Malaysia: Is Recent Economic Growth Worth The Cost?

| About: iShares MSCI (EWM)

In this article, which is the latest in a series on Emerging Markets, I will evaluate Malaysia as a potential investment opportunity. In an earlier article I demonstrated how investors in broad emerging markets ETFs such as iShares EEM could miss the growth potential of emerging markets. This is because of the bias of the MSCI EM index to larger cap stocks and markets which have already seen their most active growth period.

As an Asia-based investor, I travel frequently to the major markets and believe that this enables me to generate some useful insights.

Malaysia has been in the news following its recent election, and some subsequent unrest. In this article, I will follow the pattern of previous articles on Thailand and Indonesia and spend some time on the economic and political past of the country, as I believe that this is the key to understanding the future risks and opportunities being presented. I will then move on to consider the investment proposition.

According to my market selection model, Malaysia scores an indicative marketweight portfolio position. Malaysia is already far along along the economic development curve. 2011 GDP per capita was 1/3 of that in the US.

Malaysia has the 9th largest allocation in the MSCI EM index, with a 3.6% weighting. Malaysia is on the cusp of the transition to a developed economy, with the ability to present a serious challenge to the pre-eminent position of Singapore as a cost effective service and technology hub for South East Asia.

Malaysia's political and economic evolution

Malaysia has been a center of trade through Asia for centuries, occupying a key strategic position in control of the Malacca Straits sea-lanes. This made it a major prize for colonial powers. Early traders from the middle east brought Islam to Malaysia in the 14th century, from which time Islam became the dominant religion. The European colonial powers fought over the region from the 17th century, and several established settlements around the coastline. In 1824, a landmark treaty between Britain and the Netherlands divided the region between them, Malaysia going to the Brits, and Indonesia to the Dutch.

British rule from this stage proved influential in a number of ways, initially in the influx of a large number of Indian and Chinese immigrant workers from other British colonies. As with other colonies, the British colonial influence extended to a strong focus on developing infrastructure and the establishment of a highly organized government administration. The British system had a positive impact on literacy and educational standards. Furthermore Malaysia adopted the British judicial and financial systems.

The economy was based on mining and primary production, especially rubber plantations.

British rule was interrupted during World War II by the Japanese invasion. Under Japanese rule, a nationalist movement developed, and when British rule resumed in 1945, a communist lead insurgency against the British took place. This was finally resolved by the creation of the Federation of Malaysia in 1957. In 1963, with the inclusion of Singapore and N. Borneo, Malaysia was founded.

During this formative period, racial issues played a strong role, and specifically the imbalance between the two leading groups. These were the Chinese, an affluent and economically powerful minority, and the ethnic Malays, known as Bumiputera or "Sons of the soil". The more numerous Bumiputera had greater political power. In 1965, the Chinese dominated island of Singapore, under Lee Kuan Yew, was expelled from Malaysia. Lee founded the city-state of Singapore.

Malaysia succumbed to a period of instability, dominated by racial tension and violent confrontation. Stability was gained only by the imposition of strict emergency provisions, which impeded civil liberties. Malaysia emerged under the multi-racial National Front coalition government, Barisan Nasional (or BN). The dominant party in the BN was the United Malay National Organisation, (UMNO). BN has been in government since 1970 (and up to the present day).

The critical challenge faced by UMNO has been to manage the economic development of Malaysia alongside the economic integration of the "Bumiputera" ethnic Malays. The mainstay of this was the New Economic Policy of 1971, which has been implemented by a succession of 5 year plans. These were typified by policies designed to discriminate in favor of the Bumiputera majority, while also investing in economic opportunities.

This balance has been adroitly maintained by the Malaysian political leadership, and the economy has shown significant GDP growth.

This growth has, however, come at the cost of a comparative development of the political landscape, where a fragile status quo is (just) maintained.

In the May 5th election, the ruling BN was again returned, but with a significant challenge from the opposition who alleged electoral corruption amid public anti BN protests. The election saw the BN returned with 49%, the first election to award less than half the vote to BN. The major change was the swing of the Chinese vote away from BN.

Economic scorecard

Malaysia is an export-led economy, with key exports in the areas of electrical appliances, electronic parts and components, palm oil, and natural gas. It is currently the 37th largest global economy, measured by GDP.

Malaysia has ambitious plans, and under the revamped "New Economic Model" has targeted G20 status by 2020 - seeking to shift the economic focus from primary production to move up the economic value chain. The main target is to overtake Singapore as the leading provider to South East Asia in the technology and service sectors.

As shown in the chart below GDP growth has been strong over the period BN has been in power.

Malaysia GDP Chart

Malaysia GDP data by YCharts

This chart also shows that Malaysia is vulnerable to external shocks, with growth stalling during the mid 70's oil crisis, the late 90's Asian financial crisis, and more recently during the global economic shocks of 2001 and 2009.

In 2012 Malaysia recorded a 5.1% growth rate, and GDP growth is expected to stay at over 5% for 2013 and 2014. Growth is supported by a significant inflow of foreign direct investment, which totaled $12bn in 2012, comprising a large proportion of the overall GDP of $443bn. Unemployment is at a healthy level of 3.1%.

On this data, Malaysia seems to be doing well, however a peek under the hood uncovers some serious economic issues. Malaysia has an abnormally high level of government debt compared to Asian peers. Malaysia has one of the highest levels of debt to GDP in the region at 51% of GDP compared to 30% in Thailand and just 24% in Indonesia. The government has had to borrow heavily in order to finance the promotion of economic prosperity for the Bumiputera.

