Fdi Expected Growth In 2006
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The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies Update on Capital Flows March 30, 2006 Page 1 to Emerging Market Economies March 30, 2006
Overview This brief update of our January report confirms a surge in private capital flows to emerging market economies in 2005. Indeed, the momentum has proved stronger than suggested by the data available at that time. As a result, the estimate for 2005 and the projections for this year have been revised upwards to $400 billion and $357 billion, respectively, from the January report’s figures of $358 billion and $322 billion (Table 1, Chart 1). The deceleration that is projected from last year’s record flows reflects in part the prevalence of prefinancing in 2005. Downside risks stemming from an unanticipated slowdown in global growth and potential shocks associated with continuing large global current account imbalances could reduce net private capital flows in a more substantive way. The stronger pace of net private capital flows to emerging markets continued in the first two months of this year with large amounts of both bond and equity issuance. Emerging market bond spreads continue to hover near record low levels as investors remain enthusiastic about the asset class. This is reflected in market discussion of a shortage of foreign currency denominated bonds as several major emerging market countries have announced or are already engaged in significant buybacks of outstanding bonds. Many emerging market countries have already significantly reduced the ratio of public debt to GDP and that of external debt to exports, reflecting strong output and export growth, improving fiscal balances, and improved competitiveness. In addition, for some countries, external financing requirements have become more manageable because of increased remittances from overseas workers and, for the time being, higher commodity prices.
Table 1 Emerging Market Economies' External Financing (billions of U.S. dollars) 2003 2004 2005e
2006f
Current account balance
117.0
144.1
231.9
233.3
External financing, net: Private flows, net
228.8
329.3
399.6
356.8
134.7 97.6 37.1
182.1 143.8 38.3
219.6 157.9 61.7
240.3 169.8 70.5
94.0 26.9 67.2
147.2 63.9 83.2
180.0 88.7 91.3
116.5 51.6 64.9
-20.1 -6.4 -13.8
-24.8 -16.2 -8.7
-66.8 -40.2 -26.6
-25.9 -12.5 -13.4
-57.7
-51.4 -148.5 -164.2
Equity investment, net Direct investment, net Portfolio investment, net Private creditors, net Commercial banks, net Nonbanks, net Official flows, net IFIs Bilateral creditors Resident lending/other, net1 Reserves (- = increase)
-267.9 -397.1 -416.2 -400.0
e = estimate, f = IIF forecast 1
Including net lending, monetary gold, and errors and omissions.
Chart 1: Capital Flows to Emerging Markets (billions of U.S. dollars) 400
The positive outlook for further strong capital flows to emerging markets is also supported by favorable growth prospects for industrial countries. Well-contained inflation and long-term inflationary expectations continue to provide the basis for financial market conditions that are favorable to the maintenance of forward momentum in industrialized countries’ economies. Growth in the United States in 2006 is now projected again to exceed its potential rate, albeit slightly, while growth in the Eurozone is expected to gather some traction and the recovery in Japan seems set to become more broad-based and more sustainable. After several years of outsized returns (bringing the average per annum return over the past decade to 16 percent), the sustainability of the favorable environment that has supported the emerging market debt asset class might be at more risk now. The sharply higher valuation itself might start acting as a deterrent. Adverse developments associated with a possible spike in energy prices or a sudden unwinding of global imbalances could affect global growth, interest rates, and exchange rates with negative consequences for
300
200
100
0
-100 94
95
96
97
98
Official lending
99
00
01
Private equity
02
03
04 05e 06f
Private credit
© 2006. 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
March 30, 2006 emerging markets. Moreover, risk aversion could increase as global liquidity becomes progressively tighter. In light of this, and given the underlying strains in the global economy beneath its rather benign surface at the moment, it is important for emerging market governments to pursue policies that sustain market confidence. With emerging markets in the throes of a high-profile election cycle, there is need for countries to adhere to prudent macroeconomic policies and to re-invigorate structural reforms that foster the productivity gains required to achieve higher potential growth. There will be temptation to adopt expansionary policies in the run-up to elections. Such temptation can be compounded by generally favorable market conditions. However, continued discipline is in order given that market sentiment could turn quickly.
Page 2 “Global recovery is expected to continue in 2006 at a marginally faster pace than last year, despite facing headwinds from high energy prices.”
Global Economic Environment Growth Prospects Global recovery is expected to continue in 2006 at a marginally faster pace than last year, despite facing headwinds from high energy prices (Chart 2). A benign inflation outlook, safeguarded by a withdrawal of monetary stimulus in line with the strength of economic activity, is keeping long-term interest rates markedly lower than in past cyclical experiences, contributing to the sustainability of growth. Strong balance sheets and favorable profit margins should be supportive of continued robust investment activity in many parts of the world. However, the continuation of uneven growth in industrial countries and an unsustainable policy mix, which have contributed to global current account imbalances, remain a risk going forward.
Chart 2: Industrial Countries’ Real GDP Growth (percent change from previous year) 5 4 3 2 1 0 -1 -2 00
•
The United States is likely to record again the fastest growth among major industrial economies this year, with real GDP growth of 3.4 percent. Despite strong consumer sentiment, private consumption is expected to weaken slightly as the household savings rate edges toward positive territory in a situation where sharply weaker gains in housing prices slow the accumulation of net household wealth. Consumer durable purchases are already being affected by the significant increase in short-term interest rates. However, business investment growth should remain robust amid continued healthy profits and strong balance sheets. Core inflation is expected to remain subdued. Costly energy imports and strong growth in nonenergy imports together could push the current account deficit above 6.5 percent of GDP this year.
•
Economic recovery in the Eurozone is likely to gain some momentum in 2006 as export growth strengthens in lagged response to the weakness of the euro, with output growth reaching 2.0 percent. Recent surveys of business confidence point to a firming in investment demand. Private consumption is also expected to rebound from a lower level. With the ECB recently raising its inflation forecast to 2.2 percent for mid-year
01 U.S.
02
03 Japan
04
05e
06f
Eurozone
“A benign inflation outlook, safeguarded by a withdrawal of monetary stimulus in line with the strength of economic activity, is keeping long-term interest rates markedly lower than in past cyclical experiences, contributing to the sustainability of growth.”
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006 2007, this could presage further tightening of policy interest rates before yearend. Including its possible impact on the euro, such tightening would pose a challenge in maintaining the momentum toward higher growth. •
•
Page 3 Chart 3: Emerging Market Economies’ Real GDP Growth (percent change from previous year) 8 7
Japan is likely to record positive growth for the fourth consecutive year in 2006 with real GDP growth of 2.8 percent. Core inflation (overall less fresh foods) has settled into positive territory for the first time in more that a decade. Household consumption is poised to regain some further strength as labor market conditions continue to show improvement. Business investment is expected to remain robust. An upturn in wage growth and a strengthening in employment are not likely to be marked enough to start eroding profits. Based on our growth outlook for industrialized countries, we project overall growth of emerging market economies in 2006 of 6.2 percent, unchanged from last year (Chart 3). On a regional basis, growth in emerging Asia is expected to remain above 7 percent for the fifth consecutive year. For countries of emerging Europe, the outlook is mixed across countries, with overall regional growth expected to be unchanged from 2005 at about 5 percent. In Latin America, Brazil and Mexico are expected to register stronger GDP growth this year, boosting overall regional growth to 4.2 percent, up from 4.0 percent in 2005. In the Africa/Middle East region, growth is projected to increase to over 5 percent this year (Table 2).
Downside Risks Energy Prices Although the grave concerns prevalent in the wake of the major hurricanes that struck the United States last fall have faded, the two fundamental problems relating to oil markets nevertheless persist. The first is the very narrow margin of spare capacity in crude oil and refining, while the second is a mismatch between the kinds of oil more abundantly supplied (heavy and sour) and those highly demanded (light and sweet). If either one of those problems intensifies in any appreciable way, oil prices could spike markedly with potential negative consequences for global growth, inflation and interest rates. The current lack of spare capacity is not likely to change in the near term, as non-OPEC production is at its capacity with declining yields observed in some existing fields. Moreover, many places with potential exploration opportunities are wracked either by political instability, terrorism, or policies that limit foreign investment. With the exception of Saudi Arabia, there is little leeway for OPEC countries to increase their production capacity in any significant way in the short term. In the meantime, with demand for oil remaining strong, even a moderate disruption in supply could have an appreciable impact on prices. Iran and Nigeria are clear sources of concern in that regard. The reaction to the failed attack on oil facilities in Saudi Arabia in February attests to how quickly market participants can bid up prices.
6 5 4 3 2 1 0 98
99
00
01
02
03
04
05e
Table 2 Emerging Market Economies' Output Growth (percent change from previous year) 2003 2004 2005e Real GDP Latin America Europe Africa/Middle East Asia/Pacific
06f
2006f
5.5
7.0
6.2
6.2
1.7 5.5 4.2 7.8
5.9 6.8 4.6 7.9
4.0 5.1 4.6 7.8
4.2 5.1 5.2 7.7
e = estimate, f = IIF forecast
“With the exception of Saudi Arabia, there is little leeway for OPEC countries to increase their production capacity in any significant way in the short term.”
