Sunday, September 8, 2013

Why Subsidies Elimination will not solve our Deficit problem? What Better Solutions

Subsidy is a very sensitive economic tool for helping certain targeted sector of the economy. Farm subsidies have existed for centuries in Western Economies. Farmers are subsidized so that their produce is competitive in world markets. On top of it also ensures that their employment stays high. The effectiveness of subsidies can be viewed from different angles. One it leads to an inefficient allocation of resources and the other is providing protection to certain sectors of the economy to ensure constant supply of strategic resources like cheap food and energy while at the same time also provides full employment.

The question is whether our removal of the subsidies done at the right time? During the last Financial Crisis in 2008 it affected much of the population. Would it be the right decision for policy makers to curtail the spending of the public then when it is the last thing our economy needs when it softens? The following chart shows the Malaysian GDP annual growth rate as of 2007.


As indicated above our GDP growth rate was very robust at the beginning of 2010 by recording 10.1 and 9% growth respectively thanks in part by the expansionary fiscal and monetary policies by our Government.

We have no complains if our Government reduces its subsidies when our economy is doing well because we can still manage any possible adverse outcome. But what if they do the opposite? Is it the right thing to do by imposing the recent fuel hike when our economy is just about to go off the cliff? Or are they pressured to respond to the demand by Fitch Ratings agency to further reduce subsidies or else face another round of downgrading?

What is their policy objective of subsidy reduction? To raised funds either to pay off debts or relocate it for the development of other sectors in the economy. Anyhow will a complete subsidy removal help reduce our deficits?

Side effects of Subsidy removal

Price Inflation
The amount of subsidy in 2012 was about RM 42.4 billion or 4% of GDP and is expected to drop to RM37.61 billion in 2013. The bulk of the subsidy went to fuel which accounted for about RM25 billion.  Needless to say the price of fuel will continue to go up as subsidies is reduce in the coming years as fuel is used in most industries from transportation to manufacturing. Since demand for fuel is ‘inelastic to price increase’ the ‘trickle down’ effect will push up the prices of most goods which is also known as ‘cost push inflation’. In layman terms this is called price inflation. The following chart shows the CPI (Consumer Price Index) which tracks the prices of certain essential goods paid by consumers

Ever since the call by Minister Idris Jala in May 2010 to reduce our subsidies or face bankruptcies, the effort only result in one thing – soaring prices of goods and services as indicated by the chart above. So would you still believe the Government when it said it will not affect all of us?  

Crowding Out Effect

The chronic problem facing the Malaysian Government is the Budget Deficit. Budget deficit is a term to describe a situation where expenditure exceeds revenue. When a Government overshoots its expenditure it needs to borrow or increase taxes in order to finance this activity. As we already stated increasing taxes is not a popular option and most Government will try to avoid. This leaves us with borrowing as the other option. Again when we borrow from foreign creditors then our Government Debt to GDP will increase. Given our current Government Debt to GDP stands at 53.3% and this level is capped at 55%, there is not much option right? The last alternative will be to source from domestic. Again sourcing funds from the domestic sector will further increase the debt burden. So the last solution is by soaking up money from the public. The question is how the authorities going to do it?

To illustrate, we use an example where the total GDP for country A is $100 million and the breakdown of the GDP is as follow.

Total             RM

Government spending can be further breakdown into education, defence, preservation of law and order, subsidy and etc. So by diverting resources from reduced subsidy to the private sector it can then be channelled to other sectors such as defence and infrastructure.  However there will be no change in the final amount which is $100 million. The only change is the composition of the spending and in this case a reduction in subsidy and an increase in defence and infrastructure expenditure.

So what we can deduce from here is that whenever the Government borrows or divert resources from other sources where the source of money is already in existence it will not add to existing money supply. This is what economists called non-monetized borrowing or non-monetized deficit financing. This is mainly paper shuffling or the transfer of money from the left to the right pocket and hence will not affect the Government Debt level. But this will eventually crowd out private spending and this is not good for the economy. As government spending increases less will be available to the private sector and this will lead to reduced economic activity. How will this affect the economy?

