Malaysia Endorses Jeffrey Sachs

For the Presidency of the World Bank (site).

Differing from the International Monetary Fund, the World Bank is often associated with matters of economic development – especially with regards to poverty reduction. Throughout its existence, it has received both flak and praises on an entire array of issues. One of thorny issues is the implicit agreement that the person running this institution “must” be an American – or at least backed by the United States. There has been a growing clamor for the selection process to be a little more inclusive, meritocratic and transparent. In a world where the developing nations are taking a larger burden in shaping the world’s agenda, it makes sense that they should at least have a shot at the top job. After all, they are still the major recipients of this institution’s work.

Source: here.

I don’t understand the politics behind Malaysia’s endorsement of Jeffrey Sachs, considering the candidate isn’t even the official choice of the United States (at least not yet) nor has he received many nominations himself. As of now, only three other nations have endorsed him: Kenya, Timor-Leste and Jordan (correct me if I missed any.) I would have expected Malaysia to go for Indonesia’s former Finance Minister, Sri Mulyani, who I personally think is a rather deserving candidate herself. There is an interesting site to visit if you’re interested in the ongoing race for the Presidency of the World Bank: World Bank President.

There are no qualms as to whether Jeffrey Sachs is qualified for the job – he is, though whether he’s the right person is an entirely different question altogether. It’s just that on a cursory glance, both the World Bank and the IMF face a growing challenge of legitimacy. Institutions of their sizes cannot claim to be the stalwart of the global interests if a majority of their clients feel that they have very little say on how things are run. Perspective and expectations matter in economic policy.

I would have opted for Lula (former President of Brazil) or Mulyani. Just because I think it’s time to have a breath of fresh air. That’s only my opinion.

After all, who listens to a low-fat-ketupat anyway?

Yay, FDI FTW! Wait a minute…

I rarely care enough to think about domestic issues in Malaysia, but a severe bout of college “senioritis”[1] has led me to this intellectual exercise. My attention is turned to Lynas, an Australian mining company that plans to set up a rare earth refinery plant in Gebeng, Pahang. At this juncture, the core of the dispute appears to be the refinery’s impact on public health and the environment. With the government’s decision to grant Lynas a Temporary Operating License, this issue has never been more politically-charged. I am going to “conveniently” ignore the health/safety dimension here, not because it is unimportant, but because there is little to add to a technical discussion that remains unresolved even among the experts. It is probably more fun to poke into the economics of the issue.

So how does Lynas justify the refinery plant economically? From the onset, it attempts to impress with big numbers. According to Lynas, the RM700mn operations will turn Gebeng into a major rare earth hub – one that is projected to meet a third of the global demand for rare earth materials within 2 years. By attracting advanced chemical companies to set up shop near the refinery, Lynas also claims a regional multiplier effect of at least tenfold. This would ideally spark the virtuous cycle of job creation, asset reflation, and capital reinvestments. Perhaps the biggest revelation is this – the refinery’s annual export is estimated at over RM5bn, a cool 1% of the nation’s GDP! Surely, that would be a huge boost to our aspiration to become a high-income nation by 2020. Has Christmas come early for Malaysia?

Well, I have my reservations. One crucial caveat to note is that Lynas secured a fat 12-year tax break from the government for the refinery. This represents billions of lost corporate tax revenues over the next decade – tax revenues that could have helped build infrastructure for complementary industries or lower income/sales taxes that affect Malaysians more directly. More importantly, this tax exemption substantially curtails our opportunity to raise income per capita via Lynas. The firm now gets to retain all of its earnings, which when repatriated back to its home country, actually contributes to the Gross National Income (GNI) of Australia, not Malaysia. One may easily conflate between the two, but GNI is the indicator (not GDP) that gauges our progress towards hitting the USD15000 per capita target by 2020. While it contributes to domestic output, foreign direct investment does not necessarily create localized wealth effects, especially if the government forgoes a chunk of the firm’s capital returns.

