Malaysia should be better positioned to benefit from a recovery in the global economy, particularly trade.
KUALA LUMPUR: S&P Global Ratings expects the government to continue implementing prudent budgetary and economic policies and forecasts the economy will grow at an average rate of over 4% between now and 2020.
The ratings agency said on Thursday it had also affirmed its “A-” long-term and “A-2” short-term foreign currency sovereign credit rating on Malaysia.
At the same time, it affirmed its “A” long-term and “A-1” short-term local currency sovereign credit rating on Malaysia.
“The outlook on the long-term rating remains stable. We also affirmed our 'axAAA/axA-1+' Asean regional scale rating on Malaysia,” it said.
S&P pointed the stable outlook was based on its expectation that Malaysia's strong external position and monetary flexibility would balance its relatively weaker, but improving, public finances over the next 24 months.
“We believe Malaysia's credit fundamentals can withstand further stress in the oil and gas sector during that period,” it said.
S&P said it might raise the ratings if stronger economic growth, combined with the government's fiscal efforts, lead the government to reduce the level of public debt to GDP substantially, for example if the government started paying down outstanding public debt.
However, it might lower the ratings if it assessed Malaysia's public finances or institutional settings to have weakened.
It also cautioned it might also lower the ratings if contingent liabilities increase substantially or crystallise on the general government's own balance sheet.
S&P pointed out that stocks of public and private debt, and contingent public liabilities were considerable, but overwhelmingly denominated in the domestic currency.
“Uncertainty connected to upcoming parliamentary elections could put upward pressure on the cost of refinancing the economy's gross external financing needs, despite Malaysia's overall strong net external position,” it said.
Below is S&P's rationale:
Our sovereign credit ratings on Malaysia reflect the country's strong external position and monetary policy flexibility, as well as sound growth prospects.
We weigh these strengths against the Malaysian government's relatively weaker debt position and moderate, albeit improving, level of economic development.
We consider Malaysia's institutions to have supported generally effective policymaking. In particular, their track record on growth performance is strong and they managed the oil price shock during 2014 and 2015 effectively.
That said, the approaching parliamentary elections could slow the pace of adjustment by delaying plans to further reduce energy subsidies and to restore fiscal space.
Ongoing political challenges in relation to the corruption allegations of 1Malaysia Development Bhd. (1MDB), combined with the approaching elections, pose potential challenges to the sovereign rating over the near-to-medium term.
Those challenges could manifest themselves via a rise in the cost of refinancing Malaysia's sizable gross external financing needs, or via nonresident outflows from Malaysia's deep local-currency government bond market.
However, our ratings are based on the belief that these challenges will not materially impede policy flexibility and responsiveness.
In our view, the sovereign's credit strengths are reinforced by the economy's resilience in the face of a terms-of-trade shock beginning in late 2014.
Authorities at that time introduced new taxes, and cut subsidies to offset the effect of lower energy receipts on budgetary performance.
Malaysia's solid external position remains a strength for the ratings. Despite a decline in key export prices, Malaysia's current account remains in surplus, albeit at around 2.4% of GDP in 2016, considerably diminished compared with levels exceeding 10% of GDP in 2011.
Most of Malaysia's external liabilities are denominated in the domestic currency, while external assets, both official foreign-exchange reserves and other claims on nonresidents, are denominated in foreign currencies.
For this reason any depreciation of the Malaysian ringgit benefits the country's external position.
At the same time, on a gross basis, we forecast the Malaysian economy's external liquidity requirements to be considerable, and hence potentially vulnerable to external market volatility.
This includes acute bouts of risk aversion, which could lead to nonresidents reducing their holdings of local currency government debt, which we estimate at around 23% of the total stock as of the first quarter of 2017.
The ratio of gross external financing needs to current account receipts and usable reserves is estimated at 93% in 2017, reflecting the decline in the dollar value of Malaysia's export earnings as well as rising external borrowings by the banking sector.
We classify Malaysia's foreign-exchange regime as a managed float. Since 2014, the ringgit has depreciated by 17.4% on a trade-weighted basis; pass-through of this depreciation into inflation has been limited, although there has been some increase in prices of cooking fuel due to the reduction of official subsidies.
We estimate the real effective exchange rate has depreciated around 11.7% since end 2014, which should continue to support the competitiveness of Malaysia's manufactured goods, partially offsetting the impact of depressed energy prices.
Malaysia has a deep domestic bond market, which reduces its reliance on foreign-currency financing, though the development of this market has led to somewhat greater volatility in nonresident capital flows. Bank Negara Malaysia (BNM) has, under Governor Datuk Muhammad bin Ibrahim, made some policy adjustments over the past year.
Most notably, these include the stricter enforcement of a ban on offshore forward trading in the ringgit, as well as the decrease of the amount of foreign exchange that exporters are allowed to hold.
