- Growth outperformance matters in EM over the long run, but capital flows drive short run returns in the asset class. We believe there are complementarities between both.
The image below is taken from a recent BIS paper* which discusses currency mismatches in EM countries, and attempts to rationalize what could be behind recent vulnerabilities by focusing on corporate USD borrowing as opposed to public sector USD borrowing. This is a valuable contribution to the debate, especially because data availability on EM non-financial corporate debt is scarce and somewhat inscrutable in the best of times.
However, what the paper also neatly suggests is that while EM economic growth outperformance is a necessary condition for returns from investing in these currencies, it must also be complemented by an understanding of capital flows. It would appear from the chart below that the EM return cycle for any investor, not surprisingly, coincides with EM current account deficits/surpluses. The last few (lean) years of EM returns were partly the result of current account deficits (blue circle below).
In EM countries running deficits there is less FX reserve accumulation (e.g. China a case in point), which has the effect of withdrawing economic liquidity from the global system as a whole, as less money is recycled back to EM from the developed world that was once awash with EM surplus savings. Incidentally, this corresponds to the Bernanke savings glut thesis, seen from a different angle.
* BIS Working Papers (No 550), A new dimension to currency mismatches in the emerging markets: nonfinancial companies by Michael Chui, Emese Kuruc and Philip Turner, March 2016