• Several macro factors cited included concerns over fiscal burden, lingering political uncertainty and reduced economic activity
• Based on the macroeconomic trends and forecast assumptions by Fitch, we believe the current rating of BBB+ (with a stable outlook) will likely remain in the immediate term
• Both Standard & Poor’s Ratings Services (S&P) and Moody’s Investors Service (Moody’s) have maintained the country’s long-term foreign currency issuer default rating at A- and A3 respectively
• To prevent any further downgrade of the country’s sovereign credit rating by the international rating agencies, apart from addressing the country’s debt dynamics, we believe safeguarding current account surpluses will be key to support economic fundamentals

Downgrade reflected mainly country’s public finances and public debt burden

Fitch Ratings downgraded Malaysia's Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'BBB+' from 'A-'. Prior to this downgrade, Malaysia had maintained a rating of 'A-' since 8 November 2004, see Fig 1. Fitch revised Malaysia’s ratings outlook from negative to stable after the downgrade to BBB+, signalling current sovereign rating will likely remain in the immediate term. Fitch cited some macro factors that supported the decision on the country’s sovereign credit profile, and these concerns were i) the COVID-19 crisis on country's fiscal burden, which was already high relative to peers going into the health crisis, ii) lingering political uncertainty as well as prospects for further improvement in governance standards, and iii) weak investment and low tourism receipts due to the pandemic that reduced economic activity.

Nevertheless, we believe the downgrade reflected mainly the concern related to the deterioration in the country’s public finances and public debt burden. On the country’s public finances, Fitch expects the fiscal deficit to remain high at 5.4% of GDP in 2021, from an estimated deficit of 6.0% of GDP in 2020, with an average deficit of 4.5% of GDP projected from 2021 through 2023. Fitch cautioned on the government’s revenue shortfall partly exacerbated by the removal of GST.

On the debt level, Fitch projects general government debt to increase to 76% of GDP in 2020 from 65.2% of GDP in 2019. This includes the reported “committed government guarantees” on loans which are serviced by the government budget (12.6% of GDP in September 2020) and 1MDB’s net debt (1.3% of GDP in September 2020). According to Fitch, the debt burden is significantly higher than the medians of 59.2% and 52.7% for the 'A' and 'BBB' rating categories, respectively. However, Fitch noted that the country’s debt/GDP ratio will likely remain broadly stable after the pandemic recedes.

On Malaysia’s external finances, Fitch projects current account surplus of the balance of payments (BOP) to narrow to 3.4% of GDP projected for 2021 from 4.2% of GDP in 2020, as the import compression due to the pandemic recedes and government spending on infrastructure development is revived.

The question is whether S&P and Moody’s will follow suit

Both Standard & Poor’s Ratings Services (S&P) and Moody’s Investors Service (Moody’s) have maintained the country’s long-term foreign currency issuer default rating at A- and A3 respectively, see Fig 4. However, S&P assigned Malaysia’s outlook long-term foreign currency issuer default rating from stable to negative on 26 June 2020. After Fitch's downgraded Malaysia's sovereign rating, the question is whether S&P and Moody’s will follow suit to revise Malaysia’s actual ratings, which we believe hinges on government's budgetary consolidation measures as well as current account surplus position going forward.

Based on Malaysia’s macroeconomic fundamentals, we believe the persistent budget deficit since 1998 remains the weak link to the country’s sovereign credit rating profile. In light of the COVID-19 pandemic, it is understandable that the Government needs to implement large fiscal spending plan to stimulate economic growth. We also believe the projected Federal Government financial position for the upcoming 12th Malaysia Plan (12MP), covering 2021-2025 period, will likely be expansionary on the economy, especially through higher development expenditure (an allocation of RM69bn budgeted for 2021), which may put some downside risk to the medium term budget deficit target. However, we believe reduction in government spending should not come from the cut-back in gross development expenditure as it plays an important role to provide the necessary multiplier effect to generate domestic economic activities next year.

