IIF RESEARCH NOTE

Quantifying the Feds Impact on Capital Flows to EMs

December 4, 2013

Robin Koepke
ASSOCIATE ECONOMIST Global Macroeconomic Analysis 1-202-857-3313 rkoepke@iif.com

In this note, we present evidence that the Feds impact on portfolio inflows to emerging markets may be more nuanced than widely assumed. We estimate a simple econometric model suggesting that the recent retrenchment episode was primarily driven by a shift in market expectations towards an earlier tightening of Fed policy, rather than a markdown in expectations about EM economic performance. Looking ahead, our model suggests that the Feds impact on EM portfolio inflows depends on the pace of Fed exit relative to market expectations and the volatility of market expectations over time. A slow Fed exit and stable market expectations would tend to boost portfolio inflows, while a more rapid exit than anticipated could result in renewed retrenchment, particularly if market expectations were to fluctuate widely.

CAPITAL FLOWS AND THE FED: LESSONS FROM THREE CYCLES U.S. monetary policy is generally believed to impact capital flows to emerging markets through various channels. In the literature on the drivers of capital flows, low U.S. interest rates are considered a push factor that encourages flows to countries with higher returns. Low U.S. interest rates also tend to improve the creditworthiness of emerging markets by lowering the cost of external financing, making them more attractive investment destinations. At the same time, increased uncertainty about the path of monetary policy could lead to
Chart 1 Portfolio Equity and Bond Inflows to Emerging Markets During Fed Tightening Cycles left scales: $ billion, 4-quarter moving average; right scales: percent Portfolio Inflows 1990s Cycle 2000s Cycle Fed Funds Rate (rhs) 50 7 50

This note builds on an econometric model first presented in our October 2013 Capital Flows Report.

7 6 5 4 3 2 1 0

45 40 35 30 25 20 15 10 5 0 -5 1991 1993 1995 1997

45 6 40 5 35 30 4 25 3 20 15 2 10 1 0 5 0 -5 2001 2003 2005 2007

Source: IMF Balance of Payments Statistics, Datastream, IIF. IIF.com Copyright 2013. The Institute of International Finance, Inc. All rights reserved. CONFIDENTIAL

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market volatility and an increase in investor risk aversion that would discourage flows to EMs. A complicating factor is that shifts in monetary policy are typically a reaction to shifts in the strength of the economywhich can also impact flows to EMs. A stronger U.S. economy will typically improve economic conditions in emerging markets, making them a more attractive destination for investment. Thus, more positive views about the U.S. growth outlook could encourage investment in EMs and also lead to increases in U.S. interest rates. A key question going forward is how EM capital inflows will fare when the Fed phases out its asset purchase program and eventually hikes interest rates. On the one hand, rising U.S. interest rates are likely to reduce the search for yield that has supported EM inflows in recent years. Higher U.S. interest rates also imply less favorable external financing conditions for EMs and could be associated with higher market volatility, which may adversely affect the risk/return tradeoff of EM assets. On the other hand, rising U.S. interest rates will likely reflect an improvement in U.S. economic prospects, which should lift growth in EM economies and boost global investor confidence, supporting flows to EMs. Therefore it is unclear ex ante whether capital flows will increase or decline when U.S. policy interest rates rise. Historical evidence is not conclusive (Chart 1, page 1). In the 1990s tightening cycle that started in February 1994, portfolio flows to EMs were initially strongbut then plummeted after Mexicos tequila crisis. In the 2000s, portfolio inflows to EMs continued to gain strength almost until the end of the Feds tightening cycle. The experience over the summer of 2013 suggests that shifts in market expectations for future monetary policy can exert a sharp negative impact on capital flows in the short term. From May to September, after Chairman Bernanke had signaled that the Fed could soon start winding down asset purchases, foreign investors withdrew about $73 billion in EM stocks and bonds (based on EPFR data), which on average lost 8-10% in value during that period (Charts 2 and 3). The shift in market expectations of Fed policy also seems to have increased uncertainty and risk aversion during this period (as indicated by the VIX for example), which typically reduces portfolio flows. Note that the U.S. monetary policy stance did not change during this period, as the Fed continued to ease monetary policy by
Chart 2 Emerging Market Funds: Debt and Equity Net Flows $ billion 40 30 20 10 0 -10 -20 -30 -40 Jan 12
Source: EPFR

It is unclear whether capital flows will increase or decline when U.S. policy interest rates rise.

