1

The case for subsidy rationalisation

Economic Research






























































Economic Research
KDN No.: PP14787/11/2011(026546)




The case for
subsidy rationalisation




























MALAYSIAN RATING CORPORATION BERHAD
(364803-V)

Vol.: ER/012/2011




Economics Team


Nor Zahidi Alias
Chief Economist
+ 603 2082 2200
zahidi@marc.com.my

Mohd Afzanizam Abd Rashid
Economist
+ 603 2082 2200
afzanizam@marc.com.my

James Foo Kok Chye
Economic Analyst
+ 603 2082 2200
jamesfoo@marc.com.my









Please read the disclaimer on
the last page of this report



www.marc.com.my

31 May 2011

2

The case for subsidy rationalisation


Economic Research

In a nutshell

There are strong arguments for the government to embark on subsidy-rationalisation measures in Malaysia
as across-the-board subsidies for products such as fuel and food items tend to benefit the richest segment
of the population. Indeed, a recent study reveals that about 80 percent of gasoline subsidies in many
countries benefit the richest 40 percent of the population. Subsidies also send wrong signals to the market
and lead to misallocation of resources.
In Malaysia, the rising cost of global commodities has placed a significant burden on government coffers,
presenting a compelling reason for the government to review its subsidy policies. While the governments
budget deficit was mainly attributed to fiscal pump-priming measures during the global recession, sharp
increases in the prices of oil and other commodities have exacerbated the governments revenue-
expenditure gap.
Subsidy removals will undoubtedly affect consumer spending, especially if such measures lead to
widespread increases in the prices of consumer goods. In Malaysia, where private consumption is a major
pillar of the economy, a dent in consumer spending will adversely affect headline growth if such measures
were to be implemented aggressively. This is compounded by the fact that a large number of workers have
relatively low income levels, with 34 percent of them earning a mere RM700 and below per month according
to the National Employment Return (NER) 2009. Approximately 70 percent of the sample surveyed earn less
than RM1,500 per month, and even in a big city like Kuala Lumpur, 32 percent of workers earn less than
RM1,500 per month.

While there have been many discussions on the possible measures to mitigate the impact of rising prices on
the poorest group, the predicament of the middle-income group should also be highlighted. This group faces
the issue of relative poverty where their incomes are above the poverty level but are barely sufficient for
them to cope with the high costs of living in big cities.
All in all, subsidy rationalisation makes sense if the underlying intention is to shift the benefits accrued to the
mass population to targeted groups which are deeply affected by higher prices. However, subsidy
rationalisation efforts would best be introduced initially for non-food products which have been highly
subsidised across the board, such as fuel. The removal of subsidies for food items has to be done very
gradually as it affects the poorest segment of the population. Across-the-board assistance such as fuel
subsidies should be fine-tuned to curb overconsumption by the higher-income segments.
Subsidy rationalisation plans would ideally be accompanied by concise plans to protect the groups that will
be most affected, i.e. the poorest and the middle-income segments who live in big cities. For instance,
during the recent hike in the electricity tariff, the government clearly stated that those who use less than 300
kilowatt hours (kWh) of electricity per month will not be affected by the increase. Such information should
ideally be made available when other subsidies are gradually removed in order to reduce anxiety levels in
the community. Efforts to push prices closer to market-clearing levels should be accompanied by similar
efforts to ensure upward adjustments to the price of labour (wages). Besides handing out direct
compensation to the affected groups, disseminating information on the alternative places to shop from can
help tide consumers over this period of high prices.
The government can also take this opportunity to demonstrate their commitment to improving transparency
to achieve a two-pronged advantage: if subsidy-rationalisation efforts are transparently carried out, the
rakyat can better appreciate the rationale behind this seemingly controversial move and perceptions of
corruption could decline. Information on the amount of savings from subsidy-rationalisation efforts channeled
towards compensating the rakyat should be constantly highlighted in much the same way the Performance
Management and Delivery Unit (PEMANDU) did for investments. Certainly, regular and detailed information
flows can help eliminate doubts among the rakyat on the governments intention to reduce the countrys
unsustainable dependency on subsidies without adversely detracting from the welfare of the rakyat.






