Capital Flows to Emerging Market Economies

Capital Flows to Emerging Market Economies September 24, 2005

The Institute of International Finance, Inc Capital Flows to Emerging Market Economies September 24, 2005 Capital Flows to Emerging Market Economies Page September 24, 2005 Overview The strong recovery in net private capital flows to emerging markets that began in 2003 has continued this year Although a moderation in the pace of flows is anticipated in the next several quarters, the overall level envisaged for 2006 remains relatively elevated Downside risks have increased, however, in the face of rising concerns and unease about a potentially less hospitable global economic environment going forward Private flows are projected to reach a record high $345 billion this year before slowing to $318 billion in 2006 (Table 1, Chart 1) This year’s expected flows surpass the previous record of $323 billion reached in 1996 prior to the Asian crisis The continued robustness in flows is being supported by a further pickup in direct investment and a record pace of bond issuance as sovereign and private borrowers endeavor to stay ahead of the curve before the tightening policy interest rate cycle starts to hit bond markets visibly With many debtors having already taken the opportunity to pre-finance obligations due in 2006, the current pace of bond issuance is unlikely to be sustained next year, contributing to an overall slowdown in private capital flows to emerging markets This forecasted slowdown could become more pronounced if downside risks from a further jump in oil prices, unanticipated policy slippage or other problems in a major emerging market economy, or a sudden shift in investor risk aversion stemming, inter alia, from concerns over global imbalances or the fragility of global growth were to materialize The strong private capital flows to emerging markets in 2005 has occurred against a backdrop of strong global economic expansion, which has been supported by strong corporate profitability and buoyant housing markets in the United States and elsewhere The measured but sustained monetary tightening in the United States has yet to dampen growth, as bond yields have tended to drift down Neither have sharply higher oil prices begun to visibly affect the forward momentum of global activity, although this could now change in the aftermath of Hurricane Katrina Table Emerging Market Economies' External Financing (billions of U.S dollars) 2003 2004 2005f 2006f Current account balance 118.0 151.9 194.4 180.7 External financing, net: Private flows, net 213.7 317.4 345.2 317.8 128.9 95.9 33.0 167.5 132.2 35.3 191.3 148.9 42.3 184.4 145.8 38.7 84.8 25.4 59.4 149.8 61.1 88.7 153.9 63.5 90.4 133.3 57.8 75.5 Official flows, net IFIs Bilateral creditors -21.4 -6.6 -14.8 -30.6 -16.4 -14.2 -50.4 -23.9 -26.5 -24.2 -12.4 -11.8 Resident lending/other, net1 -37.6 -38.6 -87.7 -72.3 Equity investment, net Direct investment, net Portfolio investment, net Private creditors, net Commercial banks, net Nonbanks, net Reserves (- = increase) -272.6 -400.0 -401.4 -402.0 f = IIF forecast Including net lending, monetary gold, and errors and omissions Chart 1: Capital Flows to Emerging Markets (billions of U.S dollars) 400 300 200 100 Low yields on U.S Treasury bonds and a flat yield curve have pushed investors to purchase lower rated credits, compressing credit spreads, including those on emerging market bonds Despite the historically high price of emerging market assets, investor demand remains strong, reflecting both the search for yield and the improving fundamentals in many key countries Most of these countries have experienced robust growth with relatively little inflation while accumulating substantial international reserves as a result of current account surpluses and large capital inflows Growing confidence on the part of investors in the policy performance of some of the key emerging market -100 94 95 96 97 98 Official lending 99 00 01 Private equity 02 03 04 05f 06f Private credit © 2005 The Institute of International Finance, Inc All rights reserved The contents of this report may be neither reproduced nor distributed in whole or in part outside the membership without the prior written approval of the Institute of International Finance, Inc The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page September 24, 2005 countries has contributed to both direct and portfolio investment inflows as well as bond flows Although the general conditions in emerging markets as a whole remain broadly conducive to growth and stability, less favorable economic performance and troublesome developments, including the persistence of high debt ratios and a tendency to hold back on structural reforms, have been observed in some countries These problems could be exacerbated by a possible deterioration in global macroeconomic fundamentals stemming, for example, from high oil prices A possible weakening of global financial market stability in the face of progressive monetary tightening could also work to magnify and propagate problems associated with inadequate policy performance of individual emerging market economies Such possibilities are real as the default rates of sub-investment grade borrowers are likely to increase—partly because of the wave of high yield issuance in previous years—and as credit derivatives, which have proliferated in recent years and whose pricing has depended on relatively untested models and default correlation assumptions, are vulnerable to corrections None of the circumstances mentioned above necessarily points to major market disturbances or credit events in the period immediately ahead Nevertheless, in conjunction with gradual increases in risk aversion in world financial markets that are likely to occur, the risk of disorderly exchange rate movements among major currencies stemming from global current account imbalances, and a bunching of key elections in emerging market countries in the next 15 months, such possibilities are a cause for concern “Although the general conditions in emerging markets as a whole remain broadly conducive to growth and stability, less favorable economic performance and troublesome developments, including the persistence of high debt ratios and a tendency to hold back on structural reforms, have been observed in some countries.” “The United States has continued to be the engine of growth for the world economy with projected growth for this year the highest in the G7.” Global Economic Environment Global recovery has continued in 2005, albeit at a more moderate pace than in 2004 (Chart 2) Strong balance sheets and favorable profit margins have been supportive of investment activity while consumption has held up well in the face of higher energy costs Global growth is expected to moderate further in 2006 The pattern of uneven growth and the policies responsible for such a pattern, which together have contributed to a widening in global current account imbalances, remain a risk going forward • The United States has continued to be the engine of growth for the world economy with projected growth for this year the highest in the G7 Although GDP growth slowed to an annualized rate of 3.3 percent in the second quarter, the strength of final demand in that quarter and subsequent activity indicators suggest that, even after allowing for the effects of Katrina, full-year GDP growth in the vicinity of 3½ percent is well within reach Growth momentum is expected to slow somewhat next year on an annual average basis as high oil prices finally bite into consumption in the situation where the savings rate has hit rock bottom Business fixed investment is likely to continue to play a key role as a source of growth Chart 2: Industrial Countries’ Real GDP Growth (percent change from previous year) -1 -2 00 01 U.S 02 03 Japan 04 05f Eurozone 06f The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page September 24, 2005 • • The narrowing of the output gap that has taken place in the United States this year is not being replicated in other major industrial countries, except perhaps in Japan Indeed, recovery in the Eurozone has faltered with real GDP growth projected at 1.3 percent in 2005 While the employment situation has improved a little, the same cannot be said for consumption, which has been held back in part by higher oil prices, which have not been attenuated of late by a strengthening euro Growth next year is projected to reach 1.6 percent—with Germany showing some strength—supported by export volume growth that should benefit from the lagged effects of earlier exchange rate developments A major strengthening of domestic demand growth is not expected, however Japan seems poised to register its first sustained economic recovery since the bursting of the bubble, albeit with wide gyrations in quarterly growth, which may reflect in part problems with seasonal adjustment With signs of strengthening in the jobs market and in wages and salaries, growth this year is expected to reach 2¼ percent, underpinned by moderately strong private consumption and business investment Forward-looking indicators suggest that economic growth next year will continue at this year’s pace Survey data show that business confidence is increasing and that export growth is likely to rebound as the manufacturing sector reacts favorably to global IT sector adjustment If the current reduction in deflation continues, it should come to an end in 2006, if not earlier Emerging market growth this year is projected at 5.9 percent (Chart 3) This is nearly one percentage point lower than in 2004, when growth reached a 20-year high • Growth in Latin America is projected to decline to 4.3 percent this year after reaching nearly percent in 2004 A tightening of monetary policy in both Brazil and Mexico has dampened demand growth Growth momentum, however, has been supported in countries dependent on commodity exports by terms-of-trade gains With the exception of Brazil, all countries in Latin America are likely to experience a moderation in growth in 2006 Chart 3: Emerging Market Economies’ Real GDP Growth (percent change from previous year) 98 99 2000 00 01 02 2003 03 04 05f 2006f 06f Emerging Europe is likely to experience the most visible falloff in growth to 4.9 percent from 6.8 percent in 2004, reflecting slower export growth to the euro area and some moderation in domestic demand, most noticeably in Turkey (Table 2) In 2006, real