research briefing | global...the sharp fall in capital flows in 2011-15. fewer ems fell into...

Contact: Nafez Zouk | [email protected]

19 Oct 2016

Research Briefing | Global

Emerging Markets: Are the times really a-changing?

Economists

Guillermo Tolosa

External consultant to

Oxford Economics

Nafez Zouk

Senior Economist

+44(0)20 7803 1412

There is more to the remarkable rally in emerging market (EM) assets than mere

“risk-on” sentiment; we find that EM resilience to external shocks has

significantly improved since the late 1990s. Indeed, our detailed analysis of

historical capital flows supports the view that EMs have passed the “mother of

all stress tests.” Bottom-up fundamentals remain patchy, however, keeping

sentiment sensitive to domestic and external risks.

The turnaround in EM fortunes has been largely due to a supportive, “risk-on” external

environment, led by: (i) stabilisation of oil prices; (ii) very accommodative monetary

policy globally; (iii) associated expectations of lower-for-longer bond yields; and (iv) a

perceived decrease in external risks, particularly relating to a hard landing in China.

But EM performance also reflects a remarkable resilience to external shocks and the

rapid sell-off in EM assets since 2011, which has been very large by historical

standards. Contrary to comparable episodes, EMs have emerged relatively unscathed

this time, despite capital flows reaching their lowest level ever as a share of GDP.

Better defence mechanisms and policy frameworks have improved resilience

compared with historical “risk-off” episodes. External shocks have become less likely

to trigger negative feedback loops where currencies and spreads spiral out of control.

Still, sentiment towards EMs remains sensitive to negative shocks. Large downside

risks still exist given EMs’ rapid debt build-up, corporate weakness, slow global

growth, and the spectre of corporate defaults, which would negatively impact banking

sectors. We would argue, however, that the lower-for-longer rate environment benefits

EMs given their sensitivity to debt and leverage.

We consider the potential transmission channels of these risks; but our assessment is

that their likelihood and impact is lower than we perceived a couple of years ago.

The heavy sell-off in EM assets since 2011 has been one of the most severe episodes of capital outflows for EMs. But contrary to previous comparable episodes, EMs have emerged relatively unscathed, avoiding recession and the financial crises of the past.

The hunt for yield is

not the only factor

driving the EM rally.

We find that EM

resilience to

external shocks has

significantly

improved, lending

further support to

asset valuations.


19 Oct 2016

“For the loser now will be later to win”?

Times were definitely changing in 1964 when Bob Dylan wrote his famous tune. And they

certainly seem to be changing for emerging markets (EM) assets, which have enjoyed a

remarkable turnaround in 2016. Since the financial turmoil at the beginning of the year,

when Brent crude oil prices reached $28pb and investors feared a hard landing in China

was eminent, EM assets have rebounded sharply. In the second quarter, portfolio inflows

and bank flows staged a strong comeback, intensifying over the summer months.

Dedicated EM funds received inflows of $54 billion during that time, setting a new

historical quarterly record. Institute of International Finance (IIF) estimates indicate that

total overall portfolio inflows to emerging markets reached more than $80 billion in July-

September. These flows have supported EM currencies, pushing equities 30% higher

than their January trough, and narrowing EMBI spreads by 150 bps year-to-date.

The conventional view is that the EM rally was triggered by perceptions that interest rates

would remain lower for longer in developed markets (DM), prompting a “hunt for yield” and

a “risk-on” sentiment that saw a reallocation of funds into riskier assets. This process

started in March, when the ECB cut its interest rate. It picked up in late June after the UK

voted to leave the EU, to which the Bank of England responded by re-igniting its QE

programme—compressing global bond yields. Inaction by the US Fed at its September

meeting, and a pledge by the Bank of Japan to cap 10-year bond yields at zero percent,

have further boosted favourable risk sentiment toward EMs.

EM equities have outperformed global equities since March, driven by a “hunt for yield” spurred by the view that interest rates in developed markets (DMs) would remain lower for longer.

Chart 2

The rally since Q1 2016 has been quite remarkable. EM assets of all classes have not only rebounded sharply from last year, but have outperformed their development market (DM) counterparts by a wide margin year-to-date.

Chart 1

http://www.oxfordeconomics.com/my-oxford/publications/340821



19 Oct 2016

However, the global hunt for yield is not the only factor underpinning the EM rally. First,

EM assets have previously underperformed during periods when global interest rates

were even lower. Secondly—and conversely—EM assets continued to rally despite the

recent increases in the expected future path of the Fed funds rate. Third, the rally seems

to have withstood the volatility in commodity markets. Finally, compared with other high-

yielding assets, EMs seem to have been particularly attractive, pointing to idiosyncratic

factors underpinning the rally.

