James Bevan: Global capital flows

The notion that global capital flows, and in particular cross-border credit flows, have been in reverse this year has shaped much of our thinking on asset allocation and the latest BIS Quarterly Review for the first quarter of 2015 confirms that the volume of international lending has been declining over recent years, and that the pace has quickened over the last six to nine months.

This looks important notwithstanding that the banking system is just a part of the wider global capital flows story, with ‘shadow banking system’ flows through investment banks, hedge funds and mutual funds important too. We can acknowledge that the data are a snap shot in value terms, with the BIS reporting in US dollars at prevailing FX rates.

Declines

By location of borrower, the largest declines in international lending have been to Euroland, with the scale of the fall not simply explained by the weaker euro, and the emerging markets (EMs).

Within EM, the largest declines have occurred within Eastern Europe and Asia, which in theory declined by $200bn between mid-2014 and March 2015.  We may suspect that the pace of deflation in this series will have quickened since then.

The BIS data is, of course, far from timely and from the point of view of markets it can only really offer ‘confirmation’ after the fact (although its publication may succeed in alerting more of the mainstream media to the problem).

However, if we observe our favoured somewhat more timely ‘proxies’ for EM credit flows, namely the foreign assets of the Hong Kong and Singaporean banking systems, we find that the international credit deflation continued into the second quarter.

Potentially, we do find some signs that the pace of the deflation perhaps slowed somewhat during the second quarter, although we could easily and rationally assume that it may have quickened once again over the third quarter.

Capital outflows from Asia and the other EM affect rates of monetary base growth and represent an effective and significant tightening of monetary conditions within these economies – and we now have weak domestic money and credit series and weak international lending data, with monetary conditions in many EMs remaining tight and maybe even tightening further.

This tightening in credit conditions has occurred just as nominal export receipts have suffered from soft volume and pricing trends and also at a time when they have potentially bloated balance sheets given that when the global capital flows boom began in 2004-5, it created both an incentive and the financing for a sizeable boom in capital spending within EMs.

However, subsequent years of strong largely debt-financed capital spending may have left corporate balance sheets bloated, as suggested by the corporate data, and we have slowing nominal GDP growth and rising inventories, as a result of weak trade.

Previously…

Previous financial crises within emerging markets have tended to occur when there have been sizeable foreign debt levels (as there are now within many corporate sectors, although much less so in public sectors); when credit conditions have become significantly less accommodative (as they clearly have); and when income growth has slowed (as it has done, particularly in US dollar terms).

With these warnings signs in mind, we anticipate that it’s wise to be wary of the risks of significant financial strains beginning to emerge with companies and their creditor banks and the pre-conditions for ‘corporate credit events’ within EMs are rising, increasing the pressure on relevant authorities to introduce stimulative measures.

But as revealed in 1997, such measures can only be effective if the authorities are prepared to allow their currencies to float/weaken as they ease. Indeed, we can argue that these countries will not be able to regain control over their domestic monetary conditions until they start to pay less heed to their exchange rates, even if weaker exchange rates have the impact of exporting (more) deflation to Developed Markets. It looks way too early to buy emerging market cyclicals.