Fuel Prices, Interest Rates, FDI, and Inflation

UNCLAS SECTION 01 OF 05 KUALA LUMPUR 000357

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STATE FOR USTR - WEISEL AND BRYAN
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GENEVA FOR USTR

E.O. 12958: N/A
TAGS: ECON EFIN EINV EPETPGOV PREL MY
SUBJECT: Fuel Prices, Interest Rates, FDI, and Inflation
All On The Rise - Malaysia Economic Update - February 2006



1. U) Summary: The biggest news arrived at the end of
the month when the government of Malaysia (GOM)
announced a 23% hike in gasoline and diesel prices.
Earlier in the month, Bank Negara - Malaysia's central
bank - announced another overnight policy rate hike to
help control inflation and discourage capital outflows.
Malaysia's overall FDI increased by 37% in 2005, with
the U.S. the top investor at $1.1 billion. The GOM
decided to postpone indefinitely the looming Goods and
Services Tax because neither government nor industry
was ready to implement such a far-reaching change. The
9th Malaysia Plan -- Malaysia's tribute to Soviet era
economics -- will be delivered next month. We also
include a "man on the street" view of the Malaysian
economy to put some of these changes into perspective.
End Summary.

Fuel Prices Rise 23%
--------------


2. (U) On February 28, the government of Malaysia (GOM)
raised the price of gasoline, diesel, and liquefied
natural gas by RM 0.30 ($.08) per liter or 23%.
Gasoline now costs RM 1.92 ($.51) per liter; diesel
costs RM 1.58 ($.42) per liter; and liquefied petroleum
gas, or household cooking gas, costs RM 1.75 ($.47) per
kilogram.


3. U) This is the single highest price increase in
recent memory and the fifth in the past two years.
Gasoline prices are 42% and diesel prices are 102%
higher than the levels in May 2004. GOM has promised
consumers that this will be the only petroleum price
hike this year. Despite the recent increases,
Malaysians still pay less at the pump than any other
ASEAN nation, with the exception of Brunei. That is
due to the remaining high fuel subsidies that the
government pays on behalf of its consumers. Prime
Minister Abdullah suggested in a press conference that
the price would be more than RM 2.50 per liter should
the GOM remove all forms of subsidy entirely.


4. (U) Although Abdullah tried to downplay the
inflationary effects of the price hike, analysts
announced that inflation may rise by 3.5% to 3.8%
during 2006 due to higher transportation costs and pass
through effects to other parts of the economy. For
example, Jamarulkan Kader, the President of the
Malaysian Muslim Restaurant Owners Association
predicted that a plate of fried noodles would rise by
RM 0.50 ($0.13) per plate to RM 3.00 ($0.80 -- a 25%
increase) at hawker stalls. Although the 2000 members
of the groups may wait awhile to increase prices, Kader
expects that most will do so over the next few months.
Malaysian truckers did not have any such hesitation and
announced immediate transportation rate increases. The
Pan-Malaysian Lorry Owners' Association enacted a RM
0.15 ($0.04) per kilometer fuel surcharge on March 1.


5. (U) Minister of Domestic Trade Shafie Apdal promised
that the impact of the fuel increase would only be 0.12
percent. He suggested that he would accomplish this by
coming down hard on merchants who hike prices
unnecessarily, revoking their licenses if need be.
Yet, in the same press conference, Shafie also
announced that 285,000 bus operators and taxi drivers
would be given cards entitling them to subsidized
diesel.


6. (U) Abdullah defended the price hike by explaining
the GOM will save RM 4.4 billion ($1.2 million) in 2006
by not having to pay fuel subsidies. Due to the rise
in global oil prices over the past year, the GOM found
itself unable to sustain its program of fuel subsidies,
deficit reduction, and public project spending. GOM
paid RM 15 billion ($4 billion) last year and expected
to pay RM 16 to RM 20 billion ($4.27 to $5.33 billion)
this year. Also, with the 9th Malaysia Plan due for
roll out in one month, the GOM may be looking for a
funding for long-term development programs even though
Malaysian consumers seem much more concerned with

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inflation at the moment.


7. (SBU) Exxon Mobile's Chief Financial Officer
explained to the Economic Counselor that the GOM is
actually taking in a small "profit" on gasoline after
the latest price hike. The subsidies that the GOM has
historically paid out are composed of two pieces: a
transfer payment for the consumer (given to the
consumers through artificially low prices and repaid to
the oil seller by the government) and foregoing sales
tax on fuel. In the recent past, the GOM was paying
the subsidy and foregoing all of its potential tax
revenue. The price increase has now moved gasoline
prices into the range where the government will be
collecting a small amount of tax on each sale.
Diesel fuel, however, will remain at a low enough price
that government will still be paying out subsidy
support, in addition to foregoing tax revenues.

