The 1Malaysia Development Berhad scandal has raised investors' concerns and left Malaysia with what one fund manager describes as “astronomical” reputational risk. As the scandal at the state fund rumbles on and international authorities probe allegations of corruption, investors are assessing the damage done to Malaysia's reputation with foreign investors.

Sadly, the authorities have not shown much determination to put an end to the debacle. Last week 1MDB’s board of directors was forced to resign and Najib Razak, Malaysia’s prime minister and finance minister, had his power over 1MDB curbed, but not removed. This has done nothing for the fund’s credibility. 

The controversial Article 117 of 1MDB's memorandum and articles of association – which requires the premier's written approval for all of the fund's financial commitments – has been removed. Yet power has simply transferred from the prime minister to the finance minister - a title also held by Najib, meaning it is still his duty to appoint the new board.

Najib told a Credit Suisse investment conference back in 2010 that his government aimed to make Malaysia “a wealthy and fully-developed country by 2020”. That ambition is now in tatters as international investors are aware of how far the nation still has to go to rid itself of corruption at the highest level.

Foreigners will still invest in commercial opportunities in the private sector, but the largest foreign players, especially the global sovereign wealth funds, are likely to hold back or cut down dealings with the existing government.

Net portfolio investment in Malaysia ebbed and flowed during 2015, according to the country's balance-of-payment numbers. It was RM24.5 billion in the third quarter, but rebounded in Q4, increasing by RM16 billion. Foreign direct investment in Malaysia showed a net inflow of RM12.5 billion in Q4 2015, higher than the RM4.7 billion in Q3. In addition, domestic mutual fund sales have been suffering.

A Singapore-based fund executive told AsianInvestor that foreign investors will always view Malaysia with a wary eye, and they are right to do so.

Pre-1998 Malaysia was on its way to becoming a developed economy, but post-1998, former prime minister Mahathir Mohamad’s policies, including the freezing of foreign assets, ensured that Malaysia would struggle to achieve developed-market status for decades. Najib is just a continuation of the same political and economic corruption.

Bad governance will often have a negative impact on macro factors, noted Jakob Nilsson, Asia head of business development at Hermes Fund Managers in Singapore. He cited scams that took place in India during 2008-2014, and more recently Brazil, where political turmoil has preceded a recession.

In turn, negative political developments will affect asset allocation sentiment, added Nilsson. In all the instances cited, he said, foreign institutional investment flows were affected. "However, the flows have returned in most cases when situation has stabilised, or there were signs that the worst is over."

It would seem to be in the authorities' interest to draw a line under the scandal – something they have patently failed to do so far.

1MDB hit global headlines last July amid revelations that nearly $700 million had been transferred to the prime minister’s personal bank account from the Saudi Arabian royal family. In January, an investigation by the Malaysian attorney general’s office said it had found no evidence of wrongdoing by Najib.

1MDB is alleged to have been a vehicle to funnel money to politically connected individuals. Authorities in Singapore reportedly confirmed in February they had frozen “a large number” of accounts in Hong Kong, in connection with possible money laundering related to the 1MDB probe.

Yet even if the money paid out did lead back to the state fund, “there is absolutely no amount of evidence that can be produced to unseat Najib”, the Singapore fund manager told AsianInvestor.

“As Mahathir demonstrated during the Asian financial crisis [in 1997/1998], it’s fairly easy to blame hostile foreign intervention in domestic politics, so Najib will definitely draw upon this card when the time comes.”

Mahathir spoke out again last week on the matter of 1MDB, suggesting that any defaults by the fund would negatively affect Malaysia’s creditworthiness.

1MDB reportedly missed a $50 million interest payment on a $1.75 billion bond last week amid a dispute with Abu Dhabi’s sovereign wealth fund over who is required to make the payment. The move triggered a cross default on a RM5 billion 5.75% local-currency bond due in 2039 and RM2.4 billion of notes due to mature as early as 2021 that were issued by 1MDB project Bandar Malaysia, reported Bloomberg.

Rating agency Moody’s said the default increased the probability that contingent liabilities, particularly through cross-defaults and an associated indemnity, would crystallise on Malaysia’s public balance sheet, as “a credit negative for the sovereign”. Moody’s current outlook on Malaysia’s A3 sovereign rating is ‘stable’.

Compared with its Asia-Pacific peers, Malaysia's internal governance rating lags only Australia, New Zealand and Singapore. But concerns surrounding financial distress at 1MDB point to a weaker institutional framework than is implied by its relatively strong showing in the world govenance index.

The local investment community is naturally embarrassed by the 1MDB debacle, and senior executives in Malaysia refused to be drawn on the subject.