Sunday, March 1, 2009

How Succesful Are Malaysian Government Policies To Prevent Another Recession?

Indicators Malaysian economy is heading towards recession:

(1) Unprecedented fall in exports. Malaysian economy is export-driven. Exports account for about 120% of our GDP. For the first 9 months of 2008, the export sector recorded a robust growth of 16% before collapsing 13.4% in the last quarter. There is just no clear sign that global economy will head towards recovery, not until at least 2010. To make things worse, a new tide of protectionism is about to sweep global trade. India has banned its import of toys from China. Meanwhile in US, the latest fiscal stimulus mentioned that all infrastructure projects must use only American-made steel. One thing for sure, de-globalisation is extremely bad. It often results in retaliation. For export-led economy, fall in exports will lead to collapse in AD. As AD shifts left, real GDP will decline

(2) Very low consumer confidence. Consumer confidence is another catalyst for economic growth. Now the biggest concern for every working individual is whether they are still able to secure their current employment. News like large companies incurring millions of losses, bankruptcies, retrenchment, wage cut, cancellation of pay rise & no increment is good enough to create spending phobia. Due to uncertainties, people will not dare to assume large commitments. Spending on large items like buying a house, getting a new car etc will fall. Also people will tend to spend less, more will choose to eat at home etc while most will increase their savings for rainy days. Savings habit will normally develop in turbulent times, a phenomenon Keynes called as the paradox of thrift. Collapse in C will shift AD curve leftward. Real economy contracts

(3) Decline in private investment. Firms in Malaysia are not spared. Many are reported to have cancelled their expansion plans. Some 43% are reported to decrease their fixed capital spending in response to poor consumer response internally & externally. As private investment is a component of AD, again real GDP will fall triggering the risk of recession. However this also depends on the duration of slowdown or recession. If prolong, firms will probably make a larger cut in investment spending. By then productivity growth may be affected. Unit costs will increase & our exports will lose its price competitiveness. This is base on supply side arguments

What can Malaysian government do?

(A) Increase public investment

Government’s role is extremely crucial. Again, we have 4 components of aggregate demand (AD) & we have seen a collapse in exports (X), consumption (C) & investment (I). The forces of these 3 are large enough to pull AD downward offsetting any increase in public spending. Hence, government needs to act fast & present a bigger budget this round before the de-multiplier effect eats into the economy. More funds should be allocated to development projects like road building, bridges, schools, hospitals etc. An increase in G will have direct impact onto AD

It can also positively influence C & I. Think about this. As more contractors are engaged, they will get windfall profits. These can be channeled onto capital spending to expedite the project. Simultaneously, more people will be absorbed into employment & this will overall increase spending into the economy. If all these work as predicted, AD will begin to rise. Real economy will expand once again countering the risk of recession

Arguments for (A) (evaluations)

(1) Budget could be too small. If the government is going to present another mini budget like the previous RM7bn, probably it will not be strong enough to offset the collapse in 3 other components of AD. Some economists estimate that anything less than RM15bn will not produce visible results. I just couldn’t understand why Malaysian government is so obsess with the widening budget deficit figure. Tough time calls for tough measures! Our deficit is nothing compared to those in US, UK, France, Germany & many other developed economies. So let’s see what will the Deputy Prime Minister present in his budget at the coming 10th March

(2) Implementation & effect lags. This is probably fiscal policy’s largest setback. It may take months or worse years for a development project to take place in Malaysia. It is commonly due to problems like excessive red tapes, complicated legal procedures etc. By the time it’s put into action probably the economic situation has changed & the policy is futile. Also we need to consider that after instituting it, there could a period before the effect can be seen in the economy. The government has promised Malaysian a more efficient public transport, more availability of LRT routes etc years ago but until now, the project is not seen anywhere

(3) Depends on monetary policy. Government spending itself may not be sufficient to prevent the onslaught of recession. It needs to go hand-in-hand with monetary tools such as reducing interest rates & the lowering of SRR (Statutory Reserve Requirements, which are not covered in Edexcel A-Levels)

