Emerging market capital outflows eclipse financial crisis levels

Emerging markets (EM) have suffered bigger net capital outflows over the latest three quarters than during the 2008-09 financial crisis, indicating fragile confidence in some of the largest developing economies.

Total net outflows from the 15 largest emerging markets rose to $600.1bn over three quarters to the end of March, higher than the $545.2bn in outflows seen during the crisis-ridden three quarters to the end of March 2009, according to estimates by NN Investment Partners (formerly ING Investment Management) based partly on recently-released official data.

In spite of the magnitude of the outflows ($600bn, for reference, equates to slightly more than the GDP of Nigeria last year), the exodus of funds represents only a partial reversal of the tide of liquidity that gushed into EM during the years of US monetary loosening after the financial crisis. From July 2009 until the end of June last year, a net total of $2.2tn in capital flooded into the 15 EMs.

Many of the funds that have flowed out were portfolio investments propelled by three consecutive quarters of EM currency depreciation against the US dollar (see chart). This has been the case particularly in countries - such as China - where a "US dollar carry trade" gained popularity in the aftermath of the financial crisis.

These "carries" - which relied on borrowing in US dollars at low interest rates to invest in high-yielding EM local currency products - have been progressively unwound as the dollar strengthened and the US Federal Reserve adopted a less accommodative tone to its monetary policy.

"The capital outflows reflect the pressure that has been high for a while already," said Maarten-Jan Bakkum, senior emerging market strategist at NN Investment Partners.

"The reasons for the outflows remain in place, including the unwinding of the US dollar carry trade, the growth and financial-system problems in China and the fundamental weaknesses in many emerging economies that limit the room for a sustainable recovery," he said.

Mr Bakkum added that net capital outflows were likely to persist during the second quarter of this year, though the magnitude of the exodus may ease. Total outflows from the 15 economies hit $255.3bn in the last quarter of 2014 before narrowing to $208.8bn in the first quarter of this year, according to NN estimates.

More dramatic, however, than the capital outflows is the unprecedented plunge in EM foreign exchange reserves since December (see chart below). In March this year, total reserves held by the 15 EM countries fell by $374.4bn - by far the largest contraction since EM countries began to build up their stashes of hard currency early this century.

Even at the height of the financial crisis, EM foreign exchange reserves remained positive each quarter.

The recent slump, however, has derived from an extraordinary mix of factors. Central banks have spent US dollars to defend their currencies against waves of depreciation, while weak export performances have curbed US dollar incomes. Reserves have also been deployed to repay foreign debt.

All this comes against a backdrop of dwindling EM economic growth rates which exacerbate the fragile confidence underlying capital outflows. Capital Economics estimates that average GDP growth eased to 3.9 per cent in February across EM countries, down from 4.1 per cent in January. This was only the second time since the Argentina crisis of 2001-02 that average EM GDP growth has dipped below 4 per cent, it said.

"To compound matters, preliminary data for March suggest that worse is to come," said Neil Shearing, chief emerging markets economist. "Aggregate growth could drop to as low as 3.5 per cent year on year over the coming months."

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