3

The case for subsidy rationalisation


Economic Research


The rationale for subsidy removal

Many discussions have centred on the governments efforts to rationalise subsidies that have become well-
entrenched in the Malaysian way of life. A widely held argument is that subsidies distort the economy by
sending the wrong signals to the market, leading to gross misallocation of resources. These are well-
documented arguments that are widely embraced in the field of economics.

Ironically, this kind of distortion has been accepted throughout the world. For instance, agricultural subsidies
in the western world, while constantly drawing flak from economists for their distortionary qualities, continue
to figure prominently in these economies. As a case in point, farm programmes in US to subsidise grains,
oilseeds, cotton, sugar, and dairy products have cost the US government a whopping USD20 billion per year
in the governments budget outlays in recent years.

Why do countries continue to endure this type of distortion in their economies? Similar to free-trade
arguments, removing any distortion would only yield positive results if, and only if, there is a level playing
field. That is, if we were to remove a distortion but others do not follow suit, then the overall impact on the
economy would be rather equivocal. In the same manner, lifting distortions in the goods market and not in
the labour market will not bring about optimal results. Therefore, although subsidies are often derided, many
countries will not remove subsidies completely because their policies go beyond the economic rationale.

Undoubtedly, there exist favourable arguments for subsidy rationalisation measures in Malaysia, as some
subsidies have been implemented in an across-the-board fashion that benefit the rich, who already live
comfortable lives, as well as the poor. The fuel subsidy is a prime example. In fact, a study conducted by the
International Monetary Fund in 2010 (Petroleum Product Subsidies: Costly, Inequitable, and Rising)
revealed that 80 percent of the benefits of gasoline subsidies in different countries went to the richest 40
percent of households. In view of this, the Malaysian government is taking rationalising efforts very seriously
to ensure that subsidies benefit only the most needy groups, i.e. the low- and middle-income groups who are
struggling in the wake of rising living costs.

Rising global commodity costs have also placed additional burdens on government coffers, giving the
government yet another compelling reason to review its subsidy policies. Government finances have been
considerably strained by the astounding gain in the price of crude oil by 200 percent since hitting a low in
December 2008 and the surge in other commodity prices sugar by 273 percent, cereal by 160 percent,
dairy products by 120 percent and meat by 58 percent since 2000 due to tight supply following
unfavourable global weather conditions and natural disasters. While a significant chunk of the governments
budget deficit was attributed to fiscal pump-priming measures during the global recession, spikes in the
prices of oil and other commodities have exacerbated the governments revenue-expenditure gap. As such,
Malaysias budgetary position, having been in the red for 12 years, is expected to continue languishing in
deficit in the next several years and could add to the governments debt burden.


Chart 1: Food and Agriculture Organisation (FAO)
Food Price Index (FPI) (rebased: Jan 2000=100)
Chart 2: Breakdown of the FPI (rebased: Jan 2000=100)
90.0
110.0
130.0
150.0
170.0
190.0
210.0
230.0
250.0
J
a
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N
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S
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J
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2
M
a
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M
a
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J
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N
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S
e
p
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6
J
u
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M
a
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0
8
M
a
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9
J
a
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1
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N
o
v
-
1
0
Index


80.0
130.0
180.0
230.0
280.0
330.0
380.0
430.0
480.0
J
a
n
-
0
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N
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S
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1
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N
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v
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1
0
Meat Price Index Dairy Price Index Cereals Price Index
Oils Price Index Sugar Price Index
Index
Sources: FAO, MARC Economic Research


Sources: FAO, MARC Economic Research

4

The case for subsidy rationalisation


Economic Research

Points to ponder

However, several factors have to be taken into consideration when taking steps to rationalise subsidies and
move prices towards market-equilibrium levels if the government intends to achieve these levels.

First, there should be a realisation that subsidy removals will undoubtedly affect consumer spending,
especially if such measures lead to widespread increases in the prices of consumer goods. Consider the
following case study: from July 2007, when civil servants last received pay hikes of between 7.5 percent
and 35 percent, one can see that prices of major food items have generally increased between 20 percent
and 40 percent within that period. A breakdown of the food component of the consumer price index (CPI)
reveals that prices of meat, vegetables, rice and sugar have surged by 25 percent, 27 percent, 34 percent
and 40 percent respectively. The salary hike for civil servants in 2007 was just enough to offset price
increases within that period, and those who received less than, say, a 25 percent increase in their income
since July 2007 would definitely feel the pinch from rising consumer prices.


