Analysis: Emerging markets' capital flight jars with haven view

LONDON (Reuters) - There's always something comforting about dining in a restaurant where locals are eager to eat.

Yet even as foreign investors pile back into emerging markets this year - searching for growth, yield and sovereign credit stability so elusive in the big developed markets these days - there is something unnerving about seeing domestic capital spinning out the same revolving door in some countries.

Russia's deputy economy minister Andrei Klepach said on Monday the government may double its existing 2012 net capital outflow forecast to $50 billion, and even that's still below private forecasts of a $65 billion drain. Although more modest than last year's outflow of $80.5 billion and well under the worst moments of the 2008/09 credit shock, domestic money continues to exit the country at a brisk pace.

Some may argue Russia is a special case with a long history of money leaking overseas, reflecting fear of internal politics and government policy toward wealth and ownership.

But after a decade of one-way traffic, China too has started to record sporadic bursts of capital outflows. Last week, China's foreign exchange regulator said the country's capital and financial account swung to a $71.4 billion deficit in the second quarter from a first-quarter surplus of $56.1 billion.

Maybe, as the authorities suggest, this is all a healthy two-way flow as looser cross-border capital restrictions encourage local firms and investors to diversify overseas.

And with Chinese and Russian hard currency reserves in excess of $3 trillion and $500 billion respectively, there are pretty substantial buffers in place.

But as two of the major posterchildren of the emerging markets investment story, and by no means the only ones experiencing domestic capital flight, the outflows do jar with the headlong rush of overseas cash seeking some form of high-yielding haven there.

For long-term skeptics of the emerging markets story, this is all symptomatic of a deep-rooted risk in these markets of which investors should at least be wary.

"As foreign capital comes in, domestic capital leaves. History suggests that locals have a far better understanding of the real state of affairs in the country," said John-Paul Smith, head of emerging market equity strategy at Deutsche Bank.

"Their concerns about the underlying rate of returns on investments, the range and depth of those and security of wealth are all reasons why I'd remain concerned with emerging equities."

Smith is far from a lone voice these days, as nerves jangle this year about China's slowdown, the resultant sapping of demand for raw materials and the knock-on effect around the commodity-exporting developing world.

"China has domestic problems aplenty," Citi Private Bank's Chief Investment Officer Richard Cookson told clients, citing a credit and housing bubble, falling current account surplus and brisk money growth among a range of worries. "Put these all together and, as far as we can see, they always spell trouble."

INVESTORS PASS IN THE NIGHT

So, is domestic money telling us something the rest of the yield-starved world doesn't want to hear?

Well, the split of flows to emerging markets reveals a more nuanced story.

It's emerging bond markets - both hard currency and domestic currency - that have been the stars of 2012 so far with dollar-based total returns of 13 percent and 11 percent.

The exit from near zero or even negative-yielding core bond markets in the West of the credit-hobbled giant euro sovereigns such as Italy and Spain has seen a net $43 billion of new cash this year seek out emerging debt assets benchmarked to JP Morgan's emerging debt indices.

For all the micro fears about return on equity, the macro emerging picture still holds up. The main attractions remain stable sovereign credit ratings, high if peaking cash reserves and economic growth of 5.6 percent this year forecast by the International Monetary Fund at four times the developed world.

"The nature of emerging markets is that it can get choppy from time to time, but I really can't see a reversal of these flows any time soon. Why would you turn away from this kind of yield now?" said Kevin Daly, emerging market portfolio manager at Aberdeen Asset Management.

Critically, some 80 percent of the flow into emerging market bonds has been to the hard-currency rather than local currency segment.

In other words, investors are keenest to grab juicy basis points without the local currency risk associated with sudden capital flight or the more micro fears of regulatory or government heavy-handedness or interference. Year-to-date losses against the dollar in a host of emerging currencies - including India's rupee, China's yuan and Brazil's real - all support such an investment strategy.

Emerging market equities overall <.mscief> have indeed seen returns of just under 8 percent so far this year, but that's well short of Wall St <.spx> and emerging debt, and Boston-based fund tracker EPFR pointed out on Monday that emerging equity funds have now suffered 22 consecutive months of retail redemptions.

Turkey, Mexico and Poland may have shone this year, but both Shanghai <.ssec> and Sao Paulo <.bvsp> remain in the red and Moscow's MICEX <.mcx> has underperformed with 3 percent gains.

What's more, emerging markets equity indices are basically unchanged since the start of 2010 compared to the 25 percent gains on the S&P500.

If exiting locals say anything then, it may be that if you want the credit and yield, avoid the currency, corporate and legal risk.

(Additional reporting by Sujata Rao; graphic by Scott Barber; editing by Stephen Nisbet)

Source: http://news.yahoo.com/analysis-emerging-markets-capital-flight-jars-haven-view-055132794--business.html

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