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Rising Interest Rates Will Hurt Some EMs

Even relatively small shifts back to advanced economies’ securities relative to their outstanding volume can have a meaningful impact on emerging markets
The emerging market sovereigns most at risk from faster-than-expected monetary tightening are, in descending order:  Venezuela, Bahamas, Mozambique, Montenegro, Turkey (pictured), Ethiopia, Pakistan, Kenya, Oman and Sri Lanka.The emerging market sovereigns most at risk from faster-than-expected monetary tightening are, in descending order:  Venezuela, Bahamas, Mozambique, Montenegro, Turkey (pictured), Ethiopia, Pakistan, Kenya, Oman and Sri Lanka.

Turkey, Oman, Pakistan and Ethiopia are among emerging markets that could be most hurt as central banks in developed countries raise interest rates, according to a report from S&P, the credit rating agency.

In its global sovereign rating outlook for 2018, S&P highlights the danger for emerging markets of accelerated interest rate rises in the years ahead, leading to capital outflows from emerging market securities and a reduction in direct foreign investment, Reuters reported.

That could badly damage the economic model of some emerging economies, but to what extent remains to be seen, said the report.

According to S&P, the emerging market sovereigns most at risk from faster-than-expected monetary tightening are, in descending order: Venezuela, Bahamas, Mozambique, Montenegro, Turkey, Ethiopia, Pakistan, Kenya, Oman and Sri Lanka. Among the large emerging markets, Turkey appears the most exposed at No. 5, said S&P.

The agency said as the recovery of advanced economies gains breadth and depth, including in the eurozone, inflationary pressures could rise and trigger faster monetary normalization (higher rates) by the leading central banks than currently envisaged by the market.

The rub here, as S&P goes on to explain, is that foreign investors would then be sorely tempted to withdraw some invested funds from emerging markets to put back into advanced economies’ securities, which will provide higher real returns than they do currently.

S&P said: “Even relatively small shifts back to advanced economies’ securities relative to their outstanding volume can have a meaningful impact on emerging markets. This is because the capital market is simply so much larger in the advanced economies.”

In recent years, there have been unprecedented portfolio flows into emerging markets shares and other investment instruments that help those countries fund development and secure prosperity.

“But they also create a development model that is dependent on external financing conditions. This renders them vulnerable to sudden stops of capital inflows and possible reversals,” said S&P.

 Portfolio Inflows

The Institute of International Finance estimates that nonresident net portfolio inflows to emerging markets will reach a record $340 billion this year, followed by $435 billion in 2018. In comparison, the average for 2013-2016 was $200 billion.

Excluding flows into China, the average net inflows into emerging markets will still be 63% higher in 2017 than the average of 2013-2016, said IIF.

Added to these portfolio inflows are sizeable nonresident FDI inflows of close to $500 billion.

S&P said: “Portfolio inflows have grown particularly fast in recent years. And it is these portfolio flows that can be more volatile, potentially reversing direction very rapidly when confidence wanes or alternative investment opportunities open up.”

 What’s in Store?

The term “emerging markets” can conjure up the image of a homogeneous asset class that sits nicely on one rung of the risk ladder. Nothing could be further from the truth. As the tide of US monetary stimulus recedes, it’s becoming clearer who’s where. 

On the one end are nations with the promise of rapid growth and increasingly open economies. On the other are political tinderboxes that hold investors hostage to their power-grab dramas, Bloomberg reported.

In between are the also-rans, with spiraling debt burdens, volatile inflation and crummy trade accounts to boot. These three categories have been treated as one investable pool in the era of Federal Reserve support, but as capital becomes scarcer, it may no longer be wise to gloss over the discrepancies between them.

Real yields for investors are set to rise in many emerging markets. Bloomberg forecasts for inflation this year and the next suggest India, Indonesia, Malaysia and Latin America may witness a widening gap between nominal rates and price growth.

However, prices may rise faster in China, Russia and Brazil, shrinking real yields. Returns may even turn negative in Chile, like they already have in Turkey.

Eight of the 20 economies may see inflation accelerating next year, according to Bloomberg forecasts. The ability of central banks to increase interest rates could determine money managers’ interest in them.

Russia comes out the worst by this parameter, because economists expect a rebound in inflation, but the central bank may continue its dovish stance because of the stalled economic recovery. Policy makers are expected to deliver their second straight quarter-point cut on Friday.

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