In addition, the global risks that we were concerned about at the start of the year failed to

materialise, giving EMs an additional boost. Higher political uncertainty in developed

markets (DMs), especially after Brexit, has made EMs look comparatively less risky, and

credit default swap (CDS) spreads have declined across the board this year. Furthermore,

fears of a China hard landing have receded, and the stabilisation in commodity prices has

provided an important support factor for EM risk appetite.

Global hunt for yield is not the only factor underpinning the EM rally. Indeed, EM bond spreads have continued to narrow since June, despite an increase in the expected future path of Fed funds rate.

Chart 3

Higher political uncertainty in DMs, especially after Brexit, have made EMs look comparatively less risky, and CDS spreads have declined across the board this year.

Chart 4


19 Oct 2016

An unprecedented stress test

We believe there are also strong idiosyncratic factors driving the outperformance of EM

assets that have not received enough attention. The current reversal of sentiment toward

EMs comes on the back of a massive reduction in capital inflows into EM assets over the

past few years, which has severely tested their resilience. The evidence suggests EMs

have passed this test with flying colours.

In a detailed study of capital flows to emerging markets over recent years, we find that the

slump in inflows from 2011-2016 was very large by historical standards, larger than the

declines seen in previous episodes of financial distress. Since mid-2011, gross capital

flows into EMs fell by a massive 7% of aggregate GDP, compared with a reversal of only

4.9% of GDP in the last comparable episode, during 1996-02 in the midst of the Asian

financial crisis, the Russian debt crisis, and the Turkish banking crisis. On a net basis (i.e.

allowing for changes in EM investors’ holdings of overseas assets), the slowdown was

slightly less severe than on a gross basis, at 6.3% of EM GDP. However, net flows

actually moved further into negative territory after early 2015 than they did during the

global financial crisis. In addition to the shock’s magnitude, its breadth has been

impressive, hitting almost all EM countries, even those that experienced positive terms of

trade shocks in this period.

But EMs have fared surprisingly well in this “real-life” stress test stemming from collapsing

capital inflows, declining commodity prices, higher borrowing costs, and increased political

turmoil. If we take as reference previous times the external environment turned so sour for

emerging markets (1996-02 and 2007-09), the differences are quite striking. During the

The massive reduction in capital flows in 2011-2016 presented EMs with a significant test of resilience. Not only was the reduction of flows greater than in comparable episodes of financial distress, but the sell-off was indiscriminate, encompassing both commodity importers and exporters.

Chart 5

Despite the commodity price shock being one of the most severe on record, there have been no sovereign defaults among the commodity exporters. This compares favourably with the oil price slump in the 1980s, in which all commodity producers defaulted, except for Malaysia and the Gulf countries.

Chart 6

https://www.oxfordeconomics.com/my-oxford/publications/346461


19 Oct 2016

Asian/Russian crises, nine countries in our sample1 of 30 EMs suffered some combination

of sovereign, banking, and external crises. EMs weathered the Great Recession better,

with only five suffering crisis. This time around, only Ukraine experienced a crisis, but

under an extraordinary set of circumstances. And contrary to previous episodes, losses to

bondholders in the resulting debt restructuring were relatively modest. In net present value

terms, losses to Ukraine’s bondholders were very small indeed.

We find the same pattern of resilience when it comes to real outcomes. Most countries fell

into recession during 1996-99, a large but somewhat smaller number in 2007-09, and only

very few this time around. And although the commodity price shock was one of the largest

on record, we found, in a recent survey we conducted, that sovereign stress is less acute

than in the last oil price slump in the 1980s, when all commodity producers defaulted

except Malaysia and those in the Gulf—most of them more than once.

Resident flows have played an important role in strengthening EM resilience. Rather than

reinforce nonresident outflows, as they did in previous crises, resident flows have tended

to offset them this time around, perhaps reflecting more confidence in domestic policy

frameworks. This has led to comparatively less selling pressure, with EMBI spreads, for

example, widening by less than a quarter of their 1998 spikes, even when the increase in

cost of financing for comparably rated US corporates was similar in both episodes.

1 Argentina, Belarus, Brazil, Bulgaria, Chile, China, Colombia, Croatia, Czech Republic, Estonia, Hungary, India, Indonesia, Korea, Latvia, Lithuania, Malaysia, Mexico, Peru, Philippines, Poland, Romania, Russia, Slovakia, South Africa, Thailand, Turkey, Ukraine, Uruguay, Venezuela.

