Emerging markets’ vulnerability to a reassessment of risk
Published as part of the Financial Stability Review, May 2021.
Financial conditions in emerging market economies (EMEs) have weathered the COVID-19 crisis well so far, despite an intense but short-lived stress episode at the onset of the pandemic. Financial conditions in EMEs have rebounded strongly since March 2020; they currently stand at levels similar to before the pandemic thanks to lower bond spreads and higher equity prices. Capital flows have also recovered, with market segments typically judged to be riskier by foreign investors, such as equity and local currency debt, recording strong inflows in the second half of last year. This rebound helped to relieve pressures on financial systems and support activity in EMEs. Nevertheless, recent concerns about rising bond yields and higher than expected inflation in advanced economies have translated in a tightening of financial conditions and slowdown of capital flows to EMEs. In this context, this box assesses potential vulnerabilities facing large EMEs and the risks posed to euro area financial stability.
Many EMEs are benefiting from more solid fundamentals than in past crises, although high debt burdens and exposures to the US dollar and foreign investors may pose challenges for some countries. EMEs, with some notable exceptions, generally entered the pandemic on a sounder footing compared to past major crises (see Chart A, left panel). In recent years, EMEs have reduced their current account deficits, accumulated reserves, strengthened their banking systems and improved their institutions and policy frameworks. At the same time, the fiscal support provided during the pandemic, which follows a recent trend in rising sovereign indebtedness, resulted in increasing fiscal vulnerabilities. Additionally, EME corporates have increasingly tapped international markets over the past decade, with the share of corporate USD-denominated debt to GDP more than doubling in a number of major EMEs. Larger debt levels may, to some extent, reflect the view of investors that greater market depth and improved policy institutions have increased many EME’s capacity to carry debt. Yet, rolling over the debt crucially depends on maintaining market access at favourable financing conditions.
Global factors have been the most important driver of the recovery in EME capital flows over the past year, suggesting there is a risk of reversal. A structural decomposition of capital flows to EMEs shows that the main drivers of these flows are global risk sentiment and the US monetary policy stance (see Chart A, right panel). While capital outflows during the March 2020 turmoil were larger in those EMEs with higher shares of USD-denominated debt, this differentiation became blurred during the recovery phase, when capital flows to these countries recovered quickly and recorded large inflows, consistent with a search for yield behaviour (see Chart B, left panel). Nevertheless, this distinction returned in the first months of this year, when the slowdown of capital inflows appeared to be more substantial in more USD-exposed economies. The same picture emerges when countries are differentiated according to their external debt burden instead (i.e. debt held by foreign investors).
EMEs entered the pandemic with better fundamentals, but capital flows are mainly driven by the global risk appetite and monetary policy stance in the United States
Looking ahead, risks to EME financial stability could arise from a reversal in global risk sentiment, as well as from rising yields in the United States and other advanced economies and an appreciating US dollar. Risks may re-emerge as bond yields and inflation expectations in advanced economies increase. The net impact of such increases is uncertain, depending on the nature of the underlying driver. Nevertheless, even in a positive scenario of yield increases due to an improving global outlook, more indebted EMEs could come under pressure, especially those that are more exposed to US dollar and foreign investors. In a negative scenario, an abrupt risk reversal driven by a reassessment of the global outlook or the monetary policy stance in major advanced economies might trigger a sharp tightening in financial conditions, renewed capital outflows and pressures on domestic currencies, as vividly illustrated by past experiences, such as the taper tantrum episode back in 2013. Moreover, a prolongation of the pandemic caused by slower vaccination progress could put strains on the policy space available to governments in EMEs to support activity and financial systems.
Risk reversals rapidly translate into EME capital flow slowdowns. A shock affecting China could weigh on financial stability in the euro area, but other individual EME shocks appear less relevant
Euro area financial stability could be vulnerable to wider turbulence affecting a number of EMEs, although country-specific shocks would be unlikely to have a sizeable impact. The euro area’s financial and trade links with most individual EMEs are typically small, despite large cross-country heterogeneity. The reaction of euro area bank CDS prices to country-specific shocks in EMEs suggests that, with the exception of China, such idiosyncratic shocks would not have a sizeable impact on financial stability in the euro area (see Chart B, right panel). Yet stress simultaneously affecting several EMEs or a crisis in a large EME could act as a catalyst for a wider reassessment of global risk via a loss of investor confidence, with broader consequences for the euro area and global financial stability.
- With contributions from Pablo Andrés Anaya Longaric, Sungyup Chung, Johannes Gräb and Elena Vollmer.
- For a more detailed comparison with past crises episodes, see the box entitled “Emerging market vulnerabilities – a comparison with previous crises”, Economic Bulletin, Issue 8, ECB, 2018.
- This confirms the findings of the report by the Committee of the Global Financial System (CGFS) on “Changing patterns of capital flows” which shows that sudden stops in EME can be triggered by changes in global liquidity and risk appetite, and that the role of global factors has become larger since the global financial crisis (CGFS, 2021)