Malaysia's public finances are a weakness relative to rating peers and offer limited scope for counter-cyclical fiscal stimulus at the current rating level of 'A-'/Stable, Fitch Ratings believes.

While this has not hindered the public sector's capacity to contribute to GDP, which grew 5.2% year-on-year in the third quarter according to Bank Negara Malaysia on Friday, the growing provision of guarantees to government-linked borrowers is concerning.

Domestic demand continued to support economic growth in the face of a weak external demand. While private consumption and investment are increasing, public-sector linked activity remains a key support.

Public consumption moderated in Q3 this year, posting a 2.3% year-on-year increase (down from 10.9% in Q2 2012), while public sector gross fixed capital formation increased 22.4% year-on-year, following a 28.9% increase in Q2.

With a general election due in the first half of 2013, government and government-linked activity is expected to remain a significant contributor to growth.

Greater drawdown of existing federal government guarantees of debt issued by public sector enterprises suggests increasing use of quasi-fiscal policy to support economic activity and may apply further pressure on the sovereign credit profile.

The value of outstanding debt guaranteed by the Malaysian federal government has increased by RM23.4 billion (US$7.6 billion), or 20%, between December 2011 and September 2012.

Such debt is now equivalent to 15% of GDP compared with 9% at end-2008, and suggests a growing contingent liability on the sovereign.

Given Malaysia's lack of fiscal headroom, the increasing reliance on off-balance sheet funding could potentially call into question the meaningfulness of the 55% of GDP federal debt ceiling (debt/GDP had risen to 52.4% at end-Q3 2012).

These concerns, coupled with the need for structural reform of the public finances and a credible plan for fiscal consolidation, suggest that Malaysia's public finances will remain a weakness versus ratings peers, as has been the case for some time.

As Fitch warned when we reviewed the ratings in August 2012, fiscal trends may eventually lead to some form of negative rating action. Other areas of the credit profile including the external finances and level of foreign reserves (US$138 billion) remain strengths.

However, foreign holdings of government debt have continued to increase and now represent nearly 50% of Malaysia's foreign exchange reserves, up from 36% at end-2011.

Fitch looks to see how economic and fiscal policies develop following the elections.

- Reuters