Implications of minimum wage

By Nomura Research

Recent news suggests that Prime Minister Najib is likely to announce setting a minimum wage on Labour Day (May 1). This is authorised under the National Wages Consultative Council Act of 2011 passed by parliament in July last year.

Because of the looming general elections, the announcement is likely to be construed as politically motivated, but there are also important economic consequences of a legislated minimum wage requirement.

The minimum wage is likely to be set anywhere between RM800 to RM1,000 per month. If we assume RM1,000, this would imply a significant 17% rise in the wages of unskilled workers, which according to Malaysia's Employers Federation 2010 Salary Survey, are earning an average RM852 a month.

To put this in perspective, it compares with the average increase of wages in the manufacturing sector of only 6% per year.

This poses an upside risk to inflation, in our view. First, overall labour productivity growth, which has been slowing in the last few years to an average of 2.7% (versus 5.3% pre-1998), is likely to substantially lag the potential increase in minimum wages, resulting in a rise in unit labour costs.

Second, while one could argue that the legislation only affects a certain segment of the employed sector, in 2010 the share of private wage earners earning RM1,000 or below comprise nearly 50% of total employment, according to the Malaysian Institute of Economic Research.

Given the significant share, this is also likely to affect wage negotiations among higher skilled workers, and could stoke higher wage expectations.

As is common in other countries (e.g. Indonesia), minimum wages can be perceived as a wage-setting mechanism (which sets a floor to actual wages) rather than just a safety net for low-wage workers.

Finally, given the current strength in domestic demand (indeed Bank Negara's annual report suggests that domestic demand “will continue to be the anchor for growth,”) firms are likely to pass on rising input costs, fueling CPI inflation.

There are also longer-term concerns:

● Minimum wages could introduce rigidities into the labour market that may ultimately structurally raise unemployment rates. We think part of the reason Malaysian unemployment rates recovered quickly during the 2008/09 global financial crisis is that wage flexibility allowed downward adjustment in wages rather than employment losses during the downturn. Indeed, wages fell more sharply in 2008/09 than in the previous recession, and the unemployment rate recovered to pre-crisis levels more quickly and stayed there until now. The legislated minimum wages could reduce some of that flexibility.

● This could also hurt external competitiveness, which, as we have argued before, is facing some pressures that are not due to an appreciating real exchange rate. If a minimum wage of RM1,000 is set, Malaysia's labour costs will be nearly twice the regional average and will be the highest in South-East Asia except Singapore.

We understand that the Government is fully aware of these concerns and has pledged to address them by a broader set of structural reforms under Prime Minister Datuk Seri Najib Tun Razak 's New Economic Model and the 10th Malaysia Plan unveiled in 2010.

The problem, however, is implementation has been slow so far and without more meaningful progress, these concerns will likely persist. One key argument of the proponents of the minimum wage is that this is supposed to complement these reforms by imposing a hard constraint on firms to improve productivity and reduce their reliance on low-skilled, low-wage foreign workers.

The risk is the reforms lag the minimum wage implementation, and hence the argument fails to hold, while external competitiveness could suffer.

The extent of the impact will still depend on the level of the minimum wage set, and the enforcement among firms.

While the latter remains to be seen, for the former, we can draw on some findings from academic literature to gauge the optimal level of the minimum wage, i.e. whether it is high enough to improve living standards of wage workers but low enough to keep competitive pressures under control.

A study by the World Bank suggests that a useful rule of thumb for developing economies is that the minimum wage at the national level should be no more than 40% of average wages.

By this benchmark, a minimum wage set at RM1,000 for Malaysia seems appropriate on average, though there is considerable variation across sectors. For instance, it is around 41% of the current average in the manufacturing sector, but about 75% of the rubber sector.

In terms of the near-term monetary policy implications, although headline inflation eased for the fourth consecutive month in February to 2.2% year-on-year from 2.7% in January, we see risks to our current policy rate forecast of a total 50 basis points cut in the second half of 2012.

We think the risk of Bank Negara remaining on hold for the rest of 2012 has already increased given that in its recently released annual report, the central bank continued to assess that “at the current level (3%) of the overnight policy rate, monetary conditions remain supportive of economic activity.”

Minimum wages implemented in May could provide additional upside risks to inflation, when fiscal policy is highly expansionary and commodity prices are elevated.