Recent high-frequency global data is suggesting that forces from external headwinds cannot be underestimated. Events unfolding in the European economies have heightened risk aversion, exerting downward pressure on the real economies of Asia via weaker demand for Asian exports and, more importantly, destabilising the outflow of capital. As a consequence, business sentiment will erode while the external sector’s sluggishness will reverberate across regional economies.

The offsetting force, however, is the macro picture of the US economy, which is looking decidedly more upbeat in recent months. Although growth was revised to a subpar 1.8% (from 2%) in 3Q2011, manufacturing activity has improved, as evidenced by a steady rise in the Institute of Supply Management (ISM) new orders component.

New jobless claims have also continued to slide despite the relatively loose labour market with an unemployment rate of 8.6%. Investments are also gaining momentum, judging by the double-digit expansion in the equipment and software (E&S) sector in recent quarters.

In our base-case scenario, we foresee the ISM new orders gauge hovering at around 50 to 55 points in 2012. With such a moderate outlook, our gross exports will likely expand at a slower pace of 3% and 6% (Chart 1). Given this scenario, we anticipate industrial production to grow by between 1.5% and 3.5%.

An examination of manufacturing sale statistics also suggests that the expected increase in sales by 6% to 8% in 2012 will lead to a likely growth in Malaysian industrial production that is within our projected range of 1.5% to 3.5%.

When another mapping exercise is done using the growth rates of the composite Export-IPI indicator (which we define as a simple summation of export and industrial production index growth) and gross domestic product (GDP), we arrive at a possible GDP growth range of 4% to 4.8% for 2012.

The expected performance of the equity market is also taken into consideration as the benchmark FTSE Bursa Malaysia Kuala Lumpur Composite Index (FBM KLCI) provides a relatively good picture of future GDP growth trends.

By examining the general outlook of the equity market for 2012 and coupling it with other macro indicators, we arrive at a possible range of GDP growth through proper weightages.

Based on these indicators, we envisage the economy to expand by between 3.8% and 5% in 2012. Taking the mid-point of the range, we pencilled in our GDP projection of 4.4% for 2012.

Private consumption – still our greatest hope
Consumers will continue to support the economy with their spending, although their sentiment may be slightly dented by weak financial market performance and measures undertaken by Bank Negara Malaysia to put a lid on domestic household debt.

Thus, we anticipate private consumption to grow by 6.4% in 2012 on account of the relatively steady labour market despite the fragility of the manufacturing sector, the feel-good factor brought about by the government’s plan to upgrade the salary scale of civil servants in 2012 and the still relatively easy access to credit through bank lending to the household sector.

The last factor is crucial in supporting consumer spending patterns, although Bank Negara recently tightened financial institutions’ guidelines for lending (such as using net income to determine eligibility for loans and imposing a cap on the amount of credit extended by credit cards to cardholders with income levels of less than RM3,000 per month).

This is due to the fact that banks will continue to target households in their drive to expand loan growth and will therefore make extra efforts to reach out to more eligible borrowers while non-financial institutions like cooperatives will continue to lure civil servants to take up as much credit as they possibly can.

Private investment – not a short-term remedy
While the government is banking on the momentum of private investment to invigorate the economy in 2012, a persistent rise in risk aversion among investors following shaky global economic prospects may somewhat dampen investor enthusiasm. Thus, the pace of foreign direct investment (FDI) flows into the region (including Malaysia) will likely soften from their levels in 2011. The weakening of global FDI flows will also affect cross-border mergers and acquisitions, leading to slower growth in private investment.

Nevertheless, an encouraging offsetting effect is provided by none other than the respectable momentum of the Economic Transformation Programme (ETP) projects, which may have pushed private investments up by a double-digit pace in 2011, a phenomenon that we have rarely seen in the past decade. As of November 2011, about 53% of the 131 targeted Entry Point Projects (EPPs) had taken off. Of the total value of RM171 billion in committed investments, about RM10 billion had been realised and another RM5 billion is expected to have been realised by the end of 2011.

Notwithstanding the success of the ETP, private investment will not likely be able to carry the economy through the turbulent waters of 2012 due to its relatively small share of GDP (about 11% in 2010). While the spillover effects from private investment may trickle through the economy via a stronger construction sector (and hence service sector), the adverse effects of the external sector will likely overshadow such positive effects. Thus, we foresee private investment expanding at a slower pace of 9% in 2012 compared with the government’s forecast of 15.9%.

Headline inflation – not a major concern
Asian economies, including Malaysia, will likely see a more benign inflation environment in 2012 based on the dim growth scenario painted above. For Malaysia, we opine that the headline number has responded to both demand-pull and cost-push pressures in the past few months, causing the rate to remain above 3% for some time.

A vibrant consumer sector following stable labour market conditions, coupled with the rising cost of raw materials, have led to persistent increments in food prices. Indeed, since July 2007, when civil servants last received a broad-based salary revision, prices of food and non-alcoholic beverages have escalated by 23.9% while the headline Consumer Price Index (CPI) has risen by 12.3%.

Moving forward, we do not see a significant increase in Malaysia’s CPI, although food prices will remain a thorny issue despite a possible moderation in the Food and Beverage Index as indicated by a decline in the UN FAO Food Price Index (Chart 2).

