The controls had been removed, and the pegged ringgit was lifted in 2005 and later changed to a float system, however, the ringgit remained non-internationalized (Borio and Lowe, 2002). The liquidity of a market is its ability to enhance the purchase and the sale of its assets without causing any drastic or dynamic changes in its assets price. One of the factors that facilitated and enhanced the international investors into the emerging economies and especially those that were in need of an external financing was the interest environment (Gochoco, 2007). The developed economies boasted of their low-interest rates that enhanced their economies. Loose monetary policy and decline in international interest rates in advanced countries are some of the main reasons for the rapid economic growth in the developing countries. On the other hand, the low-interest rates in the developed countries is mainly a push factor and the financial liberalization programs in the developing countries is a major pull factor for increasing portfolio investment.
Secondly, there was abundance in the liquidity and the uncertainty consequently gave rise to the volatility in cross-border capital flows including in Malaysia (Kim et al. 2004). The Capital flows have been contributed by their global risk and especially portfolio flows towards the emerging economies (Ahmed &Zlate, 2014).
There are a number of benefits from international capital inflows especially if it is for investment purposes such as; the promotion of economic development, higher investments in the host countries, additional capital stock that contributes to economic growth and an advanced production technology (Bosworth, Barry P. & M. Collins, 2003). The history of capital controls in Malaysia is one mixed with different incentives and motives (Corbo& Hernandez, 1996). Capital controls were among the policies in the Bretton Woods System which were a system that emerged after the World War 3 and that lasted until 1970. After the 1960s some free market economies succeeded in persuading other economies that capital controls were harmful and that they ought to abandon them and encourage financial globalization.
In Sep 1998 Malaysia imposed capital controls as an emergency measure and solution to tackle its tumbling currency. The exchange controls and limits on portfolio outflows were imposedand found to be effective in containing the severity of the economic crisis. Malaysias recovery from the financial crisis -following the imposition of the capital controlswas attributed to an evident growth in the economy, a slight decline in the level of employment and the real wages reflected promising returns (Bordo& Jeanne, 2002).
In August 2015, Malaysia ruled out its capital controls as the currency plunged drastically due to capital outflows. Malaysia is well positioned to manage its capital flows because of the existence of goodpolicy tools at its disposal to manage anyexcess or shortfall in liquidity arising from capital flows. The continent at large has a policy flexibility to respond efficiently to domestic developments, although their delay is what is found to erode its scope (Adam, 2012).
Financial AssetsFinancial assets are assets that are owned by the company and regarded as intangible in nature because an investor or a financial expert cannot see or touch them (Ogawa and Yang, 2008). Some of the examples of financial assets include those of stocks, bonds, and money (Bank Negara, Malaysia, 2006).Financial assets are derived from a contractual claim, and are mainly liquid in nature such as bank deposits, stocks and bonds and traded in financial markets (Schwartz, 2002). An investor usually makes a choice as to the form of saving he will opt to use depending on the risk and return of each form of asset. Asset prices are also vital as they provide key economic information that is required when making investment and consumption decisions (Tirole, 1985). The mispricing of assets is a serious problem in the financial world because it can damage an economy (Moreno, 1998).
Investment in assets usually involves risk, and since the risk is correlated to the predictability of the outcome, it becomes a key statistical concept (White, 2006). The predictability of security is not always a sign of market failure because a high-risk security can as well result in a high return to the investor in the long run (Roubini, 2006). The Capital assets pricing model postulated by Sharpe, asserts that, the more the number of assets that correlate in the market the higher the risk involved and thus the returns will be generally more because a riskier investment would usually attract higher returns if the investor would prefer investing in such securities (Ventura, 2002).
According to the International Financial Reporting Standards (IFRS), financial assets are classified into four categories which are financial assets held for trading, financial assets with fixed maturities, financial assets that are not listed in active markets and considered to be loans and receivables and the financial assets that are categorized as available for sell (Sharma, 2004).Financial assets held for trading include those that incurred for the purpose of selling and are measured at the fair value. The financial assets with fixed maturities are those assets the company must be willing to hold until maturity (Foong, 2008).Each classification requires different accounting treatment to manage the portfolios mark-to-market gain or loss, hence will impact the portfolio managers behavior in their investment decision to buy, hold or sell in which will have huge implication on portfolio flows.
