TWN Info Service on Finance and Development (Mar14/02)
17 March 2014
Third World Network
 
Turn of year sees investors retreat from emerging economies
Published in SUNS #7760 dated 11 March 2014
 
Geneva, 10 Mar (Kanaga Raja) -- The retreat of investors from emerging market economies resumed in full force around the turn of the year, "as their subdued growth outlook continued to diverge from the optimistic sentiment in mature markets and as US monetary policy reduced the flow of easy money", the Bank for International Settlements (BIS) has said.
 
In its latest Quarterly Review of March 2014, the Basel-based central bank stated that investors were also unsettled by signs of economic weakening and growing financial risks in China.
 
"The upshot was portfolio outflows and declining asset values. In parallel, some emerging market currencies depreciated sharply, prompting authorities to defend them by raising policy rates and intervening in foreign exchange markets," it said.
 
According to BIS, while the average exchange rate dynamics during the January sell-off were similar to those in mid-2013, the underlying drivers differed.
 
After the unexpected official announcement that the Federal Reserve envisaged tapering its large-scale bond purchases, the large depreciations in the earlier episode tended to be by the currencies of emerging market economies with large external imbalances, high inflation or rapidly growing domestic credit.
 
"By contrast, the recent depreciations reflected political uncertainties and differences in growth prospects. Central banks in emerging market economies also intervened much more forcefully this time round, thereby stabilising and in some cases boosting their currencies."
 
In advanced economies, BIS noted, markets maintained their rally into the first weeks of 2014.
 
According to BIS, investors there rode on policy commitments to support growth as well as on positive economic surprises, notably in the euro area and the United Kingdom.
 
Thus, it said, they took in their stride the announcement and subsequent start of US tapering. The tightening of credit spreads continued until mid-January, while steady inflows into equity funds maintained upward pressure on stock prices.
 
"However, towards the end of January, disappointing data on US job growth and headwinds from emerging market economies led to a sharp, albeit temporary, drop of valuations in all but the safest asset classes."
 
According to the Quarterly Review, the recent sell-off in emerging market economies occurred against the backdrop of their subdued growth outlook.
 
In January, a survey-based indicator of conditions in China's manufacturing sector dropped into contraction territory for the first time since September 2012, leading market analysts to envisage adverse effects on exporters to China.
 
In the case of Brazil, India and Russia, the indicator had hovered around its neutral level since mid-2013, signalling minor contractions and expansions.
 
"Coupled with a better outlook in advanced economies and a reduction in easy money from the United States, these developments weakened the appeal of emerging markets to international investors."
 
BIS further said that perceptions of growing financial risks had also gained momentum, adding that to an extent, these perceptions were fuelled by political tensions in several countries.
 
But the underlying financial conditions played an important role as well, BIS said, noting that in January, market participants were unsettled by a near default in China's shadow banking sector.
 
"The growing importance of this sector had been revealed in a doubling of the volume of credit provided by Chinese non-banks over the past 18 months, to 25% of total credit in the country."
 
More generally, in parallel with expanding balance sheets, the capitalisation of both non-financial corporates and banks in emerging market economies had deteriorated. The region-wide average ratio of equity over total balance sheet size had fallen gradually but steadily from 2010 to the end of 2013.
 
After subsiding in September and October, investors' retrenchment from emerging markets gathered speed in November, BIS reported, stressing that as a direct manifestation, the outflows from both bond and equity funds intensified and remained sizeable up to end-January.
 
"Retail investors accounted for the bulk of these outflows, while inflows from institutional investors continued. In parallel, and on the heels of a strong two-month rally, a broad equity index lost more than 10% of its value over the three months to end-January."
 
These developments were mirrored in foreign exchange markets, BIS noted, where renewed currency depreciations put pressure on central banks to raise policy rates or tap their reserves.
 
The depreciations started at end-October, maintained their course through the Federal Reserve's tapering decision on 18 December, and accelerated on 23 January, whereby on that date, in an effort to preserve foreign exchange reserves, Argentina's central bank scaled back support for the peso, which immediately lost 10% of its value with respect to the US dollar.
 
"This event spilled over, leading to sharp concurrent depreciations of a number of other emerging market currencies and to an upward spike of the credit spreads on a broad domestic currency bond index," said BIS.
 
However, policy interventions in emerging market economies bore fruit in February, and these interventions "stabilised and in some cases boosted emerging market currencies, providing breathing space to local corporates that had increasingly tapped international markets by issuing foreign currency bonds. Likewise, stock indices recovered most of their January losses and credit spreads tightened."
 
Comparing the sell-off episodes of mid-2013 and January 2014, BIS emphasised that the two emerging markets sell-offs differed in important ways.
 
The episode in mid-2013 was triggered by an unexpected official announcement that the Federal Reserve envisaged tapering its large-scale bond purchases.
 
"This announcement had been preceded by a period of relatively stable exchange rates and low and falling interest rates in emerging economies."
 
In contrast, by end-2013, markets had digested the actual start of US tapering and the macroeconomic outlook had deteriorated in many emerging markets. Thus, during 2013, emerging market exchange rates had already depreciated by around 10% on average vis-a-vis the US dollar.
 
At the same time, interest rates had risen continuously as several emerging market countries, such as India, had already tightened policy rates in response to the sell-off in mid-2013. And when market pressure escalated on 23 January, strong policy responses translated into a much steeper interest rate hike than during the previous episode.
 
