“While the single biggest improvement we expect is a sharp decline in resident capital outflows from China, signs of a modest pickup in world trade and more stable commodity prices should underpin some improvement in banking flows and trade finance as well,” the IIF said in a recently published edition of its emerging market capital flows report.
Emerging markets attracted close to US$100bn in the first three months of 2017 alone despite a number of headwinds, including uncertainty around US government policy and the direction of the US dollar. An improving macro outlook, including stronger growth in the US and reduced commodity market volatility, is likely to drive sustained inflows through 2018, the organisation says.
According to IIF estimates, emerging market sovereign and corporate debt is likely to attract up to US$183bn in net inflows through 2017, up substantially from the US$112bn recorded in 2016. The organisation expects resident capital outflows to decrease by US$141bn in 2017 to hit US$892bn.
“All of this moderation is due to China, which has used capital controls to clamp down on outward investment with some degree of success. That said, we expect a continued rise in South-South capital flows among emerging markets, particularly in the form of FDI and cross-border banking flows,” where China plays a strong role.
China’s recent moves to bolster its domestic bond market could help drive non-resident capital inflows in the country. The People's Bank of China and the Hong Kong Monetary Authority announced plans to establish a programme connecting the offshore yuan-denominated bond market in Hong Kong with the mainland, easing access to the country’s massive interbank bond market – which accounts for over 90% of the notes traded in China.
The ‘Bond Connect’ programme will offer international institutional investors easier access to the onshore market via Hong Kong by allowing them to bypass securing onshore trade and settlement licenses from the government.
Foreign investors raised their holdings of Chinese treasury bonds by CNY5.06bn (approx. US$743.9mn) in May, according to official statistics. Foreign portfolio investors also increased their broad holdings of Chinese debt by CNY2.3bn, bringing the total held by these investors to CNY774.6bn. China's bond market is worth about CNY66.9tn, according to figures from Reuters, People's Bank of China (PBOC), and the China Central Depository and Clearing Co (CCDC).
EM Bonds Buoyed by Institutional Investors
Portfolio flows into emerging market bonds in the first quarter of 2017 were driven mainly by institutional investors, who accounted for about 80% of inflows. Interestingly, emerging market ETFs – which were seen as a significant driver of fund flows during the 2Q2016 rebound in EM assets – accounted for less than 5% of inflows in the first quarter of this year.
The asset class benefited from a broad improvement in currencies – particularly for commodity-driven economies – and higher commodity prices. The EMBI global bond index has gained nearly 5% year to date, while the GBI-EM – which tracks emerging market local currency bonds – did even better, gaining more than 10% year to date.
“While EM local currency yields have fallen 100bp or so this year, the carry-to volatility ratio remains attractive for many key emerging markets. In addition, EM currencies in aggregate are some 20% below long-run average levels in terms of real effective exchange rates, implying scope for appreciation as growth differentials with mature markets widen,” the IIF said.
“For corporate bonds, which now represent over 40% of the EM bond universe, we expect some cyclical improvement in credit risk as economic fundamentals improve and commodity prices stabilize.”
The improving global macro outlook should be broadly supportive of EM fixed income, as will falling corporate default rates and more robust EM fundamentals, but some risks remain in specific markets. Rising non-financial corporate leverage in China and Chile remain key risks, while political and policy risk are likely to continue to weigh on Brazil, Mexico, Turkey, South Africa and Nigeria.
Saudi Arabia to put GCC on the Map for Fund Managers in 2018
The IIF believes Saudi Arabi will be among the biggest drivers of capital inflows into the GCC in 2018, as the country looks to privatise a range of companies including Aramco, for which it expects up to US$50bn in exchange for a 5% share
“We foresee Saudi Arabia to become the fourth largest recipient of non-resident capital inflows [among emerging markets] in 2018, as the country continues to look for overseas investors to finance the large fiscal deficit.”
Egypt Is also projected to perform better in 2017. On the back of the Egyptian pound depreciation in November 2016, monetary tightening, and fiscal austerity measures implemented over the past 12 months, the IIF estimates capital inflows in Egypt to move into a net positive position and peak at US$32bn in 2017.
Non-resident capital flows to the GCC countries – Saudi Arabia, the UAE, Qatar, Kuwait, Oman and Bahrain – are expected to increase to US$117bn in 2017, driven largely by the issuance of international bonds. The region’s sovereign and corporate issuers raised about US$65.8bn in 2016, nearly double the US$38bn raised in 2015.
The IIF is also putting out fairly conservative oil price estimates, US$52 per barrel for 2017 and US$54 in 2018, factoring in some of the downside risks of the recent spat between Qatar and its GCC neighbours – or failure to prolong the current OPEC cuts.