What about employment then? Doesn’t the refinery plant create jobs for its surrounding community? Yes, but only on a small scale. The refinery plant, also dubbed as the Lynas Advanced Materials Plant (LAMP), requires only 350 skilled workers. Compared to the thousands of livelihood that might be at stake, this figure is miniscule. Not to mention, rare earth refining lies relatively low in the sector’s global supply chain, preceding more value-adding activities such as R&D and manufacturing. The upside is no different from that of helping Intel or Dell to assemble chips and laptop computers. The downside however, is potentially daunting. Since our engagement with Lynas is in the commodities sector, the financial health of the refinery is susceptible to the fluctuations in the price of rare earth minerals. The fact that rare earth minerals are traded in private markets, instead of exchange-traded markets makes price monitoring and hedging activities even more difficult.

And now to the extraordinary claim that the Gebeng refinery would generate a tenfold multiplier effect. This projection substantially exceeds the baseline projections of typical industrial projects, which usually range from 1.2 to 1.4. Unless Lynas can single-handedly create a thriving, mega cluster of suppliers, competitors and consumers, in other words – a Silicon Valley of rare earth players in Malaysia, I am skeptical of the refinery’s multiplier effect. Indeed, commodities-based operations usually yield lower multiplier effects due to the little need for locally-manufactured components. Besides, the industry for rare earth processing and manufacturing barely exists in Malaysia. It is hard to imagine then, how new industry players could converge in the Gebeng locality, considering the potential lack of core competencies and other barriers to entry into the industry. If anything, Lynas would probably be vertically integrated throughout its refinery operations and operate alone in the area.

Economic analysis - a game of assumptions...

Based on my personal analysis, the economic benefits of setting up the refinery plant appear to be exaggerated. Then again, economics is a game of assumptions. One could always justify the construction of the refinery by tinkering with a favorable set of counterfactuals. The point is – conceptually at least, building that plant may not be a good idea.

[1] A dramatic loss of academic motivation that plagues graduating university students, caused by the possible illusion that one’s CGPA is (pretty much) set in stone and/or a premature anticipation to post-graduation plans, for better or for worse.

EPF Housing Loan Scheme

What is this EPF financed loan-scheme for low-cost housing we read about? Is it good?

The scheme is meant to use EPF funds to provide loans for low-cost housing in KL. Borrowers who were deemed too much of a credit risk by banks, would be able to apply for these loans. The motives of the government in launching this scheme are admirable. It will help relatively risky borrowers who cannot secure home loans from banks to purchase low-cost homes. The fact that banks were unwilling to extend credit to these borrowers on similar terms however suggests that there is some credit risk involved.

Lessons from the sub-prime crash in the US might suggest this isn’t the best idea, especially if we end up encouraging people to buy houses they ultimately cannot afford. This is something the providers of the loan will have to be wary of. However, if loan values are maintained safely below the value of the house (houses can then act as collateral for the entire loan) and the houses are generally low-cost homes, this concern may be somewhat addressed. All in all, if designed properly, this policy could help the poor, albeit with someone taking on a default risk if they become unable to pay.

So, what’s all the fuss about?

Naturally, savers in the EPF are concerned about the risk of these loans turning sour, leading to a loss in the value of their savings. While the initially suggested RM1.5 billion is not a huge fraction of the EPF pool, the principle of investing in something that risky and the precedent it might set clearly angered some EPF savers.

The Federal Territories and Urban Well-being Minister suggested that this default risk was trivial, as the borrowers would be appropriately vetted for ‘outstanding DBKL flat rentals and bad loan repayment records’. If true, then one must ask why it is these people were unable to secure loans from banks directly. The explanation does not add up.

Does the EPF have a better explanation?