In addition, said BIS, foreign exchange risk gradually assumed a dominant role in sovereign credit markets over the second half of 2013. During the first sell-off in June, the yields on domestic currency and US dollar debt went up in sync, driven by perceptions of increased sovereign credit risk.
 
By contrast, while the yield on domestic currency debt increased by 80 basis points from July to January, there was virtually no change in the yield on corresponding US dollar debt over the same period.
 
"This suggests that exchange rate risk substituted for credit risk as a key driver of the borrowing costs of emerging market sovereigns," said BIS.
 
This, BIS said, provided the backdrop for different developments in foreign exchange markets across the two sell-off episodes.
 
From mid-May to end-July, it was the currencies of emerging market economies with greater external and internal imbalances that depreciated most. For instance, large current account deficits were associated with downward pressure on currency values.
 
Foreign exchange investors were also wary of those emerging markets that had high inflation rates or had seen rapidly expanding credit to the private non-financial sector. Being among the more vulnerable emerging market economies, India and Brazil saw their currencies depreciate by roughly 10% vis-a-vis the US dollar during that episode.
 
According to the BIS, even though emerging market currencies did depreciate substantially from early 2014 until they stabilised on 3 February, forceful policy actions dampened the effect of market pressure on exchange rates.
 
It noted that as the sudden depreciation of the Argentine peso spilled over, markets did penalise countries with large current account deficits. Thus, the Turkish lira and the South African rand were among the currencies that depreciated the most in the following days.
 
In order to contain these developments and their fallout, a number of central banks responded with strong policy rate hikes in late January and early February. This stabilised exchange rates and even brought them into appreciation territory more recently.
 
For their part, said BIS, the Russian authorities defended the rouble by drawing on their substantial foreign exchange reserves. The Russian central bank sold $7.8 billion in January, compared to a combined $7 billion in June and July.
 
In raising interest rates to defend their currencies, policymakers face a tradeoff, BIS explained. On the one hand, higher rates can stabilise the exchange rate, while on the other hand, they could undermine the macro-economy.
 
"At the current juncture, assessing the appropriate monetary stance in many emerging market economies is further complicated by the fact that monetary policy conditions have been extremely accommodative in past years."
 
Tightening could thus normalise the stance of policy, better aligning interest rates with underlying domestic macroeconomic conditions. Yet the prolonged period of low interest rates has fuelled the rapid build-up of debt in several countries, it said.
 
"Coupled with a weakening economic outlook, raising rates in such an environment could precipitate a disorderly unwinding of financial imbalances by increasing the debt servicing costs of overextended borrowers," BIS cautioned.
 
As for the advanced economies, BIS said that in recent months, investors in these economies acted on perceptions of a favourable growth outlook and in an environment of extraordinary monetary accommodation.
 
"The upbeat sentiment manifested itself in substantial gains in equity markets, sizeable inflows into equity funds and unabated tightening of credit spreads. This strong performance was tested at end-January by the emerging market sell-off and weaker than expected macroeconomic data from the United States."
 
From November to mid-January, BIS noted, stock prices in advanced economies maintained their upward trend, in contrast to those in emerging markets.
 
On the back of a positive growth outlook, the broad stock indices in the United States, the euro area and Japan gained 5%, 4% and 10%, respectively, between 1 November and 22 January.
 
"In the process, markets took in their stride the 18 December announcement of US tapering," it said.
 
In line with their appetite for equities, investors searched for yield in advanced economies' bond markets. As a result, high-yield spreads continued to narrow towards their pre-crisis lows.
 
The spreads on broad corporate bond indices in the United States, euro area and United Kingdom decreased steadily up to mid-January to reach their lowest levels since October 2007.
 
In parallel, said BIS, there was a similar squeeze of the spreads on investment grade corporate bond indices, while the yields on debt issued by sovereigns in the euro area periphery remained flat at lower levels than in mid-2013.
 
"Coupled with an improved growth outlook and expectations of monetary policy tightening, the appeal of relatively risky debt contributed to a repricing of assets in the safest part of the spectrum."
 
In this context, BIS noted that US and UK 10-year sovereign yields rose by roughly 40 basis points over the last two months of 2013, while the corresponding German bund yields edged up by 25 basis points.
 
At the same time, there were outflows from bond funds, said BIS, adding that these outflows were particularly sizeable in the United States, where the Federal Reserve started tapering its bond purchases.
 
Market tensions surfaced briefly in advanced economies at end-January but dissipated by mid-February. Data revealing disappointing job growth in the United States, coupled with a sell-off of emerging market assets, led to a sharp drop in valuations and a rise in equity market volatility as well as in high-yield credit spreads.
 
According to BIS, authorities in advanced economies maintained their support of the economic recovery. Central banks on both sides of the Atlantic had committed explicitly and repeatedly to keep policy rates at ultra-low levels until recovery is well entrenched.
 
"More recently, the US and UK central banks revised their forward guidance to emphasise that the monetary stance would remain accommodative despite a faster than expected reduction in the unemployment rate. Consistent with this, markets pushed back the expected date of policy rate hikes by several months."
 
Futures curves at end-February imply that markets did not expect US or euro area policy rates to rise before late 2015, said BIS.
 
"Likewise, little uncertainty about monetary policy and its impact on inflation, as well as perceptions that markets would absorb the decline in official demand for long-term paper, kept the risk premium of the US 10-year Treasury yield close to zero over the past eight months," it noted.