The Institute of International Finance, Inc. March 30, 2006 The mismatch between the various kinds of oil supplied and refined and those demanded is not likely to be resolved soon. Oil companies, in general, have been slow to undertake investment to improve refining capacity with flexibility to refine various products using various kinds of crude. Such investment is expensive, requiring long-term assumptions about trends in oil prices reaching certain thresholds in order for this type of investment to make economic sense. Oil company executives have not been easily convinced of the durability of higher prices. As a consequence, the supply/demand balance remains precarious with natural disasters such as Hurricane Katrina creating significant imbalances that produce volatile price fluctuations. It should also be noted that the spare capacity of Saudi Arabia—which is estimated at between 1.0-2.0 million barrels per day—is mostly comprised of heavy and sour oil.
Capital Flows to Emerging Market Economies Page 4 “The mismatch between the various kinds of oil supplied and refined and those demanded is not likely to be resolved soon.”
To date, the impact of oil price increases for the past two years has not been very marked relative to expectations based on simulations of many kinds, all of which are based on historical experience. The reasons for this limited effect include: •
•
High oil prices this time around, unlike earlier episodes, have been triggered by unexpectedly strong demand, partly related to strong global growth rather than to a supply shock. Unlike in the past, the strong credibility of monetary authorities has alleviated the need for higher policy rates.
This year, however, a supply shock could push prices up with different consequences.
“Growing signs of a lessening of momentum in the U.S. housing market might prove to be a precursor of a considerably sharper slowing in housing price increases, with a correspondingly large impact on U.S. consumption and residential investment with implications for global growth.”
U.S. Housing Market Growing signs of a lessening of momentum in the U.S. housing market might prove to be a precursor of a considerably sharper slowing in housing price increases, with a correspondingly large impact on U.S. consumption and residential investment with implications for global growth. Although a firm trend is not yet evident, most recent data show a drop in both existing and new home sales. In addition, the inventory of new homes has risen to its highest level on record. The various data series on housing prices could be interpreted as not giving a clear-cut picture of the situation, but most series do show signs of softening. A key series on affordability for the first-time house buyer has deteriorated to levels not seen since the end of the housing boom in the late 1980s. The lack of affordability this time around stems mainly from the level of home prices as opposed to previous periods when it resulted from high interest rates. This situation has been accompanied by a decline in the average credit quality of mortgages, with regulators in the United States warning borrowers of the potential risks they are assuming while cautioning lenders to avoid making lower credit quality loans. The share of sub-prime (low quality) mortgages as a share of total mortgages rose to more than 35 percent last year from about 28 percent in 2004 and far above the average of roughly 10 percent for the period 2000-2003.
“The share of sub-prime (low quality) mortgages as a share of total mortgages rose to more than 35 percent last year from about 28 percent in 2004 and far above the average of roughly 10 percent for the period 20002003.”
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006 So far, an unusually low number of defaults have occurred, but this could change if interest rates rise further. A slowdown in housing activity would negatively impact economic growth, both directly and indirectly. It would impact directly both residential construction activity (characterized in GDP accounts as residential investment) and housing-related employment. A weak housing sector could be extremely detrimental for employment as it is estimated that 40-50 percent of the net new jobs created in the private sector during this recovery has been in housing-related industries. However, the indirect effects could have an even more severe impact on economic growth. According to one estimate, the wealth effect and the cash-outs from refinancing added nearly two full percentage points to GDP growth in 2005. Freddie Mac forecasts that cash-outs are likely to drop by almost 50 percent this year to $114 billion from a record $204 billion in 2005. This alone reduces the contribution from cash-outs to real GDP growth by about 0.4 percentage points.
Page 5
“Despite a stronger momentum of net private capital flows into the United States in the final months of last year (influenced in part by the Homeland Investment Act and interest rate differentials), a heavy reliance on official flows for the financing of the current account highlights the precariousness of the situation.”
Current Account Imbalances Large global current account imbalances persist. The continued disparity in growth prospects for the United States relative to the Eurozone and Japan implies underlying forces working toward an even further widening of the U.S. current account deficit (Chart 4). Investors have been expressing concern over the sustainability of the flows needed to finance the outsized current account deficit. Despite a stronger momentum of net private capital flows into the United States in the final months of last year (influenced in part by the Homeland Investment Act and interest rate differentials), a heavy reliance on official flows for the financing of the current account highlights the precariousness of the situation.
Chart 4: U.S. Current Account Balance (percent of GDP)
-7.5
-6.5
-5.5
-4.5
-3.5
The lack of prospects for coordinated policy action by major economies aimed at adjustment raises the possibility of a disorderly depreciation of the dollar. Such a depreciation could push up the U.S. interest rate curve well beyond the current expectations with adverse consequences for EMBIG spreads. A sharp fall in the dollar would also weaken output growth in the Eurozone and Japan while higher U.S. interest rates would dampen U.S. domestic demand growth. This would have a negative impact on the growth of emerging markets’ exports and output. Wider EMBIG spreads and weaker growth would affect the debt dynamics of those emerging market economies with high debt levels.
2000
2001
2002
2003
2004 2005e 2006f
Outlook for Major Components of Capital Flows Since our last report in January on capital flows to emerging market economies, we have revised our projections for net private flows in 2006 to $357 billion from $322 billion. This is due to our expectation for larger net inflows of direct equity and portfolio equity investment following upward revisions of these flows for 2005. At the same time, we have revised downward our forecast for
“The lack of prospects for coordinated policy action by major economies aimed at adjustment raises the possibility of a disorderly depreciation of the dollar.”
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006 net nonbank private sector lending as several major countries have decided to buy back select outstanding bonds before they reach maturity. These revisions reinforce our view that a variety of forces are at work to support a continuation of strong flows, including robust economic growth and a generally favorable balance sheet position of many emerging market countries. Nevertheless, there is a risk that the high level of flows into some emerging market assets (particularly those that are non-investment grade) has pushed up valuations that are not commensurate with underlying fundamentals. A change in investors’ expectations for a number of key factors that have supported these valuations could result in an appreciable contraction in net private capital flows to emerging markets.
Page 6 “Prospects for direct equity investment remain favorable, reflecting the broadly positive 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.”
Direct Investment Prospects for direct equity investment remain favorable, reflecting the broadly positive 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. Continued liberalization of investment rules and regulations in a number of countries should alleviate many of the remaining roadblocks faced by corporate investors as they seek new opportunities. Thus, direct investment is projected to rise to $170 billion this year from $158 billion in 2005 and represent the highest level of flows since our survey began (Chart 5). The favorable outlook for direct investment has come at a time when stronger demand in a range of industries has improved corporate profits and the availability of investible funds. In looking for investment opportunities, there seems to be an increasing tendency for companies to search for those in the largest emerging market countries as part of a strategy to service local clients or to acquire a strategic position that could become prosperous as market development takes place. Industries expected to be at the forefront of direct investment growth are computing and internet technology, public utilities, transportation- and tourism-related services, electrical products, machinery and metals, and mining and petroleum. •
On a regional basis, the only significant increase in direct investment is expected to take place in emerging Europe, where countries like Poland and Romania are likely to see an appreciable pickup in direct investment flows as foreign companies seek to solidify their positions. Russia is projected to experience a sharp positive reversal in flows this year, but the $5.6 billion in flows forecast will still fall short of those received by half the countries in the region. China will continue to receive the vast majority of direct investment in the Asia/Pacific region. The large pipeline of commitments suggests that net inflows could increase to $51 billion this year from $50 billion in 2005. This nonetheless signifies a tapering off of these flows, albeit at an overwhelmingly high level relative to other emerging market economies. In Latin
Chart 5: Net Direct Investment by Region (billions of U.S. dollars) 180
120
60
0 EME
LA 2003
A/ME 2004
Asia 2005e
Europe 2006f
“Industries expected to be at the forefront of direct investment growth are computing and internet technology, public utilities, transportation- and tourism-related services, electrical products, machinery and metals, and mining and petroleum.”
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006 America, only Mexico is expected to see any noticeable increase in net direct investment this year, accounting for about one-third of such flows to the region. In the case of Brazil, while gross inflows of foreign direct investment are rising visibly, this is being offset by direct investment of Brazilian companies in a number of other countries.
Page 7 “Total equity issuance this year is likely to exceed the $50 billion recorded in 2005, which was the highest in a decade.”
Portfolio Investment After reaching a record high of almost $62 billion in 2005, emerging market portfolio equity investment is projected to accelerate further this year to nearly $71 billion. This figure is more than $20 billion higher than the forecast in our January report as investors continue to see value in emerging market stocks. Although the price of stocks has risen substantially in a large number of emerging market countries, positive structural trends are likely to keep emerging market equities relatively attractive in the eyes of investors. These include: •
Improved domestic and external economic fundamentals with more than 50 percent of MSCI Emerging Market Index countries rated investment grade. 80
•
Sustainable growth in capital expenditures and credit flows to firms.
