Mega-projects will bring greater opportunities to Sarawak's finance sector

The financial services sector in Sarawak is an important and growing part of Malaysia’s financial world, with many national and international financial institutions heavily involved in the state’s development and investment programmes. From large, multinational funds to local Malaysian banks, these players have historically been drawn to the state in large part by the opportunities available in financing its substantial oil, gas, timber and palm oil industries, and by its stable economic climate. Today, they are being drawn by the state’s major development plan, the Sarawak Corridor of Renewable Energy (SCORE), and other mega-projects currently being implemented.

REVENUES: Sarawak accounts for around half of Malaysia’s crude oil output and is its sole producer of liquefied natural gas (LNG), making it an important revenue generator for the federal government. At the state level, around one-third of Sarawak’s operating revenue comes from oil and gas.

For several years, state authorities have been leveraging this revenue to maintain an operating budgetary surplus, according to Standard & Poor’s (S&P) estimates, producing a strong financial base. S&P forecasts Sarawak’s operating surplus at an average of 69% of operating revenues from 2012 to 2016, allowing the state to spend with flexibility and enabling it to employ a counter-cyclical fiscal strategy. It also expects its balances after capital accounts to maintain elevated surpluses of 20-32% of revenue over the forecast period of 2013 to 2016. However, Sarawak’s surplus after capital expenditure is projected to ease slightly as it embarks on higher infrastructure spending on its SCORE plan.

These positive financial indicators are helping to draw investors to Sarawak. Furthermore, the state has a reputation for maintaining solid financial positions, while having a stable social and political environment. This reputation will be called upon in earnest as it attempts to achieve its ambitious development goals – most importantly, financing the SCORE mega-project. A huge amount of capital investment will be required for the state to meet its goals, and it is looking to source this in part by issuing bonds – both conventional and Islamic.

SOUND STATE: The state of Sarawak has received investment-grade ratings from various major international credit rating agencies, which are seen by international investors as an important vote of confidence in the state’s financial resources. Sarawak received issuer credit ratings of “A3”with stable outlook from Moody’s in November 2013 – an upgrade from its former rating of “Baa1” and on par with Malaysia’s status – and an “A-” with stable outlook from S&P in December 2014.

In its issuer credit rating report, S&P lauded the state’s strong budgetary performance and “exceptional” liquidity – supported by large amounts of cash reserves. However, the ratings agency also noted the susceptibility of the state’s elevated debt burden to market risk, in addition to its high contingent liabilities and low GDP per capita by international standards. According to S&P, the rating was a result of Sarawak’s “evolving but balanced institutional framework” and its strong track record of generating strong cash surpluses.

For its part, Moody’s statement on Sarawak’s “A3” rating pointed to the state’s positive financials, which has generated ample surpluses and boosted reserve levels in recent years. According to Moody’s, the upgrade was based on the state’s maintenance of “robust growth” in commodities-related revenues, conservative budget projections and strict controls over operating expenditures, noting that financing surpluses averaged 30% of operating revenues during the 2004-11 period. However, a further upgrade is not expected, as Sarawak’s rating was unlikely to “exceed that of the sovereign”, Moody’s said.

On the whole, credit ratings agencies have confirmed the stability of the state’s bonds and issues on the back of Malaysia’s equivalent “A3” ratings, in addition to the upgrade in the country’s ratings outlook from stable to positive in late 2013.

BONDS: In the same release, Moody’s affirmed “A3” issuer ratings with stable outlook for SSG Capital Holdings and SGOS Capital Holdings, in addition to affirming the “A3” debt ratings with stable outlook of Sarawak International’s bonds, which are guaranteed by SGOS, and SSG Resources’ bonds, which are guaranteed by SSG. The ratings demonstrate the closeness of Sarawak’s funding relationship with these state-owned corporations, which “act as conduits for state-financing activities”, Moody’s noted.

