## 1. Bank Data (wp1895)

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---

### Introduction: context and data scope
- Uses detailed balance sheets of individual banks in Malaysia and individual foreign investment funds that hold Malaysian LCY government securities.
- Key Malaysian LCY fixed-income instruments: Malaysian government securities (MGS), Shariah-compliant Malaysian Government Investment Issue (MGII), and Bank Negara Malaysia (BNM) bills.
- These instruments together account for about 50 percent of GDP.
- FX volatility relative to low and stable yields makes FX derivatives indispensable for foreign investors; derivatives attract a wider range of foreign investors and enrich price discovery and liquidity even if netted out and largely cashless.
- BNM bill issuance has been discontinued with a very small fraction of the stock remaining to date; Bank Negara Interbank Bills (BNIBs) have been introduced recently (mentioned in passing in the source).

### Foreign participation and instrument shares
- Foreign holdings of MGS:
  - reached a peak of 52 percent in October 2016;
  - declined to about 40 percent in mid-2017.
- Foreign holdings of MGII:
  - increased from close to zero in 2012 to 8 percent in mid-2017.
- Differences across instruments:
  - MGS and MGII similar in structure (bullet and fixed-coupon), supply of maturities, and secondary market turnover, yet foreign holdings differ markedly.
  - Yields: MGII are generally 5–15 bps higher than MGS with similar maturity; MGII yields act essentially as the ceiling for MGS yields.

### Roles of domestic banks and bank types in holdings and trading
- Domestic banks (local banks and subsidiaries of foreign banks; commercial and Islamic banks) hold:
  - about 30 percent of domestically owned MGS;
  - about 40 percent of domestically owned MGII.
- Bank-type allocations:
  - Commercial banks (local and foreign) allocate to both MGS and MGII, with foreign banks’ holdings biased more towards MGS.
  - Islamic banks (local and foreign) allocate almost exclusively to MGII.
- Trading vs. holdings:
  - MGS secondary-market top ranks dominated by subsidiaries of global investment banks (GIB-subs) such as Citibank, HSBC, and J.P. Morgan.
  - MGII secondary-market top ranks are almost exclusively local banks.
  - Disconnection for MGS between who trades (GIB-subs) and who holds (many local banks); for MGII, top traders and top holders largely overlap.
- Bank balance-sheet specializations:
  - GIB-subs often focus balance sheets on low credit-risk instruments and derivatives.
  - Local banks have more expertise in domestically sourced credit risk (loans, domestic corporate bonds).
- Held-to-Maturity (HTM) classification:
  - A large portion of domestic banks’ holdings in government securities are classified as HTM and thus removed from the secondary market; many local banks have substantially longer-term investment horizons.
- Asset-liability management note:
  - Domestic bonds are main suppliers of longer-term duration risk to local banks, as a majority of them carry fixed-rate coupons while most bank loans are in variable/floating rate terms.

### Market functioning and behavior during stress
- During bond sell-offs by foreign investors:
  - Foreign investors can change exposure via cash bonds and derivatives, so impacts can be felt across bond, FX, and derivatives markets.
  - When liquidity dries up, domestically owned local banks provided liquidity to purchase sold bonds in Malaysia; subsidiaries of foreign banks were as active as local banks in purchasing these bonds.
  - Domestic institutional investors played a more limited role immediately following severe sell-offs, but provide stable and sizable demand in the medium- and long-term.
- Example episodes and international parallels:
  - Convergence of Russian offshore and onshore sovereign bonds occurred during the euro area crisis.
  - Divergence in yields (MGS vs MGII) during the 2013 taper tantrum; yields on bonds with large foreign ownership may temporarily exceed mostly domestically owned bonds before domestic investors step in.

### Market structure, indices, and liquidity signals
- J.P. Morgan GBI-EM index weight for Malaysia:
  - declined from 10 percent on February 26, 2016 to 6 percent on August 31, 2017.
  - About one percentage point of the cut was due to a downgrade in liquidity status of some MGS, attributed by J.P. Morgan to recent developments in the non-deliverable forward (NDF) markets.
  - The decline in Malaysian bond issuance relative to other EMs explains most of the cut in the weight.
- Liquidity and derivatives:
  - Efficient FX derivatives markets attract broader foreign investor participation, aiding price discovery and liquidity.
  - Analysis of foreign ownership risks should ideally cover not only cash bonds but also derivatives exposures because associated cross-border liquidity flows relate to instruments with different issuers and credit quality.

### Short-term instruments (BNM bills) and absorption of short-term flows
- Role of short-term instruments:
  - Short-term instruments can supplement medium- and long-term instruments to fulfill diverse foreign investor strategies, from short-term carry trades to long-term strategic allocations.
  - Existence of multiple instrument types helps the domestic financial system absorb volatile portfolio inflows.
- Observed patterns:
  - Foreign holdings in medium- and long-term government bonds generally trended up, while holdings in short-term instruments were more volatile and could swing widely.
  - Short-term instruments typically have higher secondary-market turnover and can absorb short-term speculative capital flows.
  - Example: In Hungary (2011–12), secondary market turnover of treasury bills almost tripled due to foreign investor operations, while government bond turnover increased less.
  - In Malaysia during 2010–14, secondary market turnover of conventional BNM bills was larger relative to their outstanding stock compared to MGS and MGII, during a period of high foreign participation in BNM bills.
- Policy and market-design implication:
  - The existence of a BNM bill market helped absorb short-term speculative capital inflows and partially insulate MGS and MGII markets despite possibly encouraging more short-term flows in the past.
  - BNM bill issuance has been discontinued; only a very small fraction of stock remains.

