FPI flows exit Emerging Market dance floor


Wednesday, January 13, 2016 03:21 PM / ARM Research

Today, we assess the movement in FPI flows to emerging markets over H2 2015, and posits our outlook on the same for 2016.

Over H2 15, a confluence of factors, including the Grexit saga, downturn in commodity prices, as well as slowing economic growth worsen FPI outflows from EM. Interestingly, on the strength of the noted concerns, IIF estimated that net portfolio flows to EM shrank by 37% over FY 15.

Of all EM worries, that of China appears to have stood out in the period. To buttress, China’s growth concerns and a consequent guidance to currency devaluation by the country’s apex bank was the overriding trigger for massive sell-offs in Asian equity. Away from China, speculations over the timing and pace of US interest rate changes had equally telling impact on markets with the strengthening dollar compounding the woes of most commodity exporters.


Overall, moderate to positive economic data signals possibilities of further interest rate adjustments by the US Fed.  This should sustain economic pressures on EM markets and stoke further FPI outflows in 2016.


Softening push-pull factors drive lower FPI net flows


In its latest report, the IIF estimates that net portfolio flows to EM over 2015 should fall 37% YoY to $135 billion – the lowest level since the trough during the 2009 financial crisis. This view was hinged on the net impact of a cocktail of influences in H2 2015 which included: heightened fears over the latest episode of the Grexit saga (which ended in July), mounting uncertainty over the latest episode of the onset of US interest rate hike, an extended downturn in commodity prices and further deterioration in EM growth picture, The exodus reflects a reversal in the combination of push-pull factors (QE, EM growth and rate differential to DM and robust commodity prices) which had driven heightened flows into EM in the three years prior to 2015.

Figure 1: Annual FPI Net flows to EM

On the push side of FPI flows, as discussed under our global review, monetary policies remained broadly accommodative across major global central banks for much of H2 15 with the US Federal Reserve being the exception by hiking interest rates 25bps to 0.5% in December. On the pull side, heightened concern over deterioration in Chinese GDP growth came to a head in August after the PBoC devalued the Yuan by 3% in a surprise move which stoked concerns about a fresh currency war. FPI flows also grappled with recessionary growth in Brazil and Russia while beyond the BRICs, capital outflows from other EM countries reflect investors’ concerns about impact of sustained downdraft in commodity prices on economic growth and on fiscal and trade balance sheets. On balance of factors, the derivative effect of turmoil across commodity markets and sliding economic growth fortunes on EM exchange rate and asset prices in an atmosphere of tightening US monetary policy induced tamer FPI flows over H2 2015. In what follows we dimension how the broad theme translated in FPI flow patterns across key EM geographies. 

With similar impact across different EM geographies

In Asia, poor growth and uncertainties in China led to sharp selloffs of domestic stocks and bonds in H2 15 with the IIF estimating that net capital flows swung negative to $555 billion over 2015 (2014: +$10 billion). Tailing a steady stream of softening macroeconomic data and the sharp plunge in equity markets over June,


the perceived move towards Yuan weakness seemed to be what primarily spurred FPI outflows over H2 2015. Aside from negative sentiment arising from China’s macroeconomic growth picture, uncertainty around interest rate hike in the US underpinned negative portfolio flows to both India (H1 15: $12.5 billion, July October: -$2.1 billion) and Indonesia (H1 15:$14.7 billion, Q3 15: -$1.5 billion).


While Malaysia had witnessed capital outflows over H1 15 (RM 19.7 billion) due to depressed commodity prices, the pace of exit accelerated over H2 15 (Q3 15: RM 24.4 billion) as alleged fraudulent activities by the Prime Minister, Datuk Najib Razak, induced a political crises in the country, further exacerbating the negative sentiment of investors. 


