Lurking beneath Malaysia's solid investment-grade sovereign rating is a risk posed by a $14 billion investment fund that is not even generating enough cash from operations to cover interest costs.
Regarded as a cross between a sovereign wealth fund and a private investment vehicle, with Prime Minister Najib Razak chairing its advisory board, 1Malaysia Development Berhad (1MDB) is struggling under the burden of $11 billion in borrowed money.
The government says it only guarantees around 14 percent of the debt. The investment community assumes it would provide more if needed, and it is the potential strain on Malaysia's debt position from these contingent liabilities that raises concern.
"We don't know how well 1MDB is doing," said Christian de Guzman, senior analyst of sovereign risk group at ratings agency Moody's Investors Service. "It does pose a risk in terms of the amount of borrowing they have made over the past few years."
Controversy has dogged 1MDB almost since it was first set up months after Najib came to power in 2009, and used for funding projects that form part of his Economic Transformation Program.
Critics have questioned its investment choices, the size of its debt, $2.25 billion parked in a Cayman Island fund, hundreds of millions of dollars of revenue earned by Goldman Sachs for handling its bond issues, delays in its accounts, changes of auditors, and a perceived lack of transparency.
A $1.9 billion bridging loan that fell due in November has been rolled over twice, most recently two weeks ago, in order to give 1MDB more time to launch a $2 billion initial public offering that would reduce debt incurred buying 15 power plants. In a statement published on May 23, 1MDB said the IPO for its power division will take place in the second half of this year.
In 2013, 1MDB, with liabilities of more than $13 billion, generated cash flow of 860 million Malaysian ringgit ($267.75 million) from operations, far below the annual interest outgo of 1.62 billion. It would have made a 1.85 billion ringgit loss, but for a 2.7 billion ringgit revaluation of its property portfolio.
Opposition leader Anwar Ibrahim was quoted at a news conference in late April warning; "If we continue with this culture of accumulating debts, Najib's 1MDB will fail and become a liability that should be called 1Malaysia's Debt of Billions."
The Prime Minister's Office and 1MDB did not respond to Reuters' requests for comment.
1MDB defended itself in a statement released in February, saying that its power assets had strong growth potential.
"All this points to a high value proposition that can be expected to stimulate markets and bring significant FDI and cash profits to the shareholder - the Government of Malaysia," it said.
But independent analysts also have voiced concern that 1MDB's debts could be pushing Malaysia into risky territory.
"1MDB remains somewhat of an enigma," Bank of America Merrill Lynch economist Chua Hak Bin said in a note. "What stands out, however, is 1MDB's high leverage, which has raised concerns that 1MDB could emerge as a serious contingent liability for the government."
Malaysia's debt-to-GDP ratio stood at 53.8 percent at the end of 2013, central bank data shows, up sharply from 43 percent in 2008 and close to an official debt ceiling of 55 percent, beyond which the government must seek parliamentary approval.
Contingent liabilities, however, stood at 15.9 percent of GDP, up from 9 percent in 2008, bringing total government and government-backed debt to 69.7 percent of the economy, and the off-budget character of 1MDB raises questions.
"It can be viewed as a way to circumvent the 55 percent ceiling on government debt to GDP, while shielding this spending from parliamentary scrutiny," said Prashant Singh, a fund manager at Neuberger Berman in Singapore.
Holding a slim parliamentary majority after a controversial election victory last year, Najib, who also runs the finance ministry, can get approval to bust the debt ceiling, but it could hurt his credibility.
Economists said a further delay to 1MDB's IPO, weaker financial results and prospect of a further rollover of debt could put the government on the spot.
"The trigger points which could force investors to price 1MDB risk more seriously into the sovereign could come in various forms," said Leong Lin-Jing, assistant investment manager atAberdeen Asset Management Asia, based in Singapore.
Further explicit guarantees by the government for 1MDB projects that are regarded as not necessarily beneficial to the country would send a bad signal, Leong said.
Fitch Ratings cut the outlook on Malaysia's A- rating to negative from stable last July. Only India and Sri Lanka, in Asia ex-Japan, have higher debt ratios, according to Fitch.
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"Malaysia's negative outlook is driven by factors such as the rise in guaranteed and contingent liabilities like 1MDB, due to its sovereign ownership linkage, and the sharp erosion in current account surplus," said Andrew Colquhoun, Fitch sovereign analyst for Malaysia told Reuters.
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For now, investors remain cautiously optimistic over fiscal consolidation plans. The government will introduce a new consumption tax next year at a surprisingly high rate, and has abolished sugar subsidies and raised property taxes in steps that were welcomed by ratings agencies.
The government expects its fiscal deficit to fall to 3.5 percent of GDP this year from 3.9 percent last year, helped by those measures and a robust economy that expanded 6.2 percent in the first three months of 2014.
"If you look at other A- rated countries, Malaysia does have in general a faster growth rate, generally lower and more stable inflation rate and more robust balance of payments," said Aberdeen's Leong.
Whereas foreign investors hold about 44 percent of Malaysian bonds, one of the highest concentrations in a domestic government bond market in the region, offshore trading in Malaysian sovereign bonds is illiquid.
Any worries over Malaysia's debt would most likely show in the market for credit default swaps (CDS), which acts as an early barometer of stress in sovereign credit metrics. So far, the CDS market appears relaxed over issues surrounding 1MDB.
In the year to date the 5-year CDS contract has narrowed by 20 bps to 87/92 bps, slightly outperforming the regional benchmark iTraxx index, which has narrowed 17 bps to 109.75/112.25.