Why Malaysia’s 1MDB scandal is denting growth

Sha Ying | CNBC

Thought the long-running political scandal over Malaysia's deeply indebted sovereign fund was over?

It isn't and the festering scandal is likely to weigh on the economy and may eventually spur a ratings downgrade, Oxford Economics says.

That's bad news for Malaysia, which is already suffering from a slide in the price of commodities, an important chunk of the economy and a key source of revenue for the government. The currency has tumbled and the government's debt levels have climbed, fueling investor concerns.

"Just as it appeared that the long-running scandal over state investment company 1MDB had been satisfactorily resolved, the issue has reignited with an appeal against the ruling exonerating the prime minister," Christine Shields, lead economist at Oxford Economics, said in a note Friday. "The issue is a real worry as it is eroding confidence and contributing to risk aversion about the country."

Shields noted that both the currency and the stock market have dropped over the past year and capital outflows have picked up.

Oxford expects Malaysia's economic growth will slow to 4.2 percent in 2016 from 4.7 percent in 2015. That would be the slowest growth rate since 2009, during the Global Financial Crisis, when Malaysia's economy fell into a recession.

Earlier this week, Malaysia's Attorney General Mohamed Apandi Ali told an unscheduled press conference that Saudi Arabia's royal family gave Prime Minister Najib Razak a $681 million gift, in an effort to end months of speculation about the source of the huge personal donation that landed in Najib's personal bank account. Apandi said that no criminal offense had been committed, in a move that appeared to mark the end of the matter, at least within the country.

But on Wednesday, the Wall Street Journal reported that Malaysia's anti-corruption agency wants to review the decision to drop the investigation.

Malaysia's political establishment has been shaken by the 1MDB developments, which have been at the center of one of the country's worst political scandals.

In July, the WSJ reported that almost $700 million in funds had flowed from 1MDB to Najib's personal bank account and then in December, it reported that the funds in question may have been channeled to politicians and projects to help Najib's UMNO party win 2013 elections.

Although asset sales have helped reduce 1MDB's debt by about $9.4 billion, according to a December announcement by Najib, the fund still faces investigations in Switzerland, Hong Kong and the U.S., according to reports.

The political scandal has come as Malaysia's economy is already struggling with the more than 50 percent drop in oil prices over the past two years.

"Of most concern is the narrow tax base: almost a third of government revenue came from oil and gas in 2014, though this proportion will have fallen since with the new GST," or goods and services tax, which was introduced last year, noted Shields.

Although the budget deficit is still manageable at 3.3 percent of gross domestic product (GDP), public debt will likely rise to 56 percent of GDP this year, its highest level since 1992, stymying plans to cut the debt toward 50 percent, she said.

"While the IMF has commended the authorities for their prudent financial management and maintenance of economic stability, the challenges for the government are substantial and growing," Shields said. "Maintaining economic stability is key to maintaining the political status quo. And deterioration in either may ultimately mean a ratings downgrade."

Earlier this month, Moody's revised the outlook on Malaysia's sovereign rating to stable, from positive, but kept its overall rating at A3, the third highest rating possible. Moody's said the revision was due to deteriorating economic growth, risks from high system-wide leverage and expectations there would only be limited improvement in the public debt burden.

The central bank also doesn't have much room to boost growth, Oxford noted, as interest rate cuts would leave the ringgit vulnerable to capital outflows. At the same time, the already weaker ringgit means underlying inflation will likely remain high, it added.

Although asset sales have helped reduce 1MDB's debt by about $9.4 billion, according to a December announcement by Najib, the fund still faces investigations in Switzerland, Hong Kong and the U.S., according to reports.

Concerns about the 1MDB scandal likely impacted Malaysia's ranking in Transparency International's Corruption Perception Index, released this week. The country's ranking dropped to 54 out of 168 countries from 50 in 2014.

Shields isn't the only one who sees further trouble ahead for Malaysia's economy.

This week, the country announced plans to revise its budget to account for the drop in oil price, but analysts noted Najib was light on the details of the "prudent measures" to cut government spending. Najib did say what wouldn't be cut: civil servant pay, about a third of government spending.

Some infrastructure projects may be delayed, but "most of the projects focused on the politically important rural areas and Eastern Malaysia states will be the sacred cows," noted Wellian Wiranto, an economist at OCBC, in a note Thursday. He cut his GDP growth forecast to 4.4 percent from 4.7 percent this year. The government's official forecast was cut to 4-4.5 percent from 4.-5 percent previously.

Others are also concerned about growing debt levels.

"We remain concerned about the risks from a widening consolidated public sector deficit and growing leverage of non-financial public corporations which are undertaking the many infrastructure projects," Bank of America Merrill Lynch said in a note Thursday. "Government guarantees have been steadily rising since 2008 under Prime Minister Najib's helm and now stands at 174 billion ringgit (15.2 percent of GDP), bringing the quasi-public debt to about 70 percent of GDP."

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1