The COVID-19 pandemic led to an unprecedented sharp reversal of portfolio flows away from emerging markets, to the tune of more than $120 bn. This was more severe than during the Global Crisis and the taper tantrum in 2013, and amounted to more than 1% of GDP for many emerging markets. While flows have recovered from their bottom (compare Figure 1), the recovery has remained uneven and hard currency inflows have outpaced local currency inflows.
Figure 1 Comparison of portfolio flow episodes
Cumulative portfolio flows to EM: equity and local currency bonds (based on daily observations, percent of IIP)
Note: Sample includes Brazil, China, Hungary, India, Indonesia, Korea, Mexico, Pakistan, Philippines, Qatar, Sri Lanka, South Africa, Taiwan Province of China, Thailand, and Ukraine.
Source: July 2020 update from IMF (2020)
Increased reliance on foreign portfolio flows
Emerging and frontier markets have become more reliant on foreign portfolio flows over the last decade (Figure 2). While non-resident portfolio investment can help diversify the investor base, reliance on foreign financing also entails risks. Heightened uncertainty in the global economy resulting from trade tensions, geopolitical events, and the current pandemic, can lead to a tightening of global financial conditions and volatility. Moreover, the strong and persistent portfolio inflows in earlier periods can create vulnerabilities by encouraging excessive domestic credit creation and an overvaluation of local currency and financial assets.
Figure 2 Foreign portfolio liabilities and loans since 2008
Portfolio and cross-border loan liabilities (IIP) (percent of GDP, interquartile range, median)
Note: Emerging markets include Argentina, Brazil, Bulgaria, Chile, Colombia, Czech Republic, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Turkey, and United Arab Emirates. Frontier markets include Angola, Belarus, Costa Rica, Dominican Republic, Ecuador, Egypt, El Salvador, Georgia, Ghana, Guatemala, Jamaica, Jordan, Mongolia, Mozambique, Namibia, Nigeria, Pakistan, Paraguay, Sri Lanka, and Tanzania.
Source: IMF (2020)
What drives debt and equity portfolio flows to emerging markets?
Factors driving surges of portfolio inflows to emerging markets may be different from factors driving large outflows. Our novel analytical framework, the capital-flows-at-risk methodology, considers the joint impact that multiple drivers can have on the entire predicted distribution of portfolio flows, namely during surges, sudden stops and normal times (Figure 3). Our analysis focuses on the predicted distributions of portfolio flows over the near term (the current quarter and the next two quarters) based on global factors in the current period and on domestic factors prevailing in the previous period. Looking at the distribution of future flows is a way of quantifying a likelihood of extreme outcomes, which could help policymakers prepare for future reversals or surges of portfolio flows.
Figure 3 Stylized presentation of capital-flows-at-risk
Impact of global and domestic factors on the distribution of predicted flows
We find that, for debt portfolio flows, changes in global conditions disproportionately affect the outlook for large inflows (Figure 4). A tightening of global financial conditions leads to a deterioration in the near-term outlook for debt flows across the board but with a relatively larger impact on the tails of the predicted distribution. Lower US Treasury bond yields and a weaker US dollar increase the likelihood of strong debt portfolio inflows considerably more than they decrease the likelihood of negative or weak flows. On reason might be that debt managers often try to take advantage of favourable funding conditions to arrange funding in advance. On the other hand, risk aversion among global investors—measured by the VIX—affects the outlook for strong and weak flows in roughly equal magnitudes.
Figure 4 Drivers of debt and equity portfolio flows to emerging markets
a) Coefficients on the Global Financial Conditions Index (FCI) from quantile regressions of near-term debt portfolio flows
b) Coefficients on the US Dollar Index from quantile regress of near-term debt and equity portfolio flows
Source: IMF (2020)
While stronger domestic fundamentals do not necessarily lead to surges in portfolio inflows, they can reduce the likelihood of outflows. Stronger domestic growth is associated with a smaller likelihood of negative or weak inflows but does not seem by itself to increase the likelihood of very large inflows. Greater external vulnerabilities (a higher level of short-term foreign currency debt relative to international reserves) are linked to a larger likelihood of negative or weak debt inflows in the near term. When the level of short-term debt is higher, the likelihood of very strong inflows increases too, but to a lesser extent. This positive impact potentially reflects greater refinancing needs in countries with higher levels of short-term debt, as well as investors’ confidence in successful debt redemption. Moreover, deeper domestic financial markets improve the outlook for debt flows across the board.1
Rising issuance of local currency debt
Many emerging and frontier market sovereigns have stepped up issuance of local currency debt in the past decade (Figure 5). This reduction in the so-called ‘original sin’ affords countries greater insurance from episodes of domestic currency volatility or tightening of external financial conditions. Nevertheless, the increased role of foreign investors in local bond markets, particularly in many frontier market economies, could create an implicit debt-rollover risk, described as the “original sin 2.0.” in IMF (2015) or the “original sin redux” in Carstens and Shin (2019). Borrowing in local currency from foreign lenders mitigates currency mismatch for the borrower but shifts the currency mismatches to the lender’s balance sheets. During periods of risk aversion, when local currencies weaken and domestic assets sell off, foreign investors are likely to reduce their exposure and might not roll over maturing positions, thereby triggering outflows and disrupting bond markets.
