Inspector General of Police Khalid Abu Bakar triggered a media sensation in Kuala Lumpur on March 9, when he announced the formation of a high-powered three-agency task force to investigate the biggest financial scandal in recent Malaysian history. Khalid told a room packed with journalists that the Malaysian Anti-Corruption Commission, the police and the attorney general’s chambers would investigate whether improprieties occurred at 1Malaysia Development Berhad (1MDB) — a $14 billion sovereign wealth fund and pet project of Prime Minister Najib Razak — which was hit by losses last year and nearly defaulted on a bridge loan payment due at the end of December.
The fund is now undergoing restructuring with infusions from the private sector, but the near miss drove down Malaysia’s currency and government bonds and prompted calls from opposition leaders to make 1MDB’s accounts more transparent. The fund’s 42 billion-ringgit ($11.6 billion) debt includes a $3 billion bond sale in 2013, one of the largest issues that year from Southeast Asia.
The scandal shook a government already struggling with a host of issues, many of which are products of Malaysia’s recent prosperity. Although there is no evidence implicating the prime minister — he ordered the investigation — 1MDB is another complication for Najib and his ambitions for what he calls the New Economic Model, a plan designed to vault Malaysia out of the so-called middle-income trap. This “trap” is a condition many emerging nations encounter as they grow and find that rising costs blunt their manufacturing advantage and make further development more difficult.
The prime minister’s reform plan tackles the role of state capitalism, which has long been viewed as a driver of growth in Malaysia but which some see as an impediment to attaining that much-sought-after developed-country status.
Najib, 61, took the helm of multiethnic Malaysia’s long-ruling regime in 2009, promising to soothe racial tensions and bolster democracy. But he has come under fire from progressives for seeming to abandon those pledges and from ruling-party hardliners over, among other things, the 1MDB fiasco.
“Malaysia has reached high-middle-income status,” says Wei Shang-jin, a former division chief at the International Monetary Fund and a professor at Columbia University who became chief economist of the Manila-based Asian Development Bank (ADB) last year. “It is aiming to transform itself to become a high-income country. Its goal is to be like Singapore — it is not there yet. To get there, it needs to accelerate education reforms, legal reforms, governance reforms and capital market reforms. Malaysia is making progress, but it can do much more.”
To escape the middle-income trap and achieve Najib’s goal of per capita gross domestic product of $15,000 by 2020, a 44 percent jump from the current $10,426, Malaysia must grow between 5 and 6 percent annually over the next five years. Although the Malaysian economy expanded at 6 percent last year — a high for the past five years — and has averaged 5.1 percent since 2000, keeping up the current pace will be tough, analysts say.
Malaysia is suddenly facing a number of limitations on growth, some self-generated. As the world’s second-largest exporter of liquified natural gas and the only remaining net exporter of crude oil in Southeast Asia, the country has found low oil prices to be a problem. But two other factors also loom: a reduction in fuel subsidies, launched early this year, and the April introduction of a 6 percent goods and services tax (GST). Both measures are meant to boost government revenues and cut the deficit. Both will be a drag on growth.
Can Najib and his ministerial team, operating out of Putrajaya — the federal administrative city 25 miles south of Kuala Lumpur, begun in the ’90s by then–prime minister Mahathir Mohamad — overcome those hurdles? It’s a question global investors ask as they ponder whether to put more capital into this nation of 30 million that straddles the peninsula between Thailand and Singapore and includes a slice of the west coast of Borneo, across the South China Sea.
“The economy is doing well and will continue to do well,” Abdul Wahid Omar, Malaysia’s minister for economic planning, tells Institutional Investor. “We grew 6 percent in 2014, and we believe, despite the headwinds, that we can achieve a similar level in 2015. There is no doubt in my mind that Malaysia will achieve developed-nation status by 2020.”
Najib appears just as confident. The prime minister was all smiles when he spoke in February to a gathering of 1,000 chief executives from the ten member states of the Association of Southeast Asian Nations (ASEAN) at the Majestic Hotel, a landmark of British colonialism in Kuala Lumpur. “Malaysia’s marketplace has much to offer to the world. We have a dynamic marketplace that honors rule of law and offers a burgeoning consumer class,” he said.
The eldest son of Abdul Razak Hussein, Malaysia’s second prime minister, and a nephew of Hussein Onn, the country’s third, Najib held court at the ASEAN event. In 1967 his father was a founding signatory of the regional security bloc. This year, as incoming chairman of the group, Najib is leading ASEAN as it embarks on a five-year process of reducing tariffs and building a Southeast Asian economic community of 600 million people, with a collective GDP of $2.4 trillion.