Indeed they do; right here. For one, the initial amount being lent is RM300 million, a smaller amount for now at least. The EPF also would not be lending to the borrowers directly, but rather to a body (special purpose vehicle (SPV)) that will then disburse these loans. The houses are collateral, and will remain with the SPV until the loan has been fully settled, preventing a huge loss in the event of default. The EPF will also get security cover of at least twice the amount of the loan, although where this extra cover is coming from is not clear. All in all, from the EPFs perspective, this seems a fairly safe bet based on their statement. The default risk from this scheme appears (although this is unclear as of now) to be lying with the SPV and thus the government (and implicitly, the taxpayer), who provide the EPF with the guarantee.

As YB Khairy Jamaludin points out here in the first half of the article, there are a lot of questions about the collateral that need to be addressed. Nevertheless, on the face of it, from the EPF’s perspective, it appears no riskier than lending directly to the Malaysian government as the EPF currently does by investing in government bonds.

So, everybody should be happy then?

Not necessarily. There’s an old adage in economics that there’s no such thing as a free lunch. The EPF seems to be getting a very safe investment, at a decent return of 5.5%, while not having to bear the credit risk of the borrowers defaulting. So, why is the government (and implicitly the taxpayer) bearing this credit risk (and picking up the tab in the event of default), while the EPF gets a higher return than they would buying government bonds? (If the EPF isn’t actually getting a higher return than on government bond, we must ask why the EPF isn’t investing the money in government bonds instead). Why does the government not borrow at the presumably lower rates in the bond market and use this money to fund this loan scheme directly? Paying the EPF a premium interest rate of about 5.5% without having them bear the credit risk in return for the premium is having taxpayers implicitly subsidising the profits of the EPF. This seems peculiar; given the government has cheaper alternative sources of finance.

In conclusion, while the motives of the policy are admirable, the implementation appears unnecessarily complicated (and thus controversial) and questions remain as to why the government does not borrow the money directly from the bond markets instead (much simpler and less controversial). With a little more thought however, this could turn out to be a good policy. Although the government must ask itself whether it is missing something in the credit-worthiness of these loans. If they were indeed credit-worthy, why are banks unwilling to provide these loans?

Does it really have to be this complicated?

Happy Valentines Day!

Well, let’s take a quick departure from serious economics and commemorate this year’s Valentines Day with econ speak. For those of you who were a little attentive on Facebook, you would have noticed this site making its way to your feed:

14 Ways Economists Say I Love You

The site above does require a little economics/finance knowledge, but nothing that you would not have picked up in your Microeconomics 101 class. It’s a good laugh actually, a little refreshing in its material. Normally most economics corny jokes tend to hoover around elasticities and stickiness – at least those that I’ve chanced upon.

For those of you with twitter accounts, you guys should check out the #fedvalentines hash tag. There are big hitters making economics valentines speak over there. San Francisco Fed posted a rather cool one: “My love is elastic, my commitment too big to fail.”

And here’re some interesting Valentines Day Cards!

Anyway, we’ve got a couple of posts lined up. So stay tuned with us! And Happy Valentines Day wherever you people are!

Or Forever Alone Day, whichever suits you best.

Resource Revenue – Income or Wealth?

“So for the Norwegian people, the oil revenue is not revenue at all, it’s just wealth being moved into a more diversified portfolio for the future.”

Yngve Slyngstad, CEO of Norges Bank Investment Management (NBIM)

Reading this quote immediately got me thinking of almost all oil & gas-exporting countries, in particular Malaysia. Our revenues derived from these non-renewable resources are treated as income in our national budget. We take it in as part of our federal revenue, and a substantial part of it goes into financing our annual operating expenditure (essentially the year-to-year costs of running the country).

However, implicit in this action is the belief that this revenue belongs to us. By ‘us’, I mean the current generation in Malaysia at the time when the resources are being extracted. While this will certainly split opinions, I believe this money is wealth belonging to our country. Our country in my view includes both our generation as well as future ones. I thus believe the Norwegian model has many merits.