Shifts in market expectations for future monetary policy can exert a sharp negative impact on capital flows.

Fixed Income Equity

Chart 3 Returns on Selected Asset Classes percent EM Assets: May 22 to Sept. 5 8 Non-EM Assets: May 22 to Sept. 5 4 0 -4 -8
EM Sovereign (LC) EM Corporate (FC) EM Sovereign (FC) Commodities* 10yr U.S. Treasury BBB Corporate EM Equitites** MM equities** U.S. dollar*** EM FX Index

-12

Jul 12

Jan 13

Jul 13

* GSCI; total returns. ** MSCI; total returns, *** DXY index Sources: global corporate and U.S. Treasuries: Bank of America/Merrill Lynch indices; Bloomberg.
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Quantifying the Feds Impact on Capital Flows to EMs

Chart 4 United States: Market Expectations of Federal Funds Effective Rate percent per annum; from federal funds futures contracts 2.0

1.5

September 5, 2013 (High Point)

1.0 Latest (December 4) 0.5 First Rate Hike to 0.5% May 2, 2013 (Low Point) 0.0 2014
Source: Bloomberg, IIF.

2015

2016

purchasing $85 billion worth of assets per month. Most analysts have focused on market expectations for the Feds first reduction of asset purchases as the driving force behind this retrenchment. In our view, however, the debate about tapering was largely a placeholder for the broader question of what the Feds time path towards a normalization of monetary policy will be. This time path is best captured in the expectations of the evolution of Fed policy interest rates over time (Chart 4). Note that there are two main views about how quantitative easing affects financial markets, referred to as the flow view and the stock view.1 According to the flow view, the ongoing flow of asset purchases is the main factor affecting market conditions and financial outcomes. Thus the impact of QE depends on the amount of purchases in a given period. If market participants were predominantly guided by the flow view, increased expectations of an earlier tapering would have implied that a potential disruption to financial markets was approaching, which could have precipitated the sell-off observed over the summer. According to the stock view, it is the expected stock of total asset purchases that affects financial conditions, as markets anticipate and price in an expected path of future asset purchases by the Fed. Accordingly, the actual moment in which the Fed stops its purchases should pass without any major impact on market conditions, as long as it had already been correctly anticipated by market participants. If market participants were predominantly guided by the stock view, the shift in expectations towards an earlier tapering may have implied reduced expectations for the total stock of asset purchases under QE3, which may have triggered the sell-off. The end of QE2 in June 2011 seems more consistent with the stock view : Treasury yields saw only a temporary blip up, the EMBIG spread declined, and portfolio flows to EM economies continued (Charts 5 and 6, next page; note that the Euro Area crisis intensified shortly thereafter in August 2011, which resulted in a spike in global risk aversion and a retrenchment in portfolio flows). Under QE2, purchases of $75 billion per
1. See for example Federal Reserve Board (2011): Flow and Stock Effects of Large Scale Asset Purchases: Evidence of the Importance of Local Supply. Staff Working Paper 2012-44.
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In our view, the debate on tapering was a placeholder for the broader question of what the Feds time path towards a normalization of monetary policy will be.

There are two main views about how quantitative easing affects financial markets, referred to as the flow view and the stock view.

