In its global sovereign rating outlook for 2018, S&P highlights the danger for emerging markets of accelerated interest rate rises in the years ahead, leading to capital outflows from emerging market securities and a reduction in direct foreign investment (FDI).
That could badly damage the economic model of some emerging economies, but to what extent remains to be seen, said the report.
According to S&P, the emerging market sovereigns most at risk from faster-than-expected monetary tightening are, in descending order: Venezuela, Bahamas, Mozambique, Montenegro, Turkey, Ethiopia, Pakistan, Kenya, Oman and Sri Lanka. Among the large emerging markets, Turkey appears the most exposed at No. 5, said S&P.
The agency said as the recovery of advanced economies gains breadth and depth, including in the euro zone, inflationary pressures could rise and trigger faster monetary normalization (higher rates) by the leading central banks than currently envisaged by the market.
The rub here, as S&P goes on to explain, is that foreign investors would then be sorely tempted to withdraw some invested funds from emerging markets to put back into advanced economies’ securities, which will provide higher real returns than they do currently.
S&P said: “Even relatively small shifts back to advanced economies’ securities relative to their outstanding volume can have a meaningful impact on emerging markets. This is because the capital market is simply so much larger in the advanced economies.”
In recent years, there have been unprecedented portfolio flows into emerging markets shares and other investment instruments that help those countries fund development and secure prosperity.
“But they also create a development model that is dependent on external financing conditions. This renders them vulnerable to sudden stops of capital inflows and possible reversals,” said S&P.
The Institute of International Finance (IIF) estimates that nonresident net portfolio inflows to emerging markets will reach a record $340 billion this year, followed by $435 billion in 2018. In comparison, the average for 2013-2016 was $200 billion.
Excluding flows into China, the average net inflows into emerging markets will still be
63 percent higher in 2017 than the average of 2013-2016, said IIF.
Added to these portfolio inflows are sizeable nonresident FDI inflows of close to $500 billion.
S&P said: “Portfolio inflows have grown particularly fast in recent years. And it is these portfolio flows that can be more volatile, potentially reversing direction very rapidly when confidence wanes or alternative investment opportunities open up.”
There is a strong correlation between vulnerability to monetary tightening and the sovereign rating.
According to S&P, the average rating of the 10 most vulnerable sovereigns is “B” and none of them carry an investment-grade rating. At the other end of the spectrum, the average rating of the 10 most resilient sovereigns is “BBB,” it said.