SUMMARY

● Rising COVID-19 cases, leading to a prolong lockdown restrictions and economic slowdown amid political uncertainty have raised concerns regarding Malaysia’s sovereign credit rating outlook.

● Prospect of slower growth recovery, fiscal distress and rising debt to GDP poses a risk for a future sovereign credit rating downgrade.

● Previous sovereign credit downgrade by S&P, Moody's, and Fitch mainly attributable to the weaker growth outlook, heightened political instability and rising external pressures.

● Any potential rating downgrade in the future may dampen investor’s confidence and put pressure on the financial market, but the impact may likely be minimal as investors may have already priced it in.

● Probability of sovereign rating downgrade among major credit agencies lies heavily on political stability, but the prospect of sustainable economic recovery and future resumption of fiscal consolidation may limit the downside.

● Nonetheless, given a weak fiscal balance sheet, prospect of slower growth amid rising COVID-19 cases on top of the political uncertainty, we reckon any revision to the rating could possibly be made as soon as in the 4Q21.

● Heightened economic uncertainty causedby the rising COVID-19 cases along withpolitical power jostling,which brought the changes in government in 2020 and more recently the appointment of the 9th Prime Minister,have raised concerns over the prospect of a future sovereign credit rating downgrade

− Unsettling political front: The resignation of Tan Sri Muhyiddin Yassin as Prime Minister on August 16, capped a period of renewed political feuding amid a broader context of political uncertainty that stemmed from the sudden change in government in March 2020. Having already impacted investor confidence and the financial markets, the volatile political environment may pose further downside risk should it delay the tabling of the 12th Malaysia Plan, expected on September 20, and the 2022 Budget on October 29. The major credit rating agencies have purportedly hinted that the pressure to downgrade is building up if Malaysia’s political instability deteriorates into policy uncertainty, making policymaking less predictable. Nevertheless, the recent appointment of Dato’Sri IsmailSabriYaakob as the 9th Prime Minister of Malaysia is expected to allay some concerns that political uncertainty could deteriorate and possibly calm investors’ nerves; although thePrime Minister is still expected to face a confidence vote when parliament reconvenes on September 6, as instructed by the Yang di-Pertuan Agong.

− A weak economic recovery: The impact of the COVID-19 health crisis and its containment measures continue to weigh on economic growth. Recently Bank Negara Malaysia (BNM) has slashed 2021 GDP growth to 3.0% - 4.0% (2020: -5.6%) from previous forecast of 6.0% - 7.5%. Similarly, we have revised our growth forecast to 3.5% -4.0% from 4.0% -5.0% following the extended nationwide movement restrictions and the surged of COVID-19 cases,which caused the delay of economic reopening under the National Recovery Plan (NRP).

− Running out of fiscal space : A slower growth recovery would pressure the fiscal burden and raise the government debt to GDP ratio.The COVID-19 health crisis saw the fiscal deficit surge to 6.2% of GDP in 2020 from 3.4% in 2019 following a sharp fall in GDP growth, lower revenue, and higher expenditure due to the various fiscal stimulus measures. Though this is slightly lower than the deficit of 6.7% in 2009 (2008: 4.6%), the government has limited room to increase its spending or introduce additional fiscal stimulus to support the economy and its people, as debt risks breaching its limit unless parliament passes a motion to lift the debt ceiling limit. Additional concern would be a sharp reversal of crude oil prices as it constitutes about 16.0% share of total fiscal revenue.A sharp fall to below USD60/barrel from the current level of around USD70.5/bbl would increasingly pose a risk to the fiscal balance sheet.

− Limited debt headroom.Based on our estimates, as of July 2021, the debt headroom or the amount of debt that can be raised before hitting the statutory limit of 60.0% of GDP, stands about RM21.5b, which include offshore borrowing (RM6.8b), Malaysian Treasury Bills (RM2.0b) and statutory debt (RM12.7b). The statutory debt has reached RM893.5b or 59.2% of GDP, slightly below the debt ceiling. Given the limited space to increase borrowing and the need to spend to aid the economic recovery, we reckon the government has limited choice but to lift the debt ceiling when parliament reconvenes. Of note, our fiscal deficit forecast for this year remains at 6.3% on the expectation that Brent crude oil average price at USD65/bbl for 2021 (YTD average: USD66.9/bbl). Subsequently, the total government debt to GDPratio is expected to increase to 64.5% (2020: 62.1%). Nonetheless, if oil prices continue to fall below USD65/bbl amid fears of the COVID-19 delta variant, the risk to the fiscal balance sheet would continue to rise.

− COVID-19 and the Delta variant threat:Despite almost three months of strict COVID-19 measures, daily domestic COVID-19 cases continued to set a new record high amid the spread of the virulent Delta variant. Malaysia reported its first five-digit COVID-19 cases on July 13, 2021 and there are now a total of 1,593,602 cases and14,553reported deaths. To note, based on a 7-day average, Malaysia now has one of the highest numbers of daily new cases (651) and deaths (6) per 1.0m people (relative to the population) worldwide. Even though Malaysia has ramped up its COVID-19 tests, the 7-day average COVID-19 positivity rate remained high at 14.3%. However, there is some light at the end of the tunnel as Malaysia’s rapid vaccine rollout had led to a decline in the number of hospital admissions and the use of ICU beds in the Klang Valley (the epicentre).

