If normalisation of central bank policy happens at a fast pace and markets react abruptly as the process evolves, long-term interest rates could be pushed up much more quickly, said the report.
This scenario would provoke a rapid and disorderly adjustment to portfolios, and capital flows to developing countries could decline by 50% or more for several months, as they did in the summer of 2013. Capital flows into emerging markets are influenced more by global than domestic forces, leaving them vulnerable to disorderly changes to Fed policy.
Worst-case scenario
The World Bank also pointed to two other possible scenarios. The most likely, it said, is that as high income countries’ monetary policy normalises, capital flows to emerging markets could decline modestly. However in a worst-case scenario, where markets react even more precipitously, long-term US yields could be driven up by as much as 200 basis points in the first half of 2014, which could have disastrous consequences for emerging economies.
Countries which have large current account deficits, large proportions of external debt and those that have had big credit expansions in recent years would be among the most vulnerable, the report added.
Cheap borrowing
Colin McLean, chief executive officer and fund manager at SVM Asset Management, said the US will largely focus on what suits it best.
“The easy dollar has helped flows into emerging markets and helped them to borrow cheaply. We’ve seen a lot of emerging market sectors and economies hitting lows, and we’re seeing some overheating in economies like Taiwan and Singapore. The finance minister in Singapore has been focusing on this since last year.”
This scenario has been accepted by emerging markets and recognised by investors since the middle of last year, in McLean’s view.
“Some of the money will flow back out [of emerging markets]. Easy US policy has meant it has gone into emerging market property and infrastructure. What inflows have done for emerging markets, though, is they’ve pushed currencies up towards levels not supported by the trade balance. Whether they can manage their exit from their flows is their problem.”
Assets moving into Europe
Many global investors have found emerging markets an easy bet for a number of years, said McLean, but going forward Europe looks the best option for a positive surprise, and he can see assets moving out of emerging markets and into Europe.
“Last year’s car crash in emerging market debt and equities could be a pre-cursor to a full-blown motorway pile up later this year,” said Mark Burgess, chief investment officer at Threadneedle Investments, on whether emerging markets will be challenged by tapering, rising bond yields and a stronger US dollar in the way they were last summer.
“Deficit countries more dependent on external financing have remained under pressure since then,” added Burgess. “Both the equity and debt markets were standout underperformers last year, although equities had a bounce in the second half. If the region can withstand tighter, or at least less loose, US monetary policy, then real value will begin to appear. Bond yields are significantly higher, equity P/E ratios are much lower than the developed world and at some stage the region will become attractive. For now though we need to see evidence of stability before considering increasing our exposure.”
