Rising rates in the US are changing global capital flow dynamics. Investors will increasingly differentiate between stronger and weaker economies, rather than simply along the lines of emerging versus developed markets.
Among emerging markets, those that have been most reliant on short-term capital, such as Brazil and Turkey, will suffer the most from a tightening in developed market policy rates. However, economies which have benefited from relatively sound reforms and prudent management will be better insulated against rising interest rates.
Despite our view that Asia's net savings will diminish over the coming years, we continue to hold a bullish view on most of the region's currencies, with the notable exceptions being the Chinese yuan and the Japanese yen.
In Latin America, market friendly policies in Mexico, Colombia, Chile and Peru will help to bolster investment in the medium term, while Brazil is likely to remain at risk of losing its status as a major regional investment destination.
Across Emerging Europe only Hungary, Turkey and Russia face imminent risk of destabilising capital flight, with most Central European financial markets likely to remain relatively stable in the face of rising developed state yields.
Since the US Federal Reserve first signalled in mid-2013 that the era of ultra loose monetary policy was drawing to a close, much has been made of the impact that tapering asset purchases would have on both domestic and global economic growth. In the case of the latter, concerns that some emerging markets which grew fat on Fed liquidity would not be able to withstand higher US policy rates triggered hefty currency corrections. Following the FX wobble in August-September 2013, the most vulnerable emerging markets - Brazil, Turkey, India, Indonesia etc - have kept the wolf from the door by raising domestic policy rates.
| Risks Of A 1997 Repeat Are Limited |
|Global - Cumulative Capital Inflows Since 2005, US$trn|
Ultimately, however, hiking interest rates at home will not be sufficient to prevent the shift in global financial flows. For those emerging markets which failed to pursue structural economic reforms during the good times, economic growth will sputter and disappoint. This will underpin a reconsideration of both long-term growth projections and asset valuations. At the same time that emerging market growth models are being scrutinised, there are signs that some developed states are turning a corner, which further brings into doubt the commitment of foreign capital to previously fast growing EMs. Among developed states the US and UK stand out as robust economic growth is slowly absorbing excess capacity and labour markets are recovering. This points in the direction of monetary tightening for both economies, which will present a key policy challenge for governments and central banks in the developing world.
| US And UK Likely To Attract More Foreign Capital |
|Developed States - Financial Inflows Breakdown|
Although we believe that there will be a fundamental shift in global capital flows over the medium to longer term, this is more likely to represent a rebalancing both between and within developed and emerging markets, rather than a wholesale shift from one to the other. Indeed, capital flows will differentiate between stronger and weaker economies rather than the outdated EM-DM paradigm. While the US and UK are motoring ahead and will likely lure in more foreign capital, the heavily bruised eurozone economy is merely limping on. Even if the euro area manages to attract foreign capital with relatively cheap valuations, investors could be left bitterly disappointed as economic growth and corporate earnings eventually hit the buffers absent serious structural reform.
Among emerging markets, those that have been most reliant on short-term capital, such as Brazil and Turkey, will suffer the most from a tightening in developed market policy rates. However, economies which have benefited from relatively sound reforms and prudent management will be better insulated against rising interest rates. Finally, we would stress that compared to the 1997 East Asian financial crisis when many emerging markets were indiscriminately hammered by the shift in global capital flows, this time around many central banks have lower FX debt exposure and larger stockpiles of foreign currency reserves to buffer against external shocks. A key factor which triggered the 1997 crisis was the knowledge that central banks would not be able to defend managed currencies. This time around such concerns are confined to isolated cases.
| Emerging Markets Vulnerable |
|Emerging Markets - Financial Inflows Breakdown|
Asia - Regional Savings Surplus Set To Decline: We expect the trend of rising external assets relative to GDP across Asia, which has been in play since the Asian Financial Crisis, to reverse over the coming years due to a combination of policy, demographic, and external factors. That said, we maintain our bullish outlook for Asian FX in general (with the main exceptions being the Chinese yuan and the Japanese yen), given the strong growth outlook and expectations for subdued inflation over the medium term.
Asia's status as a net external saver is entirely driven by the excessive external assets held by just three countries: Hong Kong, Singapore, and Taiwan, which have net external assets well in excess of 100% of GDP. Despite the large reserve stocks held by central banks in Thailand, Malaysia, the Philippines, and Korea, these represent just one side of the equation, with private sector liabilities (largely in the form of FDI but also in portfolio investments) eclipsing these reserve holdings. Going forward, we expect to see Asia's next external surplus narrow, as surplus countries see their current account surpluses dwindle, while deficit countries are likely to remain in deficit. As a share of GDP, both reserves as a share of GDP, and net international investment positions (NIIP) across the region will fall, reversing a trend that has been in place since the Asian Financial Crisis.
| A Tale Of Two Asias |
|Asia - Net International Investment Balances, % of GDP|
There are three factors at play in this dynamic. Firstly, domestic savings rates are set to decline as a result of policy measures (particularly in the likes of China and Japan) and also deteriorating demographics (again, mainly, but not exclusively, in China and Japan). Secondly, Developed Markets (mainly the US) are likely to see an increase in their external savings rates relative to GDP, pressuring surplus countries within Asia to run narrower trade surpluses. Thirdly, the persistent drag posed by income account deficits across the region will remain in place, undermining current account positions and thus net external assets. Indeed, even countries with relatively large current account surpluses such as China and Malaysia have continued to run income account deficits in recent years owing to the high returns paid out on their FDI liabilities, relative to the meagre returns yielded from their reserve holdings.