● Previous sovereign credit downgrademainly associated withweaker growth outlook, heightened political instability, and rising external pressures

− S&P: In June 2020, S&P Global Ratings reaffirmed Malaysia’s A- credit rating but revised the outlook to “negative” from “stable”, citing heightened risks to the fiscal position due to the COVID-19 pandemic and elevated political uncertainty as factors leading to the revision. To recap, during the Asian Financial Crisis (AFC), Malaysia fell by five rating notches from A+ “positive” in 1996 to BBB-“negative”, immediately after Malaysian authorities introduced capital controls in September 1998. Meanwhile, during the Global Financial Crisis (GFC), S&P revised its outlook on Malaysia to A- “stable” from “positive” in 2008 due to the domestic political tsunami (Coined by the Economist in an article entitled “Malaysia’s New Political Tsunami?” on March 10, 2008), challenging external environment, expectations of a slowdown in growth and a weaker deficit and debt levels than most of its regional peers.

− Moody’s: Moody’s Investor Service reaffirmed Malaysia’s credit profile at A3 with a stable outlook on June 3, underlining the country’s strong medium-term growth outlook. Historically, Moody’s downgraded Malaysia’s credit rating from A1 “stable”to Baa3 “negative” between 1997 – 1999 but left the rating unchanged at A3 “stable” amid the GFC. The most recent outlook revision occurred in January 2016, where Moody’s affirmed the credit rating at A3 but downgraded Malaysia’s outlook to “stable” from “positive”, citing a deterioration in Malaysia’s growth and credit metrics due to external pressures.

− Fitch: Over the last 16 years, Fitch had revised its outlook several times but maintained an A- rating before it decided to downgrade Malaysia’s credit profile to BBB+ with a “Stable” outlook on December 4, 2020 following the COVID-19 pandemic crisis. The credit rating downgrade was the first time since the AFC. The decision was primarily due to the weakening of several key credit metrics, including fiscal burden, lingering political uncertainty following the change in government, and policy outlook and issues in governance standards. Historically, the last rating downgrade was back on September 9, 1998 whereby Fitch downgraded Malaysian sovereign credit rating to BB from BBB- given the sharp rise in government debt during theAFC.

− The first mover. Now the question is when will the rating agencies downgrade Malaysia’s sovereign debt rating. As Fitch was the first to downgrade Malaysia and has given the lowest rating at BBB+ (stable outlook), we reckon the most likely to make the first move to downgrade would be S&P as its latest review on Malaysia was on June 27, 2021, giving a negative outlook from stable on its A- rating. Meanwhile, Moody’s has not budged from its A3 rating with a stable outlook since January, 2016. This means, Moody’s might have to revise its A3 rating to a negative outlook from stable before it decides to downgrade.

− When?It is common to hear that rating agencies are often blamed for being behind the curve. This is due to the fact that its elaborate approach and long deliberation means it takes time to make changes to its rating decisions. Hence, it is equally difficult to predict the timeline or when the new rating announcement would likely be made.Nonetheless, given a weak fiscal balance sheet, prospect of slower growth amid rising COVID-19 cases on top of the political uncertainty, we reckon any revision to the rating could possibly be made as soon as in the 4Q21.

● Credit rating agencies’decision to downgrade Malaysia’s sovereign credit rating could diminish investor’s confidence and put pressure on the Malaysian financial markets, but likely to be temporary and limited

− USDMYR: the ringgit tends to depreciate when there is a negative change in the country’s sovereign credit rating, falling by an average of 0.4% one trading day after three of the four previous downgrades from 2016 to 2020. Any potential rating downgrade in the future may momentarily weaken the local note due to a potential knee-jerk sell-off reaction by the market. However, the selloff is expected to be short-lived as the market normally had already priced in the key factors that led to the credit rating and outlook downshift.

− Bond yields:following a downgrade to Malaysia’s credit rating or outlook, both the 10Y MGS and 3Y MGS yields tend to decline, whilst the yield curve tends to steepen. One week afterthe four previous downgrades between 2016 to 2020, the 10Y MGS and 3Y MGS yields declined by an average of 13 basis points (bps) and 16bps, respectively, with the 10Y-3Y MGS yield spread widening by an average of 7bps. As such, any future rating downgrade may lead to lower yields in the immediate term, likely driven by heightened risk-off demand for government bonds by local investors, even as the yield curve steepens.

− Capital flows: although a sovereign credit rating downgrade is typically expected to weigh on foreign demand for Malaysian equity and debt, its actual impact tends to be minimal, likely due to the market already pricing in a potential downgrade and gloomier outlook. When Fitch revised down Malaysia’s credit rating in December 2020, capital flows registered RM3.0b (Nov 2020: RM0.9b) and only declined slightly to RM2.8b in January 2021.As such, if foreign investors expect a credit rating downgrade on the horizon, Malaysia’s capital flows may be impacted in advance, which would exacerbate the recent trend of capital outflows.

● Possibility of another rating downgrade lies in political stability

− Political risk and policy uncertainty which is one of the key rating drivers may remain elevated despite the appointment of the 9th Prime Minister, given the fact that the coalition has slimmer majority support. This could soon be reflected in the World Bank 2021 Worldwide Governance Indicators (WGI), slated to be released on September24. A deterioration in WGI scores may increase the likelihood of rating downgrade among credit rating agencies, particularly Fitch and Moody’s, since the indicators will be used as input in their rating decisions. Nonetheless, the prospect of sustainable economic recovery on the back of the gradual economic reopening and a potential resumption of fiscal consolidation in the medium term may provide some support from further rating downgrades.

Source: Kenanga Research - 25 Aug 2021