China has come to occupy a prominent position on Malaysia’s trade agenda over the past few years and is now Malaysia’s fourth largest trading partner. China currently accounts for about 11 per cent of Malaysia’s global trade, lagging behind the likes of the US, Japan and Singapore.

This was not always the case. Between 1995 and 1999, only about three per cent of Malaysia’s exports moved towards China. Today, about ten per cent of Malaysia’s exports are destined for China. Only about two per cent of imports came from China in 1995, but more recently they have shot up to close to 13 per cent.

With trade figures that are galloping along at this rate, it is easy to see how China cannot be ignored by policy makers and the business community in Malaysia. The ASEAN-China Free Trade Agreement (ACFTA) that was implemented on 1 January 2010 only adds more sparks to these racy developments.

With the introduction of the ACFTA, Malaysia can expect more benefits to pour its way from China. But there is no guarantee that Malaysia will experience unalloyed gains from the ACFTA. Malaysia does not have China’s advantage of an abundant low-cost labour force, and the subsidies that China’s manufacturers enjoy may add to this surplus labour equation. The outcome can be felt even now, with companies in Malaysia feeling the effects of Chinese competitors. Manufactures of industrial valves and steel fasteners are examples of such voices from Malaysia, and they are by no means isolated.

The solution would be for Malaysia to resort to more knowledge-intensive, higher value-added production processes. This is easy to suggest but may be very difficult to implement, at least in the short run. The valve manufacturers in Malaysia have intuitively grasped this problem and are shifting to water valves which require greater technological sophistication. If these companies are to remain competitive, they have to shift to products where they will not be in direct competition with their Chinese counterparts. This is hardly a subtle point, since similar low-technology products from China are between 15 and 20 per cent cheaper than those produced in Malaysia.

The imperative to move up the value-chain, to invest in technological upgrading, and to produce goods that require knowledge-intensive production methods is garishly written all over the wall. As it stands, the major products that are exported to China from Malaysia, using preferential market access under the ACFTA, are agricultural commodities. Compound rubber, mixed vegetable oil, stearic acid and crude palm oil are among these products. In 2008 they were valued at US$1.9 billion worth of exports. This is no trifling sum.

The export of low value-added products may not continue indefinitely. It is likely that the FTA and provisions that are made under the agreement on investment will expedite China’s interest in locating its interests in Malaysia. Perhaps the first investments likely to be considered are those that will process and add value to raw materials and primary commodities. It will make sense to the Chinese to have their own factories in Malaysia to process these commodities and to push them up the value chain.

Events such as this will direct the flow of investments from China into Malaysia. By the same stroke they will also drive up the threshold of competitiveness in Malaysia. While Malaysia will gain from increased trade with China and also from the inflow of direct investment into the country, the ACFTA may also have the effect of edging Malaysia to reconsider its competitiveness in various sub-sectors. The net effect may well be positive, but the transition could be uncomfortable unless Malaysian business and policy makers act proactively.

Shankaran Nambiar is Senior Research Fellow and Head, Policy Studies Division at the Malaysian Institute of Economic Research.

1. Will ASEAN benefit from the ASEAN-China FTA?
2. Foreign direct investment in China: trading competitiveness for access?
3. India and ASEAN: an FTA and beyond

In Malaysia the doom and gloom of the global financial crisis was pervasive at the start of this year, but gradually gave way to increasing optimism following the leadership change in April. Currently, various economic indicators forecast continued improvement for Malaysia, albeit subject to occasional pullbacks, and this economic progress is due to the efforts of the Malaysian government’s introduction of policies aimed to stabilise the economy.

Economic activity rebounded in the second quarter of 2009, after bottoming out in the first quarter, with stabilising domestic and external conditions leading to further improvement in the third quarter. Sentiments among businesses and consumers also recovered, leading to more private investment and consumption along the way, with the rate of decline in inflation also slowing in October.

The Malaysia government’s response to the global downturn has been to introduce a raft of national stabilisation measures, to varying degrees of effectiveness.

In a move to increase Malaysia’s attractiveness to investors, Malaysia’s government announced a number of investment liberalisation measures. Effective from 22 April, twenty-seven services sub-sectors were fully liberalised to foreign investors, on the premise that Malaysia lacks expertise and local investments in many of these. Among the sectors to be opened up are: computer and related services, health and social services, tourism services, transport, recreational, business services, and shipping. Additionally, on 30 June, the long standing 30 per cent Bumiputra equity requirement for newly listed companies was removed, making investment conditions less restrictive. This will bring Malaysia’s equity market closer to regional benchmarks, but given the many other factors that influence investment decisions, the final impact of the reforms remains to be seen, .

The government is also aiming to promote discretionary expenditure, with the personal income tax rate being reduced from 27.0 per cent in 2009 to 26.0 per cent in 2010. Individual relief and tax deduction will also be increased. However, the impact of such measures on consumption may only be limited, given that only 1 million out of 10.5 million workers pay income taxes. Moreover, the income tax cut only affects those earning more than RM 100,000 per year. The absence of a civil servant bonus is another negative factor.

On investment in Malaysia, the government’s reintroduction of a 5.0 per cent property gains tax will lower property sales. Furthermore, slightly lower development expenditure in 2010 may reduce public investment, as some major infrastructure projects could be funded off-budget, with slow rollout.

Meanwhile, Bank Negara Malaysia decided, in November, to leave the Overnight Policy Rate (OPR) unchanged at 2.00 per cent for the sixth consecutive meeting. While Malaysia’s economic contraction is expected to further decrease, the Central Bank’s monetary policy stance is still expected to be fairly accommodative for the remainder of the year. This is also facilitated by the absence of inflationary expectations in the near term. For these reasons, the Malaysia Institute of Economic Research (MIER) expects that the OPR will remain relatively unchanged, at least until the end of 2010.

