KUALA LUMPUR (BLOOMBERG) - The escalating scandal around troubled state investment fund 1MDB is turning bond funds against Malaysia.

The disclosure that the nation's debt is almost 60 per cent higher than previous estimates at RM1 trillion (S$338 billion), largely because of hidden liabilities tied to the troubled state investment fund, is convincing even fans of the country's bonds to cut their holdings.

Throw in the removal of a goods and services tax last month, and Prime Minister Mahathir Mohamad's new government faces an increasing fiscal squeeze.

"Uncertainty over how the fiscal deficit will pan out will overhang," said Wilfred Wee, a fund manager in Singapore at Investec Asset Management, which oversees US$146 billion (S$197 billion).

"Until the dust settles, we have reduced our still overweight exposure to Malaysia, recognising that Malaysia's current account and overall fundamentals remain by and large still attractive versus peers."

A one-off crystallising of 1MDB's debt and writing off its assets may cost almost 3 per cent of gross domestic product, Wee said.

Rating agencies are likely to downgrade Malaysia sooner rather than later if its fiscal health deteriorates significantly due to liabilities arising from 1MDB, Brown Brothers Harriman said in a report this month.

ALLEGED EMBEZZLEMENT

1Malaysia Development Berhad took shape in 2009 under former prime minister Najib Razak as a vehicle to drive investment into Malaysia and boost its assets abroad.

Plagued by heavy debt and questions about its management and investment decisions, the fund became a scandal that culminated in global probes into alleged embezzlement and money laundering.

Related Story 1MDB controversy: Legal eagles hired by parties involved

Related Story Malaysia government plans to demand return of 1MDB money from banks, political parties

After the opposition's shock election victory last month, new Finance Minister Lim Guan Eng revealed that government debt and liabilities had jumped to RM1.087 trillion, inflated by state guarantees for borrowing at 1MDB. That compares with the federal debt of RM685 billion estimated by the Ministry of Finance in 2017.

Markets were spooked by the disclosure, with the ringgit sliding to a five-month low and overseas ownership of the nation's bonds dropping to the lowest since August. Global funds sold almost RM10 billion of Malaysia's sovereign debt in May, the most since March 2017.

"We hold a cautious view on Malaysia due to fiscal and political uncertainty, potential negative ratings action and uninspiring valuations," said Roland Mieth, emerging markets portfolio manager in Singapore at Pacific Investment Management, which oversees US$1.77 trillion.

"The replacement of GST with service and sales taxes adds uncertainty to Malaysia's fiscal trajectory."

Concerns about the country's worsening debt levels are overdone, according to GAM (UK).

The government remains on track to meet its 2018 budget deficit target of 2.8 per cent of GDP and the economy is growing fast enough to ensure the debt-to-GDP ratio will gradually decline, said Michael Biggs, emerging-market fixed-income investment manager in London at GAM, which oversees the equivalent of US$165 billion.

"We have a modest overweight on Malaysian government bonds," he said. "Inflation has remained contained, Malaysia's balance of payments appear solid, foreign reserves are rising, and both real and nominal yields are at attractive levels."

BNY Mellon Investment Management believes bond supply may need to increase to compensate for a decline in revenue caused by the removal of the goods and services tax.

"We would prefer to not be heavily exposed to Malaysian bonds until the fiscal uncertainty abates," said Aninda Mitra, senior sovereign analyst at the company in Singapore.

"On many metrics the ringgit remains a relatively cheap currency to own. But, we are likely to see a prolonged tussle between policy uncertainty and a broader loss of confidence, which could overwhelm any lingering perception of value."