Malaysia is currently at a crossroads, and going through some significant structural adjustments.
It would appear that a significant amount of “soul-searching” has gone into restructuring the economy and the stock market in recent years in an attempt to “get it right”. The Economic Transformation Programme (ETP) is well underway, subsidy cuts have continued, the fiscal imbalance is being addressed and more mid-cap IPOs are planned.
In short, progress is underway but the market seems impatient: put simply, the pace of transformation expected by the market appears unrealistic. We view the structural changes underway as long-term positives for the country and for the market. However, these adjustments are likely to be unsettling for the market in the short to medium term. Allow us to tell you why.
First, we must clearly understand the structural challenges. The country has an increasingly large, young population, with approximately 50% of the population below 25 years of age. This segment of the population will likely cost the government more in terms of education and basic infrastructure — we are projecting a fiscal deficit of 5.1% in 2011 and 5.0% in 2012. This greater number of emerging young voters will also mean greater pressure on the country’s fiscal position.
In addition, there is the worrying trend of growing unemployment among young graduates (12% as of 2009 or 60% of unemployed). A more disturbing aspect of youth unemployment, which has not yet been highlighted, is accelerating joblessness amongst Malaysia’s recent graduates.
Adding to this is the issue of urban drift. Malaysia is the second most urbanised country in Asean, with an urbanisation rate of 72%. In spite of this, Malaysia’s rate of urbanisation is forecast to grow at the fastest pace in the region, 2.4% per annum according to the Central Intelligence Agency (CIA) over the next five years. The demands on basic infrastructure should not be underestimated.
At the same time, the domestic asset management industry is also evolving. Our recent meetings suggest that local fund managers are deploying more assets offshore to seek growth and diversification. Non-Malaysia investments now account for 14% of domestic funds, in sharp contrast from six to seven years ago when offshore investment was insignificant at less than 5% of total funds under management, according to our estimates. This has significant repercussions for the market in the long term.
In the medium to long term, we expect Malaysia’s premium equity valuations against the region, at about 10%-30% since 2002, to gradually decline as the “support” mechanism from incremental inflows from domestic funds eases.
This trend is also consistent with Malaysian companies deploying more capital offshore. Offshore earnings accounted for 32% of total market earnings in 2010 and based on our coverage universe, we project them to rise to 36% by the end of 2011 (10% in 2005). We have seen significant diversification in Malaysian companies’ non-Malaysian earnings by geography and sector over the last five years.
Our research reveals Malaysian companies have begun to benefit from Asean growth markets and in particular, earnings derived from the financial, commodity, telco and gaming sectors — sectors which are growing strongly and/or cash generative. This is a market trait not offered by any other regional market and will help support Malaysia’s valuations as domestic funds gradually deploy funds offshore.
Last but not least, Malaysia is finally cutting back on subsidies to address its fiscal deficit. This will affect consumption patterns and the cost structure of manufacturers heavily dependent on cheap food and fuel. Though a bitter pill to swallow for many Malaysians, the cutback in subsidies is a positive and much needed move, in our view. It tells us that the government is increasingly politically brave enough to implement unpopular measures, and is committed to maintaining fiscal discipline, which is an imperative for the long-term health of the economy.
These structural adjustments may be unsettling for the country and the market, but are inevitable steps as the country moves towards developed status.
There has been meaningful progress so far. To the surprise of skeptics, since it was established in 3Q10, Pemandu, the agency tasked with implementing the ETP, has achieved some significant milestones already. The programme has clear targets and key performance indicators, which it so far has been delivering against. Seventy-two projects have been kicked off, with total projected investments of RM106.4 billion over five years and 298,865 new jobs anticipated.
Of these investments, about half are operational today or have already broken ground. Pemandu is also supporting potential privatisations in the services utility sector and recognises the Greater KL, financial services and commodities as focus sectors/areas with the greatest potential to contribute materially to the ETP.
Also encouraging are the recent moves by Bank Negara Malaysia towards liberalisation of the capital account. The recent relaxations, removing caps on direct investment abroad, or outward direct investment (ODI) and the amount of loans residents can source from offshore, is a solid indication of Malaysia’s commitment to the liberalisation of its financial account, phasing out capital controls that were implemented during the Asian financial crisis.
These moves are healthy for the development of the economy for a number of reasons. Non-resident corporates were already able to settle for goods and services in ringgit. Now they are also able to lend out ringgit they have obtained. Also, the removal of the RM50 million ODI cap makes it easier for Malaysian companies that meet prudential requirements to invest overseas, thereby helping to alleviate some of the pressure on the ringgit to appreciate.
These structural shifts may not necessarily be positive for an equity market hungry for “quick fixes” or news flow on execution. Policy or project implementation will take longer and this might frustrate equity investors. Pemandu has made significant progress in pushing ahead with policies and processes to address the shortcomings of the economy, but it might take time for the impact of these changes to filter down tangibly to equity investors.
In short, Malaysia is going through a major transition which should, in time, be for the better. However we expect the road ahead to be bumpy, economically, politically and structurally for the market.
Su-Yin Teoh is head of Asean and Malaysia strategy, Deutsche Bank. The views expressed are those of the author and do not necessarily reflect the official views of Deutsche Bank or its related entities.
This article appeared in The Edge Financial Daily, June 13, 2011.