Since 2008 the government's debt has escalated exponentially and is projected to be RM 779 billion by 2017, which creates a major debt legacy for future governments, and a drag on future growth prospects.

Malaysia Central Government Debt Chart

Malaysia Central Government Debt data by YCharts

Malaysian consumers have also taken to credit in a big way. The ratio of household debt to disposable income in Malaysia is 140 percent, one of the highest in the world. By comparison the ratio in the U.S. is 123 percent and Thailand 52 percent. Consumers have become highly leveraged and banks over-extended. This leaves the economy, and specifically the banking sector, exposed to any economic downturn.

With a population of 29 million, and relatively high per capita income of $15,500, Malaysia has limited opportunity to further develop domestic demand, which leaves the local economy particularly vulnerable to demand weakness in the global economy. According to the Malaysia trade agency, China is the top trading partner for Malaysia at 13% of total exports in 2011.

The overall picture is of a fragile balance of the economic and political landscape. The ruling BN coalition has held on to power by pork-barreling the Bumiputera with subsidies and affirmative action. This has come at the cost of economic freedom, and structural issues which impede sustainable development.

The political balance has become more delicate, as demonstrated by the recent election. The minority Chinese population has been deserting the BN, in search of a more level economic playing field.

Malaysia however has a chance to leverage its improving infrastructure, high education level, and comparative cost advantage to Singapore to secure a greater share of the high tech and service sector in South East Asia. This is the target of the BN in the campaign "Wawasan 2020", or "Vision 2020", launched by Prime Minister Mahathir in 1991.

Investing in Malaysia

Investors have been wary of investing in Malaysia, as shown by the performance of iShares EWM, the Malaysia ETF. EWM has significantly underperformed regional peers such as the Indonesian and Thai ETFs, IDX and THD.

After the election confirmed that BN will remain in power, EWM gained 7.5%. This gain demonstrated the market's confidence in political stability to secure the earnings of EWM's constituent stocks.

EWM, while underperforming its regional peers, has still fared better than EEM.

As can be seen by the 5 year price chart below, IDX and THD have significantly outperformed EWM. Both pulled back more sharply than EWM in the recent retracement.

EEM Chart

EEM data by YCharts

As mentioned above, iShares emerging markets ETF, which broadly tracks the MCSI emerging markets index, has a healthy 3.9% weighting towards Malaysia, compared to 3.6% of the MCSI index.

EWM is the simplest way for investors to gain direct exposure to Malaysia at a more granular level than the EEM allocation. EWM tracks the MCSI Malaysian index, targeting 85% of the companies listed on the Malaysian stock exchange. EWM is currently valued at a P/E multiple close to 17, and trades at a 3.5 P/B multiple.

EWM Top Ten Holdings

The table below shows the top ten holdings of EWM. The largest holdings by far are the top two, both banks, which account for nearly 20% of the fund.

EWM Top Ten Holdings
Company Sector Allocation
Malayan Banking Berhad Financial 9.78%
CIMB Group Holdings Bhd Financial 8.89%
Sime Darby Bhd Industrials 6.05%
Tenaga Nasional Berhad Utilities 5.16%
Genting Bhd Consumer Discretionary 4.87%
Petronas Chemicals Group Bhd Materials 4.29%
Public Bank Bhd Financials 4.13%
Axiata Group Bhd Telecom 4.09%
IOI Corp Bhd Consumer Staples 3.80%
Maxis Bhd Telecom 3.59%
Total Top Ten 54.65%
Source - ishares

EWM sector allocation.

EWM has 43 stock components in total, with a sector distribution as follows:

Sector Allocation
Financials 31.23%
Industrials 12.52%
Telecomms 11.77%
Consumer Staples 10.65%
Utilities 10.53%
Consumer Discretionary 10.17%
Energy 5.49%
Materials 5.03%
Healthcare 1.78%
Other 0.83%
Source - ishares

The theme of the heavy weighting to financials from the top ten holdings persists in the overall sector allocation. Given the high levels of consumer debt in Malaysia, investors might be wary of the significant banking exposure in EWM.

There is no current closed end fund devoted to Malaysia. The Malaysia Fund (NYSE:MAY),which was managed by Morgan Stanley, was wound up in 2012.

The bottom line

Malaysia is a comparative laggard in a vibrant growth region, with deep-rooted political constraints to economic development. The incumbent governing coalition has borrowed heavily to maintain political power, and the market operates with restricted economic competition.

The largest companies, which enjoy a heavy weighting in the MSCI index, are vulnerable to a change in the political landscape. The leading position many of them enjoy has been built in an environment of economic patronage. Under a new government and a level playing field, they would face increased competition.

The political balance is becoming increasingly fragile, and it appears inevitable that the BN will eventually lose power.

On the positive side, Malaysia has a well educated-population, a strong strategic geographical position, and good infrastructure comparative to its neighbors. Furthermore, it enjoys a significant cost advantage over Singapore (NYSEARCA:EWS), the current incumbent of the regional role that Malaysia targets. A change of government should initiate much needed structural reforms, which would enable Malaysia to compete on a more sustainable basis.

My asset allocation model indicates a marketweight position for Malaysia in my emerging markets portfolio. After the analysis above, I will continue to hold a marketweight position for Malaysia, and not extend via a direct participation in EWM. I will however, monitor Malaysia to position for the post-BN era.

Disclosure: I am long IDX, EEM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am a private investor, not an investment advisor. Readers should always consult an investment advisor before making investment decisions.

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