Chart 3: Prices of food in Malaysia (rebased: Jul 2007=100) Chart 4: Private consumption contribution to growth
90.0
100.0
110.0
120.0
130.0
140.0
150.0
J
u
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7
O
c
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J
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A
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1
A
p
r
-
1
1
Rice Meat Fish veg Sugar
Index



Sources: CEIC & MARC Economic Research

Sources: CEIC & MARC Economic Research


In Malaysia, where private consumption constitutes a major pillar of the economy, a dent in consumer
spending will adversely affect headline growth. Indeed, private consumption in Malaysia contributed
approximately 3.4 percentage points to headline growth (or 70 percent of the overall growth) between 2000
and 2010, of which a large part was driven by the strong labour market and easy credit provided by financial
institutions to consumers. If, for some reason, labour market conditions deteriorate and credit lines to
consumers are unplugged, private consumption will take a hit, dragging the economys growth down.
Therefore, if subsidy removal measures are strictly implemented according to schedule, the government
must be prepared to accept a more benign growth profile in the next few years, although a continuous
extension of easy credit can provide a buffer to some extent. However, should the government provide
rebates to consumers in an across-the-board fashion upon detecting a softening in growth (as was the case
after the sharp increase in pump prices in 2008), then its aims of shrinking its budget deficit and increasing
subsidies effectiveness may not be easily realised.

Consumer welfare should be given due attention as well. According to the NER 2009, a survey conducted in
2009 with a sample size of 1.3 million workers, approximately 34 percent of workers earned RM700 and
below per month, while almost 70 percent earned less than RM1,500 per month. Even in a big city like Kuala
Lumpur, 32 percent of the workers surveyed earned less than RM1,500 per month (see Charts 5 and 6).









5

The case for subsidy rationalisation


Economic Research


Chart 5: Earnings of workers (overall) Chart 6: Earnings of workers (by state)
0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
Malaysia Sabah Sarawak
Below RM700 RM700-1,499
%


0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
80.0
90.0
100.0
J
o
h
o
r
K
e
d
a
h
K
e
l
M
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l
N
S
P
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P
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P
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a
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P
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T
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S
a
b
a
h
S
a
r
a
w
a
k
K
L
L
a
b
u
a
n
Below RM700 RM700-1,499
%

Source: NER 2009

Source: NER 2009


For these groups, food represents a bigger percentage of their monthly income than other groups. As such,
sharp increases in major food items could dent their disposable incomes, causing them to hold back on
other non-essential expenses. Compounding the problem is the fact that in Malaysia, food prices tend to be
very sticky downward, i.e. after they rise following an event like a hike in pump prices, they will stay elevated
even after fuel prices come down to the previous level or more. This can be seen from the experience in
2008 when pump prices were raised by up to 40 percent in June, pushing food prices up dramatically.
Although fuel prices were reduced in the subsequent months, food prices remained on the uptrend (see
Charts 7 and 8).


Chart 7: RON 97 & CPI (rebased: Jan 2008=100) Chart 8: RON 97 & CPI food (rebased: Jan 2008=100)
100
101
102
103
104
105
106
107
108
80
90
100
110
120
130
140
150
Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10
RON 97
CPI (RHS)


100
102
104
106
108
110
112
114
80
90
100
110
120
130
140
150
Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10
RON 97
CPI - Food (RHS)


Source: CEIC Source: CEIC













6

The case for subsidy rationalisation


Economic Research

Another point to note is that while there has been a lot of discussion on the possible measures to mitigate
the impact of rising prices on the poorest group, the predicament of the middle-income group should not be
ignored. Contrary to popular belief, high petrol prices do not significantly affect the poorest group as they are
more dependent on public transport. The middle-income group, on the other hand, faces the problem of
relative poverty where their incomes are above the poverty level but are barely sufficient for them to cope
with the high cost of living in big cities. Significant chunks of their incomes go towards food, rent (or
mortgages) and hire purchase (HP) loans. Since Malaysian banks have been providing easy access to HP
loans in the past few years, the number of registered motor vehicles in Malaysia have grown exponentially
since the 1990s (see Chart 9). As such, household expenses are heavily affected by pump prices.