Despite our view that Asia's net savings will diminish over the coming years, we continue to hold a bullish view on most of the region's currencies, with the notable exceptions being the Chinese yuan and the Japanese yen. Current account and NIIP surpluses, while positive for currencies under certain circumstances (such as during times of risk aversion), are not very closely related to subsequent currency performance. Our bullish views are determined rather by expectations of relatively strong real GDP growth, the low likelihood of inflation, and cheap valuations following the recent sell-offs. With certain exceptions, the relative fiscal strength in most countries will prevent the need for central banks to exercise excessively loose monetary policy, while governments will be able to maintain attractive tax policies, which will be supportive of strong growth and modest inflation.
Latin America - Financial Account Surpluses Unlikely To Return To Recent Highs: Following a significant increase in financial account inflows in 2010, we have seen them broadly trend lower in major Latin American economies in the last few years, and we believe this trend is likely to remain in place for the foreseeable future. Indeed, we expect that direct investment inflows are likely to remain off their recent highs in Brazil, Chile and Peru due to slowing Chinese metals demand and lower average metals prices. Similarly, we expect net portfolio investment to moderate in light of ongoing monetary policy normalisation in the US and relatively slower domestic growth in these economies, in line with our view that there is more downside ahead for most regional currencies this year.
| FDI To Remain An Important Financing Source |
|Latin America - Selected Economies' Financial Account Balances, % GDP (LHS) & Aggregate Financial Account Components, USDbn (RHS)|
From an aggregate perspective, net foreign direct and portfolio investment remain in an uptrend, at least in nominal terms, and we expect that despite macroeconomic headwinds, direct investment will remain a major source of financing for most major regional economies. However, beyond the near term we anticipate increasing regional competition for capital, necessitating more significant improvements to business environments in order to incentivise investment. In this regard we highlight that market friendly policies in Mexico, Colombia, Chile and Peru will help to bolster investment in the medium term, while Brazil is likely to remain at risk of losing its status as a major regional investment destination. In particular, strong growth stories and continued efforts to mitigate operating risks in Colombia and Mexico will help to drive both portfolio and foreign direct investment in the medium term.
One trend we will be watching closely in the next few years is the potential foreign direct investment to play a larger role in Mexico's financial account, which has long been dominated by portfolio investment. Recent reforms to the labour market, education system and telecommunications sector, as well as the liberalisation of the energy sector will bolster direct investment in the coming years, making Mexico's financial account less vulnerable to sharp outflows of capital.
Emerging Europe - Capital Inflows Past Their Peak: Across Emerging Europe only Hungary, Turkey and Russia face imminent risk of capital flight, with most Central European financial markets to remain relatively stable in the face of rising developed state yields. However, the region as a whole will see much lower levels of financial account inflows over the next few years, capping growth potential. We believe Emerging Europe will see much lower levels of foreign borrowing over the next few years, as developed state yields rise, Western European banks continue to de-risk and domestic investment opportunities remain limited.
This trend has already begun to play out in regional financial accounts, with a rapid drop off in Polish financial account liabilities since US Treasury (UST) yields spiked back in Q213. Like many other regional economies, Poland has experienced two periods of major external leverage over the last decade - the 2005-08 cross-border credit binge, and the post-crisis hunt for carry. With the factors underpinning these trends either absent (because of European bank capital building) or dissipating (as UST yields rise), it is hard to see where the next wave of foreign capital will come from. This underpins our view for much narrower current account deficits and weaker growth across Central Europe over the next few years. At the same time, relative export competitiveness, stable domestic banking sectors and looser ECB monetary policy later this year support our view of regional FX (and more broadly financial market) stability, particularly when compared to higher-risk EM peers.
| Precarious |
|Turkey - Monthly Financial Account Flows, US$mn|
The main exceptions to this trend are Hungary, Turkey and Russia, where the risk of destabilising financial account outflows remains significant. In Hungary's case the government's populist policy agenda has seriously hurt foreign investor sentiment, and recent monetary easing has reduced rates to levels where it has become much cheaper to short the currency. Large foreign ownership of the local debt market further increases the risk of capital flight, although on balance we believe the country's stable current account surplus (3.0% of GDP in 2013) should limit another major selloff in the HUF (we are forecasting modest depreciation against the euro by year-end). Turkey's external account position is more precarious, with a current account deficit nearly 8% of GDP in 2013, and January recording the first financial account deficit since 2008 (see chart above). Nevertheless, we still view Turkey in a more favourable light than Russia, where a rapidly narrowing current surplus is taking place alongside massive capital flight by locals and foreigners alike. We therefore maintain a preference for lira over rouble-denominated assets.