GDP growth is expected to remain nearly unchanged from this year’s pace • “Japan seems poised to register its first sustained economic recovery since the bursting of the bubble, albeit with wide gyrations in quarterly growth, which may reflect in part problems with seasonal adjustment.” • Table Emerging Market Economies' Output Growth (percent change from previous year) 2003 2004 2005f 2006f 5.3 6.7 5.9 5.5 1.7 5.5 4.1 7.4 5.9 6.8 4.2 7.5 4.3 4.9 4.2 7.2 3.9 4.8 4.5 6.8 Real GDP Output growth in emerging Asia is expected to remain robust this year at 7.2 percent, marginally lower than 7.5 percent last year Korea and Malaysia are projected to have the weakest growth in the region (at 3.5 percent and 4.3 percent, respectively) while China is likely to register growth of 9.3 percent, down slightly from a rapid pace of 9.5 percent last year Regional growth next year is projected to fall below Latin America Europe Africa/Middle East Asia/Pacific f = IIF forecast The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page September 24, 2005 percent for the first time since 2002 with China’s growth slowing to 8.5 percent • Output in the Africa/Middle East region in 2005 is likely to grow at 4.2 percent, the same as last year, and step up to 4.5 percent next year Interest Rates Somewhat surprisingly, yields on 10-year U.S Treasury bonds have not begun a clear upward trend, although there have been a few episodes of visible but temporary spikes (Chart 4) This pattern seems to indicate the lack of conviction on the part of market participants about the robustness of U.S growth Foreign official demand as well as the demand of insurance companies and pension funds to increase their holdings in long-term bonds to reduce duration mismatches is also considered as a factor contributing to the absence of sustained upward pressure on bond yields However, a sudden rise in inflation expectations or a weakening in foreign demand for U.S securities, resulting from a change in policy by China or other Asian countries, could prompt significant financial market deleveraging and downward adjustment in asset prices, especially those of riskier assets This in turn could lead to a deterioration in the financial condition of emerging market countries, particularly those with lower credit ratings and in need of external financing • Our base case scenario sees the federal funds rate rising toward a 4.0-4.25 percent range in the course of the first half of 2006, assuming that the increase in the core personal consumption expenditure deflator hovers around 2.0 percent Given the recent movement in unit labor costs and several components of producer prices, this assumption is not without risks Chart 4: 10-year U.S Treasury Bond Yields (percentage points) 4.5 3.5 Jan-04 Jul-04 Jan-05 Jul-05 Chart 5: U.S Current Account Balance (percent of GDP) -7.0 -6.0 -5.0 -4.0 • • The yield on 10-year Treasury bonds is seen as rising to the 5.0 percent by the second half of 2006, and to a 5ẳ-5ẵ percent range by mid-2007 in step with a progressive narrowing in the margin of economic slack 2000 2001 2002 2003 2004 2005 Market interest rates in Japan are projected to remain broadly unchanged while rates in the Eurozone are likely to show a slight upward trend Current Account Balance The continued disparity in growth prospects for the United States relative to the Eurozone and Japan implies underlying forces working toward a further widening of the U.S current account deficit (Chart 5) While the dollar has been firm for most of this year, the lack of prospects for coordinated policy action by major economies raises the possibility of a disorderly depreciation of the dollar in due course Such a depreciation could push U.S interest rates—both the federal funds rate and market rates—well beyond current expectations with adverse consequences for EMBIG spreads Such a depreciation would also weaken output growth in “The continued disparity in growth prospects for the United States relative to the Eurozone and Japan implies underlying forces working toward a further widening of the U.S current account deficit.” The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page September 24, 2005 the Eurozone and Japan while higher U.S interest rates would dampen U.S domestic demand Both of these developments would reduce growth of exports and output in emerging markets Wider EMBIG spreads and weaker growth would have a negative impact on the debt dynamics of those emerging market economies with high debt levels • Adjustment in U.S fiscal policy is but one component of what is needed to reduce the current global payments imbalance Improving growth prospects for the Eurozone depends critically on structural reforms—particularly those pertaining to labor markets—that promote more flexible and responsive economies In Japan, further structural reforms, building on those that have helped improve balance sheets of the corporate sector and banking system, are needed to boost growth prospects • Emerging markets will need to their part as well, for example, through corporate and banking reform in Asia, better financial regulation and supervision in central Europe, and a more user-friendly investment and corporate governance environment in Latin America In the meantime, the aggregate current account surplus of emerging markets included in this capital flows exercise is projected to reach 2.4 percent of GDP this year, up from 2.1 percent in 2004 Double-digit export growth is expected for the third consecutive year Growth of remittances is likely to remain strong, constituting the singlelargest source of foreign exchange, excluding merchandise exports, in a number of countries Remittances are expected to remain resilient next year despite a projected decline in the overall current account surplus to 2.1 percent of GDP “Adjustment in U.S fiscal policy is but one component of what is needed to reduce the current global payments imbalance.” “Second-round effects of higher oil prices on inflation have so far been held in check by several factors, including limited pricing power of companies, adequate labor supply and benign inflation expectations.” Oil Prices The impact of higher oil prices on global activity and inflation so far has been relatively mild compared to earlier episodes in the 1970s and 80s Oil prices in real terms are still below those reached during the past three decades (Chart 6) Second-round effects of higher oil prices on inflation have so far been held in check by several factors, including limited pricing power of companies, adequate labor supply and benign inflation expectations In looking at the possible future trend of oil prices, a number of factors need to be considered The increasing concentration of global growth on several oil-intensive economies in Asia has already noticeably accelerated the growth of global oil demand Although the International Energy Agency (IEA) and others are forecasting slower growth in demand for oil in the coming year, this market has been known to surprise analysts On the supply side, despite increased production by non-OPEC countries, the global oil supply has become progressively tighter, reflecting a long period in which there has been low investment in the sector The lowest level of OPEC’s spare capacity in 25 years has accentuated market participants’ reaction to possible terrorist threats to oil supplies from the Middle East and recurrent production disturbances in non-OPEC Chart 6: Real Oil Prices (2004 U.S dollars) $100 $80 $60 $40 $20 $0 70 75 80 85 90 95 00 05 The Institute of International Finance, Inc September 24, 2005 countries Temporary refinery constraints have also contributed to oil market jitters • Brent crude oil prices are expected to fall to about $60 a barrel by end-2005 and average $60 a barrel in 2006 This forecast assumes that the increase in world demand for oil will hover around percent next year, following an increase of 1.6 percent in 2005 as expected by the IEA Our price assumption also depends on OPEC increasing its output by roughly 0.4 million barrels per day in 2006 with an increase of 1.4 million barrels per day from non-OPEC producers • Capital Flows to Emerging Market Economies Page “As has been pointed out by the IEA and others, a sharp rise in oil prices could have a significant and disproportionate negative impact on the growth prospects for key importing emerging market countries.” A further rise in oil prices could lead to a drag on growth The IEA estimates that every $10 a barrel rise in the price of oil, sustained for one year, would subtract roughly 0.5 percent from world GDP as its direct impact As has been pointed out by the IEA and others, a sharp rise in oil prices could have a significant and disproportionate negative impact on the growth prospects for key importing emerging market countries Outlook for Major Components of Capital Flows Since our last update on capital flows to emerging market economies at the end of March, we have revised our projection for net private capital flows in 2005 to $345 billion from $311 billion The most notable change in the composition of this external financing is that commercial bank net lending has been revised upward by $17 billion with nearly all of it going to Asia Net nonbank credit flows—mostly bonds—have also been revised upward by $11 billion as borrowers have taken advantage of low spreads to prefinance obligations due in 2006 Portfolio equity flows are also more robust than previously expected “China will remain the largest recipient of foreign direct investment among emerging market economies, accounting for one-third of net flows.” Key features of the main categories of net private capital flows to emerging market economies this year and next are as follows: • Net direct investment (projected at $149 billion this year and $146 billion next year) is expected to account for 43 percent of all private capital flows to emerging markets in 2005 and slightly more in 2006 China will remain the largest recipient of foreign direct investment among emerging market economies, accounting for one-third of net flows • Commercial bank net lending is projected to reach a nineyear high of $63 billion this year before slowing down to $59 billion in 2006 Emerging Europe is likely to be the major recipient of commercial bank funding as companies continue to rely on debt financing In 2006, positive net lending to Latin America is projected to