Foreign investors have withdrawn funds from emerging markets for five consecutive months in the longest streak of withdrawals on record, underscoring how recession fears and rising interest rates are rocking developing economies.
Cross-border outflows by international investors in emerging market stocks and domestic bonds reached $10.5 billion this month, according to preliminary data compiled by the Institute of International Finance. That brought outflows over the past five months to more than $38 billion – the longest stretch of net outflows since records began in 2005.
Capital outflows risk exacerbating a growing financial crisis in developing economies. Over the past three months, Sri Lanka has defaulted on its sovereign debt and both Bangladesh and Pakistan have sought IMF assistance. A growing number of other emerging market issuers are also at risk, investors fear.
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. The United States recorded its second straight quarterly contraction in output this week.
“EM has had a really, really crazy roller coaster year,” said Karthik Sankaran, senior strategist at Corpay.
Investors have also withdrawn $30 billion so far this year from emerging market currency bond funds, which invest in bonds issued in the capital markets of advanced economies, according to JPMorgan data.
Foreign-currency bonds in at least 20 frontier and emerging markets are trading at yields more than 10 percentage points higher than comparable U.S. Treasuries, according to JPMorgan data compiled 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 reversal in sentiment from late 2021 and early 2022, when many investors expected emerging economies to recover strongly from the pandemic. As recently as April this year, currencies and other assets in commodity-exporting emerging markets such as Brazil and Colombia performed well on the back of rising oil and other commodity prices following Russia’s invasion of Ukraine.
But global recession and inflation fears, aggressive U.S. interest rate hikes and slowing Chinese economic growth caused many investors to shy away from emerging market assets.
Jonathan Fortun Vargas, an economist at the IIF, said cross-border withdrawals had been unusually widespread in emerging markets; in previous episodes, exits from one region were partially offset by entries into another.
“This time the sentiment is broadly bearish,” he said.
Analysts also warned that, unlike previous episodes, there was little immediate prospect of global conditions turning in favor of emerging markets.
“The Fed’s stance appears to be very different from previous cycles,” said Adam Wolfe, emerging markets economist at Absolute Strategy Research. “He is more willing to risk a US recession and risk destabilizing financial markets in order to bring down inflation.”
There are also few signs of an economic recovery in China, the world’s biggest emerging market, he warned. This limits its ability to stimulate recovery in other developing countries that depend on it as an export market and source of financing.
“China’s financial system is being strained by last year’s economic slump and that 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 many investors wondering who will be the next sovereign borrower to restructure.
Spreads over US Treasuries on foreign bonds issued by Ghana, for example, have more than doubled this year as investors price in a growing risk of default or restructuring. Very high debt service costs are eroding 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, or a rate of $1 billion per quarter.
If this continues, “over four quarters, reserves will suddenly be at levels where markets are starting to really worry,” said Kevin Daly, chief investment officer at Abrdn. The government is almost certain to miss its fiscal targets for this year, so the drain on reserves is likely to continue, he added.
Borrowing costs in large emerging markets such as Brazil, Mexico, India and South Africa have also increased this year, but to a lesser extent. Many major economies acted early to fight inflation and have policies in place that protect them from external shocks.
The only major emerging market of concern is Turkey, where government measures to prop up the lira while refusing to raise interest rates – in effect, promising to pay local depositors the cost of currency depreciation to stay true to the currency – have a high fiscal cost.
Such measures can only work as long as Turkey runs a current account surplus, which is rare, Wolfe said. “If it needs external funding, eventually those systems will collapse.”
However, other major emerging economies face similar pressures, he added: a reliance on debt financing means that governments must eventually suppress domestic demand to get debt under control, at the risk of a recession.
Fortun Vargas said there was little escape from the sale. “What’s surprising is how much the sentiment has shifted,” he said. “Commodity exporters were the darlings of investors just a few weeks ago. There are no more darlings now.
Additional reporting by Kate Duguid in London