TWN Info Service on Finance and Development (Feb09/03)
18 February 2009
Third World Network

Capital flows to emerging markets to decline sharply this year
Published in SUNS #6640 dated 16 February 2009

Geneva, 13 Feb (Kanaga Raja) -- Net private capital flows to emerging markets are forecast to slow substantially to $165 billion this year, after an estimated $466 billion in 2008, the prime causes of the prospective decline being the recession and the financial crisis in the mature economies, the Institute of International Finance (IIF) has said.

In a recent report on "Capital Flows to Emerging Market Economies", the Washington-based global association of financial institutions said that the current slump in net private capital flows to emerging markets is shaping up to be the most dramatic on record.

In a press release accompanying the report, IIF Managing Director Charles Dallara said: "The subdued level of net private capital flows to emerging markets that is in prospect for 2009 is in line with the major slowdown of global economic growth. Indeed, we are now anticipating negative world growth for 2009."

"While all components of net private capital flows have recently weakened appreciably, the most significant weakness is for net bank lending where we now see a net outflow from the emerging markets of about $61 billion this year, after a net inflow last year of $167 billion and a record of $410 billion in 2007," he noted.

The IIF said that while declines in net private capital flows are expected for all emerging market regions, the most substantial fall from previous levels will be for Emerging Europe (Bulgaria, Czech Republic, Hungary, Poland, Romania, Russia, Turkey and Ukraine), where the projected volume is seen at just $30 billion, after an estimated $254 billion in 2008 and $393 billion in 2007.

Net private capital flows into Latin America (Argentina, Brazil, Chile, Colombia, Ecuador, Mexico, Peru and Venezuela) are expected to be halved, with a forecast 2009 volume of $43 billion, following an estimated $89 billion in 2007 and $184 billion in the previous year. For Emerging Asia (China, India, Indonesia, Malaysia, Philippines, South Korea and Thailand), the projected volume of inflows is $65 billion, after $96 billion last year and $315 billion in 2007.

The IIF said that growth in the mature economies will be negative 2.1% this year, after plus 0.9% in 2008. Emerging markets are expected to see further real growth, but with a gain of only 2.7% this year, after 5.7% last year. Overall, global output is likely to see negative growth of 1.1% in 2009 after a 2.0% advance in 2008.

The IIF said that it expects the year ahead to be something of a tale of two halves. Output contractions across all economies are currently severe, and this is likely to persist through the first few months of 2009. By mid-year, however, the combination of easier monetary and fiscal policies - including the fiscal program of the new US Administration - should begin to provide a net lift. According to IIF, the second half of 2009 is expected to produce better outcomes.

The IIF views the stresses during the recent and current phase of weak growth for emerging market borrowers as resulting mainly from difficulties in rolling over market-based debt under conditions where it is not just their own prospects that have deteriorated, but also those of their lenders. Also, borrowers in emerging markets now face the prospect of being "crowded out" by the massive borrowing needs of G10 governments.

According to the IIF report, the US Federal borrowing requirement for the current fiscal year ending 30 September is expected to be about $1.75 trillion. G7 governments are also extending significant guarantees to banks and other corporations in their own economies (including some industrial companies), while G7 central banks have provided unlimited amounts of liquidity (via swap lines) to banks within their jurisdictions.

"Many of these support programs, may be warranted and helpful, but have the side effect of creating an insider/outsider' problem, whereby relative conditions facing banks and companies in emerging market economies are made more challenging," the Washington-based group warned.

According to the IIF, the outlook for private capital flows to emerging economies has deteriorated significantly in recent months. Net flows are now projected to be just $165 billion in 2009, down from $466 billion in 2008 and $927 billion in 2007.

While all components of net private capital inflows have recently weakened, the most significant drop in prospect is for net bank lending - forecast to shift from a net inflow of $167 billion in 2008, to a net outflow of $61 billion in 2009, a negative swing of $227 billion. This would be a dramatic reversal from the peak year of banking sector net flows, of $410 billion in 2007.

