Lead Story: Financial markets strong enough to weather external shocks

This article first appeared in Capital, The Edge Malaysia Weekly, on August 20, 2018 - August 26, 2018.
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FOR many Malaysians, Turkey is known more as a holiday destination, offering prospects of a shariah-compliant European adventure, rather than ground zero for a potential financial crisis.

But as the Turkish lira continued to plunge last week, the effects were felt in emerging markets, including Malaysia.

Since early March, the lira has depreciated by almost 60% to 6.05 against the US dollar. On Aug 13, it dropped to TRY6.88 per US dollar — its lowest level on record. The ringgit followed suit a month later. Since early April, it has declined 6.25%, to RM4.10 against the greenback.

There are concerns that the Turkish currency crisis could spark a contagion effect in emerging markets, including those in Southeast Asia. All emerging market currencies are now seen as risky assets.

But is this the case? Could the risk spread to Southeast Asia, especially Malaysia?

According to Bank Negara Malaysia governor Datuk Nor Shamsiah Mohd Yunus, the Malaysian economy’s exposure to Turkey is rather small at the moment, thus limiting any contagion effect should the lira crisis worsen.

“In terms of corporate debt exposure to Turkey, it is only about 0.17% of the total, and in terms of exposure to Turkish lira-denominated borrowings, it is even smaller at 0.03% of total corporate external debt,” Shamsiah said at a question-and-answer session after announcing the gross domestic product figures for the second quarter last Friday.

She is confident Malaysia’s financial markets are strong enough to weather another shock as they have done in the past. Over the last decade, the country has been hit by the US Federal Reserve’s taper tantrum as well as the global financial crisis.

While Malaysian corporates only have a small exposure to the Turkish economy, the lingering worry of an emerging market currency crisis should not be swept under the rug.

Socio-Economic Research Centre executive director Lee Heng Guie says emerging markets with stressed macro imbalances, such as twin deficits and high foreign debt, are more vulnerable to capital reversals and tighter global financial conditions.

Surging US treasury yields, which have led to net outflows of foreign funds from Malaysian assets, the prospect of further US interest rate hikes, and fears of contagion risk have weighed down the ringgit, he says.

“What could provide counteracting strength to support the ringgit are strong economic and financial fundamentals, clarity of policies, the country’s fiscal and debt path and the affirmation of Malaysia’s sovereign ratings,” says Lee.

In a report last Thursday, UOB Global Economics & Markets Research highlighted that among Asean economies, Malaysia’s high ratio of external debt to GDP — at 66% — is one factor to watch in this period of contagion risk.”

“Noteworthy is that Malaysia’s external debt stacks up higher than the rest owing to its large local currency bond market (as a percentage of GDP) which invites greater foreign participation. Malaysia’s share of foreign inflows has slowed over the last two years, suggesting a lower level of hot money or concentration risk compared to previous periods,” it says.

UOB adds that the concern over Turkey may be justified by the fact that the bulk of its external debt (more than 90% based on 2017 data) is denominated in foreign currency, which makes repayments particularly difficult in times of rapid currency depreciation.

“Asean countries’ foreign currency portion of the external debt is relatively smaller compared to Turkey and the latter’s share of GDP is likely to have ballooned from 2017 levels due to the plunge in the lira,” it adds.


What is the correlation between ringgit and lira?

According to AmBank Research chief economist Dr Anthony Dass, the relationship between the lira and the ringgit, as well as other emerging market currencies, becomes stronger during a period of crisis.

For every 1% fall in the lira, the ringgit tends to drop by 0.04% during the trading day, and by another 0.01% in the second day following the drop, Dass explains in an emailed reply to The Edge.

However, if the market expectation is that the government has the ability to stimulate economic growth and the various asset classes, it will slow down capital outflows and thus prevent a currency crisis, he adds.

“So, the focus will be on the economic data and policies ... and weighing the risk of similarities and differences vis-à-vis emerging markets to determine if the ringgit is vulnerable to a contagion effect,” he says.

The Malaysian economy grew 4.5% year on year in the second quarter this year, below economists’ expectations, as public sector investment dropped 9.8% y-o-y during the quarter, according to Bank Negara.

It was considerably lower than the 5.4% recorded in the first quarter, when public sector investment slipped by only 0.1% y-o-y. In the second quarter last year, the economy grew at a robust 5.8%.

In her first press conference as the central bank governor, Shamsiah said the economic slowdown is expected to linger into the third quarter, reducing gross domestic product growth to 5% this year.

Besides the weaker economic growth, the vulnerability of the ringgit is partly due to the high public debt-to-GDP ratio of around 80%, gross financing needs of 10.4% of GDP and about US$8 billion debt maturities coming in 2019, says Dass.

“High public debt and gross financing needs will definitely have a negative impact on foreign exchange rates. More so if the public debt level jumps significantly from the previous estimates to, in our case, RM1.09 trillion.

“The focus will be on whether there are credible plans to deal with the high public debt level. During this process of assessment, the emphasis will be on the exposure to US dollar maturities that will be coming on board,” he says.

Despite the dark clouds on the horizon, Malaysian assets are still expected to be resilient.

Malaysia has faced many episodes of shocks to the global financial system, which resulted in massive outflows in the past. In some cases, the outflows continued over an extended period, which resulted in a faster depreciation of the ringgit, said Shamsiah.

“And yet our financial market continued to function in an orderly manner even though some of the episodes that we encountered in the past were really unexpected.”

We were blindsided and yet the financial markets were able to play their role in developing the economy, she says.


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