The biggest adjustment

FROM next week, Malaysians will say goodbye to a subsidy that has been almost a part of life. With petrol subsidies gone, Malaysia will join a growing number of countries that have rolled back on providing cheap energy prices at the pump but will be subject to volatile fuel prices going forward.

Absent from the removal of fuel subsidies by the Government has been the expected furore by the public. The one reason for the silence is that unlike previous cuts in subsidies, the removal of blanket subsidies to instituting a programme of a managed float should see prices of fuel stay where they are or in fact drop an inch as globally, crude oil prices have been on the way south for months.

With no impact on household budgets and disposable incomes for now, the man in the street has reserved their judgement on the cut in petrol subsidies. For the Government, the removal of such subsidies is also expected to be neutral at best as the low oil prices in recent historical terms means that while it will see a drop in revenue from the export of crude oil, it is no longer subsidising fuel to the tune of billions of ringgit it once did when petrol prices were north of US$100 a barrel.

Economists say the timing of the cut in fuel subsidies also has come at an opportune time. With prices where they are, the impact will be neutral across the board but the removal of such subsidies will mean that with the burden of providing cheap energy prices to the public and businesses now removed, the Government’s efforts of reigning in the fiscal deficit will likely be achieved.

Reports indicate that the Government had budgeted RM11bil next year for the provision of subsidies for RON95 and diesel.

That was sweet music to the rating agencies that have been worried about subsidies putting a strain on government finances and hindering any effort to trim the fiscal deficit.

By all accounts, the expectation is that the fiscal deficit target of 3% by the end of next year will be met.

But the removal of subsidies though throws a wrench into the future. What if the price of crude oil, although now low in historical terms, bounces back?

Plus there is confusion over what the plan will be in such a scenario with government officials saying the subsidies will return should crude oil prices cross US$80 a barrel. In the works is also a plan to offer subsidies on a targeted manner based on the income levels of individuals.

Immediate impact

The urgency to cut subsidies stems from the fact that much of the Government’s budget for next year was based on oil at US$105 a barrel for Tapis and US$100 a barrel for Brent crude.

Maybank Investment Bank Bhd says in a report that with Brent crude oil price projected at US$85 a barrel, there will be a shortfall in revenue projection of between RM5bil and RM9bil and that will stretch the deficit to be larger than the projected 3% to between 3.3% and 3.6%.

“Consequently, the Government will not be utilising the RM11bil allocated under Budget 2015 for RON95 and diesel subsidies, which we believe is enough to offset the oil-related revenue shortfalls arising from the risk of prolonged crude oil price weakness,” it says in its report.

The drop in crude oil prices, while it alleviates the necessity for cash payout for subsidies, presents another wrinkle for the Government.

Economists point out to the fact that the Government makes more money from oil and gas than it pays out in the form of dividends. And while the drop in global oil prices will benefit oil-importing countries, the reverse is true for Malaysia.

Its been estimated that for every US$10 drop in the price of crude oil, the Government actually loses RM4bil in revenue, while saving RM2bil in fuel subsidies. So the net effect is negative.

That will affect revenues, with oil and gas accounting for about 30% of government revenues, and some do even suggest that last year’s budget needs to be tweaked should the fall exacerbates.

“As Malaysia is still a net exporter of oil, sustained low prices may likely pose adverse impacts on the overall economy. Falling crude oil prices is a double-edged sword to government finances,” says AllianceDBS Research economist Manokaran Mottain.

He calculates that the net effect of a sustained fall in crude oil prices on the economy would likely be a bigger drag than the fuel subsidy savings, given that the oil and gas sector revenue contribution to GDP ratio was 6.6% versus the fuel subsidy to GDP ratio of 2.6% in 2013.

The implications of lower crude oil prices on government revenue are debated. Like the calculations above that show a tangible loss of revenue as crude oil prices start to slide despite the absence of subsidies, others feel the loss will occur should the price of crude oil hit US$60 to US$65 a barrel.

The other implication of lower crude oil and commodity prices though is on national accounts. Exports of oil and gas account for 19% of exports and with crude palm oil another 9%, the decline in prices of both those commodities will hurt the current account. Some wonder if the decline would be big enough to push the important economic indicator towards a deficit as about a third of exports are at risk from lower global prices.

Longer term impact

Right now there is no impact although households have seen two prior hikes of 20 sen each in the price of RON95 in September last year and last month. The managed float which the Government will replace subsidies with will see the price set based on an automatic pricing mechanism formula that pays oil and gas companies and petrol station owners a certain margin.

The base price will be determined by the Mean of Platts Singapore, which is used to set the price of RON97.

As the price of crude oil drops, people will see a drop in the price at the pump. That will free up finances and give breathing space when it comes to consumption and savings. The lower inflationary effect from lower furl prices will also help smoothen any increase in inflation the introduction of a Goods and Services Tax will have when introduced in April next year.

Expectations are for crude oil prices to remain soft in the near term, and some estimate for at least the next couple of years.

What happens when the price of crude oil goes up in the future?

“The transition will be painful and the economy will be impacted,” says an economist.

It will not be as painful as in 2004 when prices was hiked to RM2.70 a litre but the gradual increase in prices will slowly cut into disposable incomes of people.

Then there is the implication on inflation, and that too will push up the price of a number of goods and services.

The transport segment of the basket of goods that is used to calculate inflation carries the heaviest weightage, and the price of petrol such as RON95 and diesel influences that the most.

As it is, reports over the past week don’t paint a pretty picture of the state of households in the country. Household debt indicate that Malaysians are heavily leveraged and now about half of the population having little or no savings according to the latest report by United Nations Development Programme.

The Government did say there is a possibility of subsidies returning should crude oil prices start to rise again. Economists are adpoting a wait-and-see attitutde to see if that happens because any re-introduction of subsidies may not be viewed favourably by rating agencies and bond holders.

Then there is also the planned introduction of a tiered subsidy programme that will see the lower income group enjoy subsidies but not for those in the upper income bracket. The group between those two wiull enjoy partial subsidies.

A higher cost of petrol will make things tougher on the wallet of people, and also for companies.

Khazanah Research Institute in its State of Households report issued last week gave a snippet as what to expect. It estimates that in 2013, less than 23.8% (RM5.6bil) of the entire fuel subsidy went to households and the remaining RM17.9bil or more went to businesses, corporations and elsewhere.

With only 22% of the entire subsidy bill including that for gas going to households, that means higher energy prices will affect the profit margin of companies.

Credit Suisse in its report believes that the cut in subsidies is a message of fiscal prudence. It says elsewhere, such as India and Indonesia, the stock market rallied after fuel subsidies there were cut.

In Malaysia, the trend is not as clear as it says the Malaysian stock market has been mixed when fuel prices were increased.