Tracing Fiscal Sustainability in Malaysia

Abstract

One of the concerns in the economic policy circle is the fiscal sustainability. This current research revisit the notion of fiscal sustainability for Malaysia using the Indicator of Fiscal Sustainability (IFS) developed by Croce and Juan-Ramón (2003) where we employ samples of time-series data from 1970 to 2017. The findings reveal that 40 out of 48 years, during which the calculated IFS algorithm is above the threshold of 1, imply Malaysia was fiscally unsustainable. Despite having been fiscally unsustainable, Malaysia's fiscal stance shows improvement as a result of fiscal consolidation and fiscal reforms during the sample period. This is shown by the improved calculated IFS algorithm on average, which the value improved from 1.465 in 1970-1993 to 1.377 in 1998-2004 and to 1.146 in the 2006-2013. From the policy front, this indicator can serve as a precautionary early warning measure in formulating future fiscal path for Malaysia. This can be executed by targeting debt ratio and shifting the allocation of expenditures away from less efficient toward more growth-enhancing ones, which eventually would regain fiscal space to counter any incoming economic shocks in the future. This can enhance the fiscal transparency and assist in formulating a fiscal policy strategy in Malaysia.

1. Introduction

Fiscal sustainability is one of the important elements in maintaining a stable and growing economy. It is a state where a government is able to finance its fiscal or budgetary deficits without generating explosive increases in public debt in the long-term period (Adams, Ferrarini, & Park, 2010; Lau & Lee, 2018; Bui, 2020; Ngo & Nguyen, 2020). When this condition is met, the government budget is said to be sustainable and, vice versa, when the condition is not met. The issue of fiscal sustainability involves two important components, fiscal deficit and public debt, where these two are the common features in all countries. Fiscal deficit or budgetary deficit takes place when a government has excess of government outlay over government receipt, excluding borrowings in a given period. When a government runs persistent fiscal deficits, government resort to borrowing to finance the accumulated deficits where government borrowing finances long-run development and debt burden can strongly affect it (Neto, 2020). At this point, the accumulated value of this deficit is the public debt. To be specific, deficit and debt are interdependent or closely related to each other. Fiscal deficits increase public debt levels which leads to increase in the future net deficits as a consequence of the need to service higher interest payment on debt. This causes the debt-servicing costs to increase and raises budgetary outlays that may transfer into larger deficits and forms a potentially vicious cycle which the fiscal policy is considered to be unsustainable. With this, the assessment of fiscal policy sustainability is often built upon the solvency of a government by projecting the flows of overall fiscal balances and debt dynamics.

The definition of fiscal sustainability is frequently associated with two main concepts. One is related to solvency and another one is related to the capability of a government to maintain its fiscal position while remaining solvent. The was introduced by Domar (1944) where public debt ratio is to converge to finite value; Buiter (1985) and Blanchard (1990) further elaborated that a sustainability is when the public debt ratio is able to converge back to its initial level. Secondly, Blanchard et al. (1990) proposed that sustainability is when the present discounted future primary surpluses should be equal to the current level of public debt. In other words, to remain sustainable, a government should not be a net debtor.

There are different measures for fiscal sustainability. The first approach involves the time-series properties of variables such as government (spending and revenues), and public debt stocks and interest payment (Hamilton & Flavin, 1986; Wilcox, 1989; Trehan & Walsh, 1991). Their analogy derived from unit root testing where, if these variables are found to be stationary, then the government is expected to balance its budget in the long run. The second approach tests the cointegration relationship to evaluate the sustainability of fiscal stance (Hakkio & Rush, 1991; Haug, 1991; Quintos, 1995). These tests involve considering whether the fiscal variables share common stochastic trends are consistent with the dynamic government budget constraint and fiscal sustainability. The third approach focuses on fiscal behavior by examining the response of primary balances to changes in public debt ratio (Bohn, 1991, 1998, 2005; Chalk & Hemming, 2000). In their view, for a fiscal policy to be sustainable, the response parameter of primary surplus to changes in debt ratio should be positive in value and less than unity. Recently, Pradhan (2019) survey on the numerous fiscal sustainability approaches available in the literature where he concludes that this issue is multidimensional in nature that need continuous assessment sound macroeconomic policy of a country. Dinh (2020) support the notion of sound macroeconomic policy for sustainable and stimulating growth. Using data from state- owned enterprises’(SOE) in China, Ferrarini and Hinojales (2019) found that in the case of intervention up to 20% of SOE debt, the contingent liability at 2.7% of the GDP in 2016 or 5.5% in 2021.

