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Malaysia in transition

Malaysia's hidden debt and 'insolvent' state fund raise alarm

Investors flee as US rate hikes compound Mahathir's fiscal challenges

KUALA LUMPUR -- Fears over Malaysia's larger-than-expected national debt and the "insolvency" of its state fund have sparked a broad equities sell-off, highlighting the economic battles awaiting Prime Minister Mahathir Mohamad's new government. 

The benchmark Kuala Lumpur Composite Index was down 4.2% for the week, as of Thursday. While much of Malaysia is still basking in the afterglow of Mahathir's surprise election triumph, foreign investors are increasingly uneasy about the country's fiscal health.

Those worries are compounding concerns about capital flight, with the U.S. Federal Reserve expected to continue raising interest rates.

New Finance Minister Lim Guan Eng on Tuesday jolted investors by revealing that the national debt is far higher than figures published by the previous government, topping 1 trillion ringgit ($250 billion). Former Prime Minister Najib Razak's government had put the official debt figure at 686.8 billion ringgit at the end of 2017.

The gap has prompted speculation that officials under Najib altered records to hide the extent of corruption, possibly involving scandal-hit state fund 1Malaysia Development Berhad. "Certain 'red' files were accessible only to certain parties, which impeded officials and auditors from carrying out their responsibilities," the finance chief told reporters.

The finance minister poured further fuel on the fire on Wednesday, when he said "the directors of 1MDB confirmed that 1MDB was insolvent and unable to repay its debts."

The new administration also said Najib's government funneled about 7 billion ringgit into the fund, which was at the heart of a corruption scandal that contributed to Najib's downfall in this month's election. The former prime minister had claimed 1MDB was paying its own interest with money saved from streamlining operations, but evidence suggests otherwise. 

Mahathir's government is digging to uncover any and all illicit activity that occurred on the previous leader's watch. Najib, who denies allegations that he misappropriated money from 1MDB, was questioned on Tuesday and Thursday by the country's anti-corruption commission. He has not been charged.

Based on the finance minister's remarks, "the financial situation of the Malaysian government is more severe than previously thought," Kota Hirayama, senior emerging markets economist at SMBC Nikko Securities, wrote in a research report on Thursday. "It would not be surprising if rating agencies consider downgrading [the] country's credit rating."

Najib, for his part, on Wednesday evening blamed the new government's approach to disclosing information: "Saying that our debt is now 1 trillion ringgit without giving any details of what you mean will just unsettle the financial markets, alarm the credit rating agencies and [undermine] investors' confidence in our institutions such as our Bank Negara Malaysia," he wrote on Facebook.

"There must be a clear distinction between political narrative and facts," he added.

Yet the debt load and 1MDB's woes are not the only factors unnerving international investors. During the election campaign, Mahathir's then-opposition coalition promised to scrap the goods and services tax and revive fuel subsidies. The Finance Ministry has already announced the 6% GST will be abolished on June 1, stirring further concern about a deteriorating fiscal balance.

The government has not yet shown how it will fully offset the expected revenue decline. The GST move "increases the government's reliance on oil-related revenue and narrows the tax base, straining fiscal strength," Moody's Investors Service said in a report on Tuesday. Moody's estimates the end of the GST will result in revenue losses equivalent to 1.9% of gross domestic product this year.

The new government's policies are putting fresh pressure on a stock market that had regained ground after lagging behind its regional peers in the second half of 2017.

The benchmark index on Thursday closed at 1775.66, 1.58% lower than the previous day and down 3.8% from May 8, the day before the election. The ringgit, meanwhile, was trading around 3.99 per dollar, weaker than the 3.96 seen last week.

For the week through last Friday, the net outflow of foreign funds from the Malaysian equity market reached 2.48 billion ringgit -- the largest sell-off in nearly five years, according to MIDF Research. Many market players expect the exodus to accelerate.

Against this backdrop, the finance minister held a press conference Thursday afternoon to give more details about the hidden debt. Lim said the 1 trillion ringgit worth of liabilities include 199.1 billion ringgit of government guarantees, 201.4 billion ringgit of lease payments for public private partnership projects, on top of the previously announced debt figure of 686.8 billion ringgit. The total amount is equal to 80.3% of GDP, he said.

He tried to calm the market down by emphasizing that "the fundamentals of the economy remains strong." He also said: "We will definitely succeed in saving our country."

Malaysia is not alone in being affected by foreign investors' shifting appetites, though.

As the U.S. continues to normalize its monetary policy, money is slowly but surely leaving emerging markets. Indonesia and the Philippines are bearing the brunt: The rupiah and peso have both fallen around 4.6% against the dollar since the start of the year. Both countries have current-account deficits and are more susceptible to fund outflows.

To shore up their currencies, the Indonesian and Philippine central banks both raised their benchmark interest rates earlier this month by 25 basis points -- to 4.50% for the former and 3.25% for the latter. Yet the moves have not relieved the pressure.

Perry Warjiyo, a veteran central banker who was sworn in as Bank Indonesia's new governor on Thursday, immediately faces the daunting task of achieving and maintaining the stability of the rupiah as stipulated in the law that governs the bank. 

The U.S. Federal Reserve is expected to continue raising interest rates, which is likely to pull money out of emerging markets.   © Reuters

"My short-term priority is to strengthen the rupiah stability measures," Warjiyo told reporters after his swearing-in ceremony in Jakarta. He added that the central bank needs to strengthen the effectiveness of monetary policy for controlling inflation and keeping exchange rates stable, and that it "plans to be more pre-emptive." 

Turkey is another emerging economy playing currency defense, after the lira lost around 17% of its value against the greenback over the past month. The Turkish central bank on Wednesday raised its late liquidity window lending rate -- a key rate at which banks can borrow just before the local market closes -- to 16.5% from 13.5% after an emergency monetary policy meeting. 

The Fed looks unlikely to do emerging economies any favors. Minutes released on Wednesday for the Federal Open Market Committee meeting in May said board members "generally expected that further gradual increases in the target range for the federal funds rate would be consistent" with U.S. economic conditions, hinting it will likely raise its key interest rate at the June policy meeting as anticipated by the market.

"The recent dollar appreciation [and its combination with rising U.S. interest rates] would be expected to weigh on countries with large dollar debts and current-account deficits and therefore imply greater differentiation" across emerging markets, economists at Citi wrote in a recent report. "These developments suggest that a number of [emerging markets] will face a more challenging near-term outlook."

Nikkei staff writers Shotaro Tani in Jakarta and Wataru Suzuki in Tokyo contributed to this story.

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