BIMB SECURITIES RESEARCH

MARKET INSIGHT
PP16795/03/2013(031743)

19 June 2012

Economics

ECONOMICS

Bracing for the Fallout from a Deepening Euro Zone Crisis

In providing an insight into the Malaysian economic outlook for the second half 2012 (2H2012), we think it would be more relevant to analyse it from the perspectives of three major circumstances that will feature prominently in the global economy and will significantly influence Malaysias growth pace at least over the next 6 months: A sluggish global economic recovery due to recession in the Euro zones peripheral economies and the UK, patchy recovery in the US, slowdown in BRIC countries in particular China, India and Brazil Substantial weaknesses in Asian currencies especially vis--vis the US dollar (USD) and Japanese yen (JPY) The downtrend in global commodity prices and the impact on growth and inflation Challenging economic and financial backdrop as earlier optimism fades with the intensification of Euro zone crisis and fears of a Euro-zone breakup as the biggest downside risk The burst of optimism that we observed in the earlier part of 2012 has proven to be short-lived so far. The world economy appears set for a marked slowdown in 2012 with an expansion rate close to the lower-end of the 3%-4% range from 3.9% in 2011 following anticipations of significant deceleration in the 2H2012 due to: Protracted Euro sovereign debt crisis for more than 2 years, the major source of downside risk to the global economy given signs of crisis deepening of late and growing fears of a Euro-zone destruction Stunted growth in advanced economies either in the form of outright recession in the UK and Euro zones peripheral economies; haphazard recovery in the US and measured post-Fukushima tragedy rebound in Japan due to: o o Austerity measures and fiscal consolidation worldwide in particular in advanced economies Private sector-led deleveraging efforts in advanced economies following impairment of balance sheets of financial institutions as well as high indebtedness of businesses and households Still weak underlying health of labour and housing markets in Europe and the US despite recent tentative improvement in the US job growth

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Significant slowdown in BRIC countries in particular China, India and Brazil: o Soft landing in China with a GDP growth not far from the official target of 7.5% (the 2Q2012 GDP growth is likely to dip th below 8% YoY and will mark the 6 consecutive quarter of slowdown) Growth way below potential in India due to deepening crisis of confidence on continued Government policy inconsistency and uncertainty Stagnation for 3 consecutive quarters in Brazil

Recent escalation of the Euro zone crisis poses the most dangerous threat to the timid global recovery as fledgling signs of a somewhat firmer ground that we saw in the early part of 2012 began to wane in May 2012. Having narrowly avoided a technical recession in the 1Q2012, the Euro zone is widely anticipated to move from stagnation to contraction from the 2Q2012 onwards as even core economies struggle while peripheral economies remain mired in recession. Hopes that the more-than-two-year Euro zone crisis was nearing an end in late 1Q2012/early 2Q2012 were dashed in recent weeks with events in Greece and Spain, highlighting how limited the success so far of the bailout packages, debt restructuring measures and the 3-year Longer-Term Refinancing Operations (LTROs) undertaken by the troika namely the European Commission (EC), the European Central Bank (ECB) and the International Monetary Fund (IMF), either in concert or separately. These solutions have been often criticised for not addressing the real issues of peripheral economies in particular dwindling competitiveness, ageing populations, crippling indebtedness and imbalanced economic structure. Recent fiscal data also indicate how untenable the existing budget deficit targets for 2012 for Greece and Spain without tightening further austerity measures to rein in budget deficits. To revive growth after entering the consecutive 3 year of crisis, reinforce 13-year monetary union infrastructure and enhance credibility of and confidence in the Euro, there have been growing calls for structural reforms, closer coordination, deeper integration, more national sovereignty transfers with the right blend of debt-reduction/deficit-trimming and pro-growth measures such as: Renegotiation of the fiscal compact as the austerity-induced recession in the Euro zone curtails tax revenues and other collections, pushing further away targets for debt and deficit cuts Setting up a new fiscal authority to harmonise the fiscal policy and control public finances of Euro zone Governments, to manage the European sovereign debts, etc a step closer towards a fiscal union A new growth pact worth 120bn proposed by the newly minted French President, Franois Hollande, with sources of financing from short-term growth instruments such as project bonds, reallocated EU structural funds and fresh investment capital from the European Investment Bank (EIB) introduction of a financial transaction tax, job creation measures especially for youth Establishment of an EU banking union - the 100bn bailout announced on 10 June 2012 to rescue Spains banking system is widely seen as a precursor towards a bolder banking integration with region-wide crossborder banking supervision, EU emergency loans for troubled banks and an EU-wide deposit guarantee scheme
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Being a small, open and trade-dependent economy, Malaysia is vulnerable to external headwinds and weak global conditions through trade and financial channels. A back-to-back YoY decline in exports for March-April 2012 is evidence that global uncertainties have begun to take a toll on Malaysian exports. Fortunately, Malaysia can count on its resilient domestic demand as an anchor of growth to counter subdued exports. So far, domestic demand has held up pretty well, surging by 9.6% YoY in the 1Q2012, led by both the private and public sectors in consumption and investment. After a relatively stronger-than-anticipated GDP showing in the 1Q2012 at a 4.7% YoY pace despite moderating from 5.2% YoY in the 4Q2011, Malaysias GDP growth is likely to slow to below 4.0% YoY in the next 2 quarters before showing signs of a meaningful rebound towards year-end as weak export demand is expected to continue weighing down on the Malaysian economy given the dismal outlook of the global economy dragged by the Euro zone crisis. As such, we maintain our GDP growth forecasts of 4.2% for 2012, at the lower end of BNMs 2012 official GDP growth guidance of 4.0%-5.0%, downgraded at the release of its Annual Report 2011 in late March 2012 from the previous 5.0%-6.0% range. Apart from increasing global uncertainties, we should also be wary of a few domestic factors that could constrain growth potential in 2012: Delay in holding the 13 General Election (GE13) could be negative for the economy given the inclination among both businesses and consumers to adopt a wait-and-see attitude in the face of any form of uncertainties, The full start-up of Malaysias Gumusut-Kakap deep-sea oilfield with a full production capacity of up to 135,000 bpd has been delayed to the 2H2013 (instead of the 2H2012) due the longer-than-expected time needed to construct the floating production facility could prolong the overly modest growth in the mining sector which reversed 6 consecutive quarters of declines in the 1Q2012 with a very marginal 0.3% YoY gain. Still, the deep-sea oilfield could begin producing between 25,000-30,000 bpd in the 4Q2012 by linking some wells already drilled to another platform.
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Nevertheless, we believe some form of policy easing or stimulus measures undertaken by policymakers in a number of major economies in recent weeks such as China (25 bsp cut to Peoples Bank of Chinas 12-month lending and deposit rates to 6.31% and 3.25% respectively) and the UK (Bank of Englands liquidity plan or credit-easing operation by activating the sterling liquidity facility to inject at least 5bn a month into the system and a funding for lending programme that allows asset swap for BOEs funds to boost bank lending by about 80bn in total) could blaze the trail for a significant turnaround in the world economy towards end 2012 since growth inducement policies in particular monetary stimuli may normally take a few months to have the desired effects. Still, concerns are abound that any policy stimulus could only contain the downside or limit the damages instead of averting the slide or fuelling a sustainable recovery given the somewhat strong underlying recessionary forces.