8) (SBU) Another concern for the GOM is its status as a
net oil exporter. Deputy Prime Minister Najib, in a
March 1 television interview, admitted that Malaysia
could become a net oil importer in as few as 4 years.
He cited the need for conservation and to change the
Malaysian lifestyle as another reason to raise the fuel
prices. (Comment: Industry insiders have been aware
that Malaysian national oil company Petronas scrapes
the bottom of the wells to pump the 650,000 barrels per
day required to remain a net exporter. Najib's
comments are the first on record statement about this
looming challenge. The GOM has long relied on Petronas
as a cash cow for the nation. Petronas provides about
25 percent of the national budget, takes up the slack
when there is a need for national infrastructure (the
Petronas Towers are a national symbol of Malaysia),and
provides heavy subsidies to the state run electrical
utility, to name a few examples. End Comment.)


9. (SBU) Comment: Although Malaysia's central bank
Governor Zeti Aziz and Minister of Finance (II) Nor
Mohamed Yakhop have both stated that the inflation rate
this year would be manageable, it is hard to see how
prices will not rise. When asked if she would raise
interest rates again, Zeti exhibited her usual calm
manner and submitted that she would need to review the
outlook over time. In fact, the government of Malaysia
was anything but calm about this announcement. Prior
to releasing this news to the press, they strongly
urged that the media not refer to the price increase as
a "hike." The Deputy Minister of International Trade,
slated to participate in a joint press conference with
the Ambassador, refused to speak to the media without
assurances that there would be no questions on the rate
increase. It is worth noting that the leading English
language daily, the New Straits Times, led with the
banner: PRICE HIKE PAIN. Furthermore, the major
Islamic opposition party, incensed over the hike, has
announced that it will lead a protest on Friday, March
3, at the Mosque in central Kuala Lumpur, next to the
Petronas Towers. End Comment.

Interest Rates Hike
--------------


10. (U) On February 22, Bank Negara announced another
increase in Malaysia's overnight policy rate by 25
basis points to 3.25% from 3%. This is the second time
the Central Bank has increased the rate in the past 3
months. The last increase occurred on November 30,
2005; during the seven years prior to that increase
Bank Negara had held the overnight policy rate steady
at 2.7%.


11. (U) Several commercial banks, including foreign
banks, raised their base lending rates by 25 basis
points to 6.5% immediately after Bank Negara's
announcement. Although the rate hike was generally
expected, analysts are concerned that banks' loan
growth could be affected. In 2005, loan growth in the
banking system was 8.6%. Depositors continue to face a
negative real interest rate return with inflation

KUALA LUMP 00000357 003 OF 005


rising at 3.5% year-on-year in December 2005, and 3%
year-on-year for the whole on 2005. Inflation for
January, year-on-year, clocked in at 3.2%. Analysts
are now predicting 3.5 - 3.8% for 2006.


12. (U) Comment: While Bank Negara has concerns over
the rate of inflation, it also is worried by the
difference between Malaysian and U.S. interest rates
and the possibility of funds flowing out of the
country. But even with the increase, the gap between
Malaysian and the U.S. rates remains wide at 1.25%.
With current inflation rates (already high for
Malaysia) almost certain to increase, Bank Negara will
need to weigh the benefits of fighting inflation
through further rate hikes against the fear of slowing
economic growth. Analysts generally expect Bank Negara
to raise rates an additional 50 to 75 basis points over
the coming year. End Comment.

Malaysia's FDI Surges to 4-year High
--------------


13. (U) Foreign direct investment (FDI) in Malaysia
rose 37% to RM 17.9 billion ($4.8 billion) in 2005 from
RM 13.1 billion ($3.5 billion) in 2004. The Malaysian
Industrial Development authority (MIDA) reported that
2005 saw the highest level of approved FDI in Malaysia
since 1996. FDI accounted for 58% of total approved
investment in the manufacturing sector in 2005. The
U.S. topped the list with RM 5.2 billion ($1.4 billion)
in new FDI for approved projects, followed by Japan
($987 million) and Singapore ($773 million). This is a
major increase over 2004 when there was a mere $293
million in U.S. FDI.

Goods and Services Tax Implementation Postponed
-------------- --


14. (U) In a move that brought a sigh of relief from
businesses, both local and foreign, the GOM announced
on February 22 that it was postponing implementation of
the new Goods and Services Tax (GST). While most
businesses accept that GST is inevitable, there was
significant concern from groups such as the Federation
of Malaysian Manufacturers, the Malaysian International
Chamber of Commerce and Industry, and the American
Malaysian Chamber of Commerce as to the GOM's ability
to plan and implement the new tax system. The GOM also
may have been worried about the effect of tax increases
on some of the poorer elements of society who do not
currently pay income tax but who would be affected by a
universal GST. Further, the GOM had yet to produce its
guidelines for implementation of the GST and businesses
complained they were not being given sufficient lead
time to plan for the transition.