With the relevant literature and background, this study traced the path of fiscal sustainability in Malaysia by using IFS developed by Croce and Juan-Ramón (2003) from 1970 to 2017. Malaysia offers an interesting case for the following reasons. First, Malaysia experienced several episodes of fiscal deficits as in Figure 1. With the only exception of years 1993–1997, Malaysia fiscal deficits began to deteriorate in 1998 and reached 6.1 percent of GDP in 2000, and has been improving since then and reached around 2.6 percent of GDP in 2007. The steep increase in fiscal deficits post AFC contributed to the rising public debt. By 2007, government debt was registered at 40 percent of GDP. In 2009, Malaysian government implemented two fiscal stimulus packages totaling RM 67 billion for a return to a fiscal consolidation path post 2008–2009 Global Financial Crisis (GFC). As a consequence of the fiscal consolidation, fiscal deficit peaked at 6.5 percent of GDP in 2009. This rapid increase in fiscal deficits caused the government debt to increase and touched 51 percent of GDP in 2009.

Figure 1: Fiscal Performance in Malaysia, 1990–2017

Source: World Economic Outlook Database, 2019

Second, Malaysia experienced persistent fiscal deficits and this caused the public debt to rise as a result of countercyclical fiscal policy in the post-crisis period. The deteriorated fiscal position and relatively high debt ratio would limit the fiscal space to scope for countercyclical fiscal responses to counter economic shocks in the future (IMF, 2013). The reduced fiscal space in Malaysia generated concerns about the sustainability or solvency of the country’s fiscal position. Since independence, Malaysia has experienced several major crisis episodes. Malaysian economy has been hit hard by two major crises in the 1990s and 2000s, the Asian Financial Crisis (AFC) in 1997 and Global Financial Crisis in 2008. Malaysia has experienced continued fiscal deficits since the Asian Financial Crisis.

Malaysian revenue base is over reliant on volatile oil- and gas-related revenue, which contributed to about a third of the total revenue. The government revenue shows a declining trend post-Global Financial Crisis in 2009 (Figure 2) despite increased for the next few years and began to decline in 2012 mainly driven by declining in oil-related revenue as a result of declining global oil prices, which is narrowing the government’s revenue base. Malaysia has addressed some fiscal adjustments to broaden the revenue base in order to reduce deficits. These includes elimination of fuel subsidies and introduction of Goods and Services Tax (GST) to offset the fiscal impact of lower energy revenues and diversify budgetary revenues, balance the budget, and lower the debt ratio. More importantly, the introduction of GST helps broaden the base of Malaysian fiscal system and reduces the reliance on volatile oil and gas revenues as well as reducing the fiscal deficits. Besides that, Malaysia has undertaken reforms in government expenditure, including elimination of fuel subsidies to improve expenditure prioritization and foster government budgetary performance. These fiscal reforms and adjustments by the government have effectively improved the fiscal stance after Global Financial Crisis where the expenditure as percentage of GDP started to decline in 2010 (Figure 2). With the ongoing pandemic and the fiscal expansion, the deficit is expected to soar upwards significantly.

Figure 2: Government Expenditure and Government Revenue, 1990–2017 Source: World Economic Outlook Database, 2019

Third, the sustainability indicator can help to maintain the target debt ratio over time in which to prevent the actual debt ratio to exceed the target debt ratio. It can be used as a warning indicator to the current fiscal policies when the indicator consistently hovers in the unsustainable region. Once this occurs, the indicator can serve as a precautionary instrument where some fiscal adjustment is necessary to enhance the budgetary position. Lastly, this study provides an insight of Malaysian fiscal policy sustainability using the recursive algorithm where most of the studies in Malaysia are conducted using stationarity and cointegration tests. It sheds some light to the current literature on the solvency of fiscal policy in Malaysia where recent empirical studies on this genre including Baharumshah et al. (2017), Lau and Lee (2018), Khan (2020) and Lee (2020).

