Malaysia's Closely-Fought Elections: What's at Stake

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Supporters calling for electoral reform, ahead of the country's 13th general election this weekend.

A general election in Malaysia this Sunday is shaping up to be the most hotly-contested poll ever to be held in Southeast Asia's third biggest economy. And the outcome could be much tighter than markets are anticipating, Malaysia watchers say.

The ruling coalition led by United Malays National Organisation (UNMO), which has held power for 56 years thanks to strong economic growth and strict rule, faces stiff competition from the Pakatan Rakyat (People's Pact) opposition alliance that has benefited from fatigue with the ruling party and has pledged to stamp out corruption.

Observers say that while the most likely outcome is that the ruling coalition returns to power with a reduced parliamentary majority, the election could be just too close to call.

(Read More: Malaysia's Najib Calls Election, Close Race Expected)

"The base-case scenario for markets is that the ruling coalition will return to power with a reduced majority, but looking at some of the recent polls, the crowds turning out at rallies, it looks pretty tight," said Hak Bin Chua, a regional economist at Bank of America Merrill Lynch in Singapore.

"Markets are a bit complacent about the outcome and would probably sell off if the ruling coalition fails to secure a significant majority -- I don't think that is anticipated," he added.

Malaysia's share index, the Kuala Lumpur Stock Exchange, is trading at an all-time high. And like other regional markets it has benefited from strong foreign inflows and relatively bright economic prospects.

Malaysia's economy grew 5.6 percent in 2012, up from 5.1 percent in 2011, on the back of government investment and strong consumption at home.

Still, Malaysian stocks are among the poorest performing Asian markets this year with gains of just 1.7 percent. Compare that with stock markets in Southeast Asian peers Thailand and Indonesia which are up roughly 15 percent each so far in 2013. The stock market in the Philippines is up more than 20 percent.

"The simple fact is that Malaysian markets, if you go back over the past few years, have lagged their peers, the Philippines, Thailand, Indonesia," Yoon-Chou Chong, investment director at Aberdeen Asset Management told CNBC.

"Importantly, hanging over the market have been political concerns, the perception of corruption. And now we have a real election going on and that could be a good sign for the country," he said.

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Opposition leader Anwar Ibrahim, a former deputy prime minister, has promised to address that perception of corruption as well as change government policies that have favored Malays.

Prime Minister Najib Razak meanwhile has said a reduced parliamentary majority could weaken his push to reduce Malaysia's budget deficit and raise investment.

Bringing down Malaysia's debt levels is seen as one of the major challenges facing the next government. The country's debt-to-GDP ratio is 53 percent of GDP, just shy of the government's self-imposed 55 percent limit. The level would be higher if quasi-government debt was taken into consideration, said Chua at Bank of America Merrill Lynch.

(Read More: Malaysia Needs to End Cronyism: Anwar Ibrahim)

Wild Card

Malaysia observers say there are two potential swing factors in Sunday's election.

One is young voters whose interest in politics has risen in the wake of the opposition's best-ever showing in the 2008 election.

According to Reuters, 2.6 million Malaysians have registered to cast their ballots for the first time, that's up from 638,000 new voters in 2008. New voters will make up about a fifth of eligible voters.

The 79 independent candidates in Sunday's election are also a wild card and could determine who forms the next government.

"These guys could be the dark horse in the elections. They could swing the election either way … They could be the spoilers or the king makers," said Joseph Liow, associate dean at the S.Rajaratnam School of International Studies at Nanyang Technological University.

Bank of America Merrill Lynch's Chua said there was one last thing markets would be paying close attention to on Sunday: the prospect of unrest in the event of an unclear outcome.

"There are some worries about incidents of violence," he said, adding that there have been roughly 100 incidents of violence over the past three weeks of election campaigning. "If the election is close, then the question is: will either of the main parties take defeat graciously?"

— By CNBC.Com's Dhara Ranasinghe; Follow her on Twitter: @DharaCNBC