EMs have displayed impressive resilience to this “real-life” stress stemming from the sharp fall in capital flows in 2011-15. Fewer EMs fell into recession than in previous periods of stress. Crucially, almost all EMs avoided financial, debt, or balance-of-payments crises this time around.

Chart 7

Selling pressures have waned in comparison with previous crises, partly as resident flows have tended to offset rather than reinforce nonresident outflows.

Chart 8



19 Oct 2016

Are EMs inherently stronger?

To a certain extent, yes. Since the last round of crises 15 years ago, many EMs have

improved their macroeconomic frameworks. In practice, that has meant that external

shocks have been less potent at triggering negative feedback loops in which currencies

and spreads spiral out of control, with adverse implications for the non-financial economy

and banking systems (akin to the “when it rains, it pours” syndrome described by

Reinhart-Rogoff-Vegh). Despite the limited improvement in governance indicators in most

EMs, other factors frequently cited as enhancing external resilience have now proven their

relevance in practice:

Improved monetary frameworks. Crucially, many EMs have adopted more flexible

exchange rates, which have helped prevent the confidence shocks that were a feature of

past crises as central banks were relieved from hopelessly clinging to unsustainable

parities. Flexible exchange rates have also played an important shock-absorbing role with

a rather limited impact on domestic inflation. Indeed, all EMs in our sample saw their

currencies depreciate against the USD in 2015. While the immediate payoff in terms of

improved prospects for the exporting sector has generally been limited, depreciated

currencies underpin current forecasts of export-led economic recovery in several cases.

Higher international reserve buffers. Many EMs accumulated sufficient reserves to

withstand severe reductions in capital inflows. This has made it easier to accommodate

shocks to the balance of payments, limiting the need for harsh current account

adjustments (most prominently in China, Russia, Peru, Indonesia, and Malaysia). The

mere existence of such buffers made outflows less relevant than in the past and

speculative attacks less likely (such as in Brazil). EM economies that had built larger

buffers were able to deploy them to prevent greater contractions in aggregate demand.

These included thicker equity cushions for corporates, higher collateral valuations to

underpin new debt, and higher bank capital ratios.

Relative balance sheet strength. In practice, balance sheets have proved resilient to the

large exchange rate variations over the past few years. In fact, many EMs have managed

to improve their net foreign assets during the downturn. In 2015, a large number of EMs

EMs have significantly improved their international reserve buffers since the last round of financial crises 15 years ago, strengthening their resilience against balance-of-payments shocks and enhancing their ability to prevent large contractions in aggregate demand.

Chart 9

https://www.oxfordeconomics.com/my-oxford/publications/295886


19 Oct 2016

benefited from positive valuation effects in the wake of currency depreciations2. In

addition, a move towards accumulating FX liabilities of long maturities has provided a

further degree of insulation from abrupt currency movements. Concerns that aggregate

balance sheet strength could be concealing pockets of considerable vulnerability have not

translated to widespread corporate distress so far.

Improved policy space. Macroeconomic policies have been less pro-cyclical than in the

past. In most cases stabilisers were allowed to operate to at least some extent, and in

others full-blown countercyclical policies were implemented. Interestingly, in 2015, the

year that EMs faced the worst bout of capital outflows, most EMs saw their cyclically

adjusted budget balances improve over the previous year.

Are EMs finally off the hook?

It is certainly tempting to think so, given that the current low-rate environment could last

longer, helping ease financing pressures for many EMs by keeping borrowing costs

relatively lower. Growth prospects also seem to be picking up. Brazil and Russia are both

2 Valuation effects stemming from currency depreciations are calculated as the change in the net international investment position (NIIP) balance in 2015 stripped of the current account balance. This is then expressed as a percentage of the initial net foreign asset position in 2014.

Flexible exchange rates have helped EMs better absorb external shocks. In 2015, many EMs benefited from positive valuation effects in their net international investment positions in the wake of currency depreciations.

Chart 10

Most EMs have retained the ability to deploy countercyclical policies during times of stress. Interestingly, in 2015, the year of the most severe capital outflows, many EMs saw their cyclically adjusted budget balances improve over the previous year.

Chart 11


19 Oct 2016

expected to exit recession next year, and there have been signs of a pickup in industrial

production and exports, especially in emerging Asia. Finally, for the first time in five years,

the EM-DM growth differential, which typically underpins EM capital flows and asset

valuations, is expected to widen again.

But the widening growth differential masks considerable variation across countries,

suggesting that the rally may be more justified in some than in others. Economic

prospects remain weak in many countries, and global trade—crucial for emerging

markets—does not show signs of sustained recovery. Subdued credit conditions could

further constrain EM recovery. Rising bad loans and slowing growth will force banks to

raise provisions going forward, which will hit profits and erode capital buffers, constraining

banks’ ability to provide sufficient finance to fuel an economic recovery. Fiscal conditions

in many EMs (particularly in Latin America) are weak, with continued downgrade

pressures on sovereign credit ratings.

