The US Federal Reserve’s announcement in June 2013 of a possible tapering of its asset purchase programme led to a reversal of capital flows from emerging markets and significant market volatility.

The Fed indicated at that time that it would decrease the monthly rate of assets purchase from the current US$ 85 billion should the economy be on a sustainable recovery track. Expectations of tighter monetary conditions in the future led to an increase in long-term US Treasuries yields (Chart 1). As returns on US bonds became more attractive, capital started flowing out of emerging markets into advanced economies. Emerging market currencies came under increasing pressure as a result (see Chart 1).

Chart 1: 10-year US Treasury yields and emerging market currencies

Sources: Bloomberg and authors’ calculations

The Fed’s decision on 18 September to postpone the start of tapering brought about a rally in many emerging markets, but the expectation remains that the monetary policy in the US and other advanced economies will be gradually tightened.

The correlation between different asset classes and markets has weakened since the Fed’s announcement.

While the prices of stocks in emerging markets, those in advanced markets and prices of commodities largely moved together over the past two years, their paths have diverged since May 2013 (Chart 2). In general, reversal of capital flows pushed emerging market equities (and currencies) down and advanced market equities down, while oil prices have increased even faster reflecting concerns about geopolitical instability in the Middle East.

Chart 2: Evolution of equity and commodity indices

Sources: Bloomberg and authors’ calculations

One remarkable exception from this pattern among emerging markets is the recent performance of the new EU member states.

In these countries equity valuations have actually risen since May (Chart 3) and capital inflows continued.(Equity returns are shown in US$ terms and thus capture the combined effect of stock market corrections and currency movements linked to capital outflows.) This is in sharp contrast with the experience of other emerging markets both within the EBRD region of operations (particularly Turkey but also other countries) and globally. Some analysts started talking of a new “safe haven” in Emerging Europe. The general economic recovery could explain greater investors’ confidence in advanced economies. But what explains this “safe haven” performance of the new EU members?

Chart 3. Equity market performance before and during the emerging markets sell-off

Sources: Bloomberg and authors’ calculations

In part, it reflects stronger performance of the Eurozone, the key source of external demand for the region, which has been heading out of recession. It contrasts with a deceleration in China (to 7.5 per cent year-on-year growth in the second quarter of the year), the key external force for the Asian emerging markets, and increasing concerns about safety of China’s large shadow banking system.

It also reflects relatively low inflows of non-FDI foreign funds into CEB and SEE regions in recent years (Chart 4) compared with the large inflows into Emerging Asia (the latter almost doubled in the first quarter of 2013 compared with the first quarter of 2012). Within the EBRD region, Turkey had experienced similarly large inflows. Consequently, in the context of the emerging market sell-off after the June announcement Turkey did experience a sharp downward adjustment in its equity market and exchange rate. There was not much “hot” foreign money that could flow out of the new EU member states and depress exchange rates and asset prices.

Chart 4: Private capital flows

Finally, fundamentals in the new EU member states have been improving.

Current account deficits have narrowed markedly since the crisis (Chart 5) and fiscal consolidations have been under way (Chart 6).

Chart 5: Changes in fiscal balances

Chart 6: Current account balances

Sources: IMF and authors’ calculations

Yet the growth performance of CEB, Bulgaria, Croatia and Romania has been on average weaker than that of other Emerging markets.

In particular, countries in Asia and Latin America with comparable per capita income continued growing faster (Chart 7 shows the latest growth numbers, year-on-year, for the EBRD region (red or dark blue columns) and for selected comparator markets, light blue). Further, investors remain concerned about the situation in the banking sector and elevated levels of non-performing loans. Thus further improvements in fundamentals accompanied with structural reforms which have stalled in the region will be crucial to convince investors that the new EU member states are truly becoming a “safe haven” rather than a quiet backwater.

Chart 7: Latest GDP growth, in per cent, year-on-year

The US Federal Reserve’s announcement in June 2013 of a possible tapering of its asset purchase programme led to a reversal of capital flows from emerging markets and significant market volatility.

