Malaysia economic monitor : repositioning for growth

51624 This volume is a product of the staff of the International Bank for Reconstruction and Development / The World Bank. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. For queries and comments: Philip Schellekens pschellekens@worldbank.org (662) 686-8300 30th Floor, Siam Tower 989 Rama I Road, Pathumwan Bangkok 10330, Thailand www.worldbank.org/my 2  PREFACE The Malaysia Economic Monitor is a new report of the World Bank that reviews recent economic developments in Malaysia, provides views on the outlook for the Malaysian economy, and helps inform key policy issues. This inaugural edition marks the beginning of series that will come out twice a year. With `Repositioning for Growth' as the theme of this first issue, the Malaysia Economic Monitor comes at an opportune time. Malaysia is emerging from one of the worst export slumps in its economic history. Against this backdrop, the report addresses a number of pertinent questions. How deeply was the Malaysian economy affected by the crisis? Will the rebound translate into a sustained recovery? How can Malaysia revitalize growth and climb up the income ladder? The Malaysia Economic Monitor is part of a wider effort of promoting the sharing of knowledge among internal and external stakeholders--a requisite for the innovation- and knowledge-driven economy and a key pillar of the World Bank's partnership with the Government of Malaysia. In this spirit, the Monitor is made available to a broad audience, including decision makers, private sector leaders, market participants, civil society, think tanks, and journalists. The Monitor provides the opportunity for external parties to provide independent contributions. This first-time edition reflects the accumulated work that the World Bank has produced over the past few years on the Malaysian economy. It reviews developments following the onset of the current crisis episode, provides the broad contours of a strategy for high income and growth, and touches upon several issues of analytical interest. Future editions of the Monitor will review incremental developments over a six-month horizon and zoom in on particular themes. This inaugural edition therefore provides a baseline to what is yet to come. The Malaysia Economic Monitor was prepared by Philip Schellekens (Task Team Leader), with contributions from Frederico Gil Sander, Yue Li, Magnus Lindelow, Xubei Luo, Chanin Manopiniwes, Martin Reichhuber, Vatcharin Sirimaneetham, and Ashley Taylor. An external contribution was provided by Maslynnawati Ahmad and Hamri Tuah of Khazanah Research and Investment Strategy. Vikram Nehru and Mathew Verghis provided guidance. Ahmad Ahsan, Ivailo Izvorski, Manny Jimenez, Jamil Salmi, Xiaoqing Yu, and Shahid Yusuf participated in the internal review process and Manu Bhaskaran commented as part of the external review. Indra Irnawan designed the cover and back. Vachraras Pasuksuwan and Ruangrong Thongampai assisted in production aspects, Pichaya Fitts in external relations, and Anissa Amador Tria in web production. The Malaysia Economic Monitor benefited from fruitful interactions with various government and private sector parties in Malaysia, including among others the Bank Negara Malaysia, the Prime Minister's Economic Council, the Economic Planning Unit, Khazanah Nasional Berhad, the Ministry of Finance, and the National Economic Advisory Council, as well as various firms in the manufacturing and services sectors, think tanks and academics. Last but not least, a special word of thanks goes to the Economic Planning Unit and Khazanah for their help with the logistics of the launch of this Monitor. 3  EXECUTIVE SUMMARY Malaysia is emerging from one of the worst export slumps in its economic history as manufacturing and exports have started growing again. With East Asia leading the recovery and advanced economies showing progressive improvement, the Malaysian economy is projected to grow at 4.1 percent in 2010, following a contraction of 2.3 percent in 2009. The medium-term outlook remains promising with growth reaching 5.6 and 5.9 percent in 2011 and 2012, respectively, though that will depend on sustained global recovery from the crisis. The Malaysian economy was one of the hardest hit in the East Asia region, but it remained fundamentally resilient. As global demand plummeted in the last quarter of 2008, manufacturing firms braced for impact by cutting production, running down inventories, and slashing investment. Given the importance of exports in the economy (some 120 percent of GDP last year), the resulting impact on GDP was pronounced. But the turmoil in manufacturing did not lead to a broad-based recession. Private consumption and service sector activity was resilient: growth stalled but levels remained intact. The crisis was mostly a manufacturing-for-exports crisis. Sound fundamentals and responsive policies provided support. Strong financial supervision and limited exposures to toxic securities and troubled financial institutions shielded the economy from financial contagion. High levels of international reserves relieved the impact of capital outflows. Sound household and corporate balance sheets cushioned the impact of the downturn. On the policy side, accommodative monetary and credit policies protected the flow of credit. Successive fiscal stimulus packages (10 percent of GDP, including credit guarantees) helped boost confidence and construction activity, and are expected to lend further support throughout next year. The small rise in the unemployment rate masks the significance of the social impact of the crisis. By mid-year unemployment reached a peak of 4 percent. Underneath this was a reallocation of labor across sectors, with services hiring and manufacturing retrenching. Some 8 percent of the manufacturing workforce, more than 120,000 workers, was shed, with foreign workers taking a disproportionate hit. Job losses, shorter working hours, and lower wages are likely to have raised absolute and relative poverty in urban areas. Lower commodity prices are likely to have been detrimental to rural livelihoods. The upturn in economic activity has yet to turn into a sustained recovery. Industrial production and exports have recently increased, but whether this represents the beginning of a sustained recovery is still unclear. The strength of the recovery, and particularly export growth, continues to hinge on the firming up of final demand from advanced economies. Inventories will likely be a key driver of near-term growth. Consumption and fixed investment are expected to pick up initially slowly. With output still below potential, inflation and asset prices are likely to remain subdued. Managing the economy's recovery will be a delicate balancing act. Withdrawing policy support too early runs the risk of choking off the recovery. But extending support for too long may hamper the credibility of medium-term fiscal consolidation, reduce the room for future stimulus, increase the risk of asset price bubbles, and constrain private sector initiative once demand picks up. The authorities are mindful of these risks and have conditioned the pace of consolidation on the strength of the recovery. 