In Norway, the Government Pension Fund Global was set up to ‘support long-term management of Norway’s petroleum revenue’. Firstly, the capital is invested overseas. This prevents an overheating of the Norwegian economy arising from these large resource flows, which maintains competitiveness of the Norwegian economy (something other resource-rich nations have had issues with).*

More importantly, there is a rule that the “non-oil budget deficit shall correspond to the real return on the fund, estimated at 4 percent”. In simple words, this means that on average, the government is only allowed to spend the return on the investment of the oil revenue, rather than spend the oil revenue itself. This ensures the oil revenue obtained now will be there to generate returns for future generations to enjoy. It is also said the fund can also cushion short-term economic fluctuations as well as meet the challenges of the country’s ageing population and future drop in petroleum revenue.

An analogy to this is inheriting a huge house from your parents. The Norwegian model means you keep the house, spend only the rental income, and pass it on to your children. The conventional attitude is to sell the house (oil) and use the money (oil revenue) now.

Whether or not you agree with the Norwegian way, it is certainly food for thought.** I’ve personally taken for granted the fact that our oil and gas revenue was for us to spend until reading the above quote. I hope this will spark your thoughts too.

Please see the first comment for footnotes

The Government’s credit card?

How the government spends its money in Malaysia normally comes into the public eye during the yearly Budget announcement, when year-on-year comparisons can be made. But what about longer term trends?

Government expenditure forms an additive component of gross domestic product (GDP), the indicator used to assess a country’s growth and general (though disputable) economic wellbeing. Like individuals equipped with credit cards or credit facilities, how much the government spends in any one year need not be limited by the amount it will earn in that year, as long as it can repay its debt. This means that the figure for government spending can increase even in times of crisis when funds are low.

Conventional economic wisdom suggests that government expenditure should rise in times of economic crisis, as higher unemployment requires greater welfare spending to help cushion the fall. A country with well-implemented automatic stabilisers, as taxes and welfare benefits are called, will experience countercyclical fiscal policy: in good times, government spending should fall, and vice versa for bad times.

Source: World Bank

The story for Malaysia, however, appears to be the complete opposite. Government spending (the red line) closely tracks GDP growth, falling when there is a recession and rising in good times. In other words, we spend too much when times are good and are then forced to cut back when revenues fall. While causality can run both ways (that is, fiscal policy affecting GDP growth instead of the other way round), numerous papers have suggested that fiscal procyclicality is a real political economy problem, one that we should be wary about.

There is a general tendency for budgets to be structured as expansionary ‘election budgets’ with something for everyone, especially when times are good, but lessons should be drawn from the experiences of Japan (the lost decade) and the more recent credit crunch, where fiscal stimulus eventually became key to bringing countries out of recession and/or stagnation. Instead of finding the best way to fix a problem in the economy, we do not want to be caught in the trap of making the magnitude of a recession even worse.

——–
My Pick of the Week –Quotable Quotes:
“Markets are the essence of a market economy in the same sense that lemons are the essence of lemonade. Pure lemon juice is barely drinkable. To make good lemonade, you need to mix it with water and sugar. Of course, if you put too much water in the mix, you ruin the lemonade, just as too much government meddling can make markets dysfunctional. The trick is not to discard the water and the sugar, but to get the proportions right.” – Dani Rodrik

Subsidies

For my first post, I thought it would be good to give a layman’s explanation into the economics of subsidies, given the prominence of these in our daily lives as Malaysians. The point of this is to put some economics into everyday arguments over this issue and clarify some of the good and not-so-good arguments on either side.

One of the most frustrating arguments I hear about petrol subsidies is this: Malaysia is an oil exporter, so many other oil-exporting countries subsidise their oil, so Malaysia should do so too.  By this logic, it would not then be a stretch to argue that as one of the largest exporters of gold, South Africa should then subsidise the “consumption” of gold by its people.

The point here is not whether we can afford it or not (although that is of course a key concern), but whether or not we could put the money to better use. There will be two strands to this argument that most microeconomists use, efficiency (can we achieve the same results at a lower cost?) and equity (is our policy the best at addressing differences between the rich and the poor?).

