Assessing the impact of Europe on Malaysia

Malaysia is more affected by global demand and a European downturn would have an uneven effect

The impact and consequences of the Great Recession of 2008-2009 continues to reverberate within the global economy, with its latest manifestation the sovereign debt crisis in Europe. European banks were as much exposed to structured products and derivatives based on US assets as American banks were and Europe’s financial institutions were no less eager to use dangerous amounts of leverage in seeking yield in an environment of low interest rates. Pre-crisis, a number of European banks had leverage ratios with respect to capital approaching 60-to-1, on par with some of the more aggressive American investment banks like Bear Stearns and Lehman Brothers[1].

 

Growing downside risks

Trying to backstop Europe’s financial system from collapse, European governments not only had to deal with funding a banking rescue, but also rising fiscal deficits as economic growth and tax revenue fell (see Table 1).

This has pushed countries such as Greece and Portugal to the verge of defaulting on their debt obligations, despite having debt metrics that appeared credit-worthy before the crisis. Thus, a near collapse in the European financial system has over time morphed into a sovereign debt crisis, which threatens to push the global economy into another recession. The situation is even more critical, as sovereign defaults in Europe can potentially precipitate another financial system crisis on a scale similar to 2008-2009 – or would it?

The biggest difference between 2008-2009 and 2011-2012 is that sovereign debt crises tend to move at a snail’s pace compared to financial system collapses. Even if contagion spreads beyond the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) to the larger core countries such as France and Germany, the likely slow pace of deleveraging and restructuring means there may be adequate time to adjust bank capital needs, and provide private sector companies and individuals time to assess and manage their liquidity requirements.

Anecdotal evidence suggests that European companies and foreign companies operating in Europe have already laid in plans for the worst case scenario – a complete collapse of the Euro as a monetary union. Time will also allow European governments to change the institutional arrangements linking the Union, and address the fundamental weaknesses of the Eurozone.

Be that as it may, there may be a short term impact on an already weak global growth momentum.  Monetary and fiscal stimulus packages, particularly China’s, have helped foster a two-speed global economy, with emerging markets supporting global growth while developed economies grappled with financial fallout and structural problems.

Table 1: European Union, selected countries, government revenue and expenditure 2008:2010 (% growth)

 

  

2008

2009

2010

Expenditure

Revenue

Expenditure

Revenue

Expenditure

Revenue

European Union (27 countries)

3.8%

0.5%

2.1%

-6.9%

3.4%

4.0%

Euro area (17 countries)

4.9%

1.7%

4.9%

-3.8%

2.1%

2.4%

Germany

3.1%

2.4%

4.8%

-2.0%

3.8%

1.3%

Ireland

10.7%

-8.5%

2.0%

-12.6%

32.7%

-0.7%

Greece

11.1%

4.2%

5.8%

-7.1%

-8.4%

1.9%

Spain

9.2%

-7.2%

7.5%

-8.6%

-1.1%

3.7%

France

3.8%

2.6%

4.1%

-3.8%

2.1%

3.1%

Italy

3.4%

1.1%

2.9%

-2.4%

-0.7%

0.8%

Netherlands

6.2%

6.9%

7.1%

-5.4%

2.3%

3.5%

Portugal

2.6%

1.5%

9.1%

-5.3%

5.5%

7.2%

United Kingdom

-4.5%

-8.7%

-6.7%

-18.7%

6.6%

9.2%

 Source: Eurostat

 

Tri-channel effects…

 Europe is close to entering another technical recession as output fell 0.3% in 4Q2011, and although higher frequency indicators are bottoming out, downside risks to Europe from low consumer confidence and investment, and the threat of sovereign defaults leading to another banking crisis, would have repercussions on global trade and aggregate demand. What then would be the impact on Malaysia with its high external trade exposure and linkages to all the major advanced economies?

At present, European trade comprises just 10.5% of Malaysia’s trade (Chart 4), though this somewhat understates the exposure as indirect trade (through intermediate exports within the global supply chain) adds approximately another 3%-4%. There is also the indirect impact of Europe on Malaysia’s other trade partners, all of whom have exposures of their own to European trade and finance.

There are three specific channels we think will be important in assessing the risk factors to Malaysia from a European meltdown:

? The real economy – trade to and from Europe, and trade with other European trade partners such as Japan and China. A severe downturn in Europe would not only directly impact Malaysia’s trade with Europe, but also potentially reduce demand for Malaysian exports from other partners that are highly exposed to Europe such as China and Japan;

? The financial sector – portfolio flows are many times bigger than trade flows, and in the past two years, have been highly volatile depending on developments in the global economy. A deepening Europe crisis could trigger flight to safety, particularly to US dollar (USD) and Japanese Yen (JPY) assets, raising yields on Malaysian debt and putting downward pressure on the exchange rate;

? The intersection between finance and trade – specifically trade credit and correspondent banking. Some of the contagion in 2008-2009 occurred through this channel, as Malaysian exports and imports were hit not only by a reduction in demand, but also an almost complete drying up of trade credit.

