This Nation Could Be the Most at Risk From Capital Flight
Investors pulled $1.5 billion out from emerging market bond funds in the week ended June 5, according to fund tracker EPFR, while emerging market (EM) equity funds lost $5 billion — their biggest outflow in almost two years.
In a research note on Thursday, Morgan Stanley rated Brazil as one of the five countries most vulnerable to sudden capital outflows, due to its substantial levels of excess domestic credit, and its high loan-to-deposit ratio of 1.6. In addition, the country's primary budget balance (the budget balance after interest payments) deteriorated between 2009 and 2012.
"Brazilian banks and corporates have been among the largest beneficiaries of the recent flows into EM hard-currency funds… A sudden stop would have the largest impact on the sectors with highest leverage and/or weak balance sheet liquidity," said Morgan Stanley analysts in the note. They highlighted Brazil's metals and mining sector as the most exposed to a drop-off in capital inflows.
(Read More: Look! Hot Money Is Fast Exiting Emerging Stocks)
Meanwhile, independent research firm Capital Economics said that inflation concerns meant Brazil could be particularly pressured by currency weakness. The Brazilian real, which traded at 2.12 against the U.S. dollar on Friday, has fallen by 0.55 percent over the last week and by 1.06 percent over the past month.
"Most EMs are likely to tolerate the recent sell-off in their currencies. In some places this may even be welcomed. But there are a few exceptions. Inflation concerns mean that currency weakness will put policymakers under pressure in Brazil and India," said Capital Economics' Michael Henderson in a research note out on Friday.
Morgan Stanley forecasts Brazilian consumer price inflation will stand at 6.3 percent in 2013.
"Brazil has two inflation challenges. Firstly, high food inflation caused mostly by supply shocks has brought headline inflation to 6.5 percent, but this will abate as food inflation normalizes. However, core inflation trends point to 6.0 percent inflation and are linked to strong wage dynamics, which will require a much more substantial slowdown to solve," Morgan Stanley analysts said.
(View More: Why Brazil Will Need More Tightening)
In addition, Capital Economics said that the Latin America region as a whole suffered from weakening competitiveness. Chief Emerging Markets Economist Neil Shearing found that the dollar-cost of manufactured goods exported from Latin America has risen by 25 percent since 2004, while goods from China and the rest of Asia have only risen by 5 percent.
"The EM region that has experienced the greatest loss of competitiveness over the past decade is Latin America," said Shearing in a research note.
(Read More: Why Brazil Must Embrace a Strong Currency)
"Our long-held view has been that we should expect a strong structural drag on EM growth. The combination of a structural drag and a deteriorating risk-reward from using cyclical policy tools has generated a weak recovery. On the other side of the economic globe, the Federal Reserve's assessment of when to taper its asset purchases, end them, and finally start to end monetary accommodation, is best viewed as an exogenous tightening of EM policy," Morgan Stanley said.
The bank added that it was underweight on South Africa, Mexico and Brazil and overweight on China, Russia and Peru. It advised traders who fear a sudden end to EM inflows to sell the Ukrainian Hryvnia, Indonesian Rupiah and Polish Zloty, and buy the U.S. dollar. Morgan Stanley also suggested traders go underweight on Ukrainian and South African bonds, as well as Brazilian and South African equities.
—By CNBC's Katy Barnato