Posted on September 06, 2014

Portfolio flows to emerging markets (EMs) slowed sharply in August, based on estimates from the Institute of International Finance (IIF). Net EM portfolio flows were USD9.3bn, the lowest reading since January 2014. The fall was most severe in Emerging Europe, but Africa and the Middle East also faced outflows.  Inflows slowed to a crawl in Emerging Asia and Latin America. The latest data shows that EM flows remain highly volatile from month to month but the overall trend is negative. This suggests that investors continue to be worried about economic fundamentals in EMs and are reducing their exposure accordingly (see our commentary dated April 27, 2014). With equity markets in EMs and advanced economies near recent highs, there is also concern that the downward trend in portfolio flows could mark a turning point with a potential market correction ahead. Moreover, the end of the US asset-purchasing program—the so-called tapering of Quantitative Easing (QE)—is now expected in October and investors may be concerned about the potential economic impact of tighter monetary policy and higher global interest rates going forward.

EM capital inflows rose sharply during QE, following the 2008 global financial crisis. Near-zero interest rates in advanced economies drove capital towards higher-yielding EMs. However, since the US Federal Reserve (Fed) announced its plans to taper QE in May 2013, EMs have suffered bouts of capital outflows as yields in advanced economies rose, leading to weaker EM currencies, rising EM yields and volatile equity prices. This trend is confirmed by the latest IIF data, which showed a significant decline from the average for the first half of 2014.

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For the first time, the IIF has also published data on portfolio flows by region, which highlights the areas that investors are currently most worried about. Net portfolio outflows from Emerging Europe were estimated to be USD7.3bn in August, the largest outflow since January 2010 when the IIF dataset begins. Political instability in Ukraine has unnerved investors in the region. Portfolio outflows from Ukraine amount to USD1.1bn over the last nine months. A high current account deficit (5.5% of GDP), low international reserves (1.9 months of import cover) and a high share of foreign ownership of sovereign debt in 2013 make Ukraine vulnerable to portfolio outflows. To offset these portfolio outflows, the authorities are receiving balance of payment support under a new IMF program.

Net portfolio outflows from Africa and the Middle East were estimated at USD1.5bn in August. However, the IIF breakdown provides little information on which countries have experienced outflows. The IIF states that Africa, rather than the Middle East, was responsible for the bulk of the outflows from the region. Net portfolio flows were positive in Latin America (USD8.3bn) in August. The temporary inflow may be related to the World Cup, but the economic outlook for Brazil has deteriorated further as consumer and business confidence have slumped after the country fell into recession in the first half of 2014.

In Emerging Asia, portfolio inflows were estimated at USD9.7bn in August. India accounts for a large portion of this positive outturn with net inflows of USD4.7bn. Foreign investors may be responding to a series of new economic initiatives and reforms to boost growth since the administration of the new Prime Minister, Narendra Modi, was elected in May. However, a number of vulnerabilities in the rest of Asia remain with both Indonesia and Thailand estimated to have experienced outflows in August.

In summary, portfolio flows to EMs continue to remain volatile and are following a generally downward trend with portfolio flows slowing down sharply in August. Additionally, selected countries are particularly vulnerable based on their weak fundamentals and have experienced net portfolio outflows in recent months. With the Fed planning to end QE in October, capital flows to vulnerable EMs could come under further pressure. This is likely to lead to the re-emergence of financial market instability in EM exchange rates and equity markets going forward.