Indebted, commodity-dependent Malaysia will be in investors’ crosshairs as heavy selling of Indonesia and India’s currencies threatens to spread to other Asian economies seen as most vulnerable to a withdrawal of U.S. monetary stimulus.

After Indonesia, where concerns over a gaping current account deficit sparked a stock market and currency rout this week, Malaysia and neighbouring Thailand are seen as the most vulnerable Southeast Asian markets to contagion effects.

“There is a lot of resemblance to prior crises like 1997 and 1998. We have had two countries going down, India and Indonesia, and now you have got to start thinking about the third and fourth countries,” says Pradeep Mohinani, a Nomura credit analyst in Hong Kong.

“The likely candidates would be those with high fiscal deficits, slowing economies and high foreign ownership of government bonds. Thailand and Malaysia tick most of the boxes in that regard.”

Economists say that both those countries, as well as the fast-growing Philippines, are to some extent protected from major turmoil by their much stronger external balances compared with Indonesia and India.

Regional economies have built up hefty foreign reserves and sharply reduced foreign currency debt since they were devastated by the Asian financial crisis in 1997.

But their currencies have already been pushed to multimonth lows, and could face further pressure from panicky investors who have taken fright at signals the U.S. Federal Reserve will start winding down its $85 billion-a-month support programme soon.

Falling exports

Export plunges in recent months could push the current account into a quarterly deficit for the first time in 16 years. “People weren’t expecting the deficit to get anywhere close to zero six months ago,” says Edward Teather, regional economist at UBS in Singapore. He says a worsening deficit would add pressure on Malaysian policymakers to tighten monetary policy and tackle fiscal reforms, but saw it as much less vulnerable than Indonesia’s.

“There were big capital outflows during 2008 and Malaysia’s authorities handled them pretty well. Malaysia’s financial system is quite sophisticated.”

Southeast Asia’s third-largest economy, whose trade surplus fell in April to its lowest level since the 1997 financial crisis, is seen as particularly vulnerable because foreigners hold nearly half of its bonds. It has run up high levels of both household and government debt in recent years, and efforts at fiscal reform are being held up by a weakened prime minister following a close-run election in May.

The ringgit currency has already been driven to three-year lows around 3.3 to the dollar, down more than 7 percent this year. Traders estimate the central bank has spent close to $1.3 billion to defend the currency in recent days.

Selling spread last month to the Kuala Lumpur’s stock market - usually seen as a regional safe haven - dragging the main index down 1.85 percent. Fitch Ratings cut its outlook on Malaysia’s sovereign debt in July, citing worsening prospects for fiscal reforms such as proposed cuts in the country’s steep subsidy bill and a new consumption tax to reduce its reliance on oil revenues.

Prime Minister Najib Razak faces a possible leadership challenge from within his ruling party in October, raising uncertainty over his pledge to cut one of emerging Asia’s highest budget deficits of 4.5 percent of GDP. While most economists expect the current account to remain in surplus, its sharp fall to 8.7 billion ringgit in the first quarter from 22.8 billion in the previous period removed much of Malaysia’s perceived protection from heavy fund outflows.

Foreigners have been selling Malaysian bonds, reducing their holdings to 138 billion ringgit in June from 145 billion in May, according to the latest data. “Any period when you have a lot of redemptions, then the fundamentals have changed. There’s a risk that not everything will be rolled over and there will be further pressure,” says Daniel Wilson, an economist at ANZ in Singapore.

Thai vulnerabilities

Thailand has also begun to look vulnerable due to slumping exports that were partly to blame for a surprise  contraction in second-quarter growth last month. Its current account slipped to a deficit of $5.1 billion in the second quarter from a $1.3 billion surplus in the first three months.

“Given Thailand’s deteriorating trade and current account balances, we see some risks that similar concerns will also surface regarding the economy,” says Gundy Cahyadi, economist at OCBC Bank in Singapore. “But at this juncture, we think that risks are fairly manageable.”

Thailand’s central bank chief Prasarn Trairatvorakul said last month that the baht’s sharp fall was not a worry yet, and that the currency’s level was in line with fundamentals. “We have no such factors as in the case of Indonesia. Our macroeconomic policy is quite well regarded by markets,” Prasarn told reporters.
Just months ago, Southeast Asia was a darling of foreign investors attracted by strong growth rates, a rising middle class and mostly improved fiscal positions. Economists say most of those factors are still in place and should protect most countries from sustained heavy outflows.

“Asia’s foreign reserves and current account levels are strong and will help mitigate the impact of any liquidity outflows,” UOB’s head of research Jimmy Koh said in a note. “Similarly, Asian companies and financial institutions have built stronger balance sheets and healthier gearing levels, which will make them more resilient against market volatility.”

The Philippines appears less vulnerable than its neighbours to any market attack, thanks to a rapid annual growth of 7.8 percent in the first quarter and a current account surplus supported by remittances from its army of overseas workers. Manila’s benchmark stock index has climbed more than 12 percent this year, and is Southeast Asia’s second best-performing market after Vietnam. Foreign investors have been net buyers of $1.3 billion worth of Philippine shares year-to-date.

“In terms of the business cycle, Philippines is still very much in the early stages of the upturn,” says Michael Wan, an economist at Credit Suisse in Singapore. “The country joined the party late compared to its peers such as Indonesia and Thailand.”

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