Executive Summary

This report assesses the potential impact of subsidy rationalisation on inflation and, subsequently, on the Overnight Policy Rate (OPR), exchange rate (particularly USD/MYR) and bond yields. To sum up, this paper argues that inflation in 2024 is likely to come in higher than in 2023.

The details of subsidy rationalisation are still scant despite the early announcement of diesel subsidies on 21 May 2024. As such, this paper intends to elucidate the possible impact of higher retail oil prices on inflation in three possible scenarios; namely Low, Baseline and Elevated. The authors assume that a low inflation scenario leads to the average annual inflation to come in at 2.5%, baseline at 3.0% and elevated at 3.5%.

Under the “Low” scenario, we expect a mild appreciation in MYR due to the possible narrowing of interest rate differentials and a moderate downside to MGS yields, while BNM maintains a neutral monetary stance.Under the “Baseline” scenario, there is heightened pressure for a hike in 2025. Thus, we anticipate MYR to fare marginally better in 2H2024 while there is more upside to MGS yields, though levels have priced in a hike already, in the authors’ opinion.

Under the “High” scenario, we foresee a hawkish BNM stance to emerge and a possible 25 bps hike in the OPR before end- 2024, assuming demand-pull inflation manifestation. We also expect a more rapid appreciation in the MYR. At the same time, there is obviously more upside to bond yields than in the “Low” and “Baseline” scenarios, especially as there is a risk of larger gross issuances of government bonds in view of a possibly higher fiscal deficit.

Background

Inflation in Malaysia has been relatively benign since the government capped the RON95 price at RM2.20 per litre in April 2018. Since then, RON95 has been trending flat, with a ceiling price of RM2.08 per litre since March 2019 and, subsequently, at RM2.05 per litre since March 2021.

Malaysia’s subsidies bill, in which fuel subsidies take about 74% of the total subsidy expenditure, is a massive fiscal burden to the government. Prime Minister Anwar Ibrahim highlighted the structural issue in his speech two days ago. Bank Negara Malaysia (BNM) records show that the total subsidies bill rose 300% from RM23.9 billion in 2019 to RM71.9 billion in 2023. As global prices are expected to remain elevated for some time, while the government is determined to bring the fiscal deficit down to 4.3% in 2024 (2023: 5.0%), the need to trim the fat becomes more urgent than ever. As such, the government has mulled the idea of initiating subsidy rationalisation, slated to be implemented in 2H2024.

The Malaysian economy went through a period of disinflation throughout 2023, and the tide is changing in 2024. This is not only due to the planned demand-side interventions that will take place in 2024, but more importantly, non-food inflation has been on the rise versus headline inflation since June 2023. Considering the changing trend in inflation, the probability of non-food inflation surpassing headline inflation is higher later in the year. Food inflation appears to have fallen behind the inflation curve in recent years, so there is also a possibility that it will surpass headline inflation when non-food inflation fades in time.

As deadweight loss costs are passed to consumers, the authors posit that inflation may creep up as the subsidy rationalisation will witness retail oil prices mirror changes in the global economy more closely.

Judging from recent government announcements, the authors believe the government remains firm in pursuing full subsidy rationalisation this year. Factors that may derail its rollout, such as external/supply side shock emanating from the “higher for longer” interest rate environment and domestic politics, fall outside the ambit of this paper.

Main Findings

After a relatively tame headline inflation reading of 2.5% y/y in 2023, for 2024, inflation could hover within a large range of 2.5% - 3.5%, although the authors gravitate towards the range's mid-point. The large range reflects the complexities in accurately assessing the impact of price pressures from the government’s execution of supply side interventions (e.g. subsidy rationalisation, indirect tax revisions and readjustment of water tariffs) in 2024. Recently, the authors noticed an uptick in headline inflation in February 2024 (1.8% y/y vs. the previous 3-month average of 1.5%) due to the 22 cents per cubic meter hike in water tariff. This translated into a 0.5% surge month-on-month, the highest increase since June 2022. Interestingly, Malaysia’s inflation print in March 2024 came in flat at 1.8% despite the 2% hike in service tax, which the authors believe is attributed to the wide exclusion list of items covered by the hike.

The details of subsidy rationalisation are still scant as of writing. As such, this paper intends to elucidate the possible impact of higher retail oil prices on inflation in three possible scenarios; namely low, baseline and elevated. The authors assume that a low inflation scenario leads to the average annual inflation to come in at 2.5%, baseline at 3.0% and elevated at 3.5%.

The authors assign the probability of each scenario based on their assumption of the magnitude of fuel price increases and the coverage/exemptions. That said, if the actual rollout consists of a lower fuel price increase but larger exemptions, the probability of each scenario should be tilted toward the more modest outcome.

Subsequently, based on these possible scenarios, this paper aims to assess its impact on the ringgit and Malaysia’s bond yields. To sum up, this paper argues that inflation in 2024 is likely to come in higher than in 2023. As such, the pace and sequencing of intervention are of utmost importance to brace for impact while complementary policy to subsidy rationalisation should also be considered and rolled out concurrently.

Source: AmInvest Research - 23 May 2024