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Meanwhile, we have identified a growing list of potential downside risks to growth that could saddle Malaysia with even worse recessionary threats: A potential Greek exit from the single currency, which Standard & Poors estimated that there is a one-in-three chance could be extremely disastrous to the global economy with lasting damages if : o The economic and financial repercussions from a Greek departure are not confined solely to Greece but spread to other Euro zone countries especially those with substantial sovereign debt issues such as Portugal, Ireland and Belgium, and even Spain and Italy, which both collectively account for about 5% of the global GDP, paving the way for these countries to abandon the Euro eventually colossal impact on the global economy and financial system o A global financial turmoil with massive disruptions in global financial markets la the Lehman Brothers-type collapse or Asian crisis-style debacle in the event of disorderly departure or default of one or more Euro zone countries due to the potential contagion effect arising from heightened global financial volatility, growing market expectations of a Euro total breakup of other vulnerable Euro zone Governments Hard-landing in China with devastating impact on Malaysian exports of commodities, resource-based products and intermediate goods A sudden collapse in Malaysias domestic demand, in particular driven by the private sector, unable to provide an effective buffer to cushion the flagging external demand due to: o A major plunge in global commodity prices in particular cash crops such as palm oil and rubber with adverse impact on Malaysias rural income and hence, consumer spending o Pullback in real spending by households and businesses as consumer and business confidence dwindles if the economic outlook turns for the worse dramatically and brusquely o Untimely implementation of 10 MP and ETP projects delayed commencement, behind schedule execution, etc with negative repercussions on construction activities and investment drive

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Slump in global commodity prices as the Euro zone crisis deepens and end-user demand weakens While unfavourable weather conditions may curtail the harvest of agricultural commodities and geopolitical uncertainties may keep risk premium for global energy commodities at lofty levels, the following factors will continue to put downward pressures on global commodity prices: softening industrial and consumer demand from major commodity buyers in particular China and the Euro zone from adequate to high stockpiles worldwide depending on commodities sustained USD strength which renders commodities expensive to investors who consider commodities as one of asset classes varying market reaction to a slowing global economy including reduced speculative demand for commodities easing cross-border or domestic political tensions/security instability in the Middle East and North Africa (MENA) region

