The Bank for International Settlements (BIS) wrote in its most recent report that emerging economies, which includes Indonesia, are highly vulnerable to severe capital outflows as investments from the West have been highly speculative and can be quickly pulled out from emerging markets. Even when only a light shock occurs, capital outflows will be significant as international investors have been showing ‘herd behaviour’. This behavior can rock the financial fundamentals of emerging markets and leave these countries shattered.
Hyun Song Shin, Head of Research at BIS, said that economic growth in emerging economies has been supported by investments from the western abroad. Thanks to the loose monetary policy of the US Federal Reserve, which included a generous bond-buying program as well as low interest rates, ‘cheap’ US dollars managed to flow to lucrative yet riskier assets in emerging markets where interest rates are relatively high. Moreover, corporations from emerging markets have been eager to borrow large quantities of funds on international capital markets. However, Swiss-based BIS said that market participants underestimate the exchange rate and credit risks that are involved in this context. As US monetary tightening will surely be jerky (accompanied by shocks), it is expected to lead to high volatility in interest and exchange rates. Such global uncertainty will result in capital outflows from emerging markets, back to safe havens.
International mutual funds that are specialized in emerging markets have become powerful forces. These funds have invested more than USD $1,400 billion in emerging stocks and bonds, a growth of 56 percent compared to the amount these funds invested in October 2007. If they would withdraw part of their assets, then it would rock the financial fundamentals of the emerging economies. Meanwhile, the 500 largest asset management firms, which control about USD $70,000 billion, have a major impact on emerging markets, causing record high levels (of local stock stock exchanges and appreciating currencies) when money flows to emerging assets and steep declines when the funds are withdrawn.
The report of BIS said that previous periods of stress or global uncertainty indicated that investors show herd behaviour as they follow the same benchmarks, same news stories and do not seem to distinguish anymore between different emerging countries (which have different financial and fiscal contexts). This then reinforces the stock and currency fluctuations in developing markets.
Banks in emerging markets are particularly susceptible to capital outflows as deposit accounts have grown amid the higher interest rate environment. When carry trade becomes uninteresting due to exchange rate fluctuations, banks in emerging markets can come in acute need of money.