At 52.9 per cent of GDP in 2012, Malaysia’s public debt level is nowhere near those of many advanced economies, with much of the debt increase due to the 6.7 per cent fiscal deficit incurred during the Great Recession. Yet public sector debt remains far above the regional average and, while not in itself dangerous, limits the government’s ability to counteract future crises.

There are quite valid concerns over the sustainability of government revenue and expenditure. The tax base is narrow: less than 10 per cent of the workforce actually pays taxes while a third of government revenue comes from taxes and dividends on the oil and gas industry, which over the long term is threatened by potentially declining reserves and, more recently, lower global prices.

Still, the overall debt-to-GDP ratio is below any critical threshold, and the government carries minimal external debt with over 95 per cent raised domestically. The financial system has more than sufficient excess liquidity to absorb further debt issuance, and both interest rates across the term structure and debt-service ratios are at near all-time lows.

So while immediate concerns over a Malaysian sovereign debt crisis are substantially overblown the case for reducing the debt-to-GDP ratio makes sense.

The question is how to go about reducing this ratio. Many of the government’s financial commitments are ‘sticky’ — salaries, pensions and debt-service payments made up nearly 40 per cent of the 2013 Budget. The development budget (which is fully funded through debt) is discretionary, but cuts here would reduce future potential growth and limit investment in needed infrastructure.

Subsidy reduction offers the greatest scope for cost savings. The federal government expects to spend RM37.6 billion (about US$12.3 billion) on subsidies in 2013. In addition, there is the ‘hidden’ subsidy borne by the national oil company Petronas, which provides natural gas below market prices to domestic customers. In 2011, this subsidy amounted to RM18.7 billion (US$6.1 billion). The long overdue implementation of GST would also, on the revenue side, help close the fiscal gap.

But leaving aside efforts to improve fiscal space, Malaysia’s private sector debt, specifically household debt, is of more pressing concern. Household borrowing has increased from 72.6 per cent of GDP in 2005 to 80.5 per cent in 2012.

While much of this household debt was used to acquire properties and financial assets, which could presumably support the attendant liabilities in the event of a crisis, there is a worrying heterogeneity in the distribution and direction of borrowing. Around 80 per cent of household borrowing is by households that earn higher-than-average incomes (greater than RM3,000 per month or US$1,000), and 46.5 per cent are by households earning above RM5,000 (US$1,600) per month. The leverage ratio of the latter is in the region of 2.3–3.3 times annual incomes, a relatively comfortable level. For households earning less than RM3,000, however, the leverage ratio ranges from 4.4 to an astonishingly high 9.6 times annual income.

More worrying still, the fastest-growing component of low-income household debt is personal loans, which are increasingly provided through the non-bank sector. In 2012, loan approvals through non-banks rose 63.7 per cent.

Such loans unfortunately lie outside the ambit of central bank regulatory oversight, a deficiency that Bank Negara Malaysia hopes to plug with the Financial Services Act due to come into force by mid this year.

Still, the risk of a systemic banking crisis is low. Links between non-bank financial institutions and the broader banking system are limited as few non-bank financial institutions participate in the interbank market or rely on wholesale funding. Many of these low-income borrowers are also civil servants with good job security, and loans are paid off at source via salary deduction.

But there is still the socioeconomic problem of revenue-constrained households with overstretched budgets, implicitly backed by an already indebted government. There’s little room for error with households paying up to 60 per cent of their disposable income on principal and interest payments on debt.

This is a much harder problem to solve than the government’s explicit and direct debt burden. Unlike households, the government has some leeway in determining its own revenue streams via tax policy. But reducing household leverage by changing the behaviour and the financial incentives faced by thousands of households is a much bigger policy challenge.

Tightening monetary policy and enacting macro-prudential rules on lending might reduce loan supply but would also increase financial fragility through higher interest rates. Fiscal consolidation is needed to increase the government’s fiscal space to deal with any potential household debt crisis, but that carries the same attendant risks. There is certainly the option of growing out of the problem, but that implies a change in household borrowing behaviour that currently seems unlikely. There does not appear to be any easy answers to this conundrum.

Nurhisham Hussein is an economist based in Malaysia. He writes a blog on the Malaysian economy at Economics Malaysia.

This article was first published here on New Mandala.