Scandal Surrounding Sovereign Fund 1MDB Shakes Malaysian Government

For years Malaysia has locked horns with international agencies and investors over its economic policies, most notably during the Asian financial crisis in the late 1990s, when the government spurned the advice of the International Monetary Fund and imposed capital controls to defend its currency. But the country’s decision to createsovereign wealth fundsto harness national savings and promote development has long been seen as a plus for the economy.

Now a reassessment is in order because of the growing controversy surrounding 1Malaysia Development Berhad. Over the past five years, the Kuala Lumpur–based sovereign fund, known as 1MDB, has run up $12 billion in debt amid allegations of financial mismanagement. The controversy reached the highest corridors of power in late June, when local media and theWall Street Journalreported that the fund had sent nearly $700 million to the bank accounts of Prime Minister Najib Razak. Najib denies taking any money for “personal gain,” and a government watchdog agency has declared that the deposits, made shortly before the 2013 parliamentary elections, were donations. But the affair continues to haunt the government, with former prime minister Mahathir Mohamad, longtime leader of the ruling United Malays National Organization party, calling openly for Najib’s resignation.

The political uproar has unsettled markets and depressed the ringgit to a record low. The currency has fallen by nearly 17 percent this year, to 4.20 to the dollar. The decline accelerated in August after Bank Negara Malaysia let the currency break through 3.80 to the dollar — a level it had defended stoutly, and at great cost, during and after the Asian financial crisis. The central bank abandoned the peg after seeing its reserves drop by nearly a third since mid-2013, to $91.5 billion.

“1MDB scandal shines a light on the deep-seated institutional failings that are holding back Malaysia’s long-term development,” says Krystal Tan, economist for Capital Economics in Singapore. “If Malaysia is to achieve its potential, its institutions need a shaking up and cleaning out.”

New disclosures and allegations continue to emerge in the affair. Earlier this month, the Wall Street Journal reported that a $1.4 billion collateral payment that 1MDB claimed to have made to a subsidiary of International Petroleum Investment Co., a state investment vehicle in Abu Dhabi, as part of a 2012 power plant co-investment deal, was never received by the Abu Dhabi entity. In Hong Kong, meanwhile, police reportedly launched an investigation into more than $250 million in deposits made to a Swiss bank account from companies allegedly linked to Najib following a complaint from a former member of the prime minister’s UMNO party. A Malaysian government spokesman dismissed the allegations as “baseless and politically motivated lies.”

The 1MDB scandal erupted at a time when Malaysia’s economy was already reeling from the crashing price of oil, one of the country’s key exports, and struggling to break out of the so-called middle-income trap and join wealthy Asian countries like Singapore and South Korea. “On one front, dependence on oil revenue and external factors are driving capital outflows and weakening the ringgit,” says Ambika Ahuja, an analyst at Eurasia Group. “On the other front, the 1MDB scandal and political uncertainties are attracting unwanted attention to its structural problems, like export competitiveness, fiscal position and accountability of state firms.”The affair also comes against the backdrop of an increasingly unsettled political atmosphere. Najib carried the UMNO-led Barisan Nasional coalition to victory in the 2013 parliamentary election despite losing the popular vote by a margin of nearly 7 percentage points, thanks to BN’s strength in rural areas, which are overrepresented in Parliament. It was the worst performance ever by a party that has governed Malaysia since it won independence from the U.K. in 1957.

Najib reshuffled his government in July and removed several key players who had either investigated or criticized 1MDB, including his deputy prime minister and the attorney general, but the affair continues to overshadow the government. Switzerland’s Office of the Attorney General announced in late August that it had opened a criminal investigation into suspected corruption and money laundering involving banking transactions with 1MDB. Clare Rewcastle Brown, sister-in-law of former U.K. prime minister Gordon Brown, has published documents allegedly detailing the payments to Najib’s accounts on her website,Sarawak Report; she has turned over material to U.K. regulators, as have Mahathir’s aides.

“It may be difficult for Najib to control what regulators around the world do or what they reveal,” says Lim Kit Siang, leader of the opposition Democratic Action Party.

It also may be difficult to control the scandal at home. In late August the Malaysian Anti-Corruption Commission said it was seeking to question three men, including Low Taek Jho, a flamboyant businessman and confidant of the prime minister, who had persuaded Najib to establish 1MDB. The tabloid atmosphere of the case is such that Low is popularly known as “Jho Low” — a riff on Jennifer Lopez’s nickname J.Lo.