“A lot is expected of Malaysia — a lot is expected of you as chairman of ASEAN — [do] you feel pressured to take on leadership of ASEAN, or do you feel inspired?” recently retired ASEAN secretary general Surin Pitsuwan, a former Thai foreign minister, asked after Najib had spoken. “I am still sleeping well at night,” the prime minister quipped. “I feel some pressure. It is good one feels some pressure. When one feels pressure, one will hopefully rise to meet the challenges.”
Even as Najib spoke, his ministers were putting finishing touches on the announcement of Malaysia’s 2014 growth: The economy expanded, as Abdul Wahid said, 6 percent, the highest rate since 2010 and, among ASEAN countries, second only to the Philippines’ 6.1 percent. Malaysia’s growth, Abdul Wahid says, comes from diversification across a range of industries. Before joining Najib’s cabinet in 2013, Abdul Wahid, now 51, was CEO of Malayan Banking, Malaysia’s largest bank; during his tenure Maybank’s revenue grew by some 56 percent and net income roughly eight times.
“We are taking a multipronged approach,” Abdul Wahid says, noting that Malaysia has succeeded in moving up the value chain from oil and natural-gas extraction to refining. “We see all sectors growing. We are quite encouraged with progress in high-end manufacturing. We see growth in construction. We see agribusiness growth. We see a broad-based growth driving Malaysia.”
Malaysia won independence from Britain in 1957 and has grown from an economy reliant on agriculture, in the 1970s, to one in which 55.3 percent of GDP comes from services and 24.5 percent from manufacturing. The symbol of this drive to modernize may be the Petronas Twin Towers in Kuala Lumpur, for a time the tallest in the world. “We are upgrading, and we have been able to diversify because we have continuously invested in infrastructure that facilitates moving up the value chain,” Abdul Wahid says.
Under Najib, Malaysia has begun implementing 52 “high-impact” projects requiring a total of RM63 billion, chief among them the RM36 billion Klang Valley Mass Rapid Transit Project. (Klang Valley encompasses Kuala Lumpur and the country’s largest gateway to the sea, Port Klang.) The project will build three commuter lines linking various districts of the greater Kuala Lumpur metropolitan area, which has a population of 7 million. The government has set up an RM20 billion fund to help the private sector get financing up to RM200 million (or up to 10 percent of the project cost). The fund is part of Najib’s efforts to stimulate private sector investments to grow at 12.8 percent, or RM115 billion per year.
At the core of Najib’s program is improved governance, a growing role for the private sector, an end to reliance on state-driven capitalism and a shift from so-called bumiputra affirmative action, which favors Malays, to policies that are needs-based. Each of these initiatives represents a major shift and threatens different constituencies. The controversial changes to bumiputra would provide economic opportunities for poor members of the primarily middle-class ethnic Chinese and Indian populations, which make up about 29 percent of Malaysians.
Najib may have no choice but to seek reforms: He is being squeezed by both rising political opposition and criticism from within his own party. Some of the current political tensions can be traced to the Asian financial crisis and Malaysia’s historic clash with the IMF. In 1998 prime minister Mahathir openly defied the Fund’s and the World Bank’s demands for austerity — so-called shock therapy. Mahathir rejected the proposed aid and instead imposed exchange controls, reflated the economy by printing money and began bailing out troubled Malaysian companies, many struggling with U.S. dollar–denominated debt.
The country’s economy contracted by 7.5 percent in 1998 but was the first in Southeast Asia to recover, rebounding 5.6 percent in 1999. Aside from the economy shrinking 1.5 percent in 2009, during the global financial crisis, Malaysia enjoyed average annual growth of 5.1 percent from 2000 to 2014, according to the ADB, placing it among Asia’s better performers for the past 15 years.
“Malaysia is now one of the booming economies of Asia,” says Laurence Brahm, an American-born, Beijing-based, self-described
political economist who consulted with the ADB during the Asian crisis. Brahm has been a vocal critic of shock therapy. “If you look carefully at the growth statistics, you can’t help but notice that economies that followed IMF policies did not recover very quickly. By looking at the statistics, it would appear Malaysia did very well,” he says. Thailand and Indonesia both embraced IMF policies, Brahm adds, but the former never fully revived, and the latter bounced back slowly. “Malaysia and China did not follow the IMF,” he says. “Both fire-walled their capital markets by imposing currency controls and reflated their economy.” Mahathir’s defiance became a triumph of state capitalism.
