This article first appeared in Forum, The Edge Malaysia Weekly on June 10, 2024 - June 16, 2024

Petrol subsidies have long been a staple of Malaysia’s economic policy, intended to keep fuel prices affordable for consumers and businesses alike. Historically, these subsidies were justified to support economic growth, stabilise transport costs and protect consumers from price volatility. However, blanket subsidies have led to significant inefficiencies, including market distortions, smuggling and a substantial fiscal burden on the government. Maintaining these subsidies has become increasingly unsustainable, prompting the government to rationalise their usage.

To kick off this journey, the government announced in late May that it would first tackle diesel subsidies before moving on to RON95 petrol subsidies in the second half of 2024. The recent announcement indicates that the government will remove blanket diesel subsidies, implement a floating price mechanism and complement this with a targeted subsidy regime.

The focus on rationalising diesel subsidies is not without reason. There are serious concerns about leakages and smuggling, given that the consumption of subsidised diesel jumped nearly 80% to 10.8 billion litres between 2019 and 2023. Over the same period, the number of motorcars and trucks on the road only grew by 18.2% and 10.8%, respectively, making the sharp rise in subsidised diesel consumption particularly unreasonable. Considering the wide price gap between subsidised diesel (RM2.15/litre) and market-priced diesel (approximately RM3.50/litre), the current market structure does provide strong incentives for smugglers to make a profit. Floating diesel prices to market levels will help stamp out such leakages and the government projects that this move will save around RM4 billion per year.

While this decision marks a significant shift, it has sparked concerns about potential inflationary effects, especially considering diesel’s critical role in transport and logistics. Removing subsidies can trigger an initial price surge as markets adjust to real costs. However, the government’s measures to mitigate cost increases for households and businesses should theoretically prevent a marked rise in inflation.

First, the introduction of the diesel fleet card system is a pivotal element in the strategy to mitigate the inflationary impact of removing diesel subsidies. This system ensures that only specific groups, such as commercial transport operators, benefit from subsidised diesel, thus preventing widespread price increases. By ensuring subsidies are still available to essential services as well as targeted and crucial sectors, this approach will help mitigate the risk of a negative shock to the broader economy.

Additionally, subsidies in the form of cash transfers are available to lower-income households with diesel vehicles, which will act as a buffer against rising fuel costs. These transfers help maintain purchasing power and consumption levels among the most affected groups, thereby stabilising aggregate demand.

Moreover, most large industries in Malaysia were not eligible for subsidised diesel in the first place and have been paying commercial rates all along. The rationalisation of diesel subsidies is not expected to impact their cost base, indicating that diesel price changes should theoretically not trigger broad-based inflation on goods.

However, theory does not always translate perfectly into reality. Subsidy retargeting will never be 100% effective, and some deserving households or businesses may be left out, creating risks of price increases for goods and services or negative pressure on domestic consumption.

There is also a risk of firms exploiting the policy change for profiteering. Since most sectors heavily reliant on diesel still receive subsidies, there is no fundamental reason for significant price increases in goods and services. Price hikes could be driven by firms exploiting the situation rather than genuine cost increases. Therefore, the government must intensify monitoring efforts to prevent unjustified price surges and protect consumers.

In conclusion, while the removal of blanket diesel subsidies and floating of pump prices in Malaysia raise valid concerns about inflation, targeted disbursement of subsidies through methods such as the diesel fleet card system and cash transfers can effectively mitigate these risks. Additionally, rigorous monitoring is essential to prevent firms from taking advantage of the situation and unjustifiably raising prices. This approach addresses immediate fiscal challenges and sets the stage for long-term economic resilience. Ensuring government funds are deployed in more productive areas will contribute to the nation’s growth.

Woon Khai Jhek, CFA, is a senior economist and head of the Economic Research department at RAM Rating Services Bhd

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's App Store and Android's Google Play.