Capital markets: Emerging-market overhang
The near-term dangers in emerging markets remain high, even assuming a breakthrough in the eurozone crisis – and emerging Europe is most at risk.
Data from US funds monitor EPFR reveal total flows to emerging-market bond and equity funds since mid-2009 have been around two-and-a-half times as large as the total inflows between 2004 and the collapse of Lehman Brothers.
Despite outflows in September – and to a lesser extent in October – towards the end of last month flows to local-currency emerging-market bond funds were still in positive territory for 2011 as a whole.
Non-residents hold a larger proportion of local-currency government debt in emerging markets than in developed markets. In South Africa and Hungary, for example, close to 25% of local government bonds are held by global emerging-market funds. These funds have a greater propensity to exit in a rush compared with domestic investors.
Countries in emerging Europe outside of the former Soviet Union suffer from a lack of mineral wealth relative to other emerging markets, so their current-account deficits are worse. Bigger countries in emerging Europe, such as Turkey and Poland, are less dependent on exports, thanks to their domestic markets. However, since 2008, these countries have been under less pressure to bring down deficits than have less-favoured markets.
Hungary has a current account surplus, for example, while Romania’s deficit has dropped from 14% to 5%. Turkey’s current account deficit, however, rose to almost 10% earlier this year. Poland is endangered, too, in this regard. Erste Bank predicts a 5% current account deficit in Poland next year.
Foreign direct investment flows, particularly into the banking sector, have not recovered since 2008 in these markets, and these deficits have been more and more funded by portfolio flows. Foreign investors now hold almost a third of local-currency government bonds in Poland.
During the past two years, Hungary, despite its populist government, has benefited from the global search for yield in emerging markets. Foreign holdings of local-currency bonds in Hungary were still at all-time highs late last month.
As the tide begins to turn, Hungary’s sins will hasten the exit from more investor-friendly markets in emerging Europe such as Poland. There was a rebound in the forint when Hungary announced new talks with the IMF last month, after local-currency bond sales fell short. Yet investors might rapidly lose heart again, given the continued attacks on foreign-owned banks and because Moody’s downgraded the country’s bonds to junk status.
A short-term sell-off in Poland and Turkey might be followed by a rapid recovery, given these countries’ relatively attractive economic fundamentals. However, particularly in Central and Eastern European countries, where the proportion of eurozone-owned banks is highest, funding difficulties at banks such as UniCredit could be an even graver long-term threat than portfolio flows.