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Chart 5 U.S. Treasury Yields and Emerging Market Bond Spreads percent per annum basis points 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Jan 11 Apr 11 Jul 11 Oct 11 100 0 EMBIG Spread (rhs) 400 300 200 10-Year Treasury Yields End of QE2 600 500

Chart 6 Emerging Market Funds: Debt and Equity Net Flows $ billion 20 End of QE2 Fixed Income 10 Equity

-10

-20 Jan 11
Source: EPFR

Apr 11

Jul 11

Oct 11

Source: Bloomberg.

month ended abruptly from one week to the next, rather than being phased out gradually as currently envisaged for QE3. Importantly, however, the end date of QE2 was announced at the beginning of the program so the conclusion of the program was not a surprise and had little impact on markets. However, we are also skeptical that the summer selloff was related to a large shift in expectations about the total size of purchases under QE3. Only a few months earlier, a majority of FOMC members seem to have expected QE3 to be completed in 2013H2, as per the December 2012 FOMC minutes.2 The May/June shift in market expectations towards a September tapering thus only brought market expectations back towards where they had been just a few months earlier. This makes it difficult to argue that the shift in tapering expectations was sufficient in magnitude to trigger the sharp retrenchment observed over the summer. By contrast, the shift in market expectations of future policy interest rates over the summer months seems to have been very large, with markets pricing in about 2-3 additional rate hikes of 25 basis points by late 2015 relative to expectations in early 2013 (Chart 7).3
0.0 Jan 13 May 13 Sep 13 0.5 1.0 Chart 7 Market Expectations for Fed Funds Rate in Dec 2015 percent per annum 1.5

Source: Bloomberg

FED EXIT EXPECTATIONS AND EM CAPITAL INFLOWS We estimate a simple econometric model to quantify the impact of shifts in market expectations about future U.S. monetary policy on EM flows. We make use of data on federal fund futures contracts as a proxy for market expectations of future U.S. monetary policy. Our model builds on the extensive literature on the drivers of EM capital inflows, which has established that both global push factors and EM country-specific pull
2. The precise wording in the December 2012 FOMC minutes is as follows: In considering the outlook for the labor market and the broader economy, a few members expressed the view that ongoing asset purchases would likely be warranted until about the end of 2013, while a few others emphasized the need for considerable policy accommodation but did not state a specific time frame or total for purchases. Several others thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet. One member viewed any additional purchases as unwarranted. 3. These figures are based on Fed funds futures contracts, which are an imperfect proxy for market expectations of future policy rates in that low liquidity and high volatility may temporarily distort market pricing.
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Both global factors and country-specific factors affect EM capital flows.

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factors affect EM capital inflows.4 To our knowledge, this is the first study that attempts to quantify the impact of changes in monetary policy expectations. Our key findings are: 1. Expectations matter: Changes in U.S. monetary policy expectations have a statistically significant and economically important impact on portfolio fund flows. A one percentage point shift in market expectations for the federal funds rate three years forward is associated with $12 billion change in fund flows (with easier policy leading to greater inflows). Since EM fund flows cover about a third of total portfolio equity and debt flows, the total effect is likely to be significantly higher, perhaps in the range of $25-35 billion. (EPFR fund flows are not a representative sample of aggregate portfolio flows as retail investors are overrepresented in the EPFR sample. Anecdotal evidence suggests that retail investors reduced their EM exposures more rapidly than institutional investors during the summer of 2013 in the context of heightened expectations of Fed tapering.) 2. Bad news matters more than good news: A shift in expectations towards tighter monetary policy tends to exert a greater impact on EM portfolio inflows than a shift towards easier monetary policy. This is consistent with the recent sharp retrenchment in EM capital flows over the summer, which seems to have been driven by a sudden reassessment of Fed exit plans. In our model, the estimated coefficient is about 2.5 times as large for months when expected policy rates went up compared to months when they went down.
A shift in expectations towards tighter monetary policy seems to exert a greater impact on EM flows. Changes in U.S. monetary policy expectations have a statistically significant and economically important impact on portfolio fund flows.