Turning to Sarawak’s corporate credit ratings, RAM Ratings, Malaysia’s first ratings agency, assigned an “AA3/stable/P1” rating to Cahya Mata Sarawak (CMS) in April 2014 due to its dominance in the Sarawakian cement market. CMS is an investment holding company involved in construction-related activities, including the manufacturing of cement – CMS is the state’s only integrated cement manufacturer – as well as construction materials trading, road maintenance and property development.

Furthermore, CMS has political connections: family members of the former chief minister of Sarawak, Abdul Taib Mahmud, hold a 41% stake in the group – though this also exposes the group to a certain degree of political risk, RAM notes, were the state leadership to change. However, given the boom in construction expected from SCORE, CMS is likely to continue to profit from its market position, strong bargaining power and established distribution network – all of which contributed to its strong rating.

The state-owned energy giant Sarawak Energy has issued both conventional and Islamic bonds to underwrite its ongoing development of the state’s hydropower, natural gas and coal resources, with stated plans to become South-east Asia’s leading producer of renewable energy.

Sarawak Energy’s sukuk (sharia-compliant bonds) musharakah bond programme, with up to RM15bn ($4.56bn) in issuance, has consistently received an “AA1/stable” rating from RAM, most recently in August 2014. In reaffirming the rating, RAM noted Sarawak Energy’s electricity transmission and distribution monopoly, strong state and federal support, and central role in the SCORE mega-project. Indeed, Sarawak Energy committed in November 2014 to invest up to RM25bn ($7.61bn) over the next 10 years to build two sizeable hydroelectric dams, three additional combined-cycle gas plants and a minimum of one more coal-fired plant in Sarawak.

Sarawak Energy’s CEO, Torstein Dale Sjotveit, told the local press that the bulk of the new investment would come from “internally generated funds”, but added that it was possible the group would expand its existing sukuk programme to finance the new investments, likely by 2017 or 2018, he added.

Looking at other energy sukuk issues, in September 2014 RAM reaffirmed the “AA2(s)/stable” rating on the RM215m ($65.4m) serial sukuk musharakah programme from Sarawak Power Generation (SPG). SPG operates as an independent power producer, and built, owns and runs a 317-MW combined-cycle gas turbine facility in Bintulu.

BANKS: Although there are no Sarawak state banks, several major national and international banks, and financial services firms have branches or otherwise operate in the state. These banks offer a full complement of consumer and commercial financial services to the businesses and people living in Sarawak.

Malaysia-based banks operating in the state include branches of the central bank, Malayan Bank (Maybank), Hong Leong, RHB Bank, Public Bank, AmBank and CIMB Bank, while HSBC, Standard Chartered, and the Bank of China are among the foreign banks with branches in the state. As of end-June 2014, the banks with the most branches are Maybank (24), Hong Leong (24) and RHB (23), according to the Association of Banks in Malaysia.

For their part, Islamic and conventional banks offering sharia-compliant financing tools include Kuwait Finance House, Al Rajhi Bank, Bank Islam, HSBC’s Amanah and Standard Chartered’s Saadiq.

BUDGET 2015: In his 2015 budget speech – the last of the current five-year Malaysia Plan period, with the next scheduled for launch in 2016 – Chief Minister Adenan Satem announced a budget surplus of RM365m ($111m), with RM5.2bn ($1.58bn) in revenue, citing stable growth of 5% in 2014 and projections that the state’s economy would continue apace in 2015. He added that the 2015 budget was both rural and development-focused, allocating some 71% for development and 29% as operating expenditure. Adenan also said that while the state’s cities were growing rapidly, its rural areas were not – creating a substantial rural-urban growth gap that he expected to be addressed in the upcoming Malaysia Plan. The chief minister also expects SCORE to drive Sarawak’s economic growth until 2030.