take place for the first time since 2000 • Despite an increase in amortization payments this year, net nonbank credit flows are likely to reach an all-time high of more than $90 billion Net flows are expected to recede next “Commercial bank net lending is projected to reach a nine-year high of $63 billion this year before slowing down to $59 billion in 2006.” The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page September 24, 2005 year to $76 billion in large part because of reduced borrowing by countries in emerging Europe, one of which, Poland, used the bond market extensively this year to finance large prepayments of debt to Paris Club members Net repayments to official creditors are projected to reach a record high this year of more than $50 billion, with Poland and Russia together accounting for $31 billion of the total Net repayments are projected to be cut in half in 2006 From a geographical perspective, net private capital flows to Asia are expected to account for 42 percent of total flows to emerging markets this year, down from 52 percent in 2004 (Table 3) An increase to 46 percent is projected for next year as flows to China pick up after a moderate dip this year In terms of other regions: • Latin America’s share of total net private flows is expected to remain in the range of 13-16 percent through 2006, with Mexico continuing to garner the largest share of net inflows to the region while Brazil closes the gap as it attracts increasing investor interest • Private flows 213.7 317.8 46.2 131.5 21.6 145.9 49.9 110.8 12.3 144.8 -30.6 -50.4 -24.2 -0.6 -3.4 -2.6 -14.9 Latin America Europe Africa/Middle East Asia/Pacific 345.2 31.0 108.9 11.0 166.4 -21.4 Official flows 317.4 26.8 65.1 3.6 118.2 Latin America Europe Africa/Middle East Asia/Pacific -10.3 -9.1 -2.5 -8.7 -14.0 -34.6 -1.7 -0.1 -9.0 -15.0 -2.4 2.2 f = IIF forecast Private capital flows to emerging Europe are expected to reach nearly $132 billion in 2005, representing 38 percent of total net capital flows to emerging markets This share is likely to decline to 35 percent in 2006, but remain substantially above the 10-year average of 24 percent • Table Financial Flows to Emerging Market Economies by Region, Net (billions of U.S dollars) 2003 2004 2005f 2006f Private flows to the Africa/Middle East region are likely to remain small at 4-6 percent of total flows, with much of it accounted for by South Africa “After falling to a seven-year low of $96 billion in 2003, direct investment is expected to rise for the second consecutive year, reaching $149 billion in 2005—the highest level since 1999.” Regional notes on pages and provide greater details, including key features of the composition of net private capital flows as well as total amounts Direct Investment The generally favorable outlook for economic growth in emerging market countries, as well as improving confidence on the part of long-term investors in emerging markets policy performance, has attracted increasing amounts of direct equity investment Thus, after falling to a seven-year low of $96 billion in 2003, direct investment is expected to rise for the second consecutive year, reaching $149 billion in 2005—the highest level since 1999 (Chart 7) Direct investment is projected to remain nearly unchanged in 2006 at $146 billion Traditional mergers and acquisitions and green investment will constitute the bulk of investment inflows Larger amounts of cross-border transactions between the related entities within the ownership structures of multinational corporations also appear to be taking place In looking for investment opportunities there is an increasing tendency for companies to search in the more populous emerging market countries in the belief that these countries will provide an expanding customer base in addition to a cost advantage needed as an export Chart 7: Net Direct Investment by Region (billions of U.S dollars) 160 120 80 40 EME LA 2003 A/ME 2004 Asia 2005f Europe 2006f The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page September 24, 2005 Emerging Europe Asia/Pacific A continued strengthening of foreign direct investment and nonbank creditor flows should help raise net private capital flows to a record high $132 billion this year before slowing to an expected $111 billion in 2006 Net private capital inflows are set to moderate to $146 billion this year from $166 billion in 2004 as flows in all categories of investment are likely to recede Capital flows are expected to remain at this year’s level in 2006 • With the exception of Bulgaria, all countries in the region are likely to experience a slowdown in economic growth this year, primarily because of a weakening in the net foreign balance of most countries In 2006, real GDP in emerging Europe is expected to grow 4.8 percent, nearly identical to this year’s projected outcome • Regional growth is likely to stay above percent for the third consecutive year with China once again expected to experience the fastest growth among our survey countries at 9.3 percent A tapering off of activity in China next year will limit regional growth to a projected 6.8 percent • Privatization activity in the Czech Republic and Turkey is largely behind the expected pickup in direct investment this year Proximity to major markets in Western Europe and still relatively low labor costs are attracting direct investment in the region Direct investment is forecast to hold steady next year at $34 billion • Reserve accumulation is slated to accelerate in 2005 as a rise in net private capital flows is augmented by a reduction in net resident lending abroad Reserve accumulation is projected to reach a record high $73 billion this year, bringing the stock of reserves to nearly $335 billion, representing 5.8 months of imports of goods, services and transfers A smaller, expected current account surplus next year, along with a reduction in net private capital inflows, will hold down reserve accumulation to less than $62 billion • Capital flows to the region continue to be dominated by direct investment, which is expected to account for more than 40 percent of flows this year China remains the major recipient of direct investment in emerging Asia as these flows, along with the mobilization of the labor force, have transformed the country into a regional export base • Despite a slowdown in capital flows to the region this year, reserve accumulation is expected to exceed $280 billion for the second consecutive year as the aggregate current account surplus reaches 3.7 percent of GDP, up from 3.2 percent in 2004 Reserve accumulation is projected to hit a record high $312 billion in 2006, bringing the region’s stock of reserves to $1.7 trillion (See separate box on page 10 for details of China’s external financing.) Table Asia/Pacific: External Financing (billions of U.S dollars) Table Europe: External Financing (billions of U.S dollars) 2003 2004 2005f 2006f 99.2 117.3 151.0 164.5 118.2 166.4 145.9 144.8 91.6 55.8 35.8 95.9 64.2 31.8 93.8 63.9 29.9 96.4 64.0 32.4 26.6 13.8 12.8 70.5 37.5 32.9 52.2 28.2 24.0 48.4 22.6 25.8 Official flows, net IFIs Bilateral creditors -14.9 -10.1 -4.8 -8.7 -4.7 -4.0 -0.1 -2.7 2.5 2.2 -0.8 2.9 -36.8 Resident lending/other, net1 -12.1 25.9 -14.8 1.1 -61.6 Reserves (- = increase) 2003 2004 2005f 2006f Current account balance -1.3 6.3 7.9 2.6 External financing, net: Private flows, net 65.1 108.9 131.5 110.8 8.1 6.0 2.0 28.1 23.3 4.8 41.7 34.5 7.2 41.4 34.5 6.9 Equity investment, net Direct investment, net Portfolio investment, net 57.0 27.3 29.7 80.9 37.9 43.0 89.8 39.2 50.6 69.4 31.1 38.3 Private creditors, net Commercial banks, net Nonbanks, net -3.4 -0.1 -3.3 -9.1 -2.9 -6.2 -34.6 -7.5 -27.1 -15.0 -2.7 -12.3 Resident lending/other, net1 -24.3 -47.8 -32.0 Reserves (- = increase) -36.1 -58.4 -72.8 Equity investment, net Direct investment, net Portfolio investment, net Private creditors, net Commercial banks, net Nonbanks, net Official flows, net IFIs Bilateral creditors Current account balance External financing, net: Private flows, net f = IIF forecast f = IIF forecast 1 -190.4 -300.9 -282.0 -312.5 Including net lending, monetary gold, and errors and omissions Including net lending, monetary gold, and errors and omissions The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page September 24, 2005 Latin America Africa/Middle East Increases in equity investment for the third consecutive year and a reduction in net outflows to commercial banks will contribute to a significant expansion of net private flows this year to an expected $46 billion from $31 billion in 2004 A further moderate increase in flows is projected for 2006 Net private capital flows to the region are expected to approach nearly $22 billion this year, nearly double the amount received in 2004 A surge in direct investment is responsible for a significant portion of the overall increase in flows • All countries in the region are likely to experience some degree of a slowdown in economic activity this year with Uruguay and Venezuela expected to see the biggest declines in growth rates, following significant rebounds in activity in 2004 Regional growth is projected to dip to 4.3 percent in 2005 from 5.9 percent last year and slow further to 3.9 percent in 2006 • Growth in the region will hold up at relatively high levels this year with a further acceleration in regional growth expected next year Egypt should see the sharpest increase in growth, reflecting improved policy implementation and a rebound in tourism • Net nonbank creditor inflows are expected to increase for the second consecutive year to $11 billion from $9.5 billion in 2004 Reduced financing needs and improved public balance sheets should limit nonbank creditor flows—mostly bonds—to less than $9 billion next year with an increasing likelihood of more local currencydenominated global bond issuance • A significant increase in net resident lending, particularly from Mexico and Venezuela, is projected to limit reserve accumulation in the region to about $17 billion this year, down from more than $22 billion in 2004 A further decrease in reserve accumulation is expected next year as the current account surplus shrinks to only 0.3 percent of GDP, down from 1.1 percent in 2005 Table Latin America: External Financing (billions of U.S dollars) • The acquisition of one of South Africa’s major banks, as well as foreign interest in the natural resource sector, has been pivotal to the significant