THE economy has not fully recovered from the deep scarring effects of the two-year long Covid-19 pandemic amid lingering concerns about the highly transmissible Omicron virus.

       Our external sector remains susceptible to any persistent shocks that would threaten the world economy, as a sharp economic slowdown in Malaysia’s major trading partners would weigh on our export engine growth.

       Russia’s invasion of Ukraine has triggered massive negative supply and oil price shocks, which pose a double-blow to the world economy. This perfect storm can further dent growth prospects and drive inflation higher at a time when inflation expectations are already becoming unanchored.

       Businesses are struggling with the supply chain disruptions, increased input and logistics costs.

       The risk of global stagflation and recessionary conditions have risen in some advanced economies, especially in the United States and European countries.

       The US Federal Reserve’s resolve of reining in the persistent surge in inflationary pressures through possible aggressive interest rate hikes could slow the US economy sharply and may tip it into recession. China’s zero-Covid approach has triggered a lockdown in some provinces and its property debacle has bitten growth.

       External trade

       On the first order of trade-enhancement effect, Malaysia will benefit from higher oil and gas prices, albeit the declining production in recent years. Both crude oil and liquefied natural gas or LNG contributed to 4.6% of total exports (RM56.6bil) in 2021.

       Malaysia’s net export of crude oil surplus has narrowed from 2.6% of gross domestic product (GDP) in 2008 to between 0.1% and 1.5% of GDP in 2009-2021. Likewise, the LNG surplus also shrank from 5.3% of GDP in 2008 to 2.2% of GDP in 2021.

       If the combined impact of persistent supply chain disruptions, inflation and oil shocks causes a sharp slowdown in the global economy, it will have a knock-on effect on our exports via the second-order effect.

       This will reduce demand for Malaysia’s exports. Higher prices’ effect would be negated by the lower export volume.

       Sustained revival the key

       A sustained revival in consumer demand holds the key to ensuring a durable domestic economic recovery. But we should be wary of the impact of elevated inflation pressures on consumption; and increased costs as well as the worker shortage on business investment.

       The year-long supply chain disruption, price and cost pressures, which continued into 2022, have dampened the sentiment of both the consumer and businesses.

       Amid a gradual improvement in the jobless rate and income growth, consumers are expected to spend more discretionarily due to the shrinking purchasing power. Households find their bills rising and spending power squeezed by costlier food, household expenses and the rising cost of living.

       Businesses are expected to invest cautiously on the increasing cost of doing business and supply disruptions, as well as against the backdrop of global uncertainty due to Russia’s invasion of Ukraine.

       In addition, margins were squeezed, albeit with some partial pass-through of the increased cost to consumers. Businesses may put on hold their investment commitment plans, given the uncertainty surrounding the supply and prices of raw materials and inputs.

       While the government’s ballooning fuel subsidies will buffer domestic consumers and businesses, soaring energy prices and related negative supply shocks on commodities and industrial materials will spill over into Malaysia in the form of higher input costs such as fertilisers, cooking oil, animal feed and pesticides, etc.

       On the financial market impact, we expect to see persistent volatility in the domestic stock and bond markets due to the spillover effect from the gyrations in the global financial markets. This will have an effect on consumers, businesses and investor sentiment and confidence. The ringgit will remain on a weakening bias against the US dollar

       The overall impact of the oil shock and other related consequences on the Malaysian economy will be mildly negative. We may see a scenario of slow growth and high inflation risk, as the underlining external and domestic headwinds hit domestic demand and exports.

       Budget deficit

       We estimate that the high oil prices would be negative to the overall fiscal deficit. In Budget 2022, oil-related revenue and Petroliam Nasional Bhd or Petronas’ dividend is estimated to amount to RM43.9bil or 18.8% of total revenue based on an oil price assumption of US$66 (RM278) per barrel.

       Assuming an oil price of US$100 (RM421) per barrel, this means a difference of US$34 (RM143) per barrel, which will translate into an additional oil-related revenue of RM10.2bil (excluding Petronas’ dividend of RM25bil in Budget 2022).

       But fuel subsidies will increase to an estimated RM27bil, as the RON95 retail price has been capped at RM2.05 per litre and diesel price at RM2.15 per litre since late February 2021.

       Hence, the higher price of oil is a negative fiscal deficit estimated at RM16.8bil, unless Petronas raises its dividend contribution higher from the budgeted RM25bil.

       The overall impact of high crude oil prices may widen Budget 2022’s deficit estimate of 6% of GDP by 0.5 percentage points to 6.5%, assuming that Petronas ups its dividend contribution by an extra RM10bil to RM35bil.

       Other negative metrics on the fiscal deficit are probable higher subsidies for cooking oil, food prices and fertilisers, etc. Climate change risks such as unexpected flood damage could incur more contingency relief funding.

       Should fuel subsidies be rationalised in this current environment where inflation risk has risen considerably?

       If the current fuel price ceiling is maintained, the subsidy bill will balloon to an unsustainable level, compelling the reprioritisation of the government’s spending and expenditure programmes.

       If fuel subsidies are rationalised, fuel inflation and the second round of inflationary and cost pressures would ensue, having a knock-on impact on consumers and businesses.

       We think a viable sustainable fiscal approach now is to raise fuel prices gradually and eventually move towards a managed float regime for RON95 and diesel. The managed float regime will be accompanied by a targetted fuel subsidy for the low-income households.

       Interest rates

       Should Bank Negara raise the interest rate to tame the inflation risk and anchor inflation expectations?

       Some would argue that it is a supply shock and cost-driven inflation risk, and that interest rate hikes cannot affect an exogenous negative supply shock.

       If the central bank’s priority is to save growth, and it decides to delay interest rate hikes or a gradual pace of monetary tightening, this could accelerate the de-anchoring of inflation expectations, which will be incorporated into decisions and contracts.

       The situation today is different as the inflation risk is already rising, and continued business costs have compelled them to partially pass on these costs to consumers.

       Core inflation, which measures the underlying inflation trend, is expected to trend higher due to the pick-up in economic activities.

       Another financial risk consideration is that by keeping interest rates low for too long, it might encourage a build-up of excessive risk-taking in the financial markets, households and companies taking more debt.

       Lee Heng Guie is executive director of the Socio Economic Research Centre. The views expressed here are the writer’s own.