Capital flows to emerging markets (EMs) recovered in February and March 2014 leading to calmer financial markets. However, the fundamental weaknesses in specific EM economies have not been fully addressed, leaving them exposed to further rounds of capital outflows, weaker currencies and falling asset prices. Some EMs are likely to fare better than others, depending on their underlying fundamentals and the policy measures they have taken so far to address their imbalances.
EMs received large amounts of capital inflows during the period of Quantitative Easing (QE) following the 2008 global financial crisis. Near-zero interest rates in advanced economies drove capital towards higher-yielding EMs. However, since the announcement in May 2013 by the US Federal Reserve (Fed) of the gradual reduction of its asset-purchasing program-the so-called QE tapering-EMs suffered bouts of capital outflows as yields in advanced economies rose, leading to weaker EM currencies, rising yields and falling equity prices (see our commentary from February, Emerging Markets Continue to Suffer from QE Tapering).
Capital outflows were most severe in May 2013 after the initial announcement of QE tapering, but inflows also dropped back to very low levels in late 2013 and January 2014 when the start of QE tapering was actually implemented. Since February 2014, portfolio inflows to EMs have then recovered along with exchange rates and asset prices, begging the question, is the crisis over?
The short answer is no. The EMs that were most adversely affected by the tightening of global liquidity from QE tapering can be characterized by four principal factors. First, they had structural economic weaknesses, such as relatively large current account deficits. Second, they maintained relatively low foreign currency reserves, which act as buffers to absorb capital outflows. Third, they were confronted with high foreign ownership of debt, which has tended to result in higher capital outflows (see our commentary from March, Foreign Ownership of Debt is an Important Indicator of Vulnerability to the Emerging Market Crisis). Finally, a slow or weak policy response, such as delays in raising central bank interest rates, has exacerbated vulnerabilities.
Portfolio Debt and Equity Flows to EMs
The EMs that have experienced the most severe exchange rate depreciation include Argentina, Indonesia, South Africa, Turkey and Ukraine. Based on the factors mentioned above, these are the countries that probably remain the most vulnerable to further capital flight. Each had a high current account deficit in 2013 (3.3% of GDP in Indonesia, 5.8% in South Africa, 7.9% in Turkey and 9.2% in Ukraine), with the exception of Argentina where foreign exchange restrictions kept the current account deficit near balance. They also had relatively low foreign exchange reserves at end-2013 (all below 14% of GDP compared to an average of 21% in the 16 vulnerable EMs we analyzed), limiting their capacity to defend their exchange rates against capital outflows. Furthermore, foreign ownership of debt is high (30.0% of total sovereign debt in Argentina, 55.5% in Indonesia, 35.8% in South Africa, 42.7% in Turkey and 46.4% in Ukraine).
Central banks in Argentina, Indonesia, Turkey and Ukraine have responded. The Argentinian central bank was forced to raise interest rates dramatically (up 17 percentage points since May 2013) as FX reserves evaporated, forcing a devaluation of the Argentinian Peso in January 2014. In Indonesia, the policy rate has been increased by 150 basis points and Turkey’s repo rate has been increased by 450 basis points. The central bank in South Africa is pursuing an inflation-targeting mandate and the official interest rate has only been increased by 50 basis points so far. Ukraine’s central bank increased its policy rate by 300 basis points on April 15 to support the currency, which has weakened by over 30% since the end of February as its political crisis intensified.
On the other hand, some EMs have avoided the worst of the crisis. Brazil has hiked rates 3.5% since May 2013, helping to support the currency despite a large current account deficit (3.6% of GDP) and moderate FX reserves (17.1% of GDP) at end-2013. In India, skillful central bank policies helped limit the weakness of the Indian Rupee through policies to curb imports and encourage exports. Low levels of foreign ownership of debt (only 6.3% of sovereign debt is foreign-owned at end-2013) also helped insulate the Indian Rupee. Poland’s exchange rate has been surprisingly resilient to the crisis, partly due to a relatively small current account deficit (1.8% of GDP), moderate international reserves (18.9% of GDP) and a high share of debt held by foreigners (49.5% of sovereign debt).
In summary, the fundamental vulnerabilities amongst selected EMs remain. QE tapering is expected to continue until late 2014 and is likely to put further pressure on capital flows to vulnerable EMs. Additional exchange rate weakness, higher interest rates, weak growth and financial market instability can therefore be expected. Based on the metrics that we have analyzed, the most vulnerable EMs appear to be Argentina, Indonesia, South Africa, Turkey and Ukraine. However, there is a second tier of EMs that have so far avoided the worst of the crisis but remain exposed, including Brazil, India and Poland. Further EM instability is likely in the months ahead.
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Head of Economics