This article first appeared in The Edge Malaysia Weekly on December 14, 2020 - December 20, 2020

FITCH Ratings’ downgrade of Malaysia’s Long Term Foreign-Currency Issuer Default Rating (IDR) to “BBB+” from “A-”, has ignited a firestorm of comments, with everyone from politicians to economists providing their proverbial two cents worth on the matter.

More concerning, however, is whether other rating agencies are likely to follow in Fitch’s footsteps, analysts say, warning Malaysia needs to get down to brass tacks and detail how it intends to shrink its massive debts and consolidate its finances post Covid-19, and demonstrate a commitment to institutional reforms to avert another downgrade.

Within a few hours of the downgrade, Finance Minister Tengku Datuk Seri Zafrul Aziz released a statement conveying Putrajaya’s disappointment with Fitch’s rating outcome, “particularly during these exceptional times as the Covid-19 pandemic is still unfolding”.

“By honing in on Malaysia’s fiscal position and political situation, Fitch’s decision does not give due justice and credit to our crisis response efforts and strong economic fundamentals,” Zafrul says.

To put things into perspective, Fitch said that its downgrade stemmed from a few points.

At the top of the list is the deterioration of government debt metrics — a result of the pandemic — which Fitch projects will propel general government debt to 76% of GDP in 2020, from 65.2% 2019.

“Lingering political uncertainty following the change in government last March” was another reason cited, which Fitch said weighs on the policy outlook as well as prospects for further improvement in governance standards.

Not everyone is on the same page with Fitch.

Dr Sailesh K Jha, group chief economist and head of market research at RHB Banking Group, found Fitch’s assessment and analysis “lacking” in some areas, namely in terms of the external liquidity conditions faced by Malaysia, its assessment of the Malaysian banking sector and its usage of World Bank metrics to gauge governance in Malaysia’s policymaking process.

“Domestic and external liquidity conditions are likely to remain ample. We disagree with Fitch’s utilisation of liquid assets and liquid liabilities in its assessment of Malaysia’s external liquidity position since what is liquid and what is illiquid at different points of the business and market cycle are purely subjective in nature.

“The other metric Fitch focused on was domestic banks’ capital buffers and asset quality visibility, (which) is strange in our view since the ongoing changes in banking sector policy aren’t specific to Malaysia but also prevalent in other countries in the region.

“The usage of World Bank metrics to gauge governance in Malaysia’s policymaking process and utilising this as a major input in Fitch’s rating model we find is analytically improper. A more on-the-ground bottoms-up approach to gauging the future prospects for governance and the impact on the policymaking process in Malaysia is the correct methodology in our view,” says Jha.

In a (recorded) podcast with Taimur Baig, managing director and chief economist for DBS Group Research, Stephen Schwartz, head of Asia-Pacific sovereigns at Fitch Rating, says the Covid-19 crisis has been the most challenging crisis from a sovereign rating perspective.

“We have had a record number of downgrades at Fitch at almost 50. This year, a third of our sovereign credits globally are on negative outlook as we go into 2021. We are seeing pressure on all economies; we are seeing big build-ups in public debt and pressure points all around.

“We can’t of course downgrade everyone, so we really have to discriminate. What we have done is we looked very carefully at the starting points — which sovereigns went into the crisis with sufficient buffers, fiscal and external, to weather the crisis, and to use those buffers by way of policy stimulus.

“We also looked at track records — what is the track record for individual sovereigns in unwinding stimulus after big crises. In countries where this is an established track record, it gives us the confidence that after the Covid-19 shocks subside, they can get their public debt trajectories back on a stable or downward path,” adds Schwartz.

Still, given that Malaysia is not an outlier — at least not when it comes to its high debt levels — some find it a bit odd that Fitch downgraded Malaysia based on its higher debt-to-GDP ratio, which may affect its ability to service its debt.

“It is a bit curious given that indebtedness has gone up in most countries due to fiscal stimulus needs to battle extraordinary pandemic challenges, and not just Malaysia alone even if the initial debt level might be higher,” observes OCBC Bank economist Wellian Wiranto.

Wiranto thinks that, ultimately, the main catalyst behind the downgrade may have been the perception of continued political uncertainty, which may crimp Malaysia’s ability to undertake necessary fiscal measures when needed.

“Unless the political situation does stabilise concretely, it may be hard to imagine Fitch reversing its decision anytime soon,” he cautions.

Vishnu Varathan, head of economics and strategy at Mizuho Bank in Singapore, says to deliver the downgrade while the pandemic is still raging globally is untimely especially since the unprecedented impact of the pandemic has not spared any country, and perhaps affected many others to a greater degree.

“Point being, despite Malaysia’s vulnerabilities being exacerbated by oil channels and political risks, Malaysia’s fundamentals remain sound and economic prospects are promising as it works its way out of the crisis.

