Capital flows to EM-30 are forecast to remain at record levels, the recent Middle East related jitters notwithstanding. The stock of potentially fickle non-resident claims has increased tangibly in a number of EM since 2009. While this may increase the magnitude of a potential capital account shock, manageable foreign-currency mismatches will ensure that any sudden reflow of capital will eventually prove largely self-correcting.
Capital flows to EM-30 are forecast to remain at record levels over the next two years. Capital flows comprise foreign direct, portfolio (equity and debt securities) and other investment (trade, credits, loans and currency). By contrast, flows into dedicated EM funds, often used as a benchmark for gauging investor appetite, consist of portfolio investment, as defined above, only. As far as fund flows are concerned, there has recently been a pull-back due to the events in Egypt. The outlook for capital flows to the EM-30, on the other hand, will nonetheless remain solid and is forecast to average USD 900 bn in 2009-12 or 4.4% of aggregate EM-30 GDP. This compares to USD 800 bn in annual flows, or just shy of 7% of GDP, during the pre-crisis 2004-07 boom.
As a share of total flows, FDI and “other” debt flows will remain remarkably stable. Portfolio equity flows will jump from 10% to 20%, while bank lending will decline. This is not surprising given the capital constraints some, especially, developed market banks continue to face. It is in fact remarkable that after net inflows of 30 bn in 2008 and a small net negative flow of USD 15 bn, bank lending to EM should amount to a significant USD 125 bn annually.
Comparing 2004-07 with 2009-12, the most remarkable aspect that emerges is that a sharp increase in portfolio equity flows will almost entirely offset the decline in bank-related inflows. It is not difficult to see what is underpinning these flows. First, mega-low developed markets interest rates make it very attractive, for the moment, for developed market investors to “search for yield” in the EM space. Historically low offshore borrowing rates on account of low G3 interest rates and tight spreads also support inflows. This drives flows into both foreign- and local-currency denominated EM debt instruments. Local EM interest rates fell across the board in the aftermath of the 2008 crisis, but they have remained substantially higher than in the G3 throughout. Moreover, the short-term outlook is for rising EM rates due to growing inflationary pressures.
Second, many EM currencies looked fundamentally undervalued following the crisis and the “flight to safety”. Many EM have sought to slow down or even limit currency appreciation in an attempt to sustain export growth against the backdrop of low capacity utilization rates. Not surprisingly, EM with flexible currencies, high interest rates and open capital accounts have seen the greatest appreciation (e.g. Brazil, Turkey). Some of these currencies now look on the strong side, especially where the financing of their current account deficits is increasingly dependent on non-FDI inflows. Generally speaking, however, EM currencies do not (yet) look overvalued.
Third, improved EM creditworthiness on the back of a solid external position and sustainable public-sector debt have reduced the risk component of the risk-reward equation. This is particularly true relative to DMs, where many sovereigns have in some cases suffered multiple credit rating downgrades. EM sovereign credit ratings have resumed their improvement since the 2008 crisis. And a case can be made that the rating agencies are behind the curve with regards to both emerging and developed economies’ creditworthiness. CDS spreads signal as much. Most major EM sovereigns trade at 150 bp or below – inside of, or close to, many of the EU sovereigns.
Fourth, investors have adjusted upward their short- and medium-term growth projections for the EM, while they have downgraded their assessment of medium-term DM growth given concerns about debt sustainability and adverse demographic changes, especially in Europe and Japan. It appears reasonable for DM investors to increase exposure to EM economies, which are set to increasingly drive global economic growth for the foreseeable future.
Fifth, unlike in the 1990s, capital inflows, by and large, are not financing “excessive” current account deficits. Most major EMs are running current account surpluses, or if they do run deficits, these tend to be small and largely financed by FDI, a few EM excepted. This means that, unlike in the past, large capital inflows do not coincide with deteriorating EM fundamentals and rising net external debt. This should help lower the risk of, at least, credit-driven contagion.
The outlook is for continued, solid capital flows to the EM – short-term Middle East related jitters notwithstanding. A sudden, unexpected re-assessment of the inflation and interest rate outlook for the US and EU is perhaps the most significant near-term risk to the EM capital flow outlook. What if capital flows did stop or even reverse? After all, short-term non-resident claims have increased sharply, especially in countries with open capital accounts (e.g. Brazil, Turkey). In a scenario where foreign investors try to squeeze through a narrow doorframe on the way out, exchange rates and asset prices would decline sharply, in a way similar – though to a lesser extent – to late 2008. In the 1990s, massive capital account shocks drove emerging markets into, or to the brink of, insolvency (e.g. Mexico 1995, Asia 1997, Russia 1998, Brazil 1998/89 and 2002). Today’s more flexible exchange rates, overall improved external positions, the tendency of non-residents to accumulate short-term local- rather than foreign currency claims as well as the greater importance of intra-bank as opposed to inter-bank cross-border lending translate into generally manageable sovereign and country FCY mismatches. This will ensure that any shock will prove largely self-correcting – or, at least, it will be neither systemically destabilising nor will it risk triggering a sovereign credit event, as it would have done in the old days.