The Federal Reserve’s numerous forays into quantitative easing (QE) contributed to a global search for yield and notable capital flows into numerous emerging market (EM) economies. With the ECB now embarking on its own QE, it is reasonable to ask whether we should expect to see a similar impact on net flows to EM.
At least in theory, ECB QE is unambiguously supportive of net capital flows to emerging markets. Over time, QE should serve to bolster euro-area growth and inflation, and via trade linkages will contribute at the margin to an improved outlook for emerging markets. This is particularly the case for eastern Europe.
In addition, compared to the Federal Reserve’s more recent rounds of QE, the portfolio rebalancing effects of ECB QE may be quite large, for a number of reasons:
- European sovereign debt markets are smaller than the US market, and net issuance will be relatively small going forward. These facts, combined with a fairly sizeable (and open-ended) QE program, imply that ECB’s actions will eat into a very large portion of the Eurozone’s sovereign debt stock.
- The starting point for sovereign yields in the euro area is very low (and even negative at shorter maturities). Thus yield-seeking behavior could lead to a fairly rapid compression of intra-European sovereign spreads, leading investors to seek yield outside of peripheral Eurozone debt.
- The stock of European private sector credit instruments is quite small relative to the US market, and lack the breadth and depth to absorb significant flows out of European sovereign debt. This implies that credit spreads will compress relatively quickly, and market functioning could deteriorate as well.
All of these factors imply that there is potential not only for significant portfolio rebalancing, but for a relatively large portion of this rebalancing to spill over into non-European assets given a lack of fixed income alternatives within the Eurozone.
However, there are a number of significant countervailing factors that will, on net, lead to relatively muted capital flows to EM as a result of ECB QE, compared to what occurred under QE in the US. First, US financial markets are significantly larger than European markets. Stated differently, the pool of investor capital invested in US markets far outstrips the pool of capital invested in euro-area markets. So even if the international spillovers of portfolio rebalancing may be larger than what occurred under US QE, they will amount to a large share of a much smaller pie – and hence a smaller overall amount.
Second, even as investors in European assets look to rebalance to non-European markets, the options are not particularly attractive at present given growth slowdowns in China and Brazil; a recession in Russia; and relatively elevated concerns about the growth outlook in EM broadly. In this environment, the US remains a bright spot, and so the US will likely see a large share of any ECB QE-related rebalancing into equities and fixed income, particularly as rates in the US may head higher this year. In contrast, when the Fed conducted QE2, operation twist and QE3, Europe was not seen as a viable investment alternative due to the sovereign debt and banking crisis there, while most emerging markets were seen as recovering strongly post-crisis.
In summary, ECB QE is supportive of capital flows to EM, but the impact will be relatively muted compared to what occurred under Fed QE. Investors in European assets will face strong incentives to rebalance to non-European assets. Still, the small capitalization of European markets (compared to the US) implies that the magnitude of this reallocation will be somewhat limited by comparison. In addition, given the relatively better growth outlook for the US compared to many emerging market economies, we expect that the US will be the main beneficiaries of portfolio rebalancing flows out of Europe.
Finally, those EM economies that are oil importers, have relatively low economic growth beta to China, and have strong fundamentals (small current account deficits, low debt to GDP ratios) will see the bulk of any portfolio rebalancing that flows to emerging markets.