All this is supported by the persistence of a cautious sentiment, as revealed in the in-house Consumer Sentiment (CSI) and Business Conditions Indices (BCI). Ongoing economic uncertainties – due to global financial deleveraging activities, low wage growth, and the possibility of a sudden withdrawal of economic stimuli – still continue to repress confidence among consumers and corporate entities. While both CSI and BCI settled above the crucial 100-point mark in the third quarter of 2009, the rate of change has decreased quarter-on-quarter

Although there are glimmers that the global downturn has stabilised, Malaysia’s economic recovery is still expected to be sluggish and uneven. The rebounding from the current crisis will even harder than ever previously, due to the synchronised nature of this downturn. It will take time and huge resources to revive the deeply entangled U.S. financial sector while policy options are running out. Faster recovery will be impeded by a weak external sector, with lower commodity prices not helping either. Banks are becoming more cautious, fearing that bad loans could rise soon, which is consequently limiting the flow of funds to firms. Still, the services sector will be the pillar of strength amidst a glum manufacturing sector.

The technical recession is likely to end in the fourth quarter of 2009. But Malaysia may not regain more strength until the global economy is back on track, which is going to be at a disappointingly slow pace.

In view of improving macroeconomic indicators, and somewhat better CSI and BCI as well as sectoral indices, MIER is maintaining a GDP growth forecast for Malaysia of -3.3 per cent year-on-year (YoY) in 2009 and +3.7 per cent YoY in 2010, while projecting 2011 GDP growth rate of +5.0 per cent YoY. Downside risks are still prevalent and might perturb the road to recovery, but there are stronger positive influences that led to MIER’s projections.

This is part of the special feature: 2009 in review and the year ahead.

Dr. Foong Kee Kuan is Senior Research Fellow at the Malaysian Institute of Economic Research

1. Malaysia: a year of economic and political reversals
2. The ASEAN-China FTA: driving competitiveness in Malaysia
3. The long and rocky road to global recovery

There are signs that the global economic crisis is abating and a recovery is dawning. Economic data and earnings have surprised on the upside. While this seems reassuring, there are nagging doubts about the sustainability of the anticipated recovery.

Second-quarter numbers relating to private consumption, manufacturing production, exports and imports and gross domestic product have been encouraging, in that they have not been as bad as initially feared.

There is no suggestion that the world economy is out of the woods as it is still contracting, albeit at a slower pace than before, although some countries — notably Germany, France, Japan, South Korea and Singapore — have reported positive gross domestic product (GDP) growth in the second quarter.

The United States, the epicentre of the crisis, is itself now forecast to post a 2.9 per cent growth in the third quarter, up from an earlier forecast of 2.2 per cent.

It is important to underline that the increases in many key macroeconomic indicators thus far are measured month-on-month or quarter-on-quarter rather than year-on-year, which only suggests that the worst may be over while the recession is still lingering.

Not all indicators are moving in tandem. Job numbers remain unimpressive, with retrenchment still outpacing job creation. Bank loans and private investment remain lethargic. Consumer price indices continue to slide.

Admittedly, as previous crises have shown, employment is a lagging, not a leading, indicator. Employment responds only after normalcy returns, not in the early stages of the upturn. For instance, it took South Korea 18 months for employment growth to surge after the 1997-98 Asian financial crisis.

But it is unsafe to make sweeping generalisations, as conditions vary from country to country. Although adversely affected, China and India are not in recession: their huge domestic sectors helped cushion the impact. Exports constitute just 35 per cent of China’s GDP and 22 per cent of India’s, in sharp contrast to Singapore’s 259 per cent and Malaysia’s 118 per cent, last year.

Economies with a large external sector, such as Singapore and Malaysia, have also shown considerable resilience, thanks in part to high household savings during good times on which they could fall back upon during lean times without having to make drastic cutbacks in private consumption.

Perhaps one reason why East Asia is able to ride out the crisis with greater ease, or stay ahead in the global recovery, is that private consumption did not cave in, thanks to the households’ capacity to dig into past savings.

So far so good, as relatively stable private consumption in East Asia has helped prevent a sharper downturn even in countries with huge export dependence. But households’ capacity to continue to spend, despite job and income losses, is not unlimited. Much would also depend on consumer expectations, which have been whipped up by strong government interventions through monetary and fiscal stimuli.

There is the risk of consumer confidence wearing off under the waning effects of the fiscal stimulus packages.

It appears that the upbeat data is largely attributable to aggressive government spending under fiscal stimulus packages, and business expansion under easier credit conditions, rather than to consumer spending. Increased industrial production reported in some countries also appears to have stemmed mainly from manufacturers’ response to depleting stocks. There is no empirical evidence to link this to increased real demand.

Notwithstanding the past week’s assurances of the finance ministers of the G20 to maintain loose monetary and expansionary fiscal policies, there are limits to both.

Increased liquidity resulting from expansionary policies may have to be withdrawn through higher interest rates and budgetary restraints, which may contribute to the fragility of the so-called recovery.

Thus, there are signs that the nascent recovery will be short-lived, with the global economy suffering another bout of contraction next year before it can see a sustainable real recovery hopefully in 2011.

The possibility of a ‘double-dip’ or ‘W-shaped’ recovery is more than theoretical.

Some analysts think the double-dip scenario, even if it matters to industrialised economies, is of no relevance to emerging economies in East Asia, as the latter are in a different league altogether. Their optimism about East Asia is premised on the perceived prowess of the Chinese economy and its extensive regional links.