4  The overriding medium-term challenge is for the Malaysian economy to join the select group of high-income countries. Malaysia has experienced solid growth over the last decades, but has relied on an economic model predominantly based on capital accumulation, although private investment rates never recovered from their 20 percentage point fall after the Asian 1997/98 crisis and are now among the lowest in the region. For Malaysia to climb the next step up the income ladder, it needs to focus on improving the investment climate to raise investment rates and focus on productivity growth. Against this backdrop, the authorities are developing a `New Economic Model,' which will be squarely centered on boosting productivity. Promising reforms have already been announced in the areas of services and foreign direct investment, which will help revitalize private investment. What will it take to join the league of high-income countries? Moving up the income ladder is a difficult challenge--one which only a few countries have successfully met in the post-war period. Malaysia will need to address a number of weaknesses. An integrated strategy requires four key elements: Specializing the economy further. Given limited resources--both public and private--and the need to achieve agglomeration economies, it is important to focus on a few high value-added, innovation- based sectors with strong potential. Improvements to the enabling environment can facilitate this through the building of an internally-competitive and business-friendly economy and the provision of appropriate soft and hard infrastructure to support the knowledge economy. Focused technology, innovation and urbanization policies can nurture niches of growth by building on existing strengths in sectors such as electronics, resource-based industries, and Islamic finance. Improving the skills of the workforce. Greater specialization will assist in accelerating growth and create demand for skilled labor--and increase social and private returns to education and skills upgrading. To ensure this demand can be satisfied--with skilled labor currently at only 25 percent of the labor force--simultaneous efforts are required to improve the quantity and quality of skilled labor. This requires attention to incentives, competition, and merit-based recruitment in education, as well as curriculum development, better teacher training, and leveraging efforts with help of the private sector. Making growth more inclusive. Inclusiveness policies are yet another building block of a competitive, dynamic and flexible economy. They not only help households cope with poverty, but are also essential in promoting entrepreneurship and risk-taking. Effective social insurance programs could help mitigate unemployment risks and ensure adequate pension coverage. Well-targeted social safety nets would protect the needy in times of adversity and reduce fiscal costs. Bolstering public finances. Fiscal consolidation and reform will help address investor concerns about the rise in the fiscal deficit, broaden the narrow revenue base, lessen the significant role of subsidies in expenditures, and reduce the crowding-out of private initiative. Fiscal rules could be considered to stabilize public finances going forward. Shifts in expenditure patterns from bricks and mortar to initiatives in the areas of specialization, skills and inclusiveness will also help. 5  The export slump and recovery ... ... will drive expected growth next year 170 Export index comparing Annual GDP growth three recent crisis episodes 8 150 6.2 5.9 5.6 6 4.6 130 4.1 Asia crisis 4 110 2 90 0 Dot.com 70 crisis Global -2 recession 50 -2.3 -4 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 2007 2008 2009f 2010f 2011f 2012f Source: CEIC and World Bank staff calculations Source: CEIC and World Bank staff projections. Note: Export index equals 100 for Jul 1997 (Asia crisis), Mar 2000 (Dot.com crisis) and Sep 2008 (current global recession) As quarterly growth resumes ... ... the withdrawal of policy support requires careful management 7 Quarterly GDP growth (year-on-year) 10 Fiscal deficit to GDP 5 8 3 1 6 -1 4 -3 2 -5 -7 0 2008 Q1 2009 Q1 2010 Q1f 2002 2003 2004 2005 2006 2007 2008 2009F 2010F Source: CEIC and World Bank staff projections. Source: CEIC and World Bank staff projections. Sustained growth requires a pick-up in private ... and greater innovation efforts by firms investment Innovation effort index against GDP per capita 40% Share of private and public investment in GDP 0.6 Private 0.5 30% Public THA 0.4 PHL KOR VNM 20% IDN 0.3 MYS 10% 0.2 GDP per capita (natural log) 0.1 0% 4.5 5.5 6.5 7.5 8.5 9.5 10.5 1989 1991 1993 1995 1997 1999 2001 2003 2005 20072009F Source: CEIC and World Bank staff calculations. Source: WDI and World Bank staff calculations. Note: Index captures efforts on product development, product upgrading, process improvement, and foreign joint ventures. Climbing up the income ladder requires, among ... and targeting safety nets other things, addressing skill shortages to protect against adversity Percentage of services firms reporting item 100% Share of total retrenchments as investment obstacle (Oct 2008-mid Aug 2009) 0 10 20 30 40 50 75% 50% 33 Skilled labor shortage 39 25% Tax regulations and/or high 17 taxes 30 0% Government Real Estate Retail Trade, Manufacturin Wholesale & & Business Restaurants Insurance, Lack of business support 18 2002 Serv (FI) Services Hotel & g (Mfg) services 24 (WR) Fin, 2007 21 Bureaucratic burden 22 Source: World Bank (2005 and 2009b). Source: Department of Labor.  CONTENTS CONTENTS PREFACE ........................................................................................................................................................ 3 EXECUTIVE SUMMARY .................................................................................................................................. 4 CONTENTS ..................................................................................................................................................... 7 1. RECENT ECONOMIC DEVELOPMENTS ..................................................................................................... 12 The External Environment Was Challenging .................................................................................... 12 But The Malaysian Economy Remained Fundamentally Resilient ................................................... 15 The Crisis Was Mostly a Manufacturing-For-Exports Crisis..................................................... 16 Exports Were Hit Hard, But Are Now Recovering ................................................................... 21 The Small Rise in Unemployment Masked the Significance of the Social Impact................... 29 Financial Conditions Remained Robust ................................................................................... 32 2. ECONOMIC OUTLOOK ............................................................................................................................. 36 The Global Outlook Has Improved Markedly ................................................................................... 36 Malaysia's Economic Recovery Is Solidifying ................................................................................... 39 The Recovery Is Expected to Bring Significant Growth Next Year ........................................... 40 The Current Account Surplus Will Likely Narrow .................................................................... 48 Fiscal Consolidation Efforts Are Expected to Curb the Headline Deficit ................................. 49 Output Is Expected to Gradually Recover to Potential ........................................................... 49 Downside Risks Overshadow the Outlook ....................................................................................... 50 3. REPOSITIONING FOR GROWTH ............................................................................................................... 