February 7, 2023

Foreign investors have pulled money from emerging markets for five months in a row in the longest streak of withdrawals ever, highlighting how recession fears and rising interest rates are shaking emerging economies.

Cross-border outflows of international investors in emerging market equities and domestic bonds reached $10.5 billion this month, according to preliminary data collected by the Institute of International Finance. That brought outflows over the past five months to more than $38 billion — the longest period of net outflows since registration began in 2005.

The outflow threatens to exacerbate a deepening financial crisis in emerging economies. In the past three months, Sri Lanka has defaulted on its national debt and Bangladesh and Pakistan have both asked the IMF for help. 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, amid interest rate hikes by the US Federal Reserve and fears of recession in major advanced economies. The US registered a contraction in production for the second consecutive quarter this week.

“EM has had a really, really crazy rollercoaster year,” said Karthik Sankaran, senior strategist at Corpay.

According to data from JPMorgan, investors have raised $30 billion so far this year from emerging-market foreign currency bond funds, which invest in bonds issued on capital markets in advanced economies.

The foreign currency bonds of at least 20 frontier and emerging markets are trading at yields more than 10 percentage points above those of comparable US Treasuries, according to JPMorgan data collected by the Financial Times. Spreads at such high levels are often seen as an indicator of severe financial stress and default risk.

Column chart of % of months per year that ... shows emerging markets hit from outflows for the fifth consecutive month

It marks a sharp turnaround in sentiment from late 2021 and early 2022, when many investors expected emerging economies to recover strongly from the pandemic. As late as April of 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 the Russian invasion of Ukraine.

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But fears of a global recession and inflation, aggressive hikes in US interest rates and a slowdown in Chinese economic growth have led many investors to shy away from emerging market assets.

Jonathan Fortun Vargas, economist at the IIF, said cross-border withdrawals were unusually widespread in emerging markets; in previous episodes, the outflow from one region was partially offset by the influx to another.

“This time sentiment is generalized on the downside,” he said.

Analysts also warned that, unlike in previous installments, there was little immediate prospect of global conditions turning in EM’s favor.

“The Fed’s position appears to be very different from previous cycles,” said Adam Wolfe, EM economist at Absolute Strategy Research. “It is more willing to risk a recession in the US and destabilize the financial markets to lower inflation.”

There is also little sign of economic recovery in China, the world’s largest emerging market, he warned. That limits its ability to bring about a recovery in other developing countries that depend on it as an export market and source of finance.

“China’s financial system is under pressure from the economic slump over the past year and that has really limited the banks’ ability to continue to refinance all their loans to other emerging markets,” Wolfe said.

With Sri Lanka’s foreign debt default, many investors are wondering who will be the next sovereign borrower to restructure.

For example, US Treasury spreads on Ghana-issued foreign bonds have more than doubled this year as investors estimate an increasing risk of default or restructuring. The very high cost of debt service is shrinking 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, at a rate of $1 billion per quarter.

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If things continue like this, “reserves will suddenly be at a level in four quarters where the markets are really starting to worry,” said Kevin Daly, investment director at Abrdn. The government will almost certainly not meet its budget targets for this year, so the depletion of reserves will continue, he added.

Borrowing costs for major emerging markets such as Brazil, Mexico, India and South Africa have also risen this year, but less so. Many major economies took early action to fight inflation and implemented policies that protect them from external shocks.

The only major emerging economy of concern is Turkey, where government measures to support the lira while refusing to raise interest rates – in effect promising to pay local savers the depreciation costs of the currency – are incurring high tax costs.

Such measures can only work if Turkey has a current account surplus, which is rare, Wolfe said. “If it needs external funding, those systems eventually break down.”

However, other major emerging economies are under similar pressure, he added: A reliance on debt financing means governments will eventually have to suppress domestic demand to bring debt under control, at the risk of a recession.

Fortun Vargas said there was little escaping the sell-off. “What’s surprising is how much sentiment has turned,” he said. “A few weeks ago, commodity exporters were still the darlings of investors. There are no darlings now.”

Additional coverage by Kate Duguid in London