FACTBOX – Key political risks to watch in Malaysia

(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?

* POLITICAL CONFLICT

Political tensions spiked after the 2008 general election when unprecedented opposition gains transformed the political landscape. The National Front coalition’s 52-year grip on the country was dented when it ceded control of five states and ost its two-thirds parliamentary majority.

The ruling coalition has since lost in several by-elections including one last month in its 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 is expected to end 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.

 — Elections in Sarawak, expected by the end of this year. The National Front’s shock defeat last month in a 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 Sarawak elections could spell more losses for the National Front in the next general election which isn’t due until 2013 but 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 the 10th Malaysia Plan (10MP).

The 10MP aims to trim subsidies, boost investment and rein in Malaysia’s ballooning fiscal deficit which hit a 20-year high of 7 percent of gross domestic product last year.

Malaysia’s export-dependent economy has been losing its low-cost manufacturing competitiveness to regional neighbours such as Vietnam and needs to move up the value chain.

Key to investor confidence will be whether the government has the courage to significantly unwind crippling subsidies despite a potential voter backlash, but Najib has given few signs that he is willing to push reform before a general election.

 “We think the government is gradually making progress, but we are not yet ready to turn outright bullish on the reform prospects given the political implementation risk,” Credit Suisse said in a recent research note.

 Najib is expected to soon announce more details of his “New Economic Model” (NEM), which will reform elements of a four-decade-old affirmative action policy favouring the majority ethnic Malays in order to boost the economy’s competitiveness.

The race-based policy 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, and made the country less attractive to foreign investors than neighbouring states.

Najib has rolled back elements of the policy, and axed the rule that companies must offer stakes to Malays. But his plans face growing opposition from conservative Malay rights groups who want the policy preserved, including Perkasa which is backed by a significant number of members of 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 policy’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 skepticism over implementation after some key reforms were put on hold.

 — Moves to reduce crippling fuel and food subsidies, with a decision expected in the next several months. 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, but the measure was withdrawn.

 (For a graphic on Malaysia’s subsidy bill, click here)

* 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.

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.

 * CORRUPTION

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.