This article first appeared in The Edge Malaysia Weekly on July 4, 2022 - July 10, 2022

S&P Global Ratings’ decision on June 27 to revise its outlook on Malaysia’s sovereign rating to “stable” from “negative” after two years came as a surprise, but it was a welcome respite amid volatile fund flows and mounting pressure on central banks globally, including Bank Negara Malaysia, to make timely and correct monetary policy decisions in the face of daunting macroeconomic challenges.

Just five days earlier (June 22), the central bank’s fortnightly release showed that Malaysia’s foreign reserves had fallen US$3.6 billion in the first two weeks of June to US$109.2 billion — the largest fortnightly fall since July 2015 — to its lowest level in 15 months (20 months if one excluded the US$5 billion worth of Special Drawing Rights [SDR] from the International Monetary Fund in August 2021 that was part of a US$650 billion global programme to bolster confidence).

Bank Negara data shows that the central bank’s short position in foreign exchange (forex) swaps climbed to US$11.32 billion in May 2022, or 10% of its total foreign reserves, compared with US$9.08 billion (8.1%) in April 2022 — rising above single-digit levels for the first time in two years (since May 2020) but remaining significantly below the US$22.8 billion, or 22.4%, recorded in October 2018.

Though Bank Negara joins many other central banks in Asia in tapping into their foreign reserves to defend against excessive currency movements — Thai reserves are at their lowest in over two years, Indonesia’s reserves are at their smallest since November 2020, South Korea’s and India’s are at their lowest in over a year, Bloomberg reported on June 28 — the Malaysian central bank’s tally for the full month, scheduled for release on Thursday (July 7), will be closely watched, especially given that foreign investors turned net sellers for equities in June amid the ongoing whiplash in global equities marking quantitative tightening (QT).

“While lower, the current level of Bank Negara foreign reserves remains healthy, judging from both the [5.5 months] imports coverage and [1.1 times] short-term external debt coverage ratios. Non-resident portfolio flows is one of the factors that can cause changes in reserves, so we will monitor the developments in this area, as we think the US macro settings are shifting towards late-cycle dynamics, which has the possibility of generating wild swings in market sentiment and foreign flow volatility,” says Winson Phoon, head of fixed income research at Maybank Investment Banking Group in Singapore.

In any case, “the government welcomes S&P’s reaffirmation of Malaysia’s sovereign credit ratings at A- [that] reflects Malaysia’s effective Covid-19 policy response, which has enabled a strong economic recovery as well as the country’s resilience amid an uncertain and highly challenging global landscape,” Finance Minister Tengku Datuk Seri Zafrul Aziz said in a June 27 statement released several hours before S&P issued its press release on the rating decision that it had sent to subscribers.

“The surprise S&P upgrade to Malaysia’s sovereign outlook implies that fiscal reforms could be coming within the next 12 months,” RHB Research group chief economist Sailesh K Jha wrote in a June 28 note. Pending clarity on the timing and effectiveness of possible reforms, he expects S&P’s decision to be “neutral” on financial markets.

S&P’s decision also “came as a positive surprise” to Maybank’s Phoon. “Based on the previous quantitative negative triggers by S&P, Malaysia had exceeded those thresholds for some time and is not expected to make significant improvements in time. So, a downgrade did appear more likely than not from that perspective unless there is some ‘positive notching’ by the rating agency,” he says, noting that it is within S&P’s rating framework to apply “positive notching” on Malaysia’s economic score based on its assessment of the country’s growth prospects.

When contacted, S&P analyst Phua Yee Farn says Malaysia’s higher debt stock and weaker fiscal profile is reflected in its rating. However, the possibility of a further weakening of the country’s fiscal profile does not pose as high a risk of a rating downgrade on Malaysia today versus two years ago due to stronger medium-term growth prospects which had improved S&P’s assessment of the country’s economic profile (see table).

Based on S&P’s rating methodology, Phua says an improved “Institutional and economic profile” last month meant that Malaysia could retain its A- rating with a more forgiving fiscal and debt profile. S&P expects the country to maintain healthy growth rates more competitive than its peers on a structural basis, thus justifying the rating outlook revision back to “stable” from “negative”, explains Phua, who notes that Malaysia’s “deep domestic bond market” not only benefits from having large government-linked funds like the Employees Provident Fund, Kumpulan Wang Persaraan (Diperbadankan) and Permodalan Nasional Bhd (PNB) but also strong banking institutions with ample liquidity.

“We expect non-resident holdings of ringgit-denominated bonds to remain stable for the year. Should there be a substantial exit of foreign holdings, we believe the slack can be picked up by local investors,” says S&P’s Phua.