### Box 1 — Data processing and banking group structure
- To avoid double counting, unconsolidated financial statements of each entity are processed.
- Local banking groups in Malaysia generally have three lines of businesses located in different legal entities: commercial banking, Islamic banking, and investment banking.
- Most holdings of MGS/MGII and BNM/Treasury bills are booked on the balance sheets of commercial and Islamic banking entities; investment banking entities generally have insignificant size in both total assets and holdings of MGS/MGII and BNM/Treasury bills.

### Box 1 — Accounting categories for banks' fixed-income positions
- A given bank’s position in fixed-income instruments is split into three accounting categories:
  - Financial assets at fair value through profit or loss (“FVTPL”), broadly equivalent to financial assets held for trading (“HFT”).
  - Financial assets available for sale (“AFS”).
  - Financial assets held to maturity (“HTM”).
- HTM accounting treatment is similar in the IFRS and Malaysian FRS; positions classified as HTM are ineligible for secondary market trading except in very rare cases.
- A bank with large holdings classified as HTM will still have little impact on secondary market pricing and turnover.
- For most banks the difference between FVTPL and HFT categories is negligible; the text usually uses the name HFT for the whole FVTPL category.

### Box 1 — Foreign investment funds (FIFs) and MGS holdings
- FIFs were the largest foreign holders of Malaysian domestic bonds in Q2 2017, followed by central banks and governments, pension funds, and banks.
- Availability of micro-level FIF data (mandatory disclosure) enables analysis of FIF behavior in fixed-income, FX, and interest rate derivatives markets; focus here is holdings of MGS (foreign holdings of MGII and corporate bonds are much smaller).
- Data from Bloomberg Finance L. P. indicate:
  - More than 500 FIFs managed by about 150 foreign asset management groups had positions in MGS in Q1 2017.
  - Approximately 95 percent of the FIF holdings in MGS were managed by funds with fixed-income mandates; the remaining 5 percent were managed by funds with multi-assets mandates.
  - Approximately one-third of the FIF holdings in MGS had global mandates and the remaining two-thirds EM mandates.
  - Many FIFs had total return mandates allowing deviation from benchmarks.
- Fund size and trading behavior:
  - Most FIFs are unlikely to engage in high-frequency trading.
  - Fewer than 10 funds had more than one-billion-ringgit exposure.
  - About 85 percent had allocations smaller than 100-million-ringgit.
  - Management fees for institutional share classes generally range between 0.4 percent and 0.8 percent of AUM.
- Top 10 FIF holders of MYR-denominated bonds (end-2016) exhibited diverse FX and interest rate risk exposures:
  - Examples of funds that almost fully eliminate FX exposure to MYR: Vanguard Total International Bond Index Fund, T. Rowe Price International Bond Fund.
  - Examples with extra MYR exposure on top of cash bonds: Templeton Global Bond Fund, PIMCO Emerging Local Bond Fund.
  - Examples concentrating on short-term bonds: Templeton Global Bond Fund.
  - Examples concentrating on long-term bonds: PIMCO Emerging Local Bond Fund.
- Derivatives usage by FIFs:
  - FX forwards are present in virtually every FIF.
  - Interest rate swaps (IRSs) are less common; counterparties for FX forwards and IRSs are typically global investment banks.
  - Derivatives are usually cashless (netted versions preferred by portfolio managers).
  - Cash bonds remain the main recipients of global liquidity; availability of derivatives influences willingness to hold cash bonds.
- ETFs:
  - ETFs represent about one-tenth of the FIF holdings in MYR-denominated bonds (based on Bloomberg Finance L. P.).
  - Some ETFs actively manage portfolios (e.g., WisdomTree Emerging Market Local Debt Fund), but most passively follow indices.

### Box 1 — Key features of MGS and investor strategies
- MGS expose foreign investors to both FX and interest rate risks; LCY bonds carry currency risk unlike Eurobonds.
- MGS coupons represent a low but stable yield stream; FX volatility in Malaysia is high relative to bond yield volatility.
- Most profits and losses (P&L) of LCY bonds come from FX fluctuations.
- EM LCY bonds asset class is perceived as having a high share of actively managed funds.
- Active management in Malaysia can focus on FX exposure management to seek additional returns given high FX volatility and low yields.
- Spectrum of FIF active strategies in EM LCY bonds spans from pure bond positions to pure FX positions with alpha from “currency overlay” and/or “portable alpha” structures.