These policies may have contributed to a sell-off in nonresident holdings of ringgit-denominated government securities, somewhat tightening domestic dollar liquidity.
Nevertheless, we do not deem these adjustments to have materially undermined the strength of Malaysia's monetary policy settings; moreover, the trend on foreign-exchange policy has generally been toward higher, rather than lower, tolerance of volatility.
The current government is targeting a near-balanced budget by 2020. This goal appears ambitious, particularly given that, even in the case of a significant and sustained recovery in oil prices, spending would likely rise in tandem with revenues.
Even so, we would flag considerable progress by authorities over the past two and a half years in broadening the tax base and reducing the budget's reliance on energy-related revenues.
In April 2015, authorities introduced a 6% goods and services tax (GST). At the same time, the government has progressively lowered its subsidy bill.
In December 2014, it adopted a market-based pricing system for petrol, and in July 2016 moved toward a more market-oriented pricing mechanism for natural gas.
The government's measures to cut petroleum subsidies and introduce the GST mean that its debt burden, as a proportion of GDP, likely peaked in 2015.
We forecast that net general government debt will fall to 47.4% of GDP in 2017, from 49.4% in 2015. Nevertheless, Malaysia's general government fiscal position also carries contingent risks from its public enterprises and financial sector.
These contingent risks include guarantees on debts and letters of support (including the US$3 billion letter of support for 1MDB, which we regard as a direct financial obligation of the government).
A reported settlement made between 1MDB and Abu Dhabi sovereign wealth fund IPIC should lower the risk that these contingent liabilities crystallize in the near future. However, uncertainties surrounding 1MDB will continue to pose some risk to the sovereign.
Although the government's debt guarantees are sizable at around 15% of GDP, they have stabilized at this level.
We do not expect such contingent liabilities to materialize significantly within our forecast horizon.
Malaysia's public enterprises generally have diverse financial profiles – some with strong free cash flows and sizable liquid assets that, in the past, have been used to support other parts of the public sector.
However, the consolidated finances of Malaysia's nonfinancial public companies reflect a deficit equivalent to 4.1% of GDP in 2016, following a shortfall of 4.9% in 2015.
This suggests the potential for some quasi-fiscal activity at state-owned firms, which could give rise to elevated contingent risks in the future.
Although high household debt levels remain a risk factor for the banking system, as well as the broader economy, we believe this is somewhat contained by high levels of capitalization and a generally sound regulatory framework.
Household financial assets are also ample and rising. Our Bank Industry Country Risk Assessment for Malaysia is '4', with '1' being the strongest assessment and '10' the weakest.
However, there are some other areas of credit risk. Malaysia's relatively high share of nonresident holders of ringgit-denominated government bonds leaves the country's capital markets exposed to the potential for a sudden fund outflow.
Nonresident holders of ringgit-denominated government bonds have pared their positions dramatically so far this year, and the market has remained stable, with the ringgit itself appreciating modestly versus the U.S. dollar.
However, a continued sell-down of foreign-owned securities could undermine Malaysia's external buffers. At the same time, we maintain that risks of external outflows are attenuated by our expectations of continued sound policymaking.
We also believe authorities are committed to a floating exchange rate, to which the central bank has adhered despite financial market volatility.
Malaysia's foreign-exchange reserves have borne the brunt of external volatility over the course of the past two to three years. More recently, the BNM's sold-forward position on its foreign-exchange reserves has grown dramatically, rising to US$19.1 billion as of April 2017.
Under our calculation of "usable reserves," which excludes items not readily available for foreign-exchange operations such as reserves sold forward, Malaysia's reserve coverage has fallen to an estimated 4.4 months of current account payments, from approximately 5.4 in 2016.
While this level remains sufficient, it is near a multi-year low. Our forecast assumes that downward pressure on reserve coverage will level off over the next one to two years. Likewise, Malaysia's deep capital markets should provide another pillar of support.
We project Malaysia's GDP per capita to be about US$9,200 by the end of 2017, lower than that of most peers in the same rating category.
Malaysia's GDP per capita has experienced considerable downward pressure as a result of ringgit weakness over the past three years.
We expect the currency, along with GDP per capita, will stabilize over the forecast period, and note that Malaysia's competitiveness is somewhat enhanced due to the weaker ringgit.
Malaysia should be well positioned to benefit from a recovery in the global economy, particularly trade, which has shown strong growth potential so far this year.
We do not expect the volatile energy sector to materially impede Malaysia's economic growth over the next 24 months, given that production of crude oil and liquefied natural gas account for less than 10% of GDP.
We project Malaysia's average real per capita GDP grow approximately 2.8% a year over 2017-2020. Exports of manufactured goods and growth in private consumption and investment are likely to drive this expansion.
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