Explaining capital inflows to EM
13 February 2018
Until this month, emerging markets had seen six consecutive quarters of net capital inflows, including both portfolio and direct investment. Inflows into EM reflected three mutually reinforcing factors: the positive environment for risk assets; a healthy EM growth outlook; and the weak US dollar. However, this momentum came to a halt over the last two weeks with EM posting nearly $4 billion in outflows since 30 January, marking the biggest slump since late 2016 (see Chart 10). In line with market movements, most of the outflows (approximately $3.4 billion) have been from equities. After the recent reversal in flows, and declines in most EM equity markets, it will be important to watch how this dynamic plays out. The increase in US interest rates against a backdrop of larger-than-expected US fiscal stimulus and higher commodity prices already created a complicated environment for determining the trajectory of EM capital flows. Now with higher equity volatility and lower risk appetite, EM flows and capital accounts could be under more pressure. It is therefore worth revisiting the drivers of EM capital flows to understand how they might react in this environment, and determine which countries can better weather higher volatility.
Recent research by J.P. Morgan and others have looked at the pre- and full post-financial crisis era to determine which factors played the most significant role in EM capital flows. Looking at the various factors affecting capital flows – EM-DM interest rate differentials (both short and long-term), commodity prices, EM-DM growth gap, USD strength, and EM credit spreads – the research shows that growth differentials and dollar strength are the two most important drivers. The relationship makes sense: higher growth compensates for the additional risk of investing in EM. Importantly, this relationship held true during all periods of EM growth since 2002 – the growth boom from 2002-2007, the financial crisis period, the decline in commodity prices until 2015, and the subsequent recovery. While the EM-DM growth differential appeared to be main driver of capital flows into EM, the strength of the USD was also an important factor and, according to the analysis, it mattered more than EM-DM interest rate differentials. The interest rate differentials mattered, but much less and their impact varied widely over those periods. The composition of capital flows is also important to note in terms of the breakdown between FDI and portfolio flows; however, as it turns out, net FDI inflows have remained relatively stable despite fluctuations in the EM-DM growth differential (see Chart 11) while portfolio flows have fluctuated more in response to growth differentials. This likely underscores the longer-term nature of FDI and the fact that it responds to productivity differentials, tax incentives, labour costs, among other things.
Recent flow dynamics also appear to reflect this view of growth fundamentals on a country-by-country basis. As capital flowed out of EM assets, including large equity outflows from Korea and Thailand, India still saw sustained inflows across all asset classes, as did Brazil. This likely reflects positive consensus views on improving growth outlooks in both countries. Recent market volatility notwithstanding, EM growth still appears healthy and we expect a slight widening of the EM-DM growth differential this year. So, as long as the USD does not strengthen sharply, net capital flows into EM should be restored.