It’s the end of the unsustainable love affair for emerging market (EM) credit, bears contend, after last week's rout exposed a new normal: tighter monetary conditions in the US, which raises the spectre of slower inflows into emerging capital markets.
For bears, the jury is out about the time-scale of any unwind from pockets of EM credit and how messy the break-up could be, while the optimists point out, though positioning is high by historic standards, emerging markets can withstand the recent volatility thanks to their strong growth prospects. The high degree of volatility is causing concern as funds confront paper losses, value-at-risk challenges, event risks – amid protests from Brazil to Turkey, for endogenous reasons – and febrile market sentiment as investors awaken to the Fed’s tapering of its bond-buying plan by year-end. Most EM currencies have fallen against the US dollar in recent weeks while US Treasury yields have risen, attracting funds back to the US. The South African rand, Mexican peso, Brazilian real and Indian rupee have been hit in particular.
An additional factor aggravating volatility this time around is the current-account deficits many emerging economies are running. This external financing requirement makes them vulnerable to currency shocks and any slowing of the capital inflows that sustain their current-account deficits.
As yet it is unclear whether currency depreciation is a symptom or a cause, but much of the unwinding of positions in debt markets has been from local currency bonds, exerting downward pressure on currencies. Redemptions from EM bond funds topped $2.53 billion in the week ending June 14, the second-largest outflow on record, according to EPFR Global.
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