52 Why A New Economic Model for Malaysia? .................................................................................... 52 Private Sector Initiative Has Been Subdued ............................................................................ 53 Global and Regional Competition Will Likely Intensify ........................................................... 58 What Are The Pathways to High Income?........................................................................................ 59 Specializing the Economy Further ........................................................................................... 60 Improving the Skills of the Workforce..................................................................................... 65 Making Growth More Inclusive ............................................................................................... 70 Bolstering Public Finances ....................................................................................................... 73 APPENDIX .................................................................................................................................................... 76 REFERENCES ................................................................................................................................................ 79 7 MALAYSIA ECONOMIC MONITOR BOXES Box 1. Why Did Malaysia Enter the Recession Later Than Other East Asian Economies?.......................... 19 Box 2. Supply Chain Management: Insights from Japanese firms in the E&E Sector ................................. 23 Box 3. Comparisons between the Current Crisis and the Asian Financial Crisis ......................................... 43 Box 4. Malaysia's Intraregional Trade and US Import Demand .................................................................. 46 Box 5. Investment and Savings in Malaysia ................................................................................................ 54 Box 6. Determinants of Private Investment in Malaysia: The Role of Public Infrastructure ...................... 56 Box 7. Innovation Efforts by Malaysian Manufacturing Firms .................................................................... 63 Box 8. Skill Shortages and the Perceptions by Manufacturing and Services Firms .................................... 68 FIGURES Figure 1.1. EU and US: Confidence is picking up ........................................................................................ 13 Figure 1.2. EU and US: Stock markets are rebounding ............................................................................... 13 Figure 1.3. EU and US: Quarterly GDP growth has resumed ..................................................................... 14 Figure 1.4. EU and US: Industrial production has bottomed out................................................................ 14 Figure 1.5. EU and US: Sales growth is resuming........................................................................................ 14 Figure 1.6. EU and US: New orders are coming in ...................................................................................... 14 Figure 1.7. Emerging East Asia: Foreign reserve levels accumulated rapidly ............................................. 15 Figure 1.8. Quarter-on-quarter growth has returned................................................................................. 17 Figure 1.9. Year-on-year growth still needs to catch up ............................................................................. 17 Figure 1.10. Manufacturing drove the recession ........................................................................................ 17 Figure 1.11. Leading and coincident indicators have improved, but lagging indicators not yet ................ 17 Figure 1.12. Industrial production fell deeply but has stabilized and is recovering ................................... 17 Figure 1.13. Inflation has not been a concern ............................................................................................ 17 Figure 1.14. Malaysia entered the recession later than other East Asian economies ............................... 20 Figure 1.15. Malaysia's private consumption was much more robust ....................................................... 20 Figure 1.16. Public consumption was also supportive ................................................................................ 20 Figure 1.17. The drop in investment was comparable to that in other countries ...................................... 20 Figure 1.18. ...and the same goes for the exports of goods and services................................................... 20 Figure 1.19. Crude palm oil and rubber prices peaked early 2008 ............................................................. 20 Figure 1.20. The implementation of fiscal stimulus measures is ongoing .................................................. 21 Figure 1.21. The global recession provoked a severe export slump........................................................... 22 Figure 1.22. E&E and commodities drove the slump and E&E is driving the recovery .............................. 22 Figure 1.23. Intraregional exports collapsed, but have started to recover ................................................ 22 8  CONTENTS Figure 1.24. Commodity prices are picking up again, especially palm oil .................................................. 22 Figure 1.25. The E&E sector drove the contraction of GDP growth ........................................................... 24 Figure 1.26. Case study: This firm froze hiring, which led to a 20-percent cut in headcount ................... 24 Figure 1.27. Case study: This firm managed to slash inventories just one month after sales fell.............. 25 Figure 1.28. Intermediate imports and non-commodity exports are closely related ................................ 26 Figure 1.29. Intermediate imports drove the contraction of imports ........................................................ 26 Figure 1.30. Current account remains at high surplus ................................................................................ 26 Figure 1.31. Tourist arrivals recovered after a dip...................................................................................... 26 Figure 1.32. The decline of FDI was one of the most severe in East Asia ................................................... 27 Figure 1.33. Portfolio and other investments registered net outflows, but pressures have eased ........... 27 Figure 1.34. The ringgit stabilized after depreciating against the US dollar ............................................... 28 Figure 1.35. The performance against regional currencies was mixed ...................................................... 28 Figure 1.36. Labor market conditions are improving.................................................................................. 29 Figure 1.37. The cost of firing is rather high ............................................................................................... 29 Figure 1.38. The unemployment rate rose as GDP growth fell .................................................................. 30 Figure 1.39. Unemployment lags GDP growth one to three quarters ........................................................ 30 Figure 1.40. Retrenchments were concentrated in manufacturing ........................................................... 30 Figure 1.41. Labor reallocated across sectors............................................................................................. 