LONDON, March 14 (Reuters) - Local investors are giving emerging markets another headache as they look abroad for more liquid and stable investments, drawn by strengthening foreign currencies and encouraged by regulatory changes at home.
Money has flowed out of emerging markets with little interruption as foreign investors have withdrawn $45 billion this year from funds which invest in bonds and equities, outpacing $28 billion of outflows for 2013, according to EPFR.
Now local institutional investors in emerging economies are expected to join the bandwagon, attracted in part by regulatory changes that allow pension funds to invest a higher proportion of their assets overseas.
In Latin America, home to nearly $630 billion of pension funds assets, the behaviour of local institutional investors is increasingly becoming important, as pension funds attract inflows from young working populations.
Many countries are beginning to lift caps on how much pension funds can invest overseas, to help them meet return targets that can be as high as inflation plus 6 percent.
Local financial markets are also becoming too small to absorb these flows and less appealing as these economies slow. Growing flexibility of pension funds' asset allocation could therefore have a snowballing effect on EM capital outflows.
"Governments are modifying legislation and local investors look elsewhere to get a doubling effect from currencies. There is going to be a significant increase in outflows," said Alvaro Camunas, head of Spain and Latin America at BNP Paribas Securities Services.
Currently, Chile's pension funds have the highest offshore investment allowance of 80 percent. Brazil allows only up to 20 percent in international allocations. Mexico's pension funds also invest only around a fifth of their assets overseas.
But interest is growing. BNP Paribas notes that overseas funds distributed in Brazil nearly tripled to 37 billion reais ($16 billion) in 2013 from 2011. Foreign assets within Mexico's pension funds hit a record $22 billion last year from $17 billion in 2013.
BNP Paribas said Brazilian investors prefer to invest in money market products and high-yielding fixed income in developed markets, where they gain from both capital and currency appreciation, at a time when high interest rates weigh on local companies.
Political uncertainty in many emerging markets pending elections this year is also making local investors reluctant to invest at home.
"Political transitions are taking place in many emerging market economies... In some of these countries the degree of risk aversion in local markets is very high," said Jorge Mariscal, chief investment officer of emerging markets at UBS Wealth Management.
Pension and insurance assets in developing countries have been on the rise since the 2008 crisis. Assets stand now at $5.5 trillion, an all-time high and double pre-2008 levels, according to JP Morgan.
Turkey, Bulgaria, and Russia are some of the countries which have relaxed or scrapped caps on foreign investment in the past several years.
Oil producer Kazakhstan is merging its private pension funds into a state-run entity and plans to invest part of its assets abroad.
"You are likely to see more flexibility in pension funds investing abroad," Mariscal said.
"Their assets are growing faster than local liquidity. Pension plans are still in early stages of growth... Domestic pension funds are looking for ways to place their incremental flows."
CrossBorder Capital says locals have contributed to capital outflows from emerging markets of $86 billion at end-February, measured as total financial flows from the current account after deducting foreign direct investment and changes in foreign reserves.
"Big and highly volatile flows are from domestic offshore money. The worsening economic and political situation has encouraged that money to come to developed economies," said Mike Howell, managing director of CrossBorder.
"On top of that, legislation changes allow institutional investors to move offshore. Emerging markets have lost growth momentum as China slowed. We haven't seen the bottom of emerging markets." ($1 = 2.3557 Brazilian Reals) (Editing by Ruth Pitchford)