pickup in equity investment in the region this year Bond flows as well as commercial bank lending are also expected to rise this year before dropping in 2006 • The region’s current account is forecast to remain healthy in 2005 with a surplus of 2.5 percent of GDP An expected shift in the terms of trade is projected to result in a smaller current account surplus in 2006 Reserve accumulation is likely to reach $29 billion this year, up from $18 billion in 2004 Reduced capital flows and a smaller current account surplus will limit reserve accumulation next year to less than $16 billion Table Africa/Middle East: External Financing (billions of U.S dollars) 2003 2003 2004 2005f 2006f Current account balance 10.9 20.2 23.2 6.9 External financing, net: Private flows, net 26.8 31.0 46.2 49.9 24.8 30.1 -5.3 36.4 43.3 -6.9 39.8 41.1 -1.3 37.8 41.8 -3.9 Equity investment, net Direct investment, net Portfolio investment, net 1.9 -13.2 15.1 -5.4 -14.9 9.5 6.4 -4.8 11.2 12.1 3.4 8.6 Private creditors, net Commercial banks, net Nonbanks, net Official flows, net IFIs Bilateral creditors -0.6 4.8 -5.4 -10.3 -7.6 -2.7 -14.0 -12.9 -1.0 -9.0 -8.1 -0.9 Resident lending/other, net1 -3.7 -18.6 -38.0 -35.5 Resident lending/other, net -33.4 -22.4 -17.4 -12.2 Reserves (- = increase) Equity investment, net Direct investment, net Portfolio investment, net Private creditors, net Commercial banks, net Nonbanks, net Reserves (- = increase) 2004 2005f 2006f Current account balance 9.1 8.0 12.3 6.7 External financing, net: Private flows, net 3.6 11.0 21.6 12.3 4.4 3.9 0.5 7.1 1.5 5.6 16.0 9.5 6.5 8.9 5.6 3.3 -0.8 -2.5 1.8 3.9 0.5 3.3 5.6 0.9 4.7 3.5 0.7 2.8 -2.6 -1.3 -1.3 -2.5 -1.2 -1.3 -1.7 -0.8 -0.9 -2.4 -0.8 -1.5 2.5 1.8 -2.9 -1.0 -12.7 -18.3 -29.2 -15.6 Official flows, net IFIs Bilateral creditors f = IIF forecast f = IIF forecast 1 Including net lending, monetary gold, and errors and omissions Including net lending, monetary gold, and errors and omissions The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page 10 September 24, 2005 China: Economic Outlook and Prospects for Capital Flows • Real GDP growth is likely to remain robust this year at 9.3 percent following 9.5 percent in 2004 We expect a moderation to 8.5 percent next year • Continued strong export growth will push this year’s current account surplus to 6.7 percent of GDP and to more than percent in 2006 • Net private capital flows are expected to decline to $87 billion this year from $101 billion in 2004 as commercial bank borrowing and nonbank inflows retreat in the face of pressure by the authorities to limit overseas borrowing Table China's External Financing (billions of U.S dollars) 2003 2004 2005f 2006f Current account balance 45.9 68.7 130.0 160.0 External financing, net: Private flows, net 87.2 93.2 54.7 46.9 7.7 64.1 53.1 10.9 67.0 52.0 15.0 68.0 53.0 15.0 Private creditors, net Commercial banks, net Nonbanks, net • Net direct investment in 2005 and 2006 is forecast to remain near last year’s level of $53 billion, accounting for one-third of all direct investment to emerging markets 71.0 101.1 Equity investment, net Direct investment, net Portfolio investment, net 16.4 9.6 6.8 37.0 16.0 21.0 20.2 6.1 14.1 25.2 9.3 15.9 -0.9 -1.6 0.7 0.5 1.0 -0.4 1.1 0.9 0.1 0.8 0.8 0.0 1.0 36.1 12.0 24.0 Official flows, net IFIs Bilateral creditors • As a result of the continued widening of China’s current account surplus, reserve accumulation is likely to reach an alltime high of nearly $230 billion this year, bringing reserves to nearly $840 billion by yearend Resident lending/other, net Reserves (- = increase) -117.0 -206.4 -230.3 -278.0 f = IIF forecast Including net lending, monetary gold, and errors and omissions base Direct investment is also being attracted to areas undergoing regulatory and administrative reforms WTO accession and the termination of the Multi-Fiber Arrangement have provided impetus for new investment One aspect of direct investment that seems to be gaining more prominence but is not readily quantifiable because of the lack of reliable data is outward investment by emerging market investors Companies in relatively more advanced economies like Korea, South Africa, Brazil and Chile have taken the lead in searching for opportunities outside of their home base Some estimates suggest that “south-south” investment between emerging market economies could account for as much as one-third of global foreign direct investment flows Increasingly, emerging market based companies are seeking to integrate corporate entities in advanced industrial countries into their developing global network Some of this activity is being driven by a desire to acquire high technology and management expertise The rapid rise in commodity prices is also spurring efforts to secure natural resource based companies On a regional basis, emerging Europe and the Africa/ Middle East region are expected to see a marked increase in direct investment Emerging Europe is likely to see direct equity investment increase to $34 billion this year from $23 billion in 2004 “Increasingly, emerging market based companies are seeking to integrate corporate entities in advanced industrial countries into their developing global network.” The Institute of International Finance, Inc September 24, 2005 Direct investment is projected to hold steady at this year’s level in 2006 Several EU accession countries are seeing a further pickup in direct investment flows this year as foreign companies seek to expand into higher value-added activities • Direct investment in the Czech Republic is poised to jump to $7 billion this year from $3.6 billion in 2004 as the sale of Césky Telecom and other firms boost privatization receipts • In Russia, direct investment is reported to have risen 31 percent in the first half of 2005 from a year earlier with the bulk of investment going to manufacturing and trade, and not in natural resources as might be expected With no major privatization deals on the horizon, direct investment is expected to be held to $3.2 billion in 2006, up only marginally from $3 billion this year Page 11 “Several EU accession countries are seeing a further pickup in direct investment flows this year as foreign companies seek to expand into higher value-added activities.” In Turkey, as of mid-August, privatization implementations, including the transfer of operating rights of Istanbul airport, totaled $12.7 billion, equal to about 3.5 percent of estimated GDP The impending sales of the country’s iron and steel plant Erdemir and oil refiner Tupras could push privatization to $16 billion this year, or 4.6 percent of GDP Net direct investment inflows could reach $9.6 billion in 2005, up from only $1.5 billion last year In 2006, the privatization of 20 regional electricity distribution networks worth between $3.55.0 billion could result in overall net direct equity investment of $9.5 billion • Capital Flows to Emerging Market Economies “Trade frictions have encouraged some manufacturers to diversify production away from China, and the recent revaluation, albeit small, has signaled a more significant appreciation over time.” Direct investment in the Asia/Pacific region continues to be dominated by investment in China • At an annualized rate of $55 billion, actual inflows to China in the first eight months of 2005 were percent below the level of a year earlier, according to Chinese official statistics Trade frictions have encouraged some manufacturers to diversify production away from China, and the recent revaluation, albeit small, has signaled a more significant appreciation over time While inflows of direct investment probably have peaked after a five-year run-up, the large pipeline of new commitments suggests that net inflows should be sustained at about $53 billion in 2006 • India remains one of the top recipients of direct investment in the region although investment has not met government expectations because of bureaucratic hurdles and the slow lifting of ownership restrictions in services activities The government’s plans to hike foreign investment ceilings in insurance and banking have been delayed for over a year by strong political opposition, which may also hamper the opening of the retail sector to foreign companies like WalMart Moreover, services liberalization and market openings are part of the ongoing Doha Round of the WTO, which is making slow progress “India remains one of the top recipients of direct investment in the region although investment has not met government expectations because of bureaucratic hurdles and the slow lifting of ownership restrictions in services activities.” The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page 12 September 24, 2005 Net direct investment in Latin America is likely to slip to $41 billion this year after achieving a three-year high of $43 billion in 2004 • Mexico is the only country in the region that is expected to see a noticeable increase in net direct investment this year, accounting for more than one-third of such flows to the region • In the case of Brazil, direct investment in the first seven months of 2005 was almost double the amount in the same period last year While gross inflows are rising significantly, this is offset to an important extent by foreign direct investment of Brazilian companies in a number of countries abroad For the full year, net direct equity investment in Brazil is projected to decline to $10 billion from nearly $12 billion in 2004 A slight increase in flows is expected in 2006 • “While gross inflows are rising significantly, this is offset to an important extent by foreign direct investment of Brazilian companies in a number of countries abroad.” Direct investment in Argentina is likely to amount to $4.2 billion in 2005, up from $3.7 billion last year, but far below the annual average of flows of nearly $9 billion between 1995 and 2000 In the Africa/Middle East region, net direct equity investment is expected to jump to $9.5 billion this year from a six-year low of $1.5 billion in 2004 Roughly one-half of this year’s net inflow will be accounted for by the 60 percent purchase of South African bank ABSA by Barclays This marks the largest ever single direct investment transaction in the country In 2006, net direct investment in the region is projected to decline to $5.6 billion “Emerging market portfolio equity investment is projected to strengthen this year with net inflows amounting to $42 billion, up