Emerging Markets Outlook
By Armando Armenta
January 2, 2013
There are a number of factors effecting the flows into emerging market economies. I’d like to review several of them in the medium term outlook and let you know why I doubt they will recede soon.
Forecasts from the Institute of International Finance (IIF) show that private capital inflows to Emerging Markets (EM) are expected to increase during 2013 , supporting the positive outlook for valuations in the strategy. Total private inflows into EM would amount to $1.1 billion, an increase of 7.2% from 2012 (see Figure 1). This increase is driven by 33.8% growth in portfolio equity investment and an increase in commercial bank lending of close to 29%. It is relevant, given the historically volatile nature of the capital flow cycle to EM, to disentangle the factors behind this continued reliance of private investors on assets from emerging economies to understand the possible consequences when one or more of these conditions change.
Push and pull factors
Push factors, such as low growth and low interest rates in Developed Economies (DE) and global risk aversion, as well as pull factors like higher terms of trade, healthy public and corporate balance sheets and institutional reforms indicate consistent levels of inflows can be sustained over the coming year.
Push factors: DE growth, monetary conditions and global risk aversion
The deleveraging cycle that has followed the global financial crisis of 2007-2008 has crippled growth and employment results for DE. The recovery from systemic financial crises differs markedly from the usual recovery from past recessions. Figure 2 shows the level of US economic activity remains depressed and still needs a sustained period of growth to recover to the pre-crisis trend. This anemic growth in economic activity and employment should not be surprising if the current situation is compared with past systemic financial crises in developed and emerging economies . This scenario is expected to continue in the medium term as limited fiscal flexibility and high levels of debt in DE inhibit a more active role by the public sector to increase aggregate demand and sustain growth.
Unconventional monetary policy, such as Quantitative Easing (QE), has been effectively eliminating the tail risk of a global recession and decreasing funding risks for DE financial sectors and governments. The decision to keep interest rates at historic lows and vow to keep them low until employment recovers, anchoring expectations of future increases, has lowered real interest rates in DE amid low and stable inflation. Moreover, in the case of the Federal Reserve, the interventions have decreased the available supply of assets like mortgage-backed securities and long maturity Treasuries, a factor that would also boost flows to assets from emerging economies in the quest for higher yields.
In Europe, the Outright Monetary Transactions (OMT) mechanism enacted by the European Central Bank (ECB) has diminished the probability of a currency union break-up in the medium term, an event that was feared could increase global risk aversion to 2008 levels and derail the global economic recovery. Avoiding the “fiscal cliff” in the US, another of the major events feared to bring the global economy back to crisis, would also aid in decreasing global risk. These three push factors (low growth in DE, low interest rate expectations, and a decrease in global risk) are among the main drivers of the continued capital inflows to emerging economies. However they are not the only factors responsible for the increase in flows.
Pull factors: Commodity prices and low leverage
Pull factors such as higher terms of trade, healthy public and corporate balance sheets, and institutional reforms have also played a key role in inflows to emerging economies. These factors were in place before the global crisis of 2008 and should be considered when assessing the effect on EM with future tightening in monetary conditions in developed economies.
A factor threatening capital flows to EM in the past few months, due to the effect on commodity prices, was the possibility of China’s hard landing in economic growth. However, the latest data suggests a lower risk of this scenario as high frequency economic data supports the view that growth has bottomed. Our base case scenario remains that following the ongoing leadership transition, Chinese authorities appear able to guide their economy to a sustained level of growth. This supports the view that commodity prices, which constitute a large portion of the export basket for emerging market economies, are expected to continue supporting flows to EM in the medium term.
Another factor responsible for the increase in inflows to EM is the relative health, compared to their own historical values and to the current situation of developed economies, of public and corporate balance sheets. The emerging economies financial crisis from 1995 through 2001 permitted them to enact precautionary regulation, and most importantly, to decrease public debt to historically low levels (see Figure 5) and increase foreign exchange reserves. This process allowed emerging economies to suffer less from the global financial crisis and still remain a solid source of potential growth. Also, economic authorities have shown the willingness to respond in the monetary and fiscal front to sustain economic activity in the event that growth prospects deteriorate.
Several factors support continued capital inflows to emerging markets. These factors are not expected to recede all at once in the medium term. However, it is important to continuously monitor changes in DE growth, interest rates, global risk, commodity prices, public and corporate balance sheets, as well as the overall soundness of financial sectors. Deteriorations in these have been related to busts that followed booms in capital inflows.
The opinions expressed are those of the author, are based on current market conditions as of Dec. 10, 2012, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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Reinhart, Carmen and Rogoff, Kenneth, October 22, 2012. “This time is different, again? The US five years after the onset of subprime.” http://www.voxeu.org/article/time-different-again-us-five-years-after-onset-subprime-0