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IIF RESEARCH NOTE

Capital Flows to Emerging Market Economies


June 1, 2011

Philip Suttle
CHIEF ECONOMIST AND DEPUTY MANAGING DIRECTOR

Net private capital inflows to emerging economies are estimated to have been $990 billion in 2010, some $350 billion higher than in 2009 We project private flows to rise to $1,041 billion in 2011 and $1,056 billion in 2012 Our 2010 and 2011 estimates are both around $80 billion higher than in January, with revisions to Chinese and Brazilian inflows accounting for most of the increase We expect the political turmoil in Egypt to lead to a sharp reversal of capital flows, with foreigners, on net, withdrawing capital from the country in 2011 Although equity investment accounted for the majority of private inflows in 2010, most of the increase since 2009 is due to higher bank and non-bank debt flows There has been further monetary policy tightening and exchange rate appreciation in most emerging economies since the beginning of the year, but financial conditions remain too accommodative in many cases

1-202-857-3609 psuttle@iif.com

Jeremy Lawson
DEPUTY DIRECTOR Global Macroeconomic Analysis 1-202-857-3651 jlawson@iif.com

Julien Mazzacurati
RESEARCH ASSOCIATE Global Macroeconomic Analysis 1-202-857-3308 jmazzacurati@iif.com

Robin Koepke
RESEARCH ASSISTANT Global Macroeconomic Analysis 1-202-857-3313 rkoepke@iif.com

Private capital inflows to emerging economies revived sharply in 2010 and should continue to be relatively buoyant in 2011 and 2012 as ongoing strong growth and financial deepening encourage greater foreign investment. We forecast flows to increase to $1,041 billion in 2011 and $1,056 billion in 2012 (Table 1, next page). Most of the $81 billion upward revision of our 2011 estimate since January is due to higher inflows to China and Brazil (see Box 1, page 4). China accounts for about 30% of all private capital inflows to the emerging economies we cover, a share that is nearly twice as large as Brazils and three times that of India (Chart 1). Although political conditions have stabilized in Egypt, we expect foreigners to withdraw capital from the country in 2011.
Chart 1 Net Private Capital Inflows to Emerging Markets $ billion 300 250 200 150 100 50 0 -50 China India Brazil Russia Turkey

Matthew Barger
INTERN Global Macroeconomic Analysis

Emre Tiftik
INTERN Global Macroeconomic Analysis

2007 2008 2009 2010 2011 2012

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Capital Flows to Emerging Market Economies

Table 1 Emerging Market Economies: Capital Flows $ billion 2009 Capital Inflows Total Inflows, Net: Private Inflows, Net Equity Investment, Net Direct Investment, Net Portfolio Investment, Net Private Creditors, Net Commercial Banks, Net Nonbanks, Net Official Inflows, Net International Financial Institutions Bilateral Creditors Capital Outflows Total Outflows, Net Private Outflows, Net Equity Investment Abroad, Net Resident Lending/Other, Net Reserves (- = Increase) Memo: Current Account Balance -1073 -453 -268 -185 -620 358 -1411 -573 -269 -305 -837 358 -1487 -654 -296 -358 -833 395 -1392 -751 -321 -430 -641 294 715 644 490 357 133 154 -10 164 71 47 25 1053 990 571 371 200 419 172 247 63 38 25 1092 1041 574 423 151 467 194 273 51 23 28 1098 1056 610 435 175 446 191 256 41 10 31 2010 2011f 2012f

At the component level, most of the increase in capital inflows in 2010 was due to higher bank and non-bank debt flows, though equity investment also picked up (Chart 2). On top of this increase in private inflows, the EM current account surplus increased marginally in 2010. These sources of funds were balanced by strong EM external asset acquisition, including a surge in reserve accumulation.

Chart 2 Emerging Market Private Capital Inflows, Net $ billion 1400 1200 1000 800 600 400 200 0 -200 2003 2005 2007 2009 2011f Total, % of GDP Commercial Banks Nonbanks Portfolio Equity Direct Equity Investment

percent of GDP 10.5 9.0 7.5 6.0 4.5 3.0 1.5 0.0 -1.5

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Capital Flows to Emerging Market Economies

Our forecast for capital inflows to remain strong in 2011 and 2012 follows from how we see underlying fundamentals in emerging economies evolving. EM GDP growth is expected to remain above 6% in 2011 and 2012, with the gap to the mature economies narrowing only slightly (see pages 5 and 6). Better long-term growth prospects provide a favorable backdrop for increasing flows to EMs. Interest rate differentials with the mature economies should widen in the near-term as EMs try to combat overheating, but then stabilize in 2012 as policy normalization in the mature economies gathers pace. At a disaggregated level, we have marked down our forecasts for portfolio equity inflows in 2011 because timely fund flow data showed an abrupt fall in the first few months of the year as some of the froth came off EM equity markets. However, we expect portfolio flows to pick up again in 2012 as growth remains solid and global asset reallocation in favor of emerging markets resumes. On the other hand, FDI should continue its upward trend as strong growth provides increasing increased investment opportunities. After a strong 2010, commercial bank debt flows to emerging economies should increase again in 2011, although they remain relatively subdued by the standards of past cycles. Strong flows into EM bond funds are also likely, supported by perceptions that many EMs have sounder public finances than some mature economies. The strength of capital flows is still presenting policy challenges in a number of emerging economies, especially those already facing pressures from rising inflation, strong credit and asset price growth and rising exchange rates. But governments and central banks in EMs are reacting to these pressures in different ways. China and Turkey are relying on reserve requirements rather than higher policy interest rates as a way of tightening financial conditions without encouraging greater capital inflows. The Chinese capital account is also more closed than most other large emerging economies and the exchange rate is more tightly managed. In contrast, India is content to rely mostly on higher policy interest rates, largely because foreign capital is needed to fund the current account deficit. Meanwhile, Brazil has been experimenting with an array of measures, including higher policy interest rates, higher reserve requirements and direct capital controls to stem currency appreciation. The use of direct capital controls remains controversial. The IMF has recently made statements condoning control measures in circumstances where further exchange rate appreciation is not warranted, reserves are adequate and there is no need for tighter fiscal, monetary and macroprudential settings. The IMF has also been careful to draw attention to the potential costs of controls. However, this new stance risks encouraging greater use of capital controls before there is an international framework in place to regulate their use and ensure a level playing field across countries. We think that emerging economies should be cautious about going down this path. In most cases, strong capital flows and rising exchange rates are simply the counterparts of strong fundamentals and a necessary part of macroeconomic adjustment. Moreover, capital controls are a distraction from the main policy task of reducing credit growth and inflation. Although total credit growth is strong and rising as a share of GDP in a number of key emerging economies, the share of foreign funding in total credit growth has been falling since the financial crisis. Consequently, the emphasis should be on tools that target aggregate macroeconomic imbalances, and not just foreign capital. It is instructive that no large emerging economy has plans to tighten fiscal policy significantly in 2011, even though most are running sizable budget deficits.
The IMFs new stance risks encouraging greater use of capital controls before there is an international framework in place to regulate their use and ensure a level playing field across countries Our forecast for capital inflows to remain strong in 2011 and 2012 follows from how we see underlying fundamentals in EMs

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Capital Flows to Emerging Market Economies