Breaking it down: Trade with Europe

Malaysia’s trade with Europe has averaged around a steady 11% over the past decade, with the largest trade partners being Germany, the Netherlands, France, Italy and the UK, in that order (chart 8).

Malaysia runs a trade surplus with the European Union (EU) as a whole, though this hides considerable differences between countries. For example, Malaysia’s German trade has been in overall deficit, while that of the Netherlands has been strongly in surplus. Of the other countries, Malaysia has a general deficit with Italy, Ireland, Austria and Sweden, and runs a trade surplus with the remainder.

Malaysian trade with Europe suffered greatly from the Great Recession (Chart 5), with total trade volumes dropping 18.9% in 2009 (-32.7% yoy in 2Q2009 alone) – of Malaysia’s other major trade partners, only trade with the US suffered a sharper drop. It would be fair to say that up to 2011, export and import volumes with Europe (as with the US) have not recovered to pre-crisis levels, unlike Malaysia’s trade with other countries. Part of the reason is that, unlike with the US (where structural changes in the direction of trade have played a role) but like Japan, European GDP is also still below pre-crisis levels (Chart 6).

Assessing vulnerability

Taking the aggregate numbers, Malaysia’s overall growth and trade elasticities[2] with the world are outlined in Table 2. The column headers are the factors affecting Malaysian growth and trade, while the row headers are the factors being affected. Each number represents the percentage change in growth, exports and imports from a 1% change in the explanatory variables (the column headers).

Table 2: Elasticity estimates of Malaysian growth and trade to global growth and exchange rates

1% increase in…

 

results in % increase in…

Global Growth

Malaysian Growth

(t-1)

Nominal Effective Exchange Rate (NEER)

Malaysian Exports

Malaysian Growth

0.87%*

0.31%*

-0.12%*

n/a

Malaysian Exports

1.87%*

n/a

-0.53%*

n/a

Malaysian Imports

n/a

0.18%

0.22%*

0.89%*

 

Source: MARC Economic Research * statistically significant at the 95% confidence level.

 

From the results, Malaysia’s growth and trade are highly sensitive to global demand: every 1% change in global growth results in a 0.87% change in Malaysia’s growth rate. A 1% increase in the nominal exchange rate results in a reduction in Malaysian GDP growth of about 0.12%.

Malaysia’s trade is even more exposed to global growth – a 1% increase in global demand causes a 1.87% increase in exports, while a 1% increase in the exchange rate results in a reduction of 0.53% in Malaysia’s exports. Imports on the other hand are driven more by export demand than they are by Malaysian growth, with a 1% increase in exports resulting in a 0.89% increase in imports, while a 1% increase in the exchange rate boosts imports by 0.22%.

To isolate the impact of Europe on Malaysia, we employ a similar modeling approach, with the following results:

Table 3: Elasticity estimates of Malaysian growth and trade to European growth and the EURMYR exchange rate

 

1% increase in…

 

results in % increase in…

European Growth

Malaysian Growth

(t-1)

Nominal Exchange Rate (EURMYR)

Malaysian Exports

Malaysian Growth

0.05%

0.96%*

-0.02%

n/a

Malaysian Exports

3.5%*

n/a

-0.11%

n/a

Malaysian Imports

n/a

0.68%*

-0.50%*

0.29%**

 

Source: MARC Economic Research

** are statistically significant at the 90% confidence level.

 

There’s a startling contrast here. Quite unlike the impact of global growth on Malaysia, European growth does not appear to have an impact on Malaysian growth. The estimated coefficient implies a 1% increase in European growth results in a 0.05% increase in Malaysian growth, but the sample estimate is not statistically significant (which means that we cannot infer that the underlying true relationship is not zero).

For exports on the other hand, a 1% change in European growth results in a 3.5% change in Malaysian exports to Europe but the Euro exchange rate with the Malaysian Ringgit is not statistically significant. Imports from Europe to Malaysia respond to increases in Malaysian growth, rising 0.68% for every 1% increase in Malaysian growth. However, an appreciation of the Ringgit results in a drop in Malaysian imports from Europe, which is an unexpected result, but perhaps reflective of some European imports being inputs into Malaysian exports (which is associated with a 0.29% increase in European imports).

