August Is The EMs Key Turning Point For Capital Flows

For the coming months, several factors will influence the dynamics of capital flows, among these, the timing of inflation peaking and the outlook for the Chinese economy will be in focus, says the International Institute of Finance.

“Another important element for the outlook will be the market appetite for new issuance of external debt. Net issuance has also gone negative in recent months and – looking at regions – remains positive only for large oil exporters in the Middle East.

“We think this retrenchment in flows – both on the secondary market and in primary issuance – stems from the Fed’s hawkish shift in June, which now sets the stage for relief across emerging markets as the Fed approaches “neutral,” reducing somewhat the urgency to hike.

“That said, there are obviously pockets of weakness in EM – where real interest rates are deeply negative – and risks are rapidly mounting. Regionally, our data shows outflows across all EM regions,” says the IIF.

In July, EM securities suffered an outflow of $9.8 bn making this a record-breaking fifth consecutive month of outflows (Exhibit 1).

Equity flows and debt flows

“We estimate that EM securities suffered an outflow of $9.8 bn in July 2022. Global recession risk, geopolitics, and inflation weighed on flows, but a less hawkish Fed improves the outlook significantly. Daily flows in late July hint at this positive shift,” says the Institute.

For the month as a whole, equity outflows spilt over to debt flows. The particular feature of this month (July) was the important capital outflow from EM x/China debt (-$6.0 bn), with China debt also showing outflows of around $3.0 bn. EM x/China equities showed marginal inflows ($2.5 bn).

Most of the recent dynamics in flows can be attributed to the Dollar dynamics. In the first few months after Russia invaded Ukraine, the Dollar appreciated substantially against other advanced economies, but remained range-bound against emerging markets.

The dollar fail

The reason the Dollar failed to rise against EM is that higher commodity prices boosted commodity exporters but weighed on commodity importers.

That changed in June as the Fed accelerated its hiking cycle. Emerging markets suffered across the board as tighter global financial conditions weighed on high-beta assets.

“Our high-frequency tracking of non-resident flows to EM reflects this, with non- China flows now as negative as during the 2013 taper tantrum and the 2015 RMB devaluation scare. These outflows are non-trivial, but nowhere near the severity of outflows during the first COVID wave,” it says.