A recent report issued by the Institute of International Finance (IIF), titled Capital Flows Report, said that inflows to emerging markets (EMs) are skewing to certain markets as a sell-off streak took its toll on most emerging markets.
“Flows have seen a sharp rise since the China devaluation scare in 2015/2016 and by the end of last year had returned to a pace last seen in the run-up to the 2013 taper tantrum. That said, these flows were skewed towards a few emerging markets, including Argentina, South Africa, Colombia, Egypt, Mexico, and Indonesia,” the report noted.
The IIF also said it turned more cautious on emerging markets in February and signalled substantial overvaluation for the Argentinian peso and Turkish lira.
Both currencies have fallen sharply since then, but spill overs to the rest of the EM complex have been limited so far.
The Washington-based firm has built on the Capital Flows Report to examine contagion risk through the lens of non-resident portfolio flows to emerging markets.
It noted that the underlying driver of the sell-off is this year’s rise in the 10-year treasury yield from 2.4% to 3.0%, which is half the size of the move (from 1.6% to 3.0%) that started the taper tantrum.
“If emerging markets are this vulnerable to what can only be described as a moderate rise in global funding costs, we worry about the underlying resilience of EMs,” it added.
Non-resident portfolio flows to EMs fell sharply around the China devaluation scare in 2015/2016, but have rebounded sharply since then and are almost back to levels last seen ahead of the 2013 taper tantrum.
The rebound is not just a China story, given that flows to the rest of EMs have also risen.
“We examine where non-resident portfolio inflows have been large in relation to the local economy by scaling inflows by GDP. It is clear that Argentina emerged in recent years from quasi-autarky, with sovereign bond issuance and associated inflows putting it near the top of EM in terms of inflows,” the report read.
The IIF also examined the dispersion in non-resident portfolio flows, calculating the cross-sectional standard deviation of its GDP ratios at every point.
“Our interpretation is that it becomes harder to identify profitable opportunities as the global “flow” cycle matures, so that non-resident portfolio flows shift to increasingly idiosyncratic places. This can cause flows to become concentrated in a few places, ie for positioning to build up,” the report added.
Few emerging markets, including Argentina, South Africa, Colombia, Egypt, Mexico, and Indonesia, have received especially large inflows in relation to GDP, according to the report.
“At the same time, it is true that comparing 2015-2017 to the three years leading up to the 2013 taper tantrum shows that portfolio inflows in aggregate have been somewhat more modest recently,” it concluded.
“Overall, we remain cautious on EMs, given that the underlying driver of this sell-off—a moderate rise in core G3 rates—is modest. This leaves us worried how well the EM complex will digest a continued move higher in global funding costs,” it added.
Meanwhile, another research note issued by London-based Capital Economics said that the Argentinian peso and Turkish lira came under fire this month, prompting policymakers in both countries to aggressively hike interest rates.
The two currencies have firmed a bit but are still down by over 15% on the month.
Other EM currencies also weakened against a strengthening US dollar, but by a much smaller degree.
“This reflects the fact that other EMs’ external financing vulnerabilities are much smaller. The evidence suggests that macroeconomic stresses will also be primarily focused on Argentina and Turkey, two countries with large economic imbalances and limited reserves.”
“Our financial conditions indices—which are constructed from a range of indicators including market interest rates and credit spreads—show that conditions tightened significantly in Argentina and Turkey but remained essentially unchanged in other major EMs. Indeed, in Turkey financial conditions are now at their tightest since the aftermath of the taper tantrum,” it added.
Policymakers in Argentina and Turkey grabbed the headlines this month.
Argentina’s central bank raised its key rate by 975 basis points (bps) in an effort to support the peso.
Turkish policymakers followed suit, raising rates by 300 bps at an emergency meeting on 23 May. Both countries’ currencies recently pared their losses but are still down by about 25% against the dollar so far this year.
Elsewhere, policymakers in Romania, the Philippines, and Indonesia each hiked their rates by a more modest 25 bps. The Bank of Ghana took a different line, continuing its easing cycle with another 100 bps cut.