Global Macro Weekly Digest (Issue 17) :Foreign exchange reserves shrink in emerging markets due to s

IMF is scheduled to release the Emerging and Developing Economies Currency Composition of Official Foreign Exchange Reserves (COFER) data for 1Q15 on June 30. Emerging markets encountered significant capital outflows in the year to date, which may lead to slide in forex reserves and arouse market concerns.

    Emerging economies experienced the first YoY decline in forex reserves in 2014 over the past two decades. According to the EPFR data, equity markets in emerging countries showed severe capital outflows over the past two weeks. There may be several factors leading to capital outflows and contractions in forex reserves. Firstly, a strong US dollar weighs on asset values in emerging countries. With the Fed being likely to hike the interest rate within the year, expected continuing local currency depreciation may suppress asset values in emerging markets and induce capital outflows. Dollar appreciation may also lower the value of forex reserves in EUR, JPY and other currencies held by the emerging central banks. Secondly, a rising US dollar may increase risks of nonperforming loans for emerging countries that hold large amounts of USD dominated debt, deteriorating the capital outflows. Thirdly, the narrowing growth gap between developed and emerging markets may reduce capital inflows aiming at capturing the growth potential. Fourthly, upticks in inflation expectations are boosting bond yields in the major developed countries, which might attract investments flowing out of emerging countries. Lastly, geopolitical risks in some emerging countries may discourage foreign investments and accelerate drains on forex reserves.

    Factoring significant capital outflows since January, we expect forex reserves may continue to decline in emerging economies in 1Q15. Emerging countries that have a higher dependence on commodity exports (Malaysia), higher foreign debt (Indonesia), weaker economic growth (South Africa), and higher geopolitical risks (Turkey) may suffer more compared with other countries in the emerging world. The upcoming US rate hike should create a negative shock on the emerging economies, but given higher reserves and floating exchange rates, we do not expect a repeat of the 1997 crisis.