Cover Story: The impact of the national debt

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on June 25, 2018 - July 01, 2018.
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Malaysia’s heavy debt obligations and liabilities, the removal of a major revenue generator — the Goods and Services Tax — and alleged misappropriation of government funds have had many economists and the investor fraternity concerned about the impact of the national debt on the general public. While this state of affairs may feel fairly insulated from daily life for now, the fallout could eventually hit the man in the street if it is not properly addressed, experts tell Personal Wealth.

As it is, investor confidence in Malaysia’s credit profile has been rocked by ongoing revelations of financial mismanagement by the previous government and the removal of fiscal measures that would have compensated for it. This can be seen in the large outflows of foreign holdings in Malaysian sovereign bonds.

Kenanga Research reported that as at April, foreign holdings of Malaysian bonds were at 15.2% — the lowest in eight years. Foreign investors were also net sellers for the second consecutive month in May, with RM12.9 billion sold compared with RM4.7 billion in April.

Lee Heng Guie, an economist and executive director at the Socio-Economic Research Centre (SERC), says the national debt could lead to higher interest rates and cause a snowball effect thereafter. “The more investors fear a default on the government’s debt obligations, the more they will sell bonds. This will push bond yields higher and make the debt securities more appealing to investors, relative to stocks,” he adds.

“Yields will then rise, resulting in higher new borrowing costs for investors. If inflation rises, it will lead to higher bond yields as investors demand higher interest rates to protect against the falling value of nominal bonds.”

Professor Yeah Kim Leng, professor of economics at Sunway University Business School, agrees. He says bond yields will see upward pressure as investors demand greater compensation for what they perceive to be an increased risk premium for holding on to government debt securities.

“The selling pressure signals an increase in the risk premium for holding Malaysian government securities (MGS). But we see this only as a temporary phenomenon, largely in reaction to the government’s efforts to undertake financial restructuring to reduce our debt levels, as well as to enhance the financial position of the country, given the large-scale financial scandals that happened under the previous administration,” says Yeah.

“So, this sell-off is likely to give rise to investment opportunities in the short to medium term, particularly for local funds and investors to pick up high-quality ringgit-denominated MGS. I believe our large institutions have surplus liquidity and will be able to make up the shortfall without bond yields creeping up too high.”


Worst-case scenario

But in the unlikely event that the local market lacked the liquidity to pick up bonds offloaded by foreign investors, a painful sequence of events could unfold. “This would become an issue of whether the country is facing a credit crunch, which is to say we no longer have enough money to support bond buying. The government itself would need to step in to buy bonds and other non-performing debt securities [to provide the much-needed liquidity],” Yeah explains.

The worst-case scenario would be if the bond sell-offs become so deep that Bank Negara Malaysia is forced to print more money. But this would present yet another problem. With the runaway bond yields forcing the central bank to increase the amount of currency in circulation, an obvious consequence would be inflation. As the ringgit loses its value, the price of goods and services would begin to rise.

One of the tools the central bank has at its disposal to keep inflation in check would be to raise the overnight policy rate (OPR). This, in turn, would prompt banks to raise interest rates across the board. “The rising interest rates would act to strengthen the value of the ringgit and hopefully, attract capital inflows now that the yields of Malaysian government debt securities have increased,” says Yeah.

On the other hand, rising interest rates would dampen demand, he adds. With slowing demand, there would be weaker credit flows and overall economic activity would grind to a halt. This is where the country would enter the dreaded “austerity period”.

“As a result, the demand for real estate would be adversely affected. Obviously, property values respond negatively to rising interest rates as there would be less credit available for borrowing to purchase real estate,” says Yeah.

Eventually, the downward pressure on prices would see the economy and inflation rates return to normal levels. However, this domino effect is a worst-case scenario that Yeah does not foresee happening anytime in the near future.

“We do not see any credit constraints being created by the current bond sell-off. We still have ample liquidity in the system [to compensate for the foreign sell-off of government debt securities],” he says.

