BIS cautions EMs on risks to ‘overreliance’ on mutual funds

Emerging market economies should be cautious about “risks from an overreliance on mutual funds,” given their growing sensitivity to fluctuations in the US dollar, the Bank for International Settlements (BIS) said in a report.

The importance of the general strength of the US dollar for local currency bond and equity flows has gradually increased since a trough around 2014, the BIS report said.

When the dollar strengthens, foreign investors might decrease their investment in markets tied to weaker currencies, as the potential costs rise and returns diminish.

This impact of the dollar has become a more significant factor than interest rates in determining how money flows into these markets, the BIS study said.

Mutual funds are particularly sensitive to fluctuations in the dollar’s value, whereas foreign exchange flows from loans or bonds are less impacted, being more influenced by stable investors such as insurance companies and pension funds, BIS analysts Gaston Gelos, Pietro Patelli and Ilhyock Shim wrote in the report.

Moreover, differences in interest rates between countries also don’t play as big a role as the dollar in moving money into these markets, the report said.

In July, the Japanese central bank’s decision to raise its benchmark interest rate from 0-0.1% to 0.25%—only the second hike in 17 years since ending its loose monetary policy in March—had sent shockwaves through global financial markets, including India.

The rate hike led to yen carry trade unwinds, boosting the yen against the dollar and sinking stocks.

In a carry trade, investors borrow money in a currency with a low interest rate (Japanese yen, until last week) and invest in another currency offering higher returns, pocketing the difference.

Carry trades in yen have been popular in emerging markets in the past as volatility was low, with investors betting that Japanese interest rates would stay at rock bottom.

The latest shift in the Bank of Japan’s monetary stance could end that advantage, some analysts had said. To be sure, key Asian indices, especially in Japan, which were pushed into bear market territory the day the central bank hiked rates, bounced back the next day as they clawed back some of the losses.

The BIS report suggests that emerging markets should be ready for potential money outflows, especially when their interest rates are close to those in the US.

They should also work on strengthening their financial markets and diversifying their investors to handle large money movements without too much disruption, the report said

“Developing sufficient financial market capacity to deal with large capital inflows or outflows can help the developing economies to mitigate undesirable amplifications between exchange rates, local currency asset prices and capital flows triggered by global factors,” the report added.