(B) Tax reduction

This is another tool under the fiscal measure. Tax reduction will raise disposable income, thus giving workers more spending power. With an increase in household spending, AD will increase thus countering the risk of recession. Lower corporation tax especially onto SMEs (Small Medium Enterprise) will automatically increase the ability & willingness to invest onto capital goods. AD increases. These 2 also have supply-side effects. For instance, lower income tax may increase the productivity of workers. People will want to work longer hours as the more they work, the more they get to keep for themselves. As for firms, capital expenditure will raise productivity & increase output, resulting in lower unit costs

AD is influence by C, I, G & (X-M)
Source: economicshelp

AS is influence by the increase in the quantity & quality of factors of production & production costs
Source: economicshelp

Arguments for (B) (evaluations)

(1) Tax cut could be too small. If the tax cut is insignificant, people may not be induced to spend. For instance I strongly feel that paying the amount of tax at RM200 & RM180 (which are deducted from the paycheck every month) doesn’t make much difference anyway. The same goes for corporation tax. If the tax rate is markedly reduced, not only it will work to fuel spending, but also reduce cases of tax evasion

(2) It can’t be executed with high frequency. Changes in tax, unfortunately will be announced only once a year, & that is during the period of Annual Budget. It takes place every September in Malaysia. Compared to monetary policy, interest rates decision is made every month. As such it has the full-fledged flexibility to quickly react to any changes in macroeconomics condition. Unlike tax policy, any decisions decided much earlier are finalised & will be put in place throughout the year. However one can also argue that tax policy may be a better tool than interest rates since it could be targeted to certain segments of the economy e.g. firms, employees, consumer goods etc. Once the interest rate is set, any changes will affect entire economic activities

(C) Slash interest rates

(1) Increase consumption. Since November last year, BNM had reduced the OPR (Overnight Policy Rates, some called it as base rates) by 1.5%, with the latest cut by 0.5%. Now it is standing at 2%, a level we last seen in mid 1980s when we had one of the worst recessions. Subsequently, many banks have reduced their base lending rates (BLR) from about 5.95% to 5.5% lately. In theory, lower lending rates means costs of borrowing had fallen & this should induce more people to borrow & finance big items on credit e.g. property. Alternatively, existing homeowners will be paying lesser on their loans & it means more cash available for other form of expenses. Lastly, lower OPR will normally be followed by lower fixed deposit rates. This creates a disincentive for savers & also inducing them to spend rather than save

(2) Increase firms’ investment. Lower interest rates, in theory will induce firms to borrow & finance the purchase of capital goods, setting up a new production plant, expand their operations etc as costs of financing these have fallen. Also it may increase the rate of return on capital

(3) Boosts exports. Lower interest rates, will lead to outflow of foreign investments or hot money. Some wealthy foreigners, foreign fund managers etc will withdraw & place their money elsewhere that offers more attractive interest rates, notably China & India which are still above 5%. As such RM will depreciate against foreign currencies thus boosting its exports. Simultaneously, weakening RM will discourage imports as foreign goods are now more expensive. Net exports will increase. As consumption, private investment & net exports are component of AD, their increase will shift AD rightward thus countering the risk of recession

Evaluations for (C) (arguments)

(1) Consumer confidence is very low. Lowering interest rates may not be effective to revive the economy if consumer confidence is very low. People may not want to incur additional financial commitment due to job insecurity. For existing property buyers, anything saved might not be spent onto other goods & services since they may want to build up their financial resources to brave rainy days. Look at Japan. 0% interest rate policy from March 2001 to July 2006 had failed miserably to jump start the economy. In US, interest rate is standing at record low of 0-0.25% & yet there is no sign of increase in lending activities. Besides, the government has imposed a floor on fixed deposit rates. This means, FD rates will not fall by much in the event of cut in base rates. Savers will continue to save rather than spend. Any effort to increase spending is muted

(2) Blunt tool. Monetary policy can’t be targeted to certain sectors of the economy unlike fiscal policy. Once interest rates are set, it will virtually have impact onto all economic activities. For fiscal policy, it can be targeted for instance increase spending onto ICT sectors, education, public transports etc. Also income tax can be increased onto people with higher income bracket while at same time lowering it for people with lower income