You see our Government PRODUCES NOTHING that can add to its revenue. All of its revenues are derived from personal and corporate taxes, royalty, excise duty and so on. So when private expenditure is reduced, private investments will also be reduced and this might not only lead to lower employment but also reduces its ability to earn foreign exchange.

Will Subsidy removal help reduce Deficits?
Obligation to Interest Payments

Let take a look at our Government Debt to GDP ratio in the following chart. You should notice that our Government Debt/GDP suddenly surged from 42.8% in 2009 to 55.4% in 2010. On the YOY basis, this represents an increase of 29.4% in our government debt. One explanation for his will be the massive borrowing by our government to finance its increased expenditure on both fiscal and monetary policies. Or what is also known as the stimulus package to fence off a recession. As of late this ratio is 53.1% as shown below.

Our Government debt is a mixture of short term Treasuries, long term bonds and etc. To simplify our calculation on our Government’s interest obligation we shall use the benchmark 10 year Government bonds yield which is 3.98% currently in the following chart. How do we calculate our interest payment obligations?

From information that we gathered, we know that our GDP is valued at US$303.53 billion,10 year bond yielding 3.5% and the USD/MYR exchange rate at 3.1 as of December 2012. We can then proceed to calculate our interest obligation with the following.

(US$303.53 x 3.1) x 0.035% x 0.531 = approximation of RM 17.49 billion per year.
How much our Government squandered from us in terms of per capita income?
An opportunity costs exists when our government meets its interest payments. If our Government had not accumulate so much debts then more funds can be diverted to the development of other sectors of the economy such as subsidized or free education or maybe elimination of road tolls. To calculate how much money is squandered we shall use the following formula.

Income per capita can be derived with the following.

Interest payments/population = Income per capita

RM 33,000,000,000 (rounded up) / 26,000,000 = RM 673 per capita

Yes, RM 673 per person per year.  

From the above we know that our Government spend RM42.4 billion or 4% of GDP on subsidy in 2012. So if we were to completely eliminate the subsidy of RM42.2 billion in the next few years it still cannot get us out of the woods because by then our interest payments should soar to higher levels because of our depreciating Ringgit and also the threat of increase interest rates. Bank Negara recently announced that it is holding rates unchanged. Again as we have already mentioned many times in our previous articles that Central Banks cannot promote both Monetary Policy and Exchange Rate Policy at the same time.

To prevent our Ringgit from further depreciation, Bank Negara will have to increase our interest rates sooner or later. Given the current scenario of the free falling Rupiah and Rupee our Ringgit will be under tremendous pressure for further depreciation in the coming weeks. So I will expect either our interest rate or Ringgit to give way very soon.

If Bank Negara chooses to promote internal stability through the use of Monetary Policy to hold down interest rates then we will have to sacrifice our Ringgit. But then it poses a threat to the private sector in terms of higher debt load due to our Ringgit depreciation. I present to you below the charts of the total debts of both internal and external public and private debts.



As from above it shows that the real problem lies in the private sector. The total private sector debts accounted to 115% of GDP and 28% of it is foreign based. So whichever policy Bank Negara chooses either by holding rates low or intervening in the foreign exchange market to prop up the Ringgit the private sector is toast and done with. In short Bank Negara is in between a rock and a hard place.

But the question is since deficit is bad for the economy why is our Government still keep expanding it? It has to do with the special interest group or UMNO as we know it. When our Government spends and expand the deficit the special interest group will be benefitting from new projects and kickbacks while the losers will be the poor due to the increased in debt their future generations will have to pay. Alternatively when our Government decrease spending and reduce the deficit then obviously the losers will be the special interest group and the winner will be the public due to lower future debts their children will have to carry.