from about $35 billion in 2004, and representing the highest level since 1993.” Portfolio Investment Emerging market portfolio equity investment is projected to strengthen this year with net inflows amounting to $42 billion, up from about $35 billion in 2004, and representing the highest level since 1993 (Chart 8) Emerging Asia is expected to account for roughly three-fourths of total net inflows to emerging markets Net portfolio investment is likely to decline next year partly as a result of a narrowing in the emerging market’s discount to developed markets A number of factors could negatively affect the asset class, including continued high oil prices, which would inevitably cause overall earnings to slow in emerging markets, particularly in Asia High valuations in the United States and elsewhere could lead in time to significant corrections in light of slower earnings stemming from higher input costs to which emerging market equities, albeit being considered by many to be near fair valuations, would not be immune The Asia/Pacific region’s portfolio equity flows are expected to fall back to $29.9 billion this year from $31.8 billion in 2004 A pickup in flows to $32.4 billion is projected for next year • Chart 8: Net Portfolio Investment by Region (billions of U.S dollars) 50 40 30 20 10 -10 China is likely to account for one-half of total flows to the region this year Overseas share listings by Chinese companies generated $6.2 billion in equity inflows in the first six months EME LA 2003 A/ME 2004 Asia 2005f Europe 2006f The Institute of International Finance, Inc September 24, 2005 of 2005, up moderately from $5.6 billion a year earlier Planned overseas listings by a spate of state-owned companies and banks, including the upcoming IPOs of Bank of China and the Construction Bank, should lift net inflows of portfolio equity to $15 billion annually in the next two years from $11 billion in 2004 • Capital Flows to Emerging Market Economies Page 13 “Planned overseas listings by a spate of state-owned companies and banks, including the upcoming IPOs of Bank of China and the Construction Bank, should lift net inflows of portfolio equity to $15 billion annually in the next two years from $11 billion in 2004.” In India, despite a slowdown in privatization, the growing profitability of private sector firms as well as a large volume of funding for expansion is likely to help maintain net inflows of portfolio equity at $9-10 billion a year Increasingly, institutional investors, including venture capital and private equity funds, are stepping up their exposure to India In emerging Europe, net portfolio equity investment is expected to increase to more than $7 billion in 2005 from $4.8 billion last year A slight decline in flows is projected for next year • In Turkey, net portfolio equity investment amounted to $1.6 billion during January-May, four times as much as a year earlier This partly reflected the floatation of minority shares of two large state-owned companies It was also in response to the rebound in corporate earnings and increased interest among foreign portfolio investors following the EU’s decision to begin accession negotiations For the full year, net inflows should reach $3 billion before rising in 2006 to $3.2 billion • Poland is expected to see net portfolio equity inflows of $2 billion this year Investors are being attracted by higher corporate earnings, rising equity prices and a large number of initial public offerings, thanks to the use of the stock exchange to privatize state-owned share holdings • “Increasingly, institutional investors, including venture capital and private equity funds, are stepping up their exposure to India.” Despite record high prices on the Russian stock exchange and a record amount of IPOs ($3.3 billion) floated on the London market in the first seven months of this year, net portfolio equity inflows for the entire year are projected to amount to only $1 billion as money taken offshore in the wake of the Yukos affair has yet to fully return A pickup in net inflows is expected next year Net portfolio equity investment in Latin America is likely to show an outflow of $1.3 billion in 2005, following an outflow of nearly $7 billion last year • • Brazil is expected to be the largest recipient of net portfolio equity inflows in the region this year Net inflows gained momentum in July exceeding $1 billion, representing the largest gain in five months Although recent political events could have a dampening effect on inflows, we nonetheless project that net portfolio equity investment will reach $2.5 billion this year before declining to $1.0 billion in 2006 Mexico is likely to have a positive reversal in flows this year despite the fact that domestic pension funds are now allowed to “Poland is expected to see net portfolio equity inflows of $2 billion this year Investors are being attracted by higher corporate earnings, rising equity prices and a large number of initial public offerings, thanks to the use of the stock exchange to privatize state-owned share holdings.” The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page 14 September 24, 2005 invest in foreign stocks For the year, net inflows are projected to reach $1 billion, following net outflows of $2.5 billion in 2004 • For the fifth consecutive year, Chile will account for the bulk of net outflows in the region as pension fund managers look to continue to diversify their portfolios This year’s projected outflow of $4.3 billion is expected to be repeated in 2006 “Total equity issuance this year seems likely to exceed the nearly $33 billion recorded in 2004, which was the highest in a decade.” In the Africa/Middle East region, portfolio equity investment is likely to increase to $6.5 billion in 2005 from $5.6 billion last year • • South Africa is expected to be the recipient of more than 90 percent of these flows A large portion of the $6 billion in portfolio equity investment that is projected to flow into South Africa this year will go to firms connected with natural resource exploration, spurred by the run-up in global commodity prices and demand for diamonds, gold, platinum and palladium Chart 9: Emerging Market Equities (January 2002 = 100, MSCI, US$ terms) 300 Net portfolio equity investment in Egypt is expected to shift from an outflow of $0.1 billion last year to an inflow of $0.5 billion in 2005 Equity prices and issuance: Following a correction in March and April, emerging market equity prices as measured by the MSCI Emerging Markets Free Index resumed an upward climb in the latter part of the second quarter, albeit at a much slower pace than the percent recorded for the first two months of the year In the second quarter, the stock index rose percent For the year to September 15, the MSCI increased 17.6 percent, bringing the index level to an all-time high On a geographical basis, the emerging Europe region equity index has risen 35 percent so far this year, followed by Latin America with a 30 percent gain (Chart 9) The Asia region has been the worst performing with its index rising at less than half the rate of Latin America Markets in several countries, including Indonesia, have experienced declines After languishing during the first five months of the year, Chinese equity prices have risen sharply as investors have gained confidence that the government will be able to properly manage the “gradual” conversion of non-tradable state-owned shares into tradable shares Total equity issuance this year seems likely to exceed the nearly $33 billion recorded in 2004, which was the highest in a decade (Chart 10) A significant portion of this issuance has occurred in Asia with 48 offerings coming from China totaling more than $10 billion In Latin America, only six offerings have taken place, with five of them in Brazil amounting to $0.9 billion Issuance in emerging Europe has been dominated by Russia, with five offerings totaling $2.8 billion in the first eight months of the year compared with $0.3 billion a year earlier In the Africa/Middle East region, the amount of issuance is running at only about two-thirds of last year’s level For emerging markets as a whole, IPOs have become a bigger share of total issuance this year as privatization moves forward in several countries and more state-owned companies in China list their shares overseas 250 200 150 100 50 2003 2004 2005 Asia Emerging Europe Latin America Chart 10: Emerging Market Equity Issues (billions of U.S dollars) 2001 2002 2003 2004 2005 The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page 15 September 24, 2005 Nonbank Private Sector Lending Investors’ continued willingness to purchase emerging market bonds is projected to push net nonbank private sector lending this year to $90 billion, surpassing the record high in 1997 (Chart 11) Emerging market debt spreads have proven resilient so far this year to bouts of financial market volatility Indeed, spreads decoupled from their traditional relationship to U.S corporate high-yield spreads during the auto-sector related sell-off, remaining relatively steady as U.S high yield spreads widened thus leading to a reduced differential between the two Better economic policies and improved performance by an increasing number of emerging market economies have been accompanied by a continuing trend toward higher credit ratings of emerging market issuers (Chart 12) This has been supportive of a reduction in spreads The emerging debt market has also benefited from more investor-friendly instruments that include collective action clauses as well as from growing recognition by investors that this asset class has delivered on a risk-adjusted basis higher returns than all other traditional asset classes in the last ten-year period For now, the supply of bonds coming on stream is likely to be readily absorbed as emerging market bonds remain a diversification play for institutional and crossover investors (the latter estimated to now hold more than three-fourths of assets under management in emerging market bonds) given the relatively low correlations with other asset classes In 2006, net nonbank private sector lending is expected to amount to about $76 billion The projected reduction from this year’s likely near record level reflects the fact that many debtors have already taken the opportunity to pre-finance obligations due next year The anticipated decline in net lending could be even more pronounced if