Executive Summary
The global economy is under threat of a recession with the contagion from the US financial chaos spreading worldwide. Despite concerted interest rate cuts and massive liquidity injection, the credit crisis continues to deepen without signs of abating. Confidence has been badly dented with banks fearing to lend out while governments have raised the limits of deposit insurance to shore up confidence. Conditions would deteriorate further if the credit squeeze dries up funds for investment and household spending. The IMF foresees the impact on the global economy becoming more severe in 2009, with global growth projected to slow down to 3.0%, the slowest rate since 2002 (2008: 3.9%). In view of the ailing US economy, the IMF has drastically lowered the US growth forecast to a stagnant 0.1% in 2009 (2008: 1.6%). The spillover effects are predicted to slash Europe’s growth to 0.2% in 2009 (2008: 1.3%), and to soften Japan’s expansion to 0.5% (2008: 0.7%).

The Malaysian economy has been resilient in the first half of 2008, but is increasingly being affected by the global downturn. GDP growth has moderated to 6.3% in 2Q08 after a strong 7.1% gain in 1Q08, bringing growth to a high average of 6.7% in the first half. The growth was driven by high commodity prices, strong private consumption and steady investment, partly supported by fiscal spending. Malaysia has no direct exposure to the US market but is increasingly feeling the shock from the slowing US economy through trade and investment linkages. The external downturn has not reached bottom yet. The US economy is on the brink of a recession, Japan has reported a contraction and Europe is coming to a standstill. Singapore has gone into recession in 3Q08 based on quarter-on-quarter growth. Fearing a dismal global outlook and hit by rising prices of raw materials, the government stretched the fiscal deficit to 4.8% in 2008, reversing a nine-year progressive deficit reduction. This may be justified as difficult times call for drastic measures. The longer-term worry is the high dependency on oil revenue to finance fiscal spending. Government revenue will be affected by the decline in commodity prices if other sources of revenue are not sought. Given the heightening pressure on the economy and decreasing oil prices, the budget deficit is likely to exceed 5.0% of the GDP in 2008. The deficit may even exceed 4.0% of the GDP in 2009 with the increasingly unnerving outlook.

Monthly indicators up to July/August 2008 are starting to lose momentum. Industrial output is flattening further as the export-oriented sectors faced diminishing demand. Total exports have decelerated with electronics exports stalling, while commodity revenues are growing at a slower pace. The leading index is creeping up at its slowest pace this year, suggesting sluggish growth ahead. Inflationary pressures have gathered steam, with elevated food prices lifting inflation to 8.5% in August 2008. Despite small reductions in oil prices, domestic inflation has remained sticky so far. Despite soaring inflation, the Overnight Policy Rate (OPR) has been kept at 3.5% in view of the worsening downturn in the US economy and its potential negative effects on the domestic economy. With the risk of a severe economic slowdown exceeding that of inflation, the policy rate has been kept unchanged. The backlash to demand conditions will likely lead to the softening of inflation. Oil prices have fallen as demand subsides with the increasing slack in economic activity.

Consumer and business confidence indices have both dropped below the 100-point mark, the dividing line between optimism and pessimism as indicated by the results of MIER’s 3Q08 surveys. The Business Conditions Index (BCI), which is based largely on firm-level information, has slipped to 99.6 points in 3Q08 from 114.1 points in 2Q08, down 14.5 points, indicating that business confidence has deteriorated. Though still below 100 points, the Consumer Sentiments Index (CSI) has stabilised somewhat in 3Q08, rebounding to 88.9 points from the historical low of 70.60 points in 2Q08, aided by recent moves to lower domestic oil prices and bonus payment to public servants. With both indices staying below the threshold, the outlook for the Malaysian economy appears to be lacklustre.

With the financial crisis still unfolding and confidence failing, the bigger fear is the credit squeeze. Tight credit will have grave implications on consumer spending and investment activity, crippling the already slowing economy. The damage to the global economy will be deeper in 2009 with all major economies expected to slow down markedly. In hindsight, when the internet bubble burst in 2001 and OECD countries languished to a 1.2% growth, Malaysia’s growth came to a halt (2001: 0.5%). The IMF predicts the OECD will weaken to a 0.5% growth in 2009, putting Malaysia’s prospects in jeopardy. The internet crash did not lead to a banking crisis so the recovery was faster. The current crisis has done extensive damage and is nowhere near the bottom.

The US has managed to post a good growth in 2Q08 (2.8%) and delay a severe slowdown thanks to tax rebates, a previously weak dollar, and the cut in interest rates. In light of the resilient US economy and the higher-than-expected domestic growth during the first half of 2008, we are adjusting our estimates for GDP growth in 2008 to 5.3%, from 4.6% previously. It is likely that growth would deteriorate in late 2008, as the Malaysian economy takes the hit from the knock-on effects of a flagging global economy. Domestic demand will be propped up by fiscal spending, providing a partial cushion to the uncertain global economy. Falling commodity prices are not helping either, but may help soften inflationary pressures. The services sector will be the pillar of strength amidst a weak manufacturing sector. With the outlook for the global economy turning increasingly dismal, Malaysia’s GDP growth could decelerate to 3.4% in 2009 (2008: 5.3%). The downside risks of further fallout from the financial woes have amplified, meaning that unpleasant possibilities are not totally excluded.