### Box 1 — Separating FX exposure and duration exposure
- Practical implementation of FIF active strategies relies on separating FX exposure from duration exposure.
- Definitions:
  - FX exposure: investing US dollar liquidity in Malaysian short-term instruments and receiving Malaysian short-term yield interest income, with almost zero duration exposure (numéraire assumed to be US dollar).
  - Separated duration exposure: hedging FX risk (paying cost of hedge), receiving term-spread, and being exposed to capital gains/losses from bond price fluctuations.
- Two main ways to obtain FX exposure:
  1. Convert US dollar liquidity into MYR in FX spot market and invest in short-term instruments (BNM bills, treasury bills, or short-term government bonds).
  2. Construct synthetic exposure: invest US dollar liquidity into USD-denominated short-term instrument and engage in a cashless NDF transaction (forward purchase of MYR). Synthetic position generates interest income equal to implied yield of the NDF contract.
- Operational trade-offs:
  - The second (synthetic) approach can be more efficient because markets for US dollar-denominated short-term instruments and NDFs are more liquid than domestic Malaysian instruments.
  - Synthetic positions generally have lower interest rates than yields of domestic bills and bonds.
- Remuneration for bearing FX risk:
  - Remuneration for bearing FX risk is usually smaller in Malaysia than in other EM countries.
  - Some high-yielding currencies offer higher remuneration (e.g., Brazil BRL and Turkey TRY); some mid- to lower-yielders have lower FX volatility (e.g., Peru PEN and Philippines PHP).
  - MYR offers neither high yield nor low FX volatility.
  - A strong bullish view on Malaysia fundamentals is often a reason to build short-term MYR position.
- Separated duration exposure (fully FX-hedged purchase of Malaysian bonds):
  - Eliminating FX risk requires forward sale of MYR, equivalent to paying the short-term FX forward implied yield as cost of hedge.
  - Hedged position yields the US short-term interest rate, Malaysian term spread, and capital gains/losses of holding Malaysian domestic bond.
  - Hedged Malaysian bonds’ P&L can be rewritten as:
    - Hedged Malaysian bonds’ P&L = [P&L from US Treasuries] + [Risk Add-On]
    - Risk add-on captures the relative impact of idiosyncratic developments in the US and Malaysia domestic bonds markets (spread between return of fully FX-hedged MGS position and return of position in US treasuries).
  - The spread is small compared to hedged positions of some other EM bonds; fully-hedged Malaysian bond return is closer to returns of developed market bonds than to EM bonds.
  - Fully-hedged funds with significant Malaysian bond positions are rare (example: Vanguard Total International Bond Index Fund). Remaining funds with full-hedge mandate represent in total less than 2 percent of the FIF holdings in MYR-denominated bonds.
- Policy implication:
  - Availability of hedging instruments is important for investors to split pure FX and pure duration exposures and to close FX exposure during stress.
  - Loss of confidence in access to hedging instruments would force investors to apply stricter bond liquidity requirements, substantially narrowing the set of acceptable bonds.

### Box 2 — Templeton Global Bond Fund (GBF) case
- Fund characteristics:
  - Global fixed-income mandate.
  - NAV ranged from US$40bn to US$70bn from 2010 to 2016.
  - Operates on a total return basis; not constrained to benchmark weights (Citigroup WGBI used as benchmark but GBF heavily invests in EMs).
- MGS positions and MYR exposure:
  - GBF’s position in MGS was large and volatile; at end-2016 its position exceeded those of most domestic banking groups.
  - Historically, GBF’s position in MGS even exceeded that of the largest domestic banking group, Maybank.
  - Bond holdings could decline sharply (example: MYR16bn to less than MYR4bn from 2013 to 2014).
  - Despite large and volatile MGS holdings, GBF sold all MGS by end-March 2017 and closed NDF contracts on MYR by end-June 2017 (considered Malaysia too externally dependent).
  - GBF’s total exposure to MYR as a share of NAV was relatively stable at around 13±1 percent over 2013–16.
  - A large share of MYR exposure was obtained through FX forwards; in 2016 FX forwards accounted for about 70 percent of total MYR exposure, while in 2014 short-term bills were the main instruments.

### Box 3 — Spectrum of Investment Strategies: Currency Overlay and Yield Enhancement
- Key findings on strategy drivers and benchmarks:
  - Passive allocations to either "100 percent GBI-EM" or "100 percent ELMI+" produce similar returns because both are driven mostly by the FX performance and both include interest income component accrued at a short-term rate (for bonds) or the implied yield (for FX forwards).
  - The deviation of returns of the GBI-EM compared to the ELMI+ is explained by the accrued term spread attributed to the valuation gains and losses of longer-dated bonds.
  - Depending on expertise and willingness to manage FX positions actively, FIF portfolio managers may emphasize either:
    - bond positions (core holdings generating interest income and providing base FX and IR risks) with active FX management supplying portable alpha via currency overlay strategies; or
    - active FX trading as the primary source of return, with bond investments used mainly to increase interest income on top of FX positions.
  - An FIF may assign different countries to different points along the spectrum between pure bonds and pure FX positions, and these assignments may vary through time based on portfolio managers’ judgements.
- Technical definition:
  - J.P. Morgan Emerging Local Markets Index Plus (ELMI+) tracks total returns for local-currency denominated money market instruments in emerging market countries. It is constructed as a strategy of rolling over short-term FX forwards (deliverable and non-deliverable).
- Analytical implications for portfolio construction:
  - Both bond and FX benchmarks embed a short-term interest-income component: for bonds this is the short-term accrued interest; for FX forwards this is the implied yield.
  - Longer-dated bond exposure (GBI-EM) introduces accrued term-spread effects that can cause divergence from short-term-forward-based strategies (ELMI+).
  - Active currency overlay can be a source of portable alpha but requires expertise and willingness to take FX risk.
  - Country-level strategy assignment along the bond–FX spectrum provides flexibility for FIFs to tailor exposures and may change over time with portfolio manager judgement.

