Emerging market outflows raise heavy questions for fund managers

A long boom characterised by insatiable demand for whatever products financiers have to peddle. It all sounds a bit like the developed world in the years before the 2007 crisis.

But it is a description that could just as well apply to the situation facing emerging markets over the past half-decade; one that is poised to end as asset purchases by central banks are scaled back in the US and interest rates start to rise.

Developed market investors have been more than willing to pump debt capital into the alphabet soup of "Brics" and "Mints" since the crisis, encouraged by rapid economic growth and soaring commodities prices. According to McKinsey, total emerging market debt rose to $49tn at the end of 2013. It accounted for almost half the growth in debt worldwide since 2007.

But recent events show these same investors starting to pull back, unnerved by the strong dollar, soaring political risk in Russia and the Middle East, and tumbling commodity prices that have crushed growth rates across the developing world. The 15 largest emerging economies experienced their biggest absolute capital outflow since the crisis in the second half of last year, according to ING.

This is raising concerns about how any rebalancing might play out and whether the financial institutions that have piled in so willingly may now prove to be a source of contagion.

What makes it a particularly pertinent question is the changing nature of cross-border lending to emerging markets. Traditionally most of the capacity came from international banks. While they remain significant lenders, the banks have curbed their appetite for new exposure because of tighter regulation.

Into their shoes have stepped the capital markets. By the middle of last year, emerging market borrowers had issued $2.6tn of international bonds, three-quarters of which were in dollars.

According to Claudio Borio of the Bank for International Settlements, market-based financing of emerging markets has been growing at roughly 15 per cent a year since 2010 - half as fast again as cross-border lending by banks. A large chunk of the resulting exposure has ended up in the hands of international asset managers and mutual funds.

The systemic risks posed by fund managers are less understood than those of banks. But one concern is that managers have an incentive to chase returns when conditions are bullish out of a fear of being left behind by peers. This can amplify shocks when credit conditions turn.

The sudden change in conditions - both political and economic - has exposed some strikingly aggressive positions. For instance, Franklin Templeton, a US money manager, was recently revealed to have bought up about a third of Ukraine's international debt before Russia's seizure of Crimea last year and the subsequent insurrection in Donbass. In March the fund manager appointed Blackstone to assist it in discussions with Kiev about restructuring these bonds.

But a bigger concern is that managers may fly to quality should a weakening environment lead more underlying investors to seek to redeem their funds.

Here, the irony is that many of the regulatory initiatives taken since the crisis could actually make it harder for them to sell down their positions. Banks - the main source of liquidity - have become more reluctant to make a market when investors want to sell. A recent paper by the BIS shows they have cut their holdings of dollar bonds issued by non-banks outside the US from 18 per cent to 10 per cent since the crisis. This potentially magnifies the volatility of the asset class, along with losses to investors and disruption to emerging markets.

One way to see this is to compare the impact on asset managers' holdings of emerging market debt of the Lehman crisis in 2008 and the so-called "taper tantrum", or sell-off prompted by the US Federal Reserve's discussion of tapering that began in May 2013. In the first case, fund managers saw declines of 36 per cent in assets under management at emerging market bond funds, while in 2013 they fell by a much more modest 7.6 per cent. Strikingly though, the spike in yields in each case was roughly the same.

It all points to the fact that while the banks have been strengthened since the crisis, this may be at the cost of a new vulnerability in the chain. In its latest Global Financial Stability Review, the International Monetary Fund frets about the resilience of fund management companies in the face of another crisis. If the unravelling in emerging markets accelerates, investors may get to see how durable these institutions really are.

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