“The bigger picture here is that Malaysia’s measured fiscal slippage and manageable expansion of debt are not only the lesser of the two evils, but, crucially, the necessary policy response to entrench a recovery to avert a greater tragedy of growth potential lost over the medium to longer term. And so, the irony is that the downgrade at least in part penalises the right policy response,” he adds.

Nevertheless, some have a differing view. Former finance minister and Democratic Action Party secretary-general Lim Guan Eng was quoted by news portal Free Malaysia Today (FMT) as describing Malaysia to be in the “worst of both worlds” after the downgrade.

In the article, Lim was reported as saying that instead of spending more through borrowings to encourage economic growth and to save jobs, businesses and livelihoods, the Ministry of Finance had chosen to spend less next year to safeguard Malaysia’s sovereign credit ratings. But this clearly did not have the intended effect given the downgrade by Fitch.

“This has put the Malaysian economy in the worst-of-both-worlds situation of not spending enough next year for the people but still not convincing the independent ratings experts of the sterling quality of our country’s creditworthiness,” Lim said in the FMT report.

RHB’s Jha believes the downgrade by Fitch will unlikely impact Malaysia’s financial markets on a sustained and significant basis.

“We expect the ringgit government bond market to remain supported as bond dynamics are healthy on the back of continued support from onshore real money investors and still-compelling real yields.

“In foreign exchange, we doubt that market participants’ perceptions of the country’s risk profile have changed. Hence, we believe any selloff in ringgit will be limited and temporary.”

He does not think that Fitch’s rating downgrade is likely to be followed in the first half of 2021 by S&P Global Ratings and Moody’s.

However, Mizuho’s Varathan warns that there may be some degree of “infectiousness” to Fitch’s downgrade, particularly from S&P.

“S&P’s ‘A-’, ‘negative’ outlook is the same as Fitch’s before the downgrade. Moreover, S&P is likely to look at the same credit deterioration and political risks that Fitch cited as justification for its downgrade.”

The real danger of this, he says, is not the standalone ratings action by Fitch or potentially by S&P, rather that a second downgrade by S&P will tilt the majority of the “big three” (Fitch, S&P and Moody’s) ratings to a “BBB+”.

Associated Chinese Chambers of Commerce and Industry of Malaysia’s Socio-Economic Research Centre executive director Lee Heng Guie says the fiscal consolidation plan needs to be complete and detailed to improve fiscal sustainability and restore market confidence, but notes that challenges remain as fiscal consolidations often have considerable political and economic costs.

“If implemented as planned, the government has to decide on whether to announce and implement pre-emptive fiscal consolidation or substantial adjustment or front-loaded fiscal adjustments under market pressure.

“Merely announcing an ambitious deficit target over the medium term with no accompanying consolidation plan on how to achieve the deficit target may undermine the government’s steadfast commitment towards fiscal consolidation,” he says.

Lee adds that as global rating agencies take political factors such as political institutions, governance standards as well as the policy uncertainties into account in making their sovereign risk assessment, a government’s ability to implement reforms also sends a credible signal regarding its general willingness to reform and to reverse an unsustainable fiscal trajectory.

“If a government can easily reverse its decisions due to political pressures or being populist, the policy initiatives are only cheap talk, and lack the political will to be implemented. Rating agencies and market investors will not regard [this] as a credible signal.

“In strengthening governance standards and addressing corruption, particularly with respect to public finances, the government has to implement institutional reforms such as the migration towards accrual accounting, the introduction of a Fiscal Responsibility Act, the introduction of a Government Procurement Act, and the continued practice of open tender and zero tolerance for corruption and non-compliance of budgeting procedure, which are viewed as credit-positive by the rating agencies,” he stresses.

In a client note, Credit Suisse Malaysia managing director and head of equities Stephen Hagger warned of further misery ahead for the country “if corrupt political leaders and figures continue to walk free from corruption charges”.

News portal Malay Mail reported Hagger as referring to the recent discharge not amounting to an acquittal of former Federal Territories minister Datuk Seri Tengku Adnan Tengku Mansor in a RM1 million corruption trial after the public prosecutor dropped the charges.

Hagger noted it was the third such case this year after Riza Shahriz Abdul Aziz — stepson of former prime minister Datuk Seri Najib Razak — was let off the hook on five counts of money laundering over US$248 million allegedly misappropriated from 1Malaysia Development Bhd after agreeing to pay several million ringgit to the government in May.

In June, Tan Sri Musa Aman was acquitted of nearly four dozen corruption charges and money laundering related to the award of logging contracts during his tenure as chief minister of Sabah.

Fitch’s recent downgrade was an example of how Malaysia will suffer if corrupt political leaders and figures continue to walk free from corruption charges, Hagger cautioned.

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