### Annex I — Components of the Investor’s Portfolio Terminal Value at T (selected expressions and approximations)
- US Short-Term Instrument: 푉푉0∙(1+푟푟푈푈푈푈푈푈) (Currency: USD)
- FX Forward: − 푉푉0∙(1+푟푟푈푈푈푈푈푈) and 푉푉0∙푆푆0∙(1+푌푌푀푀푀푀푀푀) (Currency: MYR)
- Case 3: Hedged investments in Malaysian bonds — setup:
  - Initial conversion at 푇0: USD liquidity 푉푉0 → 푉푉0∙푆푆0 units of MYR.
  - Total MYR-denominated P&L approximation (from 푇0 to 푇1):
    - 푉푉0∙푆푆0∙(1 + 푌푌푀푀푀푀푀푀) + [ −푉푉0∙푆푆0∙퐷퐷푀푀푀푀푀푀∙∆푌푌푀푀푀푀푀푀 ]
    - Definitions:
      - 푌푌푀푀푀푀푀푀 = average yield of the purchased Malaysian bonds
      - 퐷퐷푀푀푀푀푀푀 = average duration
      - ∆푌푌푀푀푀푀푀푀 = change in yields (assumes parallel shift)
- FX forward contracted at 푇0 to sell MYR at 푇1:
  - Forward sale amount (MYR): 푉푉0∙푆푆0∙(1 + 푌푌푀푀푀푀푀푀)
  - USD liquidity to be received from FX forward:
    - 푉푉0∙푆푆0∙(1 + 푌푌푀푀푀푀푀푀) / 푆푆퐹퐹퐹퐹푈푈
- Annex I — Implied-yield expression and first-order approximation:
  - Exact expression for USD liquidity from FX forward (given implied yield):
    - 푉푉0∙(1 + 푟푟푈푈푈푈푈푈)∙ 1 + 푌푌푀푀푀푀푀푀 1 + 푟푟퐼퐼푀푀
  - First-order approximation:
    - 푉푉0∙(1 + 푟푟푈푈푈푈푈푈 + [푌푌푀푀푀푀푀푀 − 푟푟퐼퐼푀푀])
- USD equivalent of MYR valuation gains/losses and hedging imperfection:
  - MYR valuation term: −푉푉0∙푆푆0∙퐷퐷푀푀푀푀푀푀∙∆푌푌푀푀푀푀푀푀
  - USD equivalent:
    - −푉푉0∙푈푈0∙푈푈푀푀푀푀푀푀∙∆푀푀푀푀푀푀푈푈1 = −푉푉0∙퐷퐷푀푀푀푀푀푀∙∆푌푌푀푀푀푀푀푀∙(1 + 훿훿)
    - Definitions:
      - 푆푆1 = USDMYR spot exchange rate at 푇1
      - 훿훿 = 푆푆0/푆푆1 − 1
    - If hedging is frequent, (훿훿∙∆푌푌푀푀푀푀푀푀) is usually negligible.
    - 훿훿 term represents unavoidable minor FX exposure due to imperfect hedging because ∆푌푌푀푀푀푀푀푀 is an unexpected shock.
- Portfolio value at 푇1 (first-order approximations):
  - 푉푉1 = 푉푉0∙(1 + 푟푟푈푈푈푈푈푈 + [푌푌푀푀푀푀푀푀 − 푟푟푀푀푀푀푀푀] + [푟푟푀푀푀푀푀푀 − 푟푟퐼퐼푀푀] + [−퐷퐷푀푀푀푀푀푀∙∆푌푌푀푀푀푀푀푀])
  - Rate of return (푉푉1 − 푉푉0)/푉푉0 decomposes into:
    - US dollar short-term interest rate: 푟푟푈푈푈푈푈푈
    - Accrued income component (term spread of Malaysian bonds): [푌푌푀푀푀푀푀푀 − 푟푟푀푀푀푀푀푀]
    - Difference between Malaysian domestic short-term rate and NDF implied yield: [푟푟푀푀푀푀푀푀 − 푟푟퐼퐼푀푀]
    - Component from Malaysian domestic yield movements: [−퐷퐷푀푀푀푀푀푀∙∆푌푌푀푀푀푀푀푀]
- Alternative return decompositions and final expression:
  - Return may be written as: 푟푟푈푈푈푈푈푈 + 퐷퐷퐷퐷퐷퐷퐷퐷푀푀푀푀푀푀 (i.e., USD short-term rate plus components of pure duration exposure to Malaysian bond market).
  - Also as: 푟푟푈푈푈푈푈푈 + 퐷퐷퐷퐷퐷퐷퐷퐷푈푈푈푈푈푈 + [퐷퐷퐷퐷퐷퐷퐷퐷푀푀푀푀푀푀 − 퐷퐷퐷퐷퐷퐷퐷퐷푈푈푈푈푈푈], where 퐷퐷퐷퐷퐷퐷퐷퐷푈푈푈푈푈푈 is total return from exposure to US Treasury bonds minus the short-term USD rate.
  - Consequently, total return from the fully FX-hedged position in Malaysian bonds:
    - [Performance of US Treasury bonds] + [Risk Add-On]
    - Where [Risk Add-On] = [퐷퐷퐷퐷퐷퐷퐷퐷푀푀푀푀푀푀 − 퐷퐷퐷퐷퐷퐷퐷퐷푈푈푈푈푈푈], reflecting the relative impact of idiosyncratic developments in the US and Malaysian domestic bond markets and the relative supply of the duration risk.

*Source: IMF working paper (wp1895) — Boxed and Section material excerpted from "Bank Data".*

### 1. Bank Data ______________________________________________________________13

### 1. Bank Data

### Introduction: context and data scope
- The analysis uses detailed balance sheets of individual banks in Malaysia and individual foreign investment funds that hold Malaysian LCY government securities.
- Key Malaysian LCY fixed-income instruments: Malaysian government securities (MGS), Shariah-compliant Malaysian Government Investment Issue (MGII), and Bank Negara Malaysia (BNM) bills.
- These instruments together account for about 50 percent of GDP.
- FX volatility relative to low and stable yields makes FX derivatives indispensable for foreign investors; derivatives attract a wider range of foreign investors and enrich price discovery and liquidity even if netted out and largely cashless.
- BNM bill issuance has been discontinued with a very small fraction of the stock remaining to date; Bank Negara Interbank Bills (BNIBs) have been introduced recently (mentioned in passing in the source).

