A range of factors coincided to depress capital inflows in 2013-16, such as higher US interest rates, a strengthening dollar, concerns about a hard landing in China, falling commodity prices and weak global trade.
Capital flows to EMs were hit by successive bouts of capital flight in 2013-16, with non-resident inflows falling from USD418bn in 2012 to USD100bn in 2016. First, monetary policy in the US was tightened, beginning with the announcement in mid-2013 that the US Federal Reserve would begin tapering its quantitative easing (QE) programme.
This was followed by rising expectations for interest rate hikes with the first hike coming at the end of 2015 and the second at the end of 2016. Higher US interest rates attracted capital back from EMs and the US dollar appreciated sharply. This increased the external debt burden in EMs, further discouraging capital flows.
Second, oil prices and other commodity prices collapsed, starting in the middle of 2014 and continuing until early 2016 and remain volatile. Many of the major EMs are commodity exporters and lower prices led to worsening current account balances and weaker currencies, further undermining appetite for investing in these countries.
Third, during 2015-16, concerns about financial stability in China rose sharply, prompted by rising debt and the devaluation of the yuan. This triggered capital flight from China with spillovers to other adjacent EMs.
However, in 2017, non-resident capital inflows to EMs have recovered to USD205bn, just in the first eight months, as these trends have reversed. First, expectations for US monetary tightening have been scaled back. Although the Fed hiked twice in March and June, markets are now only expecting one more hike by the end of 2018.
This has contributed to a decline in the US dollar, with the trade weighted index down 9.3% so far this year. Second, oil and commodity prices are recovering, boosting the external balances of commodity exporting EMs.
Third, Chinese GDP growth has stabilised at a higher level than expected and the yuan has appreciated, reducing concerns about spillover effects to other EMs. Finally, a pickup in global growth and trade has helped improve risk appetite, encouraging investors to shift into riskier asset classes, such as EMs.
Regionally, Asia has been the main beneficiary of improved capital flows to EMs. These economies tend to have high export shares of GDP and have, therefore, benefited from the pickup in global growth and trade.
Many are also commodity exporters, such as Indonesia and Vietnam, and have benefitted from the recovery in commodity prices. Asian economies are closely interlinked with the Chinese economy and the improving situation in China has reduced the perceived risk of spillovers to the rest of the region.
Given recent events, the EM capital flight crisis seems to be behind us and, as we highlighted in a previous report in March (Is the EM capital flight crisis over?), EMs are now more resilient than they were at the outset of the crisis. However, a few final words of caution as risks still cloud the outlook.
First, global monetary policy could tighten next year as the Fed plans to reduce the size of its balance sheet and the European Central Bank is soon expected to announce its own tapering of QE. Second, growth in China has been partly achieved through credit stimulus, which could be withdrawn if concerns about financial stability re-emerge. Finally, political risks from North Korea to trade protectionism could undermine risk appetite and spark a further round of capital flight from EMs.