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03 March 2024

Capital flows to emerging economies weak in 2009

By Shuchita Kapur

The outlook for private capital flows to emerging economies after deteriorating significantly in recent months look weak in the year ahead, according to the Institute of International Finance (IIF) in its recent report Capital Flows to Emerging Market Economies.

As per the figures of IIF, net flows are now projected to be just $165 billion (Dh605bn) in 2009, down from $466bn in 2008. This is a decline of 82 per cent from the boom year of 2007 ($929bn).

A weak global growth outlook, fall in net bank lending, reduced foreign investments and weakness in debt flows to emerging economies from non-bank sources has impacted the flow of capital to the region. Lenders and investors have turned more risk averse and there is major drop in demand for external finance for both consumption and investment spending.

Emerging economies had exhibited remarkable resilience through the first year of the current phase of global turmoil, leading to the decoupling theory by many. These economies were certainly affected by the slowing in the US economy that became evident as 2007 progressed, particularly in the form of lost export markets.

Moreover, 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.

But these developments changed conspicuously in 2008 Q3, since which time the overall global economy has been in recession, economic growth in emerging markets has slowed precipitously, and private capital flows to emerging markets have slumped.

IIF has zeroed in upon three factors behind this sudden shift in business cycle conditions.

First, the progressive tightening in monetary policy in most emerging economies – put in place in 2007 and the first half of 2008 in order to temper rising headline inflation – began to bite in those economies.

Second, the spike in oil prices, which reached a peak in July, acted as a huge drag on global manufacturing activity, and a tax on oil consumers, that became fully evident in August. Third, and most significantly, 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 conservatorship and the failure of Lehman Brothers in September had an immediate and severe impact across emerging economies and markets.

Looking ahead and given the global conditions, IIF expects growth in emerging markets to slow very sharply, to just 2.7 per cent, which is half the pace of 2008. United States, euro area and Japan – the three largest mature economies – will see output fall by 2.1 per cent in 2009.

"All emerging regions will slow. In Emerging Asia, the moderation will be substantial, with Chinese growth slowing to 6.5 per cent and growth in the region as a whole moderating to 5.4 per cent. In Latin America, Mexico will experience a recession, and regional growth will slip below one per cent. Recession will be more widespread across Emerging Europe and the region will be the weakest among emerging economies."

Talking of falling capital flows, (due to the above-mentioned conditions) net bank lending is expected to fall substantially. Based on the sample of IIF's 28 emerging economies, net bank lending peaked at $410bn in 2007, and fell by about $240bn, to $167bn in 2008, according to IIF data. 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 $61bn for the year as a whole.

"Commercial bank debt was repaid on a sustained basis between 1998 and 2002. Until 2002, net lending by banks had tracked the overall current account deficit of emerging economies, with net repayment during 1998-2002 coinciding with the emergence and then the rise in current account surpluses of the emerging markets. Since then, bank debt has soared, even as the current account position of emerging economies improved."

This pattern of the shift in bank lending flows is common across the major groups of emerging economies, although the magnitudes are most severe in Emerging Europe and Emerging Asia, according to IIF.

The weakness in debt flows to emerging economies from non-bank sources is, in aggregate, less pronounced than in the case of bank lending flows. It is also geographically more diverse, with adjustment significant in all major regions.

"Non-bank lenders are projected to lend just $31bn, net, in 2009, which would be down from $125bn, net, in 2008 and a peak of $222bn, net, in 2007. 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, the report says.

One factor supporting carry-trade related flows, however, has been the aggression with which central banks in mature economies have cut official interest rates in recent months. In most cases, this has led to a widening in short-term interest differentials vis-à-vis emerging markets, it adds.

Another likely development in 2009 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 is an indication of the more healthy nature of many public sector balance sheets in emerging markets, the report says.

While most of the financing of these more expansionary policies will be raised in local markets, debt managers may choose to issue in international markets, especially with the absolute level of borrowing rates quite low.

"That said, a number of Latin American sovereigns – Argentina, Ecuador and Venezuela – have no access to international markets, while governments in many Emerging European countries – especially those subject to IMF programmes [in the case of our sample Hungary, Ukraine and, likely quite soon, Turkey] – will be required to run contractionary, rather than expansionary, fiscal policies."