•
Fundamentally sound balance sheet positions of firms.
50
Total equity issuance this year is likely to exceed the $50 billion recorded in 2005, which was the highest in a decade. Issuance in the first two months of this year already reached $10 billion, with more than two-thirds of it coming from Asia. IPOs seem likely to become a bigger share of the issuance in 2006 as privatization moves forward in several countries and more state-owned companies in China list their shares overseas. •
The Asia/Pacific region is expected to account for about 60 percent of total net equity portfolio flows to emerging market countries this year (Chart 6). In China, planned overseas listings by a spate of state-owned companies and banks should help to generate $25 billion in net inflows this year, up from $21 billion in 2005. An easing in new issues from the surge of the past and a more discriminatory investor community are likely to limit net portfolio equity investment in India to $8 billion this year, following $12.5 billion in 2005.
•
In emerging Europe, net portfolio equity investment is expected to increase to more than $19 billion in 2006 from $9.2 billion last year, reflecting a sharp rise in net inflows to Russia. The surge to Russia stems from the planned IPO of a minority stake in Rosneft and the removal of restrictions on foreign purchases of Gazprom shares traded domestically.
•
Chart 6: Net Portfolio Investment by Region (billions of U.S. dollars)
In Latin America, net inflows of portfolio equity investment in 2006 are projected to be cut in half from last year’s $5.5 billion
20
-10 EME 2003
LA
A/ME 2004
Asia 2005e
Europe 2006f
“IPOs seem likely to become a bigger share of the issuance in 2006 as privatization moves forward in several countries and more state-owned companies in China list their shares overseas.”
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006
Page 8
Emerging Europe
Asia/Pacific
Even though a record level of net equity investment is expected in 2006, a significant decline in net commercial bank lending should lead to an easing in overall net private capital flows from last year’s all-time high to $157 billion this year.
After approaching $170 billion in 2004, net private capital flows slipped some last year and are expected to edge slightly lower again in 2006. With a slowdown in net commercial bank lending not quite offset by a pickup in portfolio equity investment flows, net private capital flows to emerging Asia are projected to be $143 billion this year, about $4 billion less than last year.
•
•
•
While the growth outlook for the countries of emerging Europe appears mixed this year, real GDP growth for the region is expected to be 5.1 percent in 2006. This is the same as last year but well below the rapid pace seen in 2004. Both direct equity investment and portfolio investment are expected to reach record levels this year. Direct equity flows are spread relatively evenly throughout the region, with five of the eight countries in emerging Europe expected to receive at least $5 billion in net direct investment flows in 2006. Meanwhile, portfolio equity flows are projected to reach in excess of $19 billion, well above an average level of net flows of less than $3 billion in the 2000-2005 period. Even with the current account projected to decline to near balance, reserve accumulation is projected to reach $84 billion in 2006, second only to last year’s record level of reserve accumulation. As a result, the stock of reserves in the region is projected to exceed $460 billion this year, providing over 6½ months of import cover.
Table 3 Europe: External Financing (billions of U.S. dollars)
•
At 7.7 percent, projected growth in emerging Asia in 2006 should surpass 7 percent for the fifth consecutive year, and make emerging Asia the fastest growing region for the eighth straight year. While slowing somewhat from its 2005 pace, China is expected to be the fastest growing economy in our survey in 2006.
•
Direct equity investment remains the most significant segment of capital flows to the region, with China expected to receive nearly 80 percent of such flows in 2006. Nonetheless, a small downturn in net direct equity flows to China this year and last from the record level in 2004 might signal a leveling off of the trend.
•
Buoyed by a widening trade surplus, the aggregate current account surplus in 2006 is expected to be 3.8 percent of GDP for the second consecutive year. Reserve accumulation is projected to be $274 billion this year, bringing the region’s stock of reserves to over $1.6 trillion—about 3.5 times greater than just five years ago.
Table 4 Asia/Pacific: External Financing (billions of U.S. dollars)
2003
2004 2005e
2006f
2003
2004 2005e
2006f
99.2
117.9
170.6
196.8
Current account balance
-1.6
-1.4
19.4
6.7
External financing, net: Private flows, net
68.1
121.0
172.7
157.2
124.4
168.6
147.7
143.4
8.9 7.0 1.9
34.7 29.9 4.8
45.8 36.6 9.2
67.8 48.6 19.2
Equity investment, net Direct investment, net Portfolio investment, net
92.9 55.9 37.0
97.7 65.3 32.5
103.0 64.0 39.0
105.8 64.2 41.6
59.2 26.2 33.0
86.3 39.6 46.7
126.9 67.0 59.9
89.4 34.9 54.5
Private creditors, net Commercial banks, net Nonbanks, net
31.5 15.5 15.9
70.9 37.0 33.9
44.7 21.4 23.2
37.6 15.3 22.3
-3.7 -0.1 -3.6
-9.0 -3.2 -5.8
-35.2 -9.1 -26.1
-18.6 -3.8 -14.8
Official flows, net IFIs Bilateral creditors
-15.3 -10.0 -5.3
-4.8 -4.6 -0.2
1.5 -2.0 3.5
1.2 -0.3 1.5
Resident lending/other, net1
-26.7
-52.2
-53.3
-61.2
Resident lending/other, net1
-22.9
15.9
-59.2
-67.5
Reserves (- = increase)
-36.1
-58.4 -103.5
-84.2
Reserves (- = increase)
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
e = estimate, f = IIF forecast
e = estimate, f = IIF forecast
1
1
Including net lending, monetary gold, and errors and omissions.
-185.4 -297.5 -260.6 -273.8
Including net lending, monetary gold, and errors and omissions.
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006
Page 9
Latin America
Africa/Middle East
Net private capital flows to Latin America in 2006 are expected to decline to about $28 billion—some $22 billion less than last year. A significant reversal in nonbank creditor flows accounts for over 80 percent of the decline, with net equity flows only slightly lower compared to 2005.
Net private capital flows to the region are expected to be nearly $29 billion in 2006, only slightly off last year’s record pace. Behind strength in equity flows—including a likely record level of direct equity flows in 2006—net private flows this year and last are more than the sum of net flows in the preceding seven years.
•
Growth in Latin America is projected to be 4.2 percent in 2006, well above the region’s average growth rate over the past decade. While only Brazil and Mexico are expected to register improved growth in 2006, of the remaining countries in the region, only Ecuador is projected see growth below 4 percent this year.
•
With a number of debt buyback programs planned, net nonbank creditor flows are expected to shift from an inflow of $4 billion in 2005 to a net outflow of nearly $15 billion this year. Brazil alone is expected to see a net nonbank outflow of more than $13 billion, with Mexico and Venezuela together accounting for almost an additional $7 billion in outflows.
•
Behind a weakening trade surplus, the region’s current account surplus is expected to decline to less than 1 percent of GDP in 2006. With a smaller current account surplus and lower net capital inflows, reserve accumulation should fall to about $12 billion this year— leading to a decline in the region’s stock of reserves (in terms of import cover) for the third consecutive year.
Table 5 Latin America: External Financing (billions of U.S. dollars)
Regional growth is projected to increase to 5.2 percent in 2006, the fastest growth rate since 1996. Growth rates should improve, compared to 2005, in every country in the region this year, with Morocco expected to see a significant improvement after a poor agricultural outturn last year.
•
Following a record level of net equity investment in 2005, the region should experience a slight decline this year. With the exception of South Africa, all countries in the region should see a pickup in direct equity investment in 2006. Net private creditor flows are projected to be little changed, as an increase in commercial bank lending to Egypt should help offset a decline in net creditor flows to South Africa.
•
With support from the terms of trade, the region’s current account surplus is expected to increase to about 2 percent of GDP in 2006. Reserve accumulation is projected to reach $30 billion this year, pushing the region’s stock of reserves to a record high (in both import cover and nominal terms).