The region most directly affected by the slump in capital flows is Emerging Europe, which had been heavily dependent on external finance. Among IIF's sample of countries from the region, strains have been most evident in Russia and Ukraine.

The weakening global growth has also severely affected other regions.

Latin American borrowers have suffered a setback in their terms of trade, and Ecuador has chosen the course of selective external debt default. Asian manufacturers have been harder hit by the drop off in global demand than they were during the depth of the 1997-98 regional financial crisis. However, domestic financial systems in the region are in far better shape today than they were in that previous episode, according to the report.

IIF said that it expects many of these difficulties to linger, as least through the first half of 2009. The economic outlook could turn somewhat positive in the second half of the year, and this would help stabilize a number of difficult emerging market situations. Moreover, years of steady policy reform and institutional strengthening in many key emerging economies have left them in much better shape to handle the current global downturn, severe as it is. Most have some - albeit limited - latitude to run counter-cyclical fiscal and, especially, monetary policies in the months ahead, the report added.

The report however pointed to significant vulnerabilities that remain, especially for large emerging market corporate borrowers with sizeable roll-over needs. The IIF said that private sector borrowers face at least $100 billion of repayment obligations on their market-based borrowing that fall due in the first half of this year. "At the current level of market access, borrowers seem able to issue not much more than half this total. Policy makers in both mature and emerging markets would be well advised to address this refinancing problem head on in the weeks and months ahead."

Significantly reduced capital flows to emerging economies are part of the broader financial and confidence crisis that has swept through the global economy in recent months, said the report, with emerging economies exhibiting remarkable resilience through the first year of the current phase of global turmoil.

They were certainly affected by the slowing US economy, particularly in the form of lost export markets. Net private sector flows to emerging economies - which had soared to remarkably high levels in 2007 - began to fall steadily in 2008. Through the middle of 2008, however, the underlying economic performance of emerging economies was quite robust - sufficient, indeed, to provide an important global offset to US economic weakness.

However, said the report, these developments changed conspicuously in the third quarter of 2008, since when the overall global economy has been in recession, and economic growth in emerging markets has slowed precipitously, while private capital flows to emerging markets have slumped.

The IIF attributed the sudden shift in business cycle conditions to three factors: the progressive tightening in monetary policy in most emerging economies; the spike in oil prices, which reached a peak in July, acting as a huge drag on global manufacturing activity and a tax on oil consumers; and the renewed flare-up in global financial turmoil that came on the heels of the US government's taking Fannie Mae and Freddie Mac into its conservator-ship and the failure of Lehman Brothers in September had an immediate and severe impact across emerging economies and markets.

The report noted that the volume of international syndicated lending to borrowers domiciled in the 28-country IIF sample had been little affected through the first year or so of the current crisis. In the first six months of 2007, loan volume had averaged $21 billion per month. Between July 2007 and July 2008, the pace actually rose slightly, to $22 billion per month. The average monthly loan volume has however been halved to about $11 billion since August 2008.

The slump in bond issuance by emerging market borrowers has been even more extreme, according to the IIF report. In the first half of 2007, monthly bond issuance had averaged about $19 billion per month. Between July 2007 and July 2008, it fell to $10 billion per month. Since August 2008, however, it has averaged less than $2 billion per month.

"At first sight, it is not obvious why emerging economies and markets should have been so affected by the post-Lehman turmoil, especially given how well they had survived previous episodes of acute mature market weakness in August and December 2007 and March 2008," the IIF remarked.

In retrospect, according to IIF, three factors seem particularly important in explaining this rapid and severe contagion:

-- The near seizure of global interbank markets in the weeks following the collapse of Lehman Brothers delivered a sharp blow to global activity, as access to short-term financing for production and trade dried up. The result was a global scramble to preserve liquidity among banks, non-financial business and households.