MODEL DETAILS: For the dependent variable, we use monthly data from EPFR on equity and bond flows into EM-dedicated funds. These flows track total EM portfolio flows well and cover about 60% of total portfolio equity flows and about 25% of total bond flows into emerging markets.5 We use Fed funds futures contracts as a proxy for expectations about U.S. monetary policy. These contracts can be thought of as the market expectation for the federal funds target rate at the date specified in the contract.6 We employ control variables for countryspecific and global developments consistent with the literature. In our preferred specification, we use a proxy for global risk aversion (the BBB-rated U.S. corporate bond spread over Treasuries) and an aggregate EM stock market index (the MSCI EM) as a proxy for cyclical conditions in EM countries. Our sample period is from January 2010 to October 2013.
4. For an overview of the literature, see for example BIS Committee on the Global Financial System (2009): Capital Flows and Emerging Market Economies, CGFS Papers #33. 5. These ratios are estimated based on the IIFs sample of 30 major EM economies. For the relationship between EPFR fund flows and BoP portfolio flows, see Pant, M., & Miao, Y. (2012): Coincident Indicators of Capital Flows. Working Paper No. 12/55, International Monetary Fund. 6. For each observation, we use the 1-month change in the expected federal funds rate 34 months later, which is the most distant point into the future that is available (since markets in certain periods did not expected any changes in the Fed funds rate over the subsequent 1-2 years). For example, the observation for October 2013 is based on the futures contract for August 2016, and is calculated as the average fed funds rate expected for that month during October 2013 less the average expected during September 2013. Data availability on Bloomberg for federal funds futures contracts begins in February 2011. For the period from January 2010 to January 2011, we use data on expected future interest rates from Eurodollar futures contracts, which have a near-perfect correlation of 0.98 with fed funds futures contracts. The two variables are used interchangeably in the literature. One limitation of Eurodollar contracts is that they are only available for 4 out of 12 months in the year. Nonetheless, the estimation results are substantively the same when using either Eurodollar futures for the entire sample period or federal funds futures from February 2011 to present.
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We use Fed funds futures contracts as a proxy for expectations about U.S. monetary policy.

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Our baseline regression is as follows: Flowst = 0.53 * Flowst-1 12.0 * Exp_MPt 17.6 * Riskt + 1.1 * EM_Stockst (0.001) (0.011) (0.065) (0.01)

adj. R2 = 0.60, p-values in parentheses Flowst is total flows to EM-dedicated funds in month t in $ billion, Flowst-1 is the lagged dependent variable, Exp_MPt is the change in fed funds futures contracts three years into the future in percentage points, Riskt is the change in the average BBB spread in percentage points, and EM_Stockst is the percent change in the MSCI EM stock market index from the prior month. Functional forms are based on standard stationarity tests for all variables (Augmented Dickey-Fuller tests). Overall, our baseline model explains about 60% of the observed variation in EM fund flows (Chart 8). All explanatory variables are significant at least at the 10 percent level and have the expected signs. Fund flows exhibit positive serial correlation, indicating momentum in portfolio flows. A shift in market expectations towards tighter U.S. monetary policy is associated with a retrenchment in capital flows and the same holds for an increase in global risk aversion. An increase in EM stock markets is associated with positive inflows to EM economies in the following month. Instead of the EM stock market index, we also tested several proxies for EM macro conditions, such as the consensus forecast for real GDP growth and purchasing manager indices. We did not find evidence that changes in EM growth expectations were a significant driver of portfolio flows over the sample period. We also ran separate regressions for equity and bond flows, respectively. The results are qualitatively similar. Equity flows tend to be more driven by changes in risk aversion, while bond flows exhibit stronger first-order autocorrelation. The estimated coefficient on changes in monetary policy expectations is not significantly different.

Our baseline model explains about 60% of the observed variation in EM fund flows.

Chart 8 Baseline Model: Total EM Fund Flows (Equity + Bonds) $ billion 40 30 20 10 0 -10 -20 -30 -40 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Actual Fund Flows (rhs) Predicted

Source: EPFR, IIF.

