Much Ado About Ratings

20 December 2020

The situation surrounding Covid-19, exacerbated by Malaysia’s political scene, led to international firm Fitch Ratings Inc (Fitch) lowering Malaysia’s rating from A- to BBB+ on December 4, 2020 while the outlook is reverted to stable from negative.

In its statement, Fitch cited weakened key credit metrics as the depth and duration of Covid-19 crisis “necessitated a strong fiscal response which inevitably weighed on its already high debt burden.”

The international ratings agency also explained that political uncertainties may cause policy uncertainty and affect the prospects of further improvement in governance standards.

Having been consistently rated A3/A- by all three rating agencies, this is the first split rating for Malaysia since Dec 2004. Moody’s and S&P still rate Malaysia at A3/A-.

In fact, Fitch’s sovereign rating model assigns Malaysia a BBB rating, which is an extra one notch lower than BBB+.

Its rating committee decided to give a one notch uplift to the final rating by applying forward-looking qualitative overlay, taking a review that the current deterioration in GDP growth and volatility metrics are due to an unprecedented exogenous shock and Malaysia will be able to absorb it without lasting effects on the long-term macroeconomic stability.

Used as metrics to guage a country’s economic health, it comes as no surprise that a change in a country’s credit ratings will have its implications to investments.

Chua Zhu Lian, founding partner in charge of group strategy at Vision Group, explained that the importance of credit ratings to a country lies within its influence towards the confidence that foreign investors have towards the country.

This may manifest in the form of changes in exchange rate, as well as yields (or interest rates) that a government can borrow at.

“The word “may” is used because there is no conclusive evidence to prove that sovereign ratings are always a determinant of exchange rate and yield movements,” he told BizHive.

“The Malaysian government borrows money via debt issues known as the Malaysian Government Securities (MGS) and Malaysian Government Investment Issues (GII). The yields of the MGS and GII fluctuate based on a multitude of factors, one of which can be the changes in sovereign ratings.

“In reality, the borrowing cost of our government is reliant on many other factors such as global central banks’ monetary actions, global interest rates, market liquidity and other factors.

“It is certainly not a straightforward relationship between sovereign ratings on exchange rates, yield movements or even stock market performance. Investors may use sovereign ratings as just one of the references when making investment decision,” Chua added.

Researchers with MIDF Amanah Investment Bank Bhd (MIDF Research) said the downgrade by Fitch was unexpected.

“We believe that it is important to note that Malaysia is not an exception to rating agencies revision of sovereign ratings this past 12 months,” it commented on the downgrade.

“In some way, it is understandable that rating agencies are revising its sovereign ratings given the the deep impact of the Covid-19 pandemic have had on economies around the world.

“It is noteworthy that rating downgrades were performed to countries with stronger credit such as the UK and Hong Kong.”

“We also believe that it is noteworthy that Malaysia Credit Default Swap (CDS) spread is on par with other countries with a BBB+ rating. A CDS is a financial derivative that allows an investor to “swap” or offset its credit risk with that of another investor. In other words, it acts similar to an insurance.

“For example, if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk by buying a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults.

“The fees or the “spread” is the annual amount that the protection buyer must pay to the protection seller for the entire duration of the CDS contract.

“Hence, we could view it as a “price” for the insurance, the higher it is, the more risky and expensive. Based on our observation, Malaysia’s CDS spread have not spiked up significantly prior to the downgrade.”

What will S&P and Moody’s do?

Following Fitch’s move, all eyes are now on the other two global ratings players – Standards & Poor’s Global Ratings (S&P) and Moody’s Investors Services (Moody’s) – to see if they will follow suit.

FinVision’s managing partner, Jeffrey Chin, told BizHive that that the muted market reaction towards the sovereign rating downgrade could be due to two reasons.

“Firstly, Fitch is the only credit rating agency that has taken the bold action of a downgrade,” he said. “S&P has a negative outlook on its A- rating while Moody’s has a stable outlook on its A3 rating. We believe investors would have a more dramatic reaction when one of these rating agencies follow suit.

“Secondly, the timing of Fitch’s downgrade came in at the end of the year where markets are generally quieter as fund managers start their year-end breaks, added with the fact that the rating action arrived at the same time when there are positive developments surrounding the vaccines on Covid-19 which have amplified market optimism.”

Chua added the downgrade by a rating agency was something unexpected as rating agencies have adopted a more forgiving stance given that the Covid pandemic is an unprecedented event to the world.

“Lesser pressure from the rating agencies will give governments around the world more leeway and options to help their people cope with the adverse economic impact; helping the people get back to a normal track should be the no. 1 priority now and when the people’s income is restored, so will the government’s ability to repay any future obligations,” he said.

