Foreign investors have withdrawn funds from emerging markets for five straight months, the longest withdrawal streak on record, showing how fears of a recession and rising interest rates are shaking emerging economies.
According to preliminary data compiled by the Institute of International Finance, the cross-border outflow of international investors in emerging market stocks and domestic bonds reached $10.5 billion this month. This has boosted churn over the past five months to more than $38 billion, the longest period of net churn since registration began in 2005.
The outflow of funds could exacerbate the growing financial crisis in developing countries. Over the past three months, Sri Lanka has defaulted on its sovereign debt, while Bangladesh and Pakistan applied to the IMF for help. Investors fear that a growing number of other issuers in emerging markets are also at risk.
Many low- and middle-income developing countries are suffering from depreciating currencies and rising borrowing costs driven by rate hikes by the US Federal Reserve and recession fears in major advanced economies. USA this week recorded second consecutive quarterly decline in production volumes.
“EM has had a really crazy roller coaster year,” said Kartik Sankaran, senior strategist at Corpay.
Investors also raised $30 billion this year from emerging-country foreign-currency bond funds that invest in bonds issued in capital markets in advanced economies, according to JPMorgan.
Foreign currency bonds from at least 20 frontier and emerging markets are trading at yields more than 10 percentage points higher than comparable US Treasuries, according to JPMorgan data collated by the Financial Times. Spreads at such high levels are often seen as an indicator of severe financial stress and default risk.
This marks a sharp change in sentiment from late 2021 and early 2022, when many investors expected emerging market economies to recover quickly from the pandemic. Back in April of this year, currencies and other assets in emerging commodity-exporting countries such as Brazil and Colombia performed well as the prices of oil and other commodities soared following Russia’s invasion of Ukraine.
But fears of a global recession and inflation, aggressive interest rate hikes in the US and a slowdown in China have led many investors to divest from emerging markets.
Jonathan Fortan Vargas, IIF economist, said overseas withdrawals were unusually widespread in emerging markets; in previous episodes, outflow from one region was partially balanced by inflow into another.
“This time around, sentiment is generally negative,” he said.
Analysts also warned that, unlike previous episodes, there is little chance of global conditions shifting in favor of EM any time soon.
“The Fed’s position appears to be very different from what it has been in previous cycles,” said Adam Wolfe, an emerging markets economist at Absolute Strategy Research. “He’s more willing to risk a US recession and risk destabilizing financial markets to bring down inflation.”
He also warned that there were few signs of economic recovery in China, the world’s largest emerging market. This limits its ability to stimulate a recovery in other developing countries that rely on it as an export market and source of financing.
“China’s financial system is under pressure from last year’s economic downturn, and this has really limited the ability of its banks to continue to refinance all of their loans to other emerging markets,” Wolfe said.
Sri Lanka’s default on its external debt has left many investors wondering who will be the next sovereign borrower to restructure.
U.S. Treasury spreads on foreign bonds issued by Ghana, for example, have more than doubled this year as investors factor in rising risk of default or restructuring. Very high debt-servicing costs are sapping Ghana’s foreign exchange reserves, which fell from $9.7 billion at the end of 2021 to $7.7 billion at the end of June, representing $1 billion in the quarter.
If this continues, “within four quarters, reserves will suddenly be at a level where the markets will start to get seriously worried,” said Kevin Daley, chief investment officer at Abrdn. He added that the government will almost certainly fall short of its financial targets for this year, so reserve depletion will continue.
Borrowing costs for large emerging markets such as Brazil, Mexico, India and South Africa have also risen this year, but to a lesser extent. Many large countries have taken anti-inflation measures early and have adopted measures to protect them from external shocks.
The only major emerging economy of concern is Turkey, where government measures to bail out the lira when it refuses to raise interest rates — essentially promising to pay local savers the cost of currency depreciation in exchange for keeping the currency — have a high financial cost.
Such measures can only work when Turkey runs a current account surplus, which is rare, Wolfe said. “If it needs outside funding, eventually those systems will break down.”
But other major emerging economies are facing similar pressures, he added: a reliance on debt financing means governments will eventually have to suppress domestic demand to bring debt under control, which could lead to a recession.
Fortun Vargas said a sell-off is inevitable. “What’s amazing is how much sentiment has changed,” he said. “Commodity exporters were the darlings of investors just a few weeks ago. There are no favorites now.”
Additional reporting by Kate Dugid in London