Back in January, the Financial Times reported that emerging market debt and equities were attracting over $1 billion a day in investment inflows. A little bit lower in the story they added a pretty important caveat: that China accounted for the vast majority of this activity (about $800 million out of $1.1 billion in daily flows). Caveats aside, this does suggest investors are betting the U.S. Federal Reserve is reaching the end of its monetary tightening cycle and that growth in 2023 will be led by emerging markets. Are they right?
Before attempting to answer that, it’s worth taking a look at what happened in 2022, when many emerging market currencies were slammed as the Federal Reserve hiked interest rates to control inflation. When this happens, investors often exit emerging markets and move into things like U.S. Treasury bonds. When global capital shifts around like this it causes the dollar to strengthen and emerging market currencies to depreciate.
We saw it across Southeast Asia last year, and many central banks intervened aggressively in capital markets to prevent their currencies from losing too much value, which can result in debt and liquidity problems. In a few cases, like Laos, the central bank and the government were unable to stop the currency’s fall, and this set off a balance of payment crisis. By and large, though, most currencies and central banks in the region have held up pretty well.
If the U.S. Federal Reserve is indeed done – or nearly done – raising interest rates, and if emerging markets are going to grow rapidly in 2023 (as some of them did in 2022), that would certainly explain why investors are piling back in now. It also hints at the whimsical and unstable nature of global capital flows, and why central bankers in emerging markets need to be very careful about how they handle inflows during boom times.
In any case, I’m not sure this narrative captures the entire picture for some countries in Southeast Asia. Capital inflows are typically grouped into two categories. The first is foreign direct investment, where a non-resident takes a direct equity stake (usually 10 percent or more) in a local company. The second category is portfolio flows, where foreign investors buy and sell tradable assets like stocks and bonds listed on domestic exchanges. Portfolio flows are more liquid, meaning investors can sell them quickly if they think the market is turning. When a big sell-off happens, it creates currency volatility.
I don’t doubt that as the Fed raised rates last year, investors were selling off local currency bonds and pulling out of equities in Southeast Asia. This would have contributed to the currency depreciation we saw across the region. But central banks moved quickly to stabilize currencies, and this capital market volatility doesn’t seem to have migrated into the broader stock exchange or impacted foreign direct investment much, if at all.
If we look at the Indonesian stock market, despite the looming specter of capital flight the market cap of listed companies increased by 34 percent in 2022, and foreign direct investment over the last three years remained very stable at around $20 billion a year. Similar story in Thailand, where after a big retreat in 2020 investors began returning to equities in 2021 and despite some short-lived sell-offs the market has performed quite solidly since. According to the Bank of Thailand, foreign direct investment was higher in the first three quarters of 2022 than it was in the first three quarters of 2019.
This is quite different from the 1990s, when the large-scale withdrawal of foreign capital plunged the region into a financial crisis. There are many reasons things are different this time around. Floating exchange rates are important because they can adjust to capital market conditions before the point of crisis is reached. But some Southeast Asian capital markets are simply much deeper and more diversified now, and less reliant on capital from abroad. Foreign investors only account for about 10 percent of activity on the Stock Exchange of Thailand. In Jakarta, it’s around a third.
In other words, even when foreign investors pulled out of equities last year, there was a sufficiently deep domestic investor base to absorb the volatility. Coupled with central bank interventions to keep the currency stabilized, some emerging markets in Southeast Asia have found themselves reasonably well-insulated from the whims of foreign capital. It does seem likely that foreign investors will be returning to Southeast Asian debt and equities in 2023. But it may not matter quite as much as it used to.