Table 6 Africa/Middle East: External Financing (billions of U.S. dollars) 2003
2003
2004 2005e
Current account balance
11.9
21.7
34.7
18.6
Current account balance
7.4
6.0
7.2
11.2
External financing, net: Private flows, net
31.1
29.1
50.1
27.7
External financing, net: Private flows, net
5.2
10.6
29.1
28.5
27.9 30.3 -2.3
39.5 44.9 -5.3
46.7 41.2 5.5
43.3 40.5 2.7
4.9 4.5 0.5
10.1 3.7 6.4
24.1 16.1 8.0
23.5 16.5 7.0
3.2 -12.7 15.8
-10.5 -13.5 3.0
3.4 -0.7 4.1
-15.6 -0.9 -14.7
0.2 -2.2 2.4
0.5 0.9 -0.4
5.0 1.0 4.0
5.0 2.4 2.7
Official flows, net IFIs Bilateral creditors
0.2 4.8 -4.6
-8.0 -7.1 -0.9
-30.1 -28.8 -1.3
-8.5 -9.3 0.8
-1.4 -1.1 -0.2
-3.1 -1.3 -1.8
-3.0 -0.3 -2.7
0.1 0.9 -0.9
Resident lending/other, net1
-9.8
-20.3
-28.1
-26.1
Resident lending/other, net1
1.8
5.2
-7.9
-9.4
-33.4
-22.5
-26.7
-11.6
Reserves (- = increase)
-13.0
-18.7
-25.4
-30.4
Equity investment, net Direct investment, net Portfolio investment, net Private creditors, net Commercial banks, net Nonbanks, net
Reserves (- = increase)
2006f
•
Equity investment, net Direct investment, net Portfolio investment, net Private creditors, net Commercial banks, net Nonbanks, net Official flows, net IFIs Bilateral creditors
e = estimate, f = IIF forecast
e = estimate, f = IIF forecast
1
1
Including net lending, monetary gold, and errors and omissions.
2004 2005e
Including net lending, monetary gold, and errors and omissions.
2006f
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006
Page 10
with marked reductions in Colombia and Mexico. A substantial portion of the net inflows will go to Brazil. Nonbank Private Sector Lending After exceeding $91 billion last year, net nonbank private sector lending, mostly in the form of bond purchases, is expected to decrease in 2006 to about $65 billion (Chart 7). Despite continued strong bond issuance in the first two months of this year, gross issuance for the full year is likely to fall below the more than $127 billion recorded in 2005, as front-loading by sovereign and corporate borrowers has taken place in anticipation of higher global interest rates. According to one estimate, emerging market sovereigns by the end of February had already completed nearly 50 percent of planned issuance for this year. In addition, a number of important emerging market countries, including Brazil, Colombia, Ecuador, Mexico, Peru, and Turkey, have stated that they will undertake buybacks of external debt in 2006, which will further reduce net nonbank lending. The trend in recent years toward higher credit ratings of emerging market issuers has been supportive of a significant compression in spreads since the latter part of 2002 to recent record lows. However, the limited dispersion of bond spreads across countries, with different credit ratings, included in the EMBIG index suggests that investors are not discriminating sufficiently among borrowers. Indeed, sovereign spreads this year are clustered more closely together than ever before. The higher overall credit quality of emerging market debt and risk-adjusted returns of the asset class have attracted a broader investor base to absorb the explosion of bond issuance since 2003. The supply of bonds coming on stream this year should be absorbed as they remain a diversification play for institutional and crossover investors given the relatively low correlation with other asset classes. A broadening of the investor base has had a significant impact on emerging market bonds and, according to one study, has accounted for almost one-fourth of the spread compression in these bonds in the past two years.
Chart 7: Net Nonbank Lending by Region (billions of U.S. dollars) 100 80 60 40 20 0 EME
LA 2003
A/ME 2004
Asia 2005e
Europe 2006f
“The higher overall credit quality of emerging market debt and risk-adjusted returns of the asset class have attracted a broader investor base to absorb the explosion of bond issuance since 2003.”
The broadening of the investor base has given borrowers more leeway to issue in different currencies and to increase the share of financing from domestic resources as part of a more active assetliability management process. Stepped-up efforts have been made to issue global bonds denominated in local currencies in international capital markets. For U.S. dollar-based investors, gains on local currency emerging market debt instruments have been enhanced by exchange rate movements. Emerging market currencies appreciated by more than 2 percent against the U.S. dollar in the first two months of 2006. •
Emerging Europe is projected to account for roughly two-thirds of nonbank private creditor flows to emerging markets this year. Net nonbank flows to Turkey will likely fall moderately below last year’s $17 billion, but nonetheless remain the highest in the region. Net nonbank lending to the Asia/Pacific
“Stepped-up efforts have been made to issue global bonds denominated in local currencies in international capital markets. For U.S. dollar-based investors, gains on local currency emerging market debt instruments have been enhanced by exchange rate movements.”
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006 region is expected to decrease for the second consecutive year, with all countries except India and Malaysia likely to experience a reduction in net inflows. •
Page 11 “Net commercial bank lending is projected at about $52 billion in 2006, the fourth consecutive year of positive flows.”
In Latin America, Brazil is projected to see a net outflow to nonbank creditors of more than $13 billion this year, after net inflows of nearly $2 billion in 2005 as the government has decided to pay down its external debt obligations. Mexico and Venezuela are also expected to register net outflows as part of liability management operations. In Africa/Middle East, South Africa is likely to account for the bulk of net nonbank lending to the region.
Commercial Bank Lending Net commercial bank lending is projected at about $52 billion in 2006, the fourth consecutive year of positive flows. Albeit down from nearly $89 billion in 2005, the level projected for this year represents a sizable sum in light of the $132 billion cumulative net outflow during 1998-2002. Loan pricing on balance is likely to remain competitive with other sources of financing. •
•
Chart 8: Net Commercial Bank Lending by Region (billions of U.S. dollars) 90
60
Net commercial bank lending to emerging Europe is forecast to decline to about $35 billion this year from $67 billion in 2005 (Chart 8). The bulk of the falloff in net lending will take place in Russia, where a large repayment of funds used to finance the purchase by Rosneft of a stake in Gazprom and the latter’s acquisition of Sibneft is scheduled to take place. Net lending to the Asia/Pacific region is expected to decline to about $15 billion this year from more than $21 billion in 2005. China will remain one of the largest recipients in the region, but net inflows will continue to be affected by administrative measures taken by the authorities to impose quotas on banks’ overseas borrowing. Latin America is the only region likely to experience net outflows to commercial banks this year. Although total net outflows are projected to be less than $1 billion, this would nevertheless be the sixth consecutive year of net repayments, with Brazil and Mexico accounting for nearly all of the net outflows. Net commercial bank lending to Africa/Middle East could exceed $2.3 billion this year, representing the highest level of net inflows since 1997, as Egypt is expected to experience a sharp positive reversal in flows.
xxxxxxxxxxxxxxxxxxxx 30
0
-30 EME
LA 2003
A/ME 2004
Asia 2005e
Europe 2006f
Chart 9: Net Official Lending by Region (billions of U.S. dollars) 10 0
Official Flows
-10 -20
After reaching a record high of $67 billion in 2005, net repayments to official creditors from emerging market countries are expected to drop to $26 billion this year (Chart 9). In terms of the breakdown in flows by creditor group, official bilateral creditors are projected to see net repayments of $13.4 billion in 2006, down sharply from nearly $27 billion last year, when countries like Poland and Russia made prepayments of a significant portion of their Paris Club debt. For the second consecutive year, Russia will make the
-30 -40 -50 -60 -70 EME
LA 2003
A/ME 2004
Asia 2005e
Europe 2006f
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006
Page 12
largest amount of net repayments to official bilateral creditors, amounting to $11.5 billion in 2006. The next largest repayment of $2.6 billion is expected to come from Poland. International financial institutions (IFIs) as a creditor group are likely to receive net repayments this year of $12.5 billion, with Argentina accounting for more than one-half of all net repayments. Turkey is expected to make large net repayments for the second consecutive year totaling more than $4.5 billion. China, India and Egypt are projected to obtain the largest net inflows from IFIs in 2006.
“Even with the slowdown in reserve accumulation, the stock of emerging market reserves will edge up to eight months of imports of goods, services, and interest payments.”
Resident Net Lending and International Reserve Accumulation Net lending abroad by emerging market residents is expected to increase to $164 billion in 2006 from $149 billion last year. As regards reserve accumulation, despite a sharp reduction in net repayments to official creditors, the combination of smaller net private capital inflows and larger net resident lending abroad will result in a reduction in the pace of buildup to $400 billion, down from a record high of $416 billion last year (Chart 10). Even with the slowdown in reserve accumulation, the stock of emerging market reserves will edge up to eight months of imports of goods, services, and interest payments. •
On a regional basis, the Asia/Pacific region as a whole is expected to account for 70 percent of total emerging market reserve accumulation this year. Reserve accumulation in emerging Europe is likely to slow down to $84 billion this year after reaching a record high of nearly $104 billion in 2005. In the Africa/Middle East region, reserve accumulation is projected to climb to a record high $30 billion in 2006, following an increase of $25 billion last year. High energy prices in hydrocarbon-based economies like Algeria, which have pushed up its current account surplus to nearly 20 percent of GDP, are the principal factor in the sharp run-up in reserves since 2004.
Chart 10: International Reserves and Resident Net Lending (billions of U.S. dollars) -500 -400 -300 -200 -100 0 100 1996
1998
2000
2002
Reserve Accumulation Resident Lending Abroad, net1 1
Including net lending, monetary gold and errors and omissions.
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 ([email protected]).
