SINGAPORE When Malaysia forced foreign investors in its markets not to dabble in offshore derivatives in its currency last year, its target was speculative pressure on the ringgit, but it appears to have shot itself in the foot.
The ringgit was the weakest currency in emerging Asia last year after China's yuan, prompting Malaysia's central bank to get a written commitment from foreign banks to stop trading ringgit non-deliverable forwards (NDFs), offshore contracts they use to hedge their exposure to the currency.
The upshot has been a flood of money leaving Malaysian bonds as foreigners, who own $47 billion of them, were unable to hedge their risks in onshore markets because of a lack of liquidity.
"It's a market that's kind of been destroyed," said Gene Frieda, the London-based global strategist at bond giant fund Pimco, who blamed the inability to hedge for making it difficult to make significant bond trades.
Although Frieda said the currency now looked cheap compared with regional peers, he couldn't see it rallying under the circumstances.
"We don’t find the bond market particularly interesting at these levels," he said.
Analysts at Nomura say November-to-January capital outflows from Malaysia hit a record for a three-month period, when 27.9 billion ringgit ($6.3 bln) of foreign cash upped and left. Foreign holding of government bonds fell to 46 percent of the total outstanding value, from 51.6 percent in October.
The Southeast Asian nation's $97.7 billion of currency reserves are looking vulnerable after having fallen by $3 billion in three months, and the ringgit has fallen 5.7 percent since the end of October.
The central bank, Bank Negara Malaysia (BNM), insists that the NDF market is volatile, opaque and subject to abuse, and it told Reuters it was committed to its policy.
"BNM will continue to enforce the policy of non-facilitation of NDF trading rules on the onshore banks to protect consumers’ interests," it said.
It also insisted that the onshore markets were deep and broad enough to facilitate hedging, with spot and forward trade volumes worth more than $152.4 billion over January and until Feb. 22, of which non-residents accounted for 42.5 percent.
But foreign investors say that while the BNM has succeeded in drying up the NDF offshore market, there just aren't enough onshore sources of dollars to take the other side of their trade.
"The NDF market is now extremely illiquid," said Prashant Singh, lead portfolio manager with Neuberger Berman in Singapore.
"The onshore market is also illiquid, and there is no natural seller of dollars other than BNM themselves for now."
Traders say the BNM's own sales are too irregular to be reliable for their purposes.
The capital outflows do not yet represent a crisis for an economy that still runs a trade surplus, but further capital outflows could result in a sharper ringgit fall, tighten financial conditions and thus threaten both growth and market stability.
Investors' immediate concern is that the foreign money in 10.5 billion ringgit of bonds maturing in mid-March will flee. They already suspect that much of the overseas cash in an 8.75 billion ringgit chunk that matured in mid-February has left the country.
Mohammad Hasif Murad, investment manager at Aberdeen Islamic Asset Management Sdn Bhd, which holds Malaysian government bonds and has some bonds maturing in February and March, said the firm had repatriated some of the proceeds of matured bonds, but has also "strategically reinvested in specific tenors where we see value".
Aberdeen Asia has assets of $3.5 billion, and its allocation to Malaysian local currency assets is approximately $110 million.
Fixed income managers at Old Mutual Global Investors, which has 29 billion pounds ($36.4 billion) under management, paint a gloomy picture.
"We are currently underweight Malaysian bonds and underweight duration given the risk of increased outflows from offshore investors and a likely re-steepening of the local curve as domestic demand will struggle to absorb new debt supply," they said in a note.
There was little incentive to invest in Malaysian bonds without the ability to hedge, given the likelihood that the ringgit will remain undervalued due to increased capital outflows, they said in a note.
Pimco's Frieda says the currency could at some point be an attractive buy, provided there was enough liquidity to transact freely.
"You still have to be able to get in and get out," he said.
($1 = 4.4410 ringgit)
($1 = 0.8046 pounds)
(Additional reporting by Liz Lee and Praveen Menon in KUALA LUMPUR; Editing by Will Waterman)