Chin believes that S&P may likely downgrade Malaysia in the next 12 months, given that the country has already breached one of the downgrade thresholds of S&P from 2017 to 2019, namely the annual change in net general government debt surpassing four per cent on a sustained basis.

“Political instability is also one of the downgrade triggers and this has materialised, given that the current Perikatan Nasional administration has a thin majority in the Parliament. S&P already has a negative outlook on Malaysia, placed in June 2020,” he added.

“Moody’s has been the most lenient on Malaysia among the three rating agencies, maintaining its stable outlook on the A3 rating. Jeffrey thinks that Moody’s may also impose a negative outlook on Malaysia’s rating should there be a significant shake-up in the political scene threatening policy effectiveness and stability of capital flows.

“That said, the country’s weakened fiscal position resulting from the Covid-19 pandemic seems to have already been considered in the current rating. Still, Jeffrey highlights that Malaysia’s credit metrics especially its government debt/GDP ratio is on the higher side of its regional peers despite its above-average credit ratings.

Not eye to eye with Fitch’s methodology

On the other end of the spectrum, other analysts say that Fitch’s rating downgrade is unlikely to be followed by S&P and Moody’s in the next few months.

The research team with RHB Investment Bank Bhd (RHB Research), for example, believe that post the Covid-19 pandemic, Malaysia’s fiscal authorities are likely to engage in a comprehensive fiscal consolidation strategy.

“Currently, based on our medium forecasts for GDP growth, inflation, interest rates, and exchange rates, we view Malaysia’s general government debt trajectory as sustainable,” it said in its review on the matter.

“While the 2019 general government debt/GDP ratio of 65.2 per cent is higher than the median of 59.2 per cent of Malaysia’s peers and is likely to rise in 2020 and potentially to some extent in 2021, the trajectory of debt sustainability remains intact.”

RHB Research also disagreed with Fitch’s utilisation of “liquid assets and liquid liabilities” in its assessment of Malaysia’s external liquidity position since what is liquid and what is illiquid at different points of the business and market cycle are purely subjective in nature.

“The other metric Fitch focused on was domestic banks capital buffers and asset quality visibility, is strange in our view since the ongoing changes in banking sector policy aren’t specific to Malaysia but also prevalent in other countries in the region,” it added.

“The usage of World Bank metrics to gauge governance in Malaysia’s policy making process and utilising this as a major input in Fitch’s rating model we find is analytically improper.

“A more on the ground bottoms up approach to gauging the future prospects for governance and the impact on the policy making process in Malaysia is the correct methodology in our view.

“On Fitch’s comment on potential capital outflows due to the even risk from Malaysia’s non-inclusion in a bond index and relative dependency on foreign financing, we find this a bit odd.

“In the current environment, non-inclusion in a bond index while disappointing doesn’t necessarily lead to capital flight since countries’ ability to meet index requirements due to extraneous circumstances is well understood by investors.”

Meanwhile, over at Maybank Investment Bank Bhd (Maybank IB Research), while the revision is not entirely a surprise, it thought it would be a “status quo” until 1Q21, only then with the risk of split rating subject to the pace of recovery.

“We think additional negative rating action by Fitch is unlikely. A more pertinent question is whether Moody’s and S&P will follow suit, especially S&P given its negative outlook on Malaysia,” it said in its own notes.

“In 2013 when Fitch put Malaysia on negative outlook, Moody’s went against with a positive outlook, while S&P retained it at stable: all three agencies diverged. This time, their views tilt slightly to the negative.

“Moody’s may keep Malaysia at A3/stable in the next six to 12 months, as their rating matrix tends to, and may continue to view Malaysia’s metrics more favourably, unless deteriorations occur concurrently in their assessments of growth dynamics, institutional settings and political risks of Malaysia, as these factors offset the weakness in fiscal pillar.

“However, S&P rating risk remains an ongoing concern given its negative outlook, and Malaysia’s debt metrics may continue to surpass S&P’s downward rating pressure indicators of “annual change in net general government debt less than four per cent” and “interest/revenue ratio exceeding 15 per cent” for both 2020 and 2021.

“We think it could be a matter of qualitative adjustment for S&P to extend Malaysia on its negative watch for another six to 12 months.”

Downgrade no deterrent to Malaysia

Nevertheless, Malaysian leaders say Fitch Ratings’ downgrade for Malaysia’s credit rating from A- to BBB+ will not stifle efforts towards economic recovery in 2021.

