Fitch Downgrade A Wake-Up Call For Policymakers

In what we view as a wake-up call for Malaysian policymakers, Fitch Ratings downgraded its credit outlook for Malaysia from stable to negative on July 31, citing the lack of progress on budgetary reforms to address the country's deteriorating fiscal position. The latest downgrade by Fitch vindicates our long-held view that failure by the Malaysian government to speed up fiscal reforms would undermine the country's credit ratings ( see 'Election Budget Points To Widening Deficit', September 18 2012). In response to the downgrade, Prime Minister Najib Razak, who is also the finance minister, said that his administration will unveil measures to strengthen the fiscal position and bolster growth in the 2014 budget to be announced in October.

Latest figures published by Bank Negara Malaysia (BNM) showed that the budget deficit has increased from MYR4.5bn in Q412 to MYR6.1bn in Q113. This is closely in line with our forecasts for Malaysia's fiscal deficit to rise from 4.5% in 2012 to 4.9% in 2013 (due to proposed increases in welfare spending for the 2013 budget) before we begin to see a gradual narrowing of the deficit towards 4.3% and 3.6% in 2014 and 2015. Our forecasts therefore suggest that the government is very likely to miss its fiscal targets. Looking ahead, we view the introduction of a GST bill as a crucial element if the government wishes to implement any meaningful budgetary reforms. We caution that any attempts by the government to side-line the GST bill in the next budget are unlikely to sit well with investors.

Foreign Capital Outflows A Major Threat

Not An Easy Balancing Act
Malaysia - Fiscal Balance, MYRmn (LHS) & % of GDP (RHS)

In what we view as a wake-up call for Malaysian policymakers, Fitch Ratings downgraded its credit outlook for Malaysia from stable to negative on July 31, citing the lack of progress on budgetary reforms to address the country's deteriorating fiscal position. The latest downgrade by Fitch vindicates our long-held view that failure by the Malaysian government to speed up fiscal reforms would undermine the country's credit ratings ( see 'Election Budget Points To Widening Deficit', September 18 2012). In response to the downgrade, Prime Minister Najib Razak, who is also the finance minister, said that his administration will unveil measures to strengthen the fiscal position and bolster growth in the 2014 budget to be announced in October.

Latest figures published by Bank Negara Malaysia (BNM) showed that the budget deficit has increased from MYR4.5bn in Q412 to MYR6.1bn in Q113. This is closely in line with our forecasts for Malaysia's fiscal deficit to rise from 4.5% in 2012 to 4.9% in 2013 (due to proposed increases in welfare spending for the 2013 budget) before we begin to see a gradual narrowing of the deficit towards 4.3% and 3.6% in 2014 and 2015. Our forecasts therefore suggest that the government is very likely to miss its fiscal targets. Looking ahead, we view the introduction of a GST bill as a crucial element if the government wishes to implement any meaningful budgetary reforms. We caution that any attempts by the government to side-line the GST bill in the next budget are unlikely to sit well with investors.

Not An Easy Balancing Act
Malaysia - Fiscal Balance, MYRmn (LHS) & % of GDP (RHS)

Foreign Capital Outflows A Major Threat

To be sure, we do not foresee major funding risks given that a majority of the country's debt are denominated in the local currency. However, we caution that further downgrades by rating agencies could risk triggering large foreign capital outflows. This could, in turn, have a destabilising effect on the financial markets. In the worst case scenario, we expect the bond market to come under severe selling pressures as investors offload government bonds in anticipation of a wave of credit downgrades by rating agencies. The Malaysian ringgit is also likely to face selling pressure as foreign investors repatriate their funds.

Warning Signs For Policymakers
Malaysia - 10-Year Government Bond Yield, % (LHS) & Malaysian Ringgit Spot, MYR/US$ (RHS)

Indeed, we have already witnessed a glimpse of the potential impact that capital flight could have on the financial markets. As the accompanying chart shows, Malaysia's 10-year government bond yield has surged by more than 30 basis points (bps) this week while the ringgit has depreciated by 1.4% against the greenback over the same period. Overall, we maintain a cautious stance on the Malaysian ringgit and the bond market through 2013. However, should we see aggressive budgetary reforms being introduced in the next budget announcement in October, we could see a strong rebound across Malaysian assets.

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This article is tagged to:
Sector: Country Risk
Geography: Malaysia, Malaysia, Malaysia, Malaysia
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