THE DARK WORLD OF FINANCE – PART 7: “1MDB – WHAT’S NEEDED TO BE DONE” – THE ECONOMIC MANAGEMENT

SUMMARY: Malaysia do not need additional GLC of the like of 1MDB. As a country we already have too much government involvement in business through more than 450 major GLCs, and so many other smaller ones. Furthermore, the problems with GLCs is the “implicit guarantees” involved, which if we take the current debts of the government, plus the guarantees, and combined with hidden guarantees – had reached almost 100% of the GDP (note that Greece had more than 100%). This is not sustainable in the long haul. Given the drop in government revenues which had to be appended by GST, the burden on the people had increased tremendously – which calls for prudency in economic management of the country.

In this part, I will address issues related to the Economics of 1MDB affairs, with particular focus on the practice of economic management of Government linked entities.

First, we have to lay down certain principles of economic management of government “business entities” (as I would like to term it). This is different than economic management of the country such as annual budget, debts directly issued by the government, etc. – which are managed directly by the agencies within the government, in particular the Treasury. The question is why do the government needs to be in “business” through the formation and operations of business organizations owned by the government – in short, why do government need the GLCs – Government Linked Companies. They would fall under two categories: 1) as investments, and 2) for strategic reasons. Investments are mainly done through funds – such as KWSP (EPF), Tabung Haji, LTAT, KWAP, Khazanah Nasional, etc. The purpose of investments is to secure returns on investment (long term) for the public funds under the management of the government. Strategic reasons – would include ownership of TNB, Telekom, infrastructure assets and operations (MRT, Rapid, etc.) – because these are to ensure provision of services for the public. Another strategic holding is Petronas – because of management of oil and gas resources, and strategic investments in related industry.

The question is – under which category does 1MDB falls into? As I had explained before, I could not see any other economic rationale of 1MDB except being a Leveraged Buyout entity (i.e. to leverage, package the business, and sell off – with profits). Therefore it is quite safe to say that 1MDB is the only one of its kind within the GLC families.

The second principles is: Risk & Reward profiles. What kind of risk/reward profiles would 1MDB falls under? As the case of investments – generally the profile is for long-term investments (i.e. you invest for the future), hence the profile is to go for lower risk and returns, and safe (i.e. less volatilities). As in the case of strategic investments, you could shoulder more risk, and also lower returns – since the non- financial benefits to the public (in non-monetary terms) are quantifiable (e.g. TNB and Telekom). As LBO entity, 1MDB is taking right smack in the highest risk/reward profiles.

The third principle is: Governance. The basic issue of governance is process of decision making, and in particular, the business models and risk taking, and financial control of the organization. The second issue is business transparency, disclosure, financial reporting, and management of conflict of interests. Thirdly, a GLC has to ensure that the interest of the public is preserved –i.e. the Corporate Social Responsibility (CSR).

Finally, the fourth principle is: involvement of public monies. What is the source of the monies, and what would be the accountability structure applied for those monies.

My take on 1MDB on all of the above:

  1. 1MDB falls under a “new category”, which is Leveraged Buyout structure.
  2. Risk/reward profile of 1MDB – is extremely on the highly risky (due to leveraged nature and the sectors – energy and real estate), with potentials of high rewards (i.e. returns on equity).
  3. On the issue of governance – clearly 1MDB had failed on many counts. You could make your own judgement based on what had been exposed by many.
  4. On public monies – 1MDB claimed that only RM1 billion money is from the government was used (as equity/shareholders loans to the company); but in reality, 1MDB was funded mainly by massive reliance on Government guarantee. Hence, we could say that almost 100% of 1MDB’s financial resources and strength is from the public’s money.

All of the above, clarifies the economic management of 1MDB. Now let us focus on two main issues regarding: a) involvement of government in business; and b) usage of guarantees by government for business entities.

Why Governments Should Not Go Into Direct Business

  1. Governments could gain “unfair advantages” since it is in control of many matters in regards to awards of contracts, as well as regulatory advantage. What we economist termed as “regulatory arbitrage” as well as “monopolistic tendencies”. Both are bad for the economy.
  2. Open market business are best left for the market to operate. Because unnecessary risk taking should not be the business of governments. The IPP business – as had been done is best left as private sector concerned (as evidenced from our privatization exercises). Why do the government want to own something that it had given to the private sector? Furthermore, real estate is best left to private sectors. These are the two sectors that 1MDb went into.
  3. Government’s involvement in business crowd’s out private sector investments. In the long term, this is bad economic management.
  4. Principal-Agency problem: to be in business of “high-risk” would always invite a high “agency costs” – since management, who do not take personal risk on investments, could be reckless since they are not personally at risk; hence they could take high risk, and get rewarded (as management) for this risk, and yet will lose nothing if the gamble went sour.