BOX 1: REVISIONS TO OUR FORECASTS In aggregate, we have made upward revisions to our capital flows estimates. Compared to our January 2011 report, net private inflows in each of 2010 and 2011 are now estimated to be $81 billion higher (Table 2). On a regional basis, significant upward revisions for EM Asia and Latin America were partly offset by a reduction in flows to the troubled MENA region. For 2011 we expect an additional $52 and $31 billion in inflows to China and Brazil, respectively, led by increased FDI and nonbank lending. In the MENA region, we project economic uncertainty to result in a sharp retrenchment in flows. Relative to our January report, inflows to Egypt and Saudi Arabia are forecast to be some $17 and $15 billion lower this year, respectively.
Table 2 Revisions to IIF Net Capital Inflows $ billion 2008 IIF Capital Flows June 2011 January 2011 Difference Revisions by Region Latin America Emerging Europe Africa/Middle East Emerging Asia 0.1 1.6 -0.6 -5.7 2.3 3.3 11.0 15.7 11.3 -5.8 -10.0 52.5 44.8 18.6 -33.4 55.7 39.8 25.9 -20.2 19.7 620 622 -2 644 602 42 990 908 82 1,041 960 81 1,056 1,009 47 Significant upward revisions in net private capital flows to EM Asia and Latin America were partly offset by a reduction in flows to the troubled MENA region

2009

2010

2011f

2012f

Heightened political risk in the MENA region will most strongly affect portfolio investment, which is more short-term in nature and thus more sensitive to risk perceptions. This explains our net downward revision in portfolio equity inflows across our emerging market sample. All other flows categories have seen a net upward revision, led by FDI and nonbank debt flows (Chart 3).
Chart 3 Revisions to Private Capital Inflow Estimates for 2011 by Component $ billion, change between January 2011 and latest (June 2011) estimates 100 80 60 40 20 0 -20 Direct Equity Investment Portfolio Equity Commercial Banks Nonbanks Total
All flows categories except portfolio equity investment have been revised up

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Table 3 Global Output Growth percent change over previous year 2009 Mature Economies United States Euro Area Japan Emerging Economies Latin America Argentina Brazil Mexico Emerging Europe Russia Turkey Asia/Pacific China India Africa/Middle East South Africa World -3.9 -2.6 -4.1 -6.3 1.6 -2.4 -2.6 -0.6 -6.1 -5.8 -7.8 -4.8 6.8 9.2 8.0 0.6 -1.7 -2.0 2010 2.5 2.9 1.7 4.0 7.2 6.2 8.8 7.5 5.5 4.5 4.0 8.9 9.3 10.7 8.6 4.0 2.8 4.3 2011f 1.9 2.8 1.9 -0.7 6.4 4.4 5.5 4.0 5.0 4.1 4.5 5.0 8.2 9.4 7.8 4.7 3.6 3.6 2012f 2.6 3.4 1.6 3.2 6.1 4.3 4.4 4.2 4.5 3.7 3.8 4.0 8.1 9.0 8.2 3.9 4.2 4.0

A TEMPORARY BLIP IN THE GLOBAL EXPANSION The global economy ended 2010 on a solid note. Strong economic activity in emerging markets was bolstering manufacturing and exports in the mature economies, while nonmanufacturing industries were also showing more vigor. Overall, world GDP increased 4.3% in 2010, with emerging economies growing an above-trend 7.2%. However, the combination of higher oil prices in the wake of the political upheaval in the MENA region, the Japanese earthquake in March and tighter financial conditions in emerging economies, have led the global economy into a softer patch in the first half of 2011. Global PMIs generally weakened in April and May, with the ratio of new orders to inventories falling noticeably. IP in Japan fell 15%m/m in March and recovered a modest 1% in April. The quake has also disrupted supply chains outside of the country, especially in the auto industry and Asia. Overall, Q2 global growth is likely to be well below Q1. Meanwhile, the strong run-up in oil and other commodity prices over the past 6 months has cut into disposable incomes and profits. This has been most evident in the leveling off in retail sales in the mature economies since the start of the year. Overall, G3 growth is likely to moderate to 2% in 2011. In EMs, we expect the combination of currency appreciation and tighter monetary and macroprudential policy to help bring growth down a little in 2011, though output should still expand 6.4%. Our view is that most of the forces battering the mature economies are temporary and that growth should pick up in the second half of 2011. Oil and other commodity prices recently experienced a welcome correction, reconstruction spending will ratchet up in Japan in the second half of 2011 and monetary policy will remain accommodative. In the emerging
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Higher oil prices, the Japanese earthquake and tighter financial conditions in EMs have led the global economy into a softer patch in the first half of 2011

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Table 4 Consumer Prices percent change over previous year, end of period 2009 Mature Economies United States Euro Area Japan Emerging Economies Latin America Argentina Brazil Mexico Emerging Europe Russia Turkey Asia/Pacific China India Africa/Middle East South Africa World -0.1 -0.3 0.3 -1.4 5.0 6.2 17.4 4.3 3.6 6.8 8.8 6.5 3.6 1.9 10.4 5.9 6.3 1.7

2010 1.5 1.2 2.0 0.1 6.2 8.1 22.9 5.9 4.4 6.8 8.8 6.4 5.2 4.6 9.0 5.4 3.5 3.2

2011f 2.4 3.2 2.4 -0.3 6.4 8.4 25.8 6.6 3.1 7.1 9.4 7.2 5.1 4.9 6.3 6.9 5.5 3.9

2012f 1.2 1.0 1.7 0.0 5.3 6.6 11.2 5.3 3.9 6.3 8.0 6.4 4.1 3.7 5.0 6.6 5.6 2.8

economies, activity should expand at a slightly lower pace than in 2010 as policymakers apply the monetary brakes only gradually. Just as emerging economies are growing much more rapidly than the mature economies, so inflation pressures are more pronounced in the emerging world. Of most concern is that delayed policy tightening in 2010 allowed inflation to reach uncomfortably high levels in a number of countries. In Latin America, inflation rose from 6.2% in 2009 to 8.1% in 2010, while in Asia, it rose from 3.6% to 5.2%. Much of the rise over the past year was accounted for by higher food and energy prices. However, little comfort should be drawn from this. Food has a higher weight in consumption than in the mature economies and therefore raises more social concerns. The strength of EM growth is also a key explanation for the increase in commodity prices (though supply shocks have also played an important role). Inflation will likely increase again in 2011 before tighter policy and weaker commodity prices lower inflation in 2012. In the mature economies, higher commodity prices will also boost headline inflation in 2011. However, in contrast to the emerging economies, considerable product and labor market slack should keep underlying inflation subdued for some time. Japans earthquake seems to have prompted only a temporary move by corporations to repatriate funds from abroad. The risk of another cycle of yen appreciation, driven by a reversal of foreign investment flows, did not materialize. The collapse in Japans exports, however, will lead to a sharp narrowing of its current account surplus and thus a reduction in net capital flows to the rest of the world. At this stage, we expect that reduction to mainly affect other mature economies.
EMs are growing much more rapidly than the mature economies and inflation pressures are more pronounced

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Table 5 Global Current Account Balance $ billion 2009 United States Euro Area Japan Other Mature Economies Emerging Economies (IIF 30) Africa / Middle East Latin America Emerging Europe of which Russia Emerging Asia of which China Other Countries*
* Includes global discrepancy

2010 -470 -49 196 33 358 46 -42 7 71 347 305 -67

2011f -612 -28 136 81 395 161 -47 -21 74 301 280 28

2012f -548 0 148 57 294 122 -88 -70 35 330 328 49

-378 -43 142 25 358 24 -15 20 49 328 261 -104

Egypt has suffered withdrawals of about $16 billion in private foreign capital following the political turmoil earlier in the year. Moreover, a sharp slump in tourism resulted in a deterioration of the current account deficit. These two losses have been financed by running down reserves. Official reserves fell by about $8 billion between December 2010 and April 2011. Overall, global current account imbalances widened a little in 2010. The deficit in the worlds largest debtor country, the U.S., increased from around $380 billion to $470 billion, while the Japanese, German and Chinese surpluses all increased. The Chinese surplus in 2010 was almost five times bigger than Russias, the country with the next largest surplus. In 2011, higher oil and other commodity prices will translate into larger deficits (or smaller surpluses) in commodity importing emerging economies such as China and Korea, and larger surpluses (smaller deficits) in commodity exporting countries such as Saudi Arabia. The U.S. current account deficit is also likely to widen. Exchange rate and other policy distortions in emerging and mature economies continue to inhibit a more rapid unwinding of imbalances.
Global current account imbalances widened a little in 2010

