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 parliamentary majority 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 coalition 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, 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 still incapable of unseating one of the world's longest-serving governments.
Anwar, a former deputy prime minister, said in a statement on Monday that he would not accept the result because it was marred by "unprecedented" electoral fraud. He has called for a rally in the capital Kuala Lumpur on Wednesday.
Undermined by the result, Najib now faces a difficult task persuading his dominant United Malays National Organization (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 close 3.38 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 Program aimed at boosting private investment and doubling per capita incomes by 2020.
For Anwar, the election was likely the last chance to lead the country after 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, 65, 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.
"My heart is with every Malaysian who does not accept the results," Anwar said in his statement.
Malaysia's Bersih (clean) civil society movement, which has held large rallies to demand electoral reform, joined Anwar in withholding recognition of the result, saying it needed to study numerous reports of fraud.
(Additional reporting by Yantoultra Ngui and Siva Sithraputhran in Kuala Lumpur and Saeed Azhar in Singapore; Writing by Jason Szep and Stuart Grudgings.; Editing by Raju Gopalakrishnan)