SME: All of this SCORE-related growth requires large infusions of inward investment, as the government only intends to finance 20%, or RM67bn ($20.38bn), of SCORE. Meanwhile, the remaining 80%, some RM267bn ($81.22bn), will need to come from private investors, particularly in power and industry, to reach the total required investment of RM334bn by 2030. At present, investment in SCORE totals around RM30.4bn ($9.25bn), with foreign players and smaller local firms taking up the challenges and opportunities available in the corridor. Japan has shown an especially strong interest in SCORE: 18 companies invested around RM15bn ($4.56bn) from 2010 to 2015, with a focus on energy projects.

With the assistance of larger firms, more small and medium-sized enterprises (SMEs) are springing up in the corridor, making SMEs an important source of investment in SCORE, as well as creating new needs and opportunities for financing. A total of RM8.28bn ($2.52bn) in investment was committed to Sarawak’s nearly 43,830 SMEs in 2013, a 75% year-on-year increase, according to Hamim Samuri, deputy minister of international trade and industry, with sector analysts projecting investment may have grown by a further 40% in 2014.

Underwriting much of this investment is the Credit Guarantee Corporation Malaysia (CGC), a state-run entity set up to support SME growth in the country. To mitigate the risks associated with SME lending, CGC guarantees loans, offers financing facilities, and operates a credit rating and information service through its subsidiary, Credit Bureau Malaysia. The credit bureau plays a vital role for SMEs trying to establish their credit records, which in turn creates a more hospitable environment for growth of the local financial services sector.

While the central bank, or Bank Negara Malaysia (BNM), is CGC’s majority shareholder, commercial banks like Standard Chartered, Alliance, RHB, Public Bank and OCBC are partners in the venture. In total, 17 commercial banks, 15 Islamic banks and seven development finance institutions participate in the CGC’s guarantee programmes, smoothing the way for extended growth of local and national SMEs.

BIG PICTURE: The backdrop to Sarawak’s financial services sector – and at times its safety net – is the greater Federation of Malaysia and the international investment community’s involvement therein. Although both Sarawak and Sabah have a degree of fiscal autonomy in terms of levying taxes and tariffs, the state’s fortunes are bound up with those of the rest of the nation, especially the financial and economic powerhouse that is Kuala Lumpur. In short, events in the wider Malaysian financial sector have powerful ripple effects in Sarawak.

CASE IN POINT: Established within the Treasury in 2013 and supported by the Fiscal Policy Office (part of the Ministry of Finance), the executive-level Fiscal Policy Committee (FPC) was created to guide and reinforce the country’s fiscal policy and long-term economic stability. During its tenure, the FPC has announced new fiscal deficit targets, changes to fuel and electricity subsidies, and the prioritisation of public-sector projects – all of which have an effect on the state’s economy and financial sector.

Thus far, the FPC appears to be performing well. According to the BNM’s 2014 annual report, structural reforms have been bolstered by the country’s resilient financial system – both of which have helped put Malaysia in a position to better manage the volatile international environment going forward.

The country’s economy expanded by 6% in 2014, up from 4.7% in 2013, largely thanks to robust domestic demand and a marked improvement in the country’s net exports position, which was in the black for the first time in seven years. Private consumption expanded by 7.1% over the year, while public consumption grew at a much slower pace of 4.4%. Private investment, meanwhile, was up 11% in 2014, below the annual average of 15% since 2010, while public investment shrunk by 4.9% over the period.

Inflation saw an increase in 2014, from 2.1% in 2013 to 3.2% in 2014, with the inflationary effect of adjustments on price-controlled items somewhat offset by lower oil prices late in the year.

BANKING HEALTH: In third-quarter 2014, the common equity tier 1 (12.8%), tier 1 (13.5%) and total capital ratios of the country’s banks (15.5%) far exceeded the minimum regulatory levels. The large share of high quality capital – 80% of the banks’ total – was largely thanks to strong levels of paidup capital, retained earnings and reserves, the report noted. The banks’ total capital buffers totalled over RM90bn ($27.38bn). For insurers in particular, the capital adequacy ratio stood at 246.9%, with a RM24.4bn ($7.42bn) excess capital buffer.