Be that as it may, it is important to factor in the fault lines that exist in the Chinese economy, where massive public investment goes into industries already saddled with overcapacity, such as cement and steel. That consumption, which accounts for only 35 per cent of China’s GDP, with public investment making up roughly 45 per cent, does not augur well.

Moreover, China’s huge credit expansion to the tune of 7.4 trillion yuan (RM3.7 trillion) in the first half of the year has raised concerns that some of these loans might not be repaid and that the bulk of them may have gone into speculative activities in the stock and property markets, stoking fears of a market backlash.

The prospects of an imminent recovery, by which is meant a return to double-digit growth, may fuel expectations contributing to potentially dangerous bubbles in the Chinese economy.

What is worrisome is that the crisis has not led the global economy to rebalance itself. The root causes of the crisis — global imbalances — remain, which suggests that any recovery without establishing a new equilibrium will be short-lived.

Mohamed Ariff is executive director of the Malaysian Institute of Economic Research (MIER).

This article originally appeared here in the New Straits Times.

1. The long and rocky road to global recovery
2. A sluggish recovery expected for Malaysia’s economy
3. Toward a world economy with slower growth and higher inflation

The global economic crisis has brought East Asia to a crossroads. It now has three options: one, continue as before with no change; two, take a U-turn and look inward; and three, stay outward-looking but with a distinct difference.

One must, however, acknowledge that the export-led growth strategy has paid handsome dividends for the East Asian economies, enabling them to fly high. No wonder, Japan and South Korea were able to climb the development ladder rapidly through exports, especially to the United States.

This was fuelled by consumption-driven economic growth and liberal trade policies in the developed country’s export markets. Japan and South Korea took advantage of the opportunity by introducing new products and processes that made their exports highly attractive and competitive. Other East Asian economies followed suit, moving into labour-intensive operations, complementing Japan and South Korea, in this export-oriented industrialisation mode.

This does not mean that there is such a thing as an East Asian model, for there are important differences between countries. While Japan and South Korea have relied heavily on conglomerates, Taiwan’s industrialisation was driven essentially by small and medium enterprises. Likewise, foreign direct investment has played a pivotal role in Southeast Asia and China, quite unlike Japan or South Korea, where domestic investment has prevailed.

Export orientation has been the common denominator in all these cases. East Asia could produce more than what it was consuming, with sizeable trade and current account surplus, which have translated into hefty external reserves. Since one country’s surplus is the deficit of another, it is not difficult to understand why East Asia’s trade surplus is a reflection of the US’s trade deficits.

Economics textbooks tell us that such imbalances are unsustainable and that a rebalancing will take place, with rising demand for imports and stronger currency in the surplus country, and the deficit country experiencing the reverse. However, equilibrating forces have failed to correct the US-East Asia trade imbalances, given the US’s penchant for conspicuous consumption and the unique status of the US dollar as the global currency for international transactions and as a reserve currency for the central banks.

Contrary to theoretical reasoning, East Asia has enjoyed persistent trade surplus at the expense of the US for decades. This could happen simply because East Asia has been financing the US deficits, so that the US would continue to import from it. All that the US needed to do in this game was to issue dollar-denominated papers, which East Asian central banks would buy and keep.

The US-East Asia trade imbalances are also a reflection of the serious gaps in the equation between production and consumption on the one hand, and savings and investment on the other. What all this means is that the US has been consuming too much and saving too little, while East Asia has been good at saving a lot and consuming little.

To correct the trade imbalances, there is a need for East Asia to consume more and save less, and the US to consume less and save more. This in turn calls for price and expenditure adjustments on both sides of the equation, and not just in the US. The status quo cannot last for long, as the US debt is ballooning while East Asia is getting increasingly wary of its dollar-denominated assets.

The global crisis is partly an upshot of the dangerous fault lines in the world economy. Interestingly, the global recession has not done much to redress the trade imbalances, although trade flows have been drastically reduced in absolute terms in the wake of the crisis. East Asia’s exports have been declining in recent times due to depressed external demand, but so have its imports.

Most East Asian economies continue to garner trade surpluses, despite declining exports. In other words, countries that have been in the red before the crisis still remain in the red, despite shrinking gross domestic product (GDP).

What does all this mean for East Asia? Apparently, the economic crisis has revealed the risks associated with external demand. The US is unlikely to revert to the pre-crisis consumption levels after the anticipated recovery.

In any case, a return to the pre-crisis consumption levels is not an option for the US. The chances are the US will consume less and therefore import less, which means that East Asia must generate its own demand for its products in order to grow.
Instead of investing its huge savings in the West via deficit financing, East Asia should invest more within the region, thereby raising employment, income and consumer demand in the region while reducing its dependence on extra-regional markets.

This does not mean that individual East Asian economies must abandon their export-led growth strategy. This only means that they will have to import more from, and export more to, one another. This also means that exports will remain the main driver of growth for the East Asian economies, especially those with a small domestic sector.

The ratio of exports to GDP will, of course, vary from country to country, with smaller economies having higher ratios. In any case, it is important to ensure that there is no policy bias in favour of or against exports, and hence the importance of ‘neutral’ policies that will allow the market forces to determine the optimum level of exports.

Care must be taken to ensure that East Asia will not become an inward-looking entity, turning its back on the rest of the world. Such a reorientation will carry the prospect of East Asia failing to take advantage of the opportunities that exist elsewhere. For the world is too small to be fragmented into autarkies. East Asia must maintain its current outward-looking posture and continue to engage the rest of the world in this positive-sum game, in which all are winners.