During a session a the Dewan Rakyat, Finance Minister Datuk Seri Tengku Zafrul Abdul Aziz confirmed that Budget 2021 initiatives will continue the recovery momentum and are expected to contribute to the gross domestic product (GDP) growth target of between 6.5 per cent to 7.5 per cent next year.

“Many have often said this projection is too optimistic. However, Fitch itself has projected the local economy to grow 6.7 per cent, in line with Malaysia’s own projection.

“Other institutions such as the IMF (International Monetary Fund) have forecast a growth of up to 7.8 per cent, which is higher than the government’s projection.

“This generally shows confidence in the capabilities of the Malaysian economy to bounce back,” he said in response to a question from Lim Guan Eng (PH-Bagan) during the Minister’s Question Time at the Dewan Rakyat.

Tengku Zafrul said since Fitch’s announcement, there has been no knee-jerk reaction from the market.

“In this regard, the FBM KLCI and the ringgit remained stable and we recorded a high demand (Bid to Cover Ratio) which was 2.6 times more than the value of the offer for the 10-year MGII bonds (Malaysian Government Investment Issues).

“I also announced that eight venture capital fund managers from the United States, South Korea, China, Indonesia and Singapore have agreed to invest in Malaysian start-up companies with an investment value of up to RM1.57 billion.

“In simple words, investors’ confidence in the country’s long-term capital market remains strong,” he added.

‘Not a reflection of inability to service debt’

The downgrade by Fitch Ratings also reflects the impact of Covid-19 on the economy and not solely Malaysia’s ability to service its debt, said Minister in the Prime Minister’s Department (Economy) Datuk Seri Mustapa Mohamed.

“Malaysia never had a record of not servicing its debt and our record is very good. Our economic situation was also strong and diverse, with an average growth rate of 6.1 per cent during the period 1971-2019.

“This figure is among the highest in the world, where developing countries reached three per cent in the same period. It showed Malaysia’s international reserves and exports were at a good level,” he opined durign an interview in Bicara Naratif on TV1.

Nevertheless, he said, the government would take note of the downgrade and strive to improve the country’s financial position.

Mustapa said Malaysia had gone through various serious economic crises including the financial crisis of 97/98 and 2008.

“When we faced a financial crisis, our economy would recover quickly and based on past records, we are confident we will be able to repeat it.

“In any case, we need to pay attention to financial management, national governance and political stability. The government is committed to ensuring that the country recovers,” he said.

Analysts still optimistic on Malaysia

In spite of the downgrade, MIDF Research maintained its macro growth projection for Malaysia’s economy at seven per cent next year.

“Hence we expect the sovereign debt downgrade to likewise have immaterial impact on the medium-term trajectory of corporate earnings and performance of equity market.

“Nonetheless, as the sovereign downgrade may lead to short-term weakness in ringgit, an immediate kneejerk negative impact on equity prices cannot be ruled out. We maintain our baseline FBM KLCI year-end 2020 target of 1,525 points as well as our baseline FBM KLCI year-end 2021 target of 1,700 points.”

As the general economic condition is expected to improve going in 2021, the research firm expect the parameters that is included in the rating model will also improve pointing towards a better fiscal dynamics.

As announced by the government while tabling the Budget 2021, the size of fiscal deficit to GDP is expected to decline to 5.4 per cent of GDP in 2021 from six per cent in 2020.

The government will eventually shift its focus to manage its debt level on the back of sustained economic recovery, although the temporary increase in the statutory debt ceiling will allow government to borrow more up to 60 per cent before if the economy requires further support from fiscal injection.

The stable rating outlook also indicates that the rating model does not expect further revision at least in the near term, given the economy remains on a recovery path, MIDF Research added.

Affin Hwang Investment Bank Bhd (AffinHwang Capital) also affirmed that Malaysia is set for economic recovery in 2021, with better fundamentals.

“We are maintaining our full year 2021 GDP growth forecast of six per cent in 2021, as compared to the minus five per cent estimated for 2020,” it cited.

“The current account surplus is projected to narrow slightly to 2.5 per cent of GDP in 2021, from a surplus of 3.4 per cent of GDP in 2019 and 2.5 per cent of GDP in 2020.

“With Malaysia’s current account surpluses continuing to be the feature of economic fundamentals, the ringgit will likely remain stable against the US dollar, where we expect the ringgit to hover around RM4.10 per US dollar by end-2020 and RM4.20 per US dollar by end 2021.

“Going forward, to prevent any possible further downgrade of the country’s sovereign credit rating by the international rating agencies, apart from addressing the country’s debt dynamics through fiscal discipline, we believe safeguarding current account surpluses will be key to support economic fundamentals.”