• February headline inflation rose by 1.8% YoY, with a slight increase in transport's main group inflation

• Petroleum products subsidy accounts for 82% of total expenditure

• Floating diesel prices will negatively impact lower income households

• The success of PADU is crucial for this policy's effectiveness
   
• Rise in inflation is expected with the floating of diesel prices

In February 2024, headline inflation edge up 1.8% YoY, primarily attributed to the upward adjustments in prices of water tariff, passenger transport services and recreational services, which fully outpaced the moderation in food & beverages price inflation. Housing, Water, Electricity, Gas & Other Fuels costs expanded by 2.7% YoY in February (Jan: 2.0% YoY), lifted by subgroup of water supply which increased by 28.7% YoY (Jan: 2.1% YoY).Transport's main group inflation surged to a ten-month high of 1.2% (Jan: 0.7%) due to a sharp rebound in the cost of public transport services (Feb: 4.2%; Jan: -2.6%) following Chinese New Year Holiday celebration. Core inflation maintained at 1.8% YoY in February 2024.

PETROLEUM PRODUCTS SUBSIDY DOMINATES AT 82% OF TOTAL EXPENDITURE

The government allocated RM62.11bn for subsidies in 2022, as per the Auditor General’s Report on the federal government’s financial statement for that year. Most of the subsidies, totalling RM55.44bn, were included in the federal government's operating expenditure (opex), whereas a portion of the subsidy expenditure, specifically for petroleum products and cooking oil totalling RM6.67bn, was charged to the Covid-19 Trust Fund. In an opex of RM55.44bn, 81.5% was allocated to petroleum products subsidies at RM45.18bn, excluding subsidies for the Covid-19 fund. This was due to rising crude oil prices above USD100 per barrel, while Malaysia continued to cap pump prices. In 2022, the government spent RM41.8bn on fuel subsidies, with petrol (RON 95) accounting for RM23.1bn and diesel for RM18.7bn.

MALAYSIA'S FUEL PRICES ARE COMPARATIVELY LOWER THAN THOSE OF ITS REGIONAL COUNTERPARTS

Malaysia's petrol price at RM2.05 and diesel price at RM2.15 are the lowest in the region, attributed to blanket subsidies. Comparatively, Singapore's fuel prices are higher, with RON95 priced at RM9.71 and diesel at RM9.05. Hence, Malaysian government suspected a potential leakage due to diesel smuggling in 2022. According to Finance Minister II Datuk Seri Amir Hamzah Azizan, Malaysia is dealing with a significant issue of subsidised diesel leakages, with a concern that ineligible parties may still be benefiting from the subsidy. Referring to subsidised diesel usage, he noted that before the Covid-19 pandemic, it was approximately 6.1bn litres, but it has now surged to 10.8bn litres. With a 70% increase, there is a strong likelihood that the subsidy has shifted to sectors that are not eligible for it. The government aimed to halve last year's RM20bn diesel subsidies, with Subsidised Diesel Control System (SKDS) 2.0 for land transport targeting spending reduction.

The Subsidised Diesel Control System 2.0 (SKDS 2.0) for land transport, starting on March 7th, will include five petroleum companies and nine vehicle types. The SKDS 2.0 for land transport, initiated as a pilot project by the ministry, will run for two months and is designed to establish a mechanism for the retargeting of diesel subsidies. The KPDN and the Ministry of Finance are considering expanding the pilot project to other suitable land transport sectors in future planning, aiming to address the risk of diesel supply leakage and subsidised diesel smuggling more efficiently and effectively.

COMPLETE REMOVAL OF DIESEL SUBSIDY TO RESULT IN APROXIMATELY 70% PRICE RISE

The government currently subsidises RM1.60 per liter of diesel to maintain the price at RM2.15 per liter. Oil prices are anticipated to stay elevated in 2024. Brent crude oil prices were volatile last year due to Middle East conflicts, averaging USD82/bbl compared to USD85.9/bbl in 2022. OPEC+ production cuts, extended in November 2023, were offset by robust output elsewhere, leading to just over 5mb/d of spare capacity. The EIA's Shortterm Energy Outlook (STEO) report expects a crude oil deficit in 1Q24, with consumption slightly exceeding production. EIA predicts record-high oil demand in 2024-2025, suggesting a prolonged elevated crude oil price environment. Our Brent Oil assumption for 2024 remains at USD85/bbl.

TARGETED MEASURES: PRICE REFORM

Government plan to implement a floating fuel pricing mechanism while aiding target groups identified by Central Database Hub (PADU). The "fuel float" strategy aims to curb the fiscal deficit but could result in inflationary pressures. Economy Minister Rafizi Ramli mentioned that targeted subsidies for petrol and diesel are expected to be based on three mechanisms: individual net disposable income, household net disposable income through social protection, and a combined earnings approach, using a subsidies card system. The planned fuel subsidy rationalisation in the second half of 2024 is expected to increase our inflation forecast (2024F: 2.7%) due to fuel's significant contribution to the CPI. Fuel is a component of the transport sub-index, which holds a 14.6% weight in the CPI. The impact will vary depending on the speed of subsidy rationalisation. While details of the rationalisation are not yet available, the government has assured that it will proceed gradually. Deputy Finance Minister Lim Hui Ying assured that the phased implementation of targeted subsidies will depend on readiness and feasibility, with a focus on maintaining people's cost of living without disruption.

Price reforms can benefit the Malaysian economy in the short and long term by transitioning from blanket assistance to targeted support for households and firms. This shift not only reduces wastage but also promotes productivity enhancements and advances up the value chain, leading to the creation of high-income, knowledge-intensive jobs. It allows the government to allocate resources to fund essential public spending on social protection, education, healthcare, and infrastructure. Targeted measures could involve gradually raising pump prices to align with market rates, thereby excluding foreign workers and the affluent from pump subsidies under the blanket system. Additionally, higher market prices would mitigate smuggling and leakage issues caused by ineffective bans on petrol and diesel sales to foreign-registered vehicles at petrol stations.

Nevertheless, the floating of diesel prices will indeed result in higher costs for both households and firms. Managing these costs will remain challenging, as fluctuations in global commodity prices directly impact domestic cost conditions. The lack of subsidies and price controls could disproportionately impact vulnerable groups, leading to financial hardship, while firms, especially small and medium enterprises, may struggle with volatile costs and competitiveness, affecting investment and hiring decisions. The ripple effects can be profound, particularly given the prevalent income inequality in our society. However, there is hope that potential savings can be redistributed to low-income groups via PADU, enabling them to afford higher fuel costs. PADU registration rates are still low, posing a risk of leakages where cash transfers may not reach individuals who are not covered by the PADU system. The success of PADU is critical for the effectiveness of this policy.

Overall, the government is unlikely to immediately float fuel prices, preferring a gradual approach. Removing fuel subsidies suddenly could double or triple costs across the economy due to their impact on lowering sectoral costs and the expected inflation shock amid current political dynamics.

Source: BIMB Securities Research - 29 Mar 2024