To resolve these various questions, we look at the individual elasticity estimates for Malaysian trade with Europe based on the Standard International Trade Classification (SITC). The summary results for exports are presented below:

? The largest export category (51.5%), M&TE, is not driven by growth in Europe nor is it sensitive to movements in the exchange rate. Since the category represents investment items, not consumption, the likelihood is that these exports may be driven by European exports to other regions.

 

? The same applies to the second largest category of exports (15.2%), Miscellaneous Manufactured Articles – neither growth nor the exchange rate are an influence.

 

? The third largest category, Animal and Vegetable Oils and Fats (11.4%), is extremely sensitive to European demand, moving 7% in value for every 1% change in European growth. The exchange rate however is not a factor.

 

? Manufactured goods, representing 7.5% of Malaysian exports to Europe, is also sensitive to European growth, with export values changing 7.6% with every 1% movement in European growth.

 

? Inedible Crude Materials (6.8%) shows the same characteristics, moving 7.1% for every 1% change in European demand.

From the foregoing, it’s strikingly clear that Malaysia’s exports to Europe fall into two different classes – two thirds of Malaysia’s exports are not affected by changes in Europe’s economic environment, while most of the remaining third are overly sensitive. A downturn in Europe would therefore have an uneven effect on Malaysia’s exports, with the heaviest impact on finished goods, consumption goods, and intermediate inputs that go to serve European domestic demand (such as oil and fats), while largely unaffecting intermediate goods and finished goods for investment and for inputs into European exports.

The implication is that Malaysia’s export exposure to Europe is far less than the nominal value would indicate, and global demand conditions override changes in Europe itself at least insofar as most of Malaysian trade is concerned. This also explains the seeming dichotomy between the high estimated sensitivity of Malaysian exports but the non-impact on Malaysian growth.

Turning to import elasticities, the following is the summary of the results (details are tabulated in Table 5 of the Appendix):

 

? In the largest category, M&TE (61.3% of total European imports in 2011), neither Malaysian growth nor the exchange rate explain movements in imports, but every 1% movement in Malaysian exports results in a 0.8% movement in M&TE imports. A big chunk of M&TE imports are aircraft, which actually serve to boost trade in services (travel).

? Chemicals form the second biggest chunk of imports (13.5%) and this category is highly sensitive to Malaysian growth, moving 1.6% for every 1% change in Malaysian growth. Here, the coefficients for neither the exchange rate nor Malaysian exports are statistically significant, implying these imports not only serve domestic demand but that there are few supply alternatives.

 

? The third largest category, Manufactured Goods with a 10.1% share of European imports, generally moves with movements in exports, rising 0.7% for every 1% increase in exports. The exchange rate is not statistically significant as an explanatory variable, again implying few other supply alternatives to Europe.

 

? The last significant category, Miscellaneous Manufactures (6.4%), is again tied to export growth, but is partially sensitive to the exchange rate.

 

A downturn in Europe would therefore have an uneven effect on Malaysia’s exports, with the heaviest impact on finished goods, consumption goods, and intermediate inputs that go to serve European domestic demand (such as oil and fats), while largely unaffecting intermediate goods and finished goods for investment and for inputs into European exports.

The implication is that Malaysia’s export exposure to Europe is far less than the nominal value would indicate, and global demand conditions override changes in Europe itself.

 

Just as with exports, Malaysia’s imports from Europe fall into two rough classes – inputs for Malaysian exports and thus more dependent on global demand conditions than on local economic conditions, and consumption goods which depend largely on local demand.  The rationale is that as demand for these items are export oriented, increases in the exchange rate would result in less demand for Malaysian exports and thus less demand for European inputs.

We have to conclude, on the basis of the evidence presented here, that Europe’s impact on Malaysian growth through the trade channel is small and minor. Two-thirds of Malaysia’s exports to Europe and three-fourths of Malaysian imports from Europe are tied to global demand conditions and not to domestic demand in either Europe or Malaysia.

 

About the Authors

Nor Zahidi Alias & Nurhisham Hussein are chief economist and economist

at the Malaysian Rating Corporation Bhd (MARC), a full-service rating agency that provides credit ratings on issuers of commercial papers, bonds, long/short term debts, and preferred shares, as well as asset-backed securities. MARC also offers industry analyses, rating reports, and rating indices for issuers and investors locally and globally.


[1] Due to differences in accounting treatment between European and American regulators, the equivalent US ratio is 30-to-1

[2] In economic terms, elasticity is a measure of how one variable responds to changes in another variable

 

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