Here’s one more factor that could add to emerging-market headwinds


Investors in India, Lebanon and South Africa should be on the lookout, according to the IIF

Emerging markets have been struggling with rising global interest rates and stronger dollar, among other bearish factors, in 2018. But you can also add ‘hot money’ inflows to the list, as investments that could reverse quickly in times of trouble, bringing even more downside risk to emerging-market assets, according to economists at the Institute of International Finance.

‘Hot money’ inflows, as opposed to sticky capital flows, are characterized by moving the market and by being the “most likely to reverse on short notice, creating risks for those emerging markets that received a lot of them,” wrote IIF economists led by Robin Brooks.

For most emerging markets, excluding China, which is treated as separately, “it is equity and debt portfolio flows that correlate most with exchange rate changes” and are considered ‘hot’, Brooks and his team wrote, as shown in the chart below.

Between 2015 and 2016, hot money EM flows began to accelerate rapidly “such that they have been running as strong as in the run-up to the 2013 ‘taper tantrum’,” wrote the IIF economists. Brooks & Co. find even more worrying that these flows have increasingly been concentrated in certain regions, which in the analysts’ estimation is reflective of a “‘late cycle’ phenomenon when flows go to more and more exotic destinations.”

The 2013 taper tantrum came about when the Fed, then under Chairman Ben Bernanke, signaled it was ready to end its quantitative-easing program, sparking a fear of tightening financial conditions and selloffs across emerging markets that rely on dollar-denominated debt.

Since then, the U.S. central bank has been on the path toward normalizing its monetary policy and lifting rates, which it has seven times since December of 2015, and most recently in June. As many as two more hikes are expected before the end of 2018.

Read: U.S. economy roars into the fast lane, but some scratches are starting to show

Rising interest rates have helped strengthening the U.S. dollar DXY, +0.06% and push U.S. Treasury yields TMUBMUSD10Y, +0.16% higher. In comparison with its developed market peers, the U.S. central bank’s gradual tightening has increased global interest-rate differentials, making U.S. assets more attractive against global counterparts.

Worries about how escalating trade spats, which could impact export-heavy emerging economies, also have added to dollar’s strengthening trend in past months.

Don’t miss: Why the market isn’t punishing the dollar amid trade-war worries

“All this leaves us worried that EM is poorly positioned for rising global interest rates, even if a [more] hawkish Fed shift isn’t imminent,” the IIF crew wrote.

The IIF economists ranked emerging economies by how their investment inflows are split between so-called sticky capital and hot money to assess which are most at risk of a sudden reversal in sentiment and a selloff.

According to that ranking, Brazil, Chile and Colombia are in the best position, and least likely to suffer a reversal, because more of their investment flows are viewed as sticky.

Colombia’s peso USDCOP, +0.56% has been one of the best-performing EM currencies versus the dollar in the year-to-date, rising 3.7%, according to FactSet, in part thanks to rising commodity prices.

On the other end of the spectrum are India, Lebanon and South Africa, which are in the weakest position.

Also read: Here’s why South Africa could become the next emerging-market carnage

India’s rupee USDINR, +0.1463% has fallen only 7% in the year-to-date, with one dollar last buying 68.3750 rupees, while the South African rand USDZAR, -0.1500% dropped 7.3% so far this year. The greenback last bought 13.2677 rand. But this may only be the beginning of a bigger downturn.

Lebanon’s pound actually rose 0.2% versus the U.S. dollar in 2018, but that might not be here to stay. One dollar last bought 1,509.95 pounds, according to FactSet.

Earlier in the year, Argentina’s and Turkey’s assets were whacked due to both countries’ high reliance on dollar-denominated funding and ailing economies. They are also both skewed to the ‘hot money’ side of the IIF chart. Their currencies, the Argentine peso USDARS, +0.2514% and the Turkish lira USDTRY, -0.2435% paid the price and sold off 48% and 26.6% respectively in the year so far, according to FactSet.

See: Argentina may be headed for another currency crisis

The selloffs have corrected some overvaluation of the peso and lira that the IIF economists noticed before, but some risks remain. The overvaluation of these currencies came on the coattails of increased investments into Argentine and Turkish assets.