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Box 11: Which EM debt market is most vulnerable to slower portfolio flows?

EM LC debt markets recorded close to negligible inflows in 2018 vs USD76bn of inflows in 2017 (Figure 148). In fact, with the exception of Korea, Brazil and Mexico, most markets recorded much slower portfolio flows than in 2017. And, according to the IMF, this trend should continue in 2019. In October 2017, the Global Financial stability Report (GFSR), IMF estimated that, post GFC, bulk of the portfolio flows into EM have been driven by a combination of FED QE effects, FED policy expectations and global risk appetite. In October 2018, the fund estimated a cumulative USD40bn of outflows (with a higher skew towards debt flows) in 2019 as the FED continues to unwind its balance sheet (Figure 149). Although most of the impact will be felt by FX, some bond markets should take note.

IDR, COP, TRY, ZAR bond markets most vulnerable to debt outflows. The pass-through from slower portfolio flows to EM bonds happens through two channels: 1) weaker FX (especially in the basic-balance deficit economies); and 2) shallow domestic markets' ability to cope up with outflows (i.e. demand-supply imbalance). In the charts below, we show which bond markets are sitting at the overlap of above mentioned vulnerabilities, i.e. FX weakening channel and shallow domestic demand for debt. For the FX channel, we filter out the markets where basic balance is low, i.e. 0.5 % of GDP as a threshold. For the demand-supply channel, we show which markets have the lowest holdings of debt from organic domestic buyers (banks, insurance companies and pension funds; Figure 150). The bottom left quadrant of Figure 151 is what we would qualify as the most sensitive markets, i.e. IDR, COP, ZAR and TRY; the least sensitive are THB, MYR, RUB and CNY (the top right extreme).

Rohit Arora

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Box 12: What will ECB and BoJ normalisation mean for EM assets?

The rise in US rates over the past year threw the vulnerabilities of current account deficit currencies into sharp relief and they underperformed. We expect 10y UST yields to rise further in 2019, but to surpass the recent local high by only a handful of basis points. On the face it, this is a more benign scenario than EMFX faced in 2018. But we should consider another potential avenue of rate pressures. Both the ECB and BoJ have telegraphed that they are moving towards policy normalisation. As they do so, Bund and JGB yields will rise. Indeed, we expect 10y Bund yields to rise by 45bp next year and 10y JGBs to rise by 28bp.

Leaning on the work first presented here (Will ECB & BoJ make up for a tighter Fed?) we look at this question via three channels: 1) which developed market drives EM markets; 2) which DM is responsible for most of the flows into EM; and 3) which currencies are EM external liabilities denominated in?

A set of simple correlations (Figure 152) shows that EM assets are more correlated to US assets than they are to those in Europe or Japan, with equities more correlated than fixed income. Correlation is not necessarily useful on its own. Examining whether or not G3 assets ‘caused’ the performance of EM assets, we find that the performance of US equities and debt spilled over into EM equities and debt, but equivalent Japanese and European assets did not.

At the end of 2017, US investors owned roughly one-third of EM assets, more than the combined holdings of euro area, UK and Japan, which total roughly one-quarter, according to the IMF Co-ordinated Portfolio Investment Survey (Figure 153) this highlights that investment decisions by US investors are likely to be more important than the same decisions by investors in the other three countries/regions. The trends in these holdings are important (Figure 154). G3 investors reduced their holdings of EM assets in late 2015, and only rebuilt them to new highs through 2017. This dynamic came against the backdrop of slower global growth and a fall in G3 yields. The increase in holdings of EM assets in 2017 occurred with largely stable G3 yields and stronger global growth.

Unfortunately, we do not have holdings data for 2018, which has been an intriguing year, but can look at flow data from the G3 balance of payments (Figure 155). This shows us that in a year of rising US yields and an outperforming US stock market, US investors sold a notable amount of EM assets. European and Japanese investors remained net buyers year to date, while their domestic yields were broadly stable and equity markets underperformed.

There are a couple of warning signs, however. Breaking down the year-to-date data, we find that US investors were large sellers of EM assets in Q2, and German investors bought substantially fewer EM assets that quarter, even though Bund yields were low and stable. This suggests some spill-over from the effect of higher US yields to German investor behaviour. European investors may not be as big as US investors in terms of the 'stock' of their holdings, but they have dominated US investors in terms of recent 'flow' into EM.

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Box 12: What will ECB and BoJ normalisation mean for EM assets? (continued)

Lastly, EM external debt remains dominated by USD, therefore the dynamics of US rates and the USD matter more than the equivalent assets in the Euro area and Japan. In summary, the performance of US assets and therefore the appetite of US investors are likely to remain the most important dynamics in EM assets, even if Bund and JGB yields rise.

Fiona Lake, Rohit Arora and Bhanu Baweja