Malaysia - Growth Seen Moderating, Currency Stronger

Malaysia releases its Q3 GDP report on 30th November 10.00 GMT. If data elsewhere in Asia is any guide, Malaysia's growth is set to slow in Q3. Recent Asian Q3 data confirms that regional growth peaked in Q2 as favourable basing effects fade. Second half growth data has to deal with higher 2003 base figures and slowing external demand. Standard Chartered Bank forecasts Malaysian Q3 GDP growth at 6.8%, reflecting a deceleration from the 8.0% rate recorded in Q2.

As noted above, basing effects are partly responsible for this growth slowdown. Moreover, slowing manufacturing activity due to a decline in export orders has also hit growth. However, these effects have been offset in Malaysia by the fact that high oil prices have provided a cushion for the economy. This marks an important difference with the rest of Asia. As a result, we still think Malaysian 2004 full-year growth will come in at 7.0%. For 2005, even if oil prices fall to an average of USD38 per barrel (pb) - as we expect - Malaysia's economy should remain relatively resilient. We expect Malaysian 2005 full-year growth to moderate only slightly to 5.8%.

Such a moderation in growth is already widely expected and is thus unlikely to cause any significant market reaction, particularly regarding the Malaysian ringgit (MYR) peg. Recent comments from the Prime Minister stressing that the USD-MYR peg will be decided independently from any move to the Chinese peg are also unlikely to change matters. Foreign investor inflows to Malaysia are likely to continue, albeit perhaps at a slightly lower rate as growth slows. In the near term, market sentiment remains very positive with rating agency Fitch saying that an MYR revaluation - should that happen - would be a positive for ratings. Should the CNY peg-trading band be widened, as we expect in Q1, a domino effect could sweep Asia as local currencies firm against the USD. This in turn would clearly widen the gap between the MYR and the rest of Asia. On the one hand, this would boost exporter competitiveness. On the other, it would increase import costs, thus undermining onshore manufacturing margins.

The main reason for having the MYR peg is to provide stability for the development of the financial and manufacturing sectors. As such, any change in the FX regime would require that stability be maintained. A move to a managed float system, such as is used in Singapore, might be one way of responding to the need for a stronger currency while allowing for greater flexibility. It remains to be seen whether or not the authorities are prepared to tolerate such flexibility. Our base case is that the MYR peg is revalued to 3.50 in H1, 2005.