By Giulia Zino
Forbes
7/21/2015

SINGAPORE – Malaysia has generated a considerable volume of negative press coverage over the past year, but none as eye-catching as the recent scandals surrounding controversial debt-ridden sovereign investment company 1Malaysia Development Berhad (1MDB). After brewing for months, the 1MDB saga took a startling turn on July 2 when the Wall Street Journal published details of leaked bank documents, apparently showing that nearly $700m had been channelled through the investment company and directly into the personal accounts of Prime Minister Najib Razak.

Najib established 1MDB in 2009 with the visionary aim of facilitating investment and trade with the Middle East, and of developing a new financial district in Kuala Lumpur. Najib chairs 1MDB’s board and also heads the Ministry of Finance, which fully owns the company. 1MDB has collected a portfolio of 16 power and desalination plants in Asia and the Middle East and launched two ambitious, high-profile real estate developments in downtown Kuala Lumpur, accumulating debts of MYR 42bn ($11bn) along the way. Critics have centred on the company’s auditing problems: particularly MYR 8.24bn ($2.17bn) allegedly hidden somewhere in the Cayman Islands, its bond issuance program, and allegations that it has overpaid for its Malaysian power assets, essentially bailing out politically connected independent power producers.

The July 2 report dealt a huge blow for the ruling party, the United Malays National Organisation (UMNO), and brought to a head a long-brewing struggle within the party to oust the prime minister. Conservative circles surrounding former prime minister and UMNO kingmaker Mahathir Mohamad have relentlessly tried to eject Najib, whose weakness and unpopularity they view as extremely detrimental for the party’s survival. Najib appears far too compromised to see the end of his term in 2018, even if the multiple ongoing investigations do not directly implicate him in wrongdoings within 1MDB.

The most tangible impact of Najib’s removal would be felt in the cabinet, the bureaucracy, and government-linked and state-owned companies, where some personnel changes would be all but inevitable. The local business community would also see some victims Deputy Prime Minister Muhyiddin Yassin is Najib’s likeliest successor, and would almost surely sideline tycoons close to the prime minister (and his formidable and highly unpopular wife Rosmah Mansor) in favor of his own cronies. This is a concern for foreign businesses in Malaysia, as most rely on their local partners’ or agents’ political connections.

Otherwise, it will very much be business as usual in Malaysia. Muhyiddin is known to harbor markedly more nationalist and pro-ethnic Malay views than Najib, but UMNO as a whole is a pragmatic party that would be unlikely to depart from the current administration’s pro-business and pro-FDI stance. However, some of Najib’s pet projects and initiatives – particularly his flagship Economic Transformation Programme (ETP) – would be quietly shelved under a conservative leadership.

The 1MDB scandals are greatly distracting the government from broader economic problems. Malaysia has been the biggest loser in Asia Pacific from lower global prices for oil and particularly natural gas, and is grappling with high government debt, a large fiscal deficit, Asia’s highest household debt and one of its worst-performing currencies. The government has ambitious plans to transform Malaysia into a developed, high-income nation by 2020 — a vision that dates back to the Mahathir years—but the plan appears overly optimistic and the numbers do not add up.

Also at stake are the reputations of the otherwise respected Bank Negara (the central bank) and some of the larger domestic banks. They have come under fire for failing to notice or facilitating suspiciously high transactions and transfers in Najib’s accounts.

Social unrest remains a real possibility — especially if the public feels the investigation into Najib and 1MDB is inadequate. The influential Coalition for Free and Fair Elections (Bersih) has threatened a fourth wave of protests if Najib does not step down; previous Bersih rallies regularly ended in violence.

Perhaps more worryingly, the heated political climate increases the scope for religiously or ethnically motivated acts of violence, like the riots earlier this month in the Bukit Bintang neighbourhood of Kuala Lumpur. UMNO has increasingly nurtured a siege mentality and presented the party as the only true protector of Malay interests, worsening communal tensions. UMNO’s strategy requires the preservation of an image of external threats. These threats can be domestic, such as other religious and ethnic groups, or they can be foreign, such as the influence of Western culture. One effect of the latter is the potential for boycotts against products from Western countries perceived to have acted disrespectfully toward Islam.

An increasingly conservative society has also become a breeding ground for radical Islamist groups and individuals. Police have arrested at least 107 terrorist suspects, most with no previous record of involvement in terrorism-related activities, making it difficult for authorities to anticipate or prevent one-off attacks. A terrorist attack would have the potential to cause significant public alarm in a country that is relatively unaccustomed to terrorist violence.

The 1MDB scandal, combined with all of the contingent challenges that it affects, puts in sharp relief the fundamental challenge facing Malaysia’s leaders. The image the country is keen to portray to the outside world—that of a modern, moderate and multi-ethnic country — is increasingly losing credibility.

Guilia Zino is a senior analyst for Southeast Asia at Control Risks, the global risk consultancy. For more analysis, sign up for a free trial of our risk monitoring services.