The envisaged model entails a deeper regional economic integration, which may well be the end result rather than a precondition. Be that as it may, any new model will have to evolve on its own, albeit in a policy-driven fashion. There is also a need for a deeper regional capital market to funnel regional savings into regional investments.

All this would work only if the East Asian economies can bury the hatchet, close ranks, and let go of some sovereignty. What works for East Asia as a whole may not work for individual East Asian economies, were they to go it alone in the pursuit of a new model of their own aimed at reducing their dependence on exports. Exports and imports will therefore remain indispensable, although the contents and the directions of trade flows may change significantly for individual economies.

In the new paradigm, where the bulk of East Asia’s trade revolves around East Asia, the greenback will no longer dominate. This means that the US will have a somewhat lower profile in East Asia’s trade matrix with bilateral near-balances, so that the question of the need for the East Asian financing of the US current account deficits will no longer arise.

Any new model for East Asia, in the final analysis, must be able to solve the global imbalance problem, to which the ‘old’ model contributed gleefully. Rebalancing warrants simultaneous adjustments on both sides of the divide, namely the US and East Asia. While the US must spend less and save more, East Asia needs to spend more and save less. This also underscores the need for East Asia to export less to, and import more from, the US than previously.

This article first appeared here in the New Straits Times.

Mohamed Ariff is Executive Director of the Malaysian Institute of Economic Research (MIER).

1. The de facto ‘free trade area’ in East Asia
2. East Asia must share Obama’s leadership to keep trade open
3. The financial crisis and East Asia

Since opening up in a big way in the early 1990s, China has made amazing progress on the economic front, thanks mainly to its highly pragmatic, market-friendly policies.

China has emerged as the manufacturing warehouse for the whole world, facilitated by massive inflows of foreign investment into the country. China has moved up the development ladder rapidly, fuelled by blazing double-digit growth rates.

Its export-led growth strategy has paid handsome dividends. It is already the fourth-largest economy in the world and the second-largest in Asia. In purchasing-power-parity terms, China recently replaced Germany as the third-largest economy in the world.

But this growth strategy has rendered China’s economy vulnerable to external fluctuations, as trade accounts for more than 40 per cent of its gross domestic product (GDP), which is very high for a continental economy.

China is affected by the current global crisis, not only by the slump in external demand for its manufactures, especially in the United States and Europe, but also by its own exposure to the financial meltdown in the US, now that a large chunk of China’s vast foreign exchange reserves is shackled to dollar-denominated papers.

The global economic crisis has made huge dents into China’s exports, with exports shrinking month after month at the rate of 30 to 40 per cent year-on-year, in the first half of this year. This has understandably taken a toll on China’s growth performance, with GDP growth slowing down to 7 to 8 per cent from 12 to 13 per cent previously.

Still, China is not in recession, unlike many other economies. China continues to attract foreign direct investment, while such inflows have dried up for many others. Its external reserves are still growing, recently surpassing the US$2 trillion (RM7 trillion) level despite falling exports, while many others are headed in the opposite direction.

The World Bank recently upgraded China’s growth for this year to 7.2 per cent from 5.5 per cent. China posted an even more impressive 7.9 per cent growth in the second quarter.

In short, China is seen as the beacon of hope in these days of gloom and doom. This has led some observers to think China will lead East Asian economic recovery and thereby spearhead a global economic turn-around. But this faith in China as saviour may be misplaced.

China’s imports from the rest of East Asia consist mostly of raw materials, intermediate products and components and parts, the bulk of it turned into manufactures for exports. China’s imports of consumer products from the region account for no more than a small proportion.

China’s imports from its neighbours have plummeted in the wake of the slump in China’s own exports, although the Chinese economy is growing at 7 to 8 per cent, because China depends largely on domestic production for its own consumption, which does not spill over to the rest of the region through trade.

Therefore, China will import more only if it can export more. For this to happen, the demand for China’s exports in the US and European markets must first recover.

In other words, the global economic crisis must end where it began, namely in the US. A modest 3 per cent growth in the US would mean a lot more to the global economy, especially the East Asian economies, than double-digit growth in China.

And China cannot possibly grow at double-digit pace until the US economy is completely out of the woods. China cannot substitute the US as the main locomotive for the world economy, even if it were to replace the US as the world’s largest economy. Chinese consumption is unlikely to be anywhere near that of the US, even if the Chinese economy were big enough to rival the US$14 trillion American economy.

China is by no means free of woe. Current growth of 7 to 8 per cent is as painful to China as negative growth is to, say, Japan. In China, 1 per cent less growth means four million fewer jobs.

Official unemployment numbers conceal massive underemployment and disguised unemployment, especially in the western provinces. China’s debt-GDP ratio of 18 per cent also understates the weight of the debt burden, as it excludes many indirect debt items such as local government borrowing, debt of state-owned enterprises and bad loans of state-owned financial institutions. All in, the ratio of debt to GDP could exceed 50 per cent.

Fiscal problems are emerging. A fiscal deficit of less than 3 per cent targeted for this year looks fairly sanguine, but government revenue has fallen by 2.4 per cent in the first half of the year, a far cry from the planned 8 per cent increase, while forgiven debt is expected to balloon along with development expenditure.

Some analysts believe that China’s 2009 fiscal deficit could soar as high as 10 per cent of GDP.

More worrisome is a bubble in the making, creating the illusion of economic recovery. Some of the fiscal stimulus seems to have been funnelled into equities, contributing to China’s booming equity markets. There is the danger of asset bubbles being mistaken as harbingers of economic recovery.

