The big question for emerging market investors is: When will foreign portfolio inflows revive? There are clear signs that risk appetite is coming back. Money is flowing out of safe haven US money market funds and into risk assets such as emerging markets. EPFR.com’s latest data show that emerging markets equity funds have now taken in $9.4 billion year-to-date while those geared to developed markets have posted collective outflows of $60.3 billion. The Merrill Lynch Fund Manager survey’s risk appetite indicator climbed to a 12-month high in April, with investors massively raising exposure to emerging markets.
Of course, there is still plenty of uncertainty about whether the programmes for nursing the financial sector in the West back to health will work. The International Monetary Fund’s (IMF) most recent World Economic Outlook report, for instance, is uniformly bearish. Their central concern is the negative feedback loop between the financial sector and the economy. So far, much of the distress has been concentrated in the financial sector but as the economy deteriorates, job losses mount and consumers cut back on spending, that could lead to the next wave of bankruptcies and defaults.
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As the report points out, “The core of the problem is that as activity contracts across the globe, the threat of rising corporate and household defaults will imply still higher risk spreads, further falls in asset prices, and greater losses across financial balance sheets. The risks of systemic events will rise, the tasks of restoring credibility and trust will be complicated, and the fiscal costs of bank rescues will escalate further. Moreover, a wide range of financial institutions—including life insurance companies and pension funds—will run into serious difficulties.” What’s more, IMF says that in such an environment, where low interest rates may not help and consumers save more, fiscal and monetary policy may fail to work effectively. Banks may resist lending, as they are doing now.
Also See Foreign Investors Fleeing Asia? (Graphic)
The report points to the extent of deleveraging that may be required by comparing the crisis with previous ones. It says that in both Sweden and Japan, the crisis caused the ratio of bank credit to gross domestic product (GDP) to drop by around a quarter from its peak. It estimates that US and European private sector credit could contract at a 4% quarter-on-quarter annualized rate at its most negative and that a retreat of total cross-border lending to the levels seen as recently as 2004 would imply a contraction of $3 trillion. The point is that this collapse of leverage is likely to hit funding for emerging markets, including portfolio flows. Here’s its prognosis on fund flows to emerging markets: “Emerging markets experienced large portfolio outflows at the end of 2008, and outflows are likely to continue over the coming years, given continued pressures for leveraged investors to shed assets, the risk of further redemptions from emerging market funds and crowding out from government guaranteed mature market bonds. We project annual portfolio outflows of around 1% of emerging market GDP over the next few years. Foreign direct investment in emerging markets is set to slow significantly, given diminished appetite from private equity firms, the lack of credit available to finance acquisitions, and sharply deteriorating cyclical growth prospects in emerging markets. On balance, emerging markets will likely see net private capital outflows in 2009, with slim chances of a recovery in 2010 and 2011. Moreover, risks to these projections appear to be to the downside, given how protracted the current global crisis is likely to be.” Won’t the collapse of deleveraging be offset, at least partially, by central banks cranking up their printing presses? That’s the reasoning behind many explanations of the recent surge in net inflows to emerging markets.
For instance, a Citigroup report dated 24 April points out: “Not just Asian funds benefited from the significant increase in excess foreign liquidity (we look at the gap between supply and demand of money growth in G7), Global Emerging Market funds also received billions of US dollars of net cash last week.” And here’s what Goldman Sachs’ Tushar Poddar and Pranjul Bhandari say about India: “We also expect an improvement in foreign inflows from their lows in October-December 2008, as the external environment improves and given India’s relatively high growth prospects.”
The graphic above shows private portfolio flows to emerging Asia as a percentage of the region’s GDP. Note that these flows are forecast to be negative right up to 2014, the latest year for which IMF has made these forecasts. Note also that the outflows are forecast to get worse, rising from -0.74% of GDP in 2008 to -3.03% of GDP in 2014. IMF obviously believes that this will be the impact of deleveraging. If IMF is right, it does look as if the region’s markets have no hope of reviving till 2014. But take a closer look at the table. Inflows as a percentage of GDP were negative in 2005 and 2006 and only marginally positive in 2003, 2004 and 2007. Yet the period 2003-07 was also the period of the greatest bull run seen in many of these markets, including India. If the Sensex could go up so much despite IMF’s numbers, maybe it will do so again.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org
Graphics by Ahmed Raza Khan / Mint