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This article first appeared in Forum, The Edge Malaysia Weekly on September 30, 2019 - October 6, 2019

Richard Breeden, a former US Securities and Exchange Commission chairman and former chairman of Coopers Lybrand’s financial services group, once mentioned that in a developed economy the government is continuously voted upon not only by the populace in general elections, but by the bond market investors deciding daily where to invest their money according to their perceptions of risks and reward.

A key consideration and determinant of the perception of risk/reward and the consequent interest rates is the sovereign credit rating (SCR) produced by credit rating agencies’ (CRA) especially by Standard and Poor’s (S&P), Moody’s and Fitch Ratings known as the “Big Three”. The SCR, based on an analysis of a sovereign’s ability and willingness to meet debt obligations, determines the country’s borrowing cost.

The higher the quality of a debt/bond, as determined by SCRs, the lower the perception of risk and a country’s borrowing costs. Ultimately, governments who ignore bond markets are punished with higher interest rates due to perception of increased risk.

However, in the wake of the European sovereign debt crisis (along with the global financial crisis — GFC) in 2008, the Big Three drew heavy criticism, among others, for being overzealous with the downgrading of non-crisis hit eurozone major economies, such as France and Austria, that exacerbated the financial crisis, together with a slew of mistakes in the assessment of risks and, ultimately, credit ratings.

A study by the Bank for International Settlements found that despite the systematic mispricing and conflicts of interest in rating collateralised debt obligations (CDO) that led to the GFC, CRAs continue to have a significant and economically important impact on credit default swap (CDS) spreads and overall investor sentiment.

The past mistakes in ratings raise the question of whether SCRs can effectively make accurate and meaningful credit ratings given the complexities in assessing a country’s risks.


The problem with credit ratings

Credit practitioners appreciate that the methodology for credit evaluation is only effective if relevant data is availed, and it is optimal when data is homogenous and comparable. The most common and widely used indicator for a nation’s economic performance is the GDP, which, however, only measures the national income/production and not the changes in a nation’s underlying asset base or its wealth (human capital, natural resources, intellectual capital and so on).

This is odd given that conventional credit evaluation for individuals and corporations is based on the quality of the income statement and the balance sheet. Nations have complex varied structures and compositions, and thus the idea that their economic complexity could be easily analysed and translated into a band of ratings with accuracy is incomprehensible, and less so if it is to be done by short visits to countries.

The debt-to-GDP ratio heavily influences rating agencies in their assignment of SCRs. Unfortunately, the perception of the credit risk of sovereigns depends on measures similar to those of assessing risks for corporations and individuals.

Ratios used for individuals and corporations operating in a similar environment and system are generally comparable. There is a wealth of data to evaluate defaults for comparable periods. This is simply not so for countries where there are long gaps between default occurrences.

Additionally, the ratios for nations and their relevance, such as those produced by American economists Carmen Reinhart and Kenneth Rogoff, have recently received severe criticism. The Reinhart and Rogoff findings, which concluded that countries with debt-to-GDP of more than 90% tend to experience slower growth, was reported to have omitted and used wrong data along with serious elementary Excel coding errors in their models.

Instead, it was found that, after reproducing Reinhart and Rogoff’s model correctly, higher debt does not necessarily cause lower growth as much as lower growth causes higher debt as a result of lower tax receipts and increased unemployment benefits.

However, given the influence that SCR has over global investors, developing countries are at times forced to cater to the short-term interests of investors (reducing public debt and maintaining low inflation at all costs — austerity policy) at the expense of long-term developmental goals for its people or risk being downgraded and have their borrowing costs increased.


Sovereign default

We are of the view that there are two distinct scenarios of default of a sovereign on its financial obligations. First, is the default on foreign currency borrowings and second is the default in domestic currency, which is characterised by severe devaluation and/or hyperinflation.

Foreign borrowings, usually US dollar-denominated, have caused many well-known or sovereign crises in the Latin American region such as Argentina, Venezuela and Ecuador. Malaysia’s previous experience of borrowing in foreign currency should serve as a warning, notably, Malaysia’s borrowings in yen with ostensibly low interest rate which was seemingly low cost at one time, but following the appreciation of the yen against ringgit, the borrowings resulted in substantially higher costs.