### Foreign participation and instrument shares
- Foreign holdings of MGS:
  - reached a peak of 52 percent in October 2016;
  - declined to about 40 percent in mid-2017.
- Foreign holdings of MGII:
  - increased from close to zero in 2012 to 8 percent in mid-2017.
- Differences across instruments:
  - MGS and MGII are similar in structure (bullet and fixed-coupon), supply of maturities, and secondary market turnover, yet foreign holdings differ markedly.
  - Yields: MGII are generally 5–15 bps higher than MGS with similar maturity; MGII yields act essentially as the ceiling for MGS yields.

### Roles of domestic banks and bank types in holdings and trading
- Domestic banks (local banks and subsidiaries of foreign banks; commercial and Islamic banks) hold:
  - about 30 percent of domestically owned MGS;
  - about 40 percent of domestically owned MGII.
- Bank-type allocations:
  - Commercial banks (local and foreign) allocate to both MGS and MGII, with foreign banks’ holdings biased more towards MGS.
  - Islamic banks (local and foreign) allocate almost exclusively to MGII.
- Trading vs. holdings:
  - MGS secondary-market top ranks dominated by subsidiaries of global investment banks (GIB-subs) such as Citibank, HSBC, and J.P. Morgan.
  - MGII secondary-market top ranks are almost exclusively local banks.
  - There is a disconnection for MGS between who trades (GIB-subs) and who holds (many local banks); for MGII, top traders and top holders largely overlap.
- Bank balance-sheet specializations:
  - GIB-subs often focus balance sheets on low credit-risk instruments and derivatives.
  - Local banks have more expertise in domestically sourced credit risk (loans, domestic corporate bonds).
- Held-to-Maturity (HTM) classification:
  - A large portion of domestic banks’ holdings in government securities are classified as HTM and thus removed from the secondary market; many local banks have substantially longer-term investment horizons.
- Asset-liability management note:
  - Domestic bonds are main suppliers of longer-term duration risk to local banks, as a majority of them carry fixed-rate coupons while most bank loans are in variable/floating rate terms.

### Market functioning and behavior during stress
- During bond sell-offs by foreign investors:
  - Foreign investors can change exposure via cash bonds and derivatives, so impacts can be felt across bond, FX, and derivatives markets.
  - When liquidity dries up, domestically owned local banks provided liquidity to purchase sold bonds in Malaysia; subsidiaries of foreign banks were as active as local banks in purchasing these bonds.
  - Domestic institutional investors played a more limited role immediately following severe sell-offs, but provide stable and sizable demand in the medium- and long-term.
- Example episodes and international parallels:
  - Convergence of Russian offshore and onshore sovereign bonds occurred during the euro area crisis.
  - Divergence in yields (MGS vs MGII) during the 2013 taper tantrum; yields on bonds with large foreign ownership may temporarily exceed mostly domestically owned bonds before domestic investors step in.

### Market structure, indices, and liquidity signals
- J.P. Morgan GBI-EM index weight for Malaysia:
  - declined from 10 percent on February 26, 2016 to 6 percent on August 31, 2017.
  - About one percentage point of the cut was due to a downgrade in liquidity status of some MGS, attributed by J.P. Morgan to recent developments in the non-deliverable forward (NDF) markets.
  - The decline in Malaysian bond issuance relative to other EMs explains most of the cut in the weight.
- Liquidity and derivatives:
  - Efficient FX derivatives markets attract broader foreign investor participation, aiding price discovery and liquidity.
  - Analysis of foreign ownership risks should ideally cover not only cash bonds but also derivatives exposures because associated cross-border liquidity flows relate to instruments with different issuers and credit quality.

### Short-term instruments (BNM bills) and absorption of short-term flows
- Role of short-term instruments:
  - Short-term instruments can supplement medium- and long-term instruments to fulfill diverse foreign investor strategies, from short-term carry trades to long-term strategic allocations.
  - Existence of multiple instrument types helps the domestic financial system absorb volatile portfolio inflows.
- Observed patterns:
  - Foreign holdings in medium- and long-term government bonds generally trended up, while holdings in short-term instruments were more volatile and could swing widely.
  - Short-term instruments typically have higher secondary-market turnover and can absorb short-term speculative capital flows.
  - Example: In Hungary (2011–12), secondary market turnover of treasury bills almost tripled due to foreign investor operations, while government bond turnover increased less.
  - In Malaysia during 2010–14, secondary market turnover of conventional BNM bills was larger relative to their outstanding stock compared to MGS and MGII, during a period of high foreign participation in BNM bills.
- Policy and market-design implication:
  - The existence of a BNM bill market helped absorb short-term speculative capital inflows and partially insulate MGS and MGII markets despite possibly encouraging more short-term flows in the past.
  - BNM bill issuance has been discontinued; only a very small fraction of stock remains.

*Source: IMF working paper (excerpted section 1: Bank Data).*

### Box 1. Bank Data

### Box 1. Bank Data

### Data processing and banking group structure
- To avoid double counting, unconsolidated financial statements of each entity are processed.
- Local banking groups in Malaysia generally have three lines of businesses located in different legal entities: commercial banking, Islamic banking, and investment banking.
- Most holdings of MGS/MGII and BNM/Treasury bills are booked on the balance sheets of commercial and Islamic banking entities; investment banking entities generally have insignificant size in both total assets and holdings of MGS/MGII and BNM/Treasury bills.