At of the end of February 2015, the central bank’s foreign reserves came to RM386bn ($117.42bn), equivalent to 1.1 times the country’s short-term external debt and good for 7.9 months of import cover. Reserves were down by more than 12.5% since end-2013 due to large oscillations in portfolio flows and the decline of the ringgit, which was down 6.1% again the dollar in 2014. This depreciation is in line with the trend observed in emerging markets over the year, mirroring a stronger dollar and market expectations of an interest rate hike by the US Federal Reserve in the near term.

Malaysia’s current account surplus was up 24.1% over 2013, at RM49.5bn ($15.1bn), equivalent to 4.8% of GNI, compared to 4.2% the previous year. According to the BNM’s annual report, the country’s financial account recorded a RM76.5bn ($23.2bn) net outflow on weaker investor sentiment stemming from lower oil prices and US interest rate expectations – a familiar theme in 2014.

The cost of borrowing increased over the year, with the average overnight interbank rate hiked by 22 basis points in July 2014, to 3.22%, on the heels of the Monetary Policy Committee’s increase of the overnight policy rate (OPR) to 3.25%. Longer maturity rates were also up on the year. While markets were expecting another increase in the OPR in the second half of the year, this did not come to bear.

On a household level, the cost of borrowing saw a corresponding increase over the year, up 25 basis points to 6.79%. Retail deposit rates also rose, with the average commercial bank fixed deposit rate for 1- to 12-month tenures increasing from 3.07% to 3.30%, as of the end of July. While corporate lending rates were also higher on the year, interbank competition helped to temper the increase.

Although borrowing became more costly in 2014, the BNM has maintained that lending rates are lower than before the global financial crisis. Indeed, at end-2006 and end-2007, overnight interbank rates stood at 3.5% and 3.49%, respectively. The BNM holds the view that the country’s financial house is – in general – both in order and on track to achieve many of the nation’s short- to medium-term goals.

GLOBAL PERSEPCTIVE: In a March 2014 country report, the IMF highlighted the apparent consolidation strategy being followed by federal authorities – a strategy that includes reducing the country’s fiscal deficit to 4% of GDP in 2013, 3% by 2015 and to zero by 2020. According to IMF calculations, this would result in a debt-to-GDP ratio of 40%, down from the 69.6% reported by the BNM at end-2014.

These benchmarks have prompted restructuring on the part of the government in the form of subsidy cuts, entitlement reforms and the introduction of a 6% goods and services tax, slated to replace the current sales and services tax in April 2015.

OUTLOOK: As Sarawak’s many economic projects get under way in earnest, the state’s economy is seeing unprecedented levels of inward and domestic investment. This is an extremely positive development for the country as a whole because many of the goals of Malaysia’s long-term development plan, the Economic Transformation Programme (ETP), are related to power and energy generation in Sarawak. And with the federal government relying so heavily on private investors to fund the bulk of the ETP projects planned for Sarawak, there will be a major demand for project financing. As a result, finance-related activity in Sarawak is likely to grow in both importance and intensity as 2020 draws nearer. It is crucial for the state and the country that additional inward investment comes to bear in the near term.

However, as the chief minister has made clear, the state’s rising tide of economic prosperity must lift all boats. The 2015 budget is meant to address and assist the citizens who have been left behind as the state has leap-frogged from its former status as an underdeveloped, rural state to a promising economic and industrial hub for Malaysia and the greater South-east Asian area. Financing for SMEs will therefore be a major part of ensuring greater equity (see analysis). While a great deal of work remains to be done in order for Sarawak to make good on its promise of development for everyone in the state, its increased visibility and popularity among investors and financiers, both domestic and international, is a sure sign that it is headed in the right direction.