30 Figure 1.42. Manufacturing wages fell and then generally recovered ....................................................... 31 Figure 1.43. A larger part of permanent layoffs fell on foreign workers .................................................... 31 Figure 1.44. Manufacturing, construction and agriculture employed fewer foreign workers ................... 31 Figure 1.45. The last decade saw an estimated decline in poverty incidence............................................ 31 Figure 1.46. Capital ratios have increased .................................................................................................. 33 Figure 1.47. Profitability has declined ........................................................................................................ 33 Figure 1.48. Nonperforming loan ratios are overall at low levels .............................................................. 33 Figure 1.49. Liquidity surplus remained robust .......................................................................................... 33 Figure 1.50. The banking system's share of external assets to total assets has been low ......................... 33 Figure 1.51. Banks lend primarily to households ........................................................................................ 33 Figure 1.52. The distribution of NPLs tilted increasingly to manufacturing ............................................... 35 Figure 1.53. Loan disbursements dropped as approval rates and credit demand fell ............................... 35 Figure 1.54. Government bond yields have remain low ............................................................................. 35 Figure 1.55. Equity prices have rebounded ................................................................................................ 35 Figure 2.1. EU and US: Unemployment has risen sharply .......................................................................... 37 Figure 2.2. Selected Countries: G-3 import demand did not recover as quickly as China's ....................... 37 Figure 2.3. G-7: Inflation will likely remain low .......................................................................................... 39 9 MALAYSIA ECONOMIC MONITOR Figure 2.4. Malaysia's economy is recovering ............................................................................................ 40 Figure 2.5. Private consumption and exports are expected to improve .................................................... 40 Figure 2.6. Quarterly growth is resuming ................................................................................................... 40 Figure 2.7. Consumer price inflation may pick up from a low base ........................................................... 40 Figure 2.8. Compared with 1997/98, this crisis showed different expenditure patterns .......................... 44 Figure 2.9. The impact on sectoral activity was also different from 1997/98 ............................................ 45 Figure 2.10. China is overtaking the US as an export destination .............................................................. 46 Figure 2.11. Weaker linkages between US import demand and regional exports before the Asia crisis... 47 Figure 2.12. ...but much stronger linkages after the Asia crisis .................................................................. 47 Figure 2.13. Linkages have increased but not steadily ............................................................................... 47 Figure 2.14. The current account surplus remains comfortably high ......................................................... 48 Figure 2.15. Fiscal consolidation next year is expected to curb the fiscal deficit curbed in 2010 .............. 48 Figure 2.16. The collapse in government revenue drove the expansion of the fiscal deficit ..................... 48 Figure 2.17. The share of trade to GDP has increased markedly over the last few decades ..................... 50 Figure 3.1. The economy was a structural shift to services and manufacturing ........................................ 52 Figure 3.2. Private investment has remained subdued .............................................................................. 53 Figure 3.3. Investment fell but after the Asian crisis and never recovered ................................................ 54 Figure 3.4. ... which was almost entirely due to the collapse in private investment.................................. 54 Figure 3.5. As a result, the savings and investment balance of the private sector dramatically rose ....... 55 Figure 3.6. ...which unlike other countries flipped the net foreign asset position into a large surplus ..... 55 Figure 3.7. Broadband subscription is still low ........................................................................................... 62 Figure 3.8. Malaysian exports are highly technology-intensive ................................................................ 63 Figure 3.9. But innovation efforts by firms are lag those in the region ...................................................... 63 Figure 3.10. The level of educational attainment has improved somewhat .............................................. 65 Figure 3.11. The share of skilled labor is low .............................................................................................. 66 Figure 3.12. Vocational education is not yet widespread........................................................................... 67 Figure 3.13. Hiring and firing practices are comparatively rigid ................................................................. 67 Figure 3.14. Skill shortages are the main investment climate concern of manufacturing firms ................ 68 Figure 3.15. ... and this also holds true for services firms ........................................................................... 68 Figure 3.16. Manufacturing firms are concerned about crime, taxes and macro instability ..................... 69 Figure 3.17.Services firms worry about crime, skills, and anti-competitive practices ............................... 69 Figure 3.18. Manufacturing firms see skill inadequacies as the key reason for vacancies......................... 69 Figure 3.19. ... and this is even more the case for services firms ............................................................... 69 Figure 3.20. The bottom three deciles each account for less than 5 percent of total income .................. 70 Figure 3.21. Income inequality is significant, not unlike the rest of the region ......................................... 70 10  CONTENTS Figure 3.22. Poverty incidence is subject to large spatial disparities... ...................................................... 71 Figure 3.23. ...which is not due to population shares being larger in states with high poverty incidence 71 Figure 3.24. Many countries in the region anticipate fiscal consolidation ................................................. 73 Figure 3.25. The fiscal deficit is financed mainly domestically ................................................................... 74 Figure 3.26. Government revenue growth moderated .............................................................................. 75 Figure 3.27. Subsidies drove government expenditure growth ................................................................. 75 TABLES Table 2.1. East Asia and G-3: The Outlook Has Significantly Improved ...................................................... 