### Accounting categories for banks' fixed-income positions
- A given bank’s position in fixed-income instruments is split into three accounting categories:
  - Financial assets at fair value through profit or loss (“FVTPL”), broadly equivalent to financial assets held for trading (“HFT”).
  - Financial assets available for sale (“AFS”).
  - Financial assets held to maturity (“HTM”).
- HTM accounting treatment is similar in the IFRS and Malaysian FRS; positions classified as HTM are ineligible for secondary market trading except in very rare cases.
- A bank with large holdings classified as HTM will still have little impact on secondary market pricing and turnover.
- For most banks the difference between FVTPL and HFT categories is negligible; the text usually uses the name HFT for the whole FVTPL category.

### Foreign investment funds (FIFs) and MGS holdings
- FIFs were the largest foreign holders of Malaysian domestic bonds in Q2 2017, followed by central banks and governments, pension funds, and banks.
- Availability of micro-level FIF data (mandatory disclosure) enables analysis of FIF behavior in fixed-income, FX, and interest rate derivatives markets; focus here is holdings of MGS (foreign holdings of MGII and corporate bonds are much smaller).
- Data from Bloomberg Finance L. P. indicate:
  - More than 500 FIFs managed by about 150 foreign asset management groups had positions in MGS in Q1 2017.
  - Approximately 95 percent of the FIF holdings in MGS were managed by funds with fixed-income mandates; the remaining 5 percent were managed by funds with multi-assets mandates.
  - Approximately one-third of the FIF holdings in MGS had global mandates and the remaining two-thirds EM mandates.
  - Many FIFs had total return mandates allowing deviation from benchmarks.
- Fund size and trading behavior:
  - Most FIFs are unlikely to engage in high-frequency trading.
  - Fewer than 10 funds had more than one-billion-ringgit exposure.
  - About 85 percent had allocations smaller than 100-million-ringgit.
  - Management fees for institutional share classes generally range between 0.4 percent and 0.8 percent of AUM.
- Top 10 FIF holders of MYR-denominated bonds (end-2016) exhibited diverse FX and interest rate risk exposures:
  - Examples of funds that almost fully eliminate FX exposure to MYR: Vanguard Total International Bond Index Fund, T. Rowe Price International Bond Fund.
  - Examples with extra MYR exposure on top of cash bonds: Templeton Global Bond Fund, PIMCO Emerging Local Bond Fund.
  - Examples concentrating on short-term bonds: Templeton Global Bond Fund.
  - Examples concentrating on long-term bonds: PIMCO Emerging Local Bond Fund.
- Derivatives usage by FIFs:
  - FX forwards are present in virtually every FIF.
  - Interest rate swaps (IRSs) are less common; counterparties for FX forwards and IRSs are typically global investment banks.
  - Derivatives are usually cashless (netted versions preferred by portfolio managers).
  - Cash bonds remain the main recipients of global liquidity; availability of derivatives influences willingness to hold cash bonds.
- ETFs:
  - ETFs represent about one-tenth of the FIF holdings in MYR-denominated bonds (based on Bloomberg Finance L. P.).
  - Some ETFs actively manage portfolios (e.g., WisdomTree Emerging Market Local Debt Fund), but most passively follow indices.

### Key features of MGS (Malaysian Government Securities)
- MGS expose foreign investors to both FX and interest rate risks; LCY bonds carry currency risk unlike Eurobonds.
- MGS coupons represent a low but stable yield stream; FX volatility in Malaysia is high relative to bond yield volatility.
- Most profits and losses (P&L) of LCY bonds come from FX fluctuations.
- EM LCY bonds asset class is perceived as having a high share of actively managed funds.
- Active management in Malaysia can focus on FX exposure management to seek additional returns given high FX volatility and low yields.
- Spectrum of FIF active strategies in EM LCY bonds spans from pure bond positions to pure FX positions with alpha from “currency overlay” and/or “portable alpha” structures.

### Separating FX exposure and duration exposure
- Practical implementation of FIF active strategies relies on separating FX exposure from duration exposure.
- Definitions:
  - FX exposure: investing US dollar liquidity in Malaysian short-term instruments and receiving Malaysian short-term yield interest income, with almost zero duration exposure (numéraire assumed to be US dollar).
  - Separated duration exposure: hedging FX risk (paying cost of hedge), receiving term-spread, and being exposed to capital gains/losses from bond price fluctuations.
- Two main ways to obtain FX exposure:
  1. Convert US dollar liquidity into MYR in FX spot market and invest in short-term instruments (BNM bills, treasury bills, or short-term government bonds).
  2. Construct synthetic exposure: invest US dollar liquidity into USD-denominated short-term instrument and engage in a cashless NDF transaction (forward purchase of MYR). Synthetic position generates interest income equal to implied yield of the NDF contract.
- Operational trade-offs:
  - The second (synthetic) approach can be more efficient because markets for US dollar-denominated short-term instruments and NDFs are more liquid than domestic Malaysian instruments.
  - Synthetic positions generally have lower interest rates than yields of domestic bills and bonds.
- Remuneration for bearing FX risk:
  - Remuneration for bearing FX risk is usually smaller in Malaysia than in other EM countries.
  - Some high-yielding currencies offer higher remuneration (e.g., Brazil BRL and Turkey TRY); some mid- to lower-yielders have lower FX volatility (e.g., Peru PEN and Philippines PHP).
  - MYR offers neither high yield nor low FX volatility.
  - A strong bullish view on Malaysia fundamentals is often a reason to build short-term MYR position.
- Separated duration exposure (fully FX-hedged purchase of Malaysian bonds):
  - Eliminating FX risk requires forward sale of MYR, equivalent to paying the short-term FX forward implied yield as cost of hedge.
  - Hedged position yields the US short-term interest rate, Malaysian term spread, and capital gains/losses of holding Malaysian domestic bond.
  - Hedged Malaysian bonds’ P&L can be rewritten as:
    - Hedged Malaysian bonds’ P&L = [P&L from US Treasuries] + [Risk Add-On]
    - Risk add-on captures the relative impact of idiosyncratic developments in the US and Malaysia domestic bonds markets (spread between return of fully FX-hedged MGS position and return of position in US treasuries).
  - The spread is small compared to hedged positions of some other EM bonds; fully-hedged Malaysian bond return is closer to returns of developed market bonds than to EM bonds.
  - Fully-hedged funds with significant Malaysian bond positions are rare (example: Vanguard Total International Bond Index Fund). Remaining funds with full-hedge mandate represent in total less than 2 percent of the FIF holdings in MYR-denominated bonds.
- Policy implication:
  - Availability of hedging instruments is important for investors to split pure FX and pure duration exposures and to close FX exposure during stress.
  - Loss of confidence in access to hedging instruments would force investors to apply stricter bond liquidity requirements, substantially narrowing the set of acceptable bonds.

