Emerging markets face short-term capital flow weakness, but recovery expected by 2024: Fitch Ratings

March 21, 2023 (MLN): Fed tightening is likely to weigh heavily on net capital flows to emerging markets (EM) this year but flows to recover in 2024 as policy rates are cut and EM growth relative to advanced economies improves, said Fitch Ratings in its report “Emerging Market Capital Flows Hit by Fed Tightening, But Should Recover in 2024”.

Fitch has analyzed recent trends in net private capital flows to the largest EMs, focusing on the 10 countries covered in Fitch’s “Global Economic Outlook” (GEO). Net capital flows to EMs ex-China (EM9) fell sharply last year and at negative $120 billion (-2% of EM9 GDP) were almost as weak as those recorded during the global financial crisis in 2008.

However, this largely reflected a deterioration in inflows to Russia following the war in Ukraine and a rise in Russian capital outflows, it said. 

The main analysis uses an aggregate measure that excludes China given that the country’s flows dwarf those of other EM countries.

Net flows were actually positive last year and broadly in line with the average flows seen after the taper tantrum in 2013 when excluding China and Russia, it added.

Fitch has developed a model of global macro drivers of EM capital flows consisting of three key variables: the VIX measure of risk appetite, the GDP growth differential between EMs and developed markets (DM), and US monetary policy.

The model suggests that EM capital flows will remain weak this year as a result of past and prospective Fed tightening. We see net capital flows improving significantly in 2024, to 2% of EM9 GDP, as the Fed begins to cut policy rates and EM-DM growth differentials improve.

Recent banking stresses have not been associated with a sharp jump in risk aversion (as measured by VIX) so far, but bank flows are one of the more volatile components of EM capital flows.

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