15. (SBU) Comment: Although the GOM has not reset a
date for the GST implementation, observers expect that
it will not be until after the next election. That
would place GST implementation, at the earliest, in
2008 and likely 2009. This is good news for the
possible U.S.-Malaysian Free Trade Agreement (FTA)
negotiations because the GOM will be able to focus all
of its attention on the FTA. Observers have suggested
to Econoff that the GOM would not be capable of
handling extensive negotiations on the FTA while
implementing a complete tax overall. End Comment.

A "Street Level" View of the Economy
--------------


16. (SBU) A recent conversation with a senior
executive of a local department store that caters to a
lower and lower-middle class clientele provided a rare
"street level" view of the economy. (Note: this
conversation took place prior to the February 28 fuel
hike.) This retailer is seeing a slight decline in
sales, which he believes is consistent with the results
of other retailers operating in his market niche.
Asked whether this was due to inflation, he said "no."
He said his customers are feeling some pinch from

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higher transportation costs (the result of cuts in
government fuel subsidies),but inflation is not biting
too hard since the government controls the prices of
most staple goods. What is holding back his customers,
he said, is uncertainty, as many depend on construction
and other low-end jobs that have been drying up as the
government cuts back on spending.


17. (SBU) On the other hand, the executive said that
middle and upper income earners are experiencing
inflation that he estimated as being much higher than
the government's stated figure of around 3.5%. He
claimed that the "market basket" for the government's
inflation index is over-weighted toward price-
controlled items. The fixed price items act as a drag
on the index and hold down the official inflation rate.
(Comment: This also could explain Malaysians' current
thirst for consumer credit borrowing. Interest rates,
which typically are set at the official government
basis plus a couple of percent, are probably well into
the negative zone these days for upper income
borrowers. End Comment.)


18. (SBU) But while sales are down, this retailer said
his store's bottom line is up because it has been
"getting more value for its dollar." Asked to explain,
he noted that the Malaysian ringgit has been riding up
in value with the U.S. dollar against many South and
Southeast Asian currencies. Since he sources many
simple manufactured goods from India, Thailand and
other neighboring countries, he has been able to
increase his profit margin while holding his ringgit
prices constant.

9th Malaysia Plan To Be Unveiled March 31, 2006
-------------- -


19. (U) The GOM is furiously working to finalize the
9th Malaysian Plan, which will set both economic growth
targets and strategic development priorities for the
coming five years. This will be the first plan
developed under the leadership of Prime Minister
Abdullah. Although held closely, indications are that
the plan will focus on Abdullah's stated goal of
transforming Malaysia into a knowledge-driven economy.
The 9th Plan should state what programs and projects he
intends to fund (high tech education) and identify how
much and where the funds will be found. Malaysia has
been developing these five-year plans since 1966.


20. (U) At the Eight Malaysian Strategic Outlook
Conference, in January, Deputy Prime Minister Najib
stated that the GOM would foster equitable distribution
of wealth and a fairer approach to ethnicity in 9th
Malaysia Plan. Specifically, there will be three main
thrusts, none of which are surprising. They include:
more incentives for the private sector in crucial areas
such as agriculture, life sciences, information and
communications technology, tourism, health and
education; greater effort to put human capital
development as the number one priority and build a
knowledge-based economy driven by innovation and ideas;
and, improvement of the public service delivery system
and cutting cost of doing business in Malaysia.


21. (SBU) Comment: Ethnic Malays are eagerly looking
forward to the 9th Plan because, historically, this is
how some of the nation's wealth is spread around.
Former Prime Minister Mahathir used the plans to launch
his new infrastructure projects, large and small, and
pass out contracts. Abdullah had cut back much of the
pork in the 8th Plan that he inherited and there has
been grumbling over the lack of development projects,
especially among the small Bumiputera (Bumiputera are
literally 'sons of the soil" but, in practical terms,
this refers to the government's affirmative action
policies favoring the majority Malay race) Class F
contractors. There are 38,000 Class F contractors and
only they are allowed to bid on small contracts (less
than RM 200,000 or about $53,000) specifically set
aside for them. As Abdullah's government only

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announced RM 2.4 billion ($640 million) worth of
construction projects last year, this politically
important group is looking for projects. A few weeks
after the unpopular fuel increase would be a
politically astute time to announce such Bumiputera set-
asides.


22. (SBU) Comment continued: For the ethnic Chinese
and ethnic Indian Malays, Najib's mention of equitable
distribution of wealth and a fairer approach to
ethnicity raises shades of the New Economic Program of
old. This policy was set in place to transfer money
and equity in business investment from the minority
races to the majority. Only the release of the plan,
however, will confirm whether it is a step back in
time, or a path to the future. End Comment.

LAFLEUR