The remainder of the paper is organized as follows. Section 2 describes the IFS derivation and data description. Section 3 reports the results, while Section 4 concludes.

2. Indicator of Fiscal Sustainability (IFS)

The IFS developed by Croce and Juan-Ramón (2003) derives from the government intertemporal budget constraint (IBC) understanding. It is assumed that net privatization proceeds, profits made by government by issuing money, and revaluations of assets and liabilities are equal to zero. Thus, the financing needs of the public sector are defined as follows:

\(R_{t}=\left(D_{t}-D_{t-1}\right)=P D_{t}+i D_{t-1}\)       (1)

Equation (1) indicates that the public sector borrowing requirement at time t(R_t) equals to the changes in public debt stocks (domestic and foreign) to finance the primary deficit (PD_t) plus the interest payments on public debt (i_tD_t-1). Equation (2) is obtained as follows:

\(d_{t}=\beta_{t}-d_{t-1}-p s_{t}\)       (2)

in which d_t is referred as the law of motion of the debt- to-GDP ratio; ps_t is the primary surplus as a percentage of GDP; and β_t is the discounted factor that is derived from β_t = (1 + r_t)/(1 + g_t), r_t is the real interest rate and g_t is the real GDP growth rate. Equation (2) explains that in the absence of shocks and corrective policies, d_t will increase over time in the presence of persistent primary fiscal deficits coupled with a real interest rate higher than the growth rate. Assuming that the discount factor remains constant from time t to time t + N, that is β_t+i = β, solving Equation (2) forward recursively for N periods, yields:

\(d_{t}=\beta^{-1} p s_{t+1}+\beta^{-2} p s_{t+2}+\ldots+\beta^{-N} p s_{t+N}+\beta^{-1} d_{t+N}\)       (3)

Equation (3) obtained can be considered as the fiscal condition for solvency. It is stated that the public sector is solvent when the present discounted value of future primary surpluses is equal to the value of its outstanding public debt stock. For this to happen, the last term in Equation (3) is set to be equal to zero, d_{t + N} = 0, in which the public sector cannot be a net debtor in present value terms and requires the primary balance to be positive at the end of the period. There is a less strict condition for solvency, that is, d_{t + N} = d^* where 0 < d^* < d_t. Under this definition, the present value of expected primary surplus ratios will reduce the debt ratio below the current level of debt ratio.

Following Croce and Juan-Ramón (2003), there are three equations required to construct the indicator of fiscal sustainability (IFS) to assess fiscal sustainability. This includes Equation (2), the law of motion of the debt-to-GDP ratio; the target variables, Equation (4); and the government reaction function, Equation (5).

In Equation (4), the target variables ps^* and β^* are the primary surplus ratio and the discount factor that are required to achieve in order for the debt ratio to converge to d^*, the target debt ratio. Here, d^* is set to equal to the lowest value reached by the debt ration during the period under study while β^* is the value of the sample mean of the observed values of β.

\(p s^{*}=\left(\beta^{*}-1\right) d^{*}\)       (4)

\(p s_{t}=p s^{*}+\lambda_{t}\left(d_{t-1}-d^{*}\right)\)       (5)

Equation (5) is the government reaction function defined in Equation (6). Two crucial components in the equation are the target variable, ps^*, and the intensity of the policy response at time t, λ_t, given the debt ratio gap in the previous period. Equation (5) is characterized as the fiscal rule or a policy reaction function. Combining Equation (2), (4) and (5), the law of motion of the debt-to-GDP ratio including the policy reaction parameter λ_t becomes:

\(d_{t}=\left(\beta_{t}-\lambda_{t}\right) d_{t-1}-\left(\beta-\lambda_{t}-1\right) d^{*}\)       (6)

To derive the indicator of fiscal sustainability (IFS), assume that the debt ratio at time t – 1 is higher than the target debt ratio, d_t-1 > d^* Equation (6) explains that the current debt ratio would only return to the target debt ratio if only (cid:31) \(\left|\beta_{t}-\lambda_{t}\right|\). Hence, β_t −λ_t is proposed as the indicator of fiscal sustainability (IFS) expressed in Equation (7).

