Capital Flows from 2006 - 2007

A. Overview

This section examines policy challenges associated with capital flows when Malaysia adopted a managed float exchange rate regime, and implemented various liberalization measures on capital outflows. On the external front, greater risk-taking by investors in the face of high global liquidity resulted in large capital flows into emerging Asian economies.

B. Trends

In 2006–07, Malaysia continued to run a current account surplus and accumulated foreign reserves (Figure 11 [ PDF 16.4KB | 1 page ]). Higher remittances abroad by foreign workers and expatriates continued to depress current transfers (Figure 12 [ PDF 16.4KB | 1 page ]).

To mitigate the adverse effects of capital inflow, Malaysia encouraged local firms to invest abroad. Outward direct investment almost doubled to USD6.0 billion in 2006 from 2005, which negated the amount of inward direct investment (Figure 13 [ PDF 17.2KB | 1 page ]).

Table 9: Balance of Payments (USD billion) [ PDF 18.4KB | 1 page ]

Investment opportunities improved in 2007 following numerous liberalization measures in financial, plantation, and property sectors. The introduction of investment incentives covering taxation, more liberal foreign equity participation, and employment of expatriates raised the attractiveness of Malaysia as an investment destination. These factors led to higher direct capital inflows in the first half of 2007. However, the trend on outward direct investment also accelerated resulting in a small net direct inflow. By progressively relaxing controls on capital outflows, excess liquidity is drained out of the financial system and pressure on the ringgit reduced. Some caution has to be taken to ensure that outflows are of a reasonable amount that does not lead to a threatening fall in official reserves.

A greater appetite on the part of investors and strengthening macroeconomic fundamentals led to large inflows of portfolio funds into domestic equities and bonds during the first quarter of 2006 (Figure 14 [ PDF 17.2KB | 1 page ]). While equity and bond prices were driven higher by capital inflows, there were also some signs of speculative activity in the exchange rate. Repricing of risk premium attached to riskier securities investment due to a deteriorating global inflation outlook led to portfolio outflows in May to June 2006. Inflows resumed in the second half of 2006 as the risk-reward outlook improved again.

Strong economic growth and healthy corporate and household sectors led to a surge in portfolio inflow in the first half of 2007, despite several bouts of volatility. However, policies may not be effective in circumventing volatile capital flows. Sound macroeconomic conditions, financial sector sophistication, and transparent policies may lower chances of capital reversal, but external pressures and a contagion effect may lead to sudden outflows (Grenville, 2006). While there is a sizeable amount of outward direct investment, the corresponding amount is negligible in terms of portfolio investment. The main reason is domestic investors' reluctance to invest abroad, possibly due to lower returns as well as a lack of requisite investment skills by domestic financial institutions.

More recently, net inflow of direct investment amounted to USD2.0 billion in the third quarter of 2007.⁹ The bulk of the capital was channelled into manufacturing, industrial (oil and gas), and services sectors. Outward direct investment was about USD2.0 billion. Meanwhile, portfolio funds recorded a net outflow of USD6.5 billion due to liquidation of domestic securities by non-resident investors in August, following tightened global credit conditions. Inflows resumed in September.

Figure 15: Other Investment, Net [ PDF 34.3KB | 1 page ]

Meanwhile, other investment continued to record a large net outflow in 2006–07 due to intensified carry trades (Table 15 [ PDF 16.8KB | 1 page ]). However, this may be subject to heightened risk aversion, repricing of credit risk, and prolonged global financial turmoil that could lead to sharp reversal (ADB, 2007). Repayment of public external debt can also contribute to the decline in net other investment. In addition, it also reflected better portfolio diversification of the domestic banking sector following liberalization of restrictions on capital outflows.

C. Impact

In a liberalized environment, rapid capital inflows could raise domestic liquidity and credit, lead to an unstable appreciation of the currency, inflation, and possibly derail economic activity.

D. Domestic Liquidity and Credit

Domestic liquidity (M3) expanded by 13.0% in 2006 supported by rapid expansion in NFA and to a lesser degree on NDA (Figure 16 [ PDF 18.1KB | 1 page ]). To some extent, the growth in NFA also captured higher portfolio diversification as banks placed more assets abroad. Massive net inflow of portfolio funds, arising from high global liquidity and increased risk-taking by investors, generated a rise in liquidity in the financial system. To overcome inflationary pressure and to stabilize interest rates, the monetary authority conducted sterilization operations. In turn, this action together with prudential lending procedures led to a lower credit growth (Figure 17 [ PDF 17.5KB | 1 page ]).

Alternatively, swap arrangements can also stabilize domestic money supply and interest rates without issuing central bank securities. When foreign reserves accumulate beyond a desired level, the monetary authority can sell some of them to domestic financial institutions in exchange for domestic currency. The buyers are required to invest the acquired funds overseas for a specified period. At the end of the period, the regulator reimburses the buyers for any loss resulting from the interest rate differential between domestic and foreign markets, as well as any loss from changes in the exchange rate. In this respect, central bank swap arrangements also provide an avenue for increasing outward portfolio investment, which is lacking in Malaysia.

