More than $3.4 billion inflows into Emerging Markets (EMs) in the week following Brexit—the largest weekly amount on record—looks like good news. Yes, but here is why EMs should not relax in a time of global uncertainty.
The UK referendum to leave the European Union (EU) has had profound effects on global markets and outlooks. Consequentially, the Brexit vote has also forced central banks in advanced economies to re-evaluate their monetary policy plans—and yield-seeking investors are taking notice.
Last month, the US Federal Reserve voiced concerns that a Brexit decision could adversely affect financial markets and the US economy. Following a “leave” result, most investors do not expect the highly cautious Fed to raise rates in the coming months. In the advanced economies of Europe, where interest rates were never expected to increase in the near future, the chances of tighter monetary policies seem even less likely than before. Facing mounting uncertainty, the Bank of England now contemplates an August interest rate cut to 0.25 percent. The European Central Bank, which has warned that a British withdrawal from the EU would have serious economic effects on the Eurozone, is also expected to remain dovish in its policy decisions. For investors, it is a safe bet to assume that interest rates in the developed world will not be increasing for some time.
The search for yield is back
Due to lower expectations for interest rate hikes in developed economies, investors have renewed their search for yield and strong capital inflows have been pumping into Emerging Markets (EMs). The week following the referendum, EM bond funds received more than $3.42 billion, the largest weekly inflow on record since JP Morgan began tracking the data in 2004. The Goldman Sachs Financial Conditions Index shows that EMs performed better in June than they had at any other time in the past five years. EM stocks have also fared very well, with the MSCI Emerging Markets Index up 7.7 percent since June 27. As further evidence of an increase in demand for EM assets, one can look to the recent appreciation of several EM currencies. Over the past two weeks, the Indian Rupee and Chilean Peso appreciated by 3% while the South African Rand appreciated by more than 6 percent. Even in Brazil, in the midst political and economic troubles, the Real has appreciated around 3-4 percent.
Are these capital inflows good or bad news?
At first glance, large capital inflows to EMs might look as great news, especially in the context of large current account deficits and increased external financing needs in many countries. After all, in the pre-Brexit period, the norm was capital outflows from Ems. But are these inflows really good news? In my opinion, not necessarily. First, it is critical that EM central banks recognize that the current increase in inflows is most likely a temporary phenomenon. The Brexit event (together with a disappointing growth outlook in the US) has merely delayed the Fed increases in its policy rate. Even after the Brexit vote, Fed Chair Janet Yellen indicated that the US still plans on raising the interest rates sooner rather than later. With this in mind, EM central banks should consider foreign exchange interventions to contain exchange rate volatility. As a case in point, Peru’s Central Bank has been able to limit the appreciation of its currency and returned the sol to its pre-Brexit value.
Second, and more importantly, these temporary inflows may wrongly take pressure off policymakers to act on the real issue for EMs: increasing productivity via structural reforms. It is essential to understand that this latest increase in appetite for EM assets is based on investors’ portfolio re-balancing given higher volatility in international capital markets and not on an increase in the fundamental value of EMs as an asset class. The more sustainable way to increase capital inflows is by implementing structural reforms that make EMs more attractive, independently of short-term external shocks in the global economy. Among these policy reforms, increased flexibility in labor markets, reduction in red tape and bureaucratic procedures to facilitate private investment and improvements in educational achievements stand out.
Thus, Brexit should be seen as an opportunity and a wake-up call for policymakers to implement long-term enhancing reforms before US interest rates rise and investors’ assessments about the attractiveness of EMs changes once again.
CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.