Thus any Government programs that helps increase the deficit is a form of Wealth Transfer or a reverse Robin Hood operation. It takes money from the average and poor Malaysians (in taxes) and pays the rich Malaysians and Foreign Bond holders in terms of yields.

Other Solutions available?

The answer is in fact YES. For any recovery to be sustainable, initially the government will have to lead the way by increasing taxes and reducing its own spending on the fiscal and monetary framework. Yes increased taxes in the private and cost cutting in the public sector. How can it be done?

Increase Taxes

Is there a situation where a tax is not a tax? When the tax is a ‘sin tax’ and this refers to tax imposed on consumption of ‘sinful goods and services’ like alcohol, tobacco and gambling. It is often argued that consumers of sinful goods and services are causing unnecessary health care and law and order maintaining expenses. And they are causing the rest of the 90% of the population who are not ‘sinners’ to pay for those unnecessary expenses. If there are less people consume alcohol and tobacco there will be less cancer and heart attack patients and hence less health care expenses to be allocated to these patients. Similarly if less people are frequenting the casinos or even the number forecasting outlets then it not only resulted in fewer family break-up but also a reduction of crime. Naturally the government will allocate fewer resources to fight crime and maintain law and order. If this problem is not arrested then we will always face the problem of increasing police to population ratio and hence expenses.

From a Canadian study where the price of a pack of cigarette was raised from 59 cents in 1977 to $1.94 in 1993, it was found that the consumption of tobacco felled 30% during that period. What other benefits following such a reduction in the consumption of tobacco? It is estimated that at least $160 to $180 billion could be saved from related expenses in healthcare and other social costs. Moreover it also found that from the increased in price only 26 cents end up in the Government’s coffer in terms of taxes while 96 cents went to tobacco companies and their sellers.

A study by Will manning at the Rand Corporation on alcohol found that drinkers are paying much less for their cost for their activity. Their report found that for every ounce of alcohol consumed the drinkers are paying 22 cents but it costs the society 48 cents. It also found that increase taxes will lead to lower consumption. A 10% increase in alcohol tax will lead to a 3% drop in consumption.   

Cost cutting in Government

Or should we say fat trimming in the public sector. Isn’t it fair that private sector austerity type measures like wage and bonus freeze, head count reduction and other cost cutting measures be applied to the public sector? I reckon it about time and put an end to the special interest group in lobbying for the benefit of the public servants. Why are they (public servants) getting all the benefits of yearly bonus and other perks since their salaries are finance by the taxes from the private sector? So what needs to be trimmed?

Cutting Public Employees

Malaysia has again achieved another record breaking effort but this time for the wrong reason being one of the highest public servants to population ration in the world, according to the OECD standards in 2009. All I can say is that this is a perfect for sending our Government to the cleaners. With more than 1.3 million civil servants serving a population of 26 million is indeed a feat that cannot be easily accomplished. The total salary paid to our public servants in 2008 totalled RM 41 billion. Our bloated PM’s Department has about 43,000 workers in 2011 while the White House has only 1888 workers. Budget allocated for the White House is only US391 million whereas our PM’s Department was allocated RM 18.2 billion. The following table best illustrate our achievement.

Hong Kong

When public servants are trimmed there are ample room for improvement in terms of delivery and efficiency. Unproductive workers should be dropped while the productive ones should be rewarded. This also helps to reduce work redundancy in the public sector. Currently there is a trend going around the world to reduce the public servants to population ratio. But we tend to do thing the other way. In law instead of punishing the victims we punish the whistle blowers and the public sector we attest to Gresham’s Law where the worst push out the best.