downside risk from higher oil prices, a belated rise in U.S bond yields to levels more consistent with past cyclical experiences, or a sudden shift in investor risk aversion were to materialize A number of recent empirical studies have pointed to the prominent role that developments in mature economies play in accounting for changes in emerging market bond spreads One indepth study showed that about two-fifths of the change in spreads in the past two years could be explained by better domestic fundamentals with the remainder of the change explained almost equally by stronger global growth, greater global liquidity, and lower risk aversion These findings suggest that a reversion to the mean for factors mentioned above could easily cause emerging market bond spreads to rise by 100 to 150 basis points The extremely favorable environment for emerging market bonds has allowed sovereign authorities and, to a lesser extent, corporate treasurers to actively manage debt to improve their credit profiles Debt managers have taken the opportunity to broaden the investor base by issuing in different currencies and increasing the share of financing from domestic sources Efforts have been made to issue global bonds denominated in local currencies in international capital markets to overcome what has been termed the “original sin” of emerging markets—the inability to issue international bonds in local currency Several countries, including Chart 11: Net Nonbank Lending by Region (billions of U.S dollars) 100 80 60 40 20 EME LA 2003 A/ME 2004 Asia 2005f Europe 2006f Chart 12: EMBI+ Credit Ratings BB+/Ba1 BB/Ba2 BB-/Ba3 B+/B1 1993 1996 1999 2002 2005 “The extremely favorable environment for emerging market bonds has allowed sovereign authorities and, to a lesser extent, corporate treasurers to actively manage debt to improve their credit profiles.” The Institute of International Finance, Inc September 24, 2005 Poland, were able to tap the private capital market at attractive spreads in order to prepay obligations to members of the Paris Club Also, debt restructuring operations have improved the debt profile of several issuers, including the Dominican Republic where efforts were made to utilize the Principles for Stable Capital Flows and Fair Debt Restructuring in Emerging Markets in discussions with creditors Capital Flows to Emerging Market Economies Page 16 “Debt restructuring operations have improved the debt profile of several issuers, including the Dominican Republic where efforts were made to utilize the Principles for Stable Capital Flows and Fair Debt Restructuring in Emerging Markets in discussions with creditors.” Emerging Europe is projected to account for more than onehalf of nonbank private creditor flows to emerging markets this year The total amount projected for this year of more than $50 billion is nearly eight times higher than the low point of 2002 • As in 2004, Russia will account for the largest amount of borrowing in the region followed by Poland and Turkey Russian corporate Eurobond issues amounted to $7 billion in the first eight months of this year with issuance largely spread among financial, telecommunication and natural resource companies The largest single issue to date has been from Gazprom, which was worth $1.25 billion • Net nonbank lending to Poland this year is expected to exceed $14 billion, up from $8.3 billion in 2004 Government foreign bond issuance has reached $10 billion in conjunction with efforts to prepay Paris Club debt Issuance has been done in several currencies and at maturities of 15, 30, and 50 years Non-residents have also been attracted to the domestic market making net purchases of $3 billion of zloty-denominated government bonds in the first five months of 2005 • “Emerging Europe is projected to account for more than one-half of nonbank private creditor flows to emerging markets this year The total amount projected for this year of more than $50 billion is nearly eight times higher than the low point of 2002.” Net nonbank lending to Turkey is on pace to slightly exceed last year’s $10.5 billion Government issuance in the international capital market in the first eight months of this year reached $5.3 billion and is set to top $7 billion by yearend Nonresidents remain significant purchasers of domestic government securities with net purchases this year projected at more than $6 billion Non-residents as of mid-year held 20 percent of liradenominated debt, almost twice that of a year earlier Net nonbank private creditor flows to Latin America are likely to rise to $11 billion in 2005 from $9.5 billion last year A slowdown in economic growth in the region as well as political tensions in some countries not appear to be having an impact on lending as of now • After experiencing a net outflow of $3 billion last year, Brazil is expected to receive a similar-sized inflow of nonbank private credit this year The Brazilian government has been an active participant in the bond market, exchanging $4.4 billion of C-bonds for new A-bonds in July This followed issuance of $3.7 billion earlier in the year The participation rate for the C-bond exchange was high at nearly 80 percent By carrying out the exchange, the government has been able to smooth the amortization profile of public sector external debt Following the exchange, it was announced that the government would roll “After experiencing a net outflow of $3 billion last year, Brazil is expected to receive a similar-sized inflow of nonbank private credit this year.” The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page 17 September 24, 2005 over only 80 percent of its external debt due in 2006-2007 This implies that Brazil will come to the market for $9 billion of the $11.8 billion in debt maturing in the next two years • Mexico is likely to see net inflows of $3.8 billion this year, down from $4.6 billion in 2004 Pemex has been active in the international market issuing $2.8 billion in bonds In mid-July, the Mexican government announced that it had completed the raising of the foreign exchange needed to meet all external debt amortizations due in 2006-2007 This includes $1.9 billion from previous pre-funding operations • “The combination of low risk aversion by investors and a still relatively benign interest rate environment has led to large inflows into the emerging markets asset class, providing a favorable environment for bond issuance.” In July, Uruguay began pre-financing its 2006 external needs by placing €300 million in bonds due in 2016 This was the first bond issue in euros by the government After reaching an eight-year high of more than $33 billion in 2004, net nonbank creditor inflows to the Asia/Pacific region are expected to decline to less than $24 billion this year with China, Korea, and Malaysia all likely to experience a decrease in net inflows • • China is projected to receive about 60 percent of the net inflows to the region New international bond issuance by Chinese entities raised only $1.2 billion in the first seven months of 2005, which was far below the $5.2 billion received in the same period last year Borrowing by Chinese companies from foreign suppliers also appears to have slowed Chart 13: Foreign Currency-Denominated Bond Issuance in Emerging Markets (billions of U.S dollars) 10 Korea is expected to see a sharp drop in borrowing from nonbank private creditors while Indonesia is projected to experience net outflows for the eighth consecutive year Bond issuance and spreads: Overall issuance in the first eight months of this year far outpaced that for the same period in 2004 with corporate and sovereign issuance amounting to $85 billion (Chart 13) The combination of low risk aversion by investors and a still relatively benign interest rate environment has led to large inflows into the emerging markets asset class, providing a favorable environment for bond issuance Indeed, a record-high amount seems likely to take place this year as many issuers have accelerated their 2006 and in some cases 2007 borrowing programs in anticipation of higher global bond yields Corporate entities have accounted for slightly more than half of total issuance so far this year with these issuers on balance having higher credit ratings than sovereigns (Chart 14) Nevertheless, the credit quality of sovereigns has been edging up again this year to the equivalent of a BB rating on average The strong demand for emerging market bonds among a variety of institutional investors has enabled issuers to sharply increase the share of bonds issued in non-dollar currencies, particularly euros Momentum is also building for sovereign global bond issues denominated in local currencies Supranational borrowers have also begun to tap local emerging markets For example, German development bank KfW sold 500 million pesos of 2009 bonds in Mexico in August 2001 2002 2003 2004 2005 Chart 14: Sovereign versus Corporate Bond Issuance (percent of total) 70 50 30 10 2001 2002 2003 Sovereign 2004 Corporate 2005 The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page 18 September 24, 2005 The rapid pace of emerging market bond issuance this year has coincided with an overall compression in bond spreads Following our last capital flows update at the end of March, the spread on the EMBIG index peaked for the year on April 15 at 395 basis points (Chart 15) Subsequently, spreads held in a trading range of 365385 through the beginning of June as market participants sorted out the impact of the downgrading of GM and Ford on the U.S highyield market Since early June, EMBIG spreads have fallen about 120 basis points, of which approximately 50 basis points were accounted for by the replacement of defaulted securities of Argentina with new bonds issued following the completion of the debt exchange at end-May Even adjusting for the Argentina effect, the spread on the EMBIG index reached an all-time low in midSeptember Concerns about potential higher inflation and U.S interest rates not seem to be having an effect on spreads and indeed for the past few months emerging market bond spreads have largely decoupled from the movement in long-term U.S interest rates Chart 15: EMBIG Spreads (basis points) 1200 950 700 450 200 2002 On a regional basis, emerging Europe has outperformed the other sub-indices After widening 55 basis points from early March to mid-April, the spread on the emerging Europe sub-index of the EMBIG declined 85 basis points to reach