Sub-Saharan Africa - Favourable Outlook For South Africa And Kenya: Recent currency moves are a useful indicator of 'hot money' capital flows in Sub-Saharan Africa (SSA). In several key economies - Ghana, Nigeria, Uganda and Zambia - we see currency weakness as a forewarning for foreign capital outflows, while in South Africa, the increasingly positive performance of the rand potentially signals respite (at least temporarily) for outflows. The currencies of Ghana, Nigeria, Uganda and Zambia are all under pressure for various different reasons. In a nutshell, depreciation of the Ghanaian cedi is being driven by concern over the budget; in Nigeria's case the naira is suffering due to worries about the upcoming election and corruption in the management of oil revenues; in Uganda, the shilling has sold off following the introduction of controversial anti-homosexuality legislation; and in Zambia, the kwacha has depreciated owing to concern regarding exposure to the China slowdown via copper exports.
Importantly, in each case, our analyses of the foreign exchange markets indicate that the currency moves have been largely driven by domestic participants; institutions ranging from banks to export traders have sought to reduce their exposure to the local currency. We believe that increasing nervousness regarding the four economies is well-founded and will filter through to affect foreign sentiment, triggering increased capital outflows. This being the case, we hold a bearish stance on local debt and FX for Ghana, Nigeria, Uganda and Zambia.
| Currency Weakness A Bellwether For Capital Flight? |
|Sub-Saharan Africa - Exchange Rates, local currency/USD, rebased, October 2013 = 100|
South Africa, on the other hand, has far larger, more liquid financial markets wherein the rand is primarily driven by swings in global investor sentiment. The 9% depreciation of the currency over November 2013-January 2014 coincided with heavy foreign financial outflows, and the subsequent 6% appreciation has been propelled by robust foreign financial inflows across bonds and equities. Regarding the latter move, the South African Reserve Bank's decision on January 29 to hike interest rates by 50 basis points reassured markets that inflation expectations would be anchored. The rand looks promising from a technical perspective: we will be keeping a close eye on key resistance at ZAR10.5000/USD and thereafter ZAR10.0000/USD. A break through ZAR10.0000/USD would be a strong bullish signal, likely presaging further appreciation and foreign capital inflows.
We also hold a relatively positive view on Kenya. The currency has been stable in tune with its macroeconomic profile and we expect it to continue its broad sideways trading. Although there are various structural weaknesses such as the sizeable current account deficit, the economic outlook has been fairly static. A large debut eurobond (USD1.5-2.0bn) is imminent, which we expect will be favourably received given that demand massively outstrips supply for SSA eurobonds. As regards local debt, although we expect inflation and interest rates to edge upward in the second half of the year, the short-term outlook is benign, and this, in combination with positive real yields and the aforementioned currency stability, bodes well for capital inflows.
Middle East And North Africa - Limited Risk Of Further Capital Flight: The worst of the capital flight seen in much of the Middle East following the Arab Spring has passed and we forecast inflows to pick up in the coming quarters. Egypt epitomises this trend as foreign investors left the country following the political turmoil of 2011-2012 and the overthrow of President Mohammed Morsi in 2013. The country's current account deficit has been minimalised by substantial inflows from the Gulf, although this is unlikely to continue much beyond 2014. From around H214, we expect an uptick in portfolio and FDI inflows due to low base effects and a notable improvement in political stability.
| GCC Surpluses To Remain |
|Middle East - Current Account Surplus, % of GDP|
We forecast Lebanon's current account to come in deficit to the tune of 4.8% and 5.7% in 2014 and 2015, respectively. Although the current account balance has been in negative territory over the past decade, substantial financial inflows from the sizeable diaspora have historically more than offset the deficit. Inflows have remained remarkably stable despite elevated domestic political instability, and we expect this trend to continue over the coming years. Moreover, the central bank's massive arsenal of gold and foreign currency, which was equivalent to 11.5 months of imports at the start of 2014, will continue to act as an important anchor for underlying economic stability in the event of a prolonged period of capital outflows
The Gulf Cooperation Council (GCC) will remain a net exporter of capital for the foreseeable future. We forecast current account surpluses to remain elevated across the region and to be invested in each country's respective Sovereign Wealth Funds and foreign reserves. That said, given the Gulf's elevated and still-rising levels of public spending and stagnant growth in oil revenues, we highlight that by the end of the decade the current account surpluses will have narrowed significantly. This narrowing would be brought forward in the event of a sustained decline in oil prices, thus drastically curtailing capital outflows.