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What Can Emerging Markets Do to Protect Against Hot Money Flows? Not Much, Apparently
By Ian Talley October 28, 2014
The International Monetary Fund has been warning for years that emerging markets must put their economic houses in order to avoid getting burned by “hot money” cash flows when global markets freak out.
But it may not really matter.
“There is little policy makers can to do tame the effects of the global financial cycle on gross private capital inflow,” Erlend Nier, Tahsin Saadi Sedik and Tomas Mondino write in a new paper published by the IMF（见[相关阅读]）.
The three economists found that when the market’s fear gauge, the VIX, is high, foreign investors sell off without much discrimination. “During periods of stress, the VIX becomes the dominant driver of capital flows while other determinants, with the exception of interest rate differentials, lose statistical significance,” they said.
The IMF economists said that effect only increases the more a country allows free-flowing investment flows, or an open capital account, a key tenet advocated by the U.S., Europe and other major industrialized nations. Controls on cross-border investments only have marginal effects, they said. And if authorities use the tool with the biggest impact–interest rates–to counter “hot” flows, “it may also be damaging the domestic economy.”
Take the so-called “taper tantrum” that rocked emerging markets across the board last year after U.S. Fed officials changed market expectations about U.S. interest rates. In the weeks that followed the Fed’s May signaling, equity, bond and currency markets in industrializing nations plummeted, some losing more than 20% of their value, as investors pulled out cash.
“A substantial part of the flows could not be explained by emerging market’s economic fundamentals,” the IMF said in a review of the episode.
After the initial shock, the IMF and the Institute of International Finance argue that investors showed increasing discrimination between those economies that had better balance sheets and healthier growth fundamentals and those that didn’t. Since then, exchange rates, debt pricing and equity values in countries with weaker economic fundamentals and questionable balance sheets have seen the value of their currencies fall much faster and farther than those with healthier economies.
But the first round of selling hit pretty much all emerging markets as investors shied away from potential risk and put their cash into U.S. treasuries and other assets considered relatively safer bets in July 2013.
Hung Tran, executive managing director at the IIF, said data since then shows declining correlation of asset valuations among emerging markets, reflecting more differentiation by investors.
“Good policy matters, helping to contain the volatility of capital flows which has been at times a challenge to emerging market policy makers,” he said in a recent note to the IIF’s members, 500-plus of the world’s largest private financial institutions.
A main problem, says Mohamed El-Erian, chief economic advisor at Allianz, is what he calls “tourist dollars” that dominate investment in developing countries.
“A tourist dollar…is pushed to take risk as opposed to being pulled to take risk,” Mr. El-Erian said in a lecture at the Peterson Institute for International Economics. “During the good times, capital comes flooding in.…It distorts your credit system, it creates all sorts of macro difficulties, and then, virtually overnight, the capital flows out.”
Mr. El-Erian said that despite a raft of measures emerging market authorities took to dissuade investment in vulnerable sectors or control cross-border cash movements, “There’s a sense that they are unable to protect themselves from the vagaries of capital flows.”
The IIF says that recent bouts of volatility are likely to continue as rates move in different directions in the U.S., the eurozone, Japan and other major economies. As volatility spiked to multiyear highs this month, investment in emerging markets reversed in many emerging markets. The IIF estimated that portfolio capital flows fell to a net USD 1 billion for the month, with emerging Europe, Asia, Africa and the Middle East seeing net outflows of cash.
“There is an increased risk of abrupt shifts in expectations about…monetary policy paths, which could spark a rise in risk aversion and a retrenchment of EM capital flows,” said Charles Collyns, IIF’s chief economist in a recent note. For example, the bank industry group estimates annual portfolio flows to emerging markets would fall by around USD 100 billion if markets were to start expecting an increase in the federal-funds rate by 50 basis points per quarter instead of the current 25 basis points.
It’s a trend that could be exacerbated by the fact that 10 of the world’s top global asset management firms account for more than USD 19 trillion in managed assets.
The combination of asset concentration, overvaluation of asset prices and skittish investors risks more market shocks ahead, the IMF warned in its latest review of global financial conditions（见[相关阅读]）.
“Emerging markets are more vulnerable to shocks” than they’ve historically been, the IMF said.
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