Money coming from exports is also expected to see further fall. The region from which capital exports will fall sharpest in 2009 is the Gulf Co-operation Council (GCC). In large part, this is because these countries will have far smaller trade and current surpluses to deploy thanks to the lower oil price.

The region will also experience much reduced net capital flows from abroad, especially through the banking sector. The extreme swings in the oil price could stress parts of the private sector in the GCC.

As a result, the growth in the assets of sovereign wealth funds in the region will slow sharply. Most notably, the appetite by investors in this region to extend their equity stakes in financial institutions in mature markets would appear to be quite limited, says IIF.

Money coming in terms of foreign investments seems the most stable for emerging markets. "Looking into 2009, our forecasts reflect this tendency for FDI flows to be somewhat more stable than other components of private capital flows. They are forecast to decline to $197bn from $263bn in 2008 and a peak of $304bn in 2007. Once again, this decline is fairly uniform across regions."

"Another factor moderating the decline in our measure of net FDI flows is that these flows are measured as net inflows less net outflows of FDI from emerging economies to other countries. There were significant FDI outflows from China, India and Brazil to mature economies in 2007-08, and we expect these flows to drop precipitously in the year ahead."

While past performance makes it plausible to project a steady decline in FDI inflows, there are some reasons to be concerned about downside risk to our estimate, says IIF.

First, a global plunge in capital spending appears to be under way, as businesses respond immediately to tighter credit conditions and weaker demand. Second, profits have weakened sharply across most sectors, reducing reinvested earnings, which have accounted for an increasing share of FDI. Third, suddenly weak commodity prices are a gain for commodity using businesses, but will undermine new investment in commodity producing industries, which had been an important component of FDI strength in recent years. Fourth, global weakness in real estate prices will weaken FDI in the construction sector, especially in the residential and tourism sectors.

Finally, a number of firms in mature economies may be under pressure to raise cash, and may choose to liquidate equity holdings in emerging markets (depending on the size of their investment, this could either be negative FDI or negative portfolio equity investment). For example, several banks in mature markets have recently sold equity stakes in Chinese banks, says the IIF report.

Moreover, borrowers in emerging markets now face the prospect of being "crowded out" by the massive borrowing needs of G10 governments. "We estimate the US Federal borrowing requirement to be about $1.75trn in the current fiscal year. 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."

Overall, all countries within the emerging world have been affected by the slump in capital flows but Emerging Europe, which had been heavily dependent on external finance, is the worst hit. Latin American borrowers have suffered a set back in their terms of trade. In Asia, the drop in global demand has hit manufacturers harder than seen in 1997-98 regional financial crisis.

According to the predictions of IIF, many of these difficulties will continue till the second half of 2009 after which the economic outlook could turn somewhat positive. This would help stabilise 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, says IIF.

Previous crises and emerging markets

The current slump in net private capital flows to emerging markets is shaping up to be the most dramatic on record, according to IIF. This is a remarkable development since the two previous serious crisis episodes – 1981-86 and 1996-2002 – were periods of severe adjustment for emerging market economies.

"It is perfectly plausible the current downturn will be more extended than just two years; both previous episodes had an early phase of sharp adjustment, followed by a second leg down a few years later."

Net private inflows fell from a peak of 3.5 per cent of emerging market GDP in 1981 to a trough of 0.3 per cent on GDP in 1986; they fell from a peak of 5.7 per cent of GDP in 1996 to a trough of two per cent of GDP in 2002. This time around, however, net flows seem likely to fall from a peak of 6.9 per cent of GDP in 2007 to just per cent of GDP in 2009, according to IIF figures.

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 (Bear Stearns).

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

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, 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.

Some of these tensions were eased after the Federal Reserve established swap lines with central banks in Brazil, Mexico, Korea and Singapore on October 29th. By that time, however, six weeks of damage had been done.

Second, although most emerging market governments had been restrained in their borrowing through the latest expansion, borrowing by both financial and non-financial private companies – in both local and foreign currency – 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, 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.

Third, the collapse in commodity prices – especially oil prices – after September hit many emerging market borrowers hard. Many resource-based companies had increased borrowing in order to finance ambitious expansion plans. The greatest strains have come in parts of Latin America and Emerging Europe.