In short, the 1MDB business model is against the cardinal economic principles. These kind of business model should be stopped. As a matter of record – 1MDB is not the first (and may be not the last). The lists of previous 1MDB like companies are as follows: HICOM (the baby now is PROTON), PERWAJA, BAKUN, RENONG (UEM is the current baby), MRCB (then before EPF took over), and the list could go on. Note that they were all under Tun Dr. M & Tun Daim. Our track record on these types of business had failed time and time again for various reasons (economic and otherwise).

My personal conclusion is: Government should stop any direct business involvement, except for two reasons stated before: long term investments of public money (EPF, Khazanah, PNB etc), and strategic reasons (TNB, Telekom, etc.) If the investments like 1MDB doesn’t befit any of the existing bodies, such as Khazanah, then it should not be done.

Why Government Shouldn’t Guarantee Business Ventures 

If a business venture is viable, it do not need government guarantee; and if government guarantee is needed, it must be for the sole reason that it is not viable on its own. Furthermore government guarantee is given only if public interest is involved (i.e. risks that could not be covered by the nature of the business). Hence, it should be given extremely selectively, with lots of due care and process (such as involvement of the Parliament).

In case of 1MDB, the explicit guarantee given by the Government is somewhere around RM30 billion – for its business ventures. So on this count, the guarantees are wrong as a matter of principles of economic management by the government. This is the explicit part.

The implicit guarantee is even more dangerous. Since 1MDB is seen as 100% government owned, all the creditors of 1MDB would assume that it is taking “government risks”; hence banks could finance contractors, suppliers based on that assumptions. All these creditors – assumed the implicit guarantees of the government. To undertake developments of TRX and Bandar 1Malaysia would involve these kinds of risks – which if anything go wrong, will fall squarely on the government (hence the public). Similarly any borrowings by 1MDB (not guaranteed by the government) carry this implicit guarantee. In short, the final tally of “guarantees” to 1MDB will go way beyond the current RM50 billion or so debts and creditors compiled to this date.

Government really needs to get out of this guarantee business – as it is a source of economic disaster, as it had shown in the US and elsewhere.

Quick Take on Malaysian GLCs

How many GLCs are now currently in operations? All in all, there are almost 450 GLCs which are currently in operations. These are GLCs under the Federal Government only. If we take the state governments into considerations, then the numbers could be a lot more – few thousands at least. On the federal level GLCs accounted for more than 30% of KLSE market capitalization, and in the bond market, I couldn’t have my figures computed in terms of percentage of total bonds outstanding which are due to the GLCs. But the figure could well be above 30% as well. In short – our government is in business in a very big time.

Is this good for the economy? The answer is again yes and no. These GLCs provided income to the government – which could be in the range of tens of billions in dividends as well as corporate taxes. The main problem that I see is the crowding out of the private sector participations and investments; issues of monopolistic rent and quasi monopolistic rent. It is hard for private sector to compete against GLCs because of the advantages it holds over its competitors.

Quick Take on Malaysian Government Contingent Liabilities

First question: how much is the debt and liabilities of the Malaysian Government? Total direct debts of the government today stood RM 582 billion. And total guaranteed debts currently stood at RM172 billion. In total, RM754 billion. I am not so certain whether the guaranteed debts include the figures of 1MDB guarantees (of RM30 billion, approx.). Our GDP currently stood at RM1,157 billion, which means the combined liabilities now stood at about 65% of our GDP.

Are we in the danger zone as far as debts and liabilities are concerned? The answer is yes and no. There are countries which have debts even more than 100% of its GDP (Greece is an example). Debts/liabilities are only dangerous when the country’s economy is weak. So far, our economy has shown its resiliency. So far that’s not my worry. What worries me is the “hidden guarantees” or “implicit guarantees” (as I called them earlier).

Implicit or Hidden Guarantees

We must understand that under our privatization programs, the government undertook massive commitments to implicitly guarantee in forms of various performance to be made – such as increase in toll rates, electricity rates and tariffs, and so on. The current spate of issues between the IPPs and TNB is a clear example. This is not to mention the preferential treatment and commitment we gave to Proton, KTM, public transport (MRT, Putra, Star, Rapid, and so on), and various other similar projects. I don’t have the time to do detail calculations – but I could safely say that the total contingent liabilities for all of these issues combined could well be in the range of RM300 billion, and is still on the rise, as more new projects such High Speed Rail, East Coast Railway, and so on are currently being planned.

Conclusions

In conclusions, Malaysia do not need additional GLC of the like of 1MDB. As a country we already have too much government involvement in business through more than 450 major GLCs, and so many other smaller ones. Furthermore, the problems with GLCs is the “implicit guarantees” involved, which if we take the current debts of the government, plus the guarantees, and combined with hidden guarantees – had reached almost 100% of the GDP (note that Greece had more than 100%). This is not sustainable in the long haul. Given the drop in government revenues which had to be appended by GST, the burden on the people had increased tremendously – which calls for prudency in economic management of the country.

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