Given that monetary policy in developed economies is starting to normalise, especially in the US where the expected fiscal stimulus should fuel inflationary pressures and begin the Federal Reserve’s cycle in earnest, emerging markets look set to return to the limelight in 2017. As reported by Manolis Davradakis at AXA IM an important channel of transmission to EMs is through capital flows1 and their impact on EM FX and credit risk premiums, “so that outflows can pressure on the financing of EM current accounts if they are in deficit.”
Taking into account the absolute attractiveness of a particular region in terms of return premium (the “pull” factor here proxied by the nominal GDP growth differential) and the lack of investment alternatives elsewhere as well as investors’ risk appetite (the “push” factors proxied by the real 10-year US treasury yield, the VIX index and US high yield spreads), we outline a forecasting model of annual gross non- resident capital inflows to EMs over the period 2002-2018.
This model performs well in-sample historically and, complementing with futures for the VIX and acknowledging the upward bias of VIX futures, AXA IM’s analysts expect capital inflows to EMs to slow down in 2017. Yet, they do not believe they would fall off a cliff as in 2013-2015, which is likely to provide a supporting cushion in case of large (gross) capital outflows (which are historically much harder to predict). The deterioration in pull factors will dominate that of push factors and weigh on EM capital inflows. A narrower EM-developed economies growth differential relative to the past, higher VIX volatility (20) and higher US treasury yields (2.75%) and US high yield spreads (480bps) would weigh on flows in 2017 relative to 2016. Both portfolio and foreign direct investment (FDI) flows are expected to slow this year and almost at the same pace, with more volatility for portfolio flows than FDIs. According to Davradakis:
Turning to the impact for EM FX, the historical elasticity to EM capital inflows translates our forecast above to an average 1% depreciation of EM currencies (in trade-weighted terms), all else being equal. This is similar to the drop recorded in 2014. EM currencies with a high current account deficit would however suffer the most as they have a higher need to refinance their dollar-denominated debt. We acknowledge that the fall in EM currencies could be deeper should the new US administration opt for a more trade-protectionist policy, while the fact that most EM currencies are already undervalued relative to their post-2009 historical average could limit the fall.
