First 100 Days of Mahathir Version 2 Good for Malaysian Assets

Friday marks the first 100 days of Prime Minister Mahathir Mohamed’s government. The Malaysian ringgit has continued to weaken but Malaysian assets have in general outperformed this year. We expect this outperformance to continue.

POLITICAL OUTLOOK

Friday marks the first 100 days of Prime Minister Mahathir Mohamed’s government. Polls show him to be very popular, with recent surveys showing anywhere from 71-79% approval. Next general elections won’t be due until 2023.

Opposition leader Anwar Ibrahim was quickly given a royal pardon and released from jail by Mahathir. Anwar was just elected head of the Parti Keadilan Rakyat (PKR or People’s Justice Party), the main party in the opposition coalition Pakatan Harapan (PH Alliance of Hope). He takes over from his wife Wan Azizah Wan Ismail, who remains Deputy Prime Minister. Her presence in the government signals thawing relations between Mahathir and Anwar.

Mahathir will likely remain Prime Minister for two years after earlier agreeing to step aside once Anwar was freed. Anwar appears to accept this timeline. Given the awful history between these two (detailed below), this rapprochement is nothing short of stunning.

Mahathir is traveling to China. The main issue to be discussed revolves around large-scale infrastructure projects that were signed by the previous government. He said he wants to maintain good relations with China, but Mahathir hinted that some of these projects should be canceled. He has favored closer ties with Japan and Korea, which perhaps will come at the expense of China.

Ex-Prime Minister Najib Razak was recently charged with money laundering linked to 1MDB. He pled not guilty to all three counts and remains free on bail. He also pled not guilty to earlier charges of corruption and breach of trust last month. Razak is thought to have siphoned off millions of dollars from 1MDB whilst also holding the post of Finance Minister but was initially cleared in a probe that was widely regarded as fixed.

Malaysia scores very well in the World Bank’s Ease of Doing Business rankings (24 out of 190). The best components are protecting minority investors and getting electricity, while the worst are starting a business and paying taxes. However, Malaysia does slightly worse in Transparency International’s Corruption Perceptions Index (62 out of 180) and tied with Cuba.

 

A BRIEF HISTORY LESSON

Mahathir Mohamad previously served as Prime Minister from 1981-2003. He presided over a period of rapid growth and modernization for Malaysia. Like the rest of the region, much of this prosperity was fueled by opening up the economy to foreign investment and following orthodox economic policies. Many EM currencies were made fully convertible as a result of the widespread acceptance of the so-called “Washington Consensus.”

Malaysia had a front row seat to the 1997-1998 Asian crisis. Thailand was the first to come under pressure as foreign investment in the region dried up. The baht’s peg was broken on July 2 1997, and the crisis continued to spread across the region. Malaysia came under pressure and responded with FX intervention and rate hikes, though the ringgit was not pegged at that time. Next to devalue was the Philippines on July 11. Indonesia also came under pressure and responded by widening the rupiah’s trading band that same day. Thailand agreed to an IMF program on August 5.

Indonesia abandoned the trading band and floated the rupiah on August 14. However, it did not request an IMF program until October 8. An agreement was quickly reached on October 31. The pressures continued to spread, with Korea giving up its efforts to support the won on November 17. It asked for IMF aid on November 21, which was quickly approved on December 3.

What was common to all these IMF programs was a heavy reliance on austerity. As the crisis intensified, Malaysia decided on a more unorthodox and unexpected approach. Rather than enter into an IMF program that would undoubtedly prescribe tough austerity, Malaysia decided to go its own way and instituted capital controls.

In September 1998, the ringgit, which had been floating and coming under pressure, was fixed at 3.8 per dollar. Malaysia also mandated that settlement of all ringgit assets had to go through authorized domestic institutions, and required all ringgit assets abroad be repatriated. These measures effectively shut down the offshore ringgit market. Policymakers tried to ensure that the controls would not affect FDI and other current account transactions, and so repatriation of profits and dividends from documented FDI was still allowed.

Malaysia banned any repatriation of foreign investment for one year. In February 1999, this lockup was replaced by a graduated levy that fell over time. 30% would be levied on all foreign capital entering before February 15 1999 that was repatriated within the first 7 months, 20% between 7-9 months, 10% between 9-12 months, and zero after 12 months. For capital entering after February 15 1999, capital was free to enter and exit with no levies. However, profits were taxed at a rate of 30% if repatriated within one year of entry and 10% if repatriated after one year.