Current situationCapital flows to EMs has been extremely volatile since mid-2000s driven by loose monetary policies with historical low benchmark interest rates in the DMs (Ananchotikul and Zhang, 2014). Despite that, portfolio flows to EMs hit record high post GFC as global portfolio allocation into EM bonds and equities increased significantly (Global Financial Stability Report, 2014). The EMs rising role as a prominent player in the global economy also attracted portfolio flows supported by strong growth potential and attractively higher investment returns as compared to low yield environment in Developed countries (Karolyi, Ng and Prasad, 2013).
Elliott, Kate, and Ewan (2014) highlighted that the major distinction of global portfolio flows between the Developed and Emerging economies became more apparent since the 2008 GFC. The advanced economies saw a significant drop in portfolio inflows, while the EM countries recorded significant rise (Figure 1). This was attributed by the developments in the advanced countries post GFC that include structural factors that boosted EMs rising dominant in global trade, cyclical factors such as stronger relative growth in EMs and the ultra-loose monetary policies with record low interest rates that crowd-out portfolio investments away from DMs to EMs that offered attractive relative investment returns.
Figure 1: Global portfolio inflows (annual)
Source: Thomson Reuters
The shifting portfolio allocation into EM debts resulted in sharp increase of non-resident holdings of EM domestic currency bonds from US$200 billion at the end of 2007 to US$600 billion in 2014 (Arslanalp and Tsuda, 2015). Meanwhile, Arslanalp and Tsuda (2014) categorized the EM foreign portfolio flows to debt markets by the volatility of the flows and divided it into three phases that include the pre, during and post 2008 GFC crisis. There were no major flows differentiation among the EM countries during the pre-crisis period but the flow differentiation was sharper during crisis. However, the trend was much clearer post 2008 GFC as non-resident flows became positive across the board (Figure 2).
Figure 2: Volatile non-resident flows into EM bonds
Source: Arslanalp and Tsuda (2014)
Portfolio flows to EMs recorded temporary reversal following the Eurozone crisis in 2011 to 2012 (Figure 3). Despite the portfolio flows returned to EMs in 2013, the trend didnt last long. The global financial market development since mid-2013 following the growing prospect of interest rate normalization by the US Federal Reserves shifted the risk towards EMs and magnified portfolio outflows from the EMs (Global Financial Stability Report, 2015).
Figure 3: Portfolio Flows to EMs (cumulative)
Source: EPFR, IMF (Ananchotikul and Zhang, 2014).
The rising financial market expectation about interest rate normalization in the US since mid-2013 and the eventual interest rate hike by the US Federal Reserves in late 2015 triggered massive portfolio outflows and heightened financial market volatility and put tremendous pressure on EM asset classes (Ananchotikul and Zhang, 2014). Figure 4 shows the vulnerability of EM financial asset classes to foreign portfolio flows. EM Equity market indices generally rose while EM government bond yields have been trending lower with the exception during the 2008 GFC, benefitted from the availability of ample liquidity boosted by loose monetary policies in DMs. Meanwhile, EM currencies weakened to multi-year lows following its peak reached during the 2008 GFC.
Figure 4: Vulnerability of EM asset prices to foreign portfolio flows
Source: Ananchotikul and Zhang (2014)
Justification of this researchAs foreign portfolio flows has huge implication on EMs financial assets prices, this research will focus on Malaysia in specific as the country is among one of the favourite destination for foreign portfolio flows (Figure 5). Malaysia benefited from the foreign portfolio flows to EMs, especially in debt flows, due to its developed domestic currency bond market (IMF, 2011) and the openness of its economy and the depth of its capital market (Global Financial Stability Report, 2014). Figure 6 shows that foreign ownership of Malaysia government debts rose from 0.56% at the end of 2003 to 28.89% at the end of 2015 as the government debt market has quadrupled during this period while the foreign holdings in MGS has grown to 47.34% in the same period. Meanwhile, foreign holdings of listed equities at Bursa Malaysia stood at 21.80% as of end 2015 (Figure 7).
Overall, foreign exposure to Malaysia has increased significantly by 4.5 times from 2001 to 2014 to US$ 429 billion inclusive of FDI and FPI, reflecting the countrys strong integration with global financial markets (Sukhdave, 2015). As a consequence, the strong correlation between the performances of Malaysian financial assets with global markets, especially the US, has decline rapidly post the GFC due to the volatile fluctuation of portfolio flows. Despite benefiting the Malaysian economy, financial integration has the setback as it has the propensity to magnify financial shocks elsewhere and exposed the country to the systemic risk.
Figure 5: Beneficiary of Portfolio Allocations from DM to EM countries, 2012 ($US Billion)
Source: Global Financial Stability Report (2014)
Figure 6: Foreign holdings of Malaysian government debt (RM million)
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