Cheap money does not mean more capital flows

Cross-border capital flows do not just get driven by interest rates; plumbing and savings patterns may matter more

Portfolio equity inflows into emerging markets (EMs) picked up strongly in November as the US election uncertainty lifted, and several vaccine candidates reported positive phase 3 trial data. This triggered predictable comments about the profligacy of developed market central banks and the inevitability of sustained strong capital flows to emerging markets. But it is worth reminding ourselves that despite near-zero interest rates in the developed world, global capital flows kept slowing in the last decade, falling to just 4 per cent of global GDP in 2019, back to 1990 levels, having peaked at 18 per cent in 2007.

The presumption that lower interest rates trigger more risk-taking appears logical. However, the data on household financial savings in the US and European Union (EU), which accounted for nearly 70 per cent of global cross-border portfolio equity investments at the peak, shows some surprising patterns.

Contrary to what many expected, despite deposit rates going negative in the EU, the share of incremental household savings deployed in deposits has increased from just about a fourth 20 years back to nearly two-thirds in 2019. In the US too, till a year back, nearly 40 per cent of incremental household savings went into deposits despite near-zero rates. This was before the surge in bank deposits during the pandemic, driven by forced as well as precautionary savings.

In fact, households are putting less of their incremental savings in asset classes that can invest in foreign equities; these are pension and mutual funds in the US, and insurance and investment funds in the EU. US pension funds’ share in incremental savings has been touching fresh 30-year lows, and in the EU, the share of insurance funds has now dropped to a third from nearly three-fourths five years back. The share of investment funds has been falling as well.

Further, allocations to equities by pension funds in the US (from 28 per cent in 2009 to 34 per cent in 2017 and 33 per cent now) and institutional managers in the EU (30-32 per cent over the past decade) have not changed materially. Low rates have pushed institutional allocations to alternative assets in the EU (like private equity or real estate), not equities. What makes these trends doubly impactful is that the amount of annual household financial savings in the US and the EU in 2019 (that is, pre-pandemic) was broadly at the same level as 15 years ago.

Portfolio outflows from economies that are starting to geographically diversify the holdings of their pension and insurance companies, like China, Australia, and Singapore, are rising, but are not large enough yet to offset the decline from the US, the EU, and Japan. It is, therefore, not surprising that global cross-border portfolio equity flows have steadily weakened as a share of GDP.

A new category of savers emerged 15 years back: Sovereign wealth funds. Countries with sustained current-account surpluses but lacking corporate champions driving outbound foreign direct investment, or FDI (like say, Japan or South Korea), or banks extending cross-border loans (like Germany), rely on global public equity or debt markets. These are mostly oil producers with the government controlling the assets. However, with the price of oil currently at levels where their budgets as well as external accounts barely balance, these inflows may remain weak.

While portfolio equities grab headlines, they were just 15 per cent of cross-border flows in the last decade. Flows are dominated by FDI, where the savings being deployed are from companies (and not households) and the primary driver is the growth differential between the source and destination countries; interest rates play a secondary role. FDI may remain relatively stable so long as surpluses accumulate with companies (this has also driven the buybacks, which have helped the US equity market), and Asian growth is faster than in the developed world.

Illustration: Binay Sinha

Foreign loans, once adjusted for rollovers, are small and volatile, and have been weak in the last decade as banking regulations were tightened. However, portfolio debt flows have risen steadily, helped by the rising popularity of global bond benchmarks: A saver can buy into a fund benchmarked to an EM bond index without having to learn about the macroeconomic prospects of each or any of the EMs. The bundling of debt from several countries also allows for de-risking. This improved plumbing has meant that portfolio debt flows to non-Japan Asia have done well.

Benchmark-based investing, though, also causes disruptions when a large country like China opens its capital account and gets added to benchmarks. The amount of assets benchmarked to an index may not increase in the same proportion, and indeed, may not rise at all. To create space for the new addition to the benchmark, therefore, investors may have to pull funds out of other economies whose relative weighting would have fallen. It is here that the increase in India’s weighting in equity benchmarks, and a possible inclusion in global bond benchmarks, helps.

Money supply growth has picked up globally this year and may stay elevated. Contrary to some views, though, we believe it is not abnormally high (primarily as China, which accounts for a third of global money now, has not printed as much), is perhaps necessary, given low interest rates, and is by itself unlikely to drive inflation, which could force rates to rise.

This does not automatically mean a surge in global cross-border portfolio flows. The inflection in flows seen over the past month may last a few more weeks, and likely reflects funds tactically kept aside waiting for reduced uncertainty. Sustained inflows may occur only when the pattern of allocation of household savings in countries with low interest rates changes, and the amount of household financial savings picks up. The recent pandemic-driven surge in financial savings across countries is likely to drop once economies open, and in the interim may stay in deposits.

We must dissociate capital flows from asset prices: Asset prices would factor in the low rates to a large extent, just as even a thin tube connecting two water containers with different levels of water suffices to equalise them. Further, as financial assets discount future prospects, the change in prices is much faster than changes in flows.

Slow capital flows may not destabilise most Asian markets, given their current account surpluses, but can hurt growth. In this environment, markets opening up their capital accounts like China and India, with low gross external debt dependency, relatively low foreign equity ownership and medium-term growth prospects meaningfully above global averages, may do relatively well.

The writer is the co-head of APAC Strategy and India Strategist for Credit Suisse