Over in Latin America, softer commodity prices, global risk aversion, and domestic policy failures have heightened pressure on local currencies, weakened real GDP growth and discouraged foreign capital inflows in H2 15 with the IIF estimating that FPI inflows have declined 13% YoY to $274 billion. In Brazil, slowing FPI flows stem from a deteriorating economic environment, with real GDP contracting for three quarters, and political infighting, which has made it difficult for the Rousseff-led government to garner enough legislative support for the implementation of pertinent fiscal measures. The worsening domestic conditions triggered the loss of its investment grade credit rating from Standard and Poor’s in Q3 15 and resulted in tamer FPI flows with the Brazilian currency sliding 49.9% over H2 2015—the most among major currencies—to reach its weakest level in over two decades. In response to the currency slide, the Brazilian Central Bank, Banco Central do Brasil, stepped up intervention in the spot as well as the FX derivatives market and hiked rates by 50bps to 14.25% over H2 2015. In Mexico, speculation over US rate hike drove 25% YoY contraction in foreign investment flows to $41.4 billion over the first three quarters of 2015.


In turn, the cutback in FPI flows drove 16% depreciation in the Mexican peso over 2015, necessitating sizable interventions by the Mexican Central Bank (Banxico). In Argentina, capital inflows remained minimal, in part reflecting inability to tap international debt markets as the standoff with the hold-out creditors remained unresolved and capital controls on outward foreign currency transfers in place, since 2011. Nonetheless, opposition victory in the October 2015 polls, subsequent removal of capital controls in December 2015 (which drove a 30% devaluation in the Argentine peso) and pledge to negotiate with creditors, in contrast with outgoing government’s belligerence, could mark an inflection point for FPI flow activity. 

Figure 2: Net Capital flows to EM ($’billions)

In a similar light, the IIF estimates that the oil price rout has resulted in $165 billion reduction in net foreign assets across MENA exporting countries to $2.5 trillion in 2015. The development reflects outward FPI flows and impact of redemptions by Arab SWFs from the region in response to the oil price plunge with the Saudi Arabian Monetary Agency (SAMA) redeeming $70 billion while other Middle-East based Sovereign Wealth Funds withdrew $19 billion in Q3 15 from overseas funds to stem capital account pressures. Similar sentiments swung Egypt from net inflows of $316 million in 2014 to net outflows of $1.4 billion over Q3 15 using data from the Central Bank of Egypt. 


Similar to the weak trends across other regions, net FPI flows to EM Europe remained negative with the IIF estimating mean quarterly FPI inflows declined by more than half from 2014 levels to $9 billion in 2015 whilst outflows remained elevated largely driven by Russia, where concerns over impact of declining oil prices and economic sanctions continued to hurt economic growth. Further FPI slowdown reflects cutback in debt issuance across the region from $19 billion in Q1 ‘15 to $5 billion in Q3 15 on tightening US rate outlook.  On the flipside, backed by US guarantees, Ukraine returned to the Eurobond market with a $1 billion issue.    

Africa not spared as bearish commodity prices drives FPI exodus


As with other regions, lower commodity prices, weaker Chinese growth and expectations of Fed liftoff have had a negative consequence for capital flows to Sub Saharan Africa in 2015 with attendant currency depreciation in a number of countries and policy tightening to stem inflation. Though sovereign debt issuance rose 8.8% YoY to $9.25 billion, the cost of borrowing rose significantly as investors priced in prospect of rising US policy rates and softening economic fundamentals.  


In South Africa, declining commodity prices and a weakening Rand drove a 25.4% YoY contraction in FPI flows to R47.1 billion in Q3 15. In particular, the continued declines in commodity prices drove a fresh wave of job cuts and, by extension, labour unrest across the mining industry. Though data is unavailable for Q4 15, outflows likely heightened following Moody's downgrade of South Africa's debt rating to Baa2 from Baa1 in December and unanticipated removal of finance minister Nhlanla Nene and subsequent replacement with a political novice, David Van Rooyen. Though President Zuma returned former finance minister Pravin Gordhan three days after the move, the sudden nature of the changes roiled South African equity and bond markets with the rand weakening to a record low (YTD: 31%) on heightened FPI outflows. In Nigeria, the collapse in oil prices, uncertainties bothering on the new government’s policy direction as well as the Central Bank of Nigeria’s reluctance to devalue the naira have had a major impact on capital flows. Further dampening FPI sentiment was JP Morgan’s decision to phase out Nigeria from its Emerging Market Government Bond Index (GBI-EM) in early Q4 15 which was followed closely by Barclays’ announcement that it would eject Nigeria from its emerging market local currency bond index in Q1 16.


