By Niluksi Koswanage and Stuart Grudgings
KUALA LUMPUR (Reuters) - Malaysian Prime Minister Najib Razak may have to step down by the end of the year, ruling party sources said on Monday, after his coalition extended its 56-year rule but recorded its worst-ever election performance.
Najib, 59, had staked his political future on strengthening the ruling coalition's majority in parliament in Sunday's general election on the back of a robust economy, reforms to roll back race-based policies and a $2.6 billion deluge of social handouts to poor families.
But he was left vulnerable to party dissidents after his Barisan Nasional won only 133 seats in the 222-member parliament, seven short of its tally in 2008 and well below the two-thirds majority it was aiming for.
It also lost the popular vote for the first time in 44 years, local media reported, underlining opposition complaints that the electoral system is stacked against it. Opposition leader Anwar Ibrahim's People's Alliance won 89 seats, up 7 from 2008 but well short of unseating one of the world's longest-serving governments.
Undermined by the result, Najib now faces a difficult task persuading his dominant United Malays National Organisation (UMNO) to press ahead with economic reforms and phase out policies favoring majority ethnic Malays over other races.
"We could see Najib step down by the end of this year," said a senior official in UMNO, which leads the coalition.
"He may put up a fight, we don't know, but he has definitely performed worse. He does not have so much bargaining power," said the official, who spoke on condition of anonymity.
Former Prime Minister Mahathir Mohamad, still a powerful figure in UMNO, told Reuters last year that Najib must improve on the 140 seats won in 2008 or his position would be unstable.
Kuala Lumpur's stock market surged nearly 8 percent in early trade to a record high on investor relief that the untested opposition had failed to take power, but later gave up some gains to trade 3.1 percent higher. The Malaysian ringgit jumped to a 20-month high.
Ethnic Chinese, who make up a quarter of Malaysians, continued to desert Barisan Nasional, accelerating a trend seen in 2008. They have turned to the opposition, attracted by its pledge to tackle corruption and end race-based policies, undermining the National Front's traditional claim to represent all races in the nation of 28 million people.
MCA, the main ethnic Chinese party within the ruling coalition, only won seven seats, less than half its 2008 total.
Najib, the son of a former prime minister, said he had been taken by surprise by the extent of what he called a "Chinese tsunami." Alarmingly for Najib, support from ethnic Malays also weakened, particularly in urban areas, a sign that middle-class Malays are agitating for change.
Najib, who polls show is more popular than his party, could face a leadership challenge as early as October or November, when UMNO members hold a general assembly and elect the party leader.
"In the next round of elections within UMNO, you will see some dissidents emerging and asking for Najib to resign," said the official, who has held cabinet positions in government. He said Mahathir would be among those who back the dissidents.
ANWAR CRIES FOUL
Barisan Nasional also failed to win back the crucial industrial state of Selangor, near the capital Kuala Lumpur, which Najib had vowed to achieve.
"Najib is now leading a coalition that lost the popular vote, a coalition that will really struggle to prove its legitimacy," said Wan Saiful Wan Jan, head of the Institute for Democracy and Economic Affairs in Kuala Lumpur.
"My feeling is it's not going to be very easy for him."
Investors had hoped that a strong mandate for Najib would enable him to push ahead with planned reforms such as subsidy cuts and a new consumption tax to reduce Malaysia's budget deficit, which is relatively high at around 4.5 percent of GDP.
Those reforms now seem in doubt, Credit Suisse said in a report on Monday, although Najib is expected to push ahead with $444 billion Economic Transformation Programme aimed at boosting private investment and doubling per capita incomes by 2020.
"A tight election race means the government is unlikely to deliver budgetary reforms," it said, adding that the racial divide would be a "huge challenge" for Najib.
Najib himself told Reuters in an interview in March that "a strong government is necessary" to accelerate reforms.
For Anwar, the election could mark the final act of a tumultuous political career that saw him sacked as deputy prime minister in the 1990s and jailed for six years after falling out with his former boss, Mahathir.
His three-party opposition alliance had been optimistic of a historic victory, buoyed by huge crowds at recent rallies, but faced formidable obstacles including the government's control of mainstream media and a skewed electoral system.
Anwar, who vowed to step down from national politics if he lost, said the election had been marred by widespread voter fraud. He had accused the coalition of flying up to 40,000 "dubious" voters, including foreigners, across the country to vote in close races. The government says it was merely helping voters get to home towns to vote.
(Additional reporting by Yantoultra Ngui in Kuala Lumpur and Saeed Azhar in Singapore; Writing by Jason Szep and Stuart Grudgings.; Editing by Raju Gopalakrishnan)