(3) Suitable only to control inflation. In the period of high inflation, interest rates can be raised indefinitely to slow down spending. Unfortunately, in the period of recession there is a limit as to how much rates can be cut. Once the base rates reach 0%, central banks will have to resort to other method e.g. quantitative easing. That’s what US & Japan are doing since their rates have rock bottomed

(D) Reduce SRR (Statutory Reserve Requirement)

A reserve requirement is imposed by financial regulators like central banks onto ordinary banks. It is proportion of deposits that must be held by commercial banks rather than lent out to borrowers & is usually held in a bank’s account with the central bank. The main purpose of SRR is to actually control the growth in money supply by affecting the commercial banks’ ability to create lending. As such in period of boom, normally SRR will be adjusted upward & in a bust like now, it will be lowered. Recently, SRR in Malaysia have been lowered to 1% (effective 1st March) from 4% November last year. According to economists, this should be able free up to RM16 billion into the banking system. With greater liquidity, banks will be able to lend out more money, facilitating economic recovery

Evaluations for (D) (arguments)

(1) Fall in borrowing. Sometimes, I strongly feel that it is worthless to increase liquidity in the financial system. Our monetary system is still flushed with liquidity amounting to RM 180 billion. Also the recession that we currently face differs in nature compared to those in the West, Their economies are crippled by acute shortage of liquidity as banks refuse to lend to each other as can be seen by the increase in say, LIBOR (London Interbank Offered Rate). Secondly, no matter how much we flush the system with, as long as people are reluctant to borrow the effort will be futile. In short, what matter is velocity of circulation of money. Good example, quantitative easing practiced by US, UK & even Japan failed to produce any visible results to date

(2) Banks have found ways to evade that. In many countries (not so sure in Malaysia), the effectiveness of reserve requirement have been questioned. Some places like UK & Canada have eliminated RR altogether or lowered them to negligible effects. This is because banks have found ways to circumvent RR, for e.g. banks in US commonly sweep money overnight from accounts that are subject to RR to accounts that are not. Some called this as ‘financial innovation’

(E) Currency devaluation

Monetary authority can intervene in the foreign exchange market, say by selling RM & acquiring other currencies like euro, pound & dollar. As RM weakens against all the currencies of our trading partner, in theory exports will become cheaper & this shall boost the demand for our goods. Simultaneously, weaker RM will discourage consumption of imported goods. Overall effect will be the in increase in net exports. AD shifts rightward, followed by an increase in real economy. There will be more employment too. Another way to look at this will be, greater demand for manufactured electronic & electrical goods, thus regenerating jobs

Arguments for (E) (evaluations)

(1) It is not the issue of price. The fall in the demand for our manufactured goods, raw materials & other intermediate goods is not due to price but rather the slump in the economic activities in US & European market. In fact, to be realistic we are not then only one affected. Other export-driven economies like China & Japan are severely hit too

(2) May not even increase employment. Bear in mind that many factories operating in Malaysia are multinationals. As such there is little we can do if they decide to cut employment. For instance, Intel said it planned to close down 4 of its sites which actually include the test facility in Malaysia, thus affecting potentially affecting more than 1000 workers

(F) Further improvement on education system

Government spending onto the education sector is equally important. In Budget 2009, a sum of RM70 million will be allocated to train nurses in training colleges under the Ministry of Health. Some RM615 million will be channeled to the construction of additional primary & secondary schools. Last but not least a large sum of RM14.1 billion will be allocated to institutions of higher learning particularly to finance the operating expenditure & research activities. Apart from affecting AD, it can also affect the AS in the medium term through the increase in productive capacity of Malaysian workforce

Arguments for (F) (evaluations)

(1) Teaching Math & Science in English? The success of the overall education policy to create a more productive & knowledgeable workforce depends on one decision that is yet to be finalise—teaching Math & Science in national language or English?. In the recent, there is a minor riot by some language conservatives that urge the government to revert the teaching back to Bahasa. If the Ministry of Education bow to all this, possibly the ambition to produce workers that are resourceful will be futile because AS curve may shift backward

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