Volatility vs. Exposure: Understanding the Sources of Financial Distress
One of the key points of our recent publication “2016 Global Opportunity Index — Beyond FDI: Lessons from Asia” is that the region would benefit from a harmonization in the financial infrastructure and a deepening of its financial markets. This is reflected in the heterogeneity of the Index’s Financial Services component, a broad measure of the country’s financial infrastructure and access to credit.
Figure 1: Excerpt from the Global Opportunity Ranking.
This does not necessarily come as a surprise. While Singapore and Hong Kong are financial hubs, many of the other Asian countries’ capital markets are still in a developing stage. For the latter, the main difficulty in a globalizing world has been the approach toward free capital flows and how to protect domestic economies from sudden changes in flow direction.
Foreign Investment Flows
One serious obstacle in avoiding sudden capital flow reversals is the difficulty for foreign investors to reliably monitor and interpret country-specific developments. When examining U.S. fund flows into Southeast Asia, we found a strong indication that investment flows into the region are (currently) driven by regional and global macroeconomic developments, such as negative interest rates, rather than country-specific developments.
Figure 2: Correlation matrix on equity and bond flows to ASEAN-6.
Source: EPFR Global. Note that these correlations measure how strongly U.S. funds’ investment (or disinvestment) in different countries are related to each other. High (or low) correlation, measured at highs of 1 (-1) between two countries, indicates a perfect positive (inverse) relationship.
As shown in Figure 2, there are clear clusters of investment inflows within the Association of Southeast Asian Nations (ASEAN) region. This behavior is most pronounced for bond flows, which observe high correlation within the region overall, with Singapore, a financial hub, being a slight outlier. The same cannot be said for equity flows, as these are much more dependent on the underlying corporation and the economy. There is, however, a clear cluster of countries that are highly correlated for both bond and equity flows: Indonesia, Malaysia, Philippines and Thailand. This indicates that, although they may be driven primarily by expectations regarding corporate performance, they also are dependent in part on common factors, such as a generally perceived overlap in business cycle or economic development. The picture is different for Singapore and Vietnam, which still are driven by a regional component, but much more independent from the former cluster. This illustrates the difference in market structure in the two. On the one hand, Singapore is a regional financial hub that offers investors a much more distinctive investment environment and provides financial services that might not be available in local markets. On the other hand, Vietnam’s financial development remains limited while its economy is mainly on the lower end of the value chains within the region — in part due to China’s shift away from cheap labor. Together with Vietnam’s comparatively much smaller market, this explains the difference in investment drivers and the gap in correlation.
Policymakers often consider portfolio flows too volatile and procyclical for a country that is in the process of developing its domestic capital market and opening up to global capital flows. As a result, many developing countries, especially in Asia, use capital controls to limit portfolio flows. However, our report shows a more nuanced picture: While equity flows are in fact more volatile than bond flows, they do show clear clustering and short-term directional trends. Hence, the issue for developing countries is not the level of volatility but rather the overexposure to certain financing that may fuel financial distress.