Fitch downgrade and sovereign debt

By Jason Loh

The Fitch downgrade of our sovereign bond issuer default rating (IDR) on Dec 4 from A- to BBB+ has attracted mixed responses – ranging from a stance of downright vindication to a couldn’t care less attitude. Fitch is a ratings agency – meaning that it specialises in credit (i.e., financial worthiness and strength) ratings and analysis of a country (sovereign entity) or organisation (public and private).

Predictably, on the opposition side of the political arena, the responses to the Fitch downgrade were of course despondency and pessimism that their calls for institutional and political reforms went unheeded precisely because of the rating drivers that, among others, included the governance metric that mentioned “institutional capacity”.

On the other hand, economists and financial research houses are confident that the Fitch downgrade will not have a critical or sustained impact on Malaysia’s public debt market specifically and the financial sector as a whole.

For example, Juwai IQI chief economist Shan Saeed gave little credence to the Fitch downgrade by saying that markets have lost confidence in rating agencies since 2010. He was quoted as saying that “[t]heir reports and outlooks are behind the curve. They come up with banal analyses which are not germane to the market”. Bank Islam Malaysia chief economist Mohd Afzanizam Abdul Rashid opined that “the sovereign rating could be upgraded at some point in the future” when there are new developments. RHB Research Institute Sdn Bhd was reported in The Edge Markets as stating that “[c]urrently, based on our medium forecasts for gross domestic product (GDP) growth, inflation, interest rates, and exchange rates, we view Malaysia’s general government debt trajectory as sustainable”.

Notwithstanding, even those who warn about the bleak consequences of the Fitch downgrade admitted that we should not be “slavish to the perspective of rating agencies” whilst calling for the “[v]alid and credible criticisms in the … Report [to] be addressed”, as per veteran politician YB Lim Kit Siang, Member of Parliament for Iskandar Puteri. Of course, renowned economist and academician, Prof Jomo K Sundaram has warned against overly depending on credit rating agencies to decide whether to increase public spending to counter the effects of the Covid-19 epidemic (Jomo: Govt should not rely on rating agencies, The Malaysian Reserve, Oct 14). Prof Sundaram said that “rating agencies have repeatedly been proven wrong in the past, and governments, including Malaysia’s, should adopt countercyclical policies in dealing with extraordinary situations”.

There is, therefore, a near-consensus these days against unquestionable or uncritical trust in ratings agencies.

Ratings agencies do play a vital role in highlighting and warning about systemic, structural and institutional risks and weaknesses i.e., governance, political and economic, that otherwise may not be apparent or discernible to outsiders which in our immediate context refers to foreign investors (short- or long-term, public or private).

However, as alluded to, ratings agencies have tended to rigidly adopt a certain outlook that does not take into account the complexities of the real-world dynamics.

For example, rating agencies are themselves overly dependent on a particular macro-economic policy consensus that has been best exemplified by the World Bank and the International Monetary Fund (IMF).

In turn, the World Bank and IMF have been beholden to mainstream or orthodox school of economic thought – best embodied by Monetarism as the intellectual paragon – that have reigned dominant since the overturn of the Keynesian Revolution brought about by the stagflation phenomenon in the mid-1970s that marked the end of full employment as the ultimate goal of deficit spending first unleashed by US President Franklin Delano Roosevelt’s “New Deal” of the 1930s in the aftermath of the Great Depression (1929), although it’s now openly recognised that the paradigm is shifting.

Unfortunately for the ratings agencies, the policy ground is shifting precisely because the realities have moved on since the days of Reaganomics/Thatcherism and the New Public Management (NPM) phenomenon that also influenced the first Mahathir administration to modernise the civil service from regulator to enabler and embarked on the privatisation of State-owned entities. The pendulum is now swinging in the opposite direction, that is, especially because of the experience of the Great Financial Crisis of 2008-09 that has seen the soft-touch and low regulatory environment resulting in the proliferation of what is now regarded as financial “weapons of mass destruction” most notably the credit default swaps (CDS) of the collateralised debt obligations (CDOs) comprising principally of mortgage-backed securities (MBS) i.e., tranches of debt repayments pooled mainly from subprime housing loans. The CDOs were, of course, the derivatives based on the MBS. Whereas the CDS was the betting on the betting part, so to speak, of the financial game that was disguised as a form of so-called insurance swap.

Nonetheless, of immediate and practical concern here is how to deal or cope with the Fitch downgrade and verdict which would have an impact on the status of our sovereign bonds (i.e., in the majority of which is in the form of the Malaysian Government Securities/MGS)? There’s the legitimate concern over selloffs and the concomitant of capital flight in the equity markets.

As mentioned in an Emir Research article, “Alternative avenue to fund deficit”, our central bank, Bank Negara should strongly and seriously consider doing quantitative easing (QE) now, i.e., second-hand purchases of MGS to absorb the offloading and simultaneously ensure that we aren’t “captive” to the vagaries of the markets by lowering the bond yields. What ratings agencies don’t mention is that a sovereign country like Malaysia (i.e., with its own central bank and currency) unlike member-states of the eurozone (think Greece or Italy), as for example, is always in control of its interest rates and that include bond yields.

To quote Australian economist William F Mitchell who in turn appealed to the real-world policy experience of the Federal Reserve and Bank of Japan (BOJ) – “The central bank always calls the shots on yields and the bond markets only set yields if the government allows them to”.

The relevant Federal Reserve and BOJ documents are taken from the Minutes of the Federal Open Market Committee (Oct 29-30, 2019) and “Strengthening the Framework for Continuous Powerful Monetary Easing” (Jul’ 31, 2018), respectively.

Then too, ratings agencies also neglect to mention that countries that issue sovereign debt denominated in their own currency not only have an almost zero possibility of default but is a risk-free haven as a form of financial asset. This explains why Malaysia remains a top destination for foreign buyers of MGS. It’s only in September that “[f]oreign buying of … MGS and Government Investment Issues (GII) continued for the fifth consecutive month …” as reported in The Edge Markets. Moreover, our latest bid-to-cover ratio is at 2.6 times oversubscribed that is set against what is the highest to date issuance at RM136.9 billion (“Year-to-date Malaysian government bond issuance hits record high”, The Sun Daily, Nov 23, 2020).

In conclusion, whilst there’s much to take on board from the Fitch downgrade, when it comes to our national or sovereign debt (in terms of the size of issuance, debt ceiling, yield levels), the reality is that, ultimately, it’s the markets that need the State and not the other way round.

Jason Loh Seong Wei is Head of Social, Law & Human Rights at EMIR Research, an independent think tank focussed on strategic policy recommendations based on rigorous research.

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