Emerging Market Crisis And Capital Flows: New Patterns

by: Evariste Lefeuvre

At the Jackson Hole Symposium last year, Helene Rey recommended thinking about EM portfolios flows not in terms of a trilemma (it is impossible to have free capital flows, fixed exchange rates and independent monetary policies) but rather in terms of a dilemma. According to her:

i. The global financial cycle is not aligned with countries' specific macroeconomic conditions; and

ii. There is an "irreconcilable duo": independent monetary policies are possible if and only if the capital account is managed, directly or indirectly. The latest examples of Turkey and Argentina clearly highlight the importance of this dilemma.

The entire analysis rests on the observation that there is a strong common factor driving EM asset class returns and capital flows: risk aversion (proxied by VIX). Unfortunately, as can be seen below, the link between VIX and capital flows to EM countries has weakened dramatically over the recent past.

Of course it could be the fact that VIX, and its inability to properly gauge risk aversion in a time of rising global liquidity, is to blame. But the disconnect calls for further analysis.

The link with UST yields has also weakened (see chart below): in the past few years, rising yields in the US would come along with positive flows to EM. Since tapering began, this has no longer been the case.

Interestingly the link between the common factor of EM currency returns (3M) and the US Treasury yield has vanished, which suggests that the Fed policy's impact on EM markets is much less obvious than in it was mid-2013.

It explains why the Fed did not change the course of its monetary policy tightening on January 29th.

In a perfect world, this kind of situation would call for more monetary policy coordination but this remains unlikely. Ben Bernanke has stressed several times that what was good for the US economy was good for the world economy. In addition, by taking into account the spillover of US monetary policy in its reaction function, the Fed would probably quickly face some conflict with some of its domestic goals. Lastly, the multiplicity of channels through which QE impacts EM markets (liquidity, portfolio, confidence) makes it very hard to gauge the real impact of the Fed on the current crisis.

EM countries are left alone with their traditional economic policy tools: FX reserve depletion, raising interest rates, sharp depreciation and capital controls. Empirical analysis suggests that sharp depreciation and FX sales can ease the GDP loss associated with the crisis but with a strong cost in terms of inflation. It might be a serious issue for countries such as Turkey where 58% of corporate debt is invoiced in USD (33% of GDP!). Yet, rising interest rates (and capital control) do not seem to provide any more benefits. The recent interest rates moves in India, Turkey and South Africa led me to revise downward my EM economic forecasts.

Unfortunately, there is no obvious and effective policy response to an EM crisis. The fact that the global trade is stalling will probably make it harder for EM countries to export their domestic problems.

Bottom Line: capital flows towards EM countries do not react as much as they once did to global confidence as their link with risk aversion and even US treasury yields has vanished. It could be an early indicator that a negative feedback loop will hurt advanced markets soon. Some typical risk aversion cross asset moves have already been noticed (correlation UST and Stock returns for instance)

Yet, the most salient feature of the ongoing crisis is clearly its idiosyncratic (local) nature. Countries are left alone in dealing with the ongoing sudden stops. Barring any international monetary cooperation (the Fed did not consider the spillovers of its policy when it continued to taper), I do not foresee any respite in the near future and continue to favor advanced countries indexes on a relative value basis.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.