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
2004
Africa/Middle East Algeria Egypt Morocco South Africa Tunisia
2006f
Overview This brief update of our January report confirms a surge in private capital flows to emerging market economies in 2005. Indeed, the momentum has proved stronger than suggested by the data available at that time. As a result, the estimate for 2005 and the projections for this year have been revised upwards to $400 billion and $357 billion, respectively, from the January report’s figures of $358 billion and $322 billion (Table 1, Chart 1). The deceleration that is projected from last year’s record flows reflects in part the prevalence of prefinancing in 2005. Downside risks stemming from an unanticipated slowdown in global growth and potential shocks associated with continuing large global current account imbalances could reduce net private capital flows in a more substantive way. The stronger pace of net private capital flows to emerging markets continued in the first two months of this year with large amounts of both bond and equity issuance. Emerging market bond spreads continue to hover near record low levels as investors remain enthusiastic about the asset class. This is reflected in market discussion of a shortage of foreign currency denominated bonds as several major emerging market countries have announced or are already engaged in significant buybacks of outstanding bonds. Many emerging market countries have already significantly reduced the ratio of public debt to GDP and that of external debt to exports, reflecting strong output and export growth, improving fiscal balances, and improved competitiveness. In addition, for some countries, external financing requirements have become more manageable because of increased remittances from overseas workers and, for the time being, higher commodity prices.
Table 1 Emerging Market Economies' External Financing (billions of U.S. dollars) 2003 2004 2005e
2006f
Current account balance
117.0
144.1
231.9
233.3
External financing, net: Private flows, net
228.8
329.3
399.6
356.8
134.7 97.6 37.1
182.1 143.8 38.3
219.6 157.9 61.7
240.3 169.8 70.5
94.0 26.9 67.2
147.2 63.9 83.2
180.0 88.7 91.3
116.5 51.6 64.9
-20.1 -6.4 -13.8
-24.8 -16.2 -8.7
-66.8 -40.2 -26.6
-25.9 -12.5 -13.4
-57.7
-51.4 -148.5 -164.2
Equity investment, net Direct investment, net Portfolio investment, net Private creditors, net Commercial banks, net Nonbanks, net Official flows, net IFIs Bilateral creditors Resident lending/other, net1 Reserves (- = increase)
-267.9 -397.1 -416.2 -400.0
e = estimate, f = IIF forecast 1
Including net lending, monetary gold, and errors and omissions.
Chart 1: Capital Flows to Emerging Markets (billions of U.S. dollars) 400
The positive outlook for further strong capital flows to emerging markets is also supported by favorable growth prospects for industrial countries. Well-contained inflation and long-term inflationary expectations continue to provide the basis for financial market conditions that are favorable to the maintenance of forward momentum in industrialized countries’ economies. Growth in the United States in 2006 is now projected again to exceed its potential rate, albeit slightly, while growth in the Eurozone is expected to gather some traction and the recovery in Japan seems set to become more broad-based and more sustainable. After several years of outsized returns (bringing the average per annum return over the past decade to 16 percent), the sustainability of the favorable environment that has supported the emerging market debt asset class might be at more risk now. The sharply higher valuation itself might start acting as a deterrent. Adverse developments associated with a possible spike in energy prices or a sudden unwinding of global imbalances could affect global growth, interest rates, and exchange rates with negative consequences for
300
200
100
0
-100 94
95
96
97
98
Official lending
99
00
01
Private equity
02
03
04 05e 06f
Private credit
© 2006. 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
March 30, 2006 emerging markets. Moreover, risk aversion could increase as global liquidity becomes progressively tighter. In light of this, and given the underlying strains in the global economy beneath its rather benign surface at the moment, it is important for emerging market governments to pursue policies that sustain market confidence. With emerging markets in the throes of a high-profile election cycle, there is need for countries to adhere to prudent macroeconomic policies and to re-invigorate structural reforms that foster the productivity gains required to achieve higher potential growth. There will be temptation to adopt expansionary policies in the run-up to elections. Such temptation can be compounded by generally favorable market conditions. However, continued discipline is in order given that market sentiment could turn quickly.
Page 2 “Global recovery is expected to continue in 2006 at a marginally faster pace than last year, despite facing headwinds from high energy prices.”
Global Economic Environment Growth Prospects Global recovery is expected to continue in 2006 at a marginally faster pace than last year, despite facing headwinds from high energy prices (Chart 2). A benign inflation outlook, safeguarded by a withdrawal of monetary stimulus in line with the strength of economic activity, is keeping long-term interest rates markedly lower than in past cyclical experiences, contributing to the sustainability of growth. Strong balance sheets and favorable profit margins should be supportive of continued robust investment activity in many parts of the world. However, the continuation of uneven growth in industrial countries and an unsustainable policy mix, which have contributed to global current account imbalances, remain a risk going forward.
Chart 2: Industrial Countries’ Real GDP Growth (percent change from previous year) 5 4 3 2 1 0 -1 -2 00
•
The United States is likely to record again the fastest growth among major industrial economies this year, with real GDP growth of 3.4 percent. Despite strong consumer sentiment, private consumption is expected to weaken slightly as the household savings rate edges toward positive territory in a situation where sharply weaker gains in housing prices slow the accumulation of net household wealth. Consumer durable purchases are already being affected by the significant increase in short-term interest rates. However, business investment growth should remain robust amid continued healthy profits and strong balance sheets. Core inflation is expected to remain subdued. Costly energy imports and strong growth in nonenergy imports together could push the current account deficit above 6.5 percent of GDP this year.
•
Economic recovery in the Eurozone is likely to gain some momentum in 2006 as export growth strengthens in lagged response to the weakness of the euro, with output growth reaching 2.0 percent. Recent surveys of business confidence point to a firming in investment demand. Private consumption is also expected to rebound from a lower level. With the ECB recently raising its inflation forecast to 2.2 percent for mid-year
01 U.S.
02
03 Japan
04
05e
06f
Eurozone
“A benign inflation outlook, safeguarded by a withdrawal of monetary stimulus in line with the strength of economic activity, is keeping long-term interest rates markedly lower than in past cyclical experiences, contributing to the sustainability of growth.”
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006 2007, this could presage further tightening of policy interest rates before yearend. Including its possible impact on the euro, such tightening would pose a challenge in maintaining the momentum toward higher growth. •
•
Page 3 Chart 3: Emerging Market Economies’ Real GDP Growth (percent change from previous year) 8 7
Japan is likely to record positive growth for the fourth consecutive year in 2006 with real GDP growth of 2.8 percent. Core inflation (overall less fresh foods) has settled into positive territory for the first time in more that a decade. Household consumption is poised to regain some further strength as labor market conditions continue to show improvement. Business investment is expected to remain robust. An upturn in wage growth and a strengthening in employment are not likely to be marked enough to start eroding profits. Based on our growth outlook for industrialized countries, we project overall growth of emerging market economies in 2006 of 6.2 percent, unchanged from last year (Chart 3). On a regional basis, growth in emerging Asia is expected to remain above 7 percent for the fifth consecutive year. For countries of emerging Europe, the outlook is mixed across countries, with overall regional growth expected to be unchanged from 2005 at about 5 percent. In Latin America, Brazil and Mexico are expected to register stronger GDP growth this year, boosting overall regional growth to 4.2 percent, up from 4.0 percent in 2005. In the Africa/Middle East region, growth is projected to increase to over 5 percent this year (Table 2).
Downside Risks Energy Prices Although the grave concerns prevalent in the wake of the major hurricanes that struck the United States last fall have faded, the two fundamental problems relating to oil markets nevertheless persist. The first is the very narrow margin of spare capacity in crude oil and refining, while the second is a mismatch between the kinds of oil more abundantly supplied (heavy and sour) and those highly demanded (light and sweet). If either one of those problems intensifies in any appreciable way, oil prices could spike markedly with potential negative consequences for global growth, inflation and interest rates. The current lack of spare capacity is not likely to change in the near term, as non-OPEC production is at its capacity with declining yields observed in some existing fields. Moreover, many places with potential exploration opportunities are wracked either by political instability, terrorism, or policies that limit foreign investment. With the exception of Saudi Arabia, there is little leeway for OPEC countries to increase their production capacity in any significant way in the short term. In the meantime, with demand for oil remaining strong, even a moderate disruption in supply could have an appreciable impact on prices. Iran and Nigeria are clear sources of concern in that regard. The reaction to the failed attack on oil facilities in Saudi Arabia in February attests to how quickly market participants can bid up prices.
6 5 4 3 2 1 0 98
99
00
01
02
03
04
05e
Table 2 Emerging Market Economies' Output Growth (percent change from previous year) 2003 2004 2005e Real GDP Latin America Europe Africa/Middle East Asia/Pacific
06f
2006f
5.5
7.0
6.2
6.2
1.7 5.5 4.2 7.8
5.9 6.8 4.6 7.9
4.0 5.1 4.6 7.8
4.2 5.1 5.2 7.7
e = estimate, f = IIF forecast
“With the exception of Saudi Arabia, there is little leeway for OPEC countries to increase their production capacity in any significant way in the short term.”
