By Joseph Joyce
Volatility has returned to the financial markets. Stock prices in the U.S. have fallen from their September highs, and the return on 10-year Treasury bonds briefly fell below 2%. Financial markets in emerging markets have been particularly hard hit. The Institute for International Finance estimates that $9 billion was withdrawn from equity markets in those countries in October, while the issuance of new bonds fell.
The increased volatility follows a period of rising allocations of portfolio investments by advanced economies to assets in the emerging market economies. The IMF's latest Global Financial Stability Report reported that equity market allocations increased from 7% of the total stock of advanced economy portfolio investments in 2002 to almost 10% in 2012, which represented $2.4 trillion of emerging market equities. Similarly, bond allocations rose from 4% to almost 10% during the same period, reaching $1.6 trillion of emerging market bonds.
The outflows are due to several factors. The first, according to the IMF, is a decline in growth rates in these countries below their pre-crisis rates. While part of the slowdown reflects global conditions, there are also concerns about slowing productivity increases. China's performance is one of the reasons for the lower forecast. Its GDP rose at a rate of 7.3% in the third quarter, below the 7.5% that the government wants to achieve.
Second, the prospect of higher interest rates in the U.S. following the winding down of the Federal Reserve's Quantitative Easing has caused investors to reassess their asset allocations. The importance of "push" factors versus "pull" factors in driving capital flows has long been recognized, but their relative importance may have grown in recent years. A recent paper by Shaghil Ahmed and Andrei Zlate (working paper here) provides evidence that the post-crisis response in net capital inflows, particularly portfolio flows, in a sample of emerging markets to the difference between domestic and U.S. monetary policy rates increased in the post-crisis period (2009:Q3 - 2013:Q2). They also looked at the impact of the U.S. large-scale asset purchases, and found that such purchases had a statistically significant impact on gross capital inflows to these countries.
Part of the increased response in flows between advanced and emerging market economies may reflect the actions of large asset managers. In a paper in the latest BIS Quarterly Review, Ken Miyajima and Ilhyock Shim investigate the response of asset managers in advanced economies to benchmarks of emerging market portfolios. They point out that these managers often rely on performance measures of asset markets in emerging markets, which leads to an increased correlation of the assets under the managers' control. Moreover, relatively small shifts in portfolio allocation by the asset managers can have a significant impact on asset markets in emerging markets. As a result, in recent years "…investor flows to asset managers and EME asset prices reinforced each other's directional movements." Investor flows to the emerging market economies are procyclical. If other factors do not provide a reason to reverse the outflows, they will continue.
The IMF's Global Financial Stability Report also points out: "An unintended consequence of…stronger financial links between advanced and emerging market economies is the increased synchronization of asset price movements and volatility." One downside of increased financial globalization, therefore, is a decline in the ability to lower risk through geographic diversification. Similarly, any notion of "decoupling" emerging markets from the advances economies is a "mirage," according to Mexico's central bank head Agustin Carstens. To achieve international financial stability will require monitoring capital flows across asset markets in different countries; volatility does not respect geographic borders.