PUTTING $1 TRILLION OF NET PRIVATE INFLOWS INTO PERSPECTIVE Private capital inflows to emerging markets of over $1 trillion dollars per year seem large, yet they are small relative to some useful benchmarks. For example, private inflows to the U.S. alone have been some $1.24 trillion in 2010. Also, these flows still represent only a tiny fraction of the global stock of financial assets. Total global financial assets are estimated to have been around $200-$250 trillion in 2010, of which about $40 trillion are assets in emerging markets. This implies that a 1% shift in global asset allocation towards emerging markets would result in capital inflows of some $2 trillion dollars.
Capital inflows to EMs still represent only a tiny fraction of the global stock of financial assets

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Chart 4 EM vs. Mature Economies: Stock of Financial Assets percent of GDP 400 Mature Emerging 350 300 250

Chart 5 Emerging Markets: Measures of Underinvestment percent 35 30 25 20 Share of Global Output

200 150 100 50 0 90 95 00 01 02 03 04 05 06 07 08


Source: McKinsey, IIF calculations

15 10 5

Share of Global Financial Assets

Weight in Global Equity Benchmark Portfolio* 0 00 01 02 03 04 05 06 07 08


Source: McKinsey; MSCI; IIF calculations *MSCI All-Country World Index (ACWI)

Financial deepening in EMs is still at an early stage, but is proceeding rapidly. Financial assets in EMs grew at a breathtaking pace of 22% per annum between 2001 and 2007, and the ratio of EM financial assets to GDP increased from 138% to 218% over the same period (Chart 4). With aggregate nominal GDP growth expected to average around 10% a year during the current business cycle and the ratio of EM financial assets to GDP still less than half that of the advanced economies, the stage is set for further rapid asset growth (Chart 5). Strong private capital inflows not only reflect this secular financial deepening trend as investors in mature economies seek to share in the higher returns, they also support financial market development in EMs. Investment and lending from abroad helps provide both greater and cheaper financing for corporations, households and the public sector. In addition, they facilitate institutional development in the domestic financial sector. The surge in capital inflows over the past decade therefore should not be regarded as temporary, but as the permanent counterpart of rapid economic growth and financial development. Of course this does not mean that there will not be cyclical variations around this trend. The challenge for policymakers in emerging economies is to develop institutions and policy frameworks that enable sustained high capital inflows to be absorbed without generating domestic economic and financial imbalances.
Financial deepening in EMs is still at an early stage, but is proceeding rapidly

CAPITAL INFLOWS CONTRIBUTE TO PRODUCTIVITY GROWTH The acceleration in private capital inflows to emerging markets over the last decade has been associated with high labor productivity growth rates in EMs relative to mature economies. Between 2002 and 2010, labor productivity growth was around 4.3% per annum, more than four times the G7 average. In fact, labor productivity in economies such as India and China grew by an average of 7% a year between 2002 and 2010. Nonetheless, the level of labor productivity in EMs is still very low compared to the advanced economies, suggesting that there is considerable room for further catch-up in economic performance. For example, GDP per worker in China is 87.5% lower than in the U.S., while Indias is 95.4% lower.
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Chart 6 EM: Productivity Growth and Volume of Inward FDI percent $ billion 7 Inward FDI (rhs) 700 Productivity 600 6 Growth* 5 4 3 2 1 0 2002 2004 2006 2008 2010 500 400

Chart 7 EM: Equity Issuance and Porfolio Inflows percent of total 80 Equity Issuance* 60 40 20

$ billion 600

300

300 200 100 0 0 -20 -40 2000 2002 2004 Net Acquisition of Equity by Foreigners Portfolio Inflows (Inward) 2006 2008 2010 0

-300

Source: Datastream; IIF calculations. * Productivity is proxied by Real GDP per worker for the major EM countries covered in the IIF's Capital Flows to EM report, except Saudi Arabia, UAE and Nigeria.

Source: Thomson Financial; IIF calculations. * Excludes equity issued in international markets, for the 30 major EM countries covered in the IIF's Capital Flows to EM report.

An important question is how foreign capital inflows can best be used to help improve macroeconomic performance in EMs. The academic literature suggests that a countrys ability to harness capital inflows for economic productivity, its so-called absorptive capacity, depends strongly on the structural characteristics of the economy. For example, private capital inflows have a more benevolent effect in countries with higher levels of institutional development and human capital. Deeper and well regulated and supervised financial systems also enable emerging economies to absorb capital inflows more efficiently. Foreign direct investment is generally considered the most desirable type of private capital inflows since it disseminates technological practices and knowledge to the host country and usually induces positive spillovers to domestic firms, thus supporting productivity growth (Chart 6). Moreover, FDI flows are more stable because they are more costly and therefore less likely to reverse. A useful measure to gauge whether foreign capital inflows exceed a countrys absorptive capacity is to compare issuance of equity to foreign equity inflows. In 2010, domestic equity issuance in emerging market economies rebounded to a record $566 billion, exceeding portfolio investment inflows of $200 billion by a wide margin (Chart 7). The gap between domestic equity issuance and inward portfolio inflows has increased significantly over the past five years, suggesting that in aggregate, foreign portfolio inflows are not chasing too few domestic investment opportunities and that foreign investment is not crowding out investment by domestic residents.
Capital inflows have a more benevolent effect in countries with higher levels of institutional development and human capital

LENDING CONDITIONS IN EMERGING ECONOMIES STRENGTHEN A notable feature of the global recovery is the divergence in bank lending conditions between the emerging and mature economies. The mature economies are still working off the excess leverage that built up before the financial crisis. Total private sector credit has only recently begun to grow again and is rising at a pace well below that of nominal GDP.
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Chart 8 Emerging Economies: Bank Lending and Inflation percent change over a year ago (both scales), 20 EMs 30 26 22 18 14 10 2001 Headline Inflation Bank Credit to Private Sector 10 9 8 7 6 5 4 3 2 2003 2005 2007 2009 2011

Chart 9 Emerging Economies: Bank Lending to Private Sector percent change over a year ago 50 EM Europe 40 30 20 10 0 2001 EM Asia Latin America 2003 2005 2007 2009 2011

In contrast, private sector credit growth in emerging markets bottomed out at 12.5% (on a year ago basis) in the aftermath of the financial crisis and is currently growing close to 18% oya. While this is still well below the pace recorded in the years leading up to the global downturn, the mix of robust real economic activity, high commodity prices, rising inflation and rapid asset price and credit growth is raising concerns about overheating (Chart 8). With credit demand buoyant, a significant moderation in lending growth and inflation pressures is unlikely without further policy tightening (see Box 2, page 11). Although credit growth in most emerging economies is strong, there are divergences to note (Chart 9). In Asia, bank credit growth in China has slowed over the past year as the authorities have taken direct measures to reduce lending. Nonbank lending has accelerated, though. Credit growth in India and Indonesia is well above its 2010 average. In Latin America, lending has picked up strongly in Brazil, Venezuela and Columbia, but remains relatively subdued in Chile. Aggregate lending activity in Emerging Europe is well below the heights reached before the financial crisis, with one notable exceptionTurkeywhere credit growth is running around 40%.

