The Fitch Rating Downgrade: Much Ado About Nothing

Right off the bat, I should say that the timing of the release of the report – just before Hari Raya – was purely coincidental, and not in any way due to hidden motives. It just so happens that Fitch’s annual rating review of Malaysia’s sovereign rating occurs about this time every year.

Nobody pays much attention when ratings are affirmed, but up or down movements are much more visible from a news-worthy perspective, and bad news trumps goods news every time. And yes, the good news/bad news phenomenon has actually got pretty solid research behind it.

Secondly, what Fitch has done is to revise its outlook for Malaysia’s sovereign rating, not the rating itself. That stays at “A-“ for foreign currency issuance and “A” for local currency issuance, and barring any unforeseen catastrophes, there will be no change until the next rating review.

Translation: “We’re not doing anything just yet, we’re just thinking about it. We’ll tell you next year.”

Third, I think it should also be emphasised that the Fitch rating, like all other sovereign ratings from other credit rating agencies, is not a judgement about the economy but solely about public finances.

Strictly speaking, the sovereign rating is an opinion about the credit worthiness of the government and not how well the economy is doing. Any inference is indirect, as a deterioration of economic conditions would impact government finances. But the opposite isn’t necessarily true.

Moving on to the report itself, the first thing that leaps out to me is that the revision to the outlook is a direct consequence of the General Election results.

The thread of Fitch’s argument over the last couple of years has been consistent and fairly communicated – they wanted to revise the outlook last year, but waited until after the GE in the hopes that a bigger government majority would allow a follow-through on public finance reform (i.e. GST and subsidy rationalisation).

With the majority actually shrinking, Fitch thinks reform won’t happen, and as a result went ahead and revised their outlook. I don’t think you can interpret the Fitch move in any other way, as there’s been no substantial change in government finances between this rating review and the last one.

Having said that, some of Fitch’s rationales are rather weak. For example:

1. Fitch claims that the government’s revenue base is small at 24.7% compared to our peers in the same rating band. This is perfectly true, but they fail to mention that the ratio of Malaysia’s government expenditure to GDP (below 30%) is also on the low side compared to our rating peers (average appears to be around 32%).
2. Fitch has justifiable concerns over the reliance on oil revenues to bolster government revenue. However, they miss the duality involved here – both revenues and expenditures are sensitive to oil & gas prices, because of the subsidies for petrol, natural gas and diesel. Also, I’m wondering about the consistency of Fitch’s ratings when Kuwait and Saudi Arabia, who get 80%-90% of their government revenue from oil compared to Malaysia’s 30%+, are rated “AA”.
3. The increase in contingent liabilities, currently at around 15% of GDP, has been noted as a contributing factor. Again there’s a consistency problem here. For example, there’s a possibility that Fitch will upgrade the outlook for Ireland’s rating, which currently stands at “BBB+”. Ireland reports explicit contingent liabilities totalling over 100% of GDP. The United States, which is naturally rated “AAA”, has explicit and implicit contingent liabilities on the order of whole multiples of GDP (watch for a future post on this).

Lest it be thought that Fitch was all negative on Malaysia, the report is still pretty balanced and points to some credit supports – strong external position (both stock and flow), the reliance on domestic funding sources, and a stable maturity profile.

So, what happens if Fitch goes ahead and downgrades their rating for Malaysia during their next review? Honestly, I don’t think much will happen.

Remember, at “A-“ Malaysia is still well within the investment grade rating category. A downgrade to “BBB+” doesn’t change that. We’d need to go down another three notches to be classed as “speculative” i.e. junk. It’s hardly time to panic just yet.

Second, investors are all looking at the same data, so by the time Fitch gets around to revising their rating next year, it will be more in the nature of a fait accompli rather than presaging a round of investor sell-offs, i.e. a rating downgrade would probably lag, not lead, what happens in the capital markets.

Note that the selldown in the Ringgit and in the capital markets the last couple of weeks was part of a general investor retreat from emerging markets, not something specific to Malaysia per se. The Fitch news added a little push to the rush for the exit, but it wasn’t the trigger.

Lastly, while an actual downgrade to the rating should in theory make borrowing costs more expensive, there are many more factors that determine the yield the government has to pay on its borrowings. For example, the last time Fitch cut Malaysia’s rating (local currency only; February 2009) MGS yields did indeed rise, but to levels well below where they were six months earlier.

Summing up, all the commentary on this issue has the feel of a storm in a teacup. Personally, I wouldn’t factor in maintaining a particular credit rating as a primary goal of economic policy. Growth and development should be first and foremost and macroeconomic stability a close second, and that often requires leveraging the public balance sheet. If that involves a rating downgrade, then so be it.