KUALA LUMPUR (Sept 15) : While high fuel subsidies in Malaysia and Indonesia have suppressed headline inflation and allow central banks to hold rates for longer, Moody’s Investors Service points out that this could result in interest rates differentials persisting, therefore depressing the local currency.

This then would in turn keep inflationary pressures relatively high for these countries, the rating agency said in a sectoral report on Asia Pacific sovereigns released on Sept 15.

“In Malaysia and Indonesia where fuel subsidies are high, they have suppressed headline inflation allowing central banks to hold rates for longer. This could result in interest rates differentials persisting, depressing the local currency and keeping inflationary pressures relatively high.

“This will also result in a build-up in social pressures and make fiscal consolidation more difficult. For instance, Indonesia’s 2023 budget illustrates the tough balance between enhancing social protection spending and subsidies, even while moving back to a pre-pandemic deficit ceiling,” the agency noted.

The interest rates differentials in countries like Malaysia and Indonesia, where their capital markets have relatively high foreign holdings, have caused large capital outflow that pressure their local currencies.

According to data from the Institute of International Finance, cumulative portfolio outflows from emerging Asia amounted to US$48.2 billion from March to July 2022, compared with US$20.3 billion during the same period in 2021. The largest outflows have been from the Chinese and Indonesian debt markets, and Indian equity markets.

Indonesia and Malaysia’s central banks have also seen their reserves fallen by around 10% since the start of 2022, alongside Thailand and India, noted Moody’s. While for India, this is mainly driven by a wider trade deficit, in Indonesia and Malaysia, the decline in reserves has been precipitated by capital outflows despite their seemingly supportive positions as commodity exporters, the agency noted.

In Indonesia, foreign holdings, at least in local currency bonds, have materially reduced since the start of the pandemic, but still leave the government exposed to external appetite, stated Moody’s. That will add to Indonesia's debt servicing costs and further hurt debt affordability metrics, although the economy's position as a net commodity exporter has mitigated the hit from local currency weakness, the agency stated.

“Malaysia also has a high exposure of foreign investors to local currency debt, leaving it susceptible to capital flow volatility, reflected in currency pressures. However, it does not rely on foreign currency borrowings to fund its debt to the same extent as Indonesia,” the agency stated in the report.

That said, Moody’s stated that some emerging markets stack up less favourably than others by reserves in months of import cover, which captures the exposure to a higher import bill.

“By this measure, all emerging markets have reserves over the widely agreed benchmark of three months of imports. However, reserves in Indonesia, Malaysia and the Philippines are positioned toward the lower end, ranging between 4.8 and 7.5 months of imports,” it stated.

Despite some of the pressures that currency depreciation and inflation have imposed on higher-rated economies, they still benefit from some buffers that keep immediate pressures at bay.

“Higher-rated governments do not suffer from the same degree of external liquidity risks as lower-rated economies do, and additionally, most emerging markets in the region have built their external positions to levels that are stronger than they were in previous selloffs such as the 2013 taper tantrum,” Moody’s stated.

However, the agency added that Malaysia and other higher rated sovereigns will continue to face policy challenges in managing currency depreciation, inflation and weak growth.

“Thus far, spending and consumption have been on an uptick across the region because of pent-up demand for services and durable goods; growth was strong in the second quarter of 2022 for a number of economies, including Korea, Indonesia, Vietnam, Malaysia and Thailand, backed by a resurgence of tourism and strong private sector consumption.

“However, we expect tighter financial conditions and weakening consumer demand in higher-rated economies to eventually weigh on economic growth in APAC,” it noted.

Moody’s expects imported inflation from currency depreciation to keep inflation elevated in several commodity-importing countries.

“The projected growth slowdown in China will also have significant negative spillovers, particularly for the APAC economies, through trade and financial channels,”it said.

However, the recovery is more likely to be sustained in countries with large domestic markets, and those with less reliance on exports to nurture growth.