Foreign investors disappointed with Malaysia

The opposition's surprise victory in Malaysia's general election May 2018, ending the perennial ruling party's 61-year run, promised a new dawn for the country. A year later, institutional investors aren't celebrating.

Foreign ownership of Malaysian stocks and bonds has dropped considerably since Mahathir Mohamad, at the age of 92, reclaimed the prime minister's office he held from 1981 to 2003, following a campaign focused on the incumbent United Malays National Organization-led government's scandal-plagued governance. Mr. Mahathir had quit UMNO, the ruling party he once dominated, in early 2016 to rally opposition against his one-time protege, Prime Minister Najib Razak.

Foreign investors owned 23.7% of listed Malaysian equities at the end of March, down from 28.5% just before the election, according to Malaysian stock exchange data.

That selling has helped make the Kuala Lumpur Composite index the lone wallflower at what has been a wild stock market party in Asia this year.

As of April 26, the index was down 3.09% for the year, even as China, Japan, Hong Kong, Australia, New Zealand and Taiwan were all sporting double-digit gains.

Meanwhile, quarterly data from Malaysia's central bank showed foreign ownership of Malaysian government securities dropping to 22.7% of the market at the end of December from 27.4% as of March 31, 2018 — with worse to come if index provider FTSE Russell follows through on an April 15 warning that Malaysia could be dropped from its widely tracked World Global Bond index if investor concerns about foreign-exchange hedging aren't addressed.

Market veterans see a number of factors contributing to the exodus — among them the prospect of wrenching changes needed to shift the country's center of economic gravity to private hands from the government; Malaysia's shrinking weighting in benchmark indexes as heavyweights like China come in; and push-back against Malaysian regulators' latest efforts to bend the foreign-exchange market to their will.

'Incessant' selling

Foreign-investor selling of Malaysian shares "has just been incessant since the election," reflecting — in part — the fact that those investors have bigger fish to fry now, such as "getting China right," said Stephen Hagger, Credit Suisse's Kuala Lumpur-based head of equities and country head, Malaysia.

Twenty-one years ago, when MSCI Inc. launched its global emerging markets equity index, Malaysia held the kind of dominant position China enjoys now, with a 34% share of MSCI's 10-country portfolio.

Today, with a 2.3% share of a 24-country MSCI emerging markets index, Malaysia has become "a rounding error" for many investors, noted Gerald Ambrose, head of Malaysian operations and portfolio manager at Aberdeen Standard Investments (Asia) Ltd. in Kuala Lumpur.

Market veterans say the chilly reception Malaysian stocks are getting now from overseas investors partly reflects the fact that the scale of troubled off-balance-sheet liabilities the government inherited has proven greater than anticipated — constraining its fiscal options.

"We've been skeptical" about the new government's approach, concerned that it's trying to do too many things, said Aninda Mitra, Singapore-based vice president and senior sovereign analyst with BNY Mellon Investment Management Singapore Pte. Ltd. Moving to put all of the previous government's off-balance-sheet items on the balance sheet, taking populist steps like canceling the goods and services tax and at the same time looking to convince investors that they're prudent and conservative is a tall order, he said.

Meanwhile, the challenge of replacing a government-led economic culture with an entrepreneurial one defies rapid progress, observers say.

The new approach — with Finance Minister Lim Guan Eng insisting that the business of government is "getting out of business" — has resulted in considerable uncertainty in a corporate environment where having a true private-sector mindset remains the exception rather than the rule, said Mr. Ambrose.

Adding to the uncertainty is the coalition's plan for Mr. Mahathir to cede the prime minister's post after another year or so to Anwar Ibrahim, the former deputy prime minister he jailed in 1998 only to team up with again for last year's election.

Some corporate executives are delaying major decisions ahead of that prospective change at the top, another reason why the economy is not humming, said Mr. Hagger.