The rebound in the second quarter was largely attributable to massive government spending from a stimulus package of 4 trillion yuan, which is to be spread over a two-year period. As investors become addicted to stimulus, they may ask for more, while budget deficits will limit the space for more.

China could become an epicentre of a new crisis if the bubble grows and bursts. This not to suggest equity market bubbles exist only in China: while stocks in Shanghai were up 85 per cent in the first half, they climbed by 83 per cent and 61 per cent in Jakarta and Mumbai respectively, not necessarily backed by strong fundamentals. It appears that the stocks are running ahead of fundamentals, which is scary.

But stock markets are no substitutes for export markets. Stock indices are not a good barometer of the real sector of the economy. For economic recovery, the real sector must rebound. The signals thus far are pretty mixed, with some reported improvements in industrial production in several countries, including China. What is unclear is whether these are just blurbs or the beginning of an uptrend.

It is the US, and not China, that can lead the recovery. Indeed, China’s own recovery is contingent upon the US recovery in the first place.

China’s asset bubbles bursting would be a double whammy for East Asia, in which case China will become a part of the problem rather than the solution.

Mohamed Ariff is the Executive Director of the Malaysian Institute of Economic Research (MIER).

This article originally appeared here in the New Straits Times.

1. Fixing global economic imbalances
2. The long and rocky road to global recovery
3. World economy not quite out of the woods yet

The media everywhere are abuzz with talk of an impending, if not imminent, recovery for the ailing world economy in general and emerging economies in particular. This is based on signs of improvement in industrial production, corporate profits, stock market performance, etc.

Increased industrial production in the emerging Asian economies, including South Korea, Singapore and Thailand in recent months, equity market vibrancy in Japan, China, India and Vietnam, and improved profit figures from Goldman Sachs, JP Morgan Chase and the Citigroup Inc in the United States are among the beacons of the much anticipated recovery.

Some analysts are confident the recession will end in the third quarter. What is not clear is whether recovery will begin as soon as the recession ends. Much would depend on what constitutes an ‘end to recession’, and what is meant by ‘recovery’.

Some see a bottoming-out of contraction as the end of recession even though the economy may still be contracting, albeit at a slower pace. To others, recession ends only when the economy stops contracting.

Thus far, most crisis-hit economies have shown discernible improvement, prompting some to suggest that the worst is over for them, with their negative gross domestic product (GDP) growth easing in the second quarter.

For the US, the largest economy in the world, the recession appears to have lost momentum with its GDP contracting by 1.5 per cent in the second quarter, contrasting with the 5.5 per cent contraction in the first quarter. But there is no certainty that the US economy will register positive growth in the third quarter.

There is no doubt that the recession will make a huge dent in the major economies this year. The Asian Development Bank has forecast that the US economy will shrink by three per cent this year, while the European Union and Japan will contract by 4.3 per cent and 5.8 per cent, respectively.

There is no recession in China and India, given their large domestic sector and robust domestic demand, but this does not mean they are unaffected. Growth rates in China have climbed down considerably from 12 to 13 per cent previously to seven to eight per cent now, while India’s growth has slowed from 9 to 10 per cent to 5 to 6 per cent.

Emerging Asian economies are showing more vibrant signs, leading some observers to think that Asia will lead the global economic recovery, and that such a recovery is around the corner.

A word of caution: the numbers may have been misinterpreted, showing at best that the crisis-hit economies are stabilising. Signs of stabilisation should not be mistaken for signs of recovery.

There is the danger of these economies settling at a low-level equilibrium, in which case the anticipated recovery will not materialise.

Nor does positive GDP growth per se necessarily signify economic recovery, especially if it falls far short of pre-crisis levels. Strictly speaking, there will be real recovery only when normalcy returns, and that will take a long time.

It is not easy to be pessimistic amid talk of ‘green shoots’ and ‘glimmers of hope’, but such perceptions ignore hard realities on the ground. The root cause of the global economic crisis remains – namely global imbalances between saving and investment, consumption and production, exports and imports, etc.

This crisis will persist until the global economy begins to rebalance itself. There are no such signs yet. Countries with chronic balance-of-payment deficits remain in the red, while surplus countries continue to chalk up surpluses despite reduced exports.

The much needed rebalancing is not taking place, apparently because crucial price and expenditure adjustments have been slow. While interest and inflation rates have changed everywhere, exchange rates are headed in the wrong direction with the US dollar staying too strong. There can be no meaningful rebalancing without the greenback weakening.

Meanwhile, increased public expenditure for fiscal stimulus has exacerbated fiscal imbalances. While it is not difficult to defend budget deficits during difficult times, such exercises to reflate ailing economies have limits. Fiscal stimulus packages may have worked better in some countries for a variety of reasons, but the impact tends to be one-off.

The ‘green shoots’ seen in some economies, due largely to huge fiscal spending, may not be sustainable. The governments may spend more to keep the momentum, but there are limits. There is the risk of recovery fading without additional pump-priming.

There is no solid basis to postulate that a recovery is under way. Unemployment is particularly worrisome. In the US, where it is at a historic high, the situation is likely to get worse in the near term.

South Korea saw an increase in unemployment in June, despite 2.3 per cent GDP growth in the second quarter, stoking fears of a ‘jobless recovery’.

Jobs tend to take longer to recover than production, as shown by the Korean experience during the 1997-98 crisis: while industrial production was back to its pre-crisis level by end-1998, employment took another 18 months to recover.

The global economy is still in the doldrums and is unlikely to move out of the woods in the near term. Improvements in industrial production and exports reported in some countries may be due to the replenishment of depleted stocks rather than increased consumer demand. The 9.3 per cent drop in Singapore’s manufacturing in June, after rising in the previous two months, lends credence to this view.