a low of 151 basis points in mid-September (Chart 16) • • Russian bonds have had the best performance in the region with a total return for the country sub-index of more than 13 percent so far this year Investors seem to have put aside for the time being concerns about property rights and the slowdown in structural reforms in favor of the rapid accumulation of international reserves and pro-active debt management operations Despite solid policy performance in Turkey, which has resulted in an impressive decline in inflation and domestic interest rates, sovereign external bonds have underperformed the emerging Europe sub-index in part because of concerns about the widening current account deficit In terms of issuance activity, Turkey and Russia so far this year have accounted for about 40 percent of the $33 billion of issuance in the region 2003 2004 2005 Chart 16: EMBIG Regional Spreads (basis points) 1600 1200 800 400 2001 2002 2003 Asia 2004 Europe 2005 Latin Although Latin America’s EMBIG spread has shown the largest absolute decline among the regions since reaching a peak of 486 basis points in mid-April, once this is adjusted for the change in Argentine bonds in the sub-index, Latin America’s total return falls below the overall index (7.5 percent versus 7.8 percent) • • The Dominican Republic’s restructuring has paid off well for investors with a total return on the country index so far this year of nearly 27 percent—the best among all countries included in the EMBIG Uruguay has had the second best performance in the region with a total return of 11 percent “The Dominican Republic’s restructuring has paid off well for investors with a total return on the country index so far this year of 27 percent—the best among all countries included in the EMBIG.” The Institute of International Finance, Inc September 24, 2005 • • Despite strong economic performance in Brazil, political scandal has weighed on investors, which has resulted in the country index underperforming the regional index The worst performer in the region has been Argentina, with a total return of 0.4 percent Argentina has the lowest total return so far this year of all the countries in the EMBIG index Capital Flows to Emerging Market Economies Page 19 “Although economic fundamentals on balance continue to improve in emerging market countries, the nagging question of whether or not the current level of spreads is sustainable continues to persist.” In terms of issuance activity, political scandal and policy missteps that have had a negative impact on bond spreads of some countries in the region have not deterred issuance, which is on track to exceed the $29 billion recorded in 2004 In the first eight months of 2005, issuance in Latin America amounted to more than $25 billion, with Mexico and Brazil accounting for two-thirds of the total Issuance activity so far in 2005 for the Asia/Pacific region is on a pace to match last year’s placements, which totaled nearly $38 billion, the largest amount since 1997 • Korea remains the biggest issuer in the region, accounting for 40 percent of $24 billion of bonds issued in January-August 2005 • Issuance in Indonesia and Thailand has already exceeded that for the entire year of 2004 The EMBIG spread for Asia as of mid-September was 262 basis points, down 46 basis points from its peak in early July Although economic fundamentals on balance continue to improve in emerging market countries, the nagging question of whether or not the current level of spreads is sustainable continues to persist At present, it does not appear that a possible episode of bad market technicals would turn into bad credit fundamentals, which sometimes jolted the asset class in the past Nevertheless, the improvement in fundamentals, widely acknowledged by market participants and analysts, is not totally independent of the substantial capital that has flowed into emerging markets since 2004 and the global circumstances that have been behind the resurgence of these flows This does not diminish the policy accomplishments that contributed to stronger fundamentals in emerging markets, but it does suggest that borrowers could become complacent about policy in the face of the favorable reception that their new bonds have received in the international capital market Moreover, with elections looming in a number of emerging market economies, this could tempt governments to pause from further measures to secure sound fiscal and monetary policies and pursue structural reforms Although emerging markets have weathered the tightening of policy interest rates so far, the latitude for policy mistakes will necessarily narrow as the global economy adjusts to a period of tighter global liquidity Commercial Bank Lending Net commercial bank lending in 2005 is expected to be positive for the third consecutive year after having been largely negative for the period 1998-2002 Net lending is projected to be “The improvement in fundamentals, widely acknowledged by market participants and analysts, is not totally independent of the substantial capital that has flowed into emerging markets since 2004 and the global circumstances that have been behind the resurgence of these flows.” “Although emerging markets have weathered the tightening of policy interest rates so far, the latitude for policy mistakes will necessarily narrow as the global economy adjusts to a period of tighter global liquidity.” The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page 20 September 24, 2005 more than $63 billion this year, representing the highest level since 1996 Emerging Europe is likely to attract nearly two-thirds of the total net lending to emerging markets this year Net commercial bank lending to emerging markets in 2006 is projected to hold near this year’s level, with positive net flows to Latin America expected to take place for the first time since 2000 (Chart 17) The continued revival of cross-border lending by commercial banks reflects in part efforts to build relationships with emerging market countries in order to expand business opportunities in other fee-generating areas Loan pricing on balance has been competitive with other sources of financing and indeed loan margins have been almost continuously under downward pressure because of abundant liquidity Some of the activity in the global syndicated loan market this year is related to the refinancing of previous projects Banks are sometimes recycling the same money with the same clients at lower margins and a longer tenor Chart 17: Net Commercial Bank Lending by Region (billions of U.S dollars) 80 60 40 20 -20 EME LA 2003 A/ME 2004 Asia 2005f Europe 2006f Net commercial bank lending to emerging Europe is forecasted to rise this year to more than $39 billion from $38 billion last year • The largest portion of this will take place in Russia where net inflows are projected to increase to $17.7 billion from $13 billion in 2004 Despite the rapid run-up in stock prices, many Russian companies continue their financing through syndicated loans • In Turkey, net borrowing from commercial banks in 2005 is expected to decrease to $6.7 billion from $8.9 billion last year This borrowing is likely to be distributed fairly evenly between short-term trade credits and medium-term loans A large amount of corporate borrowing is taking place from the foreign branches of Turkish banks, which mostly represent roundtripped domestic lending cycled through offshore branches to avoid transaction taxes and regulatory barriers against domestic foreign exchange lending to firms with insufficient export proceeds “Some of the activity in the global syndicated loan market this year is related to the refinancing of previous projects Banks are sometimes recycling the same money with the same clients at lower margins and a longer tenor.” Net commercial bank lending to the Asia/Pacific region is expected to decline to $28 billion this year from nearly $38 billion in 2004 • China will likely account for most of the decline, reflecting administrative measures taken by the authorities to impose quotas on banks’ overseas borrowing • After reaching a record high of $8.3 billion in 2004, net commercial bank lending in India is projected to remain strong at $7.5 billion this year as robust investment demand, expanding trade and low international interest rates relative to domestic rates continue to attract borrowers • Commercial banks are likely to receive net repayments from the Philippines this year as they continue to scale back their “A large amount of corporate borrowing is taking place from the foreign branches of Turkish banks, which mostly represent round-tripped domestic lending cycled through offshore branches to avoid transaction taxes and regulatory barriers against domestic foreign exchange lending to firms with insufficient export proceeds.” The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page 21 September 24, 2005 medium- and long-term exposure, but continue extending net new short-term credits over the near term Latin America is expected to be the only region in aggregate to experience net outflows to commercial banks this year However, net outflows are projected to amount to $4.8 billion, down sharply from nearly $15 billion in 2004 • Net outflows to commercial banks are likely to decrease from Brazil in 2005 as gross disbursements rise sharply from last year and net short-term credit inflows take place for the first time in more than five years Brazil is projected to see net commercial bank lending next year for the first time since 2001 as companies draw on liquidity facilities being set up ahead of next year’s election Chart 18: Net Official Lending by Region (billions of U.S dollars) 10 -10 -20 -30 -40 -50 -60 EME LA 2003 • 2004 Asia 2005f Europe 2006f In Mexico, net outflows to commercial banks are expected to decline to $0.2 billion in 2005 from more than $3 billion last year as repayments drop significantly • A/ME Following six years of net outflows, Colombia is likely to see -500 net lending from commercial banks for the second consecutive year, with net inflows reaching $0.9 billion in 2005 A -400 continuing improvement in economic performance has given -300 banks comfort in increasing their exposure to the country -200 Official Flows -100 Net repayments to official creditors from emerging market countries are expected to reach a record high of $50 billion this year, up from $31 billion in 2004 (Chart 18) On a