Retail fund exposures make EMs more sensitive to shocks, IMF says

The rise of local-currency bond funds and global mutual funds has combined with increased investment in emerging capital markets by sovereign wealth funds and central banks to radically change the composition of investors in emerging markets (EM), according to the IMF – making those markets more sensitive to global financial shocks.

In a chapter of the latest Global Financial Stability Report (GFSR) published today, the IMF says the mix of investors in EM stocks and bonds has evolved considerably over the past 15 years, which has made capital flows and asset prices in these countries more sensitive to events outside their own borders.

The profile of international investors in emerging markets has shifted since the 1990s when it was predominantly made up of equity funds specialised in emerging markets. In the 2000s, the study says, bond funds have been on the rise – with European and US retail investors becoming particularly important, even surpassing the volume of investments made by institutional investors in emerging market bond markets in 2010 and 2012.

The type of investor matters for financial and macro-economic stability. The study shows that during the sell-off of EM stocks and bonds in 2013 and early 2014, institutional investors such as pension funds and insurance companies with long-term strategies broadly maintained their EM investments. Retail-oriented mutual funds withdrew. Different types of mutual funds, such as those focused on bonds and equity, also have shown varying degrees of sensitivity to global financial turbulence.

Mutual funds ‘more sensitive' than institutions

On Thursday, New York Fed president William Dudley expressed his view that emerging markets are better positioned than ever before to handle the Federal Reserve's exit from unconventional monetary policy – the threat of which caused dramatic outflows of capital from EMs last year, something that started again this year when the Fed actually began tapering its asset purchases.

Dudley praised emerging markets as a group for implementing "fundamental reforms" over the past 15 years, for having learned "hard lessons" from past periods of market stress. He pointed to the dropping of fixed exchange rate peg regimes; improved debt service ratios and generally moderate external debt levels; larger foreign exchange reserve liquidity cushions; and better capitalised banking systems, among other factors behind their improved preparedness.

Nevertheless, today's IMF study says more opportunities have opened up for savers in advanced economies to invest in emerging markets – and larger direct foreign participation in local financial markets can transmit global volatility to local asset prices.

Mutual fund investments are more sensitive to the ups and downs of global financial conditions than that of institutional investors, the paper argues, as many of the small investors putting money into mutual funds are less informed savers, who may ‘panic sell' at signs of volatility. Some mutual funds also invest in stocks and bonds that performed well in the short run, while selling those that did badly – a strategy called momentum trading.

Institutional investors are generally better for capital flow stability during normal and moderately volatile times, the report says, because they tend to invest for the long term. However, it cautions that these investors can pull more money out of a country and take longer to return after more extreme shocks – such as during the global financial crisis, or if a country's government bonds are downgraded to below investment grade.

EM investment ‘clearly a bubble'

The report also argues that emerging market investors have not become more sophisticated over the two decades in which they have ramped up their participation. The authors find no evidence that investor choices in times of stress in recent years were driven any more by countries' economic fundamentals than they were in crises in the late 1990s and the early 2000s. Moreover, they say the tendency of investors to mimic each other's choices, known as herding behaviour, has not declined either.

That judgement bears out the view of Paul Collier, professor of economics and public policy at the Blavatnik School of Government in Oxford, who says in a forthcoming interview with Central Banking that investment in EMs over the past couple of years "was clearly a bubble". The "meltdown in the OECD", he says, meant "wealth started to look abroad as opportunities in the OECD were so limited", so "asset prices got bid up way too high in emerging markets".

The study was published today along with one other chapter of the GFSR, measuring the size of the implicit subsidy enjoyed by banks that are considered too big to fail. The rest of the GFSR will be published on April 9.