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Why Malaysia’s latest budget may be its toughest yet

Malaysia's budget due at 4 p.m. local time (0800 GMT) may be the toughest yet for embattled Prime Minister Najib Razak as he struggles to balance declining oil revenues, spending priorities and a growing political scandal.

Limited fiscal headroom means the government is likely to cut remaining fuel subsidies but analysts expect authorities to soften the blow by targeting spending to low-income households.

"Perhaps to elicit sympathy from the common folks, Prime Minister Najib said that it is a 'difficult' budget to draft," Wellian Wiranto, economist at OCBC, said in a note Thursday. "Indeed, he would have to juggle between stimulating a sluggish economy and convincing investors of his fiscal rectitude, while keeping an eye on the political implications of it all."

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Malaysia's economy is certainly lethargic. Prices for major commodity exports crude oil and palm oil have dropped sharply and its currency, the ringgit, is trading close to its lowest levels since the Asian financial crisis in the late 1990s.

Household debt is also relatively high at around 88 percent of gross domestic product (GDP) capping consumer spending. The government forecasts the economy will grow 4.5-5.5 percent this year, although expectations are for the figure to come at the low end of the range, in danger of its slowest growth since 2009, during the Global Financial Crisis, when the economy contracted.

The government is already nearing its self-imposed debt ceiling of 55 percent of GDP -- it was at 53.8 percent at the end of the second quarter, with government debt guarantees at 15.1 percent of GDP, according to data from Maybank, an investment bank.

The budget is an annual exercise where the government outlines how it plans to spend money and tax residents.

Kiyoshi Ota | Bloomberg | Getty Images

But the latest carries special importance: this will be the first budget of the country's 11th Malaysia Plan, generally referred to as 11MP, a five-year plan aiming to plot a course for the country to leave its "emerging" status behind to become a developed nation by 2020.

So the government is stuck between the rock of boosting its spending for 11MP goals and the hard place of keeping its budget deficit under control amid declining oil revenue.

The 2015 budget deficit had to be revised to 3.2 percent of GDP from 3 percent after crude oil prices plunged, but that's down from a high of 6.7 percent in 2009 during the Global Financial Crisis, Maybank noted.

And just to make things more complicated: there's the possibility of a falling anvil from what may be the country's worst-ever political scandal from the debt-ridden economic development fund, 1Malaysia Development Berhad (1MDB).

"The primary fiscal issue for Malaysia in the near term remains its dependence on oil-related financing," Wiranto said. While oil-related dependence is down to 22 percent of 2015 government revenue from 35 percent in 2015, the country is still trying to squeeze more dividends out of state-owned oil and gas player Petronas, he said.

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Petronas was hoping to cut its contribution to 9 billion ringgit ($2.13 billion) next year, from an estimated 26 billion ringgit this year, amid a sharp earnings drop, but the government objected and the ultimate amount may come in around 18 billion ringgit, Wiranto said, noting this raises questions on revenue sustainability.

But the government likely can't raise its newly introduced goods and services tax from its current 6 percent without angering "already less-than-happy consumers," Wiranto said. Only one in ten Malaysians earn enough to pay income tax, he noted.

That's why analysts expect the government to look for operating expenditure cuts -- such as cutting remaining fuel subsidies -- even as it tries to keep up development spending and target lower-income households, often called the B40, or bottom 40 percent with incomes of less than around 2,500 ringgit a month.

JPMorgan expects measures will include affordable housing and education spending, including financial aid for B40 students. Some analysts expect increased cash handouts under the BR1M, or 1Malaysia People's Aid, program, which offers a targeted, income-based subsidy to replace fuel subsidies. Maybank expects those payouts will be raised by around 100-150 ringgit from 2015's 950 ringgit for low-income households, noting that in 2013, the government pledged BR1M payouts of 1,200 ringgit within five years.

Infrastructure projects are likely to remain a priority. But OCBC's Wiranto noted that they're likely to be targeted to regions "crucial" to keeping political power, particularly in rural heartlands.

Those efforts would come as Prime Minister Najib faces increasing political pressure -- including large protests in August calling for his ouster and opposition parties filing this week to hold a parliamentary no-confidence vote; it isn't clear when the vote would be held.

The political noise is due to a continuing scandal over one of Najib's pet projects, the 1Malaysia Development Berhad (1MDB) fund, launched in 2008 to promote economic development. It has been in the limelight for months, amid allegations of false auditing, huge debt and, more recently, financial fraud. In July, the Wall Street Journal published a report alleging nearly $700 million flowed from the fund to Prime Minister Najib Razak's personal bank account.

Najib has repeatedly denied any wrongdoing, claiming the funds were a private donation from Middle Eastern country he has declined to name. Singapore and Switzerland have both suspended bank accounts tied to 1MDB and in the U.S., media reports said the Federal Bureau of Investigation (FBI) is investigating as well.

Investigations in Malaysia have been dogged by accusations they were biased toward the government or halted entirely.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1