Still, the IMF episode created a coalition opposing Mahathir and Najib’s United Malays National Organization (UMNO), the long-dominant party. In rejecting the IMF, Mahathir in 1998 kicked out his deputy prime minister and Finance minister, Anwar Ibrahim, who then formed the current opposition coalition, Pakatan Rakyat (People’s Alliance). Anwar was subsequently convicted of what some view as trumped-up charges of sodomy (illegal in Muslim-majority Malaysia).
Despite a recent second jailing, Anwar remains a formidable Najib rival and, because of his arrests, something of a martyr. The Pakatan Rakyat, made up of the People’s Justice Party, the Democratic Action Party and the Pan-Malaysian Islamic Party (PAS), consists of disparate ideologies; what ties them together is their desire to end more than 50 years of rule by UMNO and its Barisan Nasional coalition.
Anwar, who last year called for an investigation into mismanagement at 1MDB, has long alleged that UMNO is dominated by “crony capitalism” and argued for reformasi, or political and economic reforms. His second jailing may neutralize him, but the alliance has not lost momentum. The Islamic fundamentalist PAS is positioning its leader, Abdul Hadi Awang, against Lim Guan Eng, head of the Democratic Action Party and chief minister of Penang state. Both are seen as possible Anwar successors.
In the 2008 elections Pakatan Rakyat won control of five of the nation’s 13 states, and it barely lost the hotly contested 2013 elections, in which it took a majority of the votes but failed to gain enough seats to form a government.
“Out of this we still may see an opportunity for the younger generation of new leaders to emerge,” says Bridget Welsh, a senior research associate at the Center for East Asia Democratic Studies, at National Taiwan University, and the author of a number of books on Malaysia. “There remains considerable pressure for the opposition to provide a viable alternative for the electorate, and this serves to push the alliance into some form of cooperation. It is not robust, but it remains the strongest multiethnic coalition in the country, more than the ruling Barisan Nasional coalition, as there is no longer any meaningful representation of minorities within it.”
The maneuvering to lead the alliance may create infighting, Welsh says, but it suggests that a post-Anwar era is about to begin.
The prime minister has more to worry about than the opposition. “Najib was effectively called on to resign recently by Dr. Mahathir,” says Welsh, citing a blog post by the former prime minister, the longest-serving leader in Malaysian history, criticizing Najib’s policies and leadership. At age 89, Mahathir is still widely viewed as a power in UMNO, which some critics view as a gerontocracy. “UMNO, with its lack of capable young leaders, racial bile and [no] clear policies, is in dire condition,” she says. “Remember, they lost the popular vote in 2013 and without serious irregularities lost the majority vote last time as well. It is not a coincidence that the opponent has been locked up.”
Abdul Wahid insists Najib had nothing to do with Anwar’s jailing. “One must appreciate we have a legal system that is based on the U.K. system,” he says. “We have an independent judiciary, and at the end of the day we should respect the decision of the court.” He says the prime minister will continue to push his reform agenda with or without a strong opposition.
Business leaders tend to side with UMNO and the government. “The allegations of cronyism and corruption — it exists in every nation,” says Abdul Farid Alias, Abdul Wahid’s successor as president and CEO of Maybank. “You should look at progress, whether it’s getting better or worse. In the case of Malaysia, it is getting better. There is more transparency. There is more framework for government to be transparent. The government is even going through a systematic approach when it comes to procurement. We have improved in this area 100 percent at every institution we have in Malaysia.”
YeeFarn Phua, Standard & Poor’s Singapore-based sovereign credit analyst, agrees that reshaping the deeply entrenched bumiputra policy is crucial for economic development. “Such affirmative action has made the allocation of human and financial resources inefficient, reducing the country’s growth potential,” he says. But he warns that a move to stop favoring Malays may lead to political backlash. “While the government has made minor deregulations in the past few years, any attempt to limit ethnic Malays’ privileges has faced strong opposition, especially with the recent election results showing the Barisan Nasional’s increased reliance on rural Malay votes.”
Many urban Malays side with Najib in his push to end preferential treatment, says Shamsul Bahari bin-Mokmin, an ethnic-Malay businessman and chief executive of Ofisgate Sdn, a Kuala Lumpur–based networking and broadband services provider. “I am all for opening up affirmative action to poor non-Malays,” he says. Subsidy is meant to help the real poor emerge from poverty, he says, noting that the government made the right move in the early 1970s by giving Malays subsidies and preferential treatment because they were the weakest economically among the ethnic groups. Nevertheless, after 30 years Malays have improved economically and are now able to compete fairly with others, he says. “This is the time when subsidies should be given across the board to all of those who are economically disadvantaged,” he adds. “For Malays, Chinese and Indians — for the three groups to live in harmony — fair economic policy is the answer.”
