Higher commodity prices in recent months is a double-edged sword for Malaysia as while it could mean stronger growth, higher food and fuel prices may also bring new threats of inflation.
Economists expect the Consumer Price Index to rise to as high as four per cent this year from the mild 1.7 per cent reading in 2010.
The current level of fuel prices is broadly neutral for the fiscal deficit over a two-year horizon but if it increases further, costs from fuel subsidies would outweigh the additional oil-related revenues.
"With an already high fiscal deficit, Malaysia is not as shielded from higher food and fuel prices as many would have thought," Credit Suisse economist Wu Kun Lung said.
(In its 2011 budget, the government expects the fiscal deficit to gross domestic product ratio to remain high at 5.4 per cent in 2011 compared with an estimate of 5.6 per cent in 2010)
US investment bank Citi said as a net oil exporter, Malaysia receives six times more revenue from oil than it spends on fuel subsidies.
At current prices of US$90 (RM274) per barrel, price of the RON95 fuel would have to be increased by 15 sen more per litre to maintain the subsidy at the implicit target of 30 sen per litre.
"A rise to US$100 (RM304) per barrel oil price could necessitate a 40 sen per litre hike, which could bring 2011 average inflation to 2.9-3.6 per cent," Citi economist Kit Wei Zheng said.
Alternatively, if petrol prices are not hiked, a rise in oil prices to US$100-US$110 (RM304-RM334) per barrel should be a small net-positive for the fiscal.
Wu estimates that if the government were to liberalise fuel prices at the current prices of around US$90 per barrel, it would add between 1.5 to 2 percentage points to the CPI, bringing the year-on-year inflation to 4 per cent or more.
"Given that the general election is approaching, it is unlikely that the government will hike fuel prices by a significant amount, in our view," he said.
He expects two more modest fuel price hikes in mid- and late-2011, adding about 0.7 percentage points to headline inflation.
Net exports of palm oil, liquefied natural gas, crude oil and rubber, in ringgit terms, together made up about 16 per cent of Malaysia's total GDP in 2010.
"Higher commodity prices in these products should help boost income for farmers and companies in the plantation and oil and gas sectors, which should in turn lead to higher consumption and investments," he said.
Credit Suisse has raised its GDP outlook from 5.2 per cent to 5.6 per cent for 2011, making it the fifth best performing economy behind China, India, Indonesia and Vietnam.
Wu estimated that a 10 per cent increase in palm oil prices, for instance, would add about 0.3 percentage points to the GDP while 10 per cent rise in Dubai oil prices or rubber prices would add another 0.2 percentage points to growth.
The government subsidises essential food items such as rice, sugar, flour, and cooking oil.
Food subsidies amounted to about RM3 billion or 0.4 per cent of GDP in 2010, while subsidies on food were less than one third those on fuel (about RM10 billion).
Wu said the adverse impact on the fiscal balance can be mitigated if the government reduce subsidies or allow the ringgit to appreciate further.