Key political risks to watch in Malaysia

Annual inflation accelerated to a 27-month high of 3.5 percent in June, and interest rates are likely to rise in September. U.S. and European debt troubles could slow the pace of growth in Malaysia's export-dependent economy. Growth hit a decade high of 7.2 percent in 2010 but a marked slowdown could force Najib to hasten polls to prevent voter sentiment from souring. 

Razak Ahmad, Reuters

Rising prices and discontent over the slow pace of reforms are the key challenges confronting Prime Minister Najib Razak as he considers the possibility of a snap election in early 2012.

Annual inflation accelerated to a 27-month high of 3.5 percent in June, and interest rates are likely to rise in September.

In July, police fired tear gas at protestors who were part of a rare anti-government demonstration in Kuala Lumpur that drew more than 10,000 people demanding electoral reforms.

If he comes under greater popular pressure, Najib may scrap the idea of a snap election, and hold back on reforms foreign investors would like to see, including cutting fuel subsidies and unwinding an affirmative action programme for the country's Malay majority.

Following is a summary of key Malaysia risks to watch:

POLITICAL TENSION

The opposition People's Alliance was defeated in five recent by-elections but it is regaining momentum with gains in a Sarawak state poll in April and a strong show of support in the July 9 rally in Kuala Lumpur.

Najib needs to regain the ruling coalition's two-thirds control of parliament in order to consolidate his grip on power in the next national polls which are not due until 2013.

Political uncertainty has weighed on foreign investment since 2008 but speculative inflows in search of higher-yielding markets have boosted the ringgit currency .

What to watch:

-- The risk of more protests, and government response to them, as well as racial and religious relations. Najib is trying to reach out to non-Muslim minorities who make up about 40 percent of the population, and in July set up diplomatic ties with the Vatican in a bid to win Christian support.

-- Refugee-swap deal with Australia. Under the deal, Australia would send to Malaysia 800 asylum seekers who arrive by boat, and they would have their refugee claims processed there. In return, Australia would accept 4,800 people from Malaysia who have already been granted refugee status, but in August Australia's highest court ruled the government could not deport the asylum seekers.

-- Annual meeting of Najib's party, early November. A clearer indication of the possible timing of the next polls is likely to come when the United Malays National Organisation (UMNO) meets. The party leads the ruling coalition. 

ECONOMIC REFORM

Najib has pledged to reform a decades-old affirmative action policy favouring ethnic Malays and replacing it with a "New Economic Model" to promote greater competition, though conservative Malay groups including many in UMNO oppose reform.

Investors complain that the race-based policy was abused, resulting in an economy run on patronage which deters some investors from Malaysia.

Najib cut Malaysia's fiscal deficit from a 20-year high of 7 percent of gross domestic product in 2009 to 5.6 percent in 2010 and has promised to lower it to 5.4 percent in 2011.

What to watch:

-- Monetary policy committee meeting on Sept. 8, at which the interest rate is expected to be raised by 25 basis points.

-- Fuel subsidy rollback. High oil prices are straining the government's subsidy bill but Najib has said Malaysia will look for avenues to keep fuel prices at current levels for as long as possible.

-- Continuing roll-out of the Economic Transformation Programme (ETP), an ambitious plan to attract $444 billion worth of investment over 10 years in order to double the country's national income.

-- The annual budget, to be tabled in parliament on Oct. 7. Key will be whether the government sticks to its fiscal deficit target in a budget which many expect to be a pre-election spending plan.

-- U.S. and European debt troubles could slow the pace of growth in Malaysia's export-dependent economy. Growth hit a decade high of 7.2 percent in 2010 but a marked slowdown could force Najib to hasten polls to prevent voter sentiment from souring. (Editing by Daniel Magnowski)