Abdul Wahid says Malaysia has no choice but to embrace diversity. “If you look at many countries, even in the private sector, diversity is a source of strength,” the economic planning minister says. “If you have a team that is diverse, you are able to harness the strength of each community or gender and even the generation gap, which is being addressed. We need to increase diversity in terms not only of gender but generation and ethnicity, too.” Small gains have been made in the past few years, he says: One in three senior civil servants is now a woman, up from less than one in five in 2010.
Under Najib the government has made efforts to root out corruption and increase transparency. The Malaysian Anti-Corruption Commission, which is involved in the 1MDB probe, is leading a campaign that examines the personal assets of policemen and investigates if the officers seem to be living beyond their incomes. And the government is working to improve transparency in the procurement processes for major infrastructure projects.
At the same time, the government has been reducing the fiscal deficit, from 5.4 percent of GDP in 2010 to 3.2 percent this year. Starting in April the government will begin collecting a 6 percent goods and services tax that is expected to raise an additional RM19.4 billion, boosting government coffers by 10.1 percent annually from 2015 to 2020. Ending the decades-old diesel and gasoline subsidies, which have been delivered at the pump, will save RM 10.7 billion more for spending on social programs.
The GST and fuel subsidy reductions have generated public criticism, but they seem to have won the backing of business leaders, who view them as necessary to reduce the deficit. “The economic policies they have put in place thus far in the past few years have been sound,” says Badlisyah Abdul Ghani, chief executive of CIMB Islamic Bank, Malaysia’s largest Islamic investment bank and a subsidiary of CIMB Group, the country’s second-largest lender.
“The GST is a good new source of revenues for the government to replace others, to reduce the need to rely on a few sources of income,” he says. “At the end of the day, people may complain about timing, where some people complain that it should have been done earlier and some say later. But what is required for the economy is for us to do it, and whether it is the right time or not the right time is not relevant. You just have to do it.”
However, the GST will put pressure on Malaysia’s growth, warns Tan Ting Min, head of research for Credit Suisse Malaysia. Tan expects 2015 to be challenging, with the GST hurting domestic consumption and squeezing corporate margins; she estimates growth will decelerate to 4.4 percent this year.
Though painful, the GST is a critical part of the regime’s efforts to find the right balance across a range of governance issues, says Azman bin-Haji Mokhtar, head of Khazanah Nasional, Malaysia’s $44 billion sovereign wealth fund. Khazanah, which was founded under Mahathir, has tripled its net asset base, from RM33.3 billion in 2004 to RM110.8 billion at the end of 2014.
Najib is trying to find the right balance between state-driven and private-investor-fueled capitalism, says Azman, adding that the government is encouraging private sector development and even allowing companies to compete with government-owned enterprises. He notes that Tenaga Nasional, the Malaysian power-distribution company majority-held by Khazanah, “often ends up getting the short end of power-purchase agreements with the private sector.” Many of Tenaga’s contracts were signed as long as a decade ago, when there were severe power shortages in Malaysia, later alleviated as more generating plants came on line. Tenaga has tried to renegotiate its contracts, but privately owned producers such as YTL Power International, Sime Darby and Tanjong have collectively blocked the attempt in court.
About 90 percent of Khazanah’s gross assets are invested in companies domiciled in Malaysia, giving the fund great influence over the domestic economy. Under Najib, the titular chairman of the fund, Khazanah has begun to make divestitures and has driven some of its 70 or so portfolio companies to get out of businesses they should not be in.
Last year Khazanah unloaded a 4.74 percent investment in port operator Westports Holdings for RM483 million and also trimmed its stakes in companies including Tenaga Nasional last year.
“There has been a concerted effort to rebalance state capitalism, to find the right balance between state and markets, between public and private,” Azman says. “We actively pursued a course of divesting noncore and noncompetitive assets.”
A sign that Najib is serious about opening up to the private sector can be seen in his attempt to resolve the 1MDB crisis. According to local media reports, Ananda Krishnan, Malaysia’s second-richest man, an oil and power plant tycoon (among many other businesses, including gaming and telecommunications), will lend 1MDB — which saw credit downgrades lower some of its debt to high-yield status — RM2 billion to settle a loan the fund took out with local banks. Repayment of that loan may pave the way for a $3 billion initial public offering.
