The storm sweeping over emerging markets has hit Malaysia at an especially fraught moment, with Prime Minister Najib Abdul Razak embroiled in a US$700 million funding scandal. The country’s economic difficulties are bad enough by themselves. The political turmoil makes them all the harder to deal with.

Najib denies accusations that almost US$700 million found its way from a state investment fund into his private accounts, and Malaysia's anti-corruption commission has declared that the money represents donations from anonymous Middle Eastern sources. This explanation failed to satisfy the thousands of protesters who took to the streets of Kuala Lumpur last month to demand Najib’s ouster.

Leaders of the ruling United Malays National Organisation (Umno), which has governed the country since independence in 1957 and has long prized loyalty over accountability, will certainly support Najib when they meet today. But they need to ask themselves whether maintaining the political status quo is worth the continuing damage to Malaysia’s financial reputation and prospects for growth.

China’s slowdown and plunging oil prices - Malaysia derives 22 percent of its income from oil-related sources - have hammered the ringgit, which has fallen for 11 weeks running. The currency stands near lows last reached during the 1997 financial crisis. The central bank has spent almost a fifth of its reserves trying to halt the slide. Although a full-scale crisis may not be imminent, the country is among the most vulnerable in Asia to a rise in US interest rates.

The situation requires a government that commands trust. Yet while Swiss authorities have started a criminal investigation into the fund, Najib has stalled a domestic probe by removing the attorney general and reassigning four members of a committee coordinating the inquiry.

He has dismissed as unpatriotic the crowds of largely Chinese and Indian protesters urging him to step down. Such efforts at damage control risk further undermining the credibility of Malaysia's institutions and polarising its racially mixed society.

Foreign investors are watching. Ratings company Fitch has so far maintained its A- sovereign rating, noting that “weak governance is already factored” into its judgment. The country’s anti-corruption commission “lacks genuine independence”, according to Transparency International, and the prime minister has too much influence over the appointment of judges.

Weak campaign-finance laws leave too much scope for political patronage. Parties can spend freely between elections and don’t have to account for contributions. An anonymous US$700 million donation wouldn’t, in itself, be illegal.

Politically challenging

If Umno now chooses to bolster its support by pandering to its rural Malay base, pro-growth economic policy may be sidelined. Powerful government-linked companies are stifling innovation and crowding out private investment. Reform is needed, but it’s politically challenging. Najib once promised to roll back government policies favouring Malays. That no longer looks feasible. A brain drain of able minorities is likely to continue.

Indeed, the greatest danger is that growing racial and religious polarisation might fracture Malaysia's multiethnic society. Some Umno leaders have flirted with the Pan-Malaysian Islamic Party (PAS), which favors the imposition of Sharia law. Even normally circumspect neighbours are worried.

It looks unlikely that Najib will subject himself to a truly independent and transparent investigation. US President Barack Obama, who is scheduled to visit Malaysia for a regional summit this fall, may be able to exert some quiet pressure. But ultimately, Umno leaders will have to choose: What kind of Malaysia are they trying to build?

- Bloomberg

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