Back in June 2020, S&P had revised its rating outlook for Malaysia to negative to reflect additional downside risk to the government’s fiscal metrics on the back of the Covid-19 pandemic-induced economic slowdown as well as political uncertainties following a second change of government in two years (the Perikatan Nasional coalition came to power in early March 2020 following the collapse of the Pakatan Harapan coalition that ended an uninterrupted 61-year rule of Barisan Nasional in 2018.)

Though S&P’s decision meant that all three global rating agencies had reaffirmed their respective ratings on Malaysia with a stable outlook [Fitch BBB+, Moody’s A3], Maybank’s Phoon does not expect S&P’s outlook revision to have a major impact on ringgit bonds, foreign demand for ringgit bonds or foreign exchange “because global inflation and rate drivers have been and will likely continue to be the primary drivers of market sentiment”.

Nonetheless, he is “mildly bullish” on Malaysian Government Securities (MGS) and does not expect any rating risk from any rating agency in the next six to 12 months “unless the global macro conditions experience an unexpected deterioration”.

“Inflation fears dominated the first half of this year, resulting in heavy sell-offs in bonds, but we think the US Federal Reserve is unfortunately tightening aggressively into a late cycle. US financial conditions have deteriorated and we think the currently tight US labour market conditions is a sign of late cycle rather than strengths [and] these late-cycle dynamics will drive US Treasury yields lower, benefiting MGS. Also, we think the MGS curve has fully priced in Bank Negara’s rate normalisation to 3%-3.25%. If the actual hikes fall short, rates should fall,” says Phoon.

More economists now expect Bank Negara’s monetary policy committee (MPC) to raise the overnight policy rate (OPR) by 25 basis points (bps) to 2.25% when it meets on Wednesday (July 6), and most see interest rates reaching 2.5% by November.

AmInvestment Bank’s economist, meanwhile, expects a 50bps hike to 2.5% this week — still accommodative given that the OPR was at 3% in January 2019 before the 125bps cut took place and brought interest rates to a record low of 1.75% on July 7, 2020. Even at 2.5%, the OPR will still be 100bps behind the Fed’s key policy rate, which is expected to reach 3.5% by year end.

There may well be further volatility in the near term, with the next Fed rate decision slated for July 27 (with three more after that), but AmInvestment Bank analyst Alex Goh expects “a return of foreign equity buyers in the second half of 2022 (2H2022), notwithstanding the June foreign equity outflows, amid emerging bargain valuations and prospects of a stronger 2022 GDP growth of 5.6% versus the global rate of 3.6%”.

“This will be further underpinned by expectations of a stronger ringgit in 2H2022 with our in-house economist projecting the ringgit to strengthen from 4.40 against the US dollar currently to 4.20-4.25 (consensus: 4.30) by the fourth quarter this year, subsequently improving further to 4.10-4.15 (consensus: 4.18) in 2023,” Goh wrote in a July 1 note, telling clients that value had emerged in Malaysian equities with the benchmark FBM KLCI trading at 1.4 standard deviation (SD) or a 14% discount to its five-year median of 16.4 times, compared with Thailand’s 0.2SD and Indonesia’s 0.6SD.

According to him, the RM1.3 billion net foreign equity selling in June reduced the year-to-date foreign net buying position by 18% from RM7.4 billion as at end-May to RM6.1 billion as at end-June. “In the region, only Indonesia, Thailand and Malaysia enjoyed year-to-date net foreign equity inflow, with Malaysia accounting for 17% of Asean’s net purchases,” he wrote, adding that the equity weakness seen in June stemmed from smaller net buying of only RM659 million by local institutions.

Bank Negara data shows that foreign holdings of MGS worth RM257.47 billion in May was up 3.8% year on year (y-o-y) from RM247.94 billion in May 2021 and had increased 0.2% or RM531.4 million from RM256.94 billion in April 2022 — with monthly holdings turning positive again after two months of decline totalling RM6.2 billion in March and April from RM263.15 billion or about 53% of total MGS in February.

Expectations are for 2Q2022 GDP numbers, slated for release on Aug 12, to be stronger than the 5% y-o-y growth in 1Q2022, given that the economy began the transition to the endemic phase of Covid-19 on April 1.

In his statement, Zafrul noted that S&P’s projection of Malaysia’s GDP growing 6.1% in 2022 “is in line with the government’s expectations of higher growth in subsequent quarters, and in alignment with the higher end of Bank Negara’s official estimate of 5.3% to 6.3% growth”. The government, he said, “will continue to respond strategically, proactively and decisively — given an increasingly uncertain external environment and high global inflation, which have also caused inflationary pressures domestically — to ensure the economy remains on a strong recovery trajectory”.

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