The optimal balance between state-driven and market-driven capitalism has been debated in Malaysia for years. Even the IMF seems to have accepted some aspects of state involvement in development. In its most recent Malaysia country review, published in January, the Fund noted that continued investment in infrastructure and research and development can spur homegrown innovation and that improvements in the quality of education and increased female labor force participation can “help raise productivity, support higher sustainable growth, and foster a more inclusive society.”
Yet not all is rosy in Malaysia’s economy. “Modest income levels and the vulnerability of Malaysia’s export-oriented economy to global economic conditions constrain the country’s economic resilience,” says S&P’s Phua. “We believe that escaping the middle-income trap will continue to be a challenge for Malaysia.” But, Phua adds, several factors partly offset these weaknesses: an open, diversified and competitive economy with a moderately flexible labor market; adequately developed infrastructure; and a high savings rate.
The rating agencies are cautiously optimistic. Moody’s Investors Service rates Malaysian government bonds A3, with a positive outlook, whereas Fitch Ratings gives them an A–, with a negative outlook. “The A– Negative rating reflects pressure on the sovereign credit profile arising from weak public finances, rising contingent sovereign liabilities and the ongoing leveraging-up of the economy, particularly the broader public sector and households,” Fitch wrote. “However, the rating is balanced by a strong external balance sheet. Fitch estimates that Malaysia remained a strong net external creditor at 29.8 percent of GDP at end-2014.”
Malaysia today has $116 billion in foreign exchange reserves, the 21st-largest stockpile of currency in the world. But it may need all the cushion it can get, says National Taiwan University’s Welsh. “The GST will send the economy into a two-year downturn, as is the normal pattern,” she says. “Revenue projections are overrated, and the impact of the drop in oil price will hit this year. On top of the 1MDB scandal, that points to serious fiscal management issues. A closer look at the micro fundamentals — for example, household debt, revenue and expenditures — points to more caution ahead.”
Abdul Wahid says both he and the prime minister realize there are many challenges ahead — economic, financial and political. However, he believes Malaysia can average the necessary 5 to 6 percent growth over the next five years. He contends that the fact that tariffs will significantly fall among the ASEAN member states through 2020 will particularly help Malaysian companies and more than make up for slowing trade growth with the regional bloc’s top trading partner, China. Malaysian two-way trade with China rose 2.2 percent to RM207 billion in 2014, after hitting RM203.3 billion in 2013, up 12.5 percent over 2012. Last year intraregional trade amounted to approximately 25 percent of the region’s $2.5 trillion trade with the outside world. “Intraregional trade can only go up,” the economic planning minister says, “and that certainly will benefit Malaysia.” He adds, “If you look at the top 100 companies in ASEAN, about a quarter are based in Malaysia.” According to the ADB, the ASEAN economies together grew 5.6 percent in 2014.
Another area of growth is Islamic finance, Abdul Wahid says. Malaysia boasts the largest Islamic financial center in the world in terms of issuance of sukuk — shari’a-compliant corporate bonds — hitting RM62 billion in 2014, up some 27 percent from 2013. As the Islamic nations of Central Asia develop and as demand from the Middle East continues, sukuk growth will strengthen Malaysia as an Islamic financial center.
“We always welcome collaboration with other Muslim financial centers,” Abdul Wahid says. “We are seeing the growth of a network of Islamic financial centers. Just as you have New York, London, Tokyo and Hong Kong as global financial centers, we have Kuala Lumpur, Dubai, Abu Dhabi, Singapore and Jakarta. And the greater the flows and cross-border investments, the more opportunities there are for Malaysia.”
Despite the pitfalls and problems, the minister believes the government has the tools to secure strong growth over the next five years and says it will reveal its strategy in the 11th Malaysia Plan, which Najib will present to Parliament in May. The real challenge in the medium and longer term, he notes, isn’t growth per se but equitable growth. “How do we ensure that whatever economic success we have will be translated into the well-being of the people?” he asks. “So this goes beyond the income of Malaysia and into making sure we progress toward a civil society, making sure the quality of health care will continue to improve at affordable costs, so forth and so on, and that housing is adequately provided to people.”
The long-term future of Malaysia may be bright, but the 1MDB scandal is just the kind of distraction the government could do without. So far, as the investigations get going, there’s not much more than gossip and speculation swirling around Kuala Lumpur and Putrajaya. Normally, Najib could brush away these problems — and, in fact, political observers believe his job is safe for the moment. But he finds himself buffeted by friends and foes, by external economic forces and by the effects of his own reforms. Above all, there’s that middle-income trap to escape.
As many countries have discovered, it’s not easy making that leap. It’s enough to keep anyone awake at night, even a prime minister. •
Follow Allen Cheng on Twitter at @acheng87.
