Emerging Market capital flows prove more volatile in 2018

Web Posted on : Mon, 07 May 2018

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Portfolio capital flows to emerging markets (EMs) were strong during 2017 supported by a backdrop of solid global growth and buoyant risk appetite. However, since February this year capital flows to EMs have been more volatile in the face of rising US interest rates.

The first signs of pressure in 2018 began to emerge in February when the Institute of International Finance (IIF) data shows there was a monthly portfolio capital outflow from emerging markets for the first time since November 2016. An important driver of that capital flow reversal was the continued rise in US interest rates, particularly 10-year treasury bond yields, which increases the relative attractiveness of holding US government bonds versus emerging market assets, a development we discussed in an earlier note (Rising inflation expectations spook markets).

After a period of heightened risk aversion in February, capital flows to EMs stabilised somewhat in March according to preliminary IIF data. However, more recent daily data available from the IIF point to capital flows reversing again in mid-April as US 10-year treasury yields breached 3% for the first time in over four years. Total portfolio capital outflows since 16 April are estimated to be USD5.6bn, split equally between EM equities and bonds.

In part the rise in US 10-year bond yield is being driven by the US Federal Reserve which continues to raise its Federal Funds Target Rate and reduce the size of its balance sheet, and in part by future increases in the US government’s fiscal deficit following the recently announced tax cuts, and the increasing issuance of government bonds that this implies. According to IIF estimates, a 100 basis point increase in short term interest rates in the US would result in a USD43bn reduction in capital flows to EMs in 2018. So far, the US Fed has delivered one rate hike of 25bps this year, and it’s own median projection is for a total of three 25bps rate hikes in 2018.

In a rising interest rate environment investors are likely to pay closer attention to EM economic fundamentals, and in particular to high and rising debt levels as the cost of refinancing debt climbs. In total, more than USD900bn of EM bonds mature before the end of 2018. Those EM economies that have wider current account deficits and higher debt repayments this year are likely to be seen as riskier investments and could potentially attract less foreign capital inflows for the remainder of the year. On the basis of this metric, some emerging markets are likely to be more exposed to sudden shifts in investor sentiment.

While rising US interest rates are clearly a headwind for capital flows to EM economies, this is to some degree balanced by the positive backdrop for global growth which remains supportive of risk sentiment. Instead of an across-the-board flight from emerging markets for the remainder of 2018, investors are likely to be more discriminating across countries on the basis of economic fundamentals as the cost of refinancing or repaying debt rises in the face of rising global interest rates. Those economies with solid economic fundamentals, including high or accelerating growth and lower levels of leverage (both government and private sector) are likely to be relative outperformers in terms of their ability to attract foreign capital inflows. It will no longer be a case of a rising tide lifting all boats.

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