It appears that the ‘green shoots’ may be short-lived. There is a 50 per cent chance of a double-dip, and a 30 per cent chance of a triple-dip. The road to economic recovery is likely to be bumpy and winding.

Mohamed Ariff is the Executive Director of the Malaysian Institute of Economic Research (MIER).

This article originally appeared here on the New Straits Times.

1. World economy not quite out of the woods yet
2. China’s rocky road to prosperity
3. Happy days ahead? Policy implications of the global recovery for India

Recently, the StarBizWeek in Malaysia convened a roundtable discussion to gauge the impact of the global crisis on Malaysia, best and worst-case scenarios, and how the country can mitigate the effects of a protracted downturn while keeping an eye on addressing several structural shortfalls to ensure long-term sustainability.

The panellists are former Bank Negara deputy governor Tan Sri Dr Lin See Yan, Meridian Asset Management Sdn Bhd chief investment officer Tan Beng Ling and Malaysian Institute of Economic Research executive director Prof Datuk Mohamed Ariff Abdul Kareem. The discussion was moderated by P. Gunasegaram, managing editor of The Star.

How and in what areas is the country affected by the crisis?

Mohamed Ariff (MA): This crisis has now affected almost every sector of the economy. The manufacturing sector in particular is the hardest hit, largely because of the downturn in the US and Europe with exports falling since October.

The difference between now and the Asian financial crisis of 1997 to 1998 is that the manufacturing sector was almost intact then thanks to growth in the US and Europe but this is no longer true. Even the services sector has been hit with fewer tourists coming in. Retrenchments are taking place in almost every sector now.

What’s your latest forecast for 2009?

MA: For this year, the latest forecast by MIER is 1.3% GDP growth but that is based on assumptions that no longer hold.

Things are very fluid, chances are we’ll be revising the figures downwards. I cannot rule out the possibility of a full-blown recession this year – it’s more than a theoretical possibility.

The problems are very serious because it’s deepening by the day.

The best case scenario is a GDP growth of 0.5% if we use 2001, when the dotcom bubble burst and the electronics and electrical industries were in a downcycle, as a benchmark.

Then, Malaysia registered a growth of 0.5%.

What do you expect as the worst-case scenario?

MA: I don’t think it will be as bad in terms of GDP contraction this time around compared to 1997-1998. That year we saw a GDP contraction of 7.5%.

My fear is that we’re likely to stay at the bottom for a longer period of time.

Ten years ago it was a quick recovery, sharp contraction, sharp recovery but this time around we may be stuck in the mud for two to three years.

How much of this is a confidence game?

Lin See Yan (LSY): I’ve been watching the crisis unfold for a year now and every time I look at it, a few things come up. One is the continuing uncertainty.

The general feeling is that nobody knows what is going to happen in the next three years.

What makes it worse is that the recession that started in the US has now gone global and that’s what’s driving the uncertainty.

Every time we pick up the papers, we read that things are getting worst. In fact, Japan was getting better three weeks ago but is now getting worse.

The full impact is unclear and one of the things we don’t know is how much protectionism and how much beggar-thy-neighbour policies will come through.

Some of it is already there. The Obama administration is giving out mixed signals.

On the one hand, the administration tells US companies to use American steel but on the other hand, they say they’ll honour all their trade agreements.

If there’s a large contraction this year, do you expect a bounce back next year, at least?

LSY: We’re so used to it (the expectation of a rebound next year), our minds are trained to it. This is my eighth recession and it looks as though it’s going to be the longest. The longest I’ve witnessed is 13 months, the current one is almost 13 months and will go longer.

For most, we had bounced back fairly fast – even in the crisis 10 years ago. But this one is unusual, I’ve never seen anything like it in my life.

The thing that worries me is that it’s unhelpful to talk about growth next year for a number of reasons.

Whatever is said now will not make much of a difference because people are already feeling it and it’s affecting their expectations.

People told me that PA Samuelson (a notable academic economist), who said a year ago that the US economy would recover by the end of this year, is now saying that the economy will be lucky to recover by the end of 2010 and that again depends on what is defined as recovery.

He also said that the economy will not get back to normalcy until 2012 or 2014. Maybe he’s pessimistic but what I’m trying to get through is that it’s not useful now to place scenarios and if it’s to be done, then plan for the worst scenario.

You’re saying that the uncertainty is too great?

LSY: Yes, so plan for the worst-case scenario, anything less than that is fooling ourselves. In a situation like this, the risks are higher for doing less than doing more. So do more please.

What will be your worst-case scenario?

LSY: My worst-case scenario is a recession by the end of the year. Companies are already cutting their forecasts, the second-half of last year was still good but the first-quarter of 2009 will see quite a slowdown.

People are becoming more cautious, they’re holding back on investments and spending. There’s a loss of confidence among investors and consumers. Investments are either being deferred or if the slump prolongs, then it’ll be scaled down. Pessimism breeds pessimism.

Beng Ling, what’s your take on a recent report quoting a German minister who said he expects a recovery towards the last quarter of 2009? Is that optimistic?

Beng Ling (BL): I believe this downturn is going to be draggy because we can’t export our way out of it like we did 10 years ago.

I worry that this global recession will spur the developed nations to turn inwards and there may be more protectionist tendencies coming up in the next five years as they grapple with their domestic economic problems.

We also have to be prepared for a potential structural change in global trade and not expect the kind of trade we had in the past.

What about stimulating certain sectors such as construction or even putting more money into consumers’ pockets?

