This article first appeared in The Edge Financial Daily on April 18, 2019

KUALA LUMPUR: The news on the potential downgrade of Malaysian bonds by FTSE Russell in its World Government Bond Index (WGBI) sparked heavy selling in the local bond market.

The selling is said to be done mainly by foreign investors. Both Morgan Stanley and Maybank Kim Eng estimate the outflow to be as much as RM33 billion, should the downgrade materialise.

The benchmark 10-year Malaysian Government Securities’ (MGS)yield spiked up to 3.87% yesterday from 3.78% on Monday as investors were fleeing from the government debt papers as a knee-jerk reaction.

On Monday, FTSE Russell announced that Malaysia, which is currently assigned a “2” and included in the FTSE WGBI since 2004, is being considered for a potential downgrade to “1” which would render Malaysia ineligible for inclusion in the WGBI.

The announcement came shortly after Norway announced that its sovereign wealth fund will cut emerging-market debts, including Malaysian securities from its portfolio.

When contacted, Areca Capital Sdn Bhd chief executive officer Danny Wong told The Edge Financial Daily that the market may have overreacted to the news. He pointed out that the proportion of foreign holdings in government debts had been falling over the past two years, hence the implication of the foreign outflow could be limited.

“The country’s fundamentals have not changed that much, and we believe local institutions have the liquidity to absorb the foreign selling. We are not like Indonesia; their proportion of foreign holdings in government debt is higher,” Wong commented.

Bank Negara Malaysia’s data show that the proportion of foreign holdings in Malaysian government debt papers has been on the decline since 2016, from 30.57%, to 23.04% in 2018.

Meanwhile, RAM Ratings research economist Kristina Fong pointed out that since the FTSE Russell review is done biannually and the decision is based on portfolio investors’ feedback, it is not a reflection of a country’s economic conditions.

According to her, the selling pressure is expected as a result of portfolio reallocation following the news. Fong reckons that the selling will normalise after the knee-jerk reaction and that local institutional investors have excess capacity to normalise these foreign outflows.

“MGS [foreign] holdings have been normalising on the back of tightening global liquidity conditions, so it’s not an out of the ordinary development per se.

“There have been times of some accentuated net outflows — post-GE14 (14th general election), [Donald] Trump’s presidential win, Taper Tantrum etc — but flows more or less stabilised after those bouts of volatility. That said, global uncertainties will prevail this year — the outcome of US-China trade talks, Brexit among others — and hence, flight to safety flows will be a given, even as tightening takes a back seat,” she explained.

“Local institutional investors have stepped in in the past to mop up some excessive outflows and the demand for government papers has been strong this year, thus there should be capacity to normalise much of these outflows,” she said.

UOB Malaysia senior economist Julia Goh said Malaysia’s exclusion from the WGBI is not definite yet and FTSE Russell will continue to engage the regulators and market participants ahead of the next review in September.

Goh said the concern is not about the country’s economy given that the international rating agencies have affirmed Malaysia’s sovereign ratings. “Stable fundamentals and Malaysia’s A-rated sovereign ratings provide underlying support for domestic bonds,” she added.

The issue seems to be more of market access and liquidity, which is one of the criteria in assessing eligibility for inclusion.

Yesterday, Bank Negara Malaysia affirmed that it will have a dynamic hedging programme to provide market access for institutional investors to actively hedge their foreign exchange (forex) exposure onshore, according to Goh.

“[The] question is whether there will be further relaxation of forex measures or the introduction of instruments to hedge forex ahead of the review in September.

“[In the] meantime, the risk of an exclusion will weigh on markets and the ringgit in the near term,” said Goh.

Maybank Kim Eng analyst Winson Phoon concurs with the view, commenting in a note to its clients yesterday that the risk of Malaysian bonds being excluded from the WGBI seems to be “more likely than not”, unless fundamental changes are made to improve Malaysia’s market accessibility level.