Short-term pain

In a public speech last October, Mr. Lim said short-term pain must be endured to set the stage for longer-term gains and — hopefully — return Malaysia to those "heady days of the 1980s and the early '90s, when we were amongst the darlings of investors, both local and foreign."

Mr. Lim predicted it would take "at least three years" to put Malaysia's fiscal house in order and lay the groundwork for sustainable, private sector-led growth.

While Malaysian equities remain under pressure, Malaysian bonds are facing the prospect of a more severe sell-off from foreign investors now. That potential for continued selling partly reflects developments outside of the country's control, such as the April 5 announcement by Norway's 8.89 trillion kroner ($1.05 trillion) Government Pension Fund Global, Oslo, that it had decided to get out of emerging market bonds. The fund's website showed it holding $1.96 billion of Malaysian bonds at the end of 2018.

But the bigger part of the country's vulnerability to further selling is tied to Malaysia's intervention in currency markets in November 2016 to defend the Malaysian ringgit's value by halting foreign investors' use of non-deliverable forwards to hedge their Malaysian government bond holdings.

At the time, the ringgit — which changed hands at 4.13 to the dollar as of April 26 — had weakened to 4.41 to the dollar. The foreign share of the Malaysian government securities market in late 2016 was more than 33%.

The move "forced banks to stop trading in non-deliverable forwards and start moving to settle ringgit physically" — giving the central bank much greater scope to constrain speculators but at the cost of making life much more complicated for investors and their custodians, said Hayden Briscoe, Hong Kong-based managing director and head of fixed income, Asia-Pacific with UBS Asset Management.

Malaysia has gone its own way on currency-related matters before. The country was vilified for closing its capital accounts at the height of the Asian financial crisis in 1998, fixing the ringgit's exchange rate at 3.8 to the dollar. History has been kinder, with the World Bank eventually praising the country's approach.

Malaysia's more recent gambit in late 2016 on non-deliverable forwards, while less dramatic, could leave the country's regulators facing tough choices this year.

On April 15, FTSE Russell, the provider of the widely tracked World Global Bond index, announced that Malaysia was being put on watch for a possible downgrade under a new rating system introduced in January to provide greater transparency regarding which countries are included in its indexes.

The new system includes measures of accessibility.

The FTSE Russell announcement said Malaysia, which currently enjoys the new system's top score of "2," required for inclusion in the WGBI, could be downgraded to "1" — sufficient only for FTSE Russell's emerging markets index — by the firm's next index review in September if the concerns its members have with Malaysian markets aren't addressed.

With a 0.39-basis-point weighting in the WGBI, and estimates of roughly $2 trillion in institutional money tracking the index, Malaysia's downgrade could prompt as much as $8 billion in outflows from Malaysia's bonds.

Lucie Holloway, a London-based spokeswoman for FTSE Russell, said in an email her firm's "external advisory committees have identified challenges with respect to the foreign-exchange market structure and bond liquidity for Malaysia local currency government bonds," and putting the country on the watchlist will allow FTSE Russell to "engage with local decision-makers who are able to address this specific feedback."

Unclear

Mr. Briscoe, a member of a FTSE Russell advisory committee, said it's unclear whether Malaysia will conclude that remaining in the WBGI is worth loosening its grip on the country's foreign-exchange market.

A Kuala Lumpur-based money management veteran, who declined to be named, said he sees greater odds that Malaysia will try to find some accommodation. If FTSE Russell excludes Malaysia from WGBI, which accounts for perhaps 20% of overall foreign holdings of Malaysian bonds, it would risk "contagion," with other index firms like Bloomberg Barclays Indices and J.P. Morgan Investable Indices potentially following suit, with bigger consequences, he said.

Spokesmen for Bloomberg Barclays and J.P. Morgan didn't respond to requests for comment. A Bank Negara spokeswoman couldn't be reached for comment on whether the Malaysian central bank planned to hold discussions with FTSE Russell.