Appetite Flows Back To Emerging Markets As Restrictions Ease

Demand for high yielding currencies broadly increased in May, led by the South African rand, the Russian ruble and top performer Mexican peso.

Flows are starting to move back to riskier emerging markets (EM) as investor confidence cautiously returns amid easing restrictions imposed during the Covid-19 pandemic, FX strategists say.

Foreign investors withdrew $95 billion from developing market stocks in the month and a half of global emergency starting late February, according to data from the Institute of International Finance cited by Jane Foley, Head of FX strategy at Rabobank.

Outflows were about four times the size recorded after the start of the 2008 global financial crisis, partly reflecting investor concerns over the ability of emerging governments to handle the hospital surge and borrow compared to their G10 counterparts, Foley says.

Some emerging markets closed their exchanges while others suffered foreign currency liquidity shortages, explained Derrick Leonard, Head of EM Currency Relationships and Dr. Win Thin, Global Head of Currency Strategy, at Brown Brothers Harriman (BBH): “When global risk sentiment worsened as the pandemic spread, investment flowed out of riskier assets and into so-called safe haven.” 

Authorities in restricted markets have since worked with local banks to successfully implement plans to keep markets functioning with minimal interruption, they said.

“Many of these riskier restricted markets were unable to meet the surge in demand for foreign currency, but have worked to address these issues,” Leonard and Thin added. “With risk appetite now on the upswing, restricted markets may start to enjoy some inflows in the coming weeks.” 

With lockdowns in Philippines, Bangladesh and Kuwait in place until the end of May, the Colombo stock exchange in Sri Lanka resumed operations on May 11, according to restricted market trading updates from Leonard and his colleagues Ilan Solot and Dara O’Sullivan at BBH. 

Limited foreign currency liquidity is still reported in Vietnam, Nigeria, and Kenya, among others.

Supportive monetary policies adopted by EM central banks—including their first ever asset purchasing programs—help mitigate risks in investing in high yielding assets, Rabobank’s Senior Emerging Market FX strategist Piotr Matys says.

Demand for high yielding currencies broadly increased in May, led by the South African rand, the Russian ruble and top performer Mexican peso, according to Matys.

While the US dollar has been a prime safe haven in the crisis, the lack of volatility in G10 foreign currency pairs suggests that this crisis is more about emerging markets than G10, Foley explained. 

“It is our expectation that when confidence recovers in EM, this could mark a turnaround in USD strength and flows move back into developing markets,” she said.  

However, it could take a while until confidence is fully back.

“What prevents us from exclaiming enthusiastically ‘Buy EM and wear diamonds!’ is the growing tensions between the US and China,” Matys explains.