Will MGS Withdrawal Continue its Momentum?

What is happening?

Malaysia’s capital account saw an appreciable capital flight in July and August amid concerns over the performance of domestic investments. In August, foreign holdings of Malaysian Government Securities (MGS) outstanding registered a decline (in absolute terms) of 2.53% at 45.99% compared with 48.51% in June 2015 – see Chart 1. Consequent to the withdrawal, MGS indicative yield at longer maturities were notably affected, reflecting a dip in the securities’ quotes – see Table 1.

Chart 1

Table 1

Causes of the withdrawal

Empirically, when the selling frenzy in MGS kicked off during the 07-08 subprime meltdown, USD/MYR skyrocketed 16.2% from April 2008 to March 2009 – represented by a divergence highlighted in Chart 1. In 2015, foreign holdings of MGS has nonetheless remained relatively still as USD/MYR spiked owing to the fact that the underlying causes of the recent spike this time were fueled by factors other than MGS withdrawal. These factors, inter alia, can be attributed to [1] a slump in one of Malaysia’s primary exports (crude petroleum and its byproducts); [2] yuan devaluation; [3] risk of faster-than-expected rate hikes in US; and [4] domestic political instability.

Chart 2

In all brevity, foreign investors are skeptical about the performance of Malaysia’s financial assets. Domestically, crude oil related revenue constitutes about 30% of federal government revenue – see Table 2. When crude oil price nosedived more than 50% last year, Ringgit ran into a massive selling spree on the back of an atrocious trade outlook.

Table 2

Presently, drillers are suffering from sluggish job flows while oil producers get hit by lackluster refinery inputs. In Chart 3, the strong correlation between MYR and crude oil price precisely elucidates the significance of crude oil receipts as a determinant of the value of MYR. Notwithstanding the support from government, which ate up more than 25% of Malaysia’s international reserves, MYR depreciated more than 20% against USD over a year and has subsequently become the worst-performing currency in Asia. From our field research, some money changers currently refuse to accept MYR while most quote an exorbitant spread.

Chart 3

Adding fuel to the fire, the People’s Bank of China (PBOC) has in August trimmed the reference rate for yuan against US dollar (USD) by 1.9% and 1.6% in two consecutive days – a move that instigated a currency war among export-oriented countries. Subsequent to the move, MYR continued to extend losses thereon against net importers such as the US. On the bright side, the situation is somewhat dissimilar to that of the Asian Financial Crisis 1997 during which most public sector and private sector debts were denominated in dollars, euro and yen. At present, most of the federal government’s debts (>90%) are Ringgit-denominated. Nevertheless, the latest Bank Negara Malaysia (BNM) annual report shows that more than half of total external debts (public + private) were denominated in foreign currency, plenty of which are parked short-term on banks’ balance sheet. The situation intensifies the risk of defaults or profit shrinking in the private sector which can potentially lower Malaysia’s credit rating. Such a downgrade would signify further withdrawals of foreign investments and extends the decline in the value of MYR.

In US, the likelihood of a rate hike also fuels worries about the attractiveness of Malaysia’s fixed income (FI) securities. Post last week’s Federal Open Market Committee (FOMC) meeting, Janet Yellen reiterated her stance that the central bank is on its track to lift the federal funds rate (Fed rate). The move, should it materialise, would raise question as to whether or not Malaysia still offers sufficient country risk premium (CRP).

Externality aside, foreigners are to a great extent concerned about Malaysia’s political stability no thanks to the notorious scandal in 1Malaysia Development Berhad (1MDB).  To recapitulate, it was claimed by Wall Street Journal (WSJ) earlier this year that some RM2.6 billion of 1MDB funds were allegedly transferred to the Prime Minister Datuk Seri Najib Tun Razak’s personal account. In an effort to refute denials by Najib, WSJ also released documents detailing the channeling of funds.

What to expect?

Now, is the sell-off of MGS experiencing a lag effect or is the surge of USD/MYR merely a knee-jerk? Currently, nearly half of the MGS are held in foreigners’ hands compared with more than 90% domestically owned in the past decade. In light of that, it is deducible that the current situation provides enormous room and grounds for a capital flight. In an environment with eroded investors’ confidence, matured investments being diverted to safe havens such as Australia is in the cards. So at the very least, monitoring the upcoming maturities of MGS is imperative to identify potential points of capital outflow. At present, about 10% or RM60 billion worth of federal government debt will be maturing in 1 year or less – see Table 3.

Table 3

In view of that, we expect the withdrawal to continue its momentum upon redemptions of matured securities, especially in the event of a steep Ringgit retracement.

Many believe the currency adjustment exercise in China was not a one-off event despite a promise made by President Xi Jinping pledging to halt further devaluations. According to a report from IDEAglobal’s research house, China is pondering a 15-20% devaluation by the end of 2016.

In US, as mentioned, we are looking at a good chance of welcoming one or more rate hikes this year. Such an expectation would lead to early extinguishments of USD-denominated debts, early redemptions of non-resident (NR) holdings of Ringgit-denominated debts, reduced borrowings from US, and redirection of NR deposits away from Malaysia, all of which would hurt the Ringgit.

Finally, we expect crude oil prices to hover around current levels underpinned by increasing inventory builds and slower-paced consumption from China. In September, Goldman Sachs trimmed its 2016 forecast for West Texas Intermediate (WTI) crude oil to $45 per barrel from $57 per barrel as output data beat estimates. It added that the current oversupply situation is likely to persist in 2016.

To sum up, we deem rollovers by foreign investors unlikely based on the grounds that [1] fears of further yuan devaluations erode confidence in Asia’s financial markets; [2] rate hikes in US are rather certain; and [3] crude oil prices will remain depressed in the interim.

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