By Razak Ahmad
KUALA LUMPUR, May 31 (Reuters) - Malaysian Prime Minister Najib Razak has reached a critical point after just over a year in office -- will he enact economic reforms and cut subsidies and risk alienating his voter base, or will he back off?
Poorer Malays could be hit initially by Najib's pledge to reduce subsidies and roll back a controversial racial affirmative action policy. Many analysts believe the promised economic reforms, aimed at winning back foreign investment, will be delayed, watered down or abandoned to avoid losing votes.
Malaysian bonds have rallied this year, returning 4.99 percent for dollar-based investors in the past three months, according to the industry benchmark JPMorgan Government Bond Index-Emerging Markets, outperforming the wider Asia index which rose 2.67 percent. Malaysia's outperformance is largely due to rate hikes and the ringgit's proxy as a China revaluation play.
By contrast, Thailand is up 4.77 percent and high-flying Indonesia scored a 6.81 percent return in U.S. dollars, although all markets are off their highs, roiled by global risk aversion.
Following is a summary of key Malaysia risks to watch:
* POLITICAL CONFLICT
Political tensions spiked after the 2008 general election when unprecedented opposition gains transformed the political landscape. The National Front coalition's dominance through 52 years in power was dented as it lost control in five states and its once iron-clad two-thirds control of parliament.
The ruling coalition has since lost in several by-elections including one last month in its own bastion state of Sarawak.
The political uncertainty has weighed on foreign investment with net portfolio and direct investment outflows MYFLO=ECI reaching $61 billion in 2008 and 2009 according to official data. While money has flowed into the bond market recently, according to central bank statistics, little has flowed into equities.
What to watch:
-- Opposition leader Anwar Ibrahim's sodomy trial, which ends in late August. Anwar says the case is a political conspiracy, and a contentious verdict would anger his supporters. Any marked increase in political tensions could see more foreign money pulled from stocks .KLSE, bonds and the ringgit MYR=. But with limited foreign portfolio investment still in the country, the impact will be muted. [ID:nSGE60I0BQ]
-- Elections in Sarawak which expected by the end of this year. The Front's shock defeat last month at a parliamentary by-election in Sarawak has raised doubts whether it can maintain its support levels in the state. A further weakening of Najib's coalition in the coming Sarawak elections could spell more losses for the National Front in the next general election which analysts say could be held as early as next year.
* ECONOMIC REFORM
The government's commitment to economic reform is being put to the test with a plan to cut subsidies presented to the public last month, with a decision expected in the coming months.
Malaysia spent 15.3 percent of total federal government operating spending on subsidies in its 2009 budget when its deficit surged to a 20-year high of 7 percent of GDP.
Key to investor confidence will be whether the government has the courage to significantly unwind the crippling subsidies amid a potential voter backlash. Najib's political will to reform will also be tested by the "New Economic Model" (NEM), a blueprint to replace a four-decades-old Malay affirmative policy known as the New Economic Policy (NEP).
The controversial NEP was adopted after 1969 race riots and gave a wide array of economic benefits to ethnic Malays who make up 55 percent of the population. Investors complain that abuse of the policy spawned a patronage-ridden economy, causing foreign investors to favour Indonesia and Thailand. [ID:nSGE62E002]
Najib has rolled back elements of the NEP, and axed the rule that companies must offer stakes to indigenous ethnic Malays. But his plans face growing opposition from conservative Malay rights groups who want the NEP preserved, including Perkasa (Strength) which is backed by a significant number of people within Najib's own United Malays National Organisation (UMNO) party.
What to watch:
-- The phased rollout of the NEM and how far Najib will accommodate conservative Malay pressure groups. The NEM's broad outline was released on March 30 and public reaction will be sought before the final measures are announced. Markets barely shifted when it was announced, reflecting scepticism over implementation after some key reforms were put on hold.
-- Moves to reduce crippling fuel and food subsidies. Past fuel price hikes have drawn an intense public backlash which Najib appears wary of attracting. Malaysia was supposed to cut its fuel subsidy bill from May this year as part of the 2010 budget to tackle its budget deficit which hit a more than 20-year high of 7 percent of GDP in 2009, but the measure was withdrawn.
(For a graphic on Malaysia's subsidy bill, click here)
-- The 10th Malaysia Plan, a five-year economic masterplan. Set to be tabled in parliament on June 10, the plan will contain Malaysia's revised growth and budget deficit forecasts.
* RACE AND RELIGION
Race and religion have always been explosive issues in Malaysian politics. Najib took power pledging a more inclusive approach to ethnic Chinese and Indian minorities, but his UMNO party is beginning to cast this approach aside in a bid to woo conservative Malays. The caning of three women under strict Islamic laws in February for having illicit sex signalled the government's increasing adoption of a stronger Islamic agenda, and this has worried some investors. [ID:nSGE61I07S]
A heated row over the use of the word "Allah" by Catholics, which sparked attacks on religious establishments, is also threatening to prolong minority unhappiness with the government.
What to watch:
-- Efforts to resolve religious disputes. The government has set up an interfaith committee to promote religious harmony and is trying to reach an out of court settlement with the Borneo Evangelical Church, which went to court over the "Allah" dispute.
-- If the government tries to woo Muslim voters with more conservative policies based on Islam, investors may be spooked.
-- A severe worsening of tensions could raise the spectre of sectarian unrest, but this is not regarded as likely for now.
Malaysia used to be regarded as one of the region's more reliable countries, but worsening corruption and a perceived lack of judicial independence have damaged investment.
What to watch:
-- Government efforts to deal with a scandal over a port trade zone close to Kuala Lumpur that exposed links between politics and business. False government guarantees given when the bonds were sold have triggered concerns among holders of $1 billion of bonds that they might not be repaid.
(Editing by Andrew Marshall)