New-breed global investors and emerging-market financial stability

Gaston Gelos, Hiroko Oura

The landscape of portfolio investment in emerging markets has evolved considerably over the past 15 years. Financial markets have deepened and become more internationally integrated. The mix of global investors has also changed, with more money intermediated by mutual funds. This column explains that these changes have made capital flows and asset prices in these economies more sensitive to global financial shocks. However, broad-based financial deepening and improved institutions can enhance the resilience of emerging-market economies.

The investor base matters since different investors behave differently. During the emerging-market sell-off episodes in 2013 and early 2014:

Retail-oriented mutual funds withdrew aggressively, but investors from different regions also tended to behave differently;

Institutional investors such as pension funds and insurance companies with long-term strategies broadly maintained their emerging-market investments.

Figure 1 shows the facts.

Figure 1. Bond flows to emerging-market economies

Source: J.P. Morgan.

Note: Retail investors consist of mutual funds and investment trusts. Global institutional investors include investors with long-term strategic mandates such as pension funds, insurance companies, and official funds.

Formal regression analyses confirm that emerging-market portfolio flows from mutual funds are more sensitive to global financial shocks (proxied by movements in the VIX and other similar indicators) than those from institutional investors. Redemption pressures from mutual-fund shareholders explain a part of this, in line with Jotikasthira et al. (2012) and Raddatz and Schmukler (2012), who emphasise the roles of mutual-fund shareholders (in contrast with fund managers) in driving capital flows. Furthermore, retail-oriented mutual funds are more prone to engage in momentum trading (that is, purchasing assets with high recent past returns and selling those that recently performed badly), therefore making flows more procyclical. These factors are contributing to the heightened sensitivity of mutual-fund flows to global financial shocks.

However, institutional investors are not a guarantee of capital-flow stability, either. They can sell off more than retail investors when faced with more severe shocks, such as global financial crises or sovereign downgrades to below investment grade (Figure 2).

Figure 2. Cumulative emerging-market bond flows after major sovereign downgrades (cumulative bond flows from event date, 100 at date -6)

Source: IMF (2014) based on EPFR Global and Bank of New York Mellon data.

Note: Based on average flows around 5 episodes of emerging-market sovereign downgrades to below investment grade between 2000 and 2013.

In addition, among mutual funds, fast-growing bond flows are more sensitive to global financial shocks than equity flows.

Herding and fundamentals – there is little evidence that global investors have become more discerning

There is little evidence that global investors have become more discerning and less prone to panics after two decades of investing. For one, to some extent, investors continue to engage in herd behaviour (i.e. mimicking each others’ trades). Figure 3 shows a measure of global investor herding (based on Lakonishok et al. 1992), which assesses the strength of correlated trading among funds, controlling for their overall trade trends. The measure shows no decline over the longer term. Second, while good domestic macroeconomic fundamentals do help limit the effects of global shocks on emerging-market bond and equity prices, there is no evidence that their role has increased over time. The share of the variation of cross-country contagion patterns during distress episodes (ranging from the Asian and Russian crises to the 2013 sell-off episode) that can be explained by macro fundamentals has not risen over the past 15 years.

Figure 3. Herding among equity and bond mutual funds investing in emerging markets (%)

Source: IMF (2014) using EPFR Global data.

What are the policy options for emerging-market country authorities?

Nonetheless, this does not mean that emerging-market economies’ efforts to strengthen their economies are ineffective and that these economies are purely at the mercy of global investors and policies in advanced economies. Deeper financial systems and better institutions reduce the sensitivity of emerging-market asset prices – equities, foreign- and domestic-currency bond yields, and currencies – to shocks to global financial conditions. In particular:

Developing a larger domestic investor base is important, including local mutual funds, pension funds, insurance companies, and banks.

They can fill in when foreign investors withdraw, mitigating the price impact. Over the past 15 years, the emerging-market domestic investor base has grown substantially, helped by the development of social safety nets that supported the pension and the insurance sectors. However, their size relative to GDP remains small compared to advanced economies, leaving plenty of room for catching up.

Further deepening bond and equity markets and improving their liquidity also strengthens the resilience of emerging-market asset prices.

However, recently, market liquidity has declined in some emerging markets, possibly related to reduced market-making by global banks.

Overcoming ‘original sin’ (Figure 4, and Burger et al. 2011), including through a conscious effort to develop local-currency bond markets, has reduced exchange-rate-related risk and dampened the sensitivity to global factors of both foreign- and domestic-currency bond yields.

At the same time, a larger foreign participation in domestic markets – reaching over 50% of total outstanding domestic debt in some cases – may transmit more volatility from abroad (CGFS 2007). Such foreign participation therefore needs to be monitored closely and accompanied by broader financial-sector development policies.

Figure 4. The reliance on hard currencies for emerging-market government and non-government bonds issued in international capital markets (simple average across countries)

Note: The figure shows the ‘original sin’ measure following Eichengreen et al. (2005).

More generally, improving institutional quality – that is, strengthening the rule of law, accounting standards, government transparency, and the quality of government regulation –can make emerging asset markets more resilient (in line with the literature emphasising the role of transparency in dampening volatility, including Brandao-Marques et al. 2013).

Therefore, policies to develop financial systems will better equip emerging markets to reap the benefits of financial globalisation, while reducing its potential costs.

References

Brandao-Marques, Luis, Gaston Gelos, and Natalia Melgar (2013), “Country Transparency and the Global Transmission of Financial Shocks”, IMF Working Paper 13/156.

Burger, John, Francis Warnock, and Veronica Warnock (2011), “Emerging Local Currency Bond Markets”, Financial Analysts Journal, 68(4): 73–93.

Committee on the Global Financial System (CGFS) (2007), “Financial Stability and Local Currency Bond Markets”, CGFS Paper 28.

Eichengreen, Barry, Ricardo Hausmann, and Ugo Panizza (2005), “The Pain of Original Sin”, in Barry Eichengreen and Ricardo Hausmann (eds.), Other People’s Money, Chicago: University of Chicago Press.

IMF (2014), “How Do Changes in the Investor Base and Financial Deepening Affect Emerging Market Economies?”, Chapter 2 of the April Global Financial Stability Report.

Jotikasthira, Clotibhak, Christian Lundblad, and Tarun Ramadora (2012), “Asset Fire Sales and Purchases and the International Transmission of Funding Shocks”, Journal of Finance, 67(6): 2015–2050.

Lakonishok, Josef, Andrei Shleifer, and Robert W Vishny (1992), “The Impact of Institutional Trading on Stock Prices”, Journal of Financial Economics, 32(1): 23–44.

Raddatz, Claudio and Sergio Schmukler (2012), “On the International Transmission of Shocks: Micro-Evidence from Mutual Fund Portfolios”, Journal of International Economics, 88(2): 357–374.