The Fed indicated at that time that it would decrease the monthly rate of assets purchase from the current US$ 85 billion should the economy be on a sustainable recovery track. Expectations of tighter monetary conditions in the future led to an increase in long-term US Treasuries yields (Chart 1). As returns on US bonds became more attractive, capital started flowing out of emerging markets into advanced economies. Emerging market currencies came under increasing pressure as a result (see Chart 1).

Chart 1: 10-year US Treasury yields and emerging market currencies

Sources: Bloomberg and authors’ calculations

The Fed’s decision on 18 September to postpone the start of tapering brought about a rally in many emerging markets, but the expectation remains that the monetary policy in the US and other advanced economies will be gradually tightened.

The correlation between different asset classes and markets has weakened since the Fed’s announcement.

While the prices of stocks in emerging markets, those in advanced markets and prices of commodities largely moved together over the past two years, their paths have diverged since May 2013 (Chart 2). In general, reversal of capital flows pushed emerging market equities (and currencies) down and advanced market equities down, while oil prices have increased even faster reflecting concerns about geopolitical instability in the Middle East.

Chart 2: Evolution of equity and commodity indices

Sources: Bloomberg and authors’ calculations

One remarkable exception from this pattern among emerging markets is the recent performance of the new EU member states.

In these countries equity valuations have actually risen since May (Chart 3) and capital inflows continued.(Equity returns are shown in US$ terms and thus capture the combined effect of stock market corrections and currency movements linked to capital outflows.) This is in sharp contrast with the experience of other emerging markets both within the EBRD region of operations (particularly Turkey but also other countries) and globally. Some analysts started talking of a new “safe haven” in Emerging Europe. The general economic recovery could explain greater investors’ confidence in advanced economies. But what explains this “safe haven” performance of the new EU members?

Chart 3. Equity market performance before and during the emerging markets sell-off

Sources: Bloomberg and authors’ calculations

In part, it reflects stronger performance of the Eurozone, the key source of external demand for the region, which has been heading out of recession. It contrasts with a deceleration in China (to 7.5 per cent year-on-year growth in the second quarter of the year), the key external force for the Asian emerging markets, and increasing concerns about safety of China’s large shadow banking system.

It also reflects relatively low inflows of non-FDI foreign funds into CEB and SEE regions in recent years (Chart 4) compared with the large inflows into Emerging Asia (the latter almost doubled in the first quarter of 2013 compared with the first quarter of 2012). Within the EBRD region, Turkey had experienced similarly large inflows. Consequently, in the context of the emerging market sell-off after the June announcement Turkey did experience a sharp downward adjustment in its equity market and exchange rate. There was not much “hot” foreign money that could flow out of the new EU member states and depress exchange rates and asset prices.

Chart 4: Private capital flows

Finally, fundamentals in the new EU member states have been improving.

Current account deficits have narrowed markedly since the crisis (Chart 5) and fiscal consolidations have been under way (Chart 6).

Chart 5: Changes in fiscal balances

Chart 6: Current account balances

Sources: IMF and authors’ calculations

Yet the growth performance of CEB, Bulgaria, Croatia and Romania has been on average weaker than that of other Emerging markets.

In particular, countries in Asia and Latin America with comparable per capita income continued growing faster (Chart 7 shows the latest growth numbers, year-on-year, for the EBRD region (red or dark blue columns) and for selected comparator markets, light blue). Further, investors remain concerned about the situation in the banking sector and elevated levels of non-performing loans. Thus further improvements in fundamentals accompanied with structural reforms which have stalled in the region will be crucial to convince investors that the new EU member states are truly becoming a “safe haven” rather than a quiet backwater.

Chart 7: Latest GDP growth, in per cent, year-on-year

Sources: Bloomberg, national authorities

Source:www.ebrd.com

By Alexander Plekhanov, Olga Ponomarenko and Jonathan Lehne