A Malaysian State's Suspect Investment Fund

Sovereign credit rating downgrades usually come long after a government starts a journey down a slippery slope of debt or sleaze. So those thinking about Malaysia's medium to long term credit health should be sending up red flares over the Terengganu state government's effort to borrow RM10 billion (US$2.87 billion) to start a so-called sovereign wealth fund, the Terengganu Investment Authority.

When the fund was announced late last year, it seemed more a curiosity than anything. In principle of course it is a good idea for states, be they sovereign or not (as in the Terengganu case) to set aside windfall revenues from oil and other commodity bonanzas to create an income flow for the time when such revenues can no longer support the state's residents, or at least politicians, in the style to which it has become accustomed.

However, Terengganu seems to be establishing a world first in creating a fund based on borrowed money. Should it not be called a debt fund not a wealth fund? Or maybe a new form of state slush fund.

There is merit in siphoning off some of today's windfall revenue into a fund for future use – but only if it is administered by conservative managers wholly independent of the political system. Is that really likely? If this were just a problem for the citizens of Terengganu, the rest of Malaysia and the world could treat it as an amusing little curiosity. But the federal government has bought into the idea of guaranteeing a RM5 billion Islamic bond offered to foreign investors. In addition a similar size bond is to be issued, secured on Terengganu's future oil revenues.

It is doubly alarming. Firstly there seems no good reason why a state which already has massive oil revenues – RM5-7 billion a year according to estimates – should want to borrow to create a fund with vague investment goals, rather than gradually accumulate a fund from excess annual revenues. Given the history of politically connected financial and investment institutions in Malaysia, particularly those at state level, it can easily become a slush fund to support the projects of UMNO cronies. Or it can be used to bail out failed projects whether at state or national level. In return for this high risk, the federal government will get just 10 percent of the Terengganu Investment Authority profits (if any).

Secondly, if the federal government is to guarantee such massive loans to states for ill-defined purposes, where will it end? Surely every other state can dream up some scheme to borrow in this way, opening the way for massive expansion in the federal government's contingent liabilities.

Caveat emptor.