Certainly, going forward, the likelihood to invest internationally would be to use surplus government funds as compared with borrowing for investment as done recently. The question that begs to be asked is of what relevance are international ratings if borrowings in foreign currency are kept to a minimum going forward.

As alluded above, a country could ostensibly “default” in its own currency when there is a lack of confidence in the local currency in its ability to retain its value. This usually stems from declining confidence in the government of the day, normally due to economic malaise that causes supply shortages and leads to expectations of inflation. Zimbabwe is a well-documented case of such a default, which is characterised by hyperinflation.

Similarly, severe currency devaluation would also result in a crisis with the outflow of funds when there is a complete loss of confidence in the country’s currency and this leads to a selldown of local currency assets.

With loss of confidence, domestic and foreign investors will try to sell the domestic currency, exacerbating the surge in demand of foreign currency. The shift in supply and demand causes the domestic currency to fall sharply. It is not uncommon for flight-to-quality to occur, wherein banks in financial centres benefit from increased deposits. As a result, this places additional pressure on the domestic banks’ holding of foreign currency.


Should Malaysia deserve a better rating?

In terms of US dollar borrowings, it is very unlikely that Malaysia could default given that there is no pressing reason to borrow in foreign currency as the country enjoys a trade surplus. Furthermore, a sovereign’s ability to service its financial obligations is more important than just the size of its debts.

Critical to capacity to repay foreign debt is the level of reserves. However, Malaysia’s total reserves have not increased significantly in recent times, despite the trade surplus, given the movement in the financial accounts.

The issue of outflows due in financial account can be addressed by capital controls as a last resort. This was clearly demonstrated by the seven-year period, reserves of US$25 billion in 1998 grew to US$70 billion in 2005 when capital controls were in place. We could argue that Malaysia’s capital controls were effective because of the trade surpluses, otherwise black markets would have developed to trade ringgit despite the capital controls and, hence, a serious net outflow of funds.

It is crucial that policymakers closely monitor for trade surpluses and to manage them well. To a certain extent, this may be possible by carefully undertaking imports of large ticket items, in particular, government non-financial public corporations (NFPCs) purchases. Furthermore, a fuller understanding of the international flow of funds for Malaysia is required given the large errors and omissions (EO) in its balance of payments (BOP). For example, the size of such EOs in 1Q2019-3Q2019 is larger than its current account by some three times.

A critical risk which remains is the sudden outflow of funds if there is a selldown of securities. Over time as we know from the Asian financial crisis, investors understand that a devalued currency with a fundamentally sound economy will eventually recover. Therefore, sound economic management must remain the bedrock to ensure risks are mitigated and a realisation that market movements are transient and manageable.


Should we tighten our belts during a slowdown?

During times of economic slowdown or recession, some policymakers mistakenly believe that governments should act like households and tighten budgets in anticipation of declining income. This is simply a flawed argument as governments, unlike households, have their own central banks that issue their own currencies.

Austerity proponents, like Italian economist Alberto Alesina, make the following two assumptions of high levels of public debt: (i) that rising public debt increases investors’ expectations of a default, thus leading to higher overall borrowing costs; and (ii) expectations of economic players of impending tax hikes and, hence, causing individuals and firms to invest and consume less.

The first assumption is not a rule of thumb as a country that has an independent monetary policy can freely set interest rates and by ordering the central bank to print money. This was demonstrated by the massive quantitative easing (QE) that took place in the US and the UK. We would strongly advocate fiscal policy rather than QE, which resulted in asset bubbles and weak increase in aggregate demand.

The second assumption is misplaced. Entrepreneurs do not solely base their investment decisions on government deficits and supposed subsequent future tax hikes, but instead on the back of expected future returns. A cut in government spending implies that the overall job creation will decline, which then negatively affects households’ ability to spend in the overall economy.

Austerity proponents advocating for reduced government spending is largely premised on the notion that the private sector can provide full employment to the economy. Giving market forces a free hand over the economy was in vogue during the early 1980s, as promoted by US President Ronald Reagan and British Prime Minister Margaret Thatcher.

This resulted in the weakening of trade unions and depressed employment benefits. Unfortunately, these policies of unfettered free markets are being cited as the main reasons for stagnating median income in the US since the GFC, which has also grown at a much slower pace since the late 1980s.