geographic 100 basis, the Asia/Pacific region is 2000 only one that will 2006f a the see 1996 1998 2002 2004 substantial decline in net outflows, which are projected to shrink Reserve Accumulation from nearly $9 billion in 2004Resident Lending Abroad, net1 year In to only $0.1 billion this contrast, for emerging1Europe, net lending, monetary gold, and to jump repayments are expected Including net from $9 billion last year to almost $35 billion in 2005, with Poland errors and oissions and Russia together accounting for $31 billion in outflows Despite the fact that Egypt, South Africa and Tunisia are expected to receive net inflows this year, the Africa/Middle East region in aggregate is likely to experience net outflows of $1.7 billion On the creditor side, official bilateral conditions are expected to receive net repayments of nearly $27 billion in 2005, following $14 billion last year The increase is almost entirely accounted for by the prepayment of a significant portion of Paris Club debt by Poland and Russia One-half of the countries included in our survey are projected to obtain net lending from official bilateral creditors this year, with India receiving the largest amount of net inflow at $1.5 billion In terms of international financial institutions (IFIs), the three largest recipients of financing from the International Monetary Fund—Argentina, Brazil and Turkey—are slated to make total net repayments to the IMF of $13 billion in 2005, following about $10 billion last year India and China are expected to receive $1.6 billion and $0.9 billion, respectively, from IFIs this year, far more than any other country in our survey “On the creditor side, official bilateral conditions are expected to receive net repayments of nearly $27 billion in 2005, following $14 billion last year The increase is almost entirely accounted for by the prepayment of a significant portion of Paris Club debt by Poland and Russia.” “One-half of the countries included in our survey are projected to obtain net lending from official bilateral creditors this year, with India receiving the largest amount of net inflow at $1.5 billion.” The Institute of International Finance, Inc September 24, 2005 In 2005, net repayments to official creditors from countries in emerging Europe are projected to increase to nearly $35 billion from $9 billion last year • Russia is expected to make net repayments to official creditors of $21 billion, including $17.6 billion that comprises mostly prepayments to members of the Paris Club Reflecting the country’s strong balance of payments position and large reserve holdings, the Russian government also decided to repay its remaining obligation to the IMF, totaling $3.3 billion Poland also negotiated large prepayments to the Paris Club, which for the year will reach $10 billion Capital Flows to Emerging Market Economies Page 22 “Russia is expected to make net repayments to official creditors of $21 billion, including $17.6 billion that comprises mostly prepayments to members of the Paris Club.” In 2006, net outflows from the region are projected to decline to $15 billion, with Russia accounting for nearly 85 percent of the region’s outflows as the government continues to make prepayments to the Paris Club In Latin America, repayments to official creditors are likely to rise to $14 billion this year from $10.3 billion in 2004 as Brazil’s repayments to the IMF have ratcheted up significantly • Argentina is also slated to increase its net repayments to IFIs • Colombia is expected to see a reversal from net inflows of $0.4 billion last year to net outflows of $0.9 billion in 2005 This reflects the prepayment of a $1.25 billion loan that the Inter-American Development Bank made in 2003 for the country’s Social Emergency Program Next year, Latin America is likely to experience an appreciable reduction in net outflows to official creditors as net repayments to IFIs from both Argentina and Brazil decline from this year’s record levels “Colombia is expected to see a reversal from net inflows of $0.4 billion last year to net outflows of $0.9 billion in 2005 This reflects the prepayment of a $1.25 billion loan that the Inter-American Development Bank made in 2003 for the country’s Social Emergency Program.” In the Asia/Pacific region, net repayments to official creditors are expected to decline substantially from last year’s nearly $9 billion as net outflows from Indonesia and Thailand drop sharply while at the same time a pickup in net inflows takes place in China and India • In Indonesia, the reduction in net outflows this year to only $0.9 billion from $4.0 billion last year reflects the commitment of official creditors known as the Consultative Group for Indonesia to extend in the wake of the tsunami $5.1 billion in external assistance this year in loans and grants with $1.7 billion earmarked for Aceh The reduction in net outflows from Thailand is also connected with tsunami assistance efforts • The pickup in net lending from official creditors to China this year stems from increased net disbursements from the World Bank and official bilateral creditors • In India, net lending from official creditors is projected to rise to more than $3 billion this year from $2 billion in 2004 as the government increases borrowing to fund its expanded capital investment program “In Indonesia, the reduction in net outflows this year to only $0.9 billion from $4.0 billion last year reflects the commitment of official creditors known as the Consultative Group for Indonesia to extend in the wake of the tsunami $5.1 billion in external assistance this year in loans and grants with $1.7 billion earmarked for Aceh.” The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page 23 September 24, 2005 In 2006, the Asia/Pacific region is likely to experience net inflows from official creditors for the first time in six years Resident Net Lending and International Reserve Accumulation Net lending abroad by emerging market residents is expected to increase to $88 billion in 2005 from $39 billion last year The pickup in net resident lending is concentrated in Latin America and the Asia/Pacific region In Latin America, Venezuela could see net lending abroad exceed $19 billion this year, following $6.1 billion of net outflows in 2004 The movement of private capital offshore by residents reflects several factors: an increase in nonreserve assets held abroad by the public sector, more widespread overinvoicing of imports, higher foreign exchange supply to the private sector from CADIVI, and the periodic issuance by the government of dollar-linked instruments in the domestic capital market These bonds are then sold to nonresidents and the proceeds are kept abroad In Asia, net outflows are projected to reach nearly $15 billion in 2005, following net inflows of $25 billion in 2004 China is expected to experience a drop in net inflows to $12 billion this year from $36 billion last year as speculative money flowing into the country in anticipation of further currency appreciation diminishes Despite a likely significant increase in net resident lending abroad this year, an expected increase in the aggregate current account surplus will result in reserve accumulation in 2005 that equals last year’s $400 billion (Chart 19) Reserve accumulation is projected to again reach $400 billion in 2006 • Overall, the Asia/Pacific region is expected to account for 70 percent of the total emerging market reserve accumulation this year and 78 percent in 2006 China alone will likely account for more than 80 percent of the region’s reserve accumulation of $282 billion this year and 89 percent of next year’s projected accumulation of nearly $313 billion • In Latin America, reserve accumulation is expected to be held to about $17 billion in 2005, down from more than $22 billion last year as a substantial increase in net resident lending abroad more than offsets a pickup in net private capital inflows A projected sharp reduction in the region’s aggregate current account surplus next year is expected to more than offset an acceleration in net private capital inflows This will limit reserve accumulation to about $12 billion—the smallest increase since 2002 Chart 19: International Reserves and Resident Net Lending (billions of U.S dollars) -500 -400 -300 -200 -100 100 1996 1998 2000 2002 2004 2006f Reserve Accumulation Resident Lending Abroad, net1 Including net lending, monetary gold, and errors and oissions Reserve accumulation in emerging Europe is likely to climb to a record high of nearly $73 billion this year, following an increase of $58 billion in 2004 Russia is expected to account for three-fourths of the reserve accumulation in the region as high oil prices push the current account surplus to more than percent of GDP Next year’s reserve buildup in emerging Europe is projected to be nearly $62 billion • “China is expected to experience a drop in net inflows to $12 billion this year from $36 billion last year as speculative money flowing into the country in anticipation of further currency appreciation diminishes.” “Russia is expected to account for three-fourths of the reserve accumulation in the region as high oil prices push the current account surplus to more than percent of GDP.” The Institute of International Finance, Inc Capital Flows to Emerging Market Economies Page 24 September 24, 2005 Questions or comments regarding this report may be directed to Keith Savard or Joshua Smith via telephone (202-857-3619), fax (202-775-1430), or e-mail (jsmith@iif.com) Asia/Pacific China India Indonesia Malaysia Philippines South Korea Thailand Latin America Argentina Brazil Chile Colombia Ecuador Mexico Peru Uruguay Venezuela Europe Bulgaria Czech Republic Hungary Poland Romania Russian Federation Slovakia Turkey Africa/Middle East Algeria Egypt Morocco South Africa Tunisia ... efforts were made to utilize the Principles for Stable Capital Flows and Fair Debt Restructuring in Emerging Markets in discussions with creditors Capital Flows to Emerging Market Economies Page... perspective, net private capital flows to Asia are expected to account for 42 percent of total flows to emerging markets this year, down from 52 percent in 2004 (Table 3) An increase to 46 percent is... growth prospects for key importing emerging market countries Outlook for Major Components of Capital Flows Since our last update on capital flows to emerging market economies at the end of March,