Dilemma on spending choices

PROTECTING businesses and households from higher prices comes at a cost.

Government finances are now feeling the impact from the combined subsidy for RON95 and diesel – now at RM7bil a month from RM700mil before the Middle East conflict began at the end of February, crippling shipping through the Strait of Hormuz.

Most economists who spoke to StarBiz 7 project that the government will not be able to narrow the fiscal deficit this year to 3.5% of gross domestic product (GDP) from 3.7% in 2025.

Slower economic growth – as first quarter 2026 (1Q26) data to be released next Friday will show – will not help. Advanced 1Q26 GDP showed growth of 5.3% from 6.3% in 4Q25 while Bank Negara Malaysia (BNM) has projected full-year growth of 4% to 5% in 2026 from 5.2% in 2025.

A number of scenarios have been set out to gauge the impact on the deficit in recent weeks, and while subsidy reforms, oil revenues and decent economic growth have buffered government finances in recent years, this will not last.

Much really depends on how long the Strait of Hormuz remains effectively shut to safe shipping and how long it will take for the region’s damaged oil and gas facilities to become operational again.

Amid speculation of an early general election and an economy grappling with supply chain shocks as well as escalating costs, the government has rolled out several measures to cushion the impact on targeted groups such as micro, small and medium enterprises, farmers and traders.

At the same time, it has reiterated its commitment to maintaining the fuel subsidy, which is increasingly unsustainable.

“For analytical purposes, assuming no changes to spending or revenue relative to the assumptions in Budget 2026, higher subsidy spending could increase the government’s fiscal deficit to around 4% of GDP.

“However, this is not currently our base case expectation as we believe the government will seek to manage fiscal adjustments within the existing budget framework, consistent with remarks by Communications Minister Datuk Fahmi Fadzil,” Hong Leong Investment Bank Bhd chief economist Felicia Ling says.

Fahmi recently said the government has no plans to re-table Budget 2026.

Ling adds that reprioritising expenditure and redirecting allocations from non-essential spending areas could help offset the impact of higher subsidies.

Budget 2026 projected total expenditure of RM470bil, of which RM338.2bil was earmarked for operating expenditure (opex) and RM81bil for development.

From the opex, RM49bil was allocated to subsidies and social assistance, of which RM15bil was allocated to the fuel subsidy and another RM15bil to the targeted cash aid programmes under the Rahmah Cash Contribution or STR and the Rahmah Basic Contribution or Sara.

Maybank Investment Bank Bhd chief economist Suhaimi Ilias suggests the government could explore other measures such as shifting to a targeted rather than blanket fuel subsidy for diesel for Sabah and Sarawak that aligns with Peninsular Malaysia.

Other options include higher Petroliam Nasional Bhd (PETRONAS) dividend above the RM20bil projected under Budget 2026.

He says a more progressive subsidy system can be implemented through the introduction of “means-testing” to determine eligibility for subsidies not only for fuel but also in areas such as education and healthcare, and a review of other “legacy” subsidies such as cooking oil and liquefied petroleum gas.

These subsidies can be phased out when prices stabilised, as was done with sugar, poultry and eggs.

While mindful of the evolving dynamics, including the decline in oil and gas–related revenues in recent years, Suhaimi argues that the subsidy rationalisation in recent years “is the correct step to ensure there is balance, exemplified by the success in reducing the budget deficit and containing debt growth.

“These measures have been rewarded by the markets in terms of ringgit appreciation versus the US dollar and stronger foreign investment flows into the domestic bond market and the relatively stable government bond yields,” he says.

United Overseas Bank (M) Bhd senior economist Julia Goh points out that should subsidies persist at RM7bil monthly, the annual expenditure would hit RM63bil, creating a substantial variance against the RM15bil fuel subsidy under Budget 2026 and accounting for over 2% of GDP.

“This considers some cuts to non-essential operating expenses. The variance will also depend on the growth outlook and other expenditures to support the economy,” she adds.

Recently, a directive was sent out by Finance Ministry treasury secretary-general Datuk Johan Mahmood Merican ordering all ministries and related agencies to review their remaining operational expenditures to achieve savings of up to RM10bil, with proposed budget reviews to be submitted by May 15 to the National Budget Office.

Economists understood this as a budget recalibration in the face of the fuel subsidy cost.

Goh feels that the large variance also warrants some adjustment either through the subsidised fuel price, further quota reductions and extending the subsidised diesel control system to Sabah and Sarawak.

“These will help strengthen subsidy targeting and prevent leakages and smuggling,” she adds.

Ling says that if the government aims to narrow the deficit to 3.5%, then it could also strengthen revenue collection efforts.

“One potential avenue is stronger enforcement and leakages management. For example, the government has continued enhancing initiatives such as Ops Tiris to curb fuel smuggling and minimise subsidy leakages,” she says.

Policymakers could also consider recalibrating the fuel subsidy framework to ensure fiscal sustainability.

“This could involve gradually reducing the subsidised quota or adjusting RON95 prices over time. This may also encourage more efficient energy consumption and reduce subsidy leakages,” Ling says.

At the same time, the government can also consider a more targeted subsidy mechanism, as this is generally more efficient but implementation remains key, she says.

Bank Islam Malaysia Bhd chief economist Imran Nurginias Ibrahim says higher oil prices could provide a partial fiscal offset and believes a similar dynamic is now at play.

