Malaysia's FX movement 'bizzare'. Sign of the rot deepening?

SHAH ALAM: Malaysia’s once strong foreign exchange reserve is bordering on collapse, according to a UBS Securities Asia Limited report. It says that in 2009, Malaysia experienced the biggest foreign exchange reserve losses among Asian countries.

It says official reserves fell by more than one-quarter on a valuation-adjusted basis.

Describing the situation as bizarre, it notes that Malaysia used to have the largest current account surplus in Asia–at around 17% of GDP.

“Over the past 12 months, Malaysian reserves nearly collapsed” while neighbours like Thailand, Singapore, Taiwan, Hong Kong and China “have seen sizeable increases,” it says.

It says foreign capital outflows from Malaysia in the last year was nearly 50 percent of its GDP.

“When we measure implied net flows using the same rough methodology as in used on Russia, the numbers are simply stunning. [Malaysia showed] peak outflows of nearly 50% of GDP,” it says, noting that the outflow was larger than anything witnessed in the world of emerging markets (EM).

The report also says Malaysia over the past 12 months recorded one of the biggest base money contractions in the entire EM world.

It asserts that recent outflows were “far, far bigger than those Malaysia experienced in the 1997-98 Asian financial crisis.”

The full report follows:

Malaysia–Another Bizarre Story

Confusion is a word we have invented for an order which is not understood. — Henry Miller

What it means
After last year’s series of notes on EM countries with “bizarre” money and credit behavior (Chile, Kazakhstan and Vietnam, see Tales of the Bizarre, EM Daily, 4-6 November 2009), we need to add one more to the list: the very strange case of Malaysia.
Question: which Asian country had the biggest FX reserve losses in 2009? The answer is Malaysia, and by a very wide margin; we estimate that official reserves fell by well more than one-quarter on a valuation-adjusted basis. Why is this bizarre? Well, in the first place because Malaysia runs a current account surplus – and not just a mild surplus but rather the largest in Asia, around 17% of GDP. Other structural surplus neighbors like China, Hong Kong, Singapore, Taiwan and Thailand have all seen sizeable increases in FX reserves over the past 12 months … and yet Malaysian reserves nearly collapsed.

How did this happen? In short, Malaysia must have seen massive foreign capital outflows – and sure enough, when we measure implied net flows using the same rough methodology as in our note on Russia earlier in the week (Watching Money in Russia, EM Daily, 5 January 2010), the numbers are simply stunning: peak outflows of nearly 50% of GDP, i.e., more than twice as large as in the “capital flight” case of Russia and many orders of magnitude larger than anything witnessed in the average EM country (Chart 2).1 In fact, the
recent outflows are far, far bigger than those Malaysia experienced in the 1997-98 Asian financial crisis (Chart 3).

It gets stranger. Unlike Russia, Ukraine, the Gulf states or other recent EM capital flight economies, Malaysia didn’t see any net external inflows in the run-up to the current crisis. Indeed, Malaysia has not recorded a year of positive net capital inflows since 1997, i.e., there wasn’t exactly a large pool of “hot” money parked onshore waiting to leave. Nonetheless, as shown in the above charts, capital is apparently still leaving Malaysia in large quantities as of the latest data points – long after most other emerging countries began to see net inflows again.

1 Implied capital flows in Chart 2 are defined as the difference between valuation-adjusted FX reserve accumulation and the current account balance. Flows in Chart 3 are defined as the difference between the overall balance of payments and the current account balance.

Nor, in contrast to all the above-named economies (and in contrast to Eastern Europe in general), did Malaysia have any noticeable increase in domestic leverage – both broad money M2 and bank credit actually declined as a share of GDP since the beginning of the decade.

So where on earth did the outflows come from?

Certainly not local deposits. Unlike Russia, Ukraine or other CIS economies, there was no outflow from the domestic deposit base; M2 growth in Malaysia is still very comfortably positive, in sharp contrast to the Russian figures we published a few days ago (Chart 4).

And this despite a massive, unprecedented decline in high-powered “base” money, as shown in Chart 4. Indeed, over the past 12 months Malaysia recorded one of the biggest base money contractions in the entire EM world, matched only by the Baltic states (Chart 5). This is in part because the Malaysian central bank responded with a sharp drop in reserve requirements to keep banks liquid … but still, we can’t help but note that the domestic financial system seems uniquely unaffected by apparent capital outflows.

In fact, perhaps the most surprising feature of the economy is that interest rates have fallen steadily. In 1997-98, with much lower ex-post outflow pressures, Malaysian short-term interest rates skyrocketed into the high teens; last year the same thing happened in some other countries with strong outflows pressures. Meanwhile, during 2009 Malaysian rates settled in comfortably at around 2% per annum and show no signs of rising substantially any time soon. What is going on? How do we square this circle? To be honest, we’re not really sure – but we strongly suggest the interested reader turn to ASEAN economist Ed Teather for further answers. For additional information on Malaysia, Ed Teather can be reached at edward.teather@ubs.com.

A pretty grim outlook on our foreign exchange. With such a low position, isn't our currency rendered vulnerable to attack ala Soros's run with asian currencies during 1997? We wouldn't have enough 'ammunition' to shore up the Ringgit and it will just turn into an ugly battle of attrition.

But regardless, the article is quite jargon-y. Anybody with financial insight care to decipher it for the rest of us?