\(\mathrm{IFS}_{t}=\left(\beta_{t}-\lambda_{t}\right)=\left(\frac{1+r_{t}}{1+g_{t}}-\frac{p s_{t}-p s^{*}}{d_{t-1}-d^{*}}\right)\)       (7)

Equation (7) describes the difference between the discount factor and the policy reaction parameter. The discount factor β_t measures spread between the observed real interest rate and observed real GDP growth rate while the policy reaction parameter λ_t measures the deviation between the target and the observed primary surplus and public debt ratio. Fiscal position is sustainable if the indicator of fiscal sustainability is below 1 (IFS < 1) whereas fiscal position is unsustainable if IFS is equal or above 1 (IFS ≥ 1).

The construction of the IFS algorithm consists of two components, β_t and λ_t in Equation (7). Cruz-Rodríguez(2013) adopts this indicator and found unsustainable fiscal position were indeed useful for prediction of currency crisis occurrence. For this study, we follow Croce and Juan-Ramón (2003) and set the targeted debt ratio, d^*, as the lowest value of debt ratio during the sample period under review and β^* is the sample mean value of the distribution of the observed values of β_t. First, we calculate the observed real interest rate and the observed real growth rate to obtain β_t. The value of β_t is the lead indicator. The expected value of β_t should be about 1 for mature stable economies Croce and Juan- Ramón (2003). Higher spread would lead to higher public indebtedness. Then, we calculated the targeted primary surplus value from Equation (4) with d^* is the target debt ratio set as the lowest value and β^* is the value of the sample mean of the observed values of β_t. The empirical analysis is conducted using annual time series spanning from 1970 to 2017. The primary fiscal balance and government debt as GDP were obtained from World Economic Outlook (WEO) database of International Monetary Fund (IMF) while real interest rate and real growth rate are obtained from World Development Indicators (WDI) database of World Bank.

3. Empirical Results

This section presents the results from the fiscal sustainability indicator (IFS) using recursive algorithm. Table 1 shows the behavior of the algorithm and its components, β and λ. The first row shows the frequency of the number of years as a percent of the total years during the sample period 1970–2017, which the value of IFS (β−λ) is above the threshold of 1, indicating fiscal unsustainability. Second row of Table 1 shows the frequency of the β values being higher than the expected β* values while the last row shows the frequency of λ assuming negative value implying primary deficit. Table 1 reveals that for Malaysia, the frequency of negative values of λ is higher than the frequency of high values of β. This implies that the unsustainable fiscal stance is explained mainly by government deficits rather than spreads between the real interest rates and the growth rates.

Table 1: IFS components behavior

From the IFS algorithm calculated for Malaysia, out of 48 years under the reviewed sample period, there are 40 years in which the IFS values were above the threshold of 1, accounting for 83 percent of the sample period studied. Given the β* is 0.9828, the frequency of β > β* and λ < 0 accounting for about 44 percent and 90 percent of the sample period, it explains that the unsustainable fiscal position is mostly driven by the continuous fiscal deficits (λ < 0) rather than the spread between the real interest rates and growth rates. The calculated components of IFS algorithm are tabulated accordingly in Table 2 for better understanding.