A reminder from the great recession of 2008 is that the private sector, when faced with great uncertainty, cannot continuously provide full employment. In such circumstances, it is incumbent on the government to expand its balance sheet to pick up the slack of the private sector. As John Maynard Keynes argued in January 1937, “The boom, not the slump, is the right time for austerity at the Treasury.”

Further the quote “Austerity is a tool of … financial interests — not a solution to the problems caused by them” from the book Austerity: 12 Myths Exposed by Bryan Evans, Dieter Plehwe, Moritz Neujeffski and Stephen McBride is germane to this discussion.


Going forward

The issue before us is do we as a nation focus solely on trying to reduce the fiscal deficit? Or do we ensure that a sufficient social safety nets for the weakest in society are well preserved in the face of a slowing global economy? Do we also at the same time undertake a mission-orientated approach to critical projects to develop the country more rapidly?

New thinking in economics promoting “bottom-up policies” suggests that spending on social safety nets, such as providing a universal basic income, increases spending in the economy, which ultimately increases aggregate demand. Money creation or debt in itself is not entirely bad. Notably, credit guidance is required to avoid asset bubbles (such as those in the run up to GFC caused by low interest rates) and ensure businesses benefit from funding for working capital and plant.

Also, new thinking in economics supports public policies that adopt spending on mission-critical items for the economy. We see no conflict of “crowding out” if the government and government-related companies take on radical risk that the private sector is unwilling or incapable of taking on. It is critical to ensure that such monies incurred in deficit spending do not end up in foreign properties, foreign bank accounts and so on, but to circulate in the local economy to increase aggregate demand.

It is important that policymakers understand that the government’s deficit is the private sector’s savings. Moreover, the government has a better capability of managing debt than the private sector due to its central bank with fiat money. It is worth noting that the only time the Malaysian government ran a budget surplus was the period prior to the AFC and, concurrently, the private sector racked up debt at an astonishing rate, after which a banking crisis ensued, triggered by an exchange rate crisis. This was also a period of trade deficits.

The key concern of policymakers is that an increase in the debt-to-GDP ratio or deficit will invite an adverse reaction of the Big Three. However, before policymakers pander to the views of rating agencies, they need to consider the points above and debate among themselves about what is truly in Malaysia’s best interest.

As a nation, we have travelled the unorthodox path before in respect of the economy during the AFC, and it paid dividends and earned us international recognition. However, if the government were to go against the advice of CRAs alone and ignore them, investors may be skittish and feel there is no other alternative that could assist them in making their investment decisions.

Investors, like it or not, will still be guided by the CRA for the foreseeable future despite heavy criticism of rating agencies, for example, in their assessment of CLOs (collateralised loan obligations)/CDOs prior to the GFC or even their Ba1 rating of Malaysia — just one notch above junk — in 1998 during the AFC.

Ideas that have been bandied about to counter the Big Three include establishing an Asian/Asean rating agency or even an Islamic rating agency, which may have a better understanding of issues related to Malaysia or those of emerging markets. Perhaps, another option that may merit consideration is the issuance of sovereign equity, which could pay dividends to investors based on the economic performance of a country. Equities are outside the remit of CRAs.

In the final analysis, credit ratings are merely the opinions of the CRA on borrowers’ credibility. Fear of the unknown/uncertainty by the public and global investors can lead to adverse credit ratings and even massive sudden outflows of funds. However, the government can counter this, even when taking bold steps for the economy, by establishing effective communication of its policies to the public and global investors and improving its transparency and corporate governance.

Efforts by the current administration to improve its credibility through institutional reform are commended, but more can be done in streamlining communication of its economic policies. Finally, our view is that any view or even advice by third parties to the government, such as this article, is not prescriptive, but what really is required is a discourse and the courage to challenge the existing schools of thought and the status quo. Only then can we improve significantly as a nation and do what is best for our country.

Datuk Mohd Anwar Yahya is a partner and executive director at Sage 3, a boutique corporate finance advisory firm, and currently serves on the board of directors of several Malaysian public and private corporations. He has more than 25 years of experience in public policy, corporate finance and strategy whilst working at a Big Four accounting firm earlier on.

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