KUALA LUMPUR (April 27): State-owned fund 1Malaysia Development Bhd's (1MDB) default has increased the probability that contingent liabilities, particularly through cross-defaults and an associated indemnity, will crystallise on Malaysia's government balance sheet, a credit negative for the sovereign, according to Moody's Investors Service.

In an issuer comment note today, Moody's said the recent developments have increased the likelihood of the Malaysian government expending fiscal resources to pay the indemnity to Abu Dhabi sovereign wealth fund International Petroleum Investment Co (IPIC), but the risk remains contingent.

"The potential costs should therefore be added to the government's stock of explicitly guaranteed debt, which amounted to 15.4% of gross domestic product (GDP) as of end-2015, up from 12.8% in 2011.

"Indeed, the contingent risks associated with 1MDB's non-guaranteed liabilities may be as high or even higher than the government's actual explicitly guaranteed exposures," Moody's said.

Moreover, the international rating agency said the inability to rein in these off-budget risks stands in contrast to the on-budget improvements to the government's fiscal position.

It noted that 1MDB's overall debt, according to latest publicly available data, which date back to 2014, is around RM42 billion, or less than 4% of GDP.

However, this figure does not incorporate the progress made by 1MDB over the past year in paring its debt through various asset sales. As such, Moody's assume 1MDB's total current liabilities to be much smaller.

Malaysia is currently rated A3 with stable outlook by Moody's.

The note today was released following the latest development that 1MDB did not service a coupon payment on a bond issued by a subsidiary on April 25.

The US$1.75 billion 5.75% notes in question were issued by 1MDB Energy (Langat) Ltd (1MDB Langat) and due to mature in October 2022.

Moody's noted that the failure to service the coupon payment triggered a default that has prompted a call on a guarantee by the IPIC (Aa2 review for downgrade). IPIC will ultimately backstop holders of the notes, who will not have recourse to Malaysia's government.

However, the failure to pay on the part of 1MDB also triggered a cross-default on other instruments guaranteed by the Malaysian government.

At the same time, under a bilateral agreement, 1MDB and Malaysia's Ministry of Finance (MoF) had pledged to indemnify IPIC with respect to any payments related to the guarantee, as well as other disbursements.

"We estimate the total size of these contingent liabilities associated with 1MDB's recent default to be around 2.5% of GDP," the rating agency said.

The rating agency pointed out that although the credit risks related to the ongoing coupon payments and principal payment at maturity for the 1MDB Langat bond are borne by the guarantor IPIC, the guarantees do not absolve 1MDB of this liability.

"While we understand that there is no direct recourse to the Malaysian government under the terms and conditions of the 1MDB Langat bond, in a filing to the London Stock Exchange on April 25, IPIC cites an indemnity that obliges both 1MDB and Malaysia's MoF to effectively reimburse IPIC for any costs incurred in honouring the guarantee.

"Moreover, the indemnity covers a separate guarantee on US$1.75 billion 5.99% notes issued by 1MDB Energy Ltd (unrated), as well as other payments which are currently in dispute between 1MDB and IPIC. We estimate that the amounts that IPIC is claiming under the indemnity could be as much as US$6 billion, or around 2% of GDP," it added.

Yesterday, 1MDB announced that a cross-default has been triggered on RM5 billion (US$1.3 billion) 5.75% sukuk due 2039 (1MDB Sukuk) and the RM2.4 billion 0.35% sukuk issued by Bandar Malaysia Sdn Bhd (unrated) due between 2021 and 2024.

In addition, 1MDB said there is a "material adverse effect" clause that may be triggered on a RM800 million loan from the Social Security Organisation (SOCSO).

As there are explicit government guarantees on both the 1MDB Sukuk and SOCSO loan, the cross-default increases the probability that the government will have to assume debt servicing obligations related to these 1MDB liabilities.

"The RM5.8 billion in explicit guarantees amount to about 0.5% of GDP," Moody's noted.