38 Table 2.2. Thanks to China, developing East Asia remains the fastest-growing region in the world ......... 39 Table 2.3. Manufacturing Firms Believe the Worst is Over ........................................................................ 42 Table 3.1. The long-run and short-run results of the private investment equation................................... 57 Table 3.1. Key thrusts of Budget 2010 ........................................................................................................ 59 Table 3.3. Innovation efforts by firms generally declined between 2002 and 2007 .................................. 64 Table 3.4. Skill shortages take on many forms ........................................................................................... 65 Table 3.5. Malaysian 13-year olds are outperformed in math and science ............................................... 66 Table 3.6. The federal headline deficit is generally larger than the public sector deficit (except 2008) ... 74 APPENDIX TABLES Appendix Table 1: Economic developments ............................................................................................... 76 Appendix Table 2. Developments and projections: real GDP levels ........................................................... 77 Appendix Table 3. Developments and projections: real GDP growth and other indicators....................... 78 11 MALAYSIA ECONOMIC MONITOR 1. RECENT ECONOMIC DEVELOPMENTS With East Asia in recovery mode and advanced economies progressively improving, the Malaysian economy is emerging from one of the worst export slumps in its economic history. As global demand plummeted end of last year, manufacturing firms braced for impact by cutting production, running down inventories, and slashing investment. Given the importance of exports in the economy, the resulting impact on GDP was pronounced. But the turmoil in manufacturing did not lead to a broad- based recession. Private consumption and service sector activity was resilient: growth stalled but levels remained intact. The crisis was mostly a manufacturing-for-exports crisis. The economy was one of the hardest hit in the East Asia region, but it remained resilient. Sound fundamentals and responsive policies provided support. Strong financial supervision and limited exposures to toxic securities and troubled financial institutions shielded the economy from financial contagion. High levels of international reserves relieved the impact of capital outflows. Sound household and corporate balance sheets cushioned the impact of the downturn. On the policy side, accommodative monetary and credit policies protected the flow of credit. Successive fiscal stimulus packages helped boost confidence and construction activity, and hereby contributed to the cushioning of the downturn. The small rise in the unemployment rate masks the significance of the social impact of the crisis. Underneath this, however, was a reallocation of labor across sectors, with services hiring and manufacturing retrenching large numbers of workers. Job losses, shorter working hours, and lower wages are likely to have raised absolute and relative poverty in urban areas. Lower commodity prices are likely to have been detrimental to rural livelihoods. THE EXTERNAL ENVIRONMENT WAS CHALLENGING The global economic crisis had a severe impact on Malaysia's trading partners, which was transmitted in three phases: At the outset of the crisis was the financial phase which began in the U.S. subprime market mid- 2007. The crisis accelerated following the collapse of Lehman Brothers, just as markets were assuming the worst was over, and only recently subsided because of extraordinary monetary and financial support in advanced economies. Not long after the financial shock came the real economy phase. Advanced economies entered the recession well before the Lehman shock but the failure exacerbated the contraction. Damaging macro-financial interactions put a damper on private demand. Then came labor markets, lagging--as is typically the case--behind financials and production. As businesses around the world braced for impact, working hours were cut, earnings were reduced, workers were shed, and eventually firms were closed. 12  RECENT ECONOMIC DEVELOPMENTS Figure 1.1. EU and US: Confidence is picking up Figure 1.2. EU and US: Stock markets are rebounding US consumer confidence index and EU economic sentiments index EU Dow Jones Euro Stoxx and US NYSE Composite (January (January 2007=100) 2007=100) 120 120 110 100 100 80 90 60 80 70 EU 40 US 60 EU 20 US 50 0 40 2007 2008 2009 2007 2008 2009 Source: CEIC and World Bank staff calculations. Source: CEIC and World Bank staff calculations. The US and European economies were dealt the full blow of the three phases of the crisis, and experienced the interplay between financial distress, receding growth and rising unemployment. The financial phase of the crisis was initially most pronounced in the United States, but the advanced and emerging economies of Europe quickly followed suit. The fallout put unprecedented strain on financial systems, and led to a considerable expansion of state involvement. The real economy soon followed and national income, trade and potential output all significantly declined. Policymakers attempted to mitigate the contractionary forces with unprecedented policy measures. Labor markets adjusted primarily through layoffs in the United States, with unemployment now at levels not seen since the 1980s. In Europe, the adjustment occurred predominantly through cutting hours and hoarding labor, even though unemployment has risen significantly in several countries. Signs of stabilization and modest recovery appeared around March-April, and have since gradually solidified (Figure 1.1-Figure 1.6). Financial conditions have stabilized thanks to wide-ranging government interventions in financial institutions and markets. Confidence has returned especially in the EU and risk appetite has increased. As a result, stock markets have rallied and the price of risk on corporate and sovereign instruments has fallen. Recent indicators suggest the worst is over. The US economy expanded faster than expected in the third quarter at 3.5 percent (saar), due to less rapid destocking and monetary and fiscal stimulus. Other high frequency indicators point to improvements as well. Inventory levels have fallen relative to sales, auguring well for future production. Non-manufacturing indices started rising again. Sentiment in the E.U. has improved since early 2009. Industrial output rose recently, and the purchasing managers index too, even though levels are still below pre-crisis levels. 13 MALAYSIA ECONOMIC MONITOR Figure 1.3. EU and US: Quarterly GDP growth has Figure 1.4. EU and US: Industrial production has resumed bottomed out Real GDP growth (saar, percent) Industrial production index (January 2007=100) 6 110 4 105 2 100 0 -2 95 EU -4 US EU 90 -6 US 85 -8 -10 80 2008 Q1 Q2 Q3 Q4 2009 Q1 Q2 Q3 2007 2008 2009 Source: CEIC and World Bank staff calculations Source: CEIC and World Bank staff calculations. Figure 1.5. EU and US: Sales growth is resuming Figure 1.6. EU and US: New orders are coming in Wholesale and retail sales (January 2007=100) New orders for manufactured products (January 2007=100) 115 120 110 110 105 100 100 90 EU 95 EU US US 80 90 85 70 80 60 2007 2008 2009 2007 2008 2009 Source: CEIC and World Bank staff calculations Source: CEIC and World Bank staff calculations Thanks to strong initial conditions, the overall adjustment process in East Asia to the three phases of the crisis turned out to be generally less severe. The region was largely spared the financial phase of the crisis, as exposures to toxic securities and troubled financial institutions were limited. Banks generally had much less foreign borrowing compared to the 1997-98 Asian crisis, and domestic liquidity was ample. In addition, the regional economy was in a much better capacity to withstand the shock, having accumulated large foreign reserve levels following years of current account surpluses (Figure 1.7). The improvements in prudential standards over the past decade also contributed, and financial systems were less prone to asset quality problems. 