Emerging markets hit by record string of withdrawals by foreign investors

Foreign investors have withdrawn funds from emerging markets for five consecutive months in the longest withdrawal streak on record, highlighting how recession fears and rising interest rates are shaking developing economies.

Cross-border outflows of international investors in emerging market equities and domestic bonds reached $ 10.5 billion this month according to provisional data compiled by the Institute of International Finance. This has brought outflows over the past five months to over $ 38 billion, the longest period of net outflows since record-breaking in 2005.

Outflows risk exacerbating a growing financial crisis in developing economies. In the past three months, Sri Lanka has defaulted on its sovereign debt and Bangladesh and Pakistan have both sought help from the IMF. A growing number of other issuers in emerging markets are also at risk, investors fear.

Many low- and middle-income developing countries are suffering from currency depreciation and rising borrowing costs, driven by US Federal Reserve rate hikes and fears of a recession in major advanced economies . The United States recorded its second consecutive quarterly contraction in production this week.

“EM had a really, really crazy rollercoaster year,” said Karthik Sankaran, Corpay’s senior strategist.

According to data from JPMorgan, investors have also withdrawn $ 30 billion so far this year from emerging market foreign currency bond funds, which invest in bonds issued on capital markets in advanced economies.

According to JPMorgan data collected by the Financial Times, foreign currency bonds from at least 20 frontier and emerging market countries are trading at yields more than 10 percentage points higher than comparable US Treasuries. Spreads at such high levels are often seen as an indicator of severe financial stress and risk of default.

Experiencing% Months of Year Bar Chart ... showing emerging markets hit by a fifth consecutive month of outflows

It marks a strong turnaround from late 2021 to early 2022, when many investors expected emerging economies to recover strongly from the pandemic. As of April this year, currencies and other assets in emerging commodity-exporting markets such as Brazil and Colombia performed well in the wake of rising oil and other commodity prices following the Russian invasion of Ukraine. .

But fears of global recession and inflation, aggressive US interest rate hikes and slowing Chinese economic growth have forced many investors to retire from emerging market assets.

Jonathan Fortun Vargas, an economist at the IIF, said cross-border withdrawals have been unusually common in emerging markets; in previous episodes, outflows from one region were partially offset by inflows into another.

“This time around, sentiment is generalized to the downside,” he said.

Analysts also warned that, unlike in previous episodes, there was little immediate prospect of global conditions turning in favor of emerging markets.

“The Fed’s stance appears to be very different from previous rounds,” said Adam Wolfe, EM economist at Absolute Strategy Research. “He is more willing to risk a US recession and risk destabilizing financial markets to lower inflation.”

There are also few signs of economic recovery in China, the world’s largest emerging market, he warned. This limits its ability to drive a recovery in other developing countries that rely on it as an export market and source of funding.

“China’s financial system has been severely strained by the economic crisis of the past year and this has really limited its banks’ ability to continue refinancing all their loans to other emerging markets,” Wolfe said.

Sri Lanka’s default on its external debt has left many investors wondering who will be the next sovereign borrower to go into restructuring.

Spreads on US Treasuries on foreign bonds issued by Ghana, for example, have more than doubled this year as investors price in increased risk of default or restructuring. The skyrocketing debt service costs are eroding Ghana’s foreign exchange reserves, which fell from $ 9.7 billion at the end of 2021 to $ 7.7 billion at the end of June, a rate of $ 1 billion. per quarter.

If that continues, “within four quarters, reserves will suddenly be at levels where the markets are starting to really worry,” said Kevin Daly, Abrdn’s director of investment. The government is almost certain it will not meet its fiscal targets for this year, so the drain on reserves is likely to continue, he added.

Borrowing costs for large emerging markets such as Brazil, Mexico, India and South Africa also increased this year, but to a lesser extent. Many large economies have acted promptly to fight inflation and put in place policies that protect them from external shocks.

The only major emerging market that worries is Turkey, where government measures to support the lira by refusing to raise interest rates – in effect, promising to pay local depositors the cost of depreciating the currency to stay true to the currency – they have a high tax cost.

Such measures can only work while Turkey has a current account surplus, which is rare, Wolfe said. “If it needs outside funding, those systems will eventually collapse.”

However, other large emerging economies face similar pressures, he added: relying on debt financing means governments must eventually suppress domestic demand to keep debts in check, risking a recession.

Fortun Vargas said there was little escape from the sale. “What is surprising is how strongly the sentiment has changed,” he said. Commodity exporters were the darlings of investors just a few weeks ago. We are not expensive now.

Additional reporting by Kate Duguid in London

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