By Siva Sithraputhran and Niluksi Koswanage
PUTRAJAYA, Malaysia (Reuters) - From unwinding subsidies for food and fuel to imposing a new sales tax, Malaysia's Prime Minister Najib Razak has plenty to do to rescue the country from a possible credit rating downgrade when he presents his government's annual budget this month.
One thing Najib won't dare risk is upsetting the country's majority ethnic Malays by downsizing a bloated civil service, despite its heavy impact on a fiscal deficit that is the biggest in emerging Asia after India.
Though the next election is only due by 2018, the ruling National Front coalition is already looking nervously to the future after a contentious victory last May, and Najib cannot take for granted that his own party, the United Malays National Organisation (UMNO), won't jettison him before his term is up.
"If the National Front institutes policies that make the Malays or the government servants unhappy, a 2-3 percent swing next time to the opposition will spell defeat," said Ibrahim Suffian, director at the respected pollster Merdeka Centre.
Dominated by Malays, the civil service, with its jobs for life and access to cheap loans, serves as part of a decades-old affirmative action policy. At 60 billion ringgit ($18.78 billion) its wage bill is the single largest budget item, accounting for a third of total spending.
The fiscal burden, along with a shrinking current account surplus, renders Malaysia vulnerable to foreign capital outflows at a time when investors are eyeing emerging markets with growing caution due to expectations that the U.S. Federal Reserve call time on years of easy money in the coming months.
But, mindful of preserving stability, policymakers often make ethnic considerations a priority in this nation of 29 million people, made up mostly of Malays, Chinese and Indians.
It was the Malay vote that helped the National Front, which comprises parties from each ethnic group, scrape back into power, despite losing the popular vote for the first time in 56 years since independence from British colonial rule.
UMNO holds elections later this month for senior party positions, and with conservatives circling, the more liberal-minded Najib will be keen to shore up support, though he is not facing re-election himself as party chairman.
"Now, he has to really take care of the Malays," said an ethnic Malay clerk, whose civil service unions have asked for a two-and-a-half month bonus to be included in the budget.
Faced with these compulsions, Najib is likely to make cuts elsewhere when he unveils the budget on October 25.
"Food and fuel subsidies will be the easiest expenditure for Najib to cut after the elections, but not the civil service," said Chua Hak Bin, a Singapore-based economist with Bank of America Merrill Lynch. "That is out of the question, for now."
Instead, Najib is expanding the public service, a vital source of support for UMNO. Some 200,000 people have joined the civil service since he became prime minister.
At 1.4 million people, the civil service accounts for 10 percent of the labour force, and by that measure is the largest in Southeast Asia. The hiring isn't over. This year there are plans to add 80,000 employees, double last year's intake.
Unemployment is not particularly high at 3 percent, but young Malays often struggle to find work in the private sector. Nine out of 10 unemployed graduates are Malay, raising a fear in UMNO that first-time voters in youthful Malaysia could turn against the party at the next election, unless they have jobs.
CUT OR BE CUT
In reaction to the unconvincing election victory, Fitch Ratings warned in July that deteriorating public finances or a current account swing into deficit, along with other concerns, could lead to a cut in Malaysia's credit rating, though it is comfortably lodged in investment grade.
Currently, the government receives nearly half its revenues from Petronas (PETR.UL), the state oil and gas giant.
"There may be efforts to increase the revenue base with the goods and services tax and other tax increases, but this amounts to little if government efficiency does not improve and the bureaucracy keeps on growing," said Chua.
Deputy human resources minister Ismail Abu Muttalib said the size of the civil service was not a worry as employees would find jobs in the private sector as Malaysia develops more.
"The situation will resolve itself," he told Reuters. "For now these government servants are needed to deliver the government's social programs to the wider public."
(Editing by Stuart Grudgings and Simon Cameron-Moore)