### Box 2 — Templeton Global Bond Fund (GBF) case
- Fund characteristics:
  - Global fixed-income mandate.
  - NAV ranged from US$40bn to US$70bn from 2010 to 2016.
  - Operates on a total return basis; not constrained to benchmark weights (Citigroup WGBI used as benchmark but GBF heavily invests in EMs).
- MGS positions and MYR exposure:
  - GBF’s position in MGS was large and volatile; at end-2016 its position exceeded those of most domestic banking groups.
  - Historically, GBF’s position in MGS even exceeded that of the largest domestic banking group, Maybank.
  - Bond holdings could decline sharply (example: MYR16bn to less than MYR4bn from 2013 to 2014).
  - Despite large and volatile MGS holdings, GBF sold all MGS by end-March 2017 and closed NDF contracts on MYR by end-June 2017 (considered Malaysia too externally dependent).
  - GBF’s total exposure to MYR as a share of NAV was relatively stable at around 13±1 percent over 2013–16.
  - A large share of MYR exposure was obtained through FX forwards; in 2016 FX forwards accounted for about 70 percent of total MYR exposure, while in 2014 short-term bills were the main instruments.

*Source: wp1895 - Box 1. Bank Data (PDF).*

### Box 3. Spectrum of Investment Strategies: Currency Overlay and Yield Enhancement

### Box 3. Spectrum of Investment Strategies: Currency Overlay and Yield Enhancement

### Key findings on strategy drivers and benchmarks
- Passive allocations to either "100 percent GBI-EM" or "100 percent ELMI+" produce similar returns because both are driven mostly by the FX performance and both include interest income component accrued at a short-term rate (for bonds) or the implied yield (for FX forwards).
- The deviation of returns of the GBI-EM compared to the ELMI+ is explained by the accrued term spread attributed to the valuation gains and losses of longer-dated bonds.
- Depending on expertise and willingness to manage FX positions actively, FIF portfolio managers may emphasize either:
  - bond positions (core holdings generating interest income and providing base FX and IR risks) with active FX management supplying portable alpha via currency overlay strategies; or
  - active FX trading as the primary source of return, with bond investments used mainly to increase interest income on top of FX positions.
- An FIF may assign different countries to different points along the spectrum between pure bonds and pure FX positions, and these assignments may vary through time based on portfolio managers’ judgements.
- Charts referenced: Charts 1–3 summarize return drivers and the spectrum of strategies between pure bonds and pure FX positions.

### Technical definition (from source)
- J.P. Morgan Emerging Local Markets Index Plus (ELMI+) tracks total returns for local-currency denominated money market instruments in emerging market countries. It is constructed as a strategy of rolling over short-term FX forwards (deliverable and non-deliverable).

### Analytical implications for portfolio construction
- Both bond and FX benchmarks embed a short-term interest-income component: for bonds this is the short-term accrued interest; for FX forwards this is the implied yield.
- Longer-dated bond exposure (GBI-EM) introduces accrued term-spread effects that can cause divergence from short-term-forward-based strategies (ELMI+).
- Active currency overlay can be a source of portable alpha but requires expertise and willingness to take FX risk.
- Country-level strategy assignment along the bond–FX spectrum provides flexibility for FIFs to tailor exposures and may change over time with portfolio manager judgement.

*Source: wp1895 - Box 3. Spectrum of Investment Strategies: Currency Overlay and Yield Enhancement*

### Annex I. Table 1. Components of the Investor’s Portfolio Terminal Value at T

### Annex I. Table 1. Components of the Investor’s Portfolio Terminal Value at T

### Components listed in Table 1
- US Short-Term Instrument: 푉푉0∙(1+푟푟푈푈푈푈푈푈) (Currency: USD)
- FX Forward: − 푉푉0∙(1+푟푟푈푈푈푈푈푈) and 푉푉0∙푆푆0∙(1+푟푟퐼퐼푀푀) (Currency: MYR)
- Note: If the FX Forward is deliverable, then the investor’s portfolio will have the expressed amount of the MYR liquidity.

