World Markets

Malaysia: Next emerging market whipping boy?

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Malaysia, Southeast Asia's third-largest economy, could be more vulnerable to large capital outflows than its emerging market peers like Indonesia and India when the Federal Reserve tightens monetary policy, warn market watchers.

"To the extent both India and Indonesia tightened policy in response to last year's problems, I suspect they are less vulnerable," Richard Yetsenga, head of global markets research at ANZ told CNBC on Monday, referring to efforts by both governments to rein in budget and current account deficits.

"My concerns are focused on economies where you have excessive foreign ownership [of government debt]; India doesn't seem to have that problem, but Malaysia does," he said.

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The share of Malaysian sovereign debt held by foreigners currently stands at 45 percent, according to analyst reports, the highest in the region, making the country more vulnerable to a reversal in capital flows. This compares to 32.5 percent in Indonesia and less than 2 percent in India.

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While Malaysian capital markets took a beating amid the selloff in emerging markets last summer triggered by concerns over the Fed scaling back monetary stimulus, they were not as hard hit as Indonesia's.

Malaysian 10-year government bond yields, for example, rose around 30 percent from late May-August, compared with an approximately 50 percent rise in Indonesia's equivalent debt yields. Meanwhile, the country's benchmark KL Composite stock index declined 3.4 percent over the same time period, compared with a 19.2 percent fall in Indonesia's Jakarta Composite.

Rising debt levels

Research firm Oxford Economics, which also identified Malaysia as the most vulnerable Asian country to external shocks, says the economy's high levels of debt are key risks for its stability.

"Malaysia has generally been regarded as one of Asia's success stories. Its recent economic performance has been solid, it runs a strong – though shrinking – external balance and its political background appear stable. But all is not quite what it seems," Sarah Fowler, economist at Oxford Economist, wrote in a report titled 'Why Malaysia is now a more risky prospect than Indonesia' published earlier this month.

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"Prompted by its high levels of public debt, rising external debt and shrinking current account surplus, there has been a shift in the perception of risks towards Malaysia and away from Indonesia," she said.

According to data from Oxford Economist, Malaysia's external debt – the portion of a country's debt that is borrowed from foreign lenders including commercial banks, governments or international financial institutions – has risen in recent years to close to 40 percent of GDP and is expected to remain at this level for some time.

The country's short-term component of external debt is also increasing, standing at 15.2 percent in 2013, up from 10 percent in 2007, the third-highest after Turkey and Thailand. By contrast, the short term debt accounts for less than 5 percent of GDP in India and Indonesia. Short-term debt is more risky in a crisis because it requires repaying or rolling over earlier.

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Malaysia's public finances are also a source of concern. While Malaysian authorities managed to narrow the budget deficit to 3 percent in 2012 from 6.5 percent of GDP in 2009, the country still has the highest ratio in the region other than India. Total government debt approached the self-imposed ceiling of 55 percent of GDP (gross domestic product) last year, and is expected to remain above 50 percent for the next five years.

Economies with high levels of public debt have less room for policy responses, and may struggle to finance the debt if interest rates rise.

Shrinking current account surplus

Malaysia's rising debt levels come as its economy slows and current account surplus narrows.

The economy grew 4.7 percent last year, slowing with 5.6 percent in 2012. Meanwhile, its current account surplus has fallen sharply to 3.7 percent of GDP last year from a peak of 16 percent in 2008.

"Our scorecard flags up reductions in a current account surplus as potentially risky," said Fowler of Oxford Economics, but noted the silver lining in the shrinking surplus.

"If anything, this is a sign of strength, as it largely reflects a rebalancing of the economy towards domestic demand [away from exports]," she said.