Malaysian Economy Potentially Threatened by Falling Commodity Prices

World oil prices are falling precipitously. For an oil exporter like Malaysia, that is definitely bad news. Unless the country can diversify its economy, it may find it difficult to navigate its way through the economic challenges it faces on its way to higher income status.

World oil prices are falling precipitously. For an oil exporter like Malaysia, that is definitely bad news. Unless the country can diversify its economy, it may find it difficult to navigate its way through the economic challenges it faces on its way to higher income status.

Of course, the drop in the world price of crude oil, as much as it has hogged the headlines, is just the most visible manifestation of a larger movement. Many commodity prices took a hit over the last six months. While the price of a barrel of Brent Crude has dropped 45 percent since June 2014, both soybean and iron ore prices dropped over 25 percent. Taken from the beginning of the year, the drop in iron ore, at 49 percent, has actually been steeper than crude oil, at 43 percent. This is in some portion a reflection of the stronger US dollar, but only partly explains the commodity price collapse. In truth, high commodity prices over the last decade or so was an exceptional break in a longer-term trend of declining commodity prices.

It is well established that commodity prices tend to decline over the long run relative to the prices of manufactured goods. This fact has formed one of the foundations of economic strategy: to achieve stable, higher incomes, emerging economies need to foster the development of secondary and tertiary sectors.

That piece of wisdom underscored with a vengeance. While oil-producing economies have hit the headlines, a swath of commodity producers feels the impact, from Australia (iron ore) to Brazil (soybeans) to Chile (copper). Demand for commodities tends to be inelastic — an increase in supply will lead to large falls in price rather than large increases in volume, meaning lower revenues. For commodity producing economies, changes in the world prices of the commodities they export have immediate consequences for trade balances, GDP growth, and government finances.

Malaysia’s position as a net exporter of oil and gas is a case in point. Malaysia’s exposure to global primary commodity prices remains uncomfortably high, although it is well down from the very high exposure of the 1980s, when agriculture and mining accounted for over a quarter of the Malaysian economy. Efforts to diversify the economy away from the primary sector have been for the most part successful but incomplete.

To take one example, despite a quarter of a century of extracting crude oil, Malaysia still lacks the capacity to refine all the oil it extracts. Malaysia’s palm oil industry, another major export earner, is similarly stuck in mostly upstream production. The relative failure to move downstream into higher value added production, a problem masked by the high prices prevailing over the last decade, leaves Malaysia vulnerable to global price swings in the notoriously volatile commodity markets.

The immediate consideration for Malaysia going into 2015 in this environment is in sustaining growth and maintaining macroeconomic stability. The impact on the oil and gas industry is probably manageable, except for those involved in marginal field production. Given the long gestation period for these kinds of projects, oil companies are understandably conservative in their investment decisions.

A secondary consideration would be the impact on fiscal sustainability. The oil and gas sector directly contributed a third of the government’s revenue in 2013, and an even higher proportion indirectly through corporate taxes on downstream production of commodities like liquefied natural gas (LNG). A decline in oil and gas revenues would also have secondary effects on other sectors, such as transportation and finance.

Under threat is the Malaysian government’s target of cutting the 2015 budget deficit to 3 percent of GDP, and of maintaining the soft cap on government debt at 55 percent of GDP. Falling commodity prices could also damage Malaysia’s prospects of achieving high-income status by 2020, because of a decline in the growth rate of nominal GDP as well as the depreciation of the ringgit.

There exist longer-term threats to Malaysia’s external and internal balance. The LNG market is of far greater importance than crude oil to Malaysia, and here two developments do not augur well: Japan is slowly reviving its nuclear industry (Malaysia currently supplies a fifth of Japan’s LNG demand) and the export potential of US shale gas (natural gas prices in the US are half the equivalent Asian prices). If either or both of these come to pass, it would undercut Malaysia’s export revenues.

Malaysia needs to accelerate the diversification of its economy, either by moving further into downstream production or by fostering a swifter expansion of the manufacturing and services sectors. Another priority must be reducing the dependence on oil and gas revenue in the budget. If Malaysia does not take action to limit its vulnerability to lower commodity prices, it may find 2015 marks the start of a much more difficult economic story.

Will falling commodity prices bring down Malaysian growth as well? is republished with permission from East Asia Forum