The Institute of International Finance, Inc. March 30, 2006 The mismatch between the various kinds of oil supplied and refined and those demanded is not likely to be resolved soon. Oil companies, in general, have been slow to undertake investment to improve refining capacity with flexibility to refine various products using various kinds of crude. Such investment is expensive, requiring long-term assumptions about trends in oil prices reaching certain thresholds in order for this type of investment to make economic sense. Oil company executives have not been easily convinced of the durability of higher prices. As a consequence, the supply/demand balance remains precarious with natural disasters such as Hurricane Katrina creating significant imbalances that produce volatile price fluctuations. It should also be noted that the spare capacity of Saudi Arabia—which is estimated at between 1.0-2.0 million barrels per day—is mostly comprised of heavy and sour oil.
Capital Flows to Emerging Market Economies Page 4 “The mismatch between the various kinds of oil supplied and refined and those demanded is not likely to be resolved soon.”
To date, the impact of oil price increases for the past two years has not been very marked relative to expectations based on simulations of many kinds, all of which are based on historical experience. The reasons for this limited effect include: •
•
High oil prices this time around, unlike earlier episodes, have been triggered by unexpectedly strong demand, partly related to strong global growth rather than to a supply shock. Unlike in the past, the strong credibility of monetary authorities has alleviated the need for higher policy rates.
This year, however, a supply shock could push prices up with different consequences.
“Growing signs of a lessening of momentum in the U.S. housing market might prove to be a precursor of a considerably sharper slowing in housing price increases, with a correspondingly large impact on U.S. consumption and residential investment with implications for global growth.”
U.S. Housing Market Growing signs of a lessening of momentum in the U.S. housing market might prove to be a precursor of a considerably sharper slowing in housing price increases, with a correspondingly large impact on U.S. consumption and residential investment with implications for global growth. Although a firm trend is not yet evident, most recent data show a drop in both existing and new home sales. In addition, the inventory of new homes has risen to its highest level on record. The various data series on housing prices could be interpreted as not giving a clear-cut picture of the situation, but most series do show signs of softening. A key series on affordability for the first-time house buyer has deteriorated to levels not seen since the end of the housing boom in the late 1980s. The lack of affordability this time around stems mainly from the level of home prices as opposed to previous periods when it resulted from high interest rates. This situation has been accompanied by a decline in the average credit quality of mortgages, with regulators in the United States warning borrowers of the potential risks they are assuming while cautioning lenders to avoid making lower credit quality loans. The share of sub-prime (low quality) mortgages as a share of total mortgages rose to more than 35 percent last year from about 28 percent in 2004 and far above the average of roughly 10 percent for the period 2000-2003.
“The share of sub-prime (low quality) mortgages as a share of total mortgages rose to more than 35 percent last year from about 28 percent in 2004 and far above the average of roughly 10 percent for the period 20002003.”
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006 So far, an unusually low number of defaults have occurred, but this could change if interest rates rise further. A slowdown in housing activity would negatively impact economic growth, both directly and indirectly. It would impact directly both residential construction activity (characterized in GDP accounts as residential investment) and housing-related employment. A weak housing sector could be extremely detrimental for employment as it is estimated that 40-50 percent of the net new jobs created in the private sector during this recovery has been in housing-related industries. However, the indirect effects could have an even more severe impact on economic growth. According to one estimate, the wealth effect and the cash-outs from refinancing added nearly two full percentage points to GDP growth in 2005. Freddie Mac forecasts that cash-outs are likely to drop by almost 50 percent this year to $114 billion from a record $204 billion in 2005. This alone reduces the contribution from cash-outs to real GDP growth by about 0.4 percentage points.
Page 5
“Despite a stronger momentum of net private capital flows into the United States in the final months of last year (influenced in part by the Homeland Investment Act and interest rate differentials), a heavy reliance on official flows for the financing of the current account highlights the precariousness of the situation.”
Current Account Imbalances Large global current account imbalances persist. The continued disparity in growth prospects for the United States relative to the Eurozone and Japan implies underlying forces working toward an even further widening of the U.S. current account deficit (Chart 4). Investors have been expressing concern over the sustainability of the flows needed to finance the outsized current account deficit. Despite a stronger momentum of net private capital flows into the United States in the final months of last year (influenced in part by the Homeland Investment Act and interest rate differentials), a heavy reliance on official flows for the financing of the current account highlights the precariousness of the situation.
Chart 4: U.S. Current Account Balance (percent of GDP)
-7.5
-6.5
-5.5
-4.5
-3.5
The lack of prospects for coordinated policy action by major economies aimed at adjustment raises the possibility of a disorderly depreciation of the dollar. Such a depreciation could push up the U.S. interest rate curve well beyond the current expectations with adverse consequences for EMBIG spreads. A sharp fall in the dollar would also weaken output growth in the Eurozone and Japan while higher U.S. interest rates would dampen U.S. domestic demand growth. This would have a negative impact on the growth of emerging markets’ exports and output. Wider EMBIG spreads and weaker growth would affect the debt dynamics of those emerging market economies with high debt levels.
2000
2001
2002
2003
2004 2005e 2006f
Outlook for Major Components of Capital Flows Since our last report in January on capital flows to emerging market economies, we have revised our projections for net private flows in 2006 to $357 billion from $322 billion. This is due to our expectation for larger net inflows of direct equity and portfolio equity investment following upward revisions of these flows for 2005. At the same time, we have revised downward our forecast for
“The lack of prospects for coordinated policy action by major economies aimed at adjustment raises the possibility of a disorderly depreciation of the dollar.”
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006 net nonbank private sector lending as several major countries have decided to buy back select outstanding bonds before they reach maturity. These revisions reinforce our view that a variety of forces are at work to support a continuation of strong flows, including robust economic growth and a generally favorable balance sheet position of many emerging market countries. Nevertheless, there is a risk that the high level of flows into some emerging market assets (particularly those that are non-investment grade) has pushed up valuations that are not commensurate with underlying fundamentals. A change in investors’ expectations for a number of key factors that have supported these valuations could result in an appreciable contraction in net private capital flows to emerging markets.
Page 6 “Prospects for direct equity investment remain favorable, reflecting the broadly positive 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.”
Direct Investment Prospects for direct equity investment remain favorable, reflecting the broadly positive 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. Continued liberalization of investment rules and regulations in a number of countries should alleviate many of the remaining roadblocks faced by corporate investors as they seek new opportunities. Thus, direct investment is projected to rise to $170 billion this year from $158 billion in 2005 and represent the highest level of flows since our survey began (Chart 5). The favorable outlook for direct investment has come at a time when stronger demand in a range of industries has improved corporate profits and the availability of investible funds. In looking for investment opportunities, there seems to be an increasing tendency for companies to search for those in the largest emerging market countries as part of a strategy to service local clients or to acquire a strategic position that could become prosperous as market development takes place. Industries expected to be at the forefront of direct investment growth are computing and internet technology, public utilities, transportation- and tourism-related services, electrical products, machinery and metals, and mining and petroleum. •
On a regional basis, the only significant increase in direct investment is expected to take place in emerging Europe, where countries like Poland and Romania are likely to see an appreciable pickup in direct investment flows as foreign companies seek to solidify their positions. Russia is projected to experience a sharp positive reversal in flows this year, but the $5.6 billion in flows forecast will still fall short of those received by half the countries in the region. China will continue to receive the vast majority of direct investment in the Asia/Pacific region. The large pipeline of commitments suggests that net inflows could increase to $51 billion this year from $50 billion in 2005. This nonetheless signifies a tapering off of these flows, albeit at an overwhelmingly high level relative to other emerging market economies. In Latin
Chart 5: Net Direct Investment by Region (billions of U.S. dollars) 180
120
60
0 EME
LA 2003
A/ME 2004
Asia 2005e
Europe 2006f
“Industries expected to be at the forefront of direct investment growth are computing and internet technology, public utilities, transportation- and tourism-related services, electrical products, machinery and metals, and mining and petroleum.”
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006 America, only Mexico is expected to see any noticeable increase in net direct investment this year, accounting for about one-third of such flows to the region. In the case of Brazil, while gross inflows of foreign direct investment are rising visibly, this is being offset by direct investment of Brazilian companies in a number of other countries.
Page 7 “Total equity issuance this year is likely to exceed the $50 billion recorded in 2005, which was the highest in a decade.”
Portfolio Investment After reaching a record high of almost $62 billion in 2005, emerging market portfolio equity investment is projected to accelerate further this year to nearly $71 billion. This figure is more than $20 billion higher than the forecast in our January report as investors continue to see value in emerging market stocks. Although the price of stocks has risen substantially in a large number of emerging market countries, positive structural trends are likely to keep emerging market equities relatively attractive in the eyes of investors. These include: •
Improved domestic and external economic fundamentals with more than 50 percent of MSCI Emerging Market Index countries rated investment grade. 80
•
Sustainable growth in capital expenditures and credit flows to firms.
