EM liquidity hits 5-year high

Posted on August 30, 2016

A Chinese national flag flies at the headquarters of the People's Bank of China, the country's central bank, in Beijing, China, in this January 19, 2016 file picture.©Reuters

Liquidity conditions in emerging market economies are at their strongest in five years, partially unwinding the steepest slump since the 1980s, according to CrossBorder Capital, a London-based financial research company.

The level of liquidity is a leading indicator for economic growth and financial market returns, says Michael Howell, managing director of CrossBorder Capital.

    “Normally liquidity leads the foreign exchange and fixed income markets by three to six months, equities by six to nine months and the real economy by 12-15 months,” Mr Howell says. “It drives economies.”

    CrossBorder’s measure of liquidity encompasses the creation of money by central banks, commercial banks and shadow banks, the cash flow of households and companies and net foreign inflows, such as portfolio and foreign direct investment flows. The data are sourced from central banks and finance ministries in around 80 countries.

    For emerging markets, its index of this liquidity rose to 41.2 in May, on a scale where 50 represents the long-term inflation-adjusted average. While this is still not great, and is below the equivalent measures for developed and frontier markets, it is the highest reading since mid-2011, as the first chart shows.

    A key driver was a “pronounced pick-up” in Chinese private sector liquidity in May, as well as the renewed expansion of the balance sheet of the People’s Bank of China.

    Although China reduced interest rates five times in 2015, Mr Howell says the People’s Bank was actually tightening policy last year as its balance sheet “plunged”, with a seasonally adjusted annualised six-month decline of 17.7 per cent in December. This year the PBoC has started to expand its balance sheet once again.

    Brazil, South Korea and Mexico have seen far sharper rises in liquidity in recent months, Mr Howell says, although Turkey and Indonesia have suffered a contraction.

    The continued normalisation in emerging market liquidity extends the recovery from its 2012 nadir, when liquidity was at its lowest level since the mid-1980s, according to CrossBorder Capital, as the second chart shows.

    “Before 2008 [emerging market countries] were generally very big cash generators, largely because foreign money was flowing in nicely and we also had a lot of money generation by private sectors,” says Mr Howell.

    “After 2009 foreign inflows reversed and private sector cash flow generation just collapsed. From 2010 onwards it was L-shaped.”

    However, since the third quarter of 2015, “foreign money has started to come back and, more pertinently, private sector credit generation has started to pick up very fast”, with both of these trends largely driven by currency depreciation, Mr Howell says.

    One obvious fear is that the bout of risk aversion triggered by the UK’s surprise vote to leave the EU may send emerging market liquidity spinning back towards its lows.

    Although it is too soon for the impact to show up in CrossBorder’s data, Mr Howell is relaxed about this threat. Given liquidity conditions over the past year or so, he believes it would be “remarkable” if the UK was to fall into recession in the wake of the referendum.

    More broadly, he says “the big event [for emerging markets] is what China does, not what the UK does,” and that central bank easing in the wake of the Brexit vote will be beneficial for liquidity.

    Wike Groenenberg, global head of EM strategy at BNP Paribas, also argues that anticipation of “plentiful global financial liquidity” has been a key factor in a rebound in EM assets after an initial sell-off in the immediate aftermath of the referendum result.

    The Bank of England has raised the possibility of a rate cut this summer, while the European Central Bank is looking at the option of expanding its asset-buying programme or front-loading its purchases and the market is not pricing in further tightening by the US Federal Reserve until May 2019.

    With developed world sovereign bond yields also hitting new lows in the wake of the Brexit vote, Ms Groenenberg says: “All this plentiful and cheap availability of liquidity is of critical importance to the pricing of EM assets, given the considerable rise in indebtedness in the past few years.”

    Separately, CrossBorder Capital said its Emerging Markets Risk Index fell sharply in May and is now at its lowest level since 2012, having peaked in early 2015.

    This measure is based on three components: financing risk, which measures the ability of EM entities to roll over their debt; forex risk, driven by the quality of liquidity in a country and how dependent it is on central bank money; and exposure risk, which flashes a warning sign if a high proportion of investment in a country is in risk assets such as equities and corporate debt, rather than lower-risk government bonds and cash.

    “When you get extreme movements in risk exposure, you want to be doing the opposite,” says Mr Howell of the latter measure.

    Greece, Indonesia and the Philippines are currently rated as the riskiest emerging markets by this composite measure, ahead of China and South Africa, as the final chart shows.

    In contrast, Latin America is seen as lowest risk, led by Chile and Brazil, with Israel and the Czech Republic other lower-risk options.

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