14  RECENT ECONOMIC DEVELOPMENTS The region's economy nevertheless experienced a severe contraction in production and income, primarily on account of trade-related channels. The sudden fall in end-user demand in the United States and Europe reverberated through global supply chains and caused a precipitous impact on industrial output of East Asia's manufacturing sites. As a consequence, trade--particularly intra-firm and intra-industry--collapsed. In parallel, as risk appetite retrenched, capital flowed out with adverse impact on asset prices and currencies. Labor markets weakened in the face of the manufacturing-led decline in output, but it appears that this impact was relatively muted. Unlike the 1997-98 Asian crisis episode, private consumption remained relatively resilient and external demand as well as investment suffered the largest impact. In addition, as mentioned earlier, this time around East Asia could not export its way out of the recession since it faced a synchronized decline in the demand for its goods and services. Overall, the labor market impact was muted, except for employment in sectors exposed to external demand. Figure 1.7. Emerging East Asia: Foreign reserve levels accumulated rapidly Foreign reserves minus gold (US$ billions) 4000 3500 3000 Total 2500 2000 China 1500 1000 500 0 97 98 99 00 01 02 03 04 05 06 07 08 Aug 09 Source: Haver and World Bank staff calculations Note: Total reserves include those from CHN, IDN, MYS, PHL, THA, HKG, KOR, SGP and TWN. BUT THE MALAYSIAN ECONOMY REMAINED FUNDAMENTALLY RESILIENT The Malaysian economy was one of the hardest hit in the East Asia region, but it remained fundamentally resilient. In terms of the phases of the crisis, the real economy impact was the most pronounced: Malaysia, as most other countries in the region, was largely spared from the financial spillovers and contagion that took place within and among the financial systems of the United States and advanced European economies. While the global collapse in trade affected Malaysia's large export-oriented manufacturing sector profoundly, the high import content of its exports provided a buffer and the decline in exports quickly led to a curb in import demand. Negative inward spillovers to domestic demand emerged but these proved short-lived. But the turmoil in manufacturing did not lead to a broad-based recession. Private consumption and service sector activity was resilient: growth stalled but levels remained intact. 15 MALAYSIA ECONOMIC MONITOR As the production of tradables experienced a sharp contraction, registered employment in the capital-intensive manufacturing industry sector fell, but the labor market impact on the economy more widely remained rather well contained. Unemployment has risen but the rise has been marginal. This however masks the significance of the social impact of the crisis as will be discussed. The Crisis Was Mostly a Manufacturing-For-Exports Crisis In spite of initial concerns, the crisis remained a manufacturing-for-exports crisis and did not significantly spill over into the rest of the economy. As the shock of falling external demand reeled through their global and regional supply chains, manufacturing firms cut production, ran down inventory stocks, and reduced fixed investment. Initial concerns were that the downturn would become more broad-based. However, the domestic private sector entered the downturn in a relatively strong position, with private sector consumption remaining rather resilient. The generally limited domestic economic footprint of manufacturing multinational corporations (MNCs), as reflected in the high import content of Malaysia's exports, helped curb the inward spillovers into domestic demand. The resilience of private consumption also helps explain why Malaysia entered the recession one quarter later than other countries in the region (Box 1). Activity showed signs of stabilization in the second quarter, with private consumption and fixed investment rising on the back of stimulus spending (Figure 1.8-Figure 1.10). On a seasonally adjusted basis, output rose again after 8-9 percent decline (qoq) in the previous two quarters. The annual contraction in real GDP moderated from -6.2 percent in the first quarter to -3.9 percent in the second. Private consumption and fixed investment both recovered with the former making a positive contribution to annual growth. The rise in fixed investment included the impact of the stimulus spending. On the supply side, the manufacturing sector, which had suffered deeply, made some recovery in the second quarter. The all-important services sector--accounting more than half of total activity and a third of total jobs--remained resilient and played a major role in the GDP stabilization. Industrial production has improved too, with capacity utilization in the export-oriented sectors rising again (Figure 1.11-Figure 1.12). Components of Malaysia's leading index of economic activity pointed to improvements as early as the first quarter of 2009.1 However, only in recent months have coincident indicators, such as industrial production, reported positive growth. The recovery in industrial production has lagged that in other countries within the region, largely due to the fact that the Malaysian economy was also affected by the global slowdown one quarter later.2 Capacity utilization 1 The coincident index includes: industrial production, real gross imports, real salaries and wages in manufacturing, total employment in manufacturing, real sales in manufacturing, and real contributions to the EPF. The leading index includes: the level of real M1 money supply, Bursa Malaysia's stock market index, the real total trade of eight major trading partners, inverted CPI growth for services and industrial material price inflation, the ratio of price to unit labor cost in manufacturing, the number of housing permits approved and the number of new companies registered. The lagged index components include: the 7-day call money rate, the level of real excess lending to private sector, investment projects approved, the number of defaulters, the Employees Provident Fund (inverted) and new vehicles registered. 2 The later recovery in industrial production can also be attributed to unplanned shutdowns in the mining sector (especially petroleum). 