After this past week’s EM bloodbath, policymakers are making efforts to support local asset markets. Bank Negara is attracting attention with its recent communications signaling discomfort with offshore activity. However, we downplay risks of a return to far-reaching capital controls.
Policymakers are concerned about ringgit weakness and the possible impact of offshore trading. Last week, Bank Negara’s Assistant Governor Adnan Zaylani said that recent offshore market activities had caused significant market volatility and adversely influenced onshore ringgit trading.
From Bank Negara’s website: “Bank Negara Malaysia would like to state that there is no change in the Foreign Exchange Administration (FEA) rules and there is no introduction of any new measures. Ringgit remains as a non-internationalised currency, thus any offshore trading of ringgit such as ringgit non-deliverable forward (NDF) is not recognized.”
Yet Malaysia appears to have enacted a subtle change in FX policy. Further clarity is still expected, but at this time it looks like certain types of investors will be facing a new reporting requirement, whereby fixed income-related FX transactions executed in the local market must be accompanied by an official attestation that it is being executed independently and/or does not correspond to offshore NDF FX activity.
Many foreign fixed income investors are thought to use offshore NDFs for legitimate hedging activity (as opposed to speculative bets). Yet it seems that Bank Negara views all offshore activity as undesirable, and is trying to move all hedging activity back onshore where it can be better monitored.
Given Malaysia’s past track record, investors are nervous about deeper capital controls. Recall that during the Asian crisis, the authorities pegged the ringgit at 3.8 per USD and required investors to repatriate all ringgit held offshore back to Malaysia. They also instituted a 12-month holding period for foreign investors, which prevented repatriation until that period ended. All offshore ringgit trading was prohibited, including the halt of Malaysian share trading in Singapore.
After being instituted in September 1998, some of these measures were later eased. For instance, the 12-month holding period was replaced in February 1999 with a graduated system of exit taxes that penalized short-term investments while exempting those of 12 months or more. These exit taxes were eliminated altogether in 2001. The ringgit peg itself did not end until mid-2005, which was precipitated by the end of the CNY peg.
We do not foresee a return to any of these drastic measures. The ringgit has remained a restricted currency, and so the economy should be much less vulnerable now to hot money flows than it was back in 1997, when the ringgit was unrestricted. However, there is the risk of unintended consequences. By discouraging offshore hedging, the authorities may end up scaring away foreign fixed income investment altogether at a time when EM sentiment is fragile.
There has been a lot of academic literature on whether these capital controls had the desired effect. Did the Malaysian economy perform better than it would have under a more orthodox IMF-type policy response followed by Thailand, Korea, and Indonesia? The studies are inconclusive, with many noting that the timing and strength of Malaysia’s recovery was in line with the three other crisis countries that followed the more orthodox IMF programs.
The ringgit has generally underperformed within EM. In 2015, MYR lost -18.5% vs. USD. This was behind only the worst performers ARS (-35%), BRL (-33%), ZAR (-25%), COP (-25%), RUB (-20%), and TRY (-20%). So far this year, MYR is -1.2% YTD and is near the middle of the EM pack compared to the worst performers ARS (-17%), MXN (-15%), TRY (-11%), CNY (-5%), and PHP (-4%). Our EM FX model shows the ringgit as having NEUTRAL fundamentals, so this year’s “so so” performance should continue.
Malaysian equities have underperformed this year after a decent 2015. Last year, MSCI Malaysia was -5.5% while MSCI EM was -17%. So far in 2016, MSCI Malaysia is -2.4% YTD and compares to +5.3% YTD for MSCI EM. This underperformance should ebb a bit, as our EM Equity model has Malaysia at a NEUTRAL position.
Malaysian bonds have underperformed this year. The yield on 10-year local currency government bonds is up 1 bp YTD. This is ahead of only the Philippines (+96 bp), Mexico (+81 bp), Poland (+56 bp), Turkey (+30 bp), Taiwan (+17 bp), Hungary (+14 bp), and Czech (+6 bp). With inflation likely to remain low and the central bank’s next move likely to be a cut, we think Malaysian bonds will start outperforming. Of course, this is predicated on no further capital controls on fixed income investors, who could become spooked.
As it is, data through October suggest foreign fixed income investment in Malaysia had stalled out. The existing stock of foreign fixed income investment stood at around $57 bln in October, up from $50 bln at the end of 2015 but well below the peak near $80 bln in April 2013. Note that the peak was just before the so-called Taper Tantrum of 2013, which took a big toll on EM assets. We would expect this current edition of a sharply steeper US yield curve to likewise take a toll on EM assets. Countries with high frequency data on fund flows show significant outflows month-to-date, which will likely be reflected in November Malaysian data.
Our own sovereign ratings model shows Malaysia to be correctly rated at A-/A3/A- by all three agencies. There had been some downgrade risk last year, but that has since dissipated.