Home / Market / Mark-to-market /  IMF’s global financial stability report warns of serious risks to emerging market capital flows

The International Monetary Fund’s (IMF’s) Global Financial Stability Report was spot on when it came to foretelling the meltdown in global markets. It was probably just fortunate timing, but a section of the report, published on Wednesday, is titled: Asset Valuations Remain Stretched in Major Markets and Could Adjust Abruptly. It was an eerily accurate prediction of the current mayhem. This time, the trouble started in the US and in the over-owned FAANG (Facebook, Apple, Amazon, Netflix and Google) stocks. The US market breadth was getting narrower by the day, just like in the Indian market and that’s usually a sign of a broader market sell-off.

The IMF report said, “Standard valuation metrics, such as cyclically adjusted price-to-earnings ratios, show that equity valuations in the United States have continued to be elevated well beyond pre-crisis levels despite trade tensions."

What’s the impact on emerging markets? The report says a stronger dollar, higher credit spreads, weaker equity prices and higher domestic interest rates have led to a tightening of financial conditions in recent months, very similar to the taper tantrum episode of 2013.

What is IMF’s prognosis? Well, it says that the fall in inflows to emerging markets is just getting started.

Cast your eyes on the accompanying chart, taken from the report. It details IMF’s forecasts of the fall in inflows from emerging markets on account of three factors—expectations about interest rate hikes from the US Federal Reserve, from the balance sheet contraction of the Fed and on account of risk aversion.

As the chart shows, the cumulative fall in inflows from emerging markets, estimated at $42 billion till the September quarter, is projected to go up by another $10 billion in the current quarter to a cumulative $52 billion. Note that the chart shows the cumulative fall in flows and not the fall in an individual quarter. Also, it shows that inflows are expected to fall by another $36 billion in 2019, bringing the cumulative fall in inflows from the fourth quarter of 2017 to a huge $88.6 billion.

These numbers are just forecasts and they are likely to be far from perfect, but the direction is very clear—inflows are going to fall for a long time. As the report says, this drop in inflows will pose challenges to countries that rely heavily on external financing. In other words, financing India’s rising current account deficit is going to be far from easy.

The numbers given in the chart are the report’s baseline outlook. But it also outlines the worst-case scenario. “The analysis suggests that under a severely adverse scenario… medium-term debt outflows could reach 0.6% of the combined GDP of emerging market economies, excluding China, on a par with the outflows seen during the global financial crisis... This tail-risk scenario would likely have a severe impact on economic performance in emerging markets, especially for sovereign and corporate borrowers that are dependent on external financing.

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