•
Fundamentally sound balance sheet positions of firms.
50
Total equity issuance this year is likely to exceed the $50 billion recorded in 2005, which was the highest in a decade. Issuance in the first two months of this year already reached $10 billion, with more than two-thirds of it coming from Asia. IPOs seem likely to become a bigger share of the issuance in 2006 as privatization moves forward in several countries and more state-owned companies in China list their shares overseas. •
The Asia/Pacific region is expected to account for about 60 percent of total net equity portfolio flows to emerging market countries this year (Chart 6). In China, planned overseas listings by a spate of state-owned companies and banks should help to generate $25 billion in net inflows this year, up from $21 billion in 2005. An easing in new issues from the surge of the past and a more discriminatory investor community are likely to limit net portfolio equity investment in India to $8 billion this year, following $12.5 billion in 2005.
•
In emerging Europe, net portfolio equity investment is expected to increase to more than $19 billion in 2006 from $9.2 billion last year, reflecting a sharp rise in net inflows to Russia. The surge to Russia stems from the planned IPO of a minority stake in Rosneft and the removal of restrictions on foreign purchases of Gazprom shares traded domestically.
•
Chart 6: Net Portfolio Investment by Region (billions of U.S. dollars)
In Latin America, net inflows of portfolio equity investment in 2006 are projected to be cut in half from last year’s $5.5 billion
20
-10 EME 2003
LA
A/ME 2004
Asia 2005e
Europe 2006f
“IPOs seem likely to become a bigger share of the issuance in 2006 as privatization moves forward in several countries and more state-owned companies in China list their shares overseas.”
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006
Page 8
Emerging Europe
Asia/Pacific
Even though a record level of net equity investment is expected in 2006, a significant decline in net commercial bank lending should lead to an easing in overall net private capital flows from last year’s all-time high to $157 billion this year.
After approaching $170 billion in 2004, net private capital flows slipped some last year and are expected to edge slightly lower again in 2006. With a slowdown in net commercial bank lending not quite offset by a pickup in portfolio equity investment flows, net private capital flows to emerging Asia are projected to be $143 billion this year, about $4 billion less than last year.
•
•
•
While the growth outlook for the countries of emerging Europe appears mixed this year, real GDP growth for the region is expected to be 5.1 percent in 2006. This is the same as last year but well below the rapid pace seen in 2004. Both direct equity investment and portfolio investment are expected to reach record levels this year. Direct equity flows are spread relatively evenly throughout the region, with five of the eight countries in emerging Europe expected to receive at least $5 billion in net direct investment flows in 2006. Meanwhile, portfolio equity flows are projected to reach in excess of $19 billion, well above an average level of net flows of less than $3 billion in the 2000-2005 period. Even with the current account projected to decline to near balance, reserve accumulation is projected to reach $84 billion in 2006, second only to last year’s record level of reserve accumulation. As a result, the stock of reserves in the region is projected to exceed $460 billion this year, providing over 6½ months of import cover.
Table 3 Europe: External Financing (billions of U.S. dollars)
•
At 7.7 percent, projected growth in emerging Asia in 2006 should surpass 7 percent for the fifth consecutive year, and make emerging Asia the fastest growing region for the eighth straight year. While slowing somewhat from its 2005 pace, China is expected to be the fastest growing economy in our survey in 2006.
•
Direct equity investment remains the most significant segment of capital flows to the region, with China expected to receive nearly 80 percent of such flows in 2006. Nonetheless, a small downturn in net direct equity flows to China this year and last from the record level in 2004 might signal a leveling off of the trend.
•
Buoyed by a widening trade surplus, the aggregate current account surplus in 2006 is expected to be 3.8 percent of GDP for the second consecutive year. Reserve accumulation is projected to be $274 billion this year, bringing the region’s stock of reserves to over $1.6 trillion—about 3.5 times greater than just five years ago.
Table 4 Asia/Pacific: External Financing (billions of U.S. dollars)
2003
2004 2005e
2006f
2003
2004 2005e
2006f
99.2
117.9
170.6
196.8
Current account balance
-1.6
-1.4
19.4
6.7
External financing, net: Private flows, net
68.1
121.0
172.7
157.2
124.4
168.6
147.7
143.4
8.9 7.0 1.9
34.7 29.9 4.8
45.8 36.6 9.2
67.8 48.6 19.2
Equity investment, net Direct investment, net Portfolio investment, net
92.9 55.9 37.0
97.7 65.3 32.5
103.0 64.0 39.0
105.8 64.2 41.6
59.2 26.2 33.0
86.3 39.6 46.7
126.9 67.0 59.9
89.4 34.9 54.5
Private creditors, net Commercial banks, net Nonbanks, net
31.5 15.5 15.9
70.9 37.0 33.9
44.7 21.4 23.2
37.6 15.3 22.3
-3.7 -0.1 -3.6
-9.0 -3.2 -5.8
-35.2 -9.1 -26.1
-18.6 -3.8 -14.8
Official flows, net IFIs Bilateral creditors
-15.3 -10.0 -5.3
-4.8 -4.6 -0.2
1.5 -2.0 3.5
1.2 -0.3 1.5
Resident lending/other, net1
-26.7
-52.2
-53.3
-61.2
Resident lending/other, net1
-22.9
15.9
-59.2
-67.5
Reserves (- = increase)
-36.1
-58.4 -103.5
-84.2
Reserves (- = increase)
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
e = estimate, f = IIF forecast
e = estimate, f = IIF forecast
1
1
Including net lending, monetary gold, and errors and omissions.
-185.4 -297.5 -260.6 -273.8
Including net lending, monetary gold, and errors and omissions.
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006
Page 9
Latin America
Africa/Middle East
Net private capital flows to Latin America in 2006 are expected to decline to about $28 billion—some $22 billion less than last year. A significant reversal in nonbank creditor flows accounts for over 80 percent of the decline, with net equity flows only slightly lower compared to 2005.
Net private capital flows to the region are expected to be nearly $29 billion in 2006, only slightly off last year’s record pace. Behind strength in equity flows—including a likely record level of direct equity flows in 2006—net private flows this year and last are more than the sum of net flows in the preceding seven years.
•
Growth in Latin America is projected to be 4.2 percent in 2006, well above the region’s average growth rate over the past decade. While only Brazil and Mexico are expected to register improved growth in 2006, of the remaining countries in the region, only Ecuador is projected see growth below 4 percent this year.
•
With a number of debt buyback programs planned, net nonbank creditor flows are expected to shift from an inflow of $4 billion in 2005 to a net outflow of nearly $15 billion this year. Brazil alone is expected to see a net nonbank outflow of more than $13 billion, with Mexico and Venezuela together accounting for almost an additional $7 billion in outflows.
•
Behind a weakening trade surplus, the region’s current account surplus is expected to decline to less than 1 percent of GDP in 2006. With a smaller current account surplus and lower net capital inflows, reserve accumulation should fall to about $12 billion this year— leading to a decline in the region’s stock of reserves (in terms of import cover) for the third consecutive year.
Table 5 Latin America: External Financing (billions of U.S. dollars)
Regional growth is projected to increase to 5.2 percent in 2006, the fastest growth rate since 1996. Growth rates should improve, compared to 2005, in every country in the region this year, with Morocco expected to see a significant improvement after a poor agricultural outturn last year.
•
Following a record level of net equity investment in 2005, the region should experience a slight decline this year. With the exception of South Africa, all countries in the region should see a pickup in direct equity investment in 2006. Net private creditor flows are projected to be little changed, as an increase in commercial bank lending to Egypt should help offset a decline in net creditor flows to South Africa.
•
With support from the terms of trade, the region’s current account surplus is expected to increase to about 2 percent of GDP in 2006. Reserve accumulation is projected to reach $30 billion this year, pushing the region’s stock of reserves to a record high (in both import cover and nominal terms).