Despite heavy criticism from the IMF and the Washington consensus, Malaysia recovered more quickly from the Asian crisis than those that followed the standard IMF policy prescription. While capital controls were slowly phased out after the crisis passed, the ringgit peg was maintained until 2005. The end of the CNY peg that month provided the opportunity for Malaysia to do the same. Nowadays, foreign investors are comfortable putting money into Malaysia despite its history of capital controls.

The move away from orthodoxy led to a split between Mahathir and his Deputy (and Finance Minister) Anwar Ibrahim. Anwar was removed from his post in 1998 and then jailed in 1999 on trumped up charges of corruption and sodomy. His wife Wan Azizah carried on the fight as the opposition leader until Anwar was finally freed in 2004.

Despite his release from jail, Anwar was subsequently banned from politics for five years. He was eventually able to run and win a parliamentary seat in the 2008 elections. As leader of the opposition, Anwar was jailed again in 2014 by Najib. His long-awaited ascendancy to Prime Minister will mark a new phase for his career in service of the nation.

 

ECONOMIC OUTLOOK

The economy is slowing. GDP growth is forecast by the IMF at 5.3% in 2018 and 5.0% in 2019 vs. 5.9% in 2017. GDP rose 5.4% y/y in Q1, down from 6.2% peak in Q3 and the weakest since Q4 2016. Q2 GDP data will be reported tomorrow, and consensus sees 5.2% y/y. We see downside risks to the growth forecasts.

Price pressures remain low. CPI rose 0.8% y/y in June, the lowest since February 2015. Core inflation fell to a cycle low of 0.1% y/y in June. While Bank Negara does not have an explicit inflation target, low price pressures should allow it to remain on hold this year. Indeed, Bloomberg consensus sees steady rates through much of 2019.

The central bank started the tightening cycle with a 25 bp hike to 3.25% in January. However, the bank implied that it was simply taking back the emergency 25 bp cut after the Brexit vote roiled global markets in June 2016. Next policy meeting will be held September 5, and no change is expected then.

The fiscal outlook is concerning. The budget deficit was equal to -3% of GDP in 2017, and Bloomberg consensus expects it to narrow slightly to -2.8% of GDP in both 2018 and 2019. However, Mahathir scrapped the controversial 6% goods and services tax (GST), which was expected to bring in MYR44 bln in 2019. Parliament just reintroduced a sales-and-services tax (SST) this week, but it’s not clear if the revenues will provide a full offset. Between the GST/SST and 1MDB, we see upside risks to the deficit forecasts.

The external accounts remain solid. The current account surplus was 3% of GDP in 2017, and the IMF expects the surplus to narrow to 2.4% in 2018 and 2.2% in 2018. Export growth remains robust while import growth has slowed, and so we see upside risks to the current account surplus going forward.

Foreign reserves have resumed their downward trend. Reserves stood at $104.5 bln in July, the lowest since February and down from the April peak of $109.5 bln. They cover about 4 1/2 months of imports and are equivalent to only 80% of the stock of short-term external debt. This is Malaysia’s major weak spot in terms of external vulnerability. Adding in the current account surplus only improves its standing slightly.

 

INVESTMENT OUTLOOK

The ringgit continues to outperform. In 2017, MYR rose 11% vs. USD and was behind only the best EM performers KRW (13%) and RON (11%). So far in 2018, MYR is -1.5% and is behind only the best performers MXN (+3.5%) and COP (-1%). Our EM FX model shows the ringgit to have STRONG fundamentals, and so we expect this outperformance to continue.

USD/MYR is trading at its highest level since late November. The pair is on track to test the November 6 high near 4.2435. Break of the 4.1285 area would set up a test of the August 2017 high near 4.30. The 200-day moving average comes in near 4.00.

Malaysian equities are outperforming after underperforming last year. In 2017, MSCI Malaysia was up 8% vs. 34% for MSCI EM. So far this year, MSCI Malaysia is flat YTD and compares to -11% YTD for MSCI EM. Our EM Equity Allocation Model has Malaysia at OVERWEIGHT, and so we expect Malaysian equities to continue outperforming.

Malaysian bonds are outperforming. The yield on 10-year local currency government bonds is +12 bp YTD. This is behind only the best performers China (-29 bp), Poland (-14 bp), Taiwan (-12 bp), and Korea (flat). With inflation likely to remain low and the central bank likely to remain on hold well into 2019, we think Malaysian bonds will continue to outperform.

Our own sovereign ratings model shows Malaysia’s implied rating steady at BBB+/Baa1/BBB+. As such, modest downgrade risks to actual ratings of A-/A3/A- remain on the table. As the sovereign debt numbers are updated to reflect the huge contingent liability stemming from 1MDB, we think there are growing downgrade risks for Malaysia.