“It would be unprecedented for the central bank to print more currency just to support bond buying. Such a move would signal that our economy is on the brink of collapse.

“I anticipate bond yields ticking up just a few basis points, if at all. I certainly do not see any notable percentage increase in yields.”

Despite the large foreign sell-off of government debt securities, the country’s healthy trade surplus (in excess of RM50 billion in annualised terms) could serve to cushion the outflows from the bond market, especially if the wider emerging-market rout deepens, says

Affin Hwang Asset Management director of equities and strategy Gan Eng Peng.

“We have this large domestic pool of savings, which is being used to cover the gap left by foreign bondholders. Hence, government bond yields have not spiked as much despite a RM14 billion outflow by foreign bondholders year to date (as at June 12),” he adds.

But again, in the unlikely event that a deep bond sell-off is not offset by sufficient local liquidity, the aforementioned sequence of events that force rising interest rates would affect equities. SERC’s Lee explains, “Retail investors with high gearing will incur higher debt servicing payments while equities will not be as attractive an asset class in a rising bond yield and interest rate environment.”


Critical to control debt levels

He says the government must control the debt level so that it is fiscally sustainable to service. “When I look at the direct government debt level [not including any contingent liabilities or guarantees], it has actually been falling in the last few years. Taking into account trade tensions and market volatility risk to global growth, as well as domestic political and policy transitions, Bank Negara is expected to keep the OPR steady at 3.25% for the rest of the year.”

Nonetheless, Lee cautions against complacency on this front. “Our fiscal space and debt sustainability remain manageable. However, various indicators of debt burden suggest that Malaysia’s rising public debt level (both direct debt and government guarantees) warrant close monitoring to contain the long-term risks. A ratio of between 60% and 70% is considered manageable if the government is able to generate sufficient revenue streams to service the debt.”

He notes increases in various key debt indicators for Malaysia. “The direct debt-to-gross domestic product ratio had declined from 54.5% of GDP at end-2015 to 51.4% at end-March 2018. The government guarantees-to-GDP ratio had been hovering between 15.2% and 15.4% in recent years before easing to 14.7% at the end of last year. The 10.5% annual debt growth outpaced the 6.5% annual nominal GDP growth and revenue growth of 3.6% between 2008 and 2017.

“The debt service charge (DSC) relative to revenue is rising, from 8% of total revenue in 2008 to 13.1% last year. The DSC grew at 9.5% per year between 2008 and 2017. A rising share of revenue dedicated to debt-service payments weakens a government’s ability to implement desired policies,” says Lee.

“The direct debt composition remains favourable with 96.7% of the paper denominated in ringgit while the balance is offshore borrowing, the bulk of which is denominated in the US dollar. The average-to-maturity is around 7.2 years, with a maturity profile of 10 years and above making up at least 60% of the total outstanding debt.”

He adds that about 97% of the outstanding government guarantees are denominated in ringgit while the remainder are denominated in the yen and US dollar debt. “The average-to-maturity of government guarantees stood at 8.6 years as at end-2016. That said, more than 80% of our government guarantee obligations are expected to mature beyond 2020 and require a proper refinancing framework to ensure debt stability.”

Even so, Lee believes there has been some precedent in our history on how to mitigate the effects of elevated national debt levels. “The government in the late 1980s recognised the adverse consequences of unsustainable debt levels and fiscal deficits. It undertook some painful restructuring measures, which involved the reprioritising of public projects, downsizing of the public sector and the privatisation of government agencies, in addition to adopting a prudent and active management of debt,” he points out.

“In 1987, the government embarked on a policy to prepay the more expensive external loans to contain the external debt and reduce the nation’s debt-servicing burden. This led to a progressive reduction of the debt-to-GDP ratio from 103.5% in 1987 to 31.9% in 1997, thanks partly to five successive years of fiscal surpluses between 1993 and 1997, supported by favourable economic growth, strong revenue growth and contained expenditure growth.”

