By Matthew Circosta
2014-02-16 14:16

Despite some panic in emerging economies in Asia, Europe and Latin America, the market reaction to the U.S. Federal Reserve’s decision to continue tapering asset purchases is playing to script.

Outflows of capital from Asia have led to a decline in equities and currencies and a rise in bond yields. Domestic factors such as rate hikes in India and political tension in Thailand are also affecting the region’s asset markets. Concern about a slowdown in China is exacerbating the drag on investor sentiment.

Capital will likely continue flowing out of Asia and emerging markets toward the developed world as the U.S. Federal Reserve has indicated it will stay the course of unwinding monetary stimulus.

Korean markets have not been immune to a decline in investor sentiment. Foreign investors have pulled more than $2 billion from Korea, much more than elsewhere in Asia. Only about $700 million has flown from politically troubled Thailand and even less cash (about $100 million) has been taken out of India. Indonesia, despite all its deficiencies, has enjoyed capital inflows of more than $200 million this year.

Korea’s deep and liquid markets allow for greater trade in financial assets, which make them more susceptible to a global selloff.

In good times, Korea enjoys strong capital inflows, but when investors’ risk appetite declines, money flows out. Capital outflows have weighed heavily on the Korean won, which has shed nearly 2 percent in value against the U.S. dollar to be one of the worst performing currencies in Asia this year.

The KOSPI equity index has fallen around 4 percent in 2014. Korea’s equity market capitalization is equal to more than 100 percent of GDP, which is on par with U.S. shares (at about 110 percent of GDP) and much more than Japan(where the market capitalization is about 60 percent of GDP). By contrast, Asia’s frontier markets have fared better because the lack of liquidity and smaller market capitalization (for example, around 20 percent of GDP in Pakistan and 30 percent of GDP in Vietnam) partly insulates them from a global selloff.

Korea’s 10-year bond yield rose modestly in January, but has since settled at around 3.55 percent.

This is unlikely to be sustained as a strengthening economy and rising inflation will likely prompt the Bank of Korea to begin hiking interest rates in the second half of 2014. Reflecting an increase in local short-term rates and tighter U.S. monetary settings, Korean bond yields are expected to rise as the year progresses.

Alongside fewer portfolio inflows, foreign direct investment into Korea has also weakened. According to the Ministry of Trade, Industry and Energy inbound investments into Korea fell to $9.68 billion in 2013, down 9.4 percent from a year earlier.

The manufacturing industry bore the brunt as the sharp weakening in the Japanese yen made it more expensive for Japanese firms to invest in Korea. Geopolitical tension between Japan, Korea and other Asian nations also likely contributed to weaker investment inflows. On the positive side, investment from Europe increased in 2013, helping to offset weaker FDI from the U.S.

The Fed’s tapering remains an external downside risk should it result in sustained volatility in global financial markets and sharply higher interest rates. The chance of this occurring appears low, however, as the Fed will try to avoid unsettling markets.

What bears watching is an unexpected political event or a shock in China, which would exacerbate weakness in asset markets. Moody’s Analytics expect capital inflows are expected to return swiftly toKorea when investors refocus on the country’s positive fundamentals.

Korea has a stable political system, low inflation, high foreign reserves, and low external debt, which makes investing in Korean assets attractive. Inbound foreign direct investment should also recover in 2014 as global growth gains traction.