The Malaysian ringgit has stabilized after some volatile election-related movement. While we think the advent of a true democracy is a positive long-term development, Malaysia’ short-term outlook remains cloudy as the previous government’s misdeeds are laid bare.
Prime Minister Mahathir Mohamed reclaimed his mantle in a huge election upset. Due to gerrymandering, it had been impossible to unseat the ruling Barisan Nasional (National Front) coalition. That is, until now. This marks the first time since independence from the UK was granted in 1957 that the opposition has held power.
In 2008, the ruling coalition barely won 50.3% of the vote but got 63% of the parliamentary seats. In the 2013 elections, it won only 46.5% of the vote but got 60% of the seats. The table were turned this year, as the opposition coalition Pakatan Harapan (Alliance of Hope) got 55% of the seats with slightly less than 50% of the vote.
Jailed Malaysia opposition leader Anwar Ibrahim was quickly released by the incoming government. Mahathir said he may remain Prime Minister for “one or two years” after earlier agreeing to step aside once Anwar was freed. He added that Anwar may join the cabinet for a while before taking the top post. Given the awful history between these two (detailed below), these developments are nothing short of stunning.
Ex-Prime Minister Najib Razak is coming under increasing scrutiny. He has been barred from leaving the country as the 1MDB probe continues. Furthermore, his home was raided as authorities seek evidence of potential wrongdoing and criminal charges appear imminent. Razak is thought to have siphoned off millions of dollars from 1MDB whilst also holding the post of Finance Minister but was initially cleared in a probe that was widely regarded as fixed.
New Finance Minister Lim promptly revealed that the federal government’s debt and liabilities had risen to over MYR1 trln ($250 bln) due to hidden 1MDB obligations. He added that the government had basically been bailing out 1MDB since April 2017 by covering its debt payments. A full probe may last as long as 100 days, according to senior government officials. As the sovereign debt numbers are updated to reflect this huge contingent liability, we think there are growing downgrade risks for Malaysia.
Some international probes remain ongoing as well. Members of the 1MDB task force reportedly met with US officials from the FBI and Department of Justice last week. Swiss prosecutors are hoping to coordinate their efforts with Malaysia as well. Reports suggest Singapore is now working more closely with Malaysia to recover money that was siphoned off from 1 MDB. Under Najib, Malaysia was not cooperating with these external probes.
Malaysia scores very well in the World Bank’s Ease of Doing Business rankings (24 out of 190). The best components are protecting minority investors and getting electricity, while the worst are starting a business and paying taxes. However, Malaysia does slightly worse in Transparency International’s Corruption Perceptions Index (62 out of 180) and tied with Cuba.
A BRIEF HISTORY LESSON
Mahathir Mohamad previously served as Prime Minister from 1981-2003. He presided over a period of rapid growth and modernization for Malaysia. Like the rest of the region, much of this prosperity was fueled by opening up the economy to foreign investment and following orthodox economic policies. Many EM currencies were made fully convertible as a result.
Malaysia had a front row seat to the 1997-1998 Asian crisis. Thailand was the first to come under pressure as foreign investment in the region dried up. The baht’s peg was broken on July 2, 1997, and the crisis continued to spread across the region. Malaysia came under pressure and responded with FX intervention and rate hikes, though the ringgit was not pegged at that time. Next to devalue was the Philippines on July 11. Indonesia also came under pressure and responded by widening the rupiah’s trading band that same day. Thailand agreed to an IMF program on August 5.
Indonesia abandoned the trading band and floated the rupiah on August 14. However, it did not request an IMF program until October 8. An agreement was quickly reached on October 31. The pressures continued to spread, with Korea giving up its efforts to support the won on November 17. It asked for IMF aid on November 21, which was quickly approved on December 3.
What was common to all these IMF programs was a heavy reliance on austerity. As the crisis intensified, Malaysia decided on a more unorthodox and unexpected approach. Rather than enter into an IMF program that would undoubtedly prescribe austerity, Malaysia instituted capital controls and loosened fiscal policy in September 1997. The ringgit, which had been floating and coming under pressure, was fixed then at 3.8 per dollar.
Despite heavy criticism from the IMF and the Washington consensus, Malaysia recovered more quickly from the Asian crisis than those that followed the standard IMF policy prescription. While capital controls were slowly phased out once the crisis passed, the ringgit peg was maintained until 2005. The end of the CNY peg that month provided the opportunity for Malaysia to do the same.
The move away from orthodoxy led to a split between Mahathir and his Deputy (and Finance Minister) Anwar Ibrahim. Anwar was removed from his post in 1998 and then jailed in 1999 on trumped up charges of corruption and sodomy. His wife Wan Azizah carried on the fight as the opposition leader until Anwar was finally freed in 2004.