SUBSIDIES ARE HIGHLY INEFFICIENT

For the economists reading this, the term deadweight loss will probably come straight to mind. To illustrate this point, consider the following example. In Scenario 1, we have 2 goods, apples and oranges. Apples are subsidised, from a market price of RM2 to RM1.50 (i.e. a 50 cent subsidy) while oranges are not (priced at RM2). Say you have an income of RM10 – you would aim to purchase the affordable combination of the two goods which gives you the highest level of satisfaction (or utility, in economic terms); in this instance, let us say that is 4 apples and 2 oranges. Here, the subsidy costs the government RM0.50*4 apples = RM2.

In Scenario 2, let us say the government removes the subsidy and gave you RM2 directly instead. Notice that you can still afford what was your favourite combination earlier, i.e. 4 apples and 2 oranges (which costs RM12). Since you can still get your favourite combination under Scenario 1 (i.e. 4 apples, 2 oranges), you cannot be any worse off under Scenario 2. Additionally, given that your income and relative prices have changed here, you can now also choose a different bundle of goods which can leave you better off (i.e. give you a higher level of satisfaction than from purchasing 4 apples, 2 oranges).

Essentially, this method is what economists call revealed preference. What it states is that replacing the subsidies with lump-sum transfers that do not distort relative prices and choices between goods will lead to a greater welfare improvement for a given cost to the government purse*. The only caveat to this efficiency argument is in the case of a positive externality, whereby the consumption/production of the good has positive effects to third parties not directly involved and we may want to encourage more consumption/production but it is hard to justify most subsidies in the country with this argument. An example of this would be education, which has benefits to society beyond what you receive individually. A subsidy on education might thus be justified.

SUBSIDIES ARE RELATIVELY INEQUITABLE

The second strand of my argument is that subsidies are inequitable compared to various alternatives we might have. Consider fuel subsidies. The direct benefit to the average consumer depends on whether or not they have a vehicle, and the extent to which they use it. Clearly then, the richest 5% of the population are likely to benefit far more than the poorest 5% (who are unlikely to have a fuel-powered vehicle) from a fuel subsidy. The common justification used usually applies to subsidies on necessities; this is because as a fraction of their smaller budget, the poor would benefit more from these subsidies than the rich, making it a more equitable subsidy even if in monetary terms this is not as clear.

Nevertheless, I would argue that direct monetary handouts to the poor can be more equitable than the aforementioned subsidies. With direct monetary handouts, we can ensure the overall monetary benefit of the policy benefits the poor disproportionately in both absolute and relative terms. Recent examples would include the one-off RM500 payment to households earning below RM3000. Of course, if these benefits are intended to be continued annually, they should not be removed lump-sum at a boundary like this because it can create incentive problems, e.g. for people earning just above RM3000, there is an incentive to work less in order to go below the RM3000 boundary and obtain the extra RM500.

A better way is likely to have the benefits slowly taper off as someone earns more, which reduces the distortionary effect of people suddenly losing their benefits. Nevertheless, spending money in this way is far more equitable (it is targeted specifically at the poor) than a blanket subsidy that benefits everyone in society.

WHERE DO WE GO FROM HERE?

Given the above arguments, there appears little in defence of subsidies of what economists call private goods such as food and fuel. If we truly want to help the poor, there are far more efficient and equitable ways of doing this. Therefore, in my opinion, the debate should not revolve around whether or not we want subsidies. Rather, it should revolve around what we should do with the money if we remove the subsidies. Should it go towards improving the welfare of the rakyat through direct transfers to the poor, should it go towards financing large-scale projects that should also benefit the rakyat or should it go towards paying down our national debt? To me, there is clear justification for the removal of subsidies, what is subsequently done with the money saved is the far more important issue we should be talking about.

*For those more interested in the technical aspects of subsidies, such as what might happen if producers also get some of the incidence of the subsidy, most intermediate level microeconomics textbooks will give you a comprehensive discussion of the deadweight loss and how to quantify it in a market with several consumers.