One of the effects of a strengthening dollar is the shift of capital flows out of emerging markets. There are two factors that influence the dynamics of this shift. The first is a reversal of capital flows. This is important because some emerging markets are heavily reliant on foreign inflows to fund fiscal or current account deficits.

The IMF says that between 2009 and 2013, emerging markets received about US$4.5 trillion of gross capital inflows, representing roughly half of all global capital flows in that period. If investors perceive that returns in the United States will probably be more attractive, international capital flowing away from emerging markets could accelerate and make funding the “twin deficits” more difficult.

This may already be happening, even before the Fed hikes rates. Let me explain; financial markets do not move on events but on expectations. And expectations of an acceleration in interest rates increases in the US is changing the relative expectations of returns between the two regions.

The second factor is the less visible, but probably more important, threat of US dollar denominated debt. Emerging market governments, corporations and banks took advantage of low cost dollar finance to shore up their finances. Data from the Bank of International Settlements supports similar figures reported by the IMF that emerging market borrowing has doubled in the past five years to US$4.5 trillion. This is problematic because local currency devaluation caused by a reversal of capital flows can make servicing this dollar debt more difficult. Furthermore, corporations and banks that borrowed in dollars could be facing additional pressure if they don’t have matching revenues or assets.

Estimates of exactly which countries are most exposed vary widely, but some countries seem to consistently appear on the lists of the US Fed, international banks and rating agencies. Despite a somewhat varied list, Brazil, Turkey and South Africa appear most consistently, both across sources and across time. Moody’s listed Brazil, Chile, Malaysia, Turkey and South Africa as the most vulnerable in 2015.

Looking at Credit Default Swaps, another measure of risk, seems to suggest that Brazil is most worrying, as the market implied default probability is rising. Turkey and South Africa show similar patterns.

Following the December Fed meeting, markets are pricing higher interest rates in 2017 and 2018. This will create challenges for countries and companies with external financing vulnerabilities as dollar denominated debt could become more expensive to service.


This article was issued by Antoine Briffa, Investment Manager at Calamatta Cuschieri. For more information visit, . The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions.


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