The Budget 2026 assumption was for an average Brent crude of US$65 a barrel but it is now averaging US$100.

He points to how Malaysia benefitted from a surge in petroleum-related revenue when Brent crude exceeded US$100 in 2022.

The government oil receipts rose to about RM82bil from RM43.1bil in 2021, driven by higher dividends from PETRONAS (RM50bil in 2022 versus RM25bil), higher petroleum income tax collections, and stronger royalties and export duties.

“This nearly RM40bil jump in oil‑related revenue provided a significant cushion against the subsidy bill,” Imran says.

He believes that these revenues, while insufficient to fully neutralise the subsidy burden, will help prevent the deficit from escalating.

“Overall, the current episode highlights Malaysia’s high fiscal sensitivity to global oil price shocks, reinforcing the need to reassess subsidy design and medium‑term fiscal priorities,” Imran adds.

Fiscal probity vital

Reforms in Malaysia’s extensive system of subsidies over the last two years have given the government the flexibility and buffer in responding to the current crisis through second-order effects such as supply-chain shortages and rising costs.

While responding to the crisis involves missing the fiscal deficit target through spending priorities, the market will still need reassurance on the government’s commitment to fiscal reforms.

Imran says a deficit in the range of 3.8% to 4% of GDP will need to be funded through increased issuance of government securities, implying a modest setback to fiscal consolidation efforts and raising total government liabilities.

“As such, maintaining credibility around medium‑term fiscal consolidation is crucial to anchoring bond yields and preserving investor confidence,” he says.

He adds that in the absence of meaningful savings measures or subsidy rationalisation, a wider fiscal deficit will translate into higher government borrowing, and a gradual increase in the debt‑to‑GDP ratio, higher debt‑servicing costs, and heightened credit‑rating sensitivities.

This is especially so if the slippage is viewed as structural rather than temporary.

“A key concern is the potential crowding‑out effect, where rising subsidy commitments reduce fiscal space for development expenditure, including infrastructure, education, and healthcare,” Imran says.

His deficit estimates could push gross issuance of Malaysian Government Securities (MGS) and Government Investment Issue to around RM195bil, up from the initial projection of between RM180bil and RM185bil.

This could see medium‑ to long‑tenor yields rising as investors weigh the fiscal risk premium. A rise in yields and a corresponding drop in prices signals less demand for government bonds or sukuk.

Ling and Imran both agree that the domestic bond and sukuk markets are deep and liquid enough, with a stable sovereign rating and outlook.

The three major global rating agencies, S&P Global, Moody’s and Fitch, have investment-grade ratings for the country’s sovereign credit with a stable outlook.

However, a global economic slowdown can weigh on the ratings and outlook.

Ling says these matrices should continue to support the government’s funding capacity.

It is important for the country to continue engaging investors’ confidence as the country recorded a net RM19bil in foreign inflows into the bond and sukuk markets last year.

“This suggests that investor appetite for MGS remains supported by relatively strong macroeconomic fundamentals and a stable policy environment,” she points out.

The country’s bond and sukuk markets also have the benefit of sustained institutional demand from the government-linked investment companies, the banking system and the insurance industry.

Imran says that if inflation remains contained and macroeconomic fundamentals stay stable, upward pressure on yields is likely to be measured rather than disruptive.

“Overall, the impact is expected to be a moderate steepening of the yield curve, with stable front‑end yields and gradually higher long‑term yields, while sustained credibility around medium‑term fiscal consolidation remains crucial to anchoring market confidence,” he says, adding that a stable overnight policy rate (OPR) should help anchor the front-end yields.

BNM maintained the OPR at 2.75% at the most recent Monetary Policy Meeting, after cutting 25 basis points last July.

The ringgit outlook

Prolonged uncertainties over the Middle East conflict and the Strait of Hormuz chokepoint will weigh on the economies of Asia, which depend heavily on the Persian Gulf for crude oil and liquified natural gas and the byproducts from these hydrocarbons, which include urea for fertiliser and polyethylene for plastic packaging.

In Malaysia’s case, slower economic growth and the need to boost the domestic economy in what is speculated as an election year will mean more populist measures.

The ringgit’s outlook depends on whether investors are convinced that the higher deficit is temporary or persistent.

This will really depend on the government’s messaging.

“A wider fiscal deficit and rising debt issuance could exert moderate pressure on the ringgit, particularly if markets perceive fiscal risks as persistent rather than temporary,” Imran says, adding that the overall ringgit impact is likely to be contained but sensitive to how decisively the government addresses subsidy reforms.

Goh says the ringgit has remained relatively resilient due to Malaysia’s status as a net energy exporter.

A measure of this resilience is the RM6.1bil foreign inflows into the domestic debt markets in March.

But she says for as long as the Strait of Hormuz remains closed, the risks will remain, with Asian economies and currencies bearing a disproportionate share of the fallout.

Goh has retained a near-term stance for the ringgit through 2Q26 given the elevated subsidy bill, potentially higher fiscal deficit and elevated debt levels.

“Looking further ahead, if geopolitical tensions ease and the Strait of Hormuz reopens, we think Malaysia’s fundamentals should reassert itself,” she says.

A gradual narrowing of the interest rate differential between the US federal funds rate and the OPR should also provide medium-term tailwind for the ringgit.

“If geopolitical tensions ease and the Strait of Hormuz reopens, we think Malaysia’s fundamentals should reassert itself.”