Capital Flows To Emerging Markets by Institute Of International Finance
- Capital flows to emerging markets have weakened sharply in recent months. With non-resident inflows looking likely to fall below 2008 levels and rising resident outflows, we now expect that net capital flows to EMs in 2015 will be negative for the first time since 1988 (Chart 1).
- Unlike the 2008 crisis, the pullback from EMs has been driven primarily by internal factors, basically reflecting a sustained slowdown in EM growth and amplified by rising uncertainty about China’s economy and policies.
- We project only a moderate rebound of EM capital flows in 2016 as structural factors continue to weigh on EM growth prospects.
- Monetary policy divergence in mature markets could contribute to market volatility as the Fed starts to raise rates. The possibility of further RMB weakening is another potential source of risk.
- Countries most in jeopardy from EM turbulence include those with large current account deficits, questionable macro policy frameworks, large corporate FX liabilities, and acute political uncertainties. Brazil and Turkey combine these features.
- From a markets perspective, EM equity valuations have fallen to very low levels, but near-term downside risks are high enough to keep investors cautious, absent a clear catalyst for re-entry. Risks for EM corporate bond markets remain elevated, especially given substantial corporate foreign currency exposures as well as pressure on earnings.
Deepening Drought In 2015
Capital flows to emerging markets have weakened markedly this year, after a substantial decline in 2014. We estimate that net non-resident inflows will reach only $548 billion in 2015 down from $1,074 billion last year, sinking below levels recorded in 2008/09. As a share of EM GDP, such inflows have fallen to about 2% from a record high of almost 8% in 2007. Moreover, resident outward investment flows have also accelerated amid the recent turbulence in global financial markets, putting further downward pressure on EM reserves, exchange rates and asset prices (see our September 2015 Global Economic Monitor and Capital Markets Monitor). Taken together, we expect net capital flows1 for our group of 30
EM economies to be negative—on a calendar year basis—for the first time in since 1988, with net outflows projected at $540 billion (Table 1).
On the face of it, the sharp decline in nonresident capital inflows is reminiscent of the 2008/09 financial crisis. However, the underlying factors leading to the pullback are fundamentally different. This year’s decline has been driven by a sustained slowdown in EM growth, and in particular by uncertainty about China’s economy amid continuing concerns about the impact of the Fed’s eventual turn to raise U.S. interest rates. By contrast, back then the collapse in capital flowsreflected a sudden financial crisis and deep recession in mature economies that spilled over rapidly to emerging markets. The 2008/09 crisis triggered a broadbased “sudden stop” event after years of strong capital inflows, expressed in a
massive reversal of banking and portfolio flows. By contrast, this year’s slowdown represents a marked intensification of trends that have been underway since 2012, making the current episode feel more like a lengthening drought rather than a crisis event (Chart 2).
While all regions have experienced weaker inflows, it is noteworthy that a large part of the decline in overall flows this year is attributable to flows out of China (Chart 4), which intensified after the PBOC announced a mini-devaluation of the RMB and a shift to a more market-oriented exchange rate fixing regime in August.
On a component basis, portfolio flows account for a significant portion of the recent drop in EM capital flows. Portfolio equity and debt flows saw a sharp reversal over the summer in the context of a precipitous EM stock market selloff (Chart 3). We estimate that outflows of portfolio capital in 2015Q3 amounted to $40 billion, the worst quarter since 2008Q4 at the height of the global financial crisis (Charts 4 to 6, see also our September 2015 Portfolio Flows Tracker and Flows Alert). But even before this recent turbulence, portfolio flows had been on a downward trend for several months. In light of these developments, we have slashed our projections for 2015 portfolio flows to $26 billion for equity flows (from $144 billion projected in May) and $109 billion for debt flows (from $193 billion).
However, the component that has been most affected by recent market volatility is bank lending. Our latest projections look for commercial banks to reduce crossborder exposure to EMs by $134 billion on net in 2015, led by repayments of dollardenominated loans by Chinese corporates after years of heavy offshore borrowing. In addition, Russia is projected to see a further reduction in foreign bank credit to the tune of $22 billion this year, after years of heavier retrenchment. Meanwhile, after being resilient since the crisis, FDI inflows are also showing signs of a modest decline, and are projected to dip to $535 billion this year from $586 billion in 2014, in part reflecting cutbacks in spending on commodity-related infrastructure projects in the wake of steep commodity price declines.
The factors that are driving inflows lower this year are not new, but rather reflect an intensification of recent trends. Both pull and push factors have had an adverse effect on EM capital flows. On the pull side, weaker growth in emerging economies has rendered their asset markets a less attractive investment destination. Over the past few years, EM growth has declined, both in absolute terms and relative to growth in mature economies, but that trend has intensified this year with the China slowdown and the downturn in the commodity price cycle deepening (Chart 7).
On the push side, concern about spillover effects from Fed liftoff has contributed to uncertainty and market volatility as U.S. labor markets tighten progressively, notwithstanding continued dovish messages from the Fed that policy rate increases would be gradual and data dependent. These messages have contributed to repeated downward revisions in market expectations of the Fed’s policy trajectory (Chart 8). At the same time, the ECB’s launch of full-scale quantitative easing has provided some offset, particularly for EM Europe borrowers with established access to euro funding.
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