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Malaysia sticks out like a sore thumb in terms of its vulnerability. Photo: AFP

The plunge in oil prices and the surge in the US dollar are wreaking havoc on emerging market (EM) assets, notably local currencies.

EM equities have already fallen 4 per cent since the beginning of this month, with sentiment further undermined by Tuesday’s unexpectedly sharp fall in the mainland’s closely watched stock market on fears of tightening liquidity in the banking sector.

The seemingly unending slide in the price of Brent crude - which has fallen to just under US$66 a barrel, its cheapest level in five years - and the recent strength of the greenback stemming from increasing divergences between US and European monetary policy are weighing heavily on EMs.

Emerging Asia, however, has proved relatively resilient to the deterioration in sentiment, partly because investors have been much more bullish on the region compared with Emerging Europe and Latin America but also because Asia’s main economies are all net oil importers and thus benefit from the fall in oil prices to varying degrees.

Yet one country in the region sticks out like a sore thumb in terms of its vulnerability: Malaysia.

Not only is Southeast Asia’s third-largest economy a net oil exporter, it also happens to have one of the largest shares of foreign holdings of local currency bonds in EMs, making it more sensitive to an increase in US Treasury yields.

The facts speak for themselves.

While Indonesian and Thai equities have fallen just 0.8 per cent and 2.5 per cent over the past three months, Malaysian stocks have fallen a whopping 12 per cent - one of the steepest declines among the major EMs.

Moreover, the ringgit, Malaysia’s currency, has fallen nearly 11 per cent against the US dollar since the end of August to a five-year low, compared with declines of 5.3 per cent, 3 per cent and 2 per cent for the Indonesian rupiah, Thai baht and Philippine peso respectively. India’s currency, the rupee, has fallen just 2 per cent.

While the yield on Malaysia’s 10-year local currency bonds has risen only modestly since oil prices began falling sharply in October, foreign inflows into Malaysia’s government debt market - which had been declining for some time because of the relative unattractiveness of the country’s low-yielding bonds - have turned into outflows.

Malaysia is experiencing an oil-driven deterioration in its fiscal and current account balances

According to Bank of America Merrill Lynch, which tracks foreign holdings of EM domestic debt, Malaysia’s local bond market suffered outflows of US$900 million in October (the latest available data).

This stands in sharp contrast to the US$1 billion and US$600 million of inflows into Indonesian and Indian bond markets, partly because of the significantly higher yields on offer but also because of the enthusiasm generated by the election of reform-minded leaders in both countries. Indeed, both the Indian and Indonesian governments have been able to take advantage of the fall in oil prices to undertake much-needed fiscal reforms.

Malaysia, on the other hand, is experiencing an oil-driven deterioration in its fiscal and current account balances.

With the proceeds from oil and gas exports accounting for nearly a third of government revenues, Malaysia’s public finances are coming under severe strain, with the credibility of fiscal policy now hinging even more on next April’s introduction of a goods and services tax to broaden the tax base.

Malaysia’s balance of payments position, moreover, is set to worsen significantly as a result of the fall in oil prices, with the current account surplus already declining dramatically in October and expected to shrink further next year if oil prices keep falling.

Another concern is the extremely high share of foreign ownership of Malaysia’s domestic debt market at a time when markets are volatile and the US Federal Reserve is likely to start increasing interest rates in the middle of next year.

Despite the recent outflows from Malaysia’s bond market, foreign holdings still account for 45 per cent of the market - an even higher ratio than the 38 per cent share in Indonesia, 18 per cent in Thailand, 20 per cent in Brazil and 26 per cent in Turkey, according to Bank of America Merrill Lynch.

Still, the good news is that Malaysia’s local institutional investors, such as its government-controlled pension funds, can be relied on to pick up the slack when flightier foreign investors reduce their holdings during periods of financial stress.

Indeed, the development of a domestic institutional investor base in EM bond markets - particularly Asian ones – continues to provide a solid underpinning for the EM asset class as a whole.

Yet this does little to help counter the slide in oil prices, which is Malaysia’s prime concern right now.

 

Nicholas Spiro is managing director of Spiro Sovereign Strategy

 

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