Table 2: Indicator of Fiscal Sustainability for Malaysia

It is noteworthy that, for most of the year, Malaysia has been staying in the unsustainable regions depicted in Figure 3. These unsustainable regions are identified as years 1971–1993, 1998−2004, 2006−2013, and 2015−2016. The calculation of IFS algorithm provides a real insight of the fiscal stance of Malaysia over the sample period. In the 1970s and 1980s, Malaysia experienced fiscal deficits in advent of the National Economic Policy (NEP) announced in 1970. Fiscal authorities used government spending as a policy instrument to achieve the NEP restructuring objectives, and resulting in Malaysia experiencing fiscal deficits during the ensuing period. This explains the negative values of the component λ, implying fiscal deficits, in the IFS algorithm in the 1970s to 1980s. Correspondingly, the calculated IFS algorithm also reflects the fiscal policy path during some major economic events within the examined sample period. For instance, the Malaysian economy was shaken by three major economic crises, notably the 1985−86 Commodity Shocks, 1997−98 Asian Financial Crisis, and the 2008−09 Global Financial Crisis. The impact of the Asian Financial Crisis on the Malaysian economy was felt in 1998. The economy contracted by 7.5 percent after 12 years of uninterrupted expansion averaging 7.8 percent per annum (BNM Annual Report, 1999). Expansionary fiscal policy focused on strengthening macroeconomic stability was adopted to promote recovery of the economy, which caused the overall fiscal position reverted to a deficit of 1.9 percent in 1998 from a surplus of 2.5 percent in 1997. In 2008, Malaysia experienced the impact from the Global Financial Crisis where the real GDP declined by 1.7 percent in 2009 from 4.7 percent in the previous year. In response to the global recession, the government implemented two stimulus packages in 2009 amounting RM67 million or 9.9 percent of GDP. As a result, the fiscal deficit increased to 7 percent of GDP in 2009 from 4.8 percent in 2008 (BNM Annual Report, 2010). The steep rise in the deficits also caused the gross debt to increase and surpassed pre-AFC peak and touched 52 percent of GDP in 2010 (Figure 1).

Figure 3: Fiscal Sustainability Path for Malaysia (1970–2017)

Following Croce and Juan-Ramón’s (2003) recommendation, a country is characterized as fiscally unsustainable if the IFS above the threshold of 1 is at least 75 percent of the period studied. Hence, following the IFS algorithm calculated, the fiscal policy in Malaysia presents an unsustainable path with the calculated IFS algorithm hovered above 1 at 83 percent of the time period in this study.

4. Conclusions

This study traces the fiscal sustainability of Malaysia from 1970 to 2017 using the IFS algorithm. This study finds that Malaysia has been enduring problems of fiscal unsustainability for the IFS > 1 at 83 percent in most of the period studied. The unsustainable fiscal positions are mostly driven by persistent primary fiscal deficits rather that the increasing real interest- rate-growth gap throughout the sample period. The behavior of IFS path is sensitive to economic shocks such as economic crises. The IFS values fluctuated above the threshold of 1 when the Malaysian fiscal positions were adversely impacted by the financial crises in 1997 and 2008. Despite having been fiscally unsustainable, Malaysia’s fiscal stance shows improvement as a result of fiscal consolidation and fiscal reforms during the sample period. This is shown by the improved calculated IFS algorithm on average, which the value improved from 1.465 in 1970−1993 to 1.377 in 1998−2004 and to 1.146 in the 2006−2013.

The recursive IFS algorithm is an effective and suitable monitoring device for maintaining fiscal solvency in a country. It served as a precautionary early warning measure when the IFS algorithm maintains long enough in the unsustainable region (IFS > 1). This can enhance the fiscal transparency and assist in formulating a fiscal policy strategy in Malaysia. To improve the fiscal stance in Malaysia, the government could announce the target debt ratio which would keep it within the sustainable region. An effective fiscal consolidation (higher λ) strategy would lower the real interest-rate-growth gap (lower β) and further strengthen the sustainability of fiscal policy in Malaysia. Looking forward, commitment to fiscal consolidation and possible measures to lower the fiscal deficits have to take place to broaden the revenue base. Governments can consider shifting the reallocation of expenditures away from less efficient expenditures toward more growth-enhancing ones. One good example would be increases in the spending composition of infrastructure and education projects that have long-term gains in the economy (Gemmell, Kneller & Sanz 2016). This eventually would regain fiscal space to counter any incoming economic shocks in the future.