The key highlights of Bank Negara Annual Report 2017 are:

1. Firm GDP growth supported by broad-based activities with BNM looking at GDP of 5.5% – 6.0% while we are projecting a growth of 5.5%;

2. Business activities to improve, supported by broad-based growth. We believe the potential of businesses will depend on how they are able to tap into digital activities which are gaining traction;

3. Stable inflation allows the economy to be back into the positive real returns;

4. While our base OPR is at 3.25% in 2018, we believe the normalisation of OPR is at 3.50%, suggesting room for a 30% chance of a rate hike;

5. Lower risk from household debts but need to be watchful on the lower income households;

6. Property credit risk not out of the woods yet (high-end residential properties, office space & shopping malls);

7. Debt servicing capacity for companies intact but there remain some pockets of vulnerability from banks' exposures to the oil & gas and real estate sectors;

8. Expect loans to grow at a comfortable pace.

A. Firm GDP growth supported by broad-based activities

• BNM projects the domestic GDP to grow around 5.5%-6.0% in 2018, which is aligned with our projection of 5.5%. The economy in 2018 will be driven by domestic activities i.e. private expenditure on the back of improving business sentiments and consumer spending. Besides, optimism on the performance of exports on the back of conducive external environment due to resurgence of global trade will support the domestic economic performance plus stable commodity prices.

• Investment will continue to support growth underpinned by capital expenditure in the manufacturing activities, services and continuing roll-out of large-scale infrastructure projects. Stable inflation, wage growth and pro-growth measures introduced by the government to support households will continue to underpin private consumption. The commitment to consolidate the public sector remains, which will be achieved through the reprioritisation of public spending and lower expenditure on noncritical items.

B. Business activities to improve

• Business sentiments improved in 2017 supported by broad-based growth. The positive momentum is expected to continue as the overall economy continues to expand at a credible pace on the back of broad-based growth.

• Areas of business opportunities is expected to come from: (1) the construction/infrastructure sector, which will gain from the implementation of new and ongoing projects; (2) the services sector, which will be mainly supported by continued capacity expansion in the domestic-oriented industries i.e. telecommunications and transport; (3) the retail sector, which includes fastmoving consumer goods and services; (4) healthcare; (5) tourism-related activities; (6) education; (7) utilities; (8) oil & gas; and (9) export-related activities like the E&E and resource-based activities. Business activities in relation to property sector are now under our watch from previously being negative.

• We believe the potential of businesses will depend on how they are able to tap into digital activities which are gaining traction. With the government having instituted initiatives to further develop the digital economy, it will open the door for more opportunities for businesses to go digital in their business model. However, we expect the pace of adoption will vary across the sectors as we can expect some degree of creative disruption to take place.

C. Back into positive real returns

• Headline inflation is envisaged to moderate in 2018. While BNM expects inflation to hover 2.0-3.0%, we project inflation to average around 2.8%, which is our base case while our lower end is 2.5% in 2018. Room for inflation to moderate in 2018 are due to: (1) a stronger ringgit against the USD that will help ease potential upwards pressure from import prices; (2) a stronger ringgit reduces the transfer pricing from producers consumers; and (3) high base effect.

• Thus, unlike in 2017 when we projected the economy will register a negative real returns throughout the year, for 2018, we expect the economy will sit in the positive real returns throughout the year. We expect the overnight policy rate (OPR) to stay above the inflation level throughout the year.

D. Normalisation of OPR is at 3.50%

• While our base case projection for the OPR is a one rate hike in January 2018 which already materialised, bringing the levels to 3.25%, we have placed a 30% chance of another rate hike either in September or November. Much will depend on: (1) the pace of rate hikes by the US Fed, to which we are currently looking at three hikes with the fourth hike at a 25% chance occurring in December; (2) the level of domestic inflationary pressure emanating from demand pull; and (3) the speed at which BNM will want to normalise the policy rate which we believe is at 3.50%.

• Besides, while we expect inflation to ease in 2018, uncertainties remain in the area of energy and commodity prices from geopolitical risks which suggest room for cost-push pressure to kick in if crude oil prices move up fast. BNM expects oil price to hover around US$60-US$70 per barrel. Our full-year WTI average is at US$57 per barrel and Brent is at US$61 per barrel.

• The ongoing shifts in global monetary policy and monetary policy divergence, as well as risks from trade protectionism measures could induce volatility in financial markets, making the direction of capital flows and exchange rates unpredictable as we move ahead. In the face of heightened volatility, we can expect the domestic economy and financial market to be caught in between albeit with limited downside risks owing to our healthy macroeconomic fundamentals such as growth, reserves, stable inflation and improving labour market conditions.

E. Lower risk from household debts, but need to watchful on lower income households

• Household debt grew at a slower pace by 4.9% in 2017 from 5.4% in 2016, the slowest since 2010. Slower growth in the areas of personal financing, loans for purchase of motor vehicles and non-residential properties is the key factor. Thus, the household debt/GDP eased to 84.3% in 2017 from 88.3% in 2016 and we expect the trend to improve in 2018 on the back of improving macro conditions, wage growth, stable inflation and healthy labour market.

• We expect these positive fundamentals to continue supporting the healthy household's financial assets and liquid assets to debt ratios which stood at 2.1x and 1.4x respectively in 2017 as we move along 2018. Growth in household's financial assets was at 8.6% in 2017 from 5.3% in 2016 compared to debts. With circa two-thirds of household debts being secured by properties and principal guaranteed investments, these reduce the net exposure of household debts. Besides, debt servicing capability of households remains intact and sustainable in 2018.