DOMESTIC DEBT FUNDING HAS BECOME MORE IMPORTANT OVER TIME A notable development in the current lending upswing in emerging economies is the change in the private sector's funding sources. Relative to the stock of domestic bank credit to the private sector, the stock of external debt owned by foreign private creditors (based on bank and nonbank flows) has fallen by 38% between 1999 and 2010, and 26% in the last three years. Consequently, the private sector in emerging economies has become relatively less dependent on foreign capital (Chart 11, page 12). This reduction has not occurred because foreign funding has grown slowly (the stock of debt owned by foreign private creditors has remained broadly stable as a share of GDP), but because domestic credit has increased even more rapidly. Taking the change from 2009 to 2010 for a sample of 10 major emerging economies, net debt flows from private creditors were $323 billion, compared to a
The private sector in emerging economies has become relatively less dependent on foreign capital

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BOX 2: IIF EMERGING MARKETS BANK LENDING CONDITIONS SURVEY The IIFs quarterly Emerging Markets Bank Lending Conditions Survey of 45 member banks provides some insights into what is driving strong credit growth in the emerging economies. Overall, lending conditions improved again in the first quarter of 2011, albeit at a slower pace than in the final quarter of 2010. However, there is a notable gap between demand and supply side conditions (Chart 10). Demand for loans in the first quarter remained around its 2010 highs, with demand for consumer loans particularly strong. In contrast, there was a marginal increase in credit standards at the beginning of the year, perhaps reflecting the gradual tightening of monetary and macroprudential conditions currently under way.

Chart X 10 Global Bank Lending Conditions diffusion index; 50 = breakeven (both charts) Credit Standards 56 Net Easing 53 Corporate Loans Consumer Loans Mortgages 60 55 50 50 47 45 40 EM Fed ECB EM Fed ECB BoJ 65 Demand for Loans Corporate Loans Consumer Loans Mortgages Net Increase

44

Approximately 50% of all respondents said demand was increasing in the four categories of loans the survey covers (commercial and industrial loans, commercial real estate, residential real estate, consumer loans). Demand for consumer loans increased the most, with more than 60% of participants saying demand expanded, including 88% of banks in Emerging Asia and 71% in Latin America. Credit standards increased slightly in Q1, albeit with significant regional differences. Banks in Emerging Asia continued to tighten standards, primarily in the real estate sector. This is an appropriate response to some signs of regional overheating. By contrast, banks in Emerging Europe adopted easier standards for all types of loans. This contrasts with the situation in the Euro Area and highlights better economic and financial conditions in Emerging Europe.

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$1.9 trillion increase in domestic bank lending. A lower dependency ratio thus illustrates the increasingly dominant role that domestic banks are playing in the current lending cycle, as well as the health of EM banks balance sheets compared to their G3 counterparts. This will also contribute to robust growth rates as small and medium-size enterprises and households are increasingly able to access cheap financing (or any financing), which was not always the case through international bank lending or direct external bond issuance. There are some caveats to keep in mind when comparing cross-boarder debt flows and domestic lending. First, IIF debt flows include loans and securities, implying that commercial bank flows are an imperfect proxy for intermediated international lending. Second, IIF debt flows include credit to the public sector, whereas domestic bank credit growth only refers to the private sector here. With these differences in mind, our analysis illustrates nonetheless the growing importance of domestic debt funding. This shift away from foreign financing is not uniform across emerging economies, in either timing or magnitude. In Brazil for example, where foreign creditors played an integral role in previous lending upswings, the dependency ratio has dropped 63% since 2002. Although more gradual, the relative importance of domestic banks has also increased significantly in China over the past 15 years (i.e., the ratio fell 60% over that time period). In contrast, the relative importance of foreign creditors has only recently started to level off in Mexico. Poland is the only large emerging market we monitor where the share of foreign bank credit is still increasing. This may reflect investors exiting Euro Area sovereign debt markets for safer Polish securities. During the previous lending upswing (2004-2007), commercial bank flows grew faster than domestic bank credit. However, the current cycle seems to be of a different nature, with domestic lending increasing at a much faster pace than all types of debt flows. A combination of strong EM banks balance sheets allowing for greater self-financing and deeper local bond markets is prompting EM banks to increase lending without relying as much on cross-boarder debt inflows. The current policy environment is also conducive to
Chart 11 EM: Debt Flows Funded by Private Creditors* ratio 0.22 0.20 0.18 0.16 0.14 0.12 0.10 0.08 0.06 2000 2002 2004 2006 2008 2010
* 10 emerging markets: Brazil, China, Colombia, India, Korea, Mexico, Poland, Russia, Turkey, South Africa; Stock of IIF commercial bank flows, net + other private creditors, net. Sources: IIF, Bloomberg, Datastream, national central banks IIF.com Copyright 2011. The Institute of International Finance, Inc. All rights reserved.

In the current cycle domestic lending has been increasing at a much faster pace than all types of debt flows

Other Private Creditors to Domestic Bank Credit

Total Debt Flows to Nominal GDP

Chart 12 Emerging Market External Bond Issuance* $ billion Financial Sector 70 Other Private Sector 60 Government 50 40 30 20

Through May 20

Commercial Banks to Domestic Bank Credit

10 0 08Q1 08Q3 09Q1 09Q3 10Q1 10Q3 11Q1


Source: Thomson Financial; IIF calculations. * Includes bonds issued in an external market, for the 30 major EM countries covered in the IIF's Capital Flows to EM report.

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such a development, with EM policymakers trying to mitigate capital inflows by holding interest rates very low in a buoyant economic environment. Nevertheless, EM banks have stepped up external bond issuance over the past few years, supported by cheap funding opportunities on international debt markets and favorable prospects for EM corporate profits. Financials have been most active in the capital market (Chart 12, previous page). But external issuance currently represents only 45% of total EM bond issuance, compared to 65% in early 2007, consistent with the idea that international funding is less important in the current cycle.

EM CAPITAL OUTFLOWS STRONG, LED BY RESERVE ACCUMULATION IIF analysis of capital flows has historically focused on private inflows to emerging markets. Although private inflows to emerging markets still exceed their outward investment and lending, flows by EM residents have become increasingly important over the past decade. Emerging markets as a whole have become net creditors (i.e., they now have a positive international investment position). China has led the way, though the oil exporters have also been accumulating foreign assets. The structure of emerging market outward investments differs markedly from the type of funds they are receiving. Most notably, EM outflows are primarily in the form of official reserves (Chart 13). Most of these reserves are sovereign bonds of mature economies, especially U.S. Treasuries. For example, Chinas official reserves now exceed $3 trillion. More generally, EM investments in mature economies are mainly low-yielding debt flows (Chart 14). Inflows to emerging markets on the other hand are primarily equity flows, which tend to have a higher yield (though the yields are also more volatile). Although reserves accumulation has partly been a precautionary policy to help prevent balance of payment crises, it is now primarily used to support export-led growth strategies. Reserves in major EMs like China, Brazil and Russia far exceed precautionary levels and are instead helping to keep exchange rates low so as to make exports more competitive. This strategy is not without cost. The yield differential between mature assets and EM assets is
Chart 13 Emerging Markets: Net Capital Inflows and Outflows $ trillion Equity Debt & Reserves 0.6 1.6 0.5 0.4 0.3 0.2 0.8 Chart 14 Net Capital Exports by Emerging Economies $ billion 2000 FX Reserves 1800 1600 1.2 1400 Resident Lending Portfolio Equity FDI
EM investments in mature economies are mainly lowyielding debt flows, while inflows to EMs are primarily equity flows

Inflows Outflows

1200 1000 800 600 400 200 0 98

Outflows
0.1 0.0 00 02 04 06 08 10 12

0.4

0.0

Inflows
00 02 04 06 08 10 12

00

02

04

06

08

10

12

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Capital Flows to Emerging Market Economies

substantial, which implies that the opportunity cost of holding vast amounts of reserves is large. In addition, because EM currencies that are held artificially low will have to appreciate eventually, countries with large foreign reserve balances will face large losses when and if those holdings are unwound.