Consequently, mean monthly FPI flows into equities and debt markets shrank 82% and 46% from H1 15 levels to $268 million and $32 million respectively, placing YTD flows 62% lower YoY at $5.2 billion.  

Figure 3: FPI flows into Nigerian financial markets ($’million)

Tightening US rate outlook and still soft EM growth picture


Going into 2016, while supply of QE stimulus remains unchanged with the ECB and BoJ maintaining their LSAP programs, onset of a tightening cycle in the US implies a less accommodative monetary policy outlook relative to recent past.


Following the rate lift-off, focus now switches to second guessing the timing of subsequent rate hikes with the US Fed dot plot pointing to a cumulative 100bps increases over 2016. Nonetheless, Janet Yellen’s conditioning of rate hikes on sustained improvement in the US economy implies a more gradual evenly spread rate hike over the four quarters of 2016.  


The implication of the northward rate shift for US rates on FPI flows is at least two fold. First, the rising rate trajectory raises the discount rate applied by dollar investors on all asset classes which should drive lower valuation for, and attractiveness of, EM investments. Second, the rising US key rate raises prospects of a stronger USD, which given an atmosphere of divergent monetary policy stokes probability of exchange rate volatility across EM currencies. Overlaying both implications with prevailing macro-economic conditions across EM countries who are characterized by weak-commodity-price-induced trade deficit, lower export revenues and limited fiscal leg-room, drives tame FPI flow outlook. 


In China in particular, extended deceleration in GDP growth which raises prospects for further Yuan weakness continues to underpin expectations for weaker capital flows. On the other hand, FPI flow to EM Europe is expected to improve largely on the back of diminishing outflow from Russia. Whilst Western imposed sanctions are likely to remain over 2016, concerns emanating on this front should diminish following more conciliatory gestures between Russia and Western countries following recent terrorist attacks in France. 


Across Latin America, FPI outlook is largely mixed with recent removal of currency controls and other actions of the new Mauricio Macri-led government in Argentina bolstering outlook. The IIF forecasts $15 billion-$25 billion in inflows into the country’s financial markets. On the other hand, the outlook is negative for Brazil as political uncertainties, amplified by impeachment moves against President Dilma Rousseff, and corruption cases amongst high-profile national figures will make it even more difficult for the executive and legislative arms of government to reach a consensus on fiscal measures needed to restore the country’s economic fortunes. On account of this therefore, we expect the country to continue to witness larger net capital outflows. However, Brazil’s woes may turn out to be a blessing for Mexico as it has continuously benefited from FPI flows out of Brazil. The country’s strong economy which has been forecasted to grow faster in 2016 on account of its strong fundamentals informs our expectations of higher net inflows in 2016. 


Across Africa, prospect of further currency depreciation on softening current account positions should continue to underpin tame prospects for FPI flows.


Similarly, limited visibility over Nigeria’s policy response to the oil price shock on the fiscal side, dovish monetary policy twist and trading curbs on FX trading should continue to dampen prospects for FPI flows into financial markets. In particular, continued doubts over the USDNGN, with the volatile trend in BDC-interbank premium and low FX reserves coupled with progressive ramp-up in administrative measures pose hurdles for FPI.  


On balance, continued economic weakness across EM, uplift in US interest rates which should drive global monetary policy divergence points to dampened FPI flows over 2016. 


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