This article first appeared in The Edge Malaysia Weekly, on May 2 - 8, 2016.

Of late, portfolio flows have been returning to Malaysian shores, boosting the ringgit’s strength against the US dollar. Improving prospects for crude oil prices have also sparked investor optimism about the local currency, helping it breach a major technical resistance level of 4.00 against the US dollar in March.

Foreign funds flocked back to Malaysia’s bond market, pushing up foreign holdings of Malaysian government securities (MGS) to 49% of the total outstanding from a low of 43% in September 2013 while equity investors drove the local stock market’s capitalisation up to RM1.7 trillion as at March 31, from RM1.5 trillion in August last year.

While these developments have created an upbeat mood, some investors remain decidedly cautious. For this group, the prospects for the second half of the year are still uncertain, especially because the US Federal Reserve is expected to take more steps to normalise its monetary policy, although other economies like China and the emerging markets remain wobbly.

Various other macro issues are also lodged firmly in the minds of investors, such as Malaysia’s declining current account surplus, lack of fiscal space as well as high government and household debt. Investors will no doubt keep Malaysia under close scrutiny for some time to come.

Fortunately, most of these issues are not likely to pose serious threats in the near term. For instance, the government’s consolidation plans are not likely to stray much from the path set in the budget recalibration in January. Even if the budget deficit were to increase slightly, it will not be far off the government’s forecast, at least judging from the amelioration in crude oil prices and improved overall sentiment in recent months.

The expenditure reductions announced in the revised budget will also help constrain the budget gap in 2016. Even with the recent salary increase for civil servants, the total expenses bill will not likely balloon as the pay raises were factored into the forecasts tabled in January. The only threat is the equation’s denominator — the nominal gross domestic product (GDP), which may not reach the government’s target this year due to the economic slowdown. This may affect ratios like the budget deficit and debt as a percentage of GDP, to name but a few.

Similarly, on the revenue side, the downward revision in crude oil price assumptions turned out to be a good strategy adopted by the government as the industry’s prospects have changed for the better. So far this year, Brent crude has behaved well, averaging around US$37 per barrel. It even reached US$45 per barrel in April despite the recent turmoil among Opec members, which remain in disagreement over future production cuts.

As for government debt, Malaysia’s low dependency on foreign creditors is a major advantage. While it is true that the overall debt level remains a tad lower than 55%, most of it is ringgit denominated, which does not pose any currency risk.

Statistics reveal that the portion that is exposed to foreign currency fluctuations is merely 3.4% — insignificant compared with that of countries in a similar sovereign rating band (single A). In fact, Malaysia’s situation is almost similar to Japan’s, where a large portion of its debt is owed to its people. Heightened concerns about the overall debt level are primarily due to the failure to distinguish between the impact of local and foreign-denominated debt on the economy.

As for household debt, there are reasons to believe that its risks to the economy are not lurking around the corner, although the government needs to remain vigilant in containing its growth. This is because the overall debt service ratio remains under control at this juncture.

In addition, it is not the aggregate level that matters because Malaysia has a young population that tends to borrow aggressively. Nevertheless, the impact of household debt on the lower-income group requires special attention.

Of greater concern, however, is the current account (of the balance of payments) situation, which is slipping due to the shrinking savings-investment gap. Admittedly, the current account alone is not causing any jitters in the investor fraternity. Rather, it is the combination of current account and government budget deficits that is causing concern.

There is a good reason for this. Back in the mid-1990s, Malaysia experienced twin deficits — a combination of current account and government budget deficits — due to excessive investments vis-à-vis the level of savings at the time. In fact, many countries in the region experienced the same phenomenon then. This was just before the Asian financial crisis in 1998. Thus, investors automatically associate twin deficits with the heady period before the 1998 crisis.

However, one would do well to realise that even if Malaysia’s current account turns into a deficit this time, the present situation is very different from the one in 1998. Back then, the currency was just too strong with its close tracking of the US dollar. In fact, regional currencies were somewhat overvalued. Such is not the case today.

The shrinking savings-investment gap this time is due to rapid investments meant to generate future growth capacity rather than investments in unproductive sectors. But do not tell this to the financial markets — they are not only fickle but also not very forgiving upon detecting macroeconomic conditions that remind them of a previous crisis. Indeed, the memory of the Asian financial crisis remains firmly entrenched in many minds, so any macroeconomic resemblance will rehash jitters associated with the crisis.

In essence, recent capital inflows are justified as far as the financial markets are concerned. The risks, while not totally dissipated, have faded slightly of late. The global economy is now counting on Uncle Sam to continue to turbo-charge its economy while praying that China will not succumb to the worst-case scenario envisioned by the financial markets.

Malaysia is a likely beneficiary of these developments. The crucial thing to do now is to prevent the economy from exhibiting characteristics demonstrated just before the Asian financial crisis (twin deficits). This is not because such characteristics will necessarily have significant negative repercussions for the economy at this juncture. It is to prevent the jitters from fanning out to the ever-jumpy financial market players.

Nor Zahidi Alias is chief economist at Malaysian Rating Corp Bhd. The views expressed here are his own.

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