Against this background, sentiment toward EMs is particularly sensitive to negative

shocks. A sudden change in sentiment could bring about new, potentially tougher stress

tests, with significant room for investor retrenchment should conditions for EMs turn sour.

International banks’ exposures are still above those prevailing in 2012 and double the

prevailing levels in 2006. As for funds, exposures are higher than in 2012 and around

triple 2006 levels. Such growing exposures mean that incrementally smaller reductions in

The EM-DM growth differential is expected to widen for the first time in five years, helping to further underpin capital inflows and EM asset performance.

Chart 12

Growth in world goods trade has been very slow in recent years, and we do not expect a rapid pick-up, in part because import growth from emerging markets is no longer providing much positive momentum.

Chart 13




19 Oct 2016

positioning (as a share of total exposures to EMs) could deal incrementally larger blows to

EMs (as a share of their GDP). Some investors could be especially inclined to take profits

given strong recent performance. In addition, markets could potentially turn disorderly

more easily than in the past as they have become less liquid given new regulations for

investment banks.

Views

Our baseline forecast is for DM yields to remain “lower for longer,” meaning that the hunt

for yield will continue to drive larger flows into EMs in the near term. This will be further

supported by the improved resilience of EMs to external shocks, which marks a

reassuring break with their crisis-ridden past.

In addition, if the US rate hike profile remains shallow and well communicated, as we

expect, the literature suggests that the impact of higher DM rates on EM capital flows will

be modest, especially at low levels of Fed funds rates. Indeed, capital flows to EMs

continued to rise during previous period of Fed funds rate increases (2004-06). Also, even

if policy rates were to rise in the US, longer-term yields may not increase, due to a

shortage of safe assets globally. Sustained low rates in Europe may also depress yields,

regardless of US policies. That being said, yield attraction may not be enough if

commodity prices weaken again or if DM yields rise faster than expected, which, as we

pointed out in a recent note, could jeopardise a more sustained recovery in capital flows to

EMs.

But despite improvements in the external conditions facing EMs, there is still a

considerable chance that growth will continue to disappoint, and large downside risks,

which we highlight in the table below, still exist. In particular, we remain concerned that

the large debt burden among EMs could result in a deleveraging cycle that creates strong

headwinds for growth and investment. Steadily deteriorating quality of corporate balance

sheets could trigger a credit event that could bring to the fore vulnerabilities and dent

confidence more widely—especially if state-owned enterprises are involved. Another risk

event surrounding China cannot be disregarded: A reining in of credit growth, or Trump’s

accession to the US presidency, for example, would have a material impact on EM

economies—and on commodity prices and global trade. This could end up triggering a

sustained increase in risk aversion that could set the stage for markets to turn back

against the asset class once again.

Previous periods of increases in Fed funds rate were not associated with a reversal of capital flows to EMs. Our baseline scenario is for a relatively shallow increase in US rates, which will have a manageable impact on capital flows to EMs.

Chart 14






19 Oct 2016

Risk Transmission channel Shift in views from a year ago

Steeper-than-expected yield curves in

DMs

• Unwinding of built-up positions

reverses EM portfolio flows

• Higher borrowing costs increase

short-term debt rollover risks in

corporate sector

• Higher risk of default, especially

among high-yield EM issuers

• Banks face rising funding costs,

especially in FX, exacerbating currency

mismatch and leading to tighter credit

conditions

Less risky: expect a more

shallow US rate hike profile;

global shortage of safe assets

will likely keep long-term

yields "lower for longer"

Tighter policies in China weigh on

growth

Fears of a hard landing recede, but

tighter policies and/or reigning in of

credit dampens outlook for EMs and

for commodity prices.

Less risky: hard landing in

China less likely; instead

authorities to manage

expected slowdown

Political risks emanating from DM

Rise of populist policies in Europe

and/or Trump presidency exacerbate

decline in global trade growth, hurting

EM growth prospects

More risky: increased populist

pressures could lead to

protectionist policies

Renewed volatility in commodity prices

Close correlation with oil prices (and

indirectly with US equities) removes

key element of support for EM assets

Unchanged: downside risks

still exist given sluggish nature

of world growth and past

patterns of commodity decline

Default of large state-owned entreprises

(SOEs)

Contingent liabilities of sovereign come

to the fore, especially from exposed

(and highly indebted) SOE sector

Less risky: lower borrowing

costs could make any default

more manageable

Emerging markets: Assessment of Risks

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