Malaysia’ main sovereign wealth fund, Khazanah Nasional, was created by Mahathir in 1994 as a holding company for state-owned assets, with the mission of investing in strategic sectors. It has grown into a diversified fund with net assets of 110.7 billion ringgit ($26.4 billion).

Najib established 1MDB in 2009 with the stated aims of promoting development of Malaysia’s energy, real estate and power sectors, and attracting investment from Middle Eastern sovereign wealth funds. The government injected a token RM1 million (then $284,000); 1MDB would finance its investments with debt.

The fund went on to borrow nearly $12 billion to acquire 16 power plants around the world. Its power-generation subsidiary, Edra Global Energy, is the third-largest power producer in Malaysia, with a 17 percent market share; it also owns plants in Bangladesh, Egypt, Pakistan and the United Arab Emirates. 1MDB also invested in a variety of other interests, including a joint venture with PetroSaudi International, a private, Riyadh-based oil exploration and production company.

当投资未能产生足够的cah flow to service the fund’s debts, 1MDB acquired prime real estate in Malaysia from the government at big discounts, then revalued the properties to record outsize paper profits. The purchases included a 70-acre plot in Kuala Lumpur that the fund proposes to develop as a financial district named after Najib’s father, Tun Abdul Razak, who was Malaysia’s second prime minister, from 1970 to 1976.

Goldman Sachs Group played a key role in the fund’s rise, arranging three private placement bond deals worth a combined $6.5 billion in 2012 and 2013, and earning an estimated $590 million in fees, according to published reports. Goldman said its fees reflected the complexity of the transactions, but the deals have raised eyebrows. “What investment banks can charge for arranging bonds depends on the complexity of the whole deal and the total package they bring to the table, but 9 percent is a lot by any measure,” says one banker with a global investment bank. Officials from the anticorruption commission visited Goldman’s Kuala Lumpur office seeking documents related to 1MDB; the firm said it would cooperate with the authorities.

Investigators probing the 1MDB affair are focusing on three issues: the fund’s joint venture with PetroSaudi; its $2.3 billion investment in a Cayman Islands fund managed by Bridge Partners, an obscure Hong Kong asset manager; and the deposits into Najib’s accounts. Those deposits include $682 million from what investigators have said is a Middle Eastern source and RM42 million from SRC International, an outfit that was spun out of 1MDB and taken over by the Ministry of Finance, which Najib heads in addition to serving as prime minister.

In the Saudi case, 1MDB contributed $1.83 billion to the oil exploration venture, and PetroSaudi was supposed to put in oil assets worth $1.5 billion. PetroSaudi was unable to acquire the assets, and the venture was terminated, but 1MDB never got its money back.

There is a similar dearth of information on 1MDB’s Cayman Islands investment. The fund initially said it was redeeming the investment to ease its financial strain, then it said the money was invested in a fund believed to be the Bridge Global Absolute Return Fund; it finally said the money was tied up in illiquid level-three assets that could not be valued.

Since an effort to raise $3 billion with an IPO of Edra Global Energy failed last year, 1MDB president Arul Kanda Kandasamy has been seeking to sell power plants and property to reduce the fund’s debt burden. Only state-controlled Malaysian firms are likely to pay the premiums required to keep 1MDB afloat, says Manu Bhaskaran, CEO of Centennial Asia Advisors, the Singapore arm of Washington-based strategic advisory firm Centennial Group.

In May the state-run Pilgrims Fund, which helps Muslims finance trips to Mecca, bought a parcel of land from 1MDB for a price more than 42 times what the sovereign fund had paid just a few years ago. Similar land purchases have been made recently by Affin Bank, which is controlled by the armed forces pension fund, and by civil-service retirement fund Kumpulan Wang Persaraan. The fund, known as KWAP. also lent 4 billion ringgit to SRC International when it was owned by 1MDB, and has invested 1.4 billion ringgit in 1MDB bonds and subsidiaries. The country’s largest pension fund, Employees Provident Fund, has 1.7 billion ringgit invested in 1MDB bonds and subsidiaries.

Critics including Mahathir say the support efforts are merely spreading 1MDB’s woes. “It is a bunch of incestuous deals,” says opposition leader Lim. “Government funds are helping out other government funds in distress and getting into trouble themselves.”

It’s not just the spread of financial distress that worries Centennial’s Bhaskaran. Malaysia’s “saving grace,” he says, has been well-run institutions like Khazanah, Bank Negara and state-owned oil company Petroliam Nasional. “Without reforms in the overall system,” he warns, “even these good institutions might one day be compromised.” •

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