The money supply continued to record double-digit growth in 2007, supported by growth in NFA with NDA picking up in the third quarter due to higher credit expansion.

Table 10: Domestic Liquidity and Credit [ PDF 18.1KB | 1 page ]

E. The Exchange Rate

The average standard deviation of the monthly exchange rates remained small in 2006, despite net inflow of short-term capital. These inflows emerged because of good domestic macroeconomic fundamentals as well as market expectations of further appreciation of the ringgit. However, these factors were negated by strong demand for foreign currencies for outward direct investment, repayment of external loans (other investment, net), and the repatriation of profits and dividends (current account balance). To some extent, the observed small volatility also reflected sterilization efforts by the monetary authority aimed at maintaining competitiveness.

Table 11: Average MYR/USD Volatility [ PDF 17.5KB | 1 page ]

Since Malaysia operated a large overall payment surplus due to large inflow of foreign capital, a flexible exchange rate policy would lead to an appreciation of the ringgit. By allowing (gradual) appreciation, the regulator can mitigate the cost of sterilization. If appreciation is not ongoing, the magnitude of capital inflow may be reduced via an increase in the rate of expected depreciation. The relative success of this also depends on sequential liberalization of the external financial account, and strong domestic financial institution with good regulation and enforcement (Kawai, 2005).

In 2007, the path of the exchange rate is subjected to numerous rounds of portfolio liquidation exercises in February, March, May, August, and November. Despite this, volatility was relatively small due to foreign exchange interventions by the central bank to maintain orderly market conditions.

As capital inflows continued in 2006 up to the second half of 2007, both NEER and REER appreciated (Table 12 [ PDF 17.4KB | 1 page ]). The trend in both NEER and REER started to fall in the third quarter of 2007 when investors began liquidating portfolio positions in the face of the deepening US subprime turmoil.

F. Inflation

1. Consumer Prices

Table 13: Consumer Price Inflation (2005=100) [ PDF 17.4KB | 1 page ]

Net portfolio inflows began in the first quarter of 2006 and continued until the second quarter of 2007, with a respite in the second quarter of 2006. Inflation and its components surged in the first quarter of 2006 and peaked in the next quarter, before trending downwards until the second quarter of 2007.¹⁰ Higher global oil prices and their resulting inflationary impact in the first half of 2006 prompted the central bank to raise interest rates, which led to the subsiding effect on inflation until the first half of 2007. With oil prices persistently hovering at high levels in the third quarter, the risk of higher inflation prevails. Some reduction in inflationary pressure may permeate through an increasingly flexible exchange rate and the gradual pace of appreciation.¹¹

Figure 18: Consumer Price Inflation (2005=100) [ PDF 17.8KB | 1 page ]

2. Asset Prices

Table 14: Asset Price Inflation [ PDF 17.8KB | 1 page ]

Large inflows of short-term capital have entered into Malaysian securities markets— equities, bonds, and properties—since the first quarter of 2006. This has somewhat resulted in asset price inflation (as measured by the growth in KLCI). The movement in MHPI was weaker compared to that of the KLCI because restrictions in the property market were relaxed only in late 2006 stretching into 2007. Nevertheless, the monetary authority needs to monitor this trend, given the repercussions of asset price inflation on the economy. Persistently rising asset prices may lead to bubbles with huge economic cost. Furthermore, heightened risk aversion, as exemplified by the recent US subprime turmoil, may lead to massive capital outflow.

Figure 19: Asset Price Inflation [ PDF 16.8KB | 1 page ]

G. The Real Sector

Table 16: Foreign Manufacturing Investment Approvals (By Sector) [ PDF 19KB | 1 page ]

Similar to 1999–2005, investment in the manufacturing sector by non-residents was highly volatile in 2006 to the third quarter of 2007. Moreover, the domestic share of total investment approvals seemed to be higher in 2006.¹²

For the first nine months of 2007, the main recipient of inward direct capital was the electrical and electronic products subsector. This industry continued to attract sizeable capital inflows, in particular for reinvestment and expansion of existing operations in Malaysia. The investments involved the production of semiconductors, fabricated wafers, substrates for the semiconductor industry, and printed circuit boards. This is beneficial to the real economy as it results in technological diffusion and innovation necessary for sustaining long-term economic growth. On the other hand, this industry is also highly sensitive to the health of the global economy, mainly the US. Hence, any sign of global downturn may adversely affect export growth in Malaysia and may result in capital reversal. Apart from this industry, foreign capital also flowed into the energy subsector—petroleum refineries and products, and chemicals and chemical products.

Figure 20: Manufacturing Investment Approvals [ PDF 19KB | 1 page ]

H. The Financial Sector

The trend in net portfolio capital contributed to the deepening of the financial market, as measured by the equity market capitalization to GDP ratio (Table 17 [ PDF 17.1KB | 1 page ] and Figure 21). However, it was not apparent that capital inflows affect financial intermediaries (measured by liquid liabilities ratio) or the financial sector collectively (measured by financial depth indicator).

Figure 21: Financial Sector Deepening [ PDF 17.1KB | 1 page ]

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