Despite his release from jail, Anwar was subsequently banned from politics for five years. He was eventually able to run and win a parliamentary seat in the 2008 elections. As leader of the opposition, Anwar was jailed again in 2014 by Najib.
1MDB was a sovereign wealth fund that originally began in 2008 as Terengganu Investment Authority (TIA), set up by the state of Terengganu. After Prime Minister Najib was elected in 2008, the Ministry of Finance took over TIA in 2009 and changed its name to 1Malaysia Development Berhad (1MDB). Ostensibly, the main reason for the change was to drive investment in strategic areas of development on a national scale, rather than in just one state.
Whilst TIA was originally funded with MYR10 bln ($3 bln) of seed money, 1MDB then went on a debt issuance spree totaling over $8 bln. In March 2015, questions about 1MDB amidst a stunning lack of transparency led to an audit by the Auditor General of Malaysia. However, that report never saw the light of day until the new government took over this month.
The economy is slowing. GDP growth is forecast by the IMF at 5.3% in 2018 and 5.0% in 2019 vs. 5.9% in 2017. GDP rose 5.4% y/y in Q1, down from 6.2% peak in Q3 and the weakest since Q4 2016. As such, we see downside risks to the growth forecasts going forward.
Price pressures remain low. CPI rose 1.4% y/y in April, near the cycle low of 1.3% in March. Core inflation fell to a cycle low of 1.5% y/y in April. While Bank Negara does not have an explicit inflation target, low price pressures should allow it to remain on hold this year.
The central bank started the tightening cycle with a 25 bp hike to 3.25% in January. However, the bank implied that move was just taking back the emergency 25 bp cut after the Brexit vote roiled global markets in June 2016. Next policy meeting will be held July 11, and no change is expected then.
Mahathir quickly scrapped the controversial 6% goods and services tax (GST). This was a central campaign promise and the tax will be eliminated starting June 1, according to the Ministry of Finance. The new government plans to replace it with a sales and services tax (SST), but it remains to be seen if it will be enough to offset lost GST revenues.
1MDB has basically been declared insolvent. Given that the incoming government continues to uncover hidden 1MDB debt, it appears that the sovereign will have to take this onto its balance sheet. As a result, the country’s debt/GDP ratio could easily climb back towards 60%.
Thus, the fiscal outlook has worsened. The budget deficit was equal to -3% of GDP in 2017, and the IMF expects it narrow to -2.8% in 2018 and -2.5% in 2019. However, there are clear upside risks to this forecast due to the 1MDB debacle.
The external accounts remain solid. The current account surplus was 3% of GDP in 2017, and the IMF expects the surplus to narrow to 2.4% in 2018 and 2.2% in 2018. FDI inflows are solid, but not spectacular.
Foreign reserves have risen steadily since bottoming at $93.3 bln in September 2015. Reserves stood at $109.4 bln in April, the highest since February 2015. They cover nearly 5 months of imports. Unfortunately, they are equivalent to only 85% of the stock of short-term external debt. This is Malaysia’s major weak spot in terms of external vulnerability.
The ringgit continues to outperform. In 2017, MYR rose 11% vs. USD and was behind only the best EM performers KRW (13%) and RON (11%). So far in 2018, MYR is up nearly 2% and is behind only the best performers COP (4.3%) and THB (2%). Our EM FX model shows the ringgit to have STRONG fundamentals, and so we expect this outperformance to continue.
USD/MYR has retraced about half of the December-April drop. The last major retracement objective comes in near 4.00 (62%). Break above this level would set up a test of the December 8 high near 4.0920. The 200-day moving average comes in near 4.0560.
Malaysian equities are performing a little better after underperforming significantly last year. In 2017, MSCI Malaysia was up 8% vs. 34% for MSCI EM. So far this year, MSCI Malaysia is -2% YTD and compares to -0.5% YTD for MSCI EM. Our EM Equity Allocation Model gives Malaysia a NEUTRAL weighting, and so we expect Malaysian equities aren’t expected to do much better than a market-neutral performance.
Malaysian bonds are around the middle of the EM pack. The yield on 10-year local currency government bonds is +27 bp YTD. This compares to the worst EM performers Turkey (+302 bp) and Brazil (+124 bp), as well as the best performers China (-22 bp) and Russia (-17 bp). With inflation likely to remain low and the central bank seen on hold for this year, we think Malaysian bonds will continue to hold up well.
Our own sovereign ratings model shows Malaysia’s implied rating steady at BBB+/Baa1/BBB+. As such, downgrade risks to actual ratings of A-/A3/A- remain on the table. Indeed, if the fiscal numbers worsen significantly because of 1MDB, we believe that the ratings agencies are likely to cut Malaysia sooner rather than later.