### Case 3: Hedged investments in Malaysian bonds — setup
- Initial conversion at 푇0: USD liquidity 푉푉0 → 푉푉0∙푆푆0 units of MYR.
- Total MYR-denominated P&L approximation (from 푇0 to 푇1):
  - 푉푉0∙푆푆0∙(1 + 푌푌푀푀푀푀푀푀) + [ −푉푉0∙푆푆0∙퐷퐷푀푀푀푀푀푀∙∆푌푌푀푀푀푀푀푀 ]
  - Definitions:
    - 푌푌푀푀푀푀푀푀 = average yield of the purchased Malaysian bonds
    - 퐷퐷푀푀푀푀푀푀 = average duration
    - ∆푌푌푀푀푀푀푀푀 = change in yields (assumes parallel shift)

### FX forward contracted at 푇0 to sell MYR at 푇1
- Forward sale amount (MYR): 푉푉0∙푆푆0∙(1 + 푌푌푀푀푀푀푀푀)
- USD liquidity to be received from FX forward:
  - 푉푉0∙푆푆0∙(1 + 푌푌푀푀푀푀푀푀) / 푆푆퐹퐹퐹퐹푈푈

### Annex I. Table 2. Components of the Investor’s Portfolio Terminal Value at T1
- Malaysian local bonds: 푉푉0∙푆푆0∙(1+푌푌푀푀푀푀푀푀) (Currency: MYR)
- Valuation adjustment: −푉푉0∙푆푆0∙퐷퐷푀푀푀푀푀푀∙∆푌푌푀푀푀푀푀푀 (Currency: MYR)
- FX Forward: − 푉푉0∙푆푆0∙(1+푌푌푀푀푀푀푀푀) and 푉푉0∙푆푆0∙(1+푌푌푀푀푀푀푀푀)/푆푆퐹퐹퐹퐹푈푈 (Currency: USD)

### Implied-yield expression and first-order approximation
- Exact expression for USD liquidity from FX forward (given implied yield):
  - 푉푉0∙(1 + 푟푟푈푈푈푈푈푈)∙ 1 + 푌푌푀푀푀푀푀푀 1 + 푟푟퐼퐼푀푀
- First-order approximation:
  - 푉푉0∙(1 + 푟푟푈푈푈푈푈푈 + [푌푌푀푀푀푀푀푀 − 푟푟퐼퐼푀푀])

### USD equivalent of MYR valuation gains/losses and hedging imperfection
- MYR valuation term: −푉푉0∙푆푆0∙퐷퐷푀푀푀푀푀푀∙∆푌푌푀푀푀푀푀푀
- USD equivalent:
  - −푉푉0∙푈푈0∙푈푈푀푀푀푀푀푀∙∆푀푀푀푀푀푀푈푈1 = −푉푉0∙퐷퐷푀푀푀푀푀푀∙∆푌푌푀푀푀푀푀푀∙(1 + 훿훿)
  - Definitions:
    - 푆푆1 = USDMYR spot exchange rate at 푇1
    - 훿훿 = 푆푆0/푆푆1 − 1
  - If hedging is frequent, (훿훿∙∆푌푌푀푀푀푀푀푀) is usually negligible.
  - 훿훿 term represents unavoidable minor FX exposure due to imperfect hedging because ∆푌푌푀푀푀푀푀푀 is an unexpected shock.

### Portfolio value at 푇1 (first-order approximations)
- 푉푉1 = 푉푉0∙(1 + 푟푟푈푈푈푈푈푈 + [푌푌푀푀푀푀푀푀 − 푟푟푀푀푀푀푀푀] + [푟푟푀푀푀푀푀푀 − 푟푟퐼퐼푀푀] + [−퐷퐷푀푀푀푀푀푀∙∆푌푌푀푀푀푀푀푀])
- Rate of return (푉푉1 − 푉푉0)/푉푉0 decomposes into:
  - US dollar short-term interest rate: 푟푟푈푈푈푈푈푈
  - Accrued income component (term spread of Malaysian bonds): [푌푌푀푀푀푀푀푀 − 푟푟푀푀푀푀푀푀]
  - Difference between Malaysian domestic short-term rate and NDF implied yield: [푟푟푀푀푀푀푀푀 − 푟푟퐼퐼푀푀]
  - Component from Malaysian domestic yield movements: [−퐷퐷푀푀푀푀푀푀∙∆푌푌푀푀푀푀푀푀]

### Alternative return decompositions and final expression
- Return may be written as: 푟푟푈푈푈푈푈푈 + 퐷퐷퐷퐷퐷퐷퐷퐷푀푀푀푀푀푀 (i.e., USD short-term rate plus components of pure duration exposure to Malaysian bond market).
- Also as: 푟푟푈푈푈푈푈푈 + 퐷퐷퐷퐷퐷퐷퐷퐷푈푈푈푈푈푈 + [퐷퐷퐷퐷퐷퐷퐷퐷푀푀푀푀푀푀 − 퐷퐷퐷퐷퐷퐷퐷퐷푈푈푈푈푈푈], where 퐷퐷퐷퐷퐷퐷퐷퐷푈푈푈푈푈푈 is total return from exposure to US Treasury bonds minus the short-term USD rate.
- Consequently, total return from the fully FX-hedged position in Malaysian bonds:
  - [Performance of US Treasury bonds] + [Risk Add-On]
  - Where [Risk Add-On] = [퐷퐷퐷퐷퐷퐷퐷퐷푀푀푀푀푀푀 − 퐷퐷퐷퐷퐷퐷퐷퐷푈푈푈푈푈푈], reflecting the relative impact of idiosyncratic developments in the US and Malaysian domestic bond markets and the relative supply of the duration risk.

*Annex I. Table 1. Components of the Investor’s Portfolio Terminal Value at T — wp1895*

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_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp1895.pdf_