Why Fitch Ratings revised Malaysia’s outlook to negative

Why did Fitch Ratings revise Malaysia’s outlook to negative (though it reaffirmed long-term foreign and local currency issuer default ratings at ‘A-‘ and ‘A’, respectively)?

This is happening at a time when some of us are being distracted and diverted by racial and religious issues against a backdrop of what are expected to be closely contested Umno elections.

It almost seems like there is an attempt to split the 51 per cent of the population who voted for change using tried and tested divisive issues of the Old Politics. Don’t fall for these attempts.

The revised outlook for the country has also led to a change in the outlook to negative for Maybank, Export Import Bank, Petronas and Telekom Malaysia – due to their exposure to the government’s financial health.

Anyway, I have tried to summarise the factors leading to the negative outlook for Malaysia from the Fitch Ratings’ statement:

Weaker fiscal outlook and prospects for budgetary reform since GE13
– Federal government debt rose to 53.3 per cent of GDP by the end of 2012.
– General government debt increased to 4.7 per cent of GDP in 2012 due to a 19 per cent rise in public wages ahead of GE13. Thus difficult to achieve 3.0-3.5 per cent fiscal deficit by 2015.
– Malaysia’s fiscal (GG) revenue base is low at 24.7 per cent of GDP. One third of the revenue is from petroleum.

Contingent liabilities are rising
– Federal government-guarantees have risen to 15.2 per cent of GDP by end-2012, up from 9 per cent by end-2008.
– The non-financial public sector deficit soared to 10.2 per cent of GDP in 2012 from 3.5 per cent in 2011.
– Uncertainty over off-budget sheet liabilities.

Credit fundamentals weak
– “Its average income level of USD10,400 in 2012 was much lower than the ‘A’ median of USD18,600.
– “Overall level of development and standards of governance are weak.”
– Private sector debt reached 118% of GDP at end-2012, above the ‘A’ median 94%, and this could rise further by 2015.

On the positive side for the government:
– Federal government debt is mostly in local currency and has smooth maturity profile.
– Deep domestic capital markets
– The EPF channels savings to government. The EPF holds 28.8 per cent of Malaysian government securitis (March 2013).
– Strength in external finance (foreign asset and net forex creditor positions) provides cushion against growing exposure to non-resident investors.

Among other risk factors noted:
– ‘Further erosion of the current account surplus, particularly a “twin deficit” situation where failure to consolidate the budget is associated with the emergence of a sustained current account deficit.
– “A shock to interest rates or to employment sufficient to impair household debt servicing ability and put pressure on the banking system.”

This is the full Fitch Ratings press release:

Fitch Revises Malaysia’s Outlook to Negative; Affirms IDRs at ‘A-‘/’A’ Ratings Endorsement Policy
30 Jul 2013 4:58 AM (EDT) Fitch Ratings-Hong Kong-30 July 2013: Fitch Ratings has revised Malaysia’s Outlook to Negative from Stable. Its Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) have been affirmed at ‘A-‘ and ‘A’, respectively. The Short-Term Foreign Currency IDR has been affirmed at ‘F2’ and the Country Ceiling at ‘A’.

KEY RATING DRIVERS

The revision of the Outlook to Negative reflects Fitch’s assessment that prospects for budgetary reform and fiscal consolidation to address weaknesses in the public finances have worsened since the government’s weak showing in the May 2013 general elections.

Malaysia’s public finances are its key rating weakness. Federal government (FG) debt rose to 53.3% of GDP at end-2012, up from 51.6% at end-2011 and 39.8% at end-2008. The general government (GG) budget deficit (Fitch basis) widened to 4.7% of GDP in 2012 from 3.8% in 2011, led by a 19% rise in spending on public wages in a pre-election year. Fitch believes it will be difficult for the government to achieve its interim 3% FG deficit target for 2015 without additional consolidation measures. Fitch sees risks even to the achievement of the agency’s 3.5% deficit projection, as this already factors in 1pp of GDP of spending cuts. This leaves Malaysia’s public finances more exposed to any future negative shock.

Contingent liabilities are rising. FG-guaranteed debt rose to 15.2% of GDP by end-2012 from 9% at end-2008 as state-owned enterprises (SoEs) participated in a government-led investment programme. The non-financial public sector deficit soared to 10.2% of GDP in 2012 from 3.5% in 2011. Data on consolidated indebtedness of SoEs are unavailable, which hinders analysis of the sovereign’s contingent liabilities.