• Also, asset quality for household loans is poised to stay favourable in 2018. The asset quality in 2017 showed a gross impaired loan ratio of 1.0% compared to 1.1% in 2016. While the debt servicing ratio of most households remained intact (median: 32.7%), we need to be watchful on the lower income households i.e. those with income of below RM3,000 a month since this segment may encounter challenges in meeting loan repayments due to the higher cost of living.

F. Property credit risk not out of the woods yet (high-end residential properties, office space & shopping malls)

• The quality of banks housing loans is expected to remain sound, supported by prudent lending and valuation practices. In 2017, close to 75% (2016:64.9%) of housing loans had an outstanding loan-to-value ratio of 80% and below. This places banks with a comfortable buffer against negative equity should there be a decline in property prices. First-time buyers made up 71% (2016: 72%) of the housing loans in 2017 for houses priced below RM500K.

• Borrowers with three and more outstanding housing loans, a proxy for speculative purchases, increased by a margin of 0.9%, and accounted for less than 3% of total housing loan borrowers. This reflects an improvement in the profile of housing loan borrowers. Credit profile of house financing borrowers is poised to further improve with banks' prudent underwriting standards and appetite towards financing of affordable houses acquired by genuine home buyers. All these are expected to translate into a lower share of housing loans for speculative purposes ahead.

• The government has announced the freeze on new luxury residential properties by developers in an effort to rebalance the supply of houses in the property market. However, there continues to be a shortage in supply of new affordable houses in meeting demand.

• In 1H2017, average house prices increased by a moderate pace of 7%. Unsold housing units rose by 22.7% (2016: 41%) to 129,052 units as at the end of Sep 2017. More than 80% of the unsold units comprised properties priced at RM250,000 and above.

• In 2017, loans for purchase of residential properties expanded by 8.9% (2016: 9.2%). This was supported by transactions for purchase of affordable houses. 61% of housing loan applications was for purchase of houses below RM500,000. The rejection rate for housing loans was 23.1% in 2017, lower than the 2012-2016 average of 26.1%.

• Transactions in the commercial property segment space (comprising shops, office space and shopping complexes) stayed soft. Oversupply of properties in these segments was the key contributing factor. Also, there were challenges encountered by businesses in the O&G sector. Even though the overall business sentiment is expected to turn better, risks persist in the office space segment. This is based on the continued cost-cutting measures by businesses, which include downsizing of office space or relocating to other premises to reduce operating expenses.

• 2017 saw a decline in loan approval rates for the construction and purchase of properties (office space and shops in complexes) to 70.9% and 72.8%, respectively; 2016: 76.8% and 80.2%, respectively). This reflects banks’ conservativeness in lending to these segments. Banks’ current exposures to these segments comprised loans and holdings of corporate bonds and sukuk. It accounted for 4.9% and 5.4% of banks’ total outstanding loans, and holding of corporate bonds and sukuk respectively. In 2017, impaired loans ratio for the non-residential property segment was slightly higher at 1.1% compared to 1.0% in 2016.

G. Debt servicing capacity for companies intact but there remain some pockets of vulnerability from exposures to oil & gas and real estate sectors

• 2017 saw the business sector's debt-to-GDP declined to 103.1% compared to 109.6% in 2016. Domestic non-financial companies’ debt grew by 6.1% driven by issuance of new bonds and sukuks.

• Debt servicing capacity of Malaysian companies fell to 9.1x in 2017 (2016: 11.5x) due to weaker earnings in some sectors. Aggregate leverage for companies was higher at 47% compared to 43% in 2016. The overall business sector's cash to short-term debt ratio increased to 1.5x (2016: 1.2x).

• There remain some pockets of vulnerability from banks' exposure to the oil & gas and real estate sectors. The median interest coverage ratio (ICR) for oil & gas companies of 2.9x was lower than 2016's 5.4x. Meanwhile, the median ICR of property development companies remained healthy at 6.2x (2016: 5.4x). This was despite the soft property market conditions. In 2017, cash-to-short-term debt ratio for oil & gas companies fell to 0.5x (2016: 0.8x) while that of property development companies remained stable at 0.9x.
• Business loans grew at a slower pace by 1.8% in 2017 due to repayments by large businesses. In 2017, SME loans expanded by 6% (2016: 9.5%). We expect an improvement in business loan growth in 2018 with an absence of large repayments by businesses.
• Impaired loan ratio for business loans was stable at 2.5% (SME impaired loans ratio: 2.6%) in 2017. Nevertheless by segment, the impaired loan ratio for oil & gas sector loans (including restructured loans) was elevated at 5.5% (2016: 4.2%) while that for real estate loans was stable at 1.5x. We expect the asset quality for the banking sector to be stable in 2018. While there are still some pockets of vulnerability for oil & gas companies that have been facing tight cash flows before the oil price recovery, the improvement in oil prices is poised to have a positive impact on companies with upstream activities picking up in momentum.

H. Expect loans to grow at comfortable pace

• For 2018, we expect the industry loans to grow by 5.0% y/y underpinned by a stable growth in household loans and a stronger business loan growth without the impact of large repayments. This is based on a GDP growth of 5.5% for 2018, supported by investments, major infrastructure projects and exports.

Source: AmInvest Research - 29 Mar 2018