16  RECENT ECONOMIC DEVELOPMENTS Figure 1.8. Quarter-on-quarter growth has returned Figure 1.9. Year-on-year growth still needs to catch up Percentage contributions to quarter-on-quarter GDP growth (sa) Percentage contributions to year-on-year GDP growth 15% 10% Net exports Net exports 10% 5% 5% 0% 0% -5% -5% -10% Inventory Inventory -10% investment -15% investment Private Private -15% consumption -20% consumption 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 Private consumption Public consumption Private consumption Public consumption Fixed investment Inventory investment Fixed investment Inventory investment Net exports GDP Net exports GDP Source: Haver and World Bank staff calculations. Source: CEIC and World Bank staff calculations. Figure 1.10. Manufacturing drove the recession Figure 1.11. Leading and coincident indicators have improved, but lagging indicators not yet Percentage contributions to year-on-year GDP growth Percent change of 3-month moving average, mom, sa 9% 3% 6% 2% Services 3% 1% 0% 0% -3% Manufacturing -1% -6% Leading index -2% -9% Coincident index 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 Lagging index -3% Mining and Quarrying Agriculture Construction Services Jul-07 Nov-07 Mar-08 Jul-08 Nov-08 Mar-09 Jul-09 Manufacturing GDP Source: CEIC and World Bank staff calculations. Source: CEIC and World Bank staff calculations. Notes: Seasonal adjustment based on X.12. Figure 1.12. Industrial production fell deeply but has Figure 1.13. Inflation has not been a concern stabilized and is recovering Percent, mom sa Industrial production index, log, sa 2.10 4% 3% 2.05 2% 2.00 1% 0% 1.95 -1% 1.90 -2% Consumer prices -3% Producer prices 1.85 -4% 2002 2003 2004 2005 2006 2007 2008 2009 2007 2008 2009 Source: CEIC and World Bank staff calculations. Source: CEIC and World Bank staff calculations. Notes: Seasonal adjustment based on X.12. Notes: Seasonal adjustment based on X.12. 17 MALAYSIA ECONOMIC MONITOR registered a notable increase for export-oriented industries, up from 61 percent in the first quarter to 73 percent in the second. This is consistent with other indicators, such as lower levels of retrenchments and increased vacancy levels in manufacturing. The recovery of capacity utilization in the domestic-oriented industries has been less pronounced with around 40 percent of capacity remaining unutilized in the second quarter. Inflationary pressures have been muted, due to weakened domestic demand, reduced costs, and base effects (Figure 1.13). Annual consumer price inflation moved into negative territory in June for the first time since March 1987, which was primarily the result of the base effects due to the high level of food and fuel prices in 2008. Food price inflation fell to 1 percent year-on-year in the month of September from around 10 percent at the beginning of 2009, with transport prices also contributing to the lowering of prices. After monthly contractions from mid-2008 to mid-2009, the producer price index has shown recent signs of recovery. Again, due to base effects, there remains deflation in producer prices on an annual basis, driven particularly by prices for local production, down -13.3 percent year-on- year in August, although import producer prices also fell by 2.9 percent. The gap between consumer and producer price annual inflation rates, whilst falling somewhat in recent months, remains around 7.5 percentage points. The low levels of capacity utilization, as discussed above, may weigh against a swift re-emergence of inflationary pressures in the short-term. While in large part driven by external developments, recent improvements in economic conditions have also been helped by the easing of fiscal policy.3 The Malaysian authorities announced two fiscal stimulus packages. These packages entertained multiple objectives, ranging from sustaining demand to mitigating the crisis impact and addressing medium-term growth issues. The first stimulus package, announced in November 2008, amounted to approximately 1 percent of GDP (RM7 billion) and was allocated mostly to spending measures for projects with high-multiplier effects, mostly relating to infrastructure. These measures were financed by savings in fuel subsidies, which were cut mid-2008 to reduce the fiscal burden amidst fast-rising global fuel prices. The second fiscal stimulus package was announced in March 2009 in the amount of RM60 billion or 9 percent of GDP. The second package is spread however over two years and includes spending measures (RM15 billion), guarantee funds (RM25 billion), equity investments (RM10 billion), private finance and off-budget initiatives (RM7 billion) and tax incentives (RM3 billion). The direct fiscal injection implied by the package is estimated at about 3.5 percent of GDP over two years, and is consists of about 80 percent of spending measures (mostly investment expenditure) and 20 percent tax cuts. 3 Fiscal policy issues will be discussed more fully in the next parts. 18  RECENT ECONOMIC DEVELOPMENTS BOX 1. WHY DID MALAYSIA ENTER THE RECESSION LATER THAN OTHER EAST ASIAN ECONOMIES? Malaysia seems to have entered the recession a quarter later than most other regional economies. When Malaysian yearly GDP growth stalled at 0.1 percent in the last quarter of 2008, other countries in the region, such as Thailand and the four Newly Industrialized Economies, were already well into an economic contraction. As shown in Figure 1.14, this ranged from -2.6 percent in Hong Kong SAR to -8.6 percent in Taiwan (China). The key factor for this differential performance was the more robust performance of both private and public consumption in Malaysia (Figure 1.15 and Figure 1.16). Clearly this mattered since Malaysia's consumption expenditure makes up some two-thirds of GDP (52 percent and 14 percent of GDP for private and public spending respectively). This is comparable to Hong Kong SAR, Korea and Taiwan (China), and higher than Singapore and Thailand. The rate of decline in fixed investment and exports was similar to that of other countries, so this was not a likely reason (Figure 1.17 and Figure 1.18). Similarly, base effects are not the reason either, sine the Malaysian economy expanded 7.2 percent in the last quarter of 2007, which is much higher than the other five economies considered here. What then explained the robust growth of private consumption? The peak of commodity prices in the first half of 2008 tells part of the story. Between October 2006 and March 2008, crude palm oil price jumped by 144 percent (Figure 1.19). This helped build wealth among 1.4 million workers, of which 570,000 directly employed in the industry and the remainder indirectly (Malaysian Palm Oil Council, 2008). A similar outcome applies to workers in the rubber plantations, as rubber prices rose 43 percent between August 2007 and July 2008. Private consumption in Thailand, another country with large commodity exports, was also stronger in the second half of last year compared to the NIEs. The stimulus impact of Budget 2009 played a role too. As the slowdown started to appear, government announced an expansionary Budget for 2009 in August 2008. Measures such as tax exemptions on interest from deposits previously levied at 5 percent, lower road tax for diesel vehicles, and free electricity bills for low-volume users were introduced with immediate effect and may have strengthened consumption tax rebates and lower income taxes also helped, as did measures to help the business sector which would result in positive spillovers into private consumption. What drove public consumption? Higher subsidies to support rising food and fuel prices were key. Despite a reduction in fuel price subsidies mid-2008, total subsidies stood at nearly 20 percent of government revenue in 2008. In the second half alone, they were 1.5 times that of the similar period in 2007. Price subsidies have been used to support many basic food items. Another contributory factor was the public sector pay hike in mid-2007. Emoluments as a result increased 26 percent in 2008 year-on- year. For the first time in 15 years, about one million government officials received a pay increase by as much as 35 percent. 