Malaysia's normally tranquil currency and bond markets have been whipsawed by an exodus of foreign capital as investors reassess emerging markets most at risk from a withdrawal of US easy money policy, heightening the possibility of a vicious sell-off that could hurt the economy. The ringgit currency is at three-year lows against the dollar and month-long selling has pushed 10-year Malaysian government bond yields to their highest in 2-1/2 years.
Economic growth is slowing, the country's typically large trade surplus has nearly disappeared and the government has been dragging its feet on much-needed reforms to fix a large fiscal deficit - all giving foreign investors reason to re-evaluate their exposure to the Southeast Asian country.
But a bigger worry for them has been talk that regular bulk domestic buyers of Malaysian bonds, the state pension fund and banks included, are purchasing less. That has led to heavier selling than analysts think is justified by the economic risks.
As of May, foreigners held nearly 50 percent of outstanding government bonds, the Employees Provident Fund (EPF) a little more than 30 percent and the rest by local banks and insurers. The latest central bank data shows foreign holdings slipped to 137.88 billion ringgit ($42.5 billion) in June from 144.5 billion ringgit in May. Falling bond yields and the pressure to improve returns have compelled banks to divert investments into corporate bonds and longer-term Islamic finance products, analysts said.
The EPF hasn't explicitly said it will slow its bond purchases. But 55 percent of its investments are in bonds and it has said it wants to expand its foreign portfolio in search of higher yields. Sources told Reuters last week the EPF is investing in German and French properties.
It is little surprise then that a redemption of 9.2 billion ringgit of local government bonds this week unnerved foreigners, exaggerating fears about the economy even though it far more resilient to capital flows than peers such as Indonesia, India, Thailand or South Korea. Fitch Ratings added to those worries on Tuesday, placing Malaysia's A minus rating on negative outlook, citing weak prospects for reforms to fix public finances.
So far, the selloff in Malaysia stops short of being termed turmoil. The ringgit has fallen 6.6 percent since May 22, when the Fed first raised the spectre of early stimulus withdrawal, less than the Indian rupee's 8.5 percent drop. The stock market is down 2 percent in the past week, only a fraction of the 33 percent gains in two years.
The risk is that the falling currency and the spotlight on the shrinking current account surplus will push Malaysia into a vicious feedback loop of capital outflows and plunging markets.
For emerging market investors positioning for tighter Federal Reserve policy, the possibility that the current account surplus will vanish this year puts Malaysia in the same basket as India, Indonesia and Thailand - economies that are highly vulnerable to sudden shifts in foreign capital.
That was a point Fitch made, although the delay in measures to fix government debt that is close to hitting a constitutional ceiling of 55 percent of gross domestic product (GDP) was the primary reason for the negative outlook on ratings.
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