Limited options in growth competition

The heat that has been generated recently about subsidy rationalisation exposes a clutch of knotty issues facing the economy that require nerves of steel to fix. Much attention is being focused on the effects of subsidy reduction on consumer price inflation and consequently, the hardship particularly for the bottom 40% of the population.

However, that is only one of the stress points that if neglected may affect the country’s economic viability. This much is certain: as the total burden of subsidies increases over time, they are bound to be dismantled eventually, except to ensure a decent basic quality of life for those at the bottom of the pyramid.

That time is now at hand, as Malaysia’s fuel subsidy bill for this year alone was estimated at RM21 billion, before the latest cuts.

The well-known argument against subsidies is that they encourage waste and inefficiency, and there is clearly much sense in encouraging the frugal use of finite resources. Nevertheless, there are sound reasons to provide well-targeted subsidies for social goods like healthcare, education, public transport and social amenities, which have a beneficial effect on quality of life and productivity, and so yield a larger dividend for society.

These perspectives balance the tendency of free market advocates to blindly press for market solutions to almost every need. There are enough examples of privatisation exercises gone wrong, from public transport to waste water management to water supply to health services, for the lessons not to be missed by anyone.

A point of contention about the latest subsidy rationalisation measures, and one that has dominated online discussions, is that although gas and electricity tariffs have been increased as a result of subsidy cuts, the independent power producers (IPPs) have been spared the brunt of rising fuel prices.

Electricity tariffs have risen by 7.1% from June 1, although the government estimates that 75% of consumers are not affected because of their low power usage. The increase comes as Petronas has revised the gas price to power producers by 28% to RM13.70 per MMBTU, and to industries by 17.3% to RM18 per MMTBU.
Thanks to a “fuel cost pass through” mechanism, which is reviewed every six months, increases in gas prices are absorbed by Petronas because the price for commercial use is determined by the government.

While chary of the word “subsidy”, Energy, Green Technology and Water Minister Datuk Peter Chin acknowledges that the national oil company has to forego RM19 billion in revenue because it has to sell gas to the IPPs and Tenaga Nasional at well below the market price.

The government has deflected pressure on it to reveal the power purchase agreements between the IPPs and TNB, citing the Official Secrets Act, which is intended to protect information that can affect national security. It has also claimed, incredulously, that the contracts are between private parties and that it has no say on whether they should be made public.

Regardless of these tangential justifications, this lack of transparency in matters that are primarily economic, concerning basic factors of production affecting the business environment, count on the negative side of the scorecard for investors, both foreign and domestic.

Also abolished from June 1 is the diesel super subsidy for nine categories of commercial vehicles and the fuel subsidy for some 1,200 fishing vessels. With the latest increases, all the subsidies identified and targeted for cutbacks — fuel, food, gas and electricity — have been adjusted.

Aside from the knock-on effects of higher costs, the operating environment bears watching due to external factors. The April industrial production index suffered an unexpected dip of 2.2% year-on-year for the first time in 16 months. However, the decline is expected to be short-lived, according to Maybank IB Research, which attributes this to the triple blow of the earthquake, tsunami and nuclear meltdown suffered by Japan.

With consumer essentials affected by rising costs, inflation is a concern, and is forecast at 3.4% for the full year by Maybank IB Research. The government will need to address questions about adequate wages and affordable necessities in the near term, especially with a general election, which it is expected to call before long, to clear before it can institute unpopular fiscal and policy measures.

However, postponing fiscal discipline carries the cost of keeping gross public debt at a costly level — it stood at 55.1% of GDP as at 1Q11. The arguments for reigning in the debt level naturally get stronger when the question of sustainability of growth is raised.

Besides the consumer dimension, the subsidy cuts may also make Malaysia less attractive for industries that are sensitive to the higher costs of input like gas and power. Market dominating rubber glove manufacturers, for example, which are dependent on adequate and cheap supplies of gas, could find it more cost-effective to relocate if input costs keep rising.

It is useful to remember that subsidies are almost universally used by countries to achieve competitive advantage in strategic sectors. The difference is that the subsidy regime in well-managed economies is not allowed to become a life-sapping burden on the economy. For example, the US has over 2,100 forms of subsidies for health, agriculture, education and other sectors, some of which have been a bone of contention with its major trading partners.

In the early days of its industrialisation drive, Malaysia had heavily subsidised foreign direct investments as a development strategy to create jobs and generate growth. It made its mark as an investment haven by offering highly preferential terms including tax holidays, 100% profit repatriation, low wages, a favourable labour environment, cheap land and cheap amenities.

In recent decades, other economies in the region have caught up with us, and the options of offering a low wage regime and cheap land have virtually disappeared. Cheap amenities remain one of the few attractions for investors in this period. Furthermore, Malaysia’s relatively small population and middle income status do not make it attractive as a domestic market.

The options for sustaining Malaysia’s growth path are running out. Aside from intensifying its reliance on extractive industries, it has to seriously get down to the tough job of transforming its economic enterprise into a higher value-add model. It cannot afford to wait much longer.

R B Bhattacharjee is an associate editor at The Edge.

This article appeared in The Edge Financial Daily, June 17, 2011.