THE RETURN OF CAPITAL EXPENDITURE OR CAPEX CYCLE IN MALAYSIA

PUBLIC BANK BERHAD ECONOMICS DIVISION MENARA PUBLIC BANK 146 JALAN AMPANG 50450 KUALA LUMPUR TEL : 03 2176 6000/666 FAX : 03 2163 9929 Public Bank Economic Review is published bi monthly by Economics Division, Public Bank Berhad. Materials in this publication may be used without restriction. However, an appropriate acknowledgement would be appreciated. While every effort has been taken to ensure the accuracy of the contents and analysis, Public Bank cannot accept any liability for any error or omission. THE RETURN OF CAPITAL EXPENDITURE OR CAPEX CYCLE IN MALAYSIA I. Introduction This article highlights some of the recent trends in capital expenditure (capex) by large private and public limited companies in Malaysia, based on a Business Expectations Survey of 270 companies in the country. The survey was conducted by the Department of Statistics, Malaysia, the latest being in October 2010. Trend in capital expenditure or capex provides a good indication not only on the strength of the current expansion in the Malaysian economy but also its future prospects. Capex, particularly by private companies, should be the driving force to support long-term sustainable economic growth of the Malaysian economy. Capex is an important driver for job creation and consumer spending, particularly for emerging market economies such as Malaysia. As part of the Malaysia's Economic Transformation Programme (ETP), the Malaysian Government is driving private capex and private investment to increase income and achieve a developed nation status by 2020. For emerging market economies, low capex and investment is often associated with low economic performance. Also, with low capex, the economy would perform significantly below its potential. II. Capex and Economic Growth The relationship between capex and economic growth is clear and well documented. In a simple form, growth accounting decomposes growth in output into three components, namely: growth in total factor productivity, growth in labour input and growth in capital input such as capex. The relationship between growth in output with the three input components is positive: Higher capital input will lead to higher output and thus economic growth. The economy can achieve and sustain high economic growth if there is a steady growth in capex and capital stock, particularly by the private sector. In the last two years, public investment and spending (instead of private investment) have taken a front seat in supporting economic growth in many developed and emerging market economies. The exceptional fiscal stimulus to support global demand brought down by the unprecedented global financial and economic crisis in 2007/08 has contributed to global growth. The surge in public spending and public sector deficit should only be transitory, in line with the popular proposition by the Keynesian economics that high public spending and investment can be injected to offset the fall in aggregate demand. While the debate on the effectiveness of high public spending and public investment on economic growth is still on, many economists are of the view that the high public spending in many of the developed and developing economies - coupled with other economic stimulus measures such as near 1

zero interest rates - has averted the risk of a second Great Depression. However, because of the huge rise in public spending and public debt within a relatively short period of time to the extent that it has reached an unsustainable level, many of the advanced and emerging market economies have begun to consolidate their fiscal positions through fiscal reforms and budget cuts. Some of the multilateral agencies such as the International Monetary Fund (IMF) and the Organisation for Economic Cooperation and Development (OECD) have also called for almost all OECD countries to bring public finances onto a sound footing from this year onwards. The challenge is to formulate an exit strategy of the fiscal accommodation judiciously such that it does not stall economic recovery that has gained some traction in recent months. Some economies in the eurozone have already started taking austerity measures to address sovereign debt issues and market confidence. The revival of capex and private investment to support future growth is vital. support long-term sustainable growth of the economy. As showed in Graph 1, in the post-asian financial crisis 1997/98, the percentage of private investment of GDP has fallen significantly to only 10.8 per cent in 2010 from 15.5 per cent in 2000 due to low private investment in the post-asian financial crisis period. The slow recovery in private investment during this period was attributed to overinvestment that had taken place in the pre-crisis period of the Asian financial crisis 1997/98 and low corporate profitability. At the same time, Malaysia had to face stiff competition for foreign investment due to greater economic openness and liberalisation as well as robust growth in labour abundant economies in Asia such as China. III. Need for a Strong Capex Cycle in Malaysia In Malaysia, the need for a strong capex cycle - particularly by private firms - is to support the long-term sustainable growth of the economy and to further boost its competitiveness. Malaysia needs a return of strong capex or capital investment to drive economic development and growth. Like other emerging market economies, while efforts to accelerate growth in total factor productivity through innovation activities and human capital investment are ongoing, capital accumulation still forms an important component of the growth process in Malaysia. The fact that growth in total factor productivity and skilled labour can only be accelerated in the long run, the burden to support growth rests on capital stock. It is well noted that the falling share of private investment in gross domestic product (GDP) in the Malaysian economy during the post-asian financial crisis period is being addressed to Also, the need for a fast return in capex and investment cycle stems from the need for the Government to remain on track in its fiscal consolidation which has started in 2010. The consolidation will help the Government regain its fiscal flexibility to support the economy, if growth falls below expectations in the future. Like other major economies in the west and Asia, Malaysia has introduced exceptional stimulus packages to stimulate the economy and avoid a prolonged recession in 2009. As a result of these packages, the public sector deficit which was averaging at 4.6 per cent of GDP in the period 2000-2008 spiked up to 7 per cent of GDP in 2009 before falling to 5.6 per 2