BL: A stimulus package can only cushion the impact of a severe recession. It’s a perception thing – when there’s news of job losses, people will lose confidence and won’t spend.

MA: This crisis has been in the making for almost a decade and this is simply a result of a serious fault line in the global economy and growing imbalances.

This cannot be corrected in such a short time. Governments around the world are running out of options in fighting this crisis. Monetary policy is almost exhausted and a number of countries are already facing a “liquidity-trap” situation.

A number of countries are also facing fiscal fatigue. Policies on exchange rates are also not helping because they’re erratic.

Strong currencies will not help countries that are in recession to get out of it.

What is the adjustment process that needs to be made to the international economic situation?

MA: We need coordinated efforts such as coordinated monetary, fiscal and exchange rate policies. However, there is the sticky question of sovereignty. Governments are becoming more nationalistic and that’s not going to help at all.

We’ve to cut across national boundaries. That’s easier said than done, of course.

BL: Yes, it’s easier said than done. The government in China, which is facing 20 to 30 million unemployed, will take care of its own first.

What are our positive factors in terms of facing the crisis?

LSY: The biggest thing going for Malaysia is palm oil. Besides being a food item, there are many things that we can do with it. It may be our saviour.

MA: There are many positive factors going for us. Compared to 10 years ago, Malaysia’s fundamentals are better. We have a current account surplus, before we were running deficits. The reserves are in much better position with more than 7 1/2 months equivalent of reserves for imports and we have a well-capitalised banking sector with low non-performing loans. Our external debt is small compared to what it was 10 years ago.

BL: In general, the corporate balance sheet is also better.

LSY: But don’t forget that in a bad situation, balance sheets can also deteriorate very fast.

That’s why the Government needs to do certain things to maintain that strength and part of it is to make people a bit more confident about the future.

But I think it’ll be a mistake to look at this problem and stimulate only certain sectors. It is a macroeconomic problem and one of lack of aggregate demand. The government has to look at it from that angle and of managing expectations.

The full and original interview transcript may be found here.

1. The ASEAN-China FTA: driving competitiveness in Malaysia
2. Malaysia: a year of economic and political reversals
3. Can Malaysia graduate?

A common currency for East Asia has been bandied about as a long-term goal, which may take many decades to materialise. No doubt, a common currency would be a great boon to intra-regional movement of goods and services and factors of production. But this proposition would make sense only if East Asian economies are successfully integrated and the thorny issue of national sovereignty can be sidestepped. A currency union for East Asia would represent the highest form of regional integration. It is important that this goal is not lost sight of, although it is extremely difficult to draw a timeline for it. It is best achieved through evolution, not decree.

While the common currency idea is kept on the back-burner, it will be in the interest of East Asian economies, in the interim, to cooperate and coordinate with one another in their exchange rate management.

It will not be difficult to put in place a coordinated basket peg so that there can be flexible, but stable, exchange rates in the region.

This will facilitate increased intra-regional economic transactions and render the region financially resilient.

The currency basket need not necessarily be identical. Weights assigned may vary depending on the trade patterns of countries. However, it will be necessary to have close coordination on macroeconomic matters so that exchange rate alignment stays in sync with realities.

Realising that the medium-term coordinated basket peg proposition will take a while to be debated and adopted, it will be be prudent for East Asian central banks to begin the process by immediately initiating networking.

This is urgent in the face of current erratic dollar movements.

As the global exchange rate system is in a state of flux, it is important for East Asia to work towards some kind of convergence of exchange rate policies in the immediate term.

There has to be a clear understanding among foreign exchange authorities on the kind of interventions that may have to be made in the near term.

A well-coordinated and concerted action by East Asian countries will be more effective rather than these countries going at it alone. A consultative council of East Asian central banks would provide an avenue for meaningful interaction.

Regional trading arrangements, aided by geography, have moved East Asia closer to a regional trading bloc. But regional cooperation in trade and investment would be incomplete without cooperation on exchange rates. For a start, priority should be given to building the necessary regional institutions and formulating formal mechanisms similar to those of European integration.

Exchange rate integration, given East Asia’s diversity, is likely to be a long and challenging process. Despite having greater political will and less cultural, economic, and political diversity than East Asia, it still took Europe 50 years to come together as a monetary entity.

It will not be easy to construct a collective exchange rate system that would be acceptable by all participating countries. A transitory regime, such as a coordinated basket peg system, could be the first step.

The merit of a basket peg is that it has the attributes of a currency peg without being shackled to any single anchor currency.

This means the exchange rate of a currency will be tied to a basket of key currencies (e.g. euro, dollar and yen) so that variations in the exchange rate will be smaller due to the offsetting impacts of currencies in the basket.

A common basket for all regional currencies would mean the exchange rates of regional currencies would not deviate much from one another if the weights assigned to the component currencies in the basket are identical for all. That seems a tall order, as the weights would depend greatly on the trade patterns of individual countries.

An identical foreign exchange rate regime for all East Asian countries is neither feasible nor desirable for now, because the grouping is highly heterogeneous with different economic and market structures with varying degrees of sophistication, and balance-of-payments adjustments may not be forthcoming to the extent that exchange rate movements are constrained.

A more down-to-earth approach would be to balance pragmatism and idealism. We should look for exchange rate arrangements that would allow commonality with some latitude for variation.

Given the preference for hybrid regimes in East Asia, a coordinated basket peg system could serve as an acceptable premise for exchange-rate management, providing flexibility and stability in exchange rates.

A common denominator would be the composition of the currency baskets. One suggestion is that the euro, dollar and yen constitute the basket for all East Asian countries (except Japan, whose currency is the yen). To avoid being put into straitjackets, weights given to the anchor currencies may vary from country to country or from time to time.