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BAD NEWS MATTER MORE THAN GOOD NEWS In order to test whether the impact of shifts in monetary policy expectations is symmetric, we augment our baseline model by including a dummy variable D1 that is equal to 1 for months where policy rate expectations move up and a second dummy variable D2 that is equal to 1 for months where policy rate expectations move down: Flowst = 0.57*Flowst-1 20.6*D1*Exp_MPt 8.3*D2*Exp_MPt 15.7*Riskt +1.1*EM_Stockst (0.001) (0.02) (0.13) (0.10) (0.01)

adj. R2 = 0.61, p-values in parentheses The estimation results suggest that the adverse effect on EM portfolio inflows resulting from a shift towards tighter monetary policy is much greater than the boost from a shift towards easier policy. While the estimated coefficient for shifts towards tighter policy is statistically highly significant, the impact of a shift towards easier policy seems to be so small that the estimated coefficient is not significant at the 10% level. Separate regressions for bond and equity flows also suggest that the impact of shifts in Fed policy expectations is asymmetric. When incorporating this asymmetric effect, the model captures the reversal of portfolio flows over the summer somewhat better (Chart 9). A possible explanation for this asymmetric effect relates to the fact that Fed easing by design tends to encourage risk-taking by investors. When investors are pushed into risky assets, as opposed to being attracted by the intrinsic qualities of these assets, they may be less committed to those positions and thus more likely to unwind them when the tide turns. Another possibility is that it takes longer for investors to increase their EM allocations than to unwind them, for example because of information asymmetries when entering a market. This would mean that the total effect of shifts in expectations towards easier policy may be
Chart 9 Asymmetric Model: Total EM Fund Flows (Equity + Bonds) $ billion 40 30 20 10 0 -10 -20 -30 -40 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Actual Fund Flows (rhs) Predicted
The adverse effect on EM portfolio inflows from a shift towards tighter monetary policy seems to be much greater than the boost from a shift towards easier policy.

Source: EPFR, IIF.

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not quite as different in magnitude compared to shifts towards tighter policy, but the adjustment may be less rapid.

RENEWED RETRENCHMENT IS A KEY RISK, BUT IS NOT IN OUR BASELINE Our findings have a number of implications for market behavior and policy making in coming years. First, a benign implication of our modelling is that none of the much-debated milestones of Fed policy normalization will necessarily lead to a retrenchment in EM capital inflows. As long as Fed exit takes place as anticipated by markets and the expected path of future interest rates is not affected, neither tapering nor policy rate hikes need to be accompanied by a reversal of capital flows. That said, forward guidance by central banks on the unwinding of QE policies has little track record and is inherently difficult. Thus, markets are likely to focus intensely on each of the Feds steps towards exit such as the reductions of asset purchases, discontinuation of the reinvestment policy, and policy rate hikes (See IIF Research Note: A Guide to Fed Exit). Each of these milestones could prompt changes in expectations for Fed policy and amplify any adverse market reactions in response to these shifts in expectations. A renewed reversal of capital flows in anticipation of Fed exit is thus an important risk scenario, even if it is not in our baseline outlook for capital flows. Second, the finding that swings in market expectations of future Fed policy drive crossborder investment flows highlights the importance of effective Fed communication and appropriate anchoring of market expectations. This is particularly important given that the Fed does not commit itself to a preset course for reducing the pace of asset purchases or for when the first rate hike will occur. As incoming Fed chair Janet Yellen stated in her recent Senate confirmation hearing: At each meeting we are attempting to assess whether or not the outlook is meeting the criterion we have set out to reduce the pace of purchases. Under this approach, markets will receive news about the likely evolution of Fed policy after each policy meeting and adjust their expectations accordingly, which may produce ripple effects on EM portfolio flows and asset prices. Anchoring market expectations to the Feds own expectations for its prospective policy actions can reduce excessive volatility. One step towards this objective could be for the FOMC to announce its current expectation for the time of the first policy rate hike after each policy meeting. This would be a stronger anchor for market expectations than the Feds current practice of providing policy rate forecasts based on individual participants assessments after every other policy meeting. Third, for emerging markets, asymmetric market responses to good vs. bad news from the Fed may complicate policymaking. In an environment of volatile market expectations of future Fed policy, market forces may be destabilizing rather than self-correcting. This adds to the tail risks of sudden stops in the supply of external financing available to emerging economies. In addition, asymmetric market responses mean that the cumulative effect of Fed policy on portfolio inflows to emerging markets could be negative over time (Chart 10, next page). For example, if market expectations for the future federal funds rate were to shift up by one percentage point and then shift down by the same amount, the estimated impact would be about ($20.6 bn$8.3 bn) = -$12.4 bn (using coefficient estimates from page 6). All this serves to highlight the importance of maintaining sufficient policy space and
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None of the milestones of Fed policy normalization will necessarily lead to a retrenchment in EM capital inflows.

