• July foreign selloff was across-the board. Foreign holdings of total Malaysia’s government securities in July fell for the second consecutive month at RM2.3b (June: -RM0.3b). The outflows were led by BNM Notes (-RM1.0b), followed by Malaysian Government Securities (-RM0.7b) and Government Investment Issues (-RM0.7b).
• Watchful of rising domestic risks. While the US Fed rate hike in June could have been the main reason for June’s net bonds outflows, the bigger outflows in July could have been triggered by investors’ concern of 1MDB’s inability to meet its repayment obligation to its creditor.
• But reserves and ringgit continue to hold up. Unfazed by the foreign outflows, the foreign exchange reserves inched up USD0.5b in July, while the USDMYR remained largely stable, ranging from 4.26-4.30 since end-May.
• Solid fundamentals to steer capital flows. We expect foreign fund flows to remain steady and manageable in the coming months on the back of Malaysia’s improving fundamentals.

Across-the-board decline. The foreign holdings of government securities extended its decline for second consecutive month in July. Total foreign ownership of government debt securities dropped by RM2.3b in July. (June: -RM0.3b). While the foreign outflows were across-the-board, the magnitude of foreign outflows remained manageable. To put things in perspective, government securities recorded the worst outflows for the year in March, totaling RM26.2b.

Wary of 1MDB risks. While the US Fed rate hike in June could have been the main reason for June’s net bonds outflows, the bigger outflows in July could have been triggered by investors’ concern of 1MDB’s inability to meet its large debt repayment obligation to its creditor. Foreign bond holders were spooked when 1MDB surprisingly made headlines after a long lull and this time for its failure to make a USD602.7m repayment to its Abu Dhabi creditor, the International Petroleum Investment Company (IPIC). The market is watching closely if 1MDB would be able to meet the Aug 31 extension deadline, in which a default would likely erode investor’s confidence towards Malaysian government securities and exacerbate the risks of capital outflow from Malaysia. Although for now there seemed to be no imminent threat to a major foreign funds outflows given that 1MDB had managed to partially settled a portion of the debt, the market would now be extra vigilant and sensitive to any domestic developments related to1MDB.

Withdrawal from longer term securities. MGS saw a second consecutive month of foreign outflow in July, with net foreign outflow of RM0.7b of MGS for the month (June: -RM0.9b). Similarly, GII experienced a foreign outflow of RM0.7b after three consecutive months of net foreign buying (RM0.5b) in the securities. Consequently, foreign holdings of MGS moderated to 40.1% from 41.2% in June; whereas GII declined to a 16-month low of 7.4% in July. The continued sell off by foreign funds is within our earlier expectation as some investors realign their portfolios in response to the Fed monetary tightening cycle.

Decrease in outstanding short-term bills. In a similar fashion, foreign ownership of short term government securities declined in July. Foreigners pulled out RM1.0b from BNM Notes and RM0.2b from Treasury Bills (MTB) in July. This is somewhat surprising as we expected a preference for ST securities by foreign funds amidst lingering risks in the global economy. However, it is worthwhile to note that a big chunk of the drop in foreign holdings might be attributed to a decrease in overall outstanding amount of the securities (BNM Notes: -RM1.0b, MTB: -RM2.0b).

Reserves rise while ringgit stabilizes. The foreign reserves and the ringgit seemed to remain unfazed by the bond outflows due to the market reaction on the 1MDB debt repayment issue. Malaysia’s foreign reserves rose USD0.5b to USD99.4b at end-July. This is sufficient to finance 7.9 months of retained imports and 1.1 times of short-term external debt. The central bank’s effort to build up a larger buffer of reserves could partly be attributed to a steadier ringgit. The ringgit has been relatively stable with the USDMYR trading range within a narrow range of 4.26-4.30 since end-May. Year-to-date, the ringgit has appreciated 4.3% against the US dollar. This is indicative of the resilience of the financial market despite some concerns of the risks of capital outflows. We believe the ringgit strength is increasingly leaning on improving fundamentals. Going forward, this would help to support the ringgit to gradually appreciate. Our year-end target for the USDMYR is 4.15.

Surge in equity inflows. Meanwhile, the equity market continued to experienced uninterrupted monthly capital inflows since the beginning of the year. Foreign net buying of local equity surged in July, registering net inflows of RM8.3b, a level not seen at least in the past two years. Besides market optimism of improved economic conditions and higher corporate earnings, we see the recent return of foreign funds to be a corrective phase for the outflows seen in past years. Net foreign flows reached +RM18.5b in 7M17, largely offsetting the -RM19.2b and -RM2.7b registered in 2015 and 2016 respectively.

Fund flows to remain stable. In view of the Fed’s tightening cycle, we do not rule out the possibilities of further foreign outflows from Malaysian government securities in the coming months. However, foreign fund flows are likely to remain stable and manageable. This is premised on 1MDB ability to fully settle its debt obligation to its major creditors. Only then, we believe that foreign investors will return to focus on Malaysia’s strong fundamentals. Our assessment of Malaysia’s strong fundamentals is partly based on its adequate reserves buffer, stronger ringgit, improving domestic demand and solid exports performance, among others (See “Malaysia Bond Flows Outlook” for details). Meanwhile, the 10-year bond yield spread between MGS and US Treasuries remain stable at around 177 basis points (bps) as at August 11. The yield spread has widened at around seven bps since our last report at end-July.

More balanced composition of holders. The recent capital outflows from Malaysia government securities might have raised some concerns. However, from a longer term perspective, it may turn out to be a blessing in disguise. Malaysia government debt securities, particularly MGS, have seen its proportion of foreign holdings rising to as high as 51.9% in Oct-16. A high proportion of foreign holdings can pose a threat to the market in the event of a major reversal of foreign funds. However, according to BNM it does not expect much of that anymore for the rest of the year. It feels those who had wanted to exit have done so, and feels that a more sustainable level for foreign shareholding in MGS should be between 15% and 20%. Thus we believe the mild capital outflows in the past two months (or in the near term) would actually lead to a more balanced composition of holders for Malaysian government securities with more local institutions’ participation. Barring any unforeseen circumstances, we see fund flows in domestic debt market to remain steady and fluid.

Source: Kenanga Research - 14 Aug 2017