This report builds on arguments put forward in our 2022 Global Theme detailing how sticky inflation could cause a 'tightening tantrum'.
In our recently published Global Investment Themes for 2022, we highlighted how the Fed managed to begin tapering its asset purchases without the attendant 'taper tantrum' that many had feared. However, with inflation looking to be less of a 'transitory' phenomenon, developed market (DM) central banks could be forced to tighten policy more aggressively than originally anticipated in 2022, providing scope for a potential 'tightening tantrum' in EM assets next year.
Against this backdrop, it will be increasingly important to differentiate between EMs. A key indicator of which countries are likely to be most vulnerable to a potential renewed wave of volatility is the level of non-resident holdings of domestic government debt, which can make countries particularly vulnerable to capital flight. The good news is that the average portion of domestic debt held by foreigners across our sample of 15 large EM has declined significantly in recent years, falling from a peak of 28.9% in Q3 17 and 25.8% pre-Covid to just 21% as of Q3 21.
However, select EMs have seen a large increase relative to historical norms and pre-Covid levels. Our broader monthly sample of 24 emerging and frontier countries shows that, while the unweighted average portion of domestic government debt held by foreigners has fallen to 16.5% versus the pre-Covid level of 19%, a 10-year average of 19.3%, a pre-taper tantrum level of 20.3% and a 10-year maximum of 28.2%, it has risen relative to the 10-year average in six countries, relative to pre-Covid levels in eight countries and relative to pre-taper tantrum levels in 10 countries.
Countries that have seen the largest declines relative to these three historical points include Indonesia, Hungary, Mexico, Poland, Turkey, South Africa and Ghana, meaning the risk of capital outflows is low compared with historical norms in these countries.
Conversely, countries that have seen the largest increases include Zambia, Egypt, Colombia, Czechia and Kazakhstan, making them particularly vulnerable to capital outflows if the 'tightening tantrum' materialises in 2022.