Trying to make sense of our country's debt and downgrade threat

I always believe that finance and economics, no matter how complex it might be, must makes sense - common sense. So when I stumbled upon an article from Bloomberg about Malaysia, debt ceiling, its rating and 1MDB (I post the article at the end of this blog), I found myself trying to make sense of certain issues.

First let's start which what I understand, things that make sense first.

1. Rating is important if you (issuer/borrower/Government/1MDB) have an outstanding floating rate loan. Rating is an indication of riskiness hence the lower the rating the more interest you would need to pay on your debt.
2. If you have issued fixed rate bond, then rating does not really matter because your interest payment is fixed.
3. If you plan to borrow some more, then rating matters because lower rating will cause you to pay/agree to pay  more on your future debt in terms of interest/coupon.
4. If you are a TRADER of bonds (for example institutions that bought and are holding the 1MDB bonds from Goldman Sachs), rating matters because if the rating of any bond that you are holding goes down, the value and price of that bond will go down. That means you would incur a loss in the value of the bond (unless you are holding to maturity). In this case, rating matters to the Issuer/Borrower if he plans to borrow some more by issuing debt to the Traders. If the existing rating goes down, and the traders LOSES money on the existing bonds, they might not be so keen to buy the new bonds or asks for much higher interest payment for the new bonds that the issuer plans to issue.

Now to the part which I cannot make sense:

1. Fitch is threatening to lower the Government's debt rating because of, amongst others, high debt to GDP ratio. Why we have high debt? Well it is because the government have been running on deficits since 1998. Deficit, which happens when the government spends more than it earns, would cause the government to borrow. In a growth situation this is perfectly fine as the deficit is to finance growth which will later cause the economy to grow, increase tax income and other government revenues and then we have a surplus.

2. But what if the debt is not because of the income? What if the deficit is mainly because of mismanagement, leakages and corruption? The recent AG's report has plenty on that, for years! If that is the case, trying to reduce deficit by raising revenue (taxes and such) will be like "mencurah air ke daun keladi"...kerja sia sia. If we raise revenue without plugging the hole first, we will just sink faster. It like speeding up a leaking boat, you will just let water in faster.

3. According to the PM, the rating should not really affect the government much as most of its debts are held locally by local institutions. That is true since most MGS (Malaysian Government Securities ) are in Ringgit and they are all mopped by our banks because we have so much liquidity. If that is the case, then why the adamant effort to stop the downgrade in rating; taking away subsidies and increasing taxes. I am for reduced subsidies but you got to show me you can manage the extra money first.

4. Coincidentally, 1MDB seems to have USD denominated bonds - USD6.5 billion of it. Being a 'sovereign fund' their bonds would be affected by rating movements if was a floating rate. If it is fixed rate, then the holders of its bonds would suffer losses if the rating goes south. (and on this note, I also cannot understand why borrow in USD when you are purchasing assets in ringgit? Why the currency risk?).

In the end, what really keeping me perplexed, puzzled and befuddled is are we doing all this risk-downgrade avoidance actions (subsidy cuts etc) to mainly save a  particular bond / issuer rather than the real economy as a whole? If that is the case, then we have to really think back on the strategy of affecting the whole to maintain a few.

But if we are looking at this downgrade threat as a mean to make our cash management better - then excellent! But we have to look at the leakages first, spending is a must, but leakages are not.

REPRODUCED FROM BLOOMBERG

Najib Sees Malaysia Escaping Fitch Rating Cut: Southeast Asia

By Barry Porter & Chong Pooi Koon - Oct 14, 2013 8:59 AM GMT+0800

Prime Minister Najib Razak said he believes that Malaysia can avoid a cut to its credit rating while the government will try its “level best” to prevent a breach of its self-imposed sovereign debt ceiling.
“We will manage it,” Najib said in an Oct. 11 interview in Putrajaya, the country’s administrative center near Kuala Lumpur. “We’re very closely monitoring how we manage our macro position as well as our fiscal and debt to make sure that we will not be downgraded.”

Enlarge image

Malaysia's Prime Minister Najib Razak speaks during a panel discussion at the Asia-Pacific Economic Cooperation CEO Summit in Nusa Dua, Bali, Indonesia, on Oct. 7, 2013. Malaysia has run annual budget deficits every year starting in 1998. Photographer: SeongJoon Cho/Bloomberg

2:14

Oct. 14 (Bloomberg) -- Malaysia Prime Minister Najib Razak talks about the prospects for the country's economic growth and government policies. He spoke Oct. 11 with Bloomberg News in Putrajaya, the country’s administrative center near Kuala Lumpur. (Source: Bloomberg)

