18:57 27May09 RTRS-UPDATE 1-Malaysia economy slumps in Q1 most in decade

* Biggest annual fall in GDP since Asian financial crisis * HSBC says GDP dropped s/adj 5.1 pct from previous quarter * Short-term, economy relies on global recovery * Longer term, Malaysia looking at economic reform (Adds quotes from central bank, analysts) By Loh Li Lian and Soo Ai Peng

KUALA LUMPUR, May 27 (Reuters) - Malaysia's economy shrank by 6.2 percent in the first quarter from a year ago, the central bank said, the largest fall since the fourth quarter of 1998, and it will likely contract by the same amount in the second quarter.

The fall was more than the 4 percent drop predicted in a Reuters poll although it was smaller than declines seen in neighbouring Singapore, where the economy contracted 10.1 percent in the same period, and Thailand's 7.1 percent fall. "Despite early signs of improvement... (the second-quarter will be) very similar to the first quarter," Bank Negara Governor Akhtar Aziz told a press conference on Wednesday.

The government has already said it will revise down its forecast that Asia's third-most export-dependent country would shrink by 1 percent at most this year. Malaysia's short-term growth hopes rest on a global recovery boosting demand for its electronics, oil and commodities exports and on Chinese demand holding up, thanks to that country's huge budget stimulus.

But after a prolonged period of not hitting its economic growth targets, which had envisioned the country joining the club of rich nations like fellow Asian tiger South Korea, Malaysia is now looking at big reforms to its economic model. Zeti stressed that some measures had already been taken and the data released on Wednesday showed that domestic consumption contracted by just 0.2 percent from a year ago, compared with a 15.2 percent drop in exports in the quarter.

Public sector consumption rose 2.1 percent from a year ago, reflecting the country's initial timid stimulus package that was later augmented by a 60 billion ringgit ($17.21 billion) boost in March. HSBC calculated that in seasonally adjusted terms, Malaysia's economy shrank in the first quarter by 5.1 percent from the fourth quarter but it doubted the GDP data would prompt any action from the central bank.

"The central bank will have known the GDP number when it opted to leave the overnight policy rate unchanged at yesterday's meeting," economist Robert Prior-Wandesforde said in a note referring to the central bank's decision to leave rates unchanged at 2 percent.

REFORM? Longer-term it wants to boost domestic demand and diversify into services so as to reduce its dependence on what are often low value added products made using cheap migrant labour.Malaysia's economy has grown less quickly than anticipated over a long period of time and economists say that its biggest challenge is taking advantage of the current global downturn to abandon ethnic-based policies that critics say have hampered growth and encouraged graft.

The country's current economic plan envisioned average annual growth of 6.0 percent between 2006-10, a figure that has only been achieved in 2007. If the economy contracts by 1 percent this year annual average growth from 2006 will be just 4.14 percent, a Reuters calculation shows based on annual published data.

"In my view, Malaysia needs to urgently fine-tune its economy and design a whole new growth model that is not too dependent on exports or even FDIs (foreign direct investment), giving a bigger role to domestic demand to play as a major growth engine," said Azrul Azwar Ahmad Tajudin, economist at Bank Islam in Kuala Lumpur.

At the same time as implementing economic reforms and reinvigorating the National Front coalition that has ruled Malaysia for 51 years, Prime Minister Najib Razak will soon have to deal with a debt overhang due to pump priming. The budget deficit in Malaysia is expected by the government to hit 7.5 percent of gross domestic product in 2009 and new bond issuance will be in the region of 90 billion ringgit, investment banks estimate.

Even if there is a global rebound, Malaysia's government is dependent on oil for about 40 percent of its revenues. The only way to bridge the fiscal gap, given the political and economic risks of raising new taxes and of cutting government spending, is a bold set of economic reforms, including ending an entrenched system of economic privileges for the country's majority ethnic Malay population.

The policies have done little to reduce inequality and Malaysia has the most unequal income distributions of any Asian country outside Papua New Guinea, United Nations data shows."This would be crucial... not just in positioning the country for more accelerated growth in the future, but also as a sound method to tackle the fiscal deficit problems in the country, which is threatening to balloon out of proportion if insufficient attention is paid to it," Citigroup said in a recent report.