Privatizing the Public Sector

Another reform that can be done is to privatize certain Government linked Companies (GLC) in Malaysia. Privatization creates competition between the public and private sectors. This will help improve the competitive levels among both the public and private enterprise workers. Needless to say privatization gives companies the chance to experiment with what strategies and other risky adventures that are once reserved for the private companies. A fine example will be Telekom Malaysia. I still remember when during the early 1980s where getting a phone line in remote areas is virtually close to impossible. This is due to the uncompetitive nature of the business and Telekom Malaysia has virtually being a monopoly of the business. So there is no incentive for the company to expand its business and thus improvement in delivery and customer relationship.

However since it was privatized in 1987 its services and delivery improved multiple folds and can now compete with both local and foreign private telecommunication operators.

Accountable Public Sector

A new method or an accounting system is needed to record all transactions that are free of fraudulent practices, valuations and budgeting. Rather than letting our current system which enables debts to be hidden as an off balance sheet item, we need a more robust system that is transparent, open and free from deceptive accounting which will lead to deceptive management practices. As for the precedent according to the Economist, New Zealand in 1992 became the first nation to adopt the commercial accounting principles with full balance sheet of its assets and liabilities.  

Cutting Defense Budget

Our Malaysian Defense Ministry was allocated a total of RM15.2 billion in 2012. So what is the point of having submarines that cannot submerge (lucky not emerge) and fighter jets that cannot fly (no engine)? The recent invasion in Lahad Datu,Sabah (11th Feb 2013) by militants from the southern Philippines proves that our defense forces are not up to the mark or not ready ‘here and now’. Why do we need modern fighter jets and other warfare equipment when our defense department is manned by incompetent folks. Why do we need to ‘keep up with the Joneses’ and procure the best and most modern military equipments? Isn’t it better to cut down the defense budget and use the funds for the development of the economy since procurement in defense equipment is most prone to corruptions and kickbacks.
In Wrapping Up

It is always a dream for policy makers to achieve a balance budget. The problem is that while everyone wants a balance budget nobody wants to go through the process of doing what it takes to balance the budget. Nobody likes austerity measures like reducing consumption, increasing savings and wages and bonus freeze.
To illustrate this matter let me present to you the following chart of our Government Budget to GDP as from 2004 to 2012.

As from above, it is obvious that our Government has been running a budget deficit since 2004 and the latest being 4.5% to GDP. The rule of thumb for a comfortable level of Government Budget to GDP will be 2% or less. Hence our deficit of 4.5% is considered excessive high. The problem is that our Government is not doing enough for the past few years to keep the deficit low because curtailing spending decreases economic activity and hence will not keep their special interest group (UMNO) happy. Less fiscal spending means less projects and hence less commissions and kickbacks for those rent seekers.  

Even our Bank Negara is not doing what it takes to stabilize our economy. Bank Negara is current engaging in a dangerous game called ‘Stop Go’ policy. It is a series of ad-hoc policies aim at balancing between the Monetary Policy to keep our interest rates low and at the same time intervene in the foreign exchange market by selling billions of USD in order to prop up our failing Ringgit. As been mentioned earlier Bank Negara cannot have both, it can choose interest rate for internal stability or exchange rate for external stability. From our 1998 experience, to stem further outflow of foreign funds we either have to increase our interest rates to unmanageable level (18%) or impose capital control. So our current policy on targeting both internal and external stability will not work.

Stop-Go policy will not work as seen recently in India and Indonesia. The Reserve Bank of India and bank Negara Indonesia have implemented every available policy tools and yet their Stock Markets and Currency keeps plunging. What I will foresee in the coming weeks will be the soaring interest rates or the plunging of the Ringgit. Our Stock Market will be the first to hit and you should expect very high volatility in the market. I believed the wind of currency depreciation has already blown to Malaysia and we just have to face the consequences.
We are living in an age where instant gratification is the order of the day and delayed gratification has long forgotten. Similarly, in order to balance our budget deficit, our Government will need to impose austerity measures not only on its citizen but also on itself. It about time for the public sector to share the burden of the private sector with all the excesses they have created. Further to this it is also time for the Government to treat the public with respect and taxpayers as customers.

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