Ironically, said the report, many banks in emerging economies found themselves with severe funding difficulties even though their exposures to troubled assets in the United States were limited. Despite holding substantial foreign currency reserves, their own central banks were either unable or unwilling to supply banks with dollars, leading to significant dislocations, and forcing many banks in emerging market economies to suddenly turn very restrictive in their own lending activities.

-- Although most emerging market governments had been restrained in their borrowing through the latest expansion, borrowing by both financial and non-financial private companies had been relatively heavy. Banks in emerging markets - especially (but not exclusively) in Emerging Europe - had borrowed abroad in term debt markets (as well a short-term interbank markets) in order to fund aggressive rates of local lending growth.

On the investor side, said the report, hedge funds had been important investors in emerging market corporate debt, and the post-Lehman squeeze on them added to the difficulties in emerging markets. Conditions in emerging corporate debt markets had been deteriorating before September, but took a severe turn for the worse through the fourth quarter.

-- The collapse in commodity prices - especially oil prices - after September has hit many emerging market borrowers hard. Many resource-based companies had increased borrowing in order to finance ambitious production expansion schemes. The greatest strains have come in parts of Latin America (Ecuador, Argentina and Venezuela) and Emerging Europe (Russia and Ukraine).

The strains in the global banking system, which has seen a major curtailment in new credit, have impacted flows to emerging markets in 2008 and are likely to have a still more pronounced impact on flows in coming months, said IIF.

Net bank lending to the IIF's sample of 28 emerging economies peaked at $410 billion in 2007, and declined by about $240 billion, to $167 billion in 2008. A similar pace of decline is in prospect for 2009, which would lead to net outflows (payback) from borrowers in emerging economies to banks of about $61 billion for the year as a whole, said the report.

Net banking flows into Emerging Europe peaked at $217 billion in 2007, of which $107 billion was accounted for by Russia. In 2008, these flows fell to $123 billion (of which Russia accounted for $28 billion). In 2009, net repayments by Emerging Europe borrowers to commercial banks of $27 billion are expected, with Russia repaying $49 billion.

In the case of Emerging Asia, net banking flows declined last year to just $30 billion from $156 billion in 2007.

For 2009, the IIF forecasts net repayments to banks of $25 billion. Among regions, the magnitude of the banking shock is least severe for Latin America, where net inflows of $31 billion in 2007 and $9 billion in 2008 are forecast to become net outflows of $12 billion in 2009.

The report noted that the weakness in debt flows to emerging economies from non-bank sources is, in aggregate, less pronounced than in the case of bank lending. It is also geographically more diverse, with adjustment significant in all major regions. Non-bank lenders are projected to lend just $31 billion, net, this year, down from a net $125 billion in 2008 and a peak of net $222 billion in 2007.

The report said that a key factor accounting for the broad-based weakening in flows is the unwinding of substantial investments in local fixed income markets by investors in mature markets. These flows typically leave investors exposed to currency risk and, as concerns about the economic outlook for emerging markets and global investor risk aversion have risen, many of these "carry-trades" have been unwound.

Another likely development this year is that sovereign borrowers may begin to access international markets more actively. More emerging economies are adopting expansionary fiscal policies in the current downturn than used to be the case. This, according to the report, is an indication of the more healthy nature of many public sector balance sheets in emerging markets.

However, a number of Latin American countries - Argentina, Ecuador and Venezuela - have no access to international markets, while governments in many Emerging European countries - especially those subject to IMF programs (Hungary, Ukraine and, likely quite soon, Turkey) - will be required to run contractionary, rather than expansionary, fiscal policies, said IIF.

As to foreign direct investment flows into 2009, the IIF forecasts reflect the tendency for FDI flows to be somewhat more stable than other components of private capital flows. They are forecast to decline from $263 billion in 2008 to $197 billion.

The net portfolio equity flows were strongly negative in 2008, with net outflows amounting to $89 billion. IIF forecasts that, with equity positions smaller and prices much lower, outflows this year are likely to be modest at around $3 billion. +