T his report is the latest in a biweekly series where Standard & Poor's economists examine economic and monetary developments in Europe, the Middle East, and Africa. The next report will be published in mid-August.
- While emerging-market currencies and equities suffered losses in the immediate aftermath of the U.K. referendum, foreign capital quickly returned, though to a lesser extent in emerging European economies.
- Expectations for more accommodative monetary policies by the BoE, ECB, and the Fed after the Brexit vote pushed long-term bond yields in advanced economies to record lows, compelling yield-hungry investors to look for alternatives.
- We believe capital flows into emerging markets are bound to be volatile in the coming months, given that expectations about monetary policies in advanced economies are likely to be readjusted frequently in this highly uncertain environment.
External financing conditions for emerging markets have improved over the past month as the U.K's decision to leave the EU shifted expectations of investors, who now believe central banks in major advanced economies will opt for more accommodative monetary policies. These expectations for easing pushed long-term bond yields in advanced economies to historic lows after the vote (see chart 1), sending cross-borders investors to higher-yielding emerging markets.
While emerging-market currencies and equities suffered losses in the immediate aftermath of the U.K. referendum, as investors rushed to safe-haven assets after the unexpected outcome, foreign capital quickly returned to emerging economies. Since the Brexit vote, seven emerging markets for which daily data are available have attracted US$15.6 billion of foreign portfolio inflows, of which almost $US11 billion has gone to equities and the rest to debt securities, according to the data compiled by the Institute for International Finance (IIF). IIF also reports that the week ended July 15 was the strongest one for portfolio inflows to emerging markets since the U.S. Federal Reserve delayed tapering of its asset purchases in September 2013 (see chart 2).
As a result of the foreign infusion of funds into emerging markets, their share prices have been rising and bond yields falling. The Brazilian stock market has enjoyed particularly strong gains and is now up 10.5% from its pre-referendum level. Several emerging-market currencies have strengthened. After an initial 6% fall vis-à-vis the U.S. dollar, the South African rand has recovered its losses and gained an additional 1%. And the Brazilian real and the South Korean won are up 1.5% against the U.S. dollar.
Currencies and stock markets of emerging European economies have underperformed, however. The Polish zloty is down 3%, in line with depreciation of the euro against the U.S. dollar, and the Hungarian forint is down 2%. Investors seem to be concerned about Brexit's possible second-round effects on eurozone growth and therefore on Central and Eastern European economies, given their trade, foreign direct investment, and financial links to the eurozone. Meanwhile, Turkish assets have been hit because of political developments. During the week following the attempted coup on July 15, the Turkish lira fell by 6%, while the Turkish stock market dropped 13%. Ten-year local currency-denominated government bond yields rose 110 basis points to above 10%. Currency and bond markets have since recovered some of the losses, with bond yields falling by 37 basis points to 9.65%, and the lira gaining 2% against the U.S. dollar.
Although emerging markets have so far benefited from the Brexit vote via improved external financing conditions, it remains to be seen whether this trend can be sustained. Investors' recent enthusiasm about emerging markets is mostly tied to expectations about monetary policies in advanced economies: the Fed delaying further hikes, easing by the Bank of England (BoE), and possibly some sort of accommodative measures from the European Central Bank (ECB). The question is whether these expectations will hold. Indeed, the emerging-market rally has already started to lose steam, with capital flows to emerging economies decelerating in the last few days (see chart 2).
The BoE and ECB are ready to act more forcefully
After the Brexit vote, the BoE started easing policy, but so far has preferred using macroprudential tools--lowering countercyclical capital requirements to 0% of risk-weighted assets from 0.5%--rather than cutting rates. The bank left its policy rate unchanged at its July 14 meeting by a vote of 8:1. At the same time, it has announced that most members of the committee expect monetary policy to be loosened in August. Indeed, this looks likely given the dismal Purchasing Managers' Indices for the U.K. economy in July, released by Markit on July 22. Services PMI dropped to 47.4, down from 52.3 in June, while manufacturing PMI fell to 49.1, also below the neutral 50 threshold.
The ECB offered no additional monetary stimulus at its meeting on July 21. The central bank kept its main refinancing rate at 0%, its marginal lending facility at 0.25%, and its deposit rate at -0.4%. The ECB also kept its asset purchases program at €80 billion a month, and confirmed that monthly asset purchases are intended to run until the end of March 2017, or beyond, if necessary.
The ECB confirmed that it has not yet changed its baseline scenario of an ongoing economic recovery and an increase in inflation rates. Regarding the impact of the U.K. referendum's outcome on macroeconomic conditions in the eurozone, and the likely response from the central bank, ECB President Mario Draghi stressed during his press conference that the central bank was waiting for more information, including new staff projections due in September. He also noted that "if warranted to achieve its objective, the Governing Council will act by using all the instruments available within its mandate." We believe that at its September meeting, the ECB is likely to refine some rules governing its asset purchase program, especially the issues/issuance limit and even perhaps the lower bound in terms of yields (currently at the level of the deposit rate at -0.4%) for eligible securities.
Uncertainty is likely to mean more volatility
The referendum outcome has added an additional layer of uncertainty to the already volatile external environment for emerging economies. Before the leave vote, investor sentiment toward emerging markets had been fluctuating month by month and even week to week, mostly depending on frequently changing expectations about the timing of the U.S. rate hikes. Post-Brexit, investors will also be looking at the BoE and the ECB for signs of easing. Meanwhile, the path for U.S. monetary policy normalization has become even more uncertain post-Brexit. With so much uncertainty, we believe investors will likely to more frequently re-adjust their expectations about monetary policies in these three and other advanced economies, leading to the repeated reassessments of the attractiveness of assets in emerging markets. Capital flows into emerging markets are bound to be volatile in the coming months.