POLICY SHOULD NOT OVERREACT TO STRONG CAPITAL FLOWS The post-financial crisis increase in capital flows to emerging economies has once again brought to the fore concerns that recipients countries will not be able to safely absorb the higher inflows as increased foreign investment adds to financial risks and accentuates existing domestic imbalances. It is this concern that lies behind the IMF becoming more open to emerging economies making greater use of capital control measures to help manage the challenges from higher inflows. The IMF has been careful to state that countries should exhaust other macroeconomic and exchange rate options before turning to controls, and that control measures should be targeted at specific risks. For example, the Fund argues that controls should not be used unless exchange rates are overvalued, reserves are adequate, and the fiscal and monetary stance is appropriate. Nevertheless, we have concerns about the IMFs new position. First, it does not properly acknowledge the benefits of higher capital flows. Foreign capital plays a critical role in the helping developing countries improve productivity through technology and expertise transfers, as well facilitating financial deepening. Moreover, supportive economic fundamentals are not a temporary phenomenon. Despite strong growth in many emerging economies over the past decade, convergence in living standards with the mature economies is still at an early stage, which will make it possible for high growth rates to be maintained for a long time. The combination of strong growth and underdeveloped financial markets will also promote rapid asset and debt accumulation. Second, it is important to keep in mind the potential costs of a more widespread use of controls, particularly in the absence of an international framework to regulate and coordinate their use. Historically, capital control measures have been unsuccessful in stemming aggregate capital flows, especially when driven by fundamentals. Instead, controls often encourage arbitrage to less regulated investment options within the country and divert investment to those countries imposing fewer controls. It would arguably be more appropriate to develop an effective international framework governing the use of capital control measures (as there is for international trade), before countries are encouraged use them more. Third, there is the risk that it will make it easier for more countries to turn to controls, even when other policy options have not been exhausted and controls do not address the main economic and financial risks that most emerging economies face. Although EM exchange rates have appreciated over the past year, there is no evidence that emerging market currencies are generally overvalued, and indeed, most Asian currencies are undervalued (Chart 15). Most importantly, appreciation is a necessary part of the macroeconomic adjustment to high growth, reduced spare capacity and higher inflation. At least some
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Historically, capital control measures have been unsuccessful in stemming aggregate capital flows, especially when driven by fundamentals

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Chart 15 EM: Exchange Rate Overvaluation Estimates percent overvalued vis--vis USD 60 40 20 0 -20 -40 -60
hi na ca In di a la nd il us si a ra z ey

Chart 16 China and Turkey: Monetary Policy Instruments percent (all scales) China Turkey 8 22 18 Reserve Requirements

16 14

IMF WEO Peterson Institute FEER* 7

18 14 Policy Rate 14 10 10

Policy Rate*

12 10

Reserve Requirements

8 6 4

5 2006

S. Af ri

Th ai

Tu rk

6 2008 2010

6 2006

2008

2010

*FEER = fundamental equilibrium exchange rate

*Turkeys target rate changed to the one-week repo lending rate in June 2010

emerging economies, such as Brazil, now seem to have realized that resisting appreciation in the current environment is both futile and counterproductive. Monetary policy settings are also generally too accommodative, in large part because policymakers are so focused on limiting capital inflows. This is dangerous. Foreign debt inflows are actually growing more slowly than domestic credit growth in most emerging economies. Consequently, the authorities need to look at lending growth more holistically. There is little point in choosing a suite of policy measures that succeeds in reducing foreign debt inflows at the expense of blowing a domestic credit bubble instead. It is not sustainable for emerging economies as a whole to be generating growth between 6 and 7%, but have real interest rates close to zero. Similarly, fiscal policy should play a much greater countercyclical role than at present, as most emerging economies are still running sizable deficits.
Monetary and fiscal policy settings are too accommodative in many EMs

BOX 3: WHAT ARE MACROPRUDENTIAL MEASURES? Macroprudential measures address financial stability risks such as credit booms and balance sheet vulnerabilities, which can be a by-product of capital flows surges. They are explicitly geared towards reducing systemic risk, i.e. the risk that an entire financial system will collapse. Contrary to capital controls, macroprudential measures do not discriminate on the basis of residency, i.e. they do not place foreign investors and lenders at a disadvantage relative to domestic ones. They can therefore, in principle, address financial stability concerns without undermining a global level playing field. Typical macroprudential measures include:

Reserve requirement ratios (RRRs) Caps on credit growth Cyclically varying provisioning requirements Cyclically varying Loan-to-Value (LTV) ratios Countercyclical capital buffers (Basel III)

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Table 6 Reserve Requirements by Type of Deposit percent May 07 Chile China India Indonesia Korea Mexico Poland Brazil Time Demand Colombia Current Account Savings Account CD Russia Time Demand FX 4 Turkey 5 Time Demand FX
1 2 3 4 5

May 08 16.5 8.3 9.1 7.0 0.0 3.5 18.0 48.0 8.3 8.3 6.0 4.5 4.5 5.0 to 5.5 6.0 6.0 11.0

May 09 15.5 5.0 5.0 7.0 0.0 3.5 23.0 53.0 11.5 11.5 4.5 1.0 1.0 1.0 6.0 6.0 9.0

May 10 17.0 6.0 7.5 7.0 0.0 3.0 18.0 47.0 11.0 11.0 4.5 2.5 2.5 2.0 5.0 5.0 9.5

May 11 6.6 21.0 6.0 10.5 7.0 0.0 3.5 32.0 55.0 11.0 11.0 4.5 4.0 4.0 4.0 to 5.5 5 to 16 16.0 11 to 12

11.5 6.5 7.3 0.0 3.5 18.0 48.0 13.0 6.0 2.5 3.5 3.5 3.5 6.0 6.0 11.0

Single ratio on different types of deposits Includes the additional requirements that are remunerated at the SELIC rate. With maturity > 18 months Reserve requirement depends on residency of depositor Depending on time length of the deposit

On a more positive note, emerging economies are more active users of macroprudential policy instruments than the mature economies (Box 3, previous page). In particular, reserve requirement ratios are becoming increasingly popular in many emerging economies. A reserve requirement ratio (RRR) is the proportion of deposits that a bank must hold in its account with the central bank, which cannot be lent out to borrowers. They are a way of constraining broad money and credit growth (and raise bank lending rates to the private sector) without the need to increase policy, money market and bank deposit rates, all of which would tend to attract capital inflows. By affecting the growth of bank lending, they can directly slow credit growth during booms and cushion credit squeezes in downturns. Among the large emerging economies, RRRs are being relied on most heavily in China and Turkey, two of the countries most concerned about increasing capital inflows (Chart 16, previous page, and Table 6). In China, the central bank has raised RRRs aggressively since the beginning of 2010. However, although bank credit has slowed, non-bank credit has not, indicating that higher reserve requirements (and low bank deposit rates) could be fostering disintermediation. Turkey has placed even more faith in RRRs, since they have been raised
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aggressively, even as official interest rates have been reduced. Credit growth has yet to respond significantly, however, which highlights that macroprudential measures are most successful when part of a suite of policy responses to deal with the pressures of rising inflation, rising credit growth and strong capital flows.
Among the large emerging economies, RRRs are being relied on most heavily in China and Turkey

EMERGING ASIA: NOT MUCH OF A MODERATION Private capital flows to the region are being supported by relatively strong economic growth and ample global liquidity. After real GDP rebounded 9.3% in 2010 from an eight-year low of 6.8% in 2009, growth for our sample of seven countries constituting Emerging Asia is set to fall only slightly to 8% this year and next. The region is adjusting to elevated commodity prices and restrictive policies to combat inflation, but growth is set to continue outperforming its peers as well as the mature economies. China and India will lead the region with growth of 9% and 8% respectively, followed by Indonesia at 6.5%. After plunging from around $410 billion in 2007 to a five-year low of $120 billion in 2008 due to the global financial crisis, private capital inflows to Emerging Asia rebounded to a record $500 billion last year (Table 7, previous page). Inflows this year are likely to amount to around $480 billion before moderating only slightly to around $450 billion in 2012. Emerging
Private capital flows to the region are being supported by relatively strong economic growth and ample global liquidity