As the movements in euro, dollar and yen would tend to be partially offsetting, the regional currencies would be fairly stable vis-a-vis currencies in the basket, and since the regional currencies would also be tied to similar baskets, intra-regional exchange rates would be even more stable.

This system cannot ensure that all regional currencies move strictly parallel, but it can ensure they all move in the same direction, somewhat in tandem, appreciating or depreciating together.

Such a system could work smoothly, especially if there are no serious bilateral trade imbalances within the grouping.

All this would call for continuous consultation among East Asian countries, especially regarding macroeconomic policies. East Asian central banks will have to work very closely with one another, and this process will have to be institutionalised. But there is no need for a supranational East Asian central bank in the absence of a single currency.

Emeritus Professor Datuk Dr Mohamed Ariff is executive director of the Malaysian Institute of Economic Research. This article was originally published in the New Straits Times , January 24 2009.

1. China’s monetary and exchange rate policy and the global economy
2. China’s exchange rate policy dilemma
3. India’s exchange rate policy needs a re-look

Against a backdrop of quarter-by-quarter falls in the country’s economic growth rate, 2008 was more about rare economic highlights than milestones.

In early 2008, Malaysia’s last two economic corridors, the Sabah Development Corridor and the Sarawak Corridor of Renewable Energy were launched to bring further social and economic development to the economically backward states of Sabah and Sarawak in East Malaysia. These economic corridors, including the three launched earlier in Peninsular Malaysia – Iskandar Malaysia, the Northern Corridor Economic Region and the East Coast Economic Region – aim to ensure a more regionally balanced socio-economic development of the nation. There are, however, criticisms of the speed of implementating projects.

In early June the government announced that it would remove controls on the price of petrol and allow fluctuating prices; a move that was unprecedented, given that the surge in global oil prices resulted in a ballooning fuel subsidies bill. Petrol subsidies were not totally removed, only decreased, and petrol pump prices were revised from time to time to reflect market price movements.

In December, the government announced that it would set a ceiling price at RM2.70 a litre, and give a subsidy of 30 sen per litre if the market price moved above RM1.90 a litre. Any fall in the market price to below RM1.90 a litre will result in the imposition of a tax, the quantum of which is still being discussed.

The central bank’s Overnight Policy Rate was kept at 3.50 per cent over the first three quarters of 2008, even though GDP quarterly growth had been moderating successively, from 7.1 per cent to 6.7 per cent to 4.7 per cent. In November, the central bank finally reduced its OPR by 25 basis points to 3.25 per cent.

Recently published third quarter data indicate that the country’s overall balance of payments recorded a deficit of RM31.5 billion, as compared to a surplus of RM26.2 billion in the previous quarter. This deficit was due largely to a significant drop of RM61.5 billion in the capital and financial account. In the previous quarter, the drop had been just RM12.3 billion. The current account balance, on the other hand, remained positive with a surplus of RM38.7 billion, a slight increase from the surplus of RM37 billion recorded in the previous quarter.

The fuel subsidy cut in June resulted in inflation soaring to 7.7 per cent in that month, compared to 3.8 per cent in the previous month. Compounded by escalating food prices, the inflation rate rose further to 8.5 per cent in July. By November, the inflation rate eased to 5.7 per cent.

In November, Malaysia finally announced a 7 billion-ringgit economic stimulus package to avert recession in 2009. The package has been criticized by some quarters as too late, and too little to adequately contain the impact of the global economic crisis on Malaysia. Criticism has also been leveled at how the 7 billion ringgit will be spent, as the package will go mostly to towards the construction and upgrading of low-cost housing units, schools, roads and public amenities.

Political tsunami

The results of Malaysia’s 12th general election on 8th March 2008, which has been hailed as a ‘political tsunami,’ a ‘political near-revolution’, and one that its citizens will be talking about for years, revealed an immense groundswell of public opinion against the ruling government and/or a rejection of race-based politics. Liberals regard it as a new dawn for democracy in Malaysia, a positive move towards constructive political development, and good for the nation’s long-term future.

For the first time since Malaysia gained its independence in 1957, the ruling coalition government lost its crucial two-thirds supermajority, which for a long time had enabled it to amend the constitution at will to its own advantage. On top of that, the government lost five of 13 state legislatures, as compared to only one in the 2004 election.

For the quiet Malaysian, the political change had been long in coming. There have been persistent complaints that the government has not done enough to tackle massive institutionalized corruption, issues of poor governance, non-tranparency, ethnicised politicking, and religious and ethnic insensitivities. Many share the view that the government has lost touch with the very people who voted them in.

The message of the loose coalition of opposition parties was loud and clear: that they are a viable alternative, and would tackle the issues uppermost in people’s minds. The success of the opposition alliance can be attributed to its ability to use new technologies such as blogs, mobile phone text messages and YouTube during the 2008 election, a milestone in Malaysian politics, to circumvent tight media control by the government.

Malaysia appears to have been forced by the success of the opposition parties in the 2008 election to embark on a bout of democracy. Already there are signs of change within the ruling coalition, as change will be necessary to its continued political survival.

But after a half century in power, it is hard to change, and there is much internal resistance to it, so UMNO’s days may at last be numbered.

–

Quah Boon Huat is a research fellow at the Malaysian Institute of Economic Research (MIER). Prior to joining MIER, he worked in the banking and stockbroking industry.

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead

1. Economic and political developments in Malaysia: new players new game?
2. Malaysia: the political tide runs out
3. Politics without priorities in Malaysia