International: Malaysia Is Back From the Brink

KUALA LUMPUR, MALAYSIA -- The benign U.S. inflation number did not surprise this long-term deflation watcher. Still, the Fed's Alan Greenspan may well tighten if only to appease growing market sentiment that it would be better to get the process over with and, perhaps more opportunely, to curtail the burgeoning U.S. current account deficit. A 25 b.p. hike is now discounted, and therefore should be neutral for all markets.

A 50 b.p. hike would trigger a rally in the U.S. bond market and a correction on Wall Street. To do nothing would imply more of the same, namely obsessive focus on every word uttered by the Federal governor. The positive point for Asian investors, though, is that the region, with the singular exception of dollar-linked Hong Kong, can decouple from any rise in US interest rates. This is why Asia ex-Japan is likely to continue to be the best performing equity asset class this year. So far this is already the case with the Morgan Stanley Capital International (MSCI) Far East Free ex-Japan index up 37% year to date.

Raising interest rates is certainly the last thing on the mind of Malaysian prime minister, Dr. Mahathir, at the moment. Greed & Fear has been in a conspiratorial Kuala Lumpur this week. The atmosphere is conspiratorial because of the approaching political season and the still lobotomised press. More of that anon; but first some comments on the economy since the stock market trend remains bullish, in the short term at least, in an environment of easy liquidity. The economy is clearly recovering. Government-linked economists are talking about 5% real GDP growth next year, which is not impossible. ABN AMRO Asia raised its own forecast this week to 4.5%.

Positives include rising loan approvals and a robust foreign direct-investment trend. Loan approvals rose 47% year on year in the first four months of this year, totalling 28 billion Malaysian Ringgits. FDI approvals in the manufacturing sector totalled RM6.4 billion in the first five months of this year compared with RM5.5 billion in the same period last year. So capital controls would appear to have had no impact. The impact of the credit crunch, however, is clear from domestic investment approvals in the manufacturing sector. These were RM1.2 billion in the first five months of the year, down from RM8.4 billion in the same period in 1998.

A Boost From Low Rates

The improving climate, as reflected in rebounding industrial production and consumption, is on the back of Malaysian's policy of keeping interest rates extremely low. KLibor is 3.4% which means savers only get 2.5% on deposits. This, combined with the tradition of retail punting, explains the stock market's strength in an environment where capital cannot leave the country.

The stock market surge is of fundamental importance since the index is now approaching the 800 to 850 level on the index, where shares held by the banks as collateral are no longer underwater. Further stock market gains, which seem likely, will enable banks to start the process of writing back non-performing loans creating the clear potential for a virtuous cycle. It should be remembered that the widespread use of share collateral was the chief reason for the scale of Malaysia's stock market crash, which saw the index decline by 87% in U.S. dollar terms from top to bottom. Business groups for the most part borrowed through their private companies but used listed shares as collateral.

The stock market has made its run by and large without the benefit of foreign money. The only active involvement comes from institutional investors trading stocks with money still trapped in the country post the imposition of capital controls last August. Of this, there is only some $5 billion worth, not including strategic foreign-owned stakes held by companies such as Rothmans.

This is way down from the estimated 30% foreign ownership of the stock market reached at the index's peak of 1,272 in February 1997. The market was then capitalised at $357 billion at prevailing exchange rates. So the stake then held by foreigners, assuming 30% ownership, was worth a huge $107 billion. Foreign involvement in Malaysia has therefore collapsed by a factor of more than 95%.

A Likely Boost From Indexing

The key issue for the stock market over the next few months is when Malaysia will be reincluded in the MSCI regional index, since this would imply huge renewed foreign inflow back into the market. If foreigners acquire a 25% stake in the market that would translate into a potential inflow of more than $32 billion, given the present market cap of $130 billion. A return to a full-scale weighting in the MSCI Far East Free ex-Japan index would take Malaysia to a neutral 9.8% weight based on 1 June benchmark. This is clearly too big to be ignored.

Greed & Fear has been of the view for some time that the MSCI is likely to make a formal announcement on Malaysia's reinclusion in August, with the actual index re-entry likely to occur towards the end of the year. The ground should be clear because, by then, portfolio capital will be free to leave the country and a new and more equitable settlement process is likely to be in place. It would also help if the tax on capital gains is removed since, unlike India and other emerging markets with capital gains taxes, there is no route in Malaysia to get around this tax via exploiting double taxation agreements. There is also, of course, no developed American Depository Receipt or Global Depository Receipt market.

One issue is whether Malaysia will be reincluded in the index on a full or qualified basis. This will depend on the perception of whether the market is genuinely open and whether the MSCI is assured that erratic policy flip flops have come to an end. On this point the picture is murky.

The word in Kuala Lumpur is that Dr. Mahathir remains unconvinced about the benefits of getting back into the international investment mainstream. He would see himself as a hostage to foreign sentiment, so often swayed by his musings. His economic tsar, Daim Zainnuddin, probably has a different view, however.

Politics Once Again Takes Center Stage

The ever trenchant views of Malaysia's number one raises the core issue of politics. This, rather than economics, will be the key determinant of the stock market's performance over the next two years. Focus on politics is likely to rise exponentially in Malaysia since Dr. Mahathir is on the point of announcing general elections nine months before they are due. The view of ABN AMRO's Kuala Lumpur office is that Malaysia's next general election will be held in the last week of August or immediately after National Day on 31 August to exploit to the maximum nationalistic statements. The prime minister's tactic is clearly to take advantage of the improving economy and bullish stock market to obtain a new electoral mandate.

The dominant United Malays National Organisation (UMNO), of which Dr. Mahathir is the president, faces its most dramatic challenge for years -- even though the electoral competition comes from a weird combination of three unlikely partners, the Islamic PAS, the Chinese DAP and the multi-racial National Justice Party set up by Wan Azizah, Anwar Ibrahim's wife. But UMNO controls the political machinery and has the funding. It is likely to get 66% of the seats it needs to control parliament.

So, the coming of the election season to Malaysia is likely to mark the beginning of growing political debate, not the culmination of such activity. Dr. Mahathir will help his cause if he announces during this period some clear form of succession mechanism, which will fill the yawing vacuum as a result of his imprisonment of the man he had identified as heir, namely Anwar. The prime minister's problem is that there is no one in the senior ranks of UMNO with anything like Anwar's charisma or popular following. It is therefore premature to take the view that Anwar is "finished" despite his current precarious circumstances.

The investment conclusion from all this continues to be short-term bullish, based on easy liquidity and MSCI reindexation; and medium-term bearish, based on growing political uncertainty and the realisation that the country has, courtesy of capital controls, not yet learned the lessons of Korea, Thailand and Indonesia. That means, that in Malaysia capital continues to be allocated for political reasons in what is still a command economy, where politically favoured businessmen are rewarded with the allocation of plum contracts, particularly in infrastructure and power.

Still the long-term potential remains hugely bullish given the likelihood for Malaysia to return to the fold of international acceptance. Foreign investors should not overlook the potential for what ABN AMRO Malaysia and Singapore research head, Dominic Armstrong, describes as the "Nelson Mandela effect" whereby Anwar one day returns from gaol to a prominent political position. This would undoubtedly create an environment of investment euphoria as Malaysia becomes once again "politically correct."

In Greed & Fear's view there is at least a 50% chance of this occurring on a two-year view. In the meantime Malaysian politics are about to become extremely interesting.

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