When Argentina did not secure a victory in its first showing at the 2018 World Cup against Iceland, many of their fans started to feel queasy. We can’t blame them. After all, victory only eluded Argentina three times in the past 40 years since Mario Kempes crushed Holland’s hopes by scoring twice in the memorable World Cup final in1978. And Argentina never failed to grab fans’ attention since Diego Maradona beat England’s legendary goalkeeper Peter Shilton with his ‘Hand of God’ goal at the 1986 World Cup.
There is another facet of Argentina that people (especially those in the financial markets) pay decidedly close attention to – its economy. Global investors are very attuned to what is happening in Argentina’s currency and bond markets, and monitor its capital flows actively. There is good reason for this: Argentina’s economic woes in past decades raised some questions on the health of emerging markets. The capital flight in 2000, for instance, spooked investors who lost billions during the Asian Financial Crisis just two years before.
Prior to that, Argentina’s economic crisis in 1995, taking place less than six months after Mexico’s Tequila Crisis, shook global investor confidence in emerging markets. This resulted in a run on the Argentine banking system, precipitating the traumatic credit crunch in March 1995.
Two years later, we know what happened: the Asian Financial Crisis that started with the devaluation of the Thai baht in July 1997 brought Asian countries down to their knees. Malaysia also experienced the dreaded capital flight, as evidenced by its stock market benchmark slumping by 70% at the height of the crisis.
So it was not surprising that sentiment in the emerging markets once again looked fragile when Argentina’s economic chaos stole the limelight last month. Could this be the start of another round of economic woes in the region? Nobody knows for sure – not even the most savvy forecaster.
No doubt, bond market flows in some countries have been affected. In the Malaysian market, for instance, net outflows were recorded in the January-May period, amounting to RM14 billion. As a percentage of total bonds outstanding, foreign holdings of Malaysian bonds have been on the decline since 2016 and are now hitting 14%, down from the recent peak of 21% in the third quarter of 2016. In ringgit terms, about RM18 billion had been relinquished by foreigners in April-May 2018.
However, when juxtaposed against similar events in the past, this is not all too bad. For instance, net outflows of about RM21 billion were recorded during the Trump tantrum in the first half of 2017. But surprisingly, in the second half of last year, net capital flows actually improved and resulted in total net outflows of just RM9 billion for the whole of 2017.
Frequent swings in capital movements in the Malaysian bond market is nothing new. We have seen these over the years and global investors are used to it. Even global credit rating agencies regularly point out that Malaysia is prone to capital reversals, due in part to the Malaysian bond market being one of foreign investors’ favourites. Why is this the case? For one thing, it is one of the most developed and dynamic bond markets in the region, making it fairly liquid. In addition, international credit rating agencies generally view Malaysia’s macroeconomic metrics favourably vis-à-vis other regional economies. They admitted, however, that some macro imbalances relating to the size of government debt and contingent liabilities are rising in recent years.
But with the increasing frequency of the word “contagion” being bandied about recently by journalists and economists, many are searching for more clues on whether the emerging economies could once again see investors fleeing in a big way. Rapid currency depreciations in Turkey and Brazil in the past few months did nothing to help investor sentiment either.
Certain regional developments are worth watching. First and foremost: the China factor. China’s beleaguered equity market clearly affects investor sentiment. It entered bear-market territory in late-June, with the Shanghai stock index tumbling more than 20% from its high in January. This raises the question of whether things are finally crumbling. Lingering investor concerns are gaining momentum, e.g. China’s corporate debt woes, high property prices, and so on. Compounding this is the uncertainty over the impact of a trade war with the US, i.e. how much would China be impacted in terms of headline growth. Signs of anxiety among policymakers are already evident, judging by the third reserve reduction by the People’s Bank of China in late-June amid concerns about declining market liquidity and a potential drag from a trade war with the US. 
China has a considerable amount of policy ammunition, no doubt. Reserves are mounting and monetary policy space is ample. But more critical to investors is its possible use of the exchange rate to defend its economy. Specifically, will China let the renminbi languish further in retaliation to Trump’s imposition of tariffs on some of its products? This is not impossible. After all, as at end-June, the currency has depreciated by 6% against the greenback since end-March.
Such a question is especially pertinent to us because Malaysia is just about to see a positive contribution from its net trade in 2018 that will help sustain its headline growth above 5%. In 2017, exports accelerated but net trade still detracted from headline GDP growth. Only in the first quarter of 2018 did we see net trade jumping by 76%, contributing positively to headline GDP.
A significantly weaker renminbi would likely spoil exporters’ party this year. This will, in turn, dampen investors’ hope of sustainably strong GDP growth. Many export-dependent ASEAN economies would also get hit, thus reducing their appetite for imports from each other. Bear in mind that Malaysia’s exposure to the ASEAN market was nearly 30% of total exports in 2017.
Another point of note is the trend of the ringgit. At least in the past few years, it mirrored the movements of the renminbi. Although this does not imply any causality, investors would likely expect the ringgit to soften if sentiment over the renminbi-US dollar exchange rate continues to crumble.
Secondly, in the world’s largest economy, Uncle Sam is not helping at this juncture either. Investors parsing the Fed’s transcripts have sensed the possibility of a higher-than-expected fed funds rate in 2018. But the scenario of stronger inflation as a result of Trump’s import tariffs that coincide with positive spillovers from the tax cut on the economy is probably underestimated. Just observe the numbers: the jobless rate is at its lowest since the year 2000, way below the so-called non-accelerating inflation rate of unemployment (NAIRU), whilst wage growth has been hovering around 2.5%-3%. Another significant jolt to the economy from the tax cut in 2019 could possibly induce Jerome Powell’s Fed to scramble and be ahead of the curve by raising interest rates more aggressively. The market has probably not yet discounted this. And where would Malaysia’s MGS yield be heading under such a scenario? We can already guess.
Nevertheless, beyond this possibly (and hopefully) short period of financial market volatility, the sky looks clearer for the Malaysian economy. There will be less worry about rising contingent liabilities, and fewer concerns over government debt surpassing the self-imposed limit of 55% of GDP. Expenditures could become leaner and the deficit-reduction path would be clearly paved to achieve the balanced objective of reducing the revenue-spending gap and sustaining growth. A more sustainable pace of investment would also take some pressure off Malaysia’s current account balance by improving the savings-investment gap. This will eventually bolster confidence in the ringgit in the medium term.
Hopefully, emerging market economies will recover strongly after this bout of financial market anxiety. Just like Argentina, which lost its first game in the 1990 World Cup to Cameroon, rebounded strongly in subsequent matches in that year. 
This article was first published in The Edge Malaysia Weekly on 09 July 2018 – 15 July 2018.