Table 7 Emerging Asia: Capital Flows $ billion 2009 Capital Inflows Total Inflows, Net: Private Inflows, Net Equity Investment, Net Direct Investment, Net Portfolio Investment, Net Private Creditors, Net Commercial Banks, Net Nonbanks, Net Official Inflows, Net International Financial Institutions Bilateral Creditors Capital Outflows Total Outflows, Net Private Outflows, Net Equity Investment Abroad, Net Resident Lending/Other, Net Reserves (- = Increase) Memo: Current Account Balance 328.2 346.7 300.9 329.8 -722.2 -140.7 -156.6 16.0 -581.5 -859.8 -251.0 -140.2 -110.8 -608.7 -799.4 -252.8 -176.0 -76.8 -546.6 -785.9 -294.8 -202.9 -91.9 -491.1 393.9 377.5 257.6 168.2 89.4 119.9 62.8 57.1 16.5 3.9 12.6 513.1 499.5 290.1 161.8 128.3 209.3 128.1 81.2 13.6 5.4 8.2 498.5 484.1 269.5 162.2 107.3 214.6 117.6 97.0 14.3 2.8 11.5 456.3 446.0 275.3 162.4 112.9 170.7 97.4 73.3 10.3 2.1 8.2 2010 2011f 2012f

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Asia is set to continue to account for more than 40% of private capital flows to emerging markets. Inflows of foreign direct investment should exceed $160 billion a year. This is a strong performance but below the peak of around $220 billion reached in 2008, which was fueled by large global capacity addition. Chinas manufacturing prowess means that its share will continue to exceed 60% of EM Asias total, while India is a distant second with 20%. A surprising story is the resurgence in foreign direct investment flows to Indonesia from $5 billion in 2009 to $12 billion in 2010, and is likely to edge up further to around $14 billion in 2012, or 9% of the total. The commodity boom, a large home market and efforts to improve the business environment are contributing to the upturn. There has been a dramatic shift from large withdrawals of foreign portfolio equity investment of more than $50 billion in 2008 during the financial crisis to record net inflows of around $128 billion in 2010, attracted by the strong corporate performance in Asia and asset reallocation towards emerging markets. Although foreign portfolio equity investments have moderated somewhat recently, they should still average around $107 billion this year and next, dominated by China, India and Korea. Low borrowing costs, search for yield and a turnaround in risk aversion lifted net inflows from commercial banks and nonbanks to $209 billion in 2010 from net repayments of $40 billion in 2008. These flows should be sustained in 2011 at last years level, before moderating to around $170 billion in 2012 as the positive factors start to dissipate and tighter global banking regulations have a negative impact. Along with the large capital inflows, Emerging Asia is set to maintain an aggregate current account surplus of $300-330 billion this year and next. This is primarily because of Chinas current account surplus of $280 and $330 billion this year and next. Excluding China and India, the aggregate current account surplus of the other countries falls from around $75 billion in 2010 to below $50 billion in 2012. India is the only country in the region to be running a large current account deficit of around $50 billion a year, which is being more than covered by capital inflows. Policy making in Emerging Asia is being complicated by the large current account surplus at a time when the region is grappling with inflationary pressures brought on by excess demand and elevated commodity prices. Large capital inflows also add to concerns about rising asset prices in a number of countries. In response, along with the monetary and fiscal tightening under way, regional central banks are appropriately seeking to allow exchange rates to appreciate to combat inflation. In this regard, the authorities in China have allowed slightly greater flexibility of the renminbi since mid-2010, but its appreciation so far has been the smallest in Emerging Asia. Chinas exchange rate policy remains a constraint on greater currency appreciation in the region. While official reserves accumulation in Emerging Asia should slow from $609 billion in 2010 to $491 billion in 2012, the increase remains indicative of the regional bias for limiting currency gains. Reflecting efforts to mitigate pressures from the external surplus as well as
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Along with large capital inflows, Emerging Asia is set to maintain an aggregate current account surplus of $300-330 billion this year and next

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diversification by the private sector, the region will remain a major exporter of capital as evident from greater outward direct and portfolio investments as well as in lending abroad by residents. With regard to capital controls as an additional policy tool, while old restrictions remain in place in China and India, only some limited additional measures to dampen short-term flows have been taken in the region. In Indonesia, the minimum holding period for central bank certificates was increased to six months effective mid-May from the one-month limit imposed in mid-2010 for both foreign and domestic investors. Issuance of paper of maturity less than nine months was also halted. In Korea, a 14% withholding tax on foreign holdings of government bonds and central bank securities was reintroduced in January. Restrictions on banks foreign exchange derivative positions were also put in place last year and caps on forward positions tightened. In Thailand, a 15% withholding tax on capital gains and interest income on foreign holdings of domestic government, state enterprise and central bank bonds was reinstated last October. The region rightly remains reluctant to resort to broader capital controls because of past adverse experiences and concerns about long-term dislocations. In contrast, more active use of macroprudential regulations to dampen asset prices and credit growth is being made. Recent measures have ranged from tighter provisioning requirements and caps on loan-to-value ratios in many countries to the imposition of property taxes in several Chinese cities. In Malaysia, the authorities increased the minimum income requirement for credit card eligibility in March in a bid to curb household debt. In Indonesia, the central bank also reinstated last December the pre-global crisis limit on shortterm foreign currency borrowing by domestic banks to 30% of capital on prudential grounds. In China, especially, in addition to sharply raising reserve requirements along with higher interest rates, policy makers are seeking to check the run-up in property prices. In Emerging Asia, macroprudential regulations are a tried and tested tool, having been used during previous episodes of surges in capital inflows, with further tightening likely over the near term.
Official reserves accumulation in Emerging Asia should slow from $609 billion in 2010 to $491 billion in 2012

EMERGING EUROPE: PRIVATE CAPITAL INFLOWS INCREASE SIGNIFICANTLY First-quarter balance of payments data suggest that private capital flows to Emerging Europe increased at a solid pace in early 2011. This followed a tripling in private sector inflows last year that boosted overall inflows to $172 billion from $84 billion in 2009 (Table 8, next page). Unlike 2010, when most of the jump in private sector inflows reflected a shift to modest net borrowing from foreign banks after large net repayments in 2009, this year the recovery has been broad-based. Borrowing by domestic banks has gained momentum, especially where credit growth has rebounded. Domestic banks continued making net repayments in Bulgaria, Romania and Hungary, however, where bank lending has yet to recover and, in the case of Hungary, a new bank tax constrained banks ability to lend.
Capital flows to Emerging Europe increased at a solid pace in early 2011

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BOX 4: PRIVATE CAPITAL OUTFLOWS EXCEED INFLOWS IN RUSSIA Among the major emerging market economies, Russia alone has seen net outflows of private capital exceeding net inflows thus far this year. These amounted to $16 billion during the first quarter, somewhat smaller than the post-crisis peak of $23 billion during the final quarter of last year, but substantially larger than the January-September average. Net capital outflows accelerated further to nearly $8 billion on April. Inflows of foreign capital were little changed from the fourth quarter at $14 billion, but their structure changed. Equity inflows were substantially larger with foreign direct equity inflows little changed from the fourth quarter at $6 billion (mainly reinvested earnings) and zero net portfolio equity inflows. Net foreign borrowing fell sharply, however, to $8 billion from $13 billion during the fourth quarter, reversing steady increases during 2010. The decline in foreign borrowing reflected a drop in net borrowing by domestic banks, to less than $3 billion during January-March from $4 billion during the fourth and $13 billion during the third quarter. Bank borrowing from abroad fell despite a marked acceleration in bank lending. It appears that the decline is likely to have reflected a drop in short-term deposit inflows. Banks free reserves fell by the equivalent of $10 billion during the first quarter and have recovered only marginally since, suggesting that shortterm inflows are likely to have remained modest in April as well. Short-term inflows appear to have been constrained by increased ruble volatility and a marked decline in equity prices. Indeed, the ruble has appreciated only 3% from January through May against the $0.55/0.45 basket and has weakened recently despite a 50% jump in oil prices from a year earlier. Borrowing by corporations slowed as well during the first quarter, to less than $6 billion from $9 billion during the fourth. The decline appears to have reflected both a slowdown in intercompany borrowing as well as somewhat smaller bond issuance with a number of companies deferring bond issues because of adverse market conditions. Meanwhile, resident capital outflows, at $29 billion, remained near their fourth-quarter post-crisis peak. With equity outflows little changed at $11 billion and domestic banks increasing their assets by less than during the fourth quarter, capital flight appears to have accelerated to perhaps $25 billion during January-March, including unidentified outflows. This compares with $21 billion during the fourth quarter and roughly $7.5 billion a quarter on average during January-September. The increase in capital flight appears to have reflected growing political uncertainty ahead of the March 2012 presidential election with no clear successor in sight and signs of growing discord between President Medvedev and Prime Minister Putin on a number of strategic issues. Worries about the business environment appear to have played a role as well following administrative and legal actions against a number of prominent businessmen connected with the former mayor of Moscow Mr. Luzhkov.
The increase in capital flight reflects growing political uncertainty ahead of the March 2012 presidential election Short-term inflows appear to have been constrained by increased ruble volatility and a marked decline in equity prices

