Foreign investors have withdrawn funds from emerging markets in the longest streak on record for five straight months, highlighting how recession fears and rising interest rates are rocking emerging markets.
According to preliminary data from the Institute of International Finance, cross-border outflows by international investors into EM equities and domestic bonds amounted to US$10.5 billion this month. This pushed outflows to more than $38 billion in the last five months — the longest period of net outflows since records began in 2005.
The outflows could exacerbate a deepening financial crisis in developing countries. Over the past three months, Sri Lanka has defaulted on its sovereign debt, and Bangladesh and Pakistan have both turned to the IMF for help. Investors fear that a growing number of other emerging market issuers are also at risk.
Many low- and middle-income developing countries are suffering from depreciating currencies and rising borrowing costs, driven by US Federal Reserve rate hikes and recession fears in the major advanced economies. The US posted its second straight quarterly fall in production this week.
“EM has had a really, really crazy rollercoaster year,” said Karthik Sankaran, Senior Strategist at Corpay.
Investors have also withdrawn $30 billion from EM foreign currency bond funds, which invest in bonds issued in advanced economy capital markets, so far this year, according to data from JPMorgan.
According to JPMorgan data compiled by the Financial Times, the foreign currency bonds of at least 20 frontier and emerging market countries are trading at yields more than 10 percentage points higher than comparable US Treasuries. Spreads at such high levels are often taken as an indicator of serious financial stress and risk of default.
It marks a sharp reversal in sentiment from late 2021 and early 2022, when many investors expected emerging markets to recover strongly from the pandemic. As recently as April of this year, currencies and other assets in commodity-exporting emerging economies like Brazil and Colombia performed well thanks to rising oil and other commodity prices following Russia’s invasion of Ukraine.
But fears of a global recession and inflation, an aggressive rise in US interest rates and a slowdown in Chinese economic growth have caused many investors to withdraw from EM assets.
Jonathan Fortun Vargas, economist at the IIF, said cross-border withdrawals are unusually prevalent in emerging markets; In previous episodes, outflows from one region were partially offset by inflows into another.
“The mood is generally down this time,” he said.
Analysts also warned that, unlike previous episodes, there is little immediate prospect of a turnaround in global conditions in favor of emerging markets.
“The Fed’s position appears very different from previous cycles,” said Adam Wolfe, EM economist at Absolute Strategy Research. “It’s more willing to risk a US recession and risk destabilizing financial markets to bring down inflation.”
China, the world’s largest emerging market, is also showing little sign of economic recovery, he warned. That limits its ability to spur a recovery in other developing countries that depend on it as an export market and source of finance.
“China’s financial system has been strained by last year’s economic slump, and that has really limited its banks’ ability to refinance all of their loans to other emerging markets,” Wolfe said.
A report on Sunday highlighted concerns about the strength of China’s economic recovery. An official manufacturing PMI, which surveys executives on issues such as output and new orders, fell to 49 in July from 50.2 in June.
The reading suggests that activity in the country’s sprawling manufacturing sector, a key growth engine for broader emerging markets, has slipped into contraction territory. The decline was due to “weak market demand and production cuts in energy-intensive industries,” according to Goldman Sachs economists.
Meanwhile, Sri Lanka’s default on its external debt has left many investors wondering who will be the next sovereign borrower to restructure.
US Treasury spreads to foreign bonds, such as those issued by Ghana, have more than doubled this year as investors price in increased risk of default or restructuring. Very high debt service costs are eroding Ghana’s foreign exchange reserves, which fell to $7.7 billion at the end of June from $9.7 billion at the end of 2021, a rate of $1 billion per quarter.
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If this continues, “four quarters suddenly, reserves are going to be at a level where markets start to get really concerned,” said Kevin Daly, investment director at Abrdn. The government will almost certainly miss its fiscal targets for this year, so the outflow of reserves will continue, he added.
Borrowing costs for large emerging economies such as Brazil, Mexico, India and South Africa have also risen this year, but less so. Many major economies have acted early to fight inflation and put in place measures to protect them from external shocks.
The only major emerging market country of concern is Turkey, where government action has been taken to support the lira while refusing to hike interest rates – indeed promising to pay local depositors the currency’s devaluation cost of sticking with the currency to pay – entail high fiscal costs.
Such measures can only work as long as Turkey runs a current account surplus, which is rare, Wolfe said. “If it requires external funding, those systems will eventually collapse.”
But other large emerging markets are under similar pressures, he added: A reliance on debt financing means governments will eventually have to suppress domestic demand to bring debt under control, risking a recession.
Fortun Vargas said there was little way out of the sell-off. “What’s surprising is how much the mood has changed,” he said. “Just a few weeks ago, commodity exporters were investors’ darlings. There are no favorites now.”
Additional coverage by Kate Duguid in London