● Following its inaugural fixed income country classification review, bond index provider, FTSE Russell, has announced potential exclusion of Malaysian debt from the FTSE World Government Bond Index (WGBI), placing it under a watch list for a 6-month period, with another cycle of review slated in September 2019. Reflecting a knee-jerk reaction, Ringgit has depreciated 0.8% to RM4.1423 against the USD, while the Malaysian Government Security (MGS) 10-year yield climbed to 3.81%, an increase of 4 basis points (bps), between 15th and 17th April, reflective of a big sell down.

● WGBI is comprised of sovereign debt from 23 countries, with only four countries from the Asia Pacific region, namely Japan, Australia, Singapore and Malaysia (since 2004). Entry into the WGBI requires several criteria, such as minimum credit rating of A- by S&P and A3 by Moody's, as well as Market Accessibility Level (MAL) of 2 (2: highest; 0: lowest). In its official statement, FTSE Russell stated that Malaysia is being assessed for a downgrade of its MAL, from the current level-2, to level-1. At the same time, it is assessing a potential upgrade of China’s debt to MAL “2” from “1”. Failure to achieve full compliance of the four dimensions of market accessibility (i.e. Market, Macroeconomic and Regulatory Environment, Foreign Exchange Market Structure, Bond Market Structure and Global Settlement and Custody) by the next review cycle means Malaysian debt would be ousted from the WGBI.

● Based on IMF’s estimate of USD2.0t of WGBI’s assets under management and Malaysia’s weightage of 0.39% of WGBI, the estimated amount of funds at risk is USD7.8b, equivalent to 8.3% of total outstanding MGS and 21.4% of total foreign holdings of MGS. However, we foresee risks of capital flight to be rather contained, with outflow of foreign funds estimated to possibly be anywhere between USD3.0-5.0b, in part due to FTSE Russell’s emphasis that “inclusion on our Watch List is not a guarantee of future action”. This should somewhat help soften the damage to investors’ sentiment, given that the statement suggests enhanced engagement with the government, central bank and regulators in adressing investors’ concerns in the interim period. In this regard, we expect the government will do whatever is necessary, regulatory and policy-wise, to ensure its bonds remain in the WGBI and hopefully send a positive signal to the global market in terms of quality of its debt instruments. Pertaining to BNM’s policy rate, our expectation for a rate cut of 25 bps in 2019 remains intact, though the window to cut may have narrowed marginally given the additional outflow at hand arising from the FTSE Russell’s announcement.

Source: Kenanga Research - 18 Apr 2019