The concern over food prices is due to unfavourable supply factors as Malaysia remains a major importer of food and a trickle-down effect from continual subsidy-rationalisation efforts by the government. Notwithstanding this, opposing forces, such as a more cautious stance by consumers, the high-base effect and a general slowdown in economic growth, will likely tame the headline inflation number for 2012. Thus, we foresee CPI inflation to be about 2.5% in 2012 following a 3.3% pace in 2011.

Interest rate – on a downward trajectory, naturally
With economic growth set to moderate in 2012, the interest rate bias will likely be on the downside as Bank Negara shifts its focus to prevent any sharp decline in economic activity. Such growth bolstering measures have, to some extent, been undertaken by regional central banks. Indonesia’s central bank, for instance, frontloaded its interest rate cut by 75 basis points for fear of a sharp decline in its GDP growth.

Similarly, China’s central bank reduced domestic banks’ reserve requirement ratio in mid-December — the first time in the last three years — and is expected to continue loosening its monetary policy following a drop in export growth to the slowest pace in two years in November and a decline in the growth of money supply to the lowest level in a decade.
As for Malaysia, recent remarks by Bank Negara suggest that policymakers are ready to implement measures to support growth, although there are limits to what monetary policy can do and that fiscal measures are needed to provide more impetus to economic growth.

Taking cognisance of the fact that the government’s fiscal side is constrained by the need to keep budget deficits in check, we think that there is a likelihood of Bank Negara undertaking mild accommodative measures to complement the government’s measures to defend the economy from a sharp deterioration in 2012.

At the same time, with inflationary pressures likely to remain benign following softer demand-pull and cost-push factors, lowering interest rates will not likely bring about any adverse repercussions for the general economy. Hence, we think that a 25 to 50 basis point cut in the overnight policy rate (OPR) could be on the cards in 2012, bringing the policy rate down to a range of 2.5% to 2.75%.

Capital flows – something worth watching
Recent statistics on the balance of payments (BoP) raised some eyebrows due to a sizeable amount of net capital outflows in 3Q2011. On the whole, the BoP registered a much smaller surplus of RM10.9 billion, down from RM61.7 billion in the preceding quarter following net outflows of RM23.3 billion in the financial account, which was largely attributed to equally massive RM23.4 billion net outflows in portfolio investment.

This is hardly surprising as global portfolio managers switched back to the greenback in search of safe haven financial instruments amidst heightening risk aversion.

It is worth highlighting that we deem such a trend in outflows to persist in the near future as international investors continue to move funds into US dollar-denominated assets. The reasons are as follows:
• Any jitters in the financial market will lure asset managers back to the greenback for safe haven purposes;

• Further signs of a steady recovery in the US economy will make Asian economies less appealing on a relative basis as the latter will continue to be confounded by the conflicting aims of containing asset price inflation while supporting economic growth at the same time; and

• Massive amount of inflows into Malaysian Government Securities (MGS) in the past year will mean higher probability of outflows when investors start to rebalance their portfolios in favour of the US market.

Given such a scenario, Asian currencies — the ringgit included — will likely be on a downward trajectory going forward.

Ringgit – to sail through a rough sea due to market volatility
Rising volatility in global exchange rates in recent years has indubitably complicated the task of evaluating the ringgit’s movement. Of all the forces that could influence the ringgit’s movement, possible outflows of portfolio investment are probably the most crucial in determining the trend of the ringgit in the near term.

This is based on the possible reversal in capital flows following a dramatic increase in the percentage of foreign holdings of MGS to total MGS outstanding to an all-time high of 35% in August 2011. Neighbouring Indonesia also experienced massive inflows into its government debt instruments.

As for the ringgit, judging by the outlook for growth and inflation, interest rate expectations as well as the trend in capital flows, we expect the ringgit to continue hovering above the RM3 level against the US dollar in 2012.

We generally believe that the ringgit will have limited upside against the US dollar due to these reasons that have been generally described: rising flow of funds into US dollar-denominated assets as the US economy continues to emit positive signals; lower growth prospects for the Malaysian economy and Asia in general following the lag effects of the European economic turmoil; and portfolio outflows from Malaysian shores as investors seek to rebalance their positions after being heavily invested in MGS in the past two years. Therefore, we opine that the ringgit will trade mostly in a range of 3.10 to 3.30 against the greenback in 2012.

The government’s financial condition – no qualms about the target
Although the government’s budget deficit target for 2012 of 4.7% of the country’s GDP may seem like a tall order, we think that this is achievable if GDP growth does not fall too drastically in 2012. This confidence is derived from the observation that the projected deficit target is based on relatively low growth in government revenue which we think can be surpassed if the economy does not shrink dramatically in 2012.

Our view is also strengthened by the fact that Malaysia’s tax-to-GDP ratio is one of the highest in the region. Barring any unforeseen need to aggressively expand fiscal policy to support growth and with an increase in the efficiency of revenue collection as well as the government’s cautious expenditure patterns, we opine that the 4.7% deficit target level is well within reach in 2012.

The article is prepared by the economic team of the Malaysian Rating Corporation Bhd