Chart 9: Number of registered motor vehicles
-
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
20.0
Y86 Y88 Y90 Y92 Y94 Y96 Y98 Y00 Y02 Y04 Y06 Y08 Y10
489%
Source: CEIC



Under these circumstances, subsidy-rationalisation efforts would best be introduced initially for non-food
products which have been highly subsidised across the board, i.e. fuel. The removal of food items subsidies
has to be done very gradually as it affects the poorest segment of the population. At the same time, readily
available information on the plan to offset adverse impacts on the poorest group will be instrumental in
reducing anxiety levels in the community. Efforts to push prices closer to market-clearing levels should be
ideally accompanied by similar efforts to ensure upward adjustments to the price of labour (wages). In other
words, while there is a clear plan to elevate prices of goods like sugar in stages within a predetermined
period, there should also be a clear plan to raise labour compensation by a certain degree within the same
period.

Understandably, it would be a challenge to induce private-sector employers to conduct periodical reviews of
their remuneration packages as each firm would have different objectives and priorities. However, the public
sector can draft a plan of salary increases for civil servants within certain periods which could encourage the
private sector to follow suit. For instance, salary revisions similar to the one introduced in July 2007 (the first
in 15 years) can be done more frequently for those who work in big cities to ensure that they can cope with
the perpetually rising cost of living arising from lower (or eliminated) subsidies. While the government may
incur additional costs on such measures, it can be offset by a reduction in the intake of workers in the future.
In fact, measures such as redeployment of staff from overstaffed departments to ministries facing shortages
in manpower can reduce further bloating of the civil service.

Besides handing out direct compensation to the affected groups, disseminating information on the
alternative places to shop from can help tide consumers over this period of high prices. This is due to the
fact that in some areas, consumers only have access to shopping outlets in limited places, preventing them
from looking for best prices. Those who wish to go to hypermarkets have to travel far, and the greater cost of
travelling reduces or negates the benefits of lower prices afforded by such retailers. On the other hand, in
big cities, consumers can easily compare prices of goods being sold in competing hypermarkets located not
too far away from each other.




7

The case for subsidy rationalisation


Economic Research


The government can also take this opportunity to demonstrate their commitment to improving transparency
to achieve a two-pronged advantage: if subsidy rationalisation efforts are transparently carried out, the
rakyat can better appreciate the rationale behind this seemingly controversial move, and perceptions of
corruption could decline. Information on the amount of savings from subsidy rationalisation efforts channeled
towards compensating the rakyat should be constantly highlighted in much the same way PEMANDU did for
investments. Regular and detailed information flows can help eliminate doubts among the rakyat on the
governments intention to reduce the countrys untenable dependency on subsidies without adversely
detracting from the welfare of the rakyat.

Subsidy removals in other countries are commonly accompanied by some form of compensation to the
affected groups to alleviate the initial pain associated with higher prices. In Indonesia, for instance, a
temporary cash transfer programme was instituted to provide aid to approximately 19 million poor families in
2005 after petroleum prices were doubled. A similar measure was also implemented in 2008. In Jordan, the
minimum wage was increased and greater wage increases were given to low-paid government employees
after product prices soared by between 33 percent and 76 percent following the reductions in petroleum
subsidies in 2005 and 2008.

In Malaysia, the recent hike in the electricity tariff provides a good example on how the government can
reduce the countrys unsustainable dependency on subsidies without adversely detracting from the welfare
of the rakyat by clearly outlining a plan to protect the lowest income group. Such information should ideally
be made available when other subsidies are gradually removed in order to reduce anxiety levels in the
community.


Chart 10: The latest hike in domestic electricity tariff (starting June 1, 2011)
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
0 - 200 201 - 300 301 - 400 401 - 600 601 - 800 801 - 1000
0%
0%
0.1%- 0.6%
2.4%- 10%
10%
8.8%- 10%
Consumptionband (Kwh)
% customer in the band
Tariff
adjustment

Source: TNB



All in all, subsidy rationalisation makes sense if the primary intention is to shift the benefits accrued to the
mass population to targeted groups which are deeply affected by higher prices. Across-the-board assistance
such as fuel subsidies should be fine-tuned to curb overconsumption by the higher-income segments.
Subsidy-rationalisation plans are ideally accompanied by similar concise plans to protect the groups that will
be highly affected, i.e. the poorest and the middle-income segments who live in big cities. A move towards
market-clearing prices of goods should also be accompanied by efforts to bring labour-market compensation
closer to the market equilibrium.




8

The case for subsidy rationalisation


Economic Research













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