Affin Hwang’s Gan says the challenge is not to tank the economy while going through the current austerity drive. “The bond market, and therefore the currency (as our government debt is half funded by foreigners), tends to be the adjusting factor as the fiscal deficit goes out of control. The risk would be if government revenue falls too drastically while cost rises when the more populist policies kick in. The impact to the populace is that a weaker ringgit could offset whatever benefits we have for consumers from removing GST.”

In the medium to longer term, if the government can implement the promised reforms and work towards a lower debt position, the country will certainly be in a stronger social and economic position, says Gan. “There will be less leakages, outflows and inefficiencies in the economy.”


How should investors position their portfolios?

While there continues to be news flow on Malaysia’s fiscal position, experts believe that there are opportunities investors can capitalise on going forward. OCBC Bank (M) Bhd vice-president of wealth management research Michael Lai breaks down the current investment climate.

“I think we have already seen the market discount a lot of the negative news that has come to light in recent weeks,” he says.

“Thus, construction-related counters by and large are down more than 20% since the general election while consumer-related stocks are up almost 10%. However, some of the consumer run-ups have been in excess of 50%. So, that does seem overdone.”

Looking back on last year, Lai says Malaysian exporters greatly benefited from strong growth globally. “This year, we believe that global growth will remain about the same as that of 2017. So, we see export-related sectors continuing to do quite well.”

Additionally, it makes sense to invest in local companies that contribute to the country’s ongoing trade surplus.

Amid this pocket of opportunity, however, Lai advises investors to be mindful of the protectionist rhetoric coming out of the US and China. “Malaysian exports tend to comprise intermediate goods, which are shipped to China. Those goods are then exported to the US,” he points out.

“So, if you are worried about trade tensions, investors would do well to look at local exporters that manufacture finished products, rather than just intermediate goods. For example, Malaysian furniture manufacturers are very competitive in the global export markets but unfortunately, only a few are listed on the stock exchange.”

Even so, broader capital outflows out of emerging markets mean local investors should consider moving some funds into the more developed markets. “It is always important to keep a diversified portfolio. Since Malaysia enjoys good access to global funds, local investors should take advantage, especially considering that we have seen a lot of short-term capital moving to the US dollar and US markets on the anticipation of higher US interest rates and bond yields,” says Lai.  

Overall, the options in traditional asset classes appear limited. “Fixed-income assets are facing tightening monetary policies around the world, or at least across the developed markets. Fixed income as an asset class obviously still has a part to play in a portfolio, but it does not have very good prospects for capital gains,” he says.

“Meanwhile, on the equities front, we are coming up on a decade-long bull run. We have seen short-term sell-offs across many equity markets so far this year, so investors are wondering just when this bull run will come to a halt.

“So, in both fixed income and equities, there are concerns about valuations and performance. Under the circumstances, if an investor has access to alternative investment classes that are not correlated with the performance of traditional assets, I think having some exposure there would help your portfolio.”


Breaking down the national debt

In the weeks since the historic downfall of the Barisan Nasional coalition at the 14th general election, Finance Minister Lim Guan Eng has been regularly updating the public on the government’s debts and liabilities. At one of his briefings last month, his explained that the RM1 trillion debt is made up of official federal government debt (RM686.8 billion), government guarantees for various entities (RM199.1 billion) and Public-Private Partnership projects (RM201.4 billion).

Socio-Economic Research Centre executive director and economist Lee Heng Guie explains, “Technically speaking, federal government guarantees are not included in the public debt total until there is a call on the guarantees. The International Monetary Fund has classified government guarantees as an explicit contingent liability to the government, where it is not accounted as direct debt, but recognised as a memorandum item on the government’s balance sheet.

“However, for better control of total borrowings, the adding of contingent liabilities would provide a full picture of the longer-term implications of the government’s debt obligations. A closer scrutiny of both direct and contingent liabilities provides more transparency, accountability and sound financial management.”

National debt in itself is not a bad thing. Like any private household, governments need to borrow money to finance certain big-ticket expenditures. “Governments need to borrow money if their revenue and savings are not enough to cover their operating expenses and capital investments,” says Lee.