Instead, the Government needs to demonstrate fiscal responsibility and budget management to consolidate its budget deficit after the pandemic recedes, with medium term measures and strategies to lower the allocation or optimise government operating expenditure as well as generate sustainable sources of revenue. Based on the Medium-Term Fiscal Framework 2021-2023 (MTFF), Ministry of Finance (MOF) guided that the country’s fiscal deficit position will maintain a path of fiscal consolidation, improving from -5.4% of GDP in 2021 to about -4.2% of GDP in 2022. Over the medium term, the Government is expecting fiscal deficit target to improve by an average of 4.5% of GDP, in line with Fitch’s medium term forecast.

The Malaysian banking system is still on sound capital footing, and with improving economic prospects, sustainable current account surpluses, steady foreign exchange reserves and given the country's manageable external debt, we believe agencies like Standard and Poor’s and Moody’s will unlikely follow suit to revise the country’s sovereign rating. MOF highlighted that banks’ excess capital buffers currently stand at RM123.7bn, more than three times the levels seen during the 2008/09 Global Financial Crisis. Malaysia holds a sizeable net foreign currency external asset position of RM1 trillion or 71.8% of GDP. Fitch also highlighted that the banking sector maintains sufficient loss-absorption capital buffers, given the system's common equity Tier 1 ratio of 14.6% in October 2020, and remains liquid with a liquidity coverage ratio of 153%. We believe the depth of Malaysia's local capital markets (with deep and developed domestic bond market) support the sovereign's domestic financing needs.

Safeguarding current account surpluses will be key to economic fundamentals

Going forward, based on the macroeconomic trends and forecast assumptions by Fitch, we believe the current rating of BBB+ (with a stable outlook) will likely remain in the immediate term. The current account surpluses will continue to be the feature of economic fundamentals in Malaysia. If the current account surplus position were to narrow significantly, we believe the government need to delay or sequence projects with high import content and a low multiplier effect on the economy. Instead, focus on projects that have low import content and a high multiplier effect to safeguard the current account surplus. Given that Malaysia is an open and wellintegrated in the global economy, the uncertainties and issues prevailing in the external sector will impact on Malaysia’s economic fundamentals.

Malaysia’s current domestic economic fundamentals remain largely intact, as reflected in healthy current account surpluses, supported partly by healthy domestic demand, and better global growth prospects next year. Malaysia is unlikely to experience a twin deficit (i.e. a deficit in both its budget and current account on the balance of payments), as experienced before the 1997/1998 AFC, which was also a major concern for foreign investors. During the Asian Financial Crisis (AFC), Fitch assigned a rating of BB on 9 September 1998, this was the lowest rating on record.

In the near term, following the downgrade by Fitch, market observers raised some concerns on external funding due to slightly higher borrowing costs to finance part of the government’s expenditure, if the need arises. However, we believe the bulk of deficit financing would continue to be raised from the domestic market given ample liquidity in the system. As domestic borrowings will still be the main source of funding (99.98% of total gross borrowings estimated in 2020), we believe this will also minimise foreign exchange risk exposure.

Malaysia is set for economic recovery in 2021, with better fundamentals

We are maintaining our full year 2021 GDP growth forecast of +6% in 2021, as compared to -5.0% estimated for 2020 (+4.3% in 2019). The current account surplus is projected to narrow slightly to 2.5% of GDP in 2021, from a surplus of 3.4% of GDP in 2019 and 2.5% of GDP in 2020. Given the ongoing uncertainty from the resurgence of COVID-19 cases on the global economic outlook, we believe BNM will maintain an accommodative monetary policy, keeping its OPR unchanged at 1.75% throughout 2021. With Malaysia’s current account surpluses continuing to be the feature of economic fundamentals, Ringgit will likely remain stable against the US$, where we expect the Ringgit to hover around RM4.10/US$ by end 2020 and RM4.20/US$ by end 2021 (from the current RM4.06/US$). Going forward, to prevent any possible further downgrade of the country’s sovereign credit rating by the international rating agencies, apart from addressing the country’s debt dynamics through fiscal discipline, we believe safeguarding current account surpluses will be key to support economic fundamentals.

Source: Affin Hwang Research - 7 Dec 2020