Anchoring market expectations to the Feds own expectations for its prospective policy actions can reduce excessive volatility.

Asymmetric market responses to good vs. bad news from the Fed may complicate EM policymaking.

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Quantifying the Feds Impact on Capital Flows to EMs

Chart 10 Contribution of Fed Policy Expectations to EM Flows $ billion, cumulative flows; based on EPFR data on bond and equity flows 70 60 50 40 30 20 10 0 -10 Jan 10
Source: EPFR, IIF.

Baseline Model

Asymmetric Model ("Bad news matters more than good news.")

Jul 10

Jan 11

Jul 11

Jan 12

Jul 12

Jan 13

Jul 13

encouraging prudent risk management practices to buffer the impact of external pressures. For example, EM central banks should maintain sufficient foreign exchange reserves to counteract excessive FX volatility if needed, governments should use prudent fiscal policy and avoid excessive dependence on external financing, and businesses should reduce currency mismatches between liabilities and assets to shield themselves from swings in FX rates.

CAVEATS, ROBUSTNESS CHECKS AND ADDITIONAL WORK A number of caveats are in order when interpreting our estimation results. The first is that our estimations are based on a limited sample period from January 2010 to October 2013 (46 observations). This is partly due to data availability constraints, but it also reflects what the model is designed to capture. In its current form, the model is geared towards the early/mid-cycle expansion phase in the U.S. business cycle, which is the period when market focus on prospective policy rate hikes is likely to be greatest. By contrast, the model may be less well-suited to capture the dynamics of an economic downturn such as the global recession of 2008/09, when capital flows are likely to be driven by financial stability concerns rather than by expectations of Fed easing. In addition, other factors not captured by the model are likely to play a role in driving capital flows. The baseline and the augmented model explain roughly 60% of the variation in portfolio fund flows over time, leaving 40% to be explained by other factors. We have tested a number of additional country-specific macro variables to control for local conditions in emerging markets (such as manufacturing PMIs and changes in the consensus growth forecast), but these regressions did not yield conclusive evidence that these alternative pull variables are in fact driving portfolio flows at the monthly frequency. A useful expansion of the model would be to test the relationships at the quarterly frequency,

Other factors not captured by the model are likely to play a role in driving capital flows.

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where macroeconomic variables may be more important drivers. We have also tested additional proxies for expected interest rates such as the 5y/5y forward rate for U.S. Treasury yields, which did not improve the fit of our model. We also tested a number of additional hypotheses. For example, we included the month on month change in total Federal Reserve assets as an explanatory variable to test whether the implementation of asset purchases under QE yielded a significant effect.7 This variable is not significant in our model, however. Building on the earlier discussion of the flow vs. the stock view of asset purchases, a useful extension of the model would be to test whether changes in the expected total stock of asset purchases under QE3 are a predictor of portfolio flows. However, we did not test this hypothesis due to lack of appropriate time series data to capture this variable. Finally, we tested for the impact of changes in U.S. 10-year Treasury yields on capital flows, including by decomposing the yield into the term premium and future short rates according to Kim & Wright (2005).8 Theory suggests that changes in the term premium should be more closely related to announcements and implementation of QE due to the portfolio balance effect of asset purchases. In our simple model, none of these variables yielded a significant relationship, however.
A useful extension of the model would be to incorporate the expected total stock of asset purchases under QE3.

7. A recent study found a significant impact of asset purchases on asset prices and portfolio flows using weekly data. See Fratzscher, M., Lo Duca, M. and Straub, R (2011): Quantitative Easing, Portfolio Choice and International Capital Flows. 8. Kim, Don H. and Wright, Jonathan H. (2005): An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates, Finance and Economics Discussion Series 200533. Washington: Board of Governors of the Federal Reserve System.

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