Ranking vulnerability to US Federal Reserve action

How vulnerable are emerging markets to capital outflows? With the US Federal Reserve on a long-term course of balance sheet shrinkage even as the European Central Bank embarks on expansion, it is a question that EM investors are struggling to answer.

Suppose, for example, that an earlier than expected rise in US interest rates prompted international investors to sell 10 per cent of their holdings of EM debt and equities. Which emerging markets would be best or least prepared to withstand the shock?

In a recent report, David Spegel, head of EM debt at BNP Paribas, looks at foreign ownership of bonds and equities in 80 emerging markets as a percentage of each country's outstanding stock.

The two charts below show the 31 riskiest countries by this measure. Hungary looks especially vulnerable. Several other eastern European countries also look exposed, as do Mexico, Nigeria and Indonesia.

But this is far from the full story. Spegel's analysis covers not only the absolute and relative sizes of foreign holdings in each market but also the impact of a 10 per cent redemption of those holdings in relation to each country's foreign exchange reserves and GDP. His full table is available here.

On this basis, Spegel produces the following chart (click to enlarge).

It is no surprise, he notes, that Venezuela and Ukraine now rank among the most risky emerging markets (with banking centre Bahrain looking riskier than it really is). But, he writes, "so do [investment grade] names like South Africa and Mexico, where foreign investors have substantial holdings".

Other names that leap out are Poland, often regarded as the least risky place in eastern Europe, and South Korea and Malaysia, both of which have come under scrutiny for recent surges in their ratios of debt to GDP. Hungary drops down the list thanks to its $42bn in foreign reserves, as does Russia, with $338bn. Brazil, with $361bn, still looks risky because foreigners own 40 per cent of its equities and 13 per cent of its debt. China's $3.8tn of reserves constitute a powerful defence, especially given that foreign portfolio investors own less than 5 per cent of its equities and just 1.6 per cent of its debt.

But if substantial FX reserves are a buffer against outflows, there are other, aggravating factors. During the early stages of the taper tantrum two years ago, as the IMF noted at the time, there was a 7.6 per cent reduction in assets under management at EM fixed-income funds. So Spegel's 10 per cent looks like a reasonable yardstick. But as the chart below shows, those outflows were enough to provoke a reaction in EM bond yields of almost the same magnitude as that seen after the fall of Lehman Brothers in 2008, when EM fixed-income AUM fell by a much bigger 36 per cent.

One reason for the difference is that liquidity on secondary markets, where bonds and equities are traded, has become so much tighter. As the Fed's first rate rise approaches, EM investors have plenty to struggle with.

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