Posted on April 27, 2014

Capital flows to emerging markets (EMs) recovered in February and March 2014 leading to calmer financial markets. However, the fundamental weaknesses in specific EM economies have not been fully addressed, leaving them exposed to further rounds of capital outflows, weaker currencies and falling asset prices.

Some EMs are likely to fare better than others, depending on their underlying fundamentals and the policy measures they have taken so far to address their imbalances.

EMs received large amounts of capital inflows during the period of Quantitative Easing (QE) following the 2008 global financial crisis. Near-zero interest rates in advanced economies drove capital towards higher-yielding EMs. However, since the announcement in May 2013 by the US Federal Reserve (Fed) of the gradual reduction of its asset-purchasing program—the so-called QE tapering—EMs suffered bouts of capital outflows as yields in advanced economies rose, leading to weaker EM currencies, rising yields and falling equity prices (see our commentary from February, Emerging Markets Continue to Suffer from QE Tapering).

QNB Group Calm in emerging [].jpg

Capital outflows were most severe in May 2013 after the initial announcement of QE tapering, but inflows also dropped back to very low levels in late 2013 and January 2014 when the start of QE tapering was actually implemented. Since February 2014, portfolio inflows to EMs have then recovered along with exchange rates and asset prices, begging the question, is the crisis over?

The short answer is no.

The EMs that were most adversely affected by the tightening of global liquidity from QE tapering can be characterized by four principal factors. First, they had structural economic weaknesses, such as relatively large current account deficits. Second, they maintained relatively low foreign currency reserves, which act as buffers to absorb capital outflows. Third, they were confronted with high foreign ownership of debt, which has tended to result in higher capital outflows (see our commentary from March, Foreign Ownership of Debt is an Important Indicator of Vulnerability to the Emerging Market Crisis.

Finally, a slow or weak policy response, such as delays in raising central bank interest rates, has exacerbated vulnerabilities.