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Table 8 Emerging Europe: Capital Flows $ billion 2009 Capital Inflows Total Inflows, Net: Private Inflows, Net Equity Investment, Net Direct Investment, Net Portfolio Investment, Net Private Creditors, Net Commercial Banks, Net Nonbanks, Net Official Inflows, Net International Financial Institutions Bilateral Creditors Capital Outflows Total Outflows, Net Private Outflows, Net Equity Investment Abroad, Net Resident Lending/Other, Net Reserves (- = Increase) Memo: Current Account Balance -104.3 -82.3 -45.9 -36.4 -22.0 20.5 -178.7 -90.8 -47.3 -43.5 -88.0 6.6 -234.9 -168.7 -54.2 -114.5 -66.2 -20.6 -231.2 -188.2 -55.7 -132.5 -43.0 -69.9 83.8 56.0 63.1 54.2 9.0 -7.1 -73.2 66.1 27.8 30.1 -2.3 172.1 148.4 71.4 64.8 6.6 77.0 4.1 72.9 23.6 20.2 3.5 255.5 246.6 108.2 98.0 10.2 138.4 43.3 95.1 8.9 11.4 -2.5 301.1 300.1 125.6 109.5 16.1 174.5 60.1 114.4 1.0 -1.9 2.9 2010 2011f 2012f

Nonresident purchases of local currency-denominated government bonds jumped as well, especially in Turkey, Poland and Hungary. Foreign purchases of local currency bonds have been supported by reduced global risk aversion and growing interest rates differentials as monetary policies have begun to be tightened. Eurobond issues rose both by governments and, in Russia and Ukraine, by private sector issuers. The recovery in FDI has been more modest, however, mainly reflecting larger reinvested earnings in line with rising profits of foreign-invested companies. Portfolio equity flows have been volatile, especially in Russia. For 2011 as a whole, inflows of private foreign capital look likely to increase by more than half from 2010 to $247 billion. This would still be less than those during 2004-2008, however, with private capital inflows likely to reach the 2008 level only in 2012. Roughly onethird of the increment is likely to reflect a further increase in FDI, mainly through higher reinvested earnings. Borrowing from commercial banks abroad will continue recovering but at a somewhat slower pace, remaining well below the pre-crisis level for some time. Borrowing from banks is likely to be constrained by ongoing liquidity pressures among Western European banks amid growing concerns about public finances in the Euro Area periphery. Capital inflows are likely to increase the most in Poland and especially Turkey, where growth has rebounded the most, domestic interest rates are attractive and markets are most liquid.
This year as a whole, inflows of private capital will increase by more than half to $245 billion

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Despite macroprudential measures aimed at discouraging short-term inflows, Turkey will remain the country most exposed to such inflows in the region. In Russia, by contrast, shortterm inflows are likely to remain modest, discouraged by low interbank rates, considerable ruble volatility and growing uncertainty ahead of the 2012 presidential election with no apparent successor in sight. In the rest of central Europe, capital inflows look likely to increase at a steady but more gradual pace, with output growth more modest, investment demand subdued and current account deficits sharply narrower or shifted to surpluses. Ukraine will remain the only country in the region with an effective IMF program, but dependence on IMF funding will ease this year thanks to the renewed access to private markets. Financing pressures are likely to intensify next year, however, when repayments begin to the IMF on loans extended in 2008 and in 2009. In central Europe, Hungary and Romania will remain most vulnerable to shifts in market sentiment. Recent moves in Hungary to diminish the independence of the monetary and the fiscal councils and the imposition of large temporary taxes on banks and other, mostly foreign owned, firms are likely to keep investors cautious. In Romania, the approaching parliamentary elections in late 2012 will test the resolve of the fragile ruling coalition to sustain unpopular austerity measures that have been key to advancing fiscal adjustment since last year. Political uncertainty in Russia will keep foreign inflows constrained this year and resident capital outflows outsized. In Turkey, by contrast, the approaching June 2011 parliamentary elections, unlike in the past, has had little impact on economic policies or market confidence. The main downside risk for the region is the debt crisis in the Euro Area periphery. Hungary, given the high level of government debt, is likely to be most vulnerable should market worries about the sustainability of government finances spread to central Europe. Poland and Romania could be affected as well, but vulnerabilities in both should be contained by the formers access to an IMF flexible credit line and a precautionary EU-IMF program in the latter. Turkey, meanwhile, remains most exposed to abrupt shifts in market sentiment given its high dependence on short-term capital and volatile portfolio debt inflows. A sustained drop in commodity prices poses a downside risk for Russia and especially for Ukraine. On the other hand, continued strong recovery in Germany would substantially improve the nearterm growth outlook for central Europe and Turkey, helping accelerate FDI inflows.
Capital inflows will be the strongest in Poland and Turkey, but are likely to remain constrained in Russia

LATIN AMERICA: STRONG CAPITAL INFLOWS WILL CONTINUE TO CHALLENGE POLICY MAKING Private capital inflows to Latin America are forecast to be $255 billion in 2011, slightly lower than in 2010 (Table 9). Robust inflows reflect strengthening foreign direct investment (FDI) driven by expectations of a permanent increase in commodity prices and comparatively stronger growth prospects. We project net FDI inflows to approach $101 billion this year, up from $90 billion in 2010 and $59 billion in 2009. Following a record inflow last year, portfolio equity investment is to moderate somewhat. Carry trade inflows will likely remain substantial as key countries continue to tighten monetary policy in order to rein in inflation.

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Capital Flows to Emerging Market Economies

Table 9 Latin America: Capital Flows $ billion 2009 Capital Inflows Total Inflows, Net: Private Inflows, Net Equity Investment, Net Direct Investment, Net Portfolio Investment, Net Private Creditors, Net Commercial Banks, Net Nonbanks, Net Official Inflows, Net International Financial Institutions Bilateral Creditors Capital Outflows Total Outflows, Net Private Outflows, Net Equity Investment Abroad, Net Resident Lending/Other, Net Reserves (- = Increase) Memo: Current Account Balance -163.9 -123.8 -54.6 -69.2 -40.1 -15.0 -245.2 -158.8 -70.2 -88.6 -86.4 -42.1 -231.2 -109.3 -54.5 -54.8 -121.9 -46.5 -172.1 -134.0 -51.3 -82.7 -38.1 -87.9 178.9 155.5 116.2 59.0 57.3 39.3 0.0 39.3 23.4 8.8 14.5 287.2 264.9 155.0 90.3 64.8 109.9 29.2 80.7 22.3 9.3 13.0 277.8 254.7 150.7 100.6 50.1 104.0 29.9 74.1 23.1 4.2 18.9 260.0 238.5 151.1 98.6 52.6 87.3 27.6 59.7 21.5 3.7 17.8 2010 2011f 2012f

Robust, albeit moderating private capital inflows, combined with further terms of trade gains, will most likely continue to put upward pressure on local currencies, thereby complicating policymaking. We expect the region to accumulate a record amount of international reserves (about $120 billion) this year as economic authorities seek to forestall currency appreciation. Increased use of controls on capital inflows also cannot be ruled out. Even though in many countries inflation is above official targets, central banks have carefully gauged the pace of monetary tightening in order to avoid fueling further currency appreciation. If inflation pressures intensify, we expect the introduction of further macroprudential measures to slow growth of domestic demand while minimizing capital inflows. Macroprudential measures could encompass additional reserve requirements on both domestic and foreign currency bank deposits, higher capital requirements on bank lending and enhanced regulation of the non-deliverable forward foreign currency market. While the governments of some countries, such as Chile and Brazil, have announced spending cuts to support monetary policy, we believe that more forceful fiscal adjustments may be needed to accommodate increased capital inflows while protecting international competiveness.