Najib raised subsidized fuel prices for the first time since 2010 and said he’d delay some public projects after Fitch Ratings cut Malaysia’s credit outlook to negative in July, citing rising debt levels and a lack of budgetary reform. The country, which has a long-term foreign-currency denominated rating of A- at Fitch, has run annual budget deficits every year starting in 1998.
At 53.3 percent, Malaysia’s debt-to-gross domestic product ratio is the highest among 12 emerging Asian markets after Sri Lanka, according to data compiled by Bloomberg. Moody’s Investors Service said last month the budget gap may exceed Najib’s target of 4 percent of GDP this year and warned fiscal targets will become “increasingly out of reach” unless further measures are taken. Moody’s rates Malaysia government bonds A3 with a stable outlook.
The government will further cut state subsidies, broaden its tax base and manage spending “prudently,” said Najib, 60, who is also finance minister, without elaborating. Cabinet will meet before the 2014 budget is released Oct. 25 to decide if there’s enough public support to introduce a goods and services tax, he said.

Taxing Challenge

“We are quite positive on Malaysia,” Enrico Tanuwidjaja, a Singapore-based economist at Nomura Holdings Inc., said by phone yesterday. “They are on a fiscal consolidation path and they will boost the revenue base if the government can push through the GST in the coming budget. A sub-3 percent fiscal deficit could happen in 2016, if not in 2015 as per the official aim.”
The ringgit has fallen 4 percent this year, the fifth worst performer among 11 most traded Asian currencies tracked by Bloomberg. The currency could gain over time if the nation’s fundamentals remain strong, central bank Governor Zeti Akhtar Aziz said in an Oct. 12 interview with Bloomberg News in Washington.
“We believe that, over the medium term, yes, it should reflect underlying fundamentals, and if the underlying fundamentals remain strong, then over time it should be an appreciating trend,” said Zeti, predicting stronger economic growth in 2014.
The government earlier planned to introduce a 4 percent GST by 2011. It hasn’t said what the rate may be if it now goes ahead.

‘Level Best’

“We are one of the very, very few countries in the world which doesn’t have a GST,” said Najib, who was returned to power in a general election in May with a reduced majority as his coalition lost the popular vote for the first time. “But there are challenges. Anything to do with any new form of tax, like consumption tax in Japan, carbon tax in Australia, these are big issues that cannot be easily decided.”
The government will “try our level best” not to go beyond its debt ceiling of 55 percent of GDP, said Najib, a U.K.- educated industrial economics graduate. If Malaysia can achieve 5 to 6 percent GDP growth “we should be able to manage the debt ceiling,” he said. “The weakening external global economy is of concern to us.”
Southeast Asia’s third-largest economy withstood faltering overseas demand in the past year as Najib gave handouts to voters and boosted investment ahead of the May vote. GDP expanded more than 4 percent in each of the 15 quarters through June 2013.

State Guarantees

“This year we should be able to get somewhere between 4 to 5 percent” growth, the prime minister said. “I think probably slightly beyond 4.5 percent. That’s the best estimate that we have currently.”
With state guarantees added to public debt the government’s credit exposure was 70.2 percent of GDP as of the end of the second quarter, up from 66.6 percent a year earlier, Bank of America Corp said in a report on Sept. 17.
“It’s not so much the level of debt, it’s the ability to pay,” said Najib. “Fortunately, most of our debts are long-term debts and are domestic debts, so we think we will be able to manage it.”
1Malaysia Development Bhd., a sovereign wealth fund better known as 1MDB, has accumulated total bonds and outstanding loans of about 30 billion ringgit ($9.4 billion) since it was formed four years ago, according to data compiled by Bloomberg.

Goldman Fees

The Kuala Lumpur-based fund has acquired 12 billion ringgit of energy assets in the last two years. It is also building a new financial district in the capital called Tun Razak Exchange, named after Najib’s late father, Malaysia’s second prime minister.
“It has borrowings, but its total assets exceed its borrowings,” Najib said of 1MDB. “We’ve got a few projects and programs in mind that will really strengthen 1MDB.”
The fund is talking to potential U.S. investors about venturing into solar energy, said the prime minister, who is chairman of the fund’s advisory board.
1MDB came under scrutiny in parliament in July after hiring Goldman Sachs Inc. to help manage $6.5 billion of bond sales to fund expansion. The U.S. bank made about $500 million in commissions and trading gains, a person familiar with the matter said May 9.
“If you talk in terms of international scale of fees, I think that’s within a margin,” said Najib. “Goldman Sachs have got certain ability and name in the market and they are able to deliver what’s been required. In terms of that relationship, 1MDB is quite happy with what Goldman Sachs has done.”
To contact the reporters on this story: Barry Porter in Kuala Lumpur at bporter10@bloomberg.net; Chong Pooi Koon in Kuala Lumpur at pchong17@bloomberg.net
To contact the editors responsible for this story: Rosalind Mathieson at rmathieson3@bloomberg.net; Stephanie Phang at sphang@bloomberg.net