19 MALAYSIA ECONOMIC MONITOR Figure 1.14. Malaysia entered the recession later than Figure 1.15. Malaysia's private consumption was much other East Asian economies more robust Real GDP growth, percent, yoy Real private consumption growth, percent, yoy 8 12 Malaysia 6 10 Thailand Korea 4 8 Hong Kong 2 Singapore 6 0 Taiwan 4 -2 Malaysia 2 -4 Thailand Korea 0 -6 Hong Kong -8 -2 Singapore -10 Taiwan -4 -12 -6 08 Q1 Q2 Q3 Q4 09 Q1 Q2 08 Q1 Q2 Q3 Q4 09 Q1 Q2 Source: CEIC and World Bank staff calculations. Source: CEIC and World Bank staff calculations. Figure 1.16. Public consumption was also supportive Figure 1.17. The drop in investment was comparable to that in other countries Real public consumption growth, percent, yoy Malaysia Real gross fixed investment growth, percent, yoy Thailand 35 15 Korea Malaysia 30 Hong Kong Thailand 25 Singapore Korea Taiwan 20 10 15 Hong Kong 10 Singapore 5 Taiwan 5 0 -5 -10 0 -15 -20 -25 -5 -30 -35 08 Q1 Q2 Q3 Q4 09 Q1 Q2 08 Q1 Q2 Q3 Q4 09 Q1 Q2 Source: CEIC and World Bank staff calculations. Source: CEIC and World Bank staff calculations. Figure 1.18. ...and the same goes for the exports of Figure 1.19. Crude palm oil and rubber prices peaked goods and services early 2008 Real exports of goods and services, percent, yoy US$ per ton 20 12,000 Rubber (left) 4,000 Crude palm oil (right) 3,500 10 10,000 3,000 0 Malaysia 8,000 2,500 Thailand -10 Korea 2,000 Hong Kong 6,000 -20 Singapore 1,500 Taiwan -30 4,000 1,000 08 Q1 Q2 Q3 Q4 09 Q1 Q2 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan Source: CEIC and World Bank staff calculations. Source: CEIC and World Bank staff calculations. 20  RECENT ECONOMIC DEVELOPMENTS The stimulus measures helped shore up confidence and provided direct support to the construction sector, but the overall impact on the economy during the first two quarters of 2009 was likely limited. Decision and implementation lags affected the speed and rate of disbursement. As of end-October 2009, 66 percent of stimulus expenditures were spent for the first package, whereas this was so far 30 percent for the second package (Figure 1.20). Fiscal stimulus also typically takes time to multiply itself into higher income and growth, a process which is in Malaysia hampered by import and remittance leakages due the high degree of openness of the economy. Figure 1.20. The implementation of fiscal stimulus measures is ongoing RM billion 16 14 12 10 8 Not yet spent 6 Spent 4 2 0 First stimulus Second stimulus Source: Ministry of Finance and World Bank staff calculations. Exports Were Hit Hard, But Are Now Recovering The current export slump is one of the most severe in Malaysia's economic history (Figure 1.21). As global conditions deteriorated, Malaysia's exports contracted sharply in the second half of 2008 and continued to do so early 2009. In the past, the decline in exports was either limited, as during the Asian financial crisis in 1997/98, or gradual as following the puncturing of the technology bubble in 2001. During the current episode, exports plunged both rapidly and sharply--in 8 months Malaysia's total exports declined by 31 percent on a seasonally adjusted basis. While the steep decline in exports deeply affected the manufacturing sector, the impact on the economy as a whole was mitigated by the compression in processing imports. Malaysia's economy is highly dependent on external markets with an export-to-GDP ratio of 1.2 and a trade-to-GDP ratio of 2.2 in 2008. More than 40 percent of Malaysia's exports are electrical and electronics (E&E) products with high import content and produced in large part by firms under foreign ownership. This helped reduce the economy-wide significance of the shock. Exports are recovering now (Figure 1.22). Renewed demand abroad, driven by a turn in the global inventory cycle and import demand from China, helped the export recovery. Malaysia's exports began to gradually climb out of the trough in the second quarter. On a month-on-month seasonally adjusted basis, exports resumed growth for two successive months in June/July. Total exports grew at 4.6 percent and 2.6 percent (month-on- month sa) in June and July, respectively; non-commodity exports at 3.3 percent and 4.6 percent. 21 MALAYSIA ECONOMIC MONITOR Figure 1.21. The global recession provoked a severe Figure 1.22. E&E and commodities drove the slump export slump and E&E is driving the recovery Export value index, sa Export index, Sep 2008=100, sa 170 110 150 100 E&E 90 130 Asia crisis 80 110 70 Total 90 Dot.com crisis 60 70 Global recession 50 Commodity 50 40 0 3 6 9 12 15 18 21 24 Sep-2008 Nov-2008 Jan-2009 Mar-2009 May-2009 Jul-2009 Source: CEIC and World Bank staff calculations Source: CEIC and World Bank staff calculations. Note: Export index = 100 for Jul 1997 (Asia crisis), Mar 2000 (Dot.com crisis and Sep 2008 (current crisis). Figure 1.23. Intraregional exports collapsed, but have Figure 1.24. Commodity prices are picking up again, started to recover especially palm oil Changes to previous period, RM million, sa Unit value of exports, RM/ton 10000 3500 5000 3000 0 -5000 2500 -10000 2008 May-Aug -15000 2008 Sep-Dec 2000 Crude 2009 Jan-Apr oil -20000 2009 May-Aug -25000 1500 Palm oil LNG USA Japan EU China Emerging East Asia except 1000 China 2006 2007 2008 2009 Source: CEIC and World Bank staff calculations Source: CEIC and World Bank staff calculations Key drivers were stronger demand from China and other emerging East Asian economies while the decline in the demand of G-3 also moderated (Figure 1.23). Demand from China picked up sharply in the first four months of 2009 by increasing RM4.2 billion or 25 percent over the previous period on a seasonally adjusted basis and the growth trend has continued till August 2009. Demand from other East Asian economies, including Singapore, Thailand, and Hong Kong SAR, has also resumed modest growth since 2009. The demand from G-3 remained a drag to exports growth but declined at a more moderate pace over May-August. 22  RECENT ECONOMIC DEVELOPMENTS The better performance of E&E goods was key (Figure 1.22 and Box 2). Accounting for over 40 percent of total exports, E&E exports have driven the recent recovery of exports. This was helped first by the turnaround in the global inventory cycle, with firms starting to restock in response to rising orders. A second factor was the economic stimulus package of China. Although most of China's stimulus package is infrastructure-oriented investment, measures such as subsidies for rural consumption of electronic appliances have boosted domestic demand and buoyed imports4. The recovery of commodity exports lagged due to subdued prices and weakened demand in most markets (Figure 1.22 and Figure 1.24). Global commodity prices witnessed a sharp contraction in the second half of 2008 as a correction to overshooting in the first half. The trend reversed somewhat early 2009. Yet, export prices for LNG, crude oil and petroleum products have remained below previous levels due to demand weakness and large overhang of stocks globally. The exception is palm oil where lower production domestically and in the region lifted export prices much closer to the pre-crisis level. Global demand uncertainties meant that volume gains remained patchy. BOX 2. SUPPLY CHAIN MANAGEMENT: INSIGHTS FROM JAPANESE FIRMS IN THE E&E SECTOR The electrical and electronics (E&E) sector makes a large contribution to the economy of Malaysia, representing 38 percent of exports and 9 percent of GDP in 2008. Drastic production cuts in the E&E sector have also been a key contributor to the sharp drop in GDP observed in the fourth quarter of 2008 and first quarter of 2009 (Figure 1.25)