Table 6 Africa/Middle East: External Financing (billions of U.S. dollars) 2003
2003
2004 2005e
Current account balance
11.9
21.7
34.7
18.6
Current account balance
7.4
6.0
7.2
11.2
External financing, net: Private flows, net
31.1
29.1
50.1
27.7
External financing, net: Private flows, net
5.2
10.6
29.1
28.5
27.9 30.3 -2.3
39.5 44.9 -5.3
46.7 41.2 5.5
43.3 40.5 2.7
4.9 4.5 0.5
10.1 3.7 6.4
24.1 16.1 8.0
23.5 16.5 7.0
3.2 -12.7 15.8
-10.5 -13.5 3.0
3.4 -0.7 4.1
-15.6 -0.9 -14.7
0.2 -2.2 2.4
0.5 0.9 -0.4
5.0 1.0 4.0
5.0 2.4 2.7
Official flows, net IFIs Bilateral creditors
0.2 4.8 -4.6
-8.0 -7.1 -0.9
-30.1 -28.8 -1.3
-8.5 -9.3 0.8
-1.4 -1.1 -0.2
-3.1 -1.3 -1.8
-3.0 -0.3 -2.7
0.1 0.9 -0.9
Resident lending/other, net1
-9.8
-20.3
-28.1
-26.1
Resident lending/other, net1
1.8
5.2
-7.9
-9.4
-33.4
-22.5
-26.7
-11.6
Reserves (- = increase)
-13.0
-18.7
-25.4
-30.4
Equity investment, net Direct investment, net Portfolio investment, net Private creditors, net Commercial banks, net Nonbanks, net
Reserves (- = increase)
2006f
•
Equity investment, net Direct investment, net Portfolio investment, net Private creditors, net Commercial banks, net Nonbanks, net Official flows, net IFIs Bilateral creditors
e = estimate, f = IIF forecast
e = estimate, f = IIF forecast
1
1
Including net lending, monetary gold, and errors and omissions.
2004 2005e
Including net lending, monetary gold, and errors and omissions.
2006f
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006
Page 10
with marked reductions in Colombia and Mexico. A substantial portion of the net inflows will go to Brazil. Nonbank Private Sector Lending After exceeding $91 billion last year, net nonbank private sector lending, mostly in the form of bond purchases, is expected to decrease in 2006 to about $65 billion (Chart 7). Despite continued strong bond issuance in the first two months of this year, gross issuance for the full year is likely to fall below the more than $127 billion recorded in 2005, as front-loading by sovereign and corporate borrowers has taken place in anticipation of higher global interest rates. According to one estimate, emerging market sovereigns by the end of February had already completed nearly 50 percent of planned issuance for this year. In addition, a number of important emerging market countries, including Brazil, Colombia, Ecuador, Mexico, Peru, and Turkey, have stated that they will undertake buybacks of external debt in 2006, which will further reduce net nonbank lending. The trend in recent years toward higher credit ratings of emerging market issuers has been supportive of a significant compression in spreads since the latter part of 2002 to recent record lows. However, the limited dispersion of bond spreads across countries, with different credit ratings, included in the EMBIG index suggests that investors are not discriminating sufficiently among borrowers. Indeed, sovereign spreads this year are clustered more closely together than ever before. The higher overall credit quality of emerging market debt and risk-adjusted returns of the asset class have attracted a broader investor base to absorb the explosion of bond issuance since 2003. The supply of bonds coming on stream this year should be absorbed as they remain a diversification play for institutional and crossover investors given the relatively low correlation with other asset classes. A broadening of the investor base has had a significant impact on emerging market bonds and, according to one study, has accounted for almost one-fourth of the spread compression in these bonds in the past two years.
Chart 7: Net Nonbank Lending by Region (billions of U.S. dollars) 100 80 60 40 20 0 EME
LA 2003
A/ME 2004
Asia 2005e
Europe 2006f
“The higher overall credit quality of emerging market debt and risk-adjusted returns of the asset class have attracted a broader investor base to absorb the explosion of bond issuance since 2003.”
The broadening of the investor base has given borrowers more leeway to issue in different currencies and to increase the share of financing from domestic resources as part of a more active assetliability management process. Stepped-up efforts have been made to issue global bonds denominated in local currencies in international capital markets. For U.S. dollar-based investors, gains on local currency emerging market debt instruments have been enhanced by exchange rate movements. Emerging market currencies appreciated by more than 2 percent against the U.S. dollar in the first two months of 2006. •
Emerging Europe is projected to account for roughly two-thirds of nonbank private creditor flows to emerging markets this year. Net nonbank flows to Turkey will likely fall moderately below last year’s $17 billion, but nonetheless remain the highest in the region. Net nonbank lending to the Asia/Pacific
“Stepped-up efforts have been made to issue global bonds denominated in local currencies in international capital markets. For U.S. dollar-based investors, gains on local currency emerging market debt instruments have been enhanced by exchange rate movements.”
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006 region is expected to decrease for the second consecutive year, with all countries except India and Malaysia likely to experience a reduction in net inflows. •
Page 11 “Net commercial bank lending is projected at about $52 billion in 2006, the fourth consecutive year of positive flows.”
In Latin America, Brazil is projected to see a net outflow to nonbank creditors of more than $13 billion this year, after net inflows of nearly $2 billion in 2005 as the government has decided to pay down its external debt obligations. Mexico and Venezuela are also expected to register net outflows as part of liability management operations. In Africa/Middle East, South Africa is likely to account for the bulk of net nonbank lending to the region.
Commercial Bank Lending Net commercial bank lending is projected at about $52 billion in 2006, the fourth consecutive year of positive flows. Albeit down from nearly $89 billion in 2005, the level projected for this year represents a sizable sum in light of the $132 billion cumulative net outflow during 1998-2002. Loan pricing on balance is likely to remain competitive with other sources of financing. •
•
Chart 8: Net Commercial Bank Lending by Region (billions of U.S. dollars) 90
60
Net commercial bank lending to emerging Europe is forecast to decline to about $35 billion this year from $67 billion in 2005 (Chart 8). The bulk of the falloff in net lending will take place in Russia, where a large repayment of funds used to finance the purchase by Rosneft of a stake in Gazprom and the latter’s acquisition of Sibneft is scheduled to take place. Net lending to the Asia/Pacific region is expected to decline to about $15 billion this year from more than $21 billion in 2005. China will remain one of the largest recipients in the region, but net inflows will continue to be affected by administrative measures taken by the authorities to impose quotas on banks’ overseas borrowing. Latin America is the only region likely to experience net outflows to commercial banks this year. Although total net outflows are projected to be less than $1 billion, this would nevertheless be the sixth consecutive year of net repayments, with Brazil and Mexico accounting for nearly all of the net outflows. Net commercial bank lending to Africa/Middle East could exceed $2.3 billion this year, representing the highest level of net inflows since 1997, as Egypt is expected to experience a sharp positive reversal in flows.
xxxxxxxxxxxxxxxxxxxx 30
0
-30 EME
LA 2003
A/ME 2004
Asia 2005e
Europe 2006f
Chart 9: Net Official Lending by Region (billions of U.S. dollars) 10 0
Official Flows
-10 -20
After reaching a record high of $67 billion in 2005, net repayments to official creditors from emerging market countries are expected to drop to $26 billion this year (Chart 9). In terms of the breakdown in flows by creditor group, official bilateral creditors are projected to see net repayments of $13.4 billion in 2006, down sharply from nearly $27 billion last year, when countries like Poland and Russia made prepayments of a significant portion of their Paris Club debt. For the second consecutive year, Russia will make the
-30 -40 -50 -60 -70 EME
LA 2003
A/ME 2004
Asia 2005e
Europe 2006f
The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
March 30, 2006
Page 12
largest amount of net repayments to official bilateral creditors, amounting to $11.5 billion in 2006. The next largest repayment of $2.6 billion is expected to come from Poland. International financial institutions (IFIs) as a creditor group are likely to receive net repayments this year of $12.5 billion, with Argentina accounting for more than one-half of all net repayments. Turkey is expected to make large net repayments for the second consecutive year totaling more than $4.5 billion. China, India and Egypt are projected to obtain the largest net inflows from IFIs in 2006.
“Even with the slowdown in reserve accumulation, the stock of emerging market reserves will edge up to eight months of imports of goods, services, and interest payments.”
Resident Net Lending and International Reserve Accumulation Net lending abroad by emerging market residents is expected to increase to $164 billion in 2006 from $149 billion last year. As regards reserve accumulation, despite a sharp reduction in net repayments to official creditors, the combination of smaller net private capital inflows and larger net resident lending abroad will result in a reduction in the pace of buildup to $400 billion, down from a record high of $416 billion last year (Chart 10). Even with the slowdown in reserve accumulation, the stock of emerging market reserves will edge up to eight months of imports of goods, services, and interest payments. •
On a regional basis, the Asia/Pacific region as a whole is expected to account for 70 percent of total emerging market reserve accumulation this year. Reserve accumulation in emerging Europe is likely to slow down to $84 billion this year after reaching a record high of nearly $104 billion in 2005. In the Africa/Middle East region, reserve accumulation is projected to climb to a record high $30 billion in 2006, following an increase of $25 billion last year. High energy prices in hydrocarbon-based economies like Algeria, which have pushed up its current account surplus to nearly 20 percent of GDP, are the principal factor in the sharp run-up in reserves since 2004.
Chart 10: International Reserves and Resident Net Lending (billions of U.S. dollars) -500 -400 -300 -200 -100 0 100 1996
1998
2000
2002
Reserve Accumulation Resident Lending Abroad, net1 1
Including net lending, monetary gold and errors and omissions.
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 ([email protected]).
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
2004
Africa/Middle East Algeria Egypt Morocco South Africa Tunisia
2006f
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