KUALA LUMPUR (July 23): Malaysia faces the risk of a “multi-notch downgrade” in its sovereign credit rating, despite Fitch Ratings affirming its “A-” rating on the Malaysian sovereign last month, warned BNP Paribas.

In its Asia Desknote today, the French bank said investors should remain “fundamentally wary” of Malaysia due to the marked deterioration in the country’s external finances, which may result in a “BBB-” rating.

It said as Malaysia’s credit default swap (CDS) widening was triggered by a confluence of pressure on the public and external finances and has persisted for six months, the potential for a multi-notch sovereign downgrade remains.

“Ironically, a Fitch-developed tool to gauge the CDS-implied rating level indicates the Malaysian sovereign is a ‘BBB-’ credit, three notches below the official rating,” BNP Paribas pointed out.

BNP Paribas also criticised Fitch’s latest rating report which focused solely on “Malaysia-centric developments” and overlooks a crucial underpinning of sovereign credit ratings — that they should be ordinal rankings reflecting how a particular credit stands relative to a chosen peer group.

“Malaysia’s public finance performance trends against rating peer medians are a particular concern.

“Our analysis suggests Malaysia fell further behind the ‘A’ range on key indicators like debt-to-revenues since Fitch initially placed the rating on a negative outlook in mid-2013. Against the ‘BBB’ range it has fared only marginally better,” it said.

It added that the persistence of this relative deterioration suggests that Malaysia’s sovereign rating should have been downgraded regardless of the reforms implemented.

“That it wasn’t speaks to a potentially more concerning state of affairs: sovereign rating committees are reluctant to take negative rating actions. The International Monetary Fund research highlights that such reluctance is not a new trend,” said BNP Paribas.

The bank also noted that Fitch’s latest report indicated that external finances were no longer emphasised a credit strength. Instead, it had been replaced by “hope that fiscal reform leads to improved macroeconomic policy”.

“Unfortunately, policy challenges now lie more with Bank Negara Malaysia (BNM) than with the Ministry of Finance. Deterioration in external liquidity metrics, such as short-term external debt coverage and international liquidity ratio, is central to this assessment,” it said.

According to BNP Paribas, lower global oil prices and consistently negative political news flow have aggravated balance of payments deterioration have produced an escalation in ringgit volatility and depreciation pressure.

“If history is any guide, rating agencies’ attempt to catch up with the market may further escalate balance of payments strain, leading to a substantial market overshoot in USDMYR beyond 4.0,” warned the bank.

It explained that BNM’s response to currency strains has been to deplete foreign exchange (FX) reserves, leading to a weakening of external solvency.

"We estimate BNM’s defence of its MYRNEER (MYR Nominal Effective Exchange Rate) peg has cost about US$40 billion since April 2013.

“These actions look to have escalated as USDMYR approached its post-Asian Financial Crisis peg level of 3.80, which coincidentally our FX strategists estimate is the fundamentally fair value. So much so that FX reserves could soon dip below US$100 billion for the first time since 2010,” said the bank.

Malaysia had rolled out two important fiscal reforms to bolster its public finances — the implementation of the goods and services tax and the abolishment of fuel subsidies — which should result in greater future fiscal flexibility and narrowing its fiscal deficit.

Nevertheless, BNP Paribas pointed out that the government’s ability to meet its 55% government debt-to-gross domestic product (GDP) is more constrained by its ability to reach strong nominal GDP growth rather than reducing the fiscal deficit.

“With trend real GDP growth of 4.5%–5% per year and long-run average inflation of about 3% per year, translating to nominal growth of about 7.5%, such outcomes appear achievable.

“However, this assessment overlooks Malaysia’s growing reliance on commodities as an economic growth engine and the subsequent potential for terms of trade shocks,” it said.