Malaysia’s fiscal (GG) revenue base is low at 24.7% of GDP, against an ‘A’ range median of 32.8%. Fitch has long emphasised two key budgetary vulnerabilities: reliance on petroleum-derived revenues and the high and rising weight of subsidies in expenditure. Petroleum-derived revenues contributed 33.7% of federal revenues in 2012, broadly comparable with lower-rated Mexico (BBB+/Stable), another sovereign with a narrow and oil-dependent fiscal revenue base.

Notwithstanding these weaknesses, Fitch acknowledges strengths in the composition of Malaysia’s debt and in its funding base. FG debt is overwhelmingly denominated in local currency (97% at end-2012) and has a smooth maturity profile. Sovereign funding conditions benefit from deep domestic capital markets and from the role of the broader public sector in funnelling savings to the government. The state-run Employees’ Provident Fund held 28.8% of Malaysian government securities at end-March 2013. The rising role of non-resident investors points to growing exposure to global investor risk appetite, but Fitch views strengths in Malaysia’s external finances as a buffer against volatility. The impact of heightened market tensions on Malaysia’s government debt market since June has been mild compared with some regional and rated peers, so far.

Malaysia’s credit fundamentals are weak by ‘A’ range standards. Its average income level of USD10,400 in 2012 was closer to the ‘BBB’ range median of USD11,300 than the ‘A’ median of USD18,600. Its overall level of development and standards of governance are also considered weak for its ‘A-‘ rating. Fitch’s Banking System Indicator of ‘bbb’ suggests the standalone strength of Malaysian banks does not weigh on the credit profile. However, Malaysia’s high level of private sector leverage is a risk from a credit perspective. Credit to the private sector reached 118% of GDP at end-2012, above the ‘A’ median 94%. Fitch projects the divergence from the ‘A’ median will widen out to 2015.

Malaysia’s external finances remain its key sovereign credit and rating strength. The economy recorded a net external creditor position worth 30% of GDP at end-2012 against the ‘A’ range median creditor position of 17%. The sovereign’s own net foreign asset position of 21.3% of GDP and net FX creditor position of 44% were stronger than ‘A’ medians of 16.8% and 14.4% respectively. This is despite a decline in the current account surplus to a projected 3% of GDP in 2013 from double digits each year from 2003 to 2011 amid rising investment and a drop in the savings rate, led by the public sector.

Malaysia’s five-year average GDP growth rate of 4.3% (2009-2013) compares favourably with the ‘A’ median of 2.6% and the ‘BBB’ median of 2.7%. However, growth is being boosted by the government’s investment programme. Real gross domestic fixed capital formation (GFCF) grew 19.9% in 2012 against a five-year average of 5.6%pa over 2007-2011. GFCF contributed +4.4 percentage points to 2012’s 5.6% GDP growth.

RATING SENSITIVITIES

The Negative Outlook reflects the following risk factors that may, individually or collectively, result in a downgrade of the ratings, most likely by one notch:

-Fiscal slippage relative to the government’s targets and lack of progress on structural budgetary reform; further accumulation of contingent or other off-balance-sheet liabilities
-Further erosion of the current account surplus, particularly a “twin deficit” situation where failure to consolidate the budget is associated with the emergence of a sustained current account deficit
-A shock to interest rates or to employment sufficient to impair household debt servicing ability and put pressure on the banking system
-Significantly slower GDP growth than Fitch’s current projection of about 5% per year out to 2015

Given the Negative Outlook, Fitch’s sensitivity analysis does not currently anticipate developments with a material likelihood, individually or collectively, of leading to a rating upgrade. However, future developments that may, individually or collectively, lead to the Outlook being revised to Stable include:

-Faster progress on fiscal consolidation and budgetary reform than Fitch expects

KEY ASSUMPTIONS

-The ratings assume a global economic recovery in line with the agency’s June Global Economic Outlook. In particular, the ratings assume China avoids a slowdown to low single digit growth
-The ratings assume oil prices do not diverge significantly from the agency’s base-case projection of USD100/barrel on average over 2014-2015
-The ratings assume Malaysia continues to experience broad social and political stability