Except precious metals such as gold and silver, commodity prices in general have a further leg to come down in view of the mounting Euro zone crisis with a potential Euro zone split and ebbing end-user demand notably in China and advanced economies. Although Japans post-Fukushima tragedy rebuilding activities may have provided some impetus to global demand for commodities in particular industrial, energy and building materials related given the estimated cost of material damage of about 25 trillion, this recovery-from-disaster boost may not be adequate to offset a pullback in Chinese and European orders as the reconstruction spending will be spread over at least two to three years. Headline global inflation has been on an easing trend in 2012 in most major economies, advanced and emerging since falling commodity prices have a significant downward impact on inflation. With substantial spare capacity in many advanced economies, this trend will most likely continue in the coming months as the global recovery loses steam. Reflecting this easing cycle in global inflation, inflation in Malaysia as measured by the Consumer Price Index (CPI) growth has also been in retreat after peaking at 3.5% in June 2011. Moderating sharply to 1.9% YoY in April 2012, we forecast Malaysias CPI growth to ease further to 1.6% YoY by mid-2012 before a gradual pick-up in the 2H2012, to average at around 2.0% for the full year assuming no upward revision to retail prices of subsidised items in particular petrol and diesel and barring other unforeseen circumstances. Factors for a pull-down in inflation in 2012 include: Favourable base effects Cost-push and demand-pull inflation dynamics have shown signs of leveling off in the absence of significant price strain from labour market, credit expansion or supply bottlenecks Receding pressures from food and energy inflation thanks to the sustained downtrend in global commodity prices in particular agricultural commodities and oil & gas Relatively well-anchored inflation expectations

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With deteriorating external outlook and receding price pressures, the balance of risks at the Monetary Policy Committee (MPC) should tilt towards buttressing growth. Nonetheless, since incoming economic data are not expected to be weak enough to prompt a rate-cut, we expect the MPC to stay on hold and leave the OPR at 3.0% throughout 2012. The outlook for both growth and inflation should be carefully assessed to avoid over or under adjustment of monetary policy. For BNM to consider a new round of rate-cuts, policymakers may opt to wait for further worsening of the Euro zone crisis and more worrying signs of contagion effects as a result of events in Europe such as: Trigger of a severe liquidity crunch in global interbank markets, leading to another global financial and credit crisis Sharp and abrupt falls in inflation expectations that could lead to a pullback in spending by households and businesses Although ebbing inflation provides flexibility for a greater degree of monetary stimulus, Malaysias current interest rate levels remain largely accommodative and supportive of growth. Any consideration for a new rate-trimming cycle must be weighed against potential upside risks to inflation especially given lingering inflation concerns due to the spare capacity squeeze in the economy Below are among the major threats that we think could alter the inflation outlook or sources from where inflationary pressures could emerge: Sudden reversal in global commodity prices in particular related to energy, food and building materials jump in global surplus liquidity, rising risk premium of global oil & gas prices due to heightened geopolitical concerns, supply chain disruptions due to natural catastrophes and adverse weather conditions due to climate change Reduction to subsidies if half-yearly reviews of prices and tariffs of 4 categories of goods & services, namely toll, petrol & diesel, gas & electricity and sugar & flour under PEMANDUs Subsidy Rationalisation Plan (SRP) are strictly implemented in particular after the GE13. Inflation due to income effects from the implementation of: o minimum wage for some 3.2m private sector workers of RM800 and RM900 in Sabah & Sarawak and Peninsular Malaysia respectively within the next 6 to 12 months 7%-13% increments for civil servants

Weakness in Asian currencies to persist until year-end In general, emerging Asian currencies including MYR typically perform rather poorly in times of heightened global financial volatility and risk aversion. After a strong start at the beginning of the year, Asian currencies have been hammered since late April/early May 2012 as: Renewed concerns over the health of the global economy in particular the future of the Euro zone and its currency have resulted in a dramatic turn in global risk appetite and led to capital flight to safety capital outflows from Asia and other emerging market assets including MYR denominated assets in favour of safe-haven currencies in particular USD, JPY and CHF

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Deteriorating trade balance or at least narrowing trade surpluses of export-driven economies such as Malaysia - depressed export earnings due to falling commodity prices as well as faster deceleration of exports compared to imports on rising imports of capital and consumption goods, an indicator of Malaysias resilient domestic demand especially investment and consumer spending

Moving forward, we foresee further downward pressures on Asian currencies including MYR given expectations of a worsening Euro zone crisis since safe-haven demand may intensify in times of stress and Investors may continue to reduce their exposure to risky assets for a while. Notwithstanding the scope for continued vulnerability as the Euro zone crisis deepens, we foresee Asian currencies to gain significant grounds towards yearend. As such, being broadly in synch with its regional peers, MYR may end the year 2012 within the RM3.07-RM3.12 range in view of: More sanguine growth prospects in the 4Q2012 as various forms of stimulus measures conducted by the worlds largest economies recently to counter the slowdown should bring the intended results by then Potential introduction of additional policy stimulus measures such as the rd 3 Quantitative Easing (QE) may reduce the safe-haven appeal of the USD Support from portfolio inflows by default since Asia remains the worlds fastest-growing region with the most reliable growth story compared to other regions

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BIMB SECURITIES SDN BHD (290163-X) A Participating Organisation of Bursa Malaysia Securities Berhad Level 32, Menara Multi Purpose, Capital Square, No. 8 Jalan Munshi Abdullah, 50100 Kuala Lumpur Tel: 03-2691 8887, Fax: 03-2691 1262 http://www.bimbsec.com.my

Kenny Yee Head of Research

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