cent of GDP in 2010 (Graph 2). With lower development expenditure and modest rise in operating expenditure, the Government plans to further reduce its deficit to 5.4 per cent of GDP in 2011. and rising business sentiment. During the first half of 2010, the Malaysian economy recorded robust GDP growth of 9.4 per cent, helped by sustained domestic demand and inventory rebuilding. For the whole year of 2010, total capex - as showed by the Business Expectations Survey - was estimated to rise by 16.7 per cent from the preceding year (Graph 3). The increase was significantly higher than the 7 per cent estimated GDP growth for the year. It is important to note that a large portion of the increase in the capex was financed by own funds, supplemented by local and foreign bank loans. The way the capex was financed indicated that large private and public companies in Malaysia maintained a strong balance sheet, despite the economic recession in 2009. It is well noted that excessive public spending to drive economic growth is unsustainable. While high public spending and public deficits may be justified on the basis that it is only transitory to stabilise the economy, it could drag future growth if it resulted in unsustainable public debt. Private investment and capex have to come to the fore to replace public spending and lead economic growth. IV. Recent Trends of Capex in Malaysia In 2009, total capital expenditure by private and public limited companies in Malaysia bottomed out when the Malaysian economy hit a recession. Based on the Business Expectations Survey by the Department of Statistics, Malaysia, in October 2010, total capex by large private and public limited companies dropped by over 31 per cent in 2009. However, the drop in the capex was reversed in 2010 when it began to show a rising trend in the first half of 2010, in line with the broad-based recovery in the Malaysian economy The increase in the capex in 2010 was also consistent with the rising trend of the rate of capacity utilisation of the manufacturing sector in the country. During the period, the rate of capacity utilisation of the manufacturing sector rose significantly from 59 per cent in the first quarter of 2009 to 75 per cent in the third quarter of 2010 (Graph 4). The increase in the rate of capacity utilisation took place in both domestic- and exportoriented industries, confirming a broad-based recovery in the Malaysian economy. 3

The Business Expectations Survey by the Department of Statistics, Malaysia, in October 2010 also showed that the largest capex was for acquisition of new machinery and equipment and also for acquisition of information technology (hardware and software). The type of the capex showed the effort by the companies to further enhance their efficiency and productivity. Sectors which showed a significant increase in capital spending in 2010 included transport and communication sector, real estate and business sector, construction and manufacturing sectors. Within the manufacturing sector, the highest capital spending was in industries such as other non-metallic mineral products; radio, television and communication equipment and apparatus; and food products and beverages. V. Factors to Boost Capex Several factors will continue to further reinforce the rising trend of capital expenditure in Malaysia in 2011. Stable Economic Outlook First, the present positive outlook for the global economy will have a significant bearing on the prospects and growth of the Malaysian economy and capital spending. As an open economy, the prospects of the global economy matter to investment plans by firms in Malaysia. Based on the positive trend of global indicators (such as the Global Purchasing Managers' Index which reflects global activities in the manufacturing and services sectors) and the latest OECD Leading Economic Indicator, the global economy remains on a recovery track. Also, recent economic assessments show that the global recovery is likely to remain on course in 2011, although the rate of the recovery will remain slow and disappointing in the developed economies. Various headwinds such as ongoing deleveraging process in the US which is expected to take several years to be resolved, tight credit, high unemployment, loss of household wealth and unsustainable sovereign debt will continue to test the global recovery. However, with the strong commitment by major central banks to keep their monetary policy supportive of economic growth with low interest rates amidst low inflation, the global recovery, nevertheless, should continue. At the same time, fiscal consolidation in the developed economies, while it is an urgent task to be pursued, is expected to be proceeded cautiously, realising that the recovery is still fragile. The expectations for robust growth in emerging market economies will contribute to the global recovery. Based on the IMF World Economic Outlook in October 2010, Brazil and Russia are expected to grow by 4.1 per cent and 4.3 per cent, respectively in 2011. Asia is expected to remain robust with India and China to continue to lead regional growth. India is expected to grow by 8.4 per cent and China by 9.6 per cent in 2011. The strong growth outlook for Asia will have a positive impact on Malaysia through higher intra-regional trade. Competitive Economy Second, Malaysia is a highly competitive economy and remains attractive as an investment destination for foreign direct investment. The overall Global Competitiveness Index (GCI) for Malaysia is high: In the 2010-2011 GCI, Malaysia was ranked 26th out of 139 countries in terms of international competitiveness. The high ranking was contributed 4

