A resurgence in capital flows to emerging markets is likely to be sowing the seeds for the next financial crisis in the developed world, according to analysis by Oxford Economics, a consultancy.
Net capital flows to emerging markets turned positive for the first time since 2013 last year, according to the Institute of International Finance, an industry association, with the pace of inflows accelerating the early weeks of the new year, a trend that is expected to continue.
However Guillermo Tolosa, economic adviser at Oxford Economics, believed much of this money would be ultimately recycled into the developed world’s fixed income markets, as happened before the global financial crisis, sparking dangerous imbalances in the world’s financial system.
“On the back of revived flows, emerging markets once again stepped up foreign asset accumulation in 2017,” said Mr Tolosa, who calculated that EMs bought more than 70 per cent of US Treasury bond issuance last year. “The EM recycling machine will most likely continue to operate on full power,” he added.
His contention is that the bulk of developed market capital flows into emerging markets tend to be in the form of equity investment, primarily foreign direct investment but also into public equity markets.
Until the 1990s, emerging markets would simply have spent this money, leading to large current account deficits and making EMs vulnerable to any reversal in hot money flows, as was seen during Asian financial crises that swept across the region from Indonesia to South Korea.
However, in the wake of those crises, many emerging market countries adopted a different strategy when strong capital inflows returned in early 2000s. Central banks intervened to stop currencies appreciating markedly, recycling the inflows into foreign assets, primarily fixed income due to their risk averse nature.
The first chart shows the result of this during two waves of inflows, 2003 to the outbreak of the global financial crisis in the second quarter of 2008, and Q3 2009, when inflows returned to 2014, when they reversed again.
The second and third charts both show that it was these gross capital inflows that primarily drove emerging market economies’ purchases of foreign debt securities, rather than their current account surpluses, as some have argued.
Mr Tolosa’s contention is that this approach has helped reduce the risk of crises in EMs. Between 2015 and 2017, for instance, when flows reversed, they were able to draw down a fraction of their foreign reserves to support their currencies and economies, as illustrated in the second chart.
“Because emerging markets had these massive buffers they didn’t have to adjust their consumption in such a radical way as was the case in the past,” he said. Moreover, “the very existence of these buffers made foreign and local investors less likely to panic and create an even larger outflow”.
Conversely, however, this strategy increased risk in the developed world, and may even have caused the global financial crisis, or at the very least helped worsen it, Mr Tolosa argued.
Between 2003 and 2008, emerging market countries accumulated $3tn of foreign debt securities, he calculates, while over the same period US households accumulated $5.5tn of debt, much of which was securitised and sold into global markets.
Mr Tolosa believes this debt accumulation simply would not have been possible without EMs buying some of these asset-backed securities directly and, by also buying safer assets such as Treasuries, inducing developed world investors into buying ABSs instead.
“[EMs’] buffers involved the purchase of $3tn of foreign debt securities. Governments didn’t have large deficits so someone else had to provide this $3tn stock of debt securities to them. The financial sector engineered a way to provide these securities by issuing asset-backed securities which represented household debt in a securitised way,” he argued.
“[There was a] binge of $5.5tn. EMs financed $3tn directly and indirectly. [Without this] the household sector in the US would not have been able to borrow as much as it did.”
Emerging markets’ voracious appetite for foreign debt securities “has fundamentally changed the landscape and made advanced markets more likely to engage in borrowing binges”, he added.
While “it’s hard to tell” whether or not there would still have been a global financial crisis without this recycling of capital flows, there would have been “much less financial stress for households [so] it would have made it much less likely”, Mr Tolosa said.
In one sense developed markets might seem to be the winners in this asset exchange: the equities they hold should, in theory, provide stronger returns than the fixed-income assets emerging markets have majored in, meaning a steady stream of net payments to DMs.
However, as Mr Tolosa noted, the downside of debt securities is that they “have to pay no matter what the state of the global economy”, unlike equities where dividend streams can be switched off in times of adversity.
Despite this, Hung Tran, executive director of the Institute of International Finance, was not convinced by the analysis.
Mr Tran accepted that emerging markets had made themselves less vulnerable to crises by “self insuring” in building up their foreign reserves, giving them ammunition to support their currencies in difficult times and provide support to companies that have over-borrowed in foreign currency. However, he said the extent of protection varied widely from country to country.
Mr Tran also accepted that this asset accumulation had helped hold down market interest rates in the developed world, which “did probably play a role” in the build-up to the global financial crisis. However, he argued that the crisis was driven by lax lending standards in the US, rather than low interest rates.
As for the location of potential future financial crises in the developed world, Mr Tran identified countries such as Italy, where the government debt-to-GDP ratio has risen to 133 per cent, even though “very few emerging market central banks really hold Italian government bonds”.
“There is some logic,” in Mr Tolosa’s arguments, he added, but “it is very simplistic and not helpful,” to say that developed economies were now more vulnerable to crises because of the build-up of buffers by emerging market countries.
These buffers now amount to $6tn of foreign fixed income securities, Oxford Economics calculates, based on EM countries’ disclosures. The list is headed by China, with $3.3tn, followed by South Korea ($516bn), Brazil ($345bn) and Russia ($335bn). For the first time since early 2015, this stockpile is rising once again, as seen in the final chart.
Mr Tolosa believes the rebound in emerging markets’ foreign exchange reserves since last year is already making its mark in the developed world, calculating that these countries accounted for 70 per cent of gross purchases of US Treasuries in 2017, although in part this was due to a switch out of lower-yielding eurozone paper, rather than pure net accumulation of bonds.
The potential risk of future developed world crises might be reduced if EMs started buying more equities instead. This might seem a logical next step, as once they have a level of safe, precautionary reserves they consider adequate, they could afford to take a little more risk with excess reserves.
This is indeed happening in a small way, with some of the reserves being pumped into sovereign wealth funds, which have a remit to buy equities. Mr Tolosa did not see this taking off in a big way, however.
“This is public money. It’s very difficult to explain losses to the public, so they play safe,” he said.
Indeed, he believed the risk of crisis would continue to grow. At present, US and European investors tend to display a high degree of home country bias.
With emerging markets accounting for an ever larger share of the global economy and earnings, Mr Tolosa believed it was inevitable that, over time, these investors will direct more of their equity investment to developing markets. If so, this will only increase the equity-debt mismatch between EMs and DMs and induce more recycling of the inflows into developed world debt securities.
All that advanced countries can do is improve financial supervision to “make sure no sectors are borrowing more than they can afford,” Mr Tolosa said, something he is not sure they are achieving, given the “massive increases in housing debt” in the likes of Australia, Canada and Norway.