Doha: Qatar National Bank (QNB) stated that despite significant global macro uncertainty and volatility, emerging markets (EM) are benefiting from moderately positive capital inflows. These inflows have been driven by a depreciating USD, the current cycle of monetary policy easing across major advanced economies, and the availability of high real yields in several sizable EMs.

According to Qatar News Agency, the Institute of International Finance (IIF) noted that non-resident portfolio inflows to EM, which represent allocations from foreign investors into local public assets, experienced a significant shift from negative territory to positive in late 2023 and continues to be moderately strong this year, even accelerating. The strong performance of EM assets is surprising in a year marked by record global economic policy uncertainty and volatility. Traditionally, EM assets tend to sell-off with increasing uncertainty, as investors seek safe-havens. However, this time seems to be different, and two main factors contribute to explaining the inflows to EM.

Firstly, a softer dollar continues to bolster the attractiveness of higher-yielding EM assets, providing a tailwind for capital inflows. Under favorable conditions, global investors fund positions in relatively low-yielding currencies of advanced economies, such as the USD, and seek higher-yielding EM assets. A weaker dollar reinforces this tendency by reducing the currency risk for investing in EM. Furthermore, a weaker dollar lessens the burden of debt service of USD-denominated debt for sovereigns and corporates in EM, improving credit quality and reducing risk premiums, therefore favoring portfolio rebalancing towards EM assets.

Structural factors also point to further selling pressure for the greenback. The Trump administration seems to be keen on engineering a major adjustment of the economy, favoring narrower current account deficits and the re-shoring of critical manufacturing activities, which would call for additional USD depreciation. This lessens the role of the USD and US Treasuries as safe havens amid global economic instability, contributing to calls for the diversification of portfolios, including via EM assets.

Secondly, the easing of monetary policy by major central banks results in lower yields and looser financial conditions in advanced economies, increasing the relative attractiveness of EM assets. This year, the European Central Bank (ECB) continued its easing cycle, bringing the benchmark interest rate to a neutral stance of 2%, after cutting rates by 200 basis points since mid-2024. The Federal Reserve re-started its downward cycle with a 25 bps cut, with markets currently pricing a federal funds rate of 3% by end-2026, which will continue to diminish the opportunity cost for investing in EM assets. This backdrop of lower rates in advanced economies provides additional support to positive capital flows into EM.

Thirdly, several large EMs, particularly in Asia and Latin America, are currently offering yields that are significantly higher than their inflation rates. Those positive 'real rates' from countries like Indonesia, Brazil, Mexico, and South Africa contribute to providing higher gain potential and re-assure investors against potential risks of undue currency depreciation. This favors the so-called 'carry trade' of borrowing from low-yielding currencies to invest in high-yielding EM currencies.

Importantly, the carry trade seems to be the dominant feature of the capital flows to EMs so far in 2025, as the vast majority of inflows are concentrated in debt rather than equity and in jurisdictions with more floating currencies as well as higher real yields.