Figure 5 Currency composition of emerging and frontier market debt
a) Emerging market government debt, 2010 and 2019 (percent of GDP)
b) Frontier market government debt, 2010 and 2019 (percent of GDP)
Source: IMF (2020)
Hard vs local currency debt portfolio flows
Our work implies that a much weaker growth outlook for emerging markets due to the COVID-19 outbreak will significantly worsen the outlook for local currency flows, while the outlook for hard currency flows will be relatively more affected by the sharp tightening in global financial conditions. Local currency debt flows appear to be more sensitive to the level of external vulnerabilities than hard currency debt flows. A higher level of short-term debt and weaker reserve adequacy significantly increase the likelihood of negative or weak inflows, especially for local currency flows (Figure 6). Local currency debt flows are more sensitive to domestic growth prospects than hard currency debt flows. Higher growth boosts expected flows but affects the tails of the portfolio flow distribution twice as much. Deeper domestic financial markets improve the outlook for both hard currency and local currency flows and significantly limit the likelihood of negative or weak flows. Tighter global financial conditions decrease expected portfolio flows and have a disproportionately larger impact on the likelihood of extreme flows. Moreover, hard currency flows are almost twice as sensitive as local currency flows to changes in global financial conditions.
Figure 6 Drivers of local currency and hard currency debt portfolio flows
a) Coefficients for Global Financial Conditions Index for hard currency and local currency flows
b) Coefficients of domestic growth for hard currency and local currency flows
Source: IMF (2020)
When is foreign participation a vulnerability?
Foreign participation in local currency bond markets can be a mixed blessing. Non-resident holdings of bonds can reduce borrowing costs, currency mismatches, and rollover risks associated with external borrowing, and by diversifying the investor base, issuers can increase their flexibility and boost the potential size of the market beyond the absorption capacity of their domestic investor base. Local currency bond outflows can also increase term premiums and increase long-term interest rates, which in turn affects domestic activity (Carstens 2019). Domestic financial deepening can also be at play in determining funding costs, since depth of domestic financial markets can help countries mobilize savings, promote information sharing, and diversify risk. Deep financial systems can support financial stability by buffering the economy against external shocks and by dampening the volatility of asset prices.
Using a panel regression with data from emerging markets for 2004-2017, we find that greater foreign participation in local currency bond markets increases the volatility of yields beyond a threshold. On the contrary, further domestic financial deepening helps reduce the volatility of yields. Conditional on domestic factors, when foreign investor bond holdings exceed about 40 %of the country’s international reserves, the volatility of yields is found to increase by about 15%. At the same time, domestic financial market deepening helped emerging market economies dampen volatility by 39% on average during 2004–2017. Looking forward, we conclude that foreign investor participation may be a vulnerability for frontier markets as several of these recently had relatively high levels of foreign participation in local currency bond markets, despite a lack of financial deepening (Figure 7). Our analysis suggests that there are potentially large gains for frontier market economies if they reduce the volatility of yields by deepening domestic financial markets.
Figure 7 Foreign holdings of local debt and financial depth
a) Foreign holdings of local debt (percent of reserves)
b) Financial market institutions depth score (index)
Source: IMF (2020)
Specific policy responses to external pressures depend on the nature of the shock but our work suggests some common principles to help guide policy (see IMF 2020 for more details). To prepare for long-term external funding disruptions, countries should aim to promote a stable and diversified local investor base. Foreign currency interventions may become necessary to lean against market illiquidity. In the face of an imminent crisis, introducing capital outflow management measures could be part of a broad policy package, but these measures cannot substitute for, or avoid, warranted macroeconomic adjustment. If non-resident outflows are a significant driver of overall outflows, minimum holding periods, caps, and other limits on non-residents’ transfers abroad might be an option, with due consideration for international obligations, however. Such measures should be implemented in a transparent manner, temporary, and lifted once crisis conditions abate. Macroprudential tools can also play an important role and macroprudential buffers can be relaxed where available to reduce the impact of shocks.
Disclaimer: The views expressed in this paper are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
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1 Equity flows seem to be less sensitive to global and domestic factors than debt flows.