1MDB Default Shows Malaysia SOE Debt, Governance Risks, Says Fitch

1Malaysia Development Berhad's (1MDB) missed bond coupon payment in April highlights ongoing uncertainty around the finances and governance of the state-owned fund.

The situation is unlikely to lead to an immediate crystallization of the existing guarantee obligations of the Malaysian sovereign for 1MDB securities affected by cross-defaults, Fitch Ratings says. The risk to the sovereign credit profile lies more in the potential for the affair to weaken policy focus or contribute to political instability. However, there is little sign of these risks materializing as yet.

On 25 April Malaysian state-owned investment company 1MDB missed a USD50m coupon payment on a 5.75% bond due in 2022 as part of its dispute with International Petroleum Investment Corporation (IPIC), Abu Dhabi's sovereign wealth fund. IPIC had guaranteed the bonds under a debt-for-asset swap agreement made in 2015. IPIC subsequently made the payment.

The affected bonds are not explicitly guaranteed by the Malaysian sovereign. However, the default on the 2022 bond triggered a cross-default on a 1MDB MYR5bn (USD1.2bn) sukuk due in 2039 that benefits from an explicit sovereign guarantee.

Payment under the guarantee would only be required if bondholders vote to require acceleration under the cross-default clause. Fitch believes that there is unlikely to be a majority among bondholders for acceleration.

The only other 1MDB debt benefiting from an explicit sovereign guarantee is a MYR800m loan from the country's social security organization (SOCSO). The default on the 2022 bond does not trigger a cross-default on this loan. The lender could require acceleration under a "material adverse developments" clause, but Fitch believe that this is unlikely.

Close contingent liability

"We have long viewed 1MDB as a close contingent liability of the sovereign, given its strong links with the state, including Prime Minister Najib Razak's role as chairman of its advisory board (which is being dissolved as the fund is wound down)," says Fitch.

At MYR5.8bn, 1MDB's sovereign guaranteed debt amounts to roughly 0.5% of forecast 2016 GDP. Total debt currently disclosed by 1MDB is close to MYR33bn, or nearly 2.7% of forecast 2016 GDP. Federal debt was 54.5% of GDP at end-2015, so the assumption of the guaranteed debt would risk breaching Malaysia's statutory 55% ceiling, a risk that would increase if additional, unguaranteed debt were assumed.

A breach would probably not in itself trigger a negative sovereign rating action (as we said when we affirmed Malaysia at 'A-'/Stable in February), assuming the sums involved were around our estimates. The 'A' category median debt:GDP ratio is 52%.

However, the ceiling has helped provide fiscal discipline. The potential rating impact would depend on whether breaching it led to a sustained deterioration in fiscal discipline and public finances and a sharper than anticipated rise in debt ratios, as noted in our rating sensitivities.

Other points to monitor will be any effect on government policy-making and effectiveness, and on investor confidence. The 1MDB affair has not had a discernible impact on policy-making, as the government has maintained fiscal consolidation and budget reforms.

However, if its ability to implement economic policy weakened, this could be negative for the sovereign rating. So too could a broader deterioration in political stability, or in governance (already a credit weakness for Malaysia) that damaged the credibility of policy-making institutions.

The ruling coalition, Barisan Nasional (BN), secured a majority in the Sarawak state assembly elections held recently, suggesting that the spillover from the 1MDB affair on politics remains contained so far.

Market reaction has been relatively modest, but a large or sudden pullback by international investors could create risks to economic performance or financial market stability, given the large non-resident holdings of government securities. 




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