by key factors such as quality infrastructure, stable macroeconomic environment, strong financial market development, strong banking sector, easy access to credit and efficient labour market. The competitiveness of the economy will continue to support strong investment in capital stock in Malaysia. Consistent with the findings of the GCI, Malaysia was also ranked high by the World Bank and the International Finance Corporation (IFC) report on the ease of doing business in Malaysia. Out of 183 economies assessed by the World Bank and the IFC in its Doing Business Report 2011, Malaysia was ranked 21st based on key factors such as getting credit, protecting investors, paying taxes and trading across borders. In the World Bank and the IFC's report, Malaysia was ranked ahead of some of the developed economies such as Germany and France. Strategies to Boost Private Investment Third, the Malaysian Government has introduced important measures which will support capital spending and other investments in the country. For example, the Government has reduced the rate for corporate tax to 25 per cent, effective from 2009. In the last two budgets (i.e. Budget 2010 and Budget 2011), the Government has introduced aggressive measures to enhance both domestic and foreign direct investment by providing business-friendly environment, reducing government involvement in economic activities via privatisation, enhancing public-private partnership initiatives and relaxing conditions and procedures for foreign companies to operate in Malaysia. The two Budgets also provide concrete steps to boost the development of key industries such as tourism, information technology and communication, agriculture, construction, finance and Islamic banking, halal food and green technology. Small- and medium-sized enterprises (SMEs) will be strengthened via SME Development programmes. Efforts to crystallise investment plans in the ETP and the 12 National Key Economic Areas (NKEAs) will accelerate growth in capex and other investments. Easy Access to Financing and Low Funding Cost Fourth, easy access to financing and low cost of financing matter to capex and other investments. In this regard, the role and capacity of the banking system in Malaysia to provide adequate financing and serve the real economy is important to meet the expected increasing financing needs. As highlighted in the Public Bank Economic Review published in December 2010, the banking system in Malaysia is strong based on its strong capitalisation, strong profitability and strong asset quality. With ample liquidity in the banking system and modest inflation outlook, interest rates and thus funding costs to firms in Malaysia are expected to remain low. No Major Constraints by Firms Finally, whether or not planned investment will turn into realised investment depends partly on firms' expectations of their operational constraints in the future. The Business Expectations Survey in October 2010 showed that over 45 per cent of the firms surveyed did not anticipate any significant constraint (such as high prices of raw materials, manpower issue or tough competition) to affect their business operations, going forward. This positive indication by the firms should result in high realised investment and capex this year. VI. Conclusions In Malaysia, capex cycle has resumed and is expected to further strengthen in 2011 which in turn will boost the prospects and growth of the Malaysian economy. Based on the Business Expectations Survey by the Department of Statistics, Malaysia in October last year, capital expenditure by private and public limited companies showed a rising and healthy trend in 2010, in line with the strong recovery in the Malaysian economy. The rising trend of the capex was consistent with the increasing trend of the capacity utilisation rate of the manufacturing sector due to sustained growth 5

in domestic demand and improved external demand after a sharp economic contraction in 2009. Looking forward, the rising trend in capex in Malaysia is expected to be reinforced by several factors such as ongoing recovery in the global outlook, Malaysia's stable economic outlook, competitiveness of the Malaysian economy, strong banking sector with sufficient liquidity, and low interest rates. Also, the Government has introduced strategies and measures to boost private investment (such as lower corporate tax) and to further improve the cost of doing business and the efficiency of public sector's delivery in Malaysia. Copyright 2011 Public Bank Berhad (6463 H) ALL RIGHTS RESERVED 6