The Malaysian ringgit plunged to its lowest level in over three years on Thursday amid the brutal sell-off across emerging market assets, and strategists say the pain may not be over for the currency.
The ringgit has declined 10 percent against the U.S. dollar since late-May on concerns over a potential capital flight from the country's government bond market in favor of rising U.S. Treasury yields.
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As illustrated in the chart, foreigners hold almost 50 percent of Malaysia's government bonds, an exceptionally high level compared with other emerging markets in the region, placing the currency in a precarious position.
Malaysia's deteriorating economic fundamentals - seen in surging levels of household debt - and the risk of a credit rating downgrade exacerbates the risk of outflows from the country's debt market, say experts.
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"In Malaysia, the key risk to capital flows emanates from the large foreigners' holding of bonds. The fiscal concerns and the risk of Fitch downgrading Malaysia's rating could trigger net outflows from the bond market, hitting the currency," Santitarn Sathirathai, research analyst at Credit Suisse wrote in a recent note this week.
In July, Fitch Ratings cut the nation's credit outlook to negative from stable, citing a lack of budgetary reform and rising debt levels.
Consumer indebtedness rose to 80 percent of gross domestic product (GDP) at the end of 2012, an increase of 20 percent over the last five years, according to RBS.
"The debt servicing ratio or the proportion of household income used for interest and debt repayments is close to 44 percent. This poses a headwind to growth and high risk of financial stress if interest rates rise," Sanjay Mathur, chief Asia economist at RBS wrote in a report called 'The case for a weaker ringgit' this week.
Despite the headwinds, Barclays believes the potential capital flight risk by foreign investors from government debt has been largely priced into the ringgit moves.
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"We expect further ringgit depreciation in the near term, as investors remain focused on the potential for bond outflows. Further ahead, the ringgit is likely to be supported by Malaysia's robust domestic growth, large current account surplus and manageable short-term external debt," the bank said in a recent report.
Malaysia's current account surplus fell to 2.6 billion ringgit ($785 million) in the second quarter from 8.7 billion ringgit in the first three months, as a result of plunging exports and robust imports.
Barclays expects the currency to appreciate to 3.25 against the U.S. dollar over the next three months, from 3.31 currently.
—By CNBC's Ansuya Harjani; Follow her on Twitter @Ansuya_H
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