian currencies might embark on competitive devaluation in the future as it is highly unlikely that the Chinese, Korean and Taiwanese authorities will tolerate currency appreciation of the same magnitude in the next two years.

The ending of US QE need not necessitate a global contraction of liquidity as the Europeans and Japanese have embarked on their own versions of QE. Future crises need not follow the same mechanism as the past but the transmission mechanism through the financial markets is likely to be more pronounced. Looking beyond the shock from GST, falling inflation is likely to be a concern. With strong external forces, a lower Ringgit also seems to be the path of lesser resistance.

References

1 http://penangmonthly.com/asian-financialcrisis-act-ii/



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