Robust inflows and further terms of trade gains will most likely continue to put upward pressure on local currencies, thereby complicating policymaking

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AFRICA AND MIDDLE EAST: AGGREGATE FLOWS IN 2011 DENTED BY THE POLITICAL TURMOIL Aggregated capital flows to the Africa and Middle East region in 2011 and 2012 disguise some sharp divergences in performance between oil exporting countries (Saudi Arabia and the UAE), other countries in the MENA region that have been impacted by the political upheaval that has swept the Arab world over the past few months (Egypt and Lebanon) and countries with more mature capital markets (South Africa), whose fortunes are more closely tied to developments in the global economy. Overall, however, private capital inflows are projected to slip to $56 billion this year from $77 billion in 2010 (Table 10). An increase in foreign direct investment to $62 billion will help offset an outflow of portfolio equity and a drop in inflows from banks and other private creditors. Sharply higher oil prices have resulted in a more than doubling in the current account surpluses in Saudi Arabia and the UAE this year. The accumulation of foreign assets, mostly in liquid fixed income securities, will show up as a large outflow of resident lending abroad. In addition, we expect the surplus countries in the GCC to provide financial support to other countries in the region whose balance of payments have come under pressure as a result of higher oil import bills or a drop in export earnings due to the social unrest. In Saudi Arabia, resident lending abroad jumps from about $10 billion last year to over $60 billion in both 2011 and 2012. Egypt has suffered large capital outflows following the political turmoil earlier in the year (Box 5). Reserves fell by about $8 billion between December 2010 and April 2011 and the Central Bank has also run down its foreign exchange deposits at banks to provide dollar liquidity to the market. This, together with sharply lower foreign direct investment and deterioration in BOX 5: POLITICAL TURMOIL RESHUFFLES CAPITAL FLOWS IN MENA The political turmoil in the MENA region, which started in Tunisia, moved to Egypt, then spread to countries in the Mashreq and beyond, has resulted in major shifts in capital flows in the region. The sharp increase in oil prices has nearly doubled the export receipts of oil producing countries (see IIF Research Note The Arab World in Transition: Assessing the Economic Impact, May 2, 2011). The windfall has been used to finance large-scale infrastructure projects and higher current spending by governments, with the bulk of the remaining surpluses being recycled back into the global capital markets. The larger current account surpluses are also being used to assist other countries in the region, which have suffered large capital outflows. Previously robust private capital inflows to Egypt, Tunisia, Lebanon, Jordan, and to a lesser extent Libya have slowed considerably or, as in the case of Egypt, reversed as nonresidents sharply reduced their holdings of Treasury bills and equity positions. These developments, together with bigger current account deficits as a result of a slump in tourism and a drop in remittances, have left a sizable gap in the balance of payments of these countries. The shortfall will be met by concessionary assistance from the oil producers as well as increased borrowing from multilateral institutions such as the IMF and World Bank, and from regional developments institutions.
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Sharply higher oil prices have resulted in a more than doubling in the current account surpluses in Saudi Arabia and the UAE this year.

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Capital Flows to Emerging Market Economies

Table 10 Africa and Middle East: Capital Flows $ billion 2009 Capital Inflows Total Inflows, Net: Private Inflows, Net Equity Investment, Net Direct Investment, Net Portfolio Investment, Net Private Creditors, Net Commercial Banks, Net Nonbanks, Net Official Inflows, Net International Financial Institutions Bilateral Creditors Capital Outflows Total Outflows, Net Private Outflows, Net Equity Investment Abroad, Net Resident Lending/Other, Net Reserves (- = Increase) Memo: Current Account Balance 24.2 46.3 161.3 122.1 -82.4 -106.0 -10.8 -95.2 23.6 -126.9 -72.8 -10.9 -62.0 -54.1 -221.5 -122.9 -11.3 -111.6 -98.6 -202.6 -133.8 -10.7 -123.0 -68.8 58.2 54.6 53.1 75.5 -22.4 1.5 0.0 1.5 3.6 3.8 -0.1 80.6 76.9 54.4 53.8 0.7 22.5 10.7 11.8 3.7 3.3 0.4 60.3 55.7 46.1 62.1 -16.1 9.6 3.0 6.6 4.6 4.0 0.5 80.4 71.8 58.1 64.3 -6.2 13.7 5.5 8.2 8.6 6.3 2.3 2010 2011f 2012f

the current account as a result of the slump in tourism, suggests that nearly $16 billion has already flowed out of the country this year. The authorities are now seeking financial assistance from official creditors such as the IMF, multilateral development banks and from oil-rich countries in the region. This will help compensate for a drop in private inflows, which have turned negative this year. The bulk of the assistance is likely to come in FY 2011/12 (July to June). Domestic and regional events have taken a toll on the Lebanese economy as well. The current account deficit is projected to widen from 15.9% of GDP in 2010 to 17.7% this year, reflecting a higher import bill due to the surge in oil prices and weaker earnings from tourism. The capital and financial accounts will remain in large surplus, albeit much smaller than in the past three years. Net private capital inflows to Lebanon are expected to decline from an estimate of $7.7 billion in 2010 to $3.9 billion in 2011 (equivalent to 10% of GDP), due to heightened political uncertainty. Most of these flows continue to be in the form of FDI and nonresident deposits in domestic banks. Away from the turmoil in the MENA region, South Africa is likely to continue to benefit from robust private capital inflows this year and in 2012, underpinned by a rebound in FDI. A number of large deals are in the pipeline in the retail and mining sectors and we expect these to be concluded this year. As a result, we project direct equity investment to shift from a $1 billion net outflow in 2010 to a net inflow of about $6 billion this year. This will comfortably

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IIF RESEARCH NOTE

Capital Flows to Emerging Market Economies

offset a slowdown in portfolio equity inflows from $3.1 billion last year to a projected $0.5 billion in 2011. Flows from nonbank private creditors are also expected to slow from $6.4 billion to about $4.2 billion as foreign investors, who bought a record amount of highyielding government bonds in the local market in 2010, exercise more caution. Over the past couple of years yield-seeking investors have taken advantage of the large interest rate differential between South Africa and the United States, but as global imbalances start to unwind the relative attractiveness of South African assets may diminish and exchange rate risk could reemerge. Nigeria is also likely to continue to attract robust inflows of FDI of about $5-6 billion a year, primarily into the energy sector.
South Africa is likely to continue to benefit from robust private capital inflows this year and in 2012

IIF CAPITAL FLOW REPORT COUNTRY SAMPLE (30) Emerging Europe (8) Bulgaria Czech Republic Hungary Poland Romania Russian Federation Turkey Ukraine Latin America (8) Argentina Brazil Chile Colombia Ecuador Mexico Peru Venezuela

Emerging Asia (7)

China India Indonesia Malaysia Philippines South Korea Thailand

Africa/Middle East (7)

Egypt Lebanon Morocco Nigeria Saudi Arabia South Africa UAE

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