LONDON, June 7 Major developing countries with big foreign financing needs are acutely vulnerable to the risk of a sudden stop in investment flows which has unnerved emerging markets in recent weeks.
Emerging economies such as South Africa, Indonesia, India, Turkey and Poland are on the front line as investors reconsider exposure to markets which have attracted trillions of dollars of cheap money printed by developed world central banks.
Waves of stimulus cash have barrelled into emerging bonds rather than equities, leaving countries with heavy financing needs - especially in local currency debt - vulnerable to any abrupt withdrawal.
Yields on JPMorgan's benchmark domestic bond index have risen almost 80 basis points since early May, dragging returns deep into the red. Currencies have meanwhile crashed to multi-year lows against the dollar, while emerging equities are down 7 percent on the year. (link.reuters.com/sab78t)
"Countries with large current account deficits certainly are vulnerable," said Michael Gomez, head of emerging debt at PIMCO. "Twin deficits on the fiscal side and the current account side, those are natural places to look" for dangers.
In Turkey, whose Prime Minister Tayyip Erdogan responded to anti-government protests on Friday by rounding on an "interest rate lobby" of speculative investors, local stocks have had all this year's gains wiped out in just two weeks.
Yields on Turkey's lira bonds have risen almost 200 bps while South African yields have jumped 150 bps, portending a steep rise in borrowing costs for governments and companies.
Currencies in countries heavily dependent on foreign cash flows have also depreciated more than elsewhere.
Recent moves may have been exaggerated because bumper gains have attracted investors who - unlike traditional emerging funds - are not used to the sector's periodic bouts of volatility.
Around a third of emerging domestic debt is now in foreign hands, but in some countries the ratio is close to half.
What's more, many economies' financing gaps have widened as tax revenues slow and bricks-and-mortar direct investment dries up. That has left countries such as Turkey and India almost fully reliant on foreigners' stock and bond buying.
To put that into perspective, Turkey has a balance of payments deficit of over 6 percent of its economy, or around $50 billion. India's deficit is around 5 percent, meaning it will have to find almost $100 billion of foreign financing this year.
Other countries which have received hefty overseas flows also look vulnerable. Poland, with a current account deficit of 3.2 percent of GDP, has seen portfolios snap up domestic debt equivalent to nearly 13 percent of GDP since the second quarter of 2009 - second only to Mexico, according to Morgan Stanley.
Indonesia has attracted equity portfolio inflows of over 4 percent of GDP in the same period, and Poland over 3 percent.
"The foundations are shifting and in any sell-off when people are reducing risk in emerging markets, there's no logic," said Insight Investment's head of emerging debt Colm McDonagh.
"Just imagine if these flows dry up. You could easily get a balance of payments crisis."
WHEN THE MUSIC STOPS
Behind the sell-off are the first signs of an end to easy money with the Federal Reserve beginning to talk of phasing out its stimulus programme as the U.S. economy improves.
With growth looking up in the United States and Japan, so are investment opportunities. U.S. real yields now have the edge on many emerging markets where inflation is running far higher, while Japanese 2013 equity returns top 24 percent.
Recent flow data shows the magnitude of the moves. Fund tracker EPFR reports outflows of $1.5 billion from emerging bond funds in the week to June 5. Equity funds lost $5.5 billion, their biggest outflow since mid 2011.
Given emerging markets' smaller size - the market value of developed equity markets is seven times bigger at $29 trillion - a slight shift in investor attitude can create havoc.
That's what Turkey has experienced over the past week, as intensifying political risk has added to financing concerns.
"We're going to see more and more of this. A lot of imbalances that have been accumulated in the past years may ultimately explode," said Stephen Jen, managing partner of hedge fund SLJ Macro Partners.
"A lot of money has been chased away by developed central banks ... Money has been pushed, not pulled in by emerging markets. If conditions change... the underlying process that has propelled capital into emerging markets can suddenly stop."
In Japan, where retail investors have been keen buyers of emerging debt - especially Turkey and South Africa - recent yen volatility could dampen enthusiasm. Assets managed by Japanese emerging market-oriented investment trusts stand around $61 billion, JPMorgan data shows.
Some recent moves also stem from increased hedging of emerging currency exposure, which creates demand for dollars.
There may also be a snowball effect of falling local currencies eating into foreign investors' returns, prompting them to sell securities and so amplifying refinancing concerns.
"A spark - such as the Fed's prospective tapering - could ignite crisis-like price action in some EM currencies," Jen said. "(A move of) 20-25 percent in a few weeks - that's what I call crisis-like price action without a crisis." (Additional reporting by Carolyn Cohn in London and Krista Hughes in Mexico City; Editing by Catherine Evans and Ruth Pitchford)