BERKELEY – Emerging market economies have experienced hard times in recent months. Net capital flows to these economies declined by an estimated $122 billion, or about 9.6% year on year, in 2013, and fell sharply again during the first two months of this year. What is driving the decline, and how long will it continue?
Global investors have become more risk-averse in response to expectations of tighter monetary conditions in the United States and Europe, as well as concerns about China’s slowing growth and its negative effects on global demand and commodity prices. And, in keeping with past experience, weak sentiment has reduced capital flows to emerging-market economies in general, especially those like Turkey, Indonesia, and Brazil that have large external financing needs or face upcoming elections with uncertain outcomes. The unexpected Crimea crisis, anxiety about Russia’s intentions in the region, and Western sanctions have further unnerved already skittish investors.
From 2002 to 2007, and again after the global financial crisis in 2008-2009, capital flows to emerging economies surged, as global investors searched for yield in conditions of slow growth and recession in developed countries, low interest rates, and ample liquidity. During this period, investors overlooked individual countries’ economic and political risks, lumping very different economies into a single “asset class,” which was viewed as a one-way bet. Flows of foreign direct investment (FDI), portfolio equity, and portfolio debt to emerging markets reached record highs, with portfolio debt, the most volatile and most sensitive to sudden shifts in investor sentiment, growing the fastest.
Unfortunately, several emerging economies – with the notable exception of China – relied on these abnormally large capital flows to finance domestic demand, and their current accounts slid into unsustainably large deficits. Their real exchange rates also appreciated, eroding external competitiveness. The emerging economies hit hardest by short-term capital outflows and equity-market declines during the last year had experienced large appreciations in their real exchange rates and large deteriorations in their current-account positions.
In response to heightened sensitivity to risk and unanticipated losses on their emerging-market assets, investors have become more discriminating, differentiating among countries and sectors. Mexico, with its popular and reform-minded government, strong growth, and a current-account deficit below 2% of GDP, has gained favor with investors, who have turned away from Brazil, with its political risk, faltering growth, and yawning external deficit. At the sector level, businesses providing consumer goods to the growing middle class in emerging markets have become more attractive to global investors, while capital-intensive and cyclical businesses have lost their luster.
Three of the largest emerging markets – India, China, and Russia – confront distinctive challenges. India is suffering from a marked growth slowdown, substantial fiscal and current-account deficits, labor-market rigidities, and uncertainty about economic policy until after its month-long general election ends in May. The Russian economy was slowing even before the Kremlin’s destabilizing incursion into Crimea. Now Russia is teetering on the brink of recession and expects capital outflows to top $70 billion during the first quarter of this year, exceeding the outflows for all of 2013.
With its excess of domestic saving and its maintenance of capital controls, China is comparatively insulated from volatility in short-term flows. But global investors’ sentiment about China manifests itself in a variety of ways, including in the Hong Kong stock market, where many Chinese companies have dual listings, and in the performance of China-tracking exchange-traded funds. Right now, sentiment is decidedly bearish, reflecting concerns about slowing growth, excessive buildup of local-government debt, and possible defaults in the shadow banking sector.
Aggregate capital flows to emerging markets are likely to rebound later this year, but not all countries and all sectors will benefit. And there are significant downside risks to the rebound forecast. A sharp slowdown in China would have negative spillover effects on manufacturing exporters like Korea and Taiwan and commodity exporters like Brazil and South Africa. Stronger-than-expected growth could trigger an increase in long-term US interest rates, encouraging investors to shift more of their holdings from emerging market assets to US assets. A more rapid “taper” of quantitative easing by the Federal Reserve in response to signs of incipient inflationary pressure would have a similar effect. And now there are new risks emanating from worsening East-West relations, escalating sanctions on Russia, and possible contagion effects on other emerging-market countries.
Over the long term, however, the outlook for investing in emerging-market economies, particularly those with strong macroeconomic fundamentals, stable political environments, and an expanding middle class, is promising. The current wave of industrialization and urbanization – associated with faster productivity growth as resources move to higher-productivity activities – is far from over. With faster population and productivity growth, most emerging-market economies’ relative growth advantage over the developed economies will remain sizeable, albeit smaller than in the last decade. Major emerging-market multinational corporations like Samsung, Tata, and Alibaba will also drive growth in their home countries and foster FDI flows among emerging markets.
Stronger interest by institutional investors in emerging-market assets should also boost future capital flows. As part of long-term portfolio-diversification strategies, many large institutional investors have set targets for the share of their funds in emerging-market assets. When retail investors sold off their holdings of such assets during the summer of 2013, institutional investors kept buying.
The next several months are likely to be marked by volatility in capital flows to emerging economies, with significant pressure on vulnerable countries. But a broad-based and sustained withdrawal by global investors from these markets is unlikely. For both retail and institutional investors who distinguish between individual countries’ and sectors’ prospects, emerging markets will remain attractive long-term investment opportunities.