Massive fiscal stimulus to counter deflation during the financial crisis, the commodities boom and surging demand for Malaysian investments from the global carry trade triggered by developed-world quantitative easing have all boosted asset prices in Malaysia.
While borrowing costs plummeted, property, equities and bonds, and the ringgit have all been pushed higher. Almost 45% of Malaysia’s local sovereign bond market is foreign held, according to Bank Negara figures, stocks are up by 120%, and $32.5 billion in FDI has been thrown at more than 3,000 projects – $6 billion of it in the eight months to August alone.
The Malaysian economy is exhibiting classic signs of overheating, including credit growth that is racing ahead of GDP growth and incomes, and a currency that has seen sustained appreciation, notwithstanding recent volatility.
Ultra-low interest rates have sent debt levels soaring across the board, with the government debt-to-GDP ratio nudging its 55% ceiling, household debt at an all-time high of around 86% of GDP and corporate debt approaching 96% of GDP.
All this credit is fuelling an unprecedented consumer spending spree on durable goods, cars and – most of all – houses, with mortgage loan growth accounting to a large degree for the rapid increase in household debt.
According to Standard & Poor’s, more than half of Malaysian banks’ lending is to the household sector, with mortgages the largest segment, accounting for 27% of loan portfolios and growing.
“Interest rates were slashed during the global financial crisis and they’ve remained at pretty low levels ever since, and so what that has encouraged is for households to take on more debt, more banks loans and mortgages,” says Gareth Leather, Asia economist at Capital Economics.
“There’s concern, first of all, as to how sustainable these levels of household debt are and the implications for monetary policy. Obviously, the central bank wants to tighten monetary policy to prevent this from continuing but at the same time, if it tightens too quickly, then you could see consumers starting to default on their loans.”
Leather says it’s a problem facing a number of central banks in the region, including Thailand and Korea, where household indebtedness hit 91.6% of GDP at the end of the second quarter.
S&P is warning that the provision of larger loans to finance more expensive properties, even as mortgage rates are falling, is leading to a build-up of economic imbalances in Malaysia.
Bank Negara, the Malaysian central bank, recently limited personal loan terms to 10 years. And in a bid to curb property speculation, it cut the maximum mortgage term to 35 years and imposed 70% loan-to-value ratios for borrowers taking out third mortgages, but stopped short of raising stamp duty.
While Malaysia’s debt overhang is seen as the result of excessive growth – large capital inflows, an appreciating real exchange rate and rapid credit growth – the robust, sustained nature of the economic expansion has also meant it has remained manageable.
Malaysia has been growing at around 6% a year since the financial crisis, thanks to credit-fuelled domestic demand, exports of crude oil and gas, palm oil and rubber, and government investment in large infrastructure projects. Importantly, inflation has remained low.
However, there are signs the party might be winding down. Inflation, which has been distorted by government subsidies on some of the key constituents of CPI, is ticking up, jumping to 2.6% in September from 1.9% in August, according to government figures.
The central bank forecasts growth will slow to 4.5% to 5% this year and analysts are bearish on growth for 2014 and inflation, which they have revised up to 3.5% from 2.8%. This will likely see the bank hike rates 50 basis points to 3.5% in the second half of next year, with an increasing risk of tightening being brought forward to the first half.
Some of the upward pressure on inflation is coming from the slashing of fuel and food subsidies, part of prime minister Najib Razak’s effort to reduce the fiscal deficit from 4.5% of GDP to 3%.
A 6% goods and services tax (GST) due to be implemented in April 2015 will also help Malaysia’s stretched public finances, which have placed it at risk of a downgrade of its sovereign credit rating. However, it will also hit growth by cooling private consumption and push inflation above 5%, prompting fears that unless inflation expectations are anchored by second order effects or anticipation of GST, further tightening might be necessary.
External risks might also begin to weigh on the economy in the medium term. Trade with China, much of it in commodities, accounts for almost 25% of Malaysia’s $303 billion economy.
Its current-account surplus is being rapidly whittled away under the pressure of weaker exports, which make up almost 70% of GDP. The finance ministry projects the surplus will more than halve this year to RM26.6 billion ($8.4 billion) from RM57.3 billion in 2012.
“Malaysia has benefited tremendously from gains in terms of trade from the China-driven commodities boom, helping drive domestic demand,” says Shweta Singh, emerging markets economist at Lombard Street Research. “But as China moves away from a commodity-intensive investment-led growth model, it will be payback time.”
The resulting currency appreciation, combined with too much focus on developing the commodities sector, led to the non-commodities manufacturing sector not only being ignored but becoming uncompetitive, explains Singh.
“It’s actually got two very big exposures because on the other hand it doesn’t really have any domestic demand drivers, in the sense that it’s still suffering from tremendous supply-side bottlenecks, particularly in human capital,” she says. “Malaysia has a lot of subsidies and perks for ethnic Malays, at the expense of the larger population, that act as a drag on development of human capital.
“This is one of the key reasons it stacks up poorly against other countries on a per capita basis because the government has used fiscal policy to distribute the benefits from commodities in a very preferential way that has skewed development.”
Singh says once it loses support from exports and capital, the economy will have to fall back on productivity led by the labour segment, but that’s unlikely to happen unless more structural reforms are undertaken.
She concludes: “I don’t have a very positive view on the economy. A lot of imbalances have been corrected, forced by Fed tapering comments. But after May, when we saw surplus economies outperform deficit economies, Malaysia still underperformed, so it’s due for a lot more correction.”