IIF - Capital Flows to Emerging Markets

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IIF RESEARCH NOTE

Capital Flows to EmergingMarket EconomiesJune 1, 2011

IIF.com © Copyright 2011. The Institute of International Finance, Inc. All rights reserved.

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

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 Brazil’s 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.

Robin Koepke

RESEARCH ASSISTANT

Global Macroeconomic Analysis

1-202-857-3313

[email protected]

Julien Mazzacurati

RESEARCH ASSOCIATE


1-202-857-3308

[email protected]

Jeremy Lawson

DEPUTY DIRECTOR


1-202-857-3651

[email protected]

-50

0

50

100

150

200

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300

China India Brazil Russia Turkey

2007

2008

2009

20102011

2012

Chart 1

Net Private Capital Inflows to Emerging Markets

$ billion

Matthew Barger

INTERN


Emre Tiftik

INTERN


Philip Suttle

CHIEF ECONOMIST AND

DEPUTY MANAGING DIRECTOR

1-202-857-3609

[email protected]



IIF RESEARCH NOTE

page 2

Capital Flows to Emerging Market Economies


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.

Table 1Emerging Market Economies: Capital Flows

$ billion2009 2010 2011f 2012f

Capital Inflows

Total Inflows, Net: 715 1053 1092 1098

Private Inflows, Net 644 990 1041 1056

Equity Investment, Net 490 571 574 610

Direct Investment, Net 357 371 423 435

Portfolio Investment, Net 133 200 151 175

Private Creditors, Net 154 419 467 446

Commercial Banks, Net -10 172 194 191

Nonbanks, Net 164 247 273 256

Official Inflows, Net 71 63 51 41

International Financial Institutions 47 38 23 10

Bilateral Creditors 25 25 28 31

Capital Outflows

Total Outflows, Net -1073 -1411 -1487 -1392

Private Outflows, Net -453 -573 -654 -751

Equity Investment Abroad, Net -268 -269 -296 -321

Resident Lending/Other, Net -185 -305 -358 -430

Reserves (- = Increase) -620 -837 -833 -641

Current Account Balance 358 358 395 294

Memo:

-200

0

200

400

600

800

1000

1200

1400

2003 2005 2007 2009 2011f

-1.5

0.0

1.5

3.0

4.5

6.0

7.5

9.0

10.5Commercial Banks

Nonbanks

Portfolio Equity

Direct Equity Investment

Chart 2

Emerging Market Private Capital Inflows, Net

$ billion percent of GDP

Total, % of GDP



IIF RESEARCH NOTE

page 3



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 f lows 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 becautious 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.

Our forecast for capital

inflows to remain strong in

2011 and 2012 follows from

how we see underlying

fundamentals in EMs

The IMF’s new stance risks

encouraging greater use of

capital controls before

there is an international

framework in place toregulate their use and

ensure a level playing field

across countries



IIF RESEARCH NOTE

page 4



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.

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).

Table 2

Revisions to IIF Net Capital Inflows

$ billion

2008 2009 2010 2011f 2012f

IIF Capital Flows

June 2011 620 644 990 1,041 1,056

January 2011 622 602 908 960 1,009

Difference -2 42 82 81 47

Revisions by Region

Latin America 0.1 2.3 11.3 44.8 39.8

Emerging Europe 1.6 3.3 -5.8 18.6 25.9

Africa/Middle East -0.6 11.0 -10.0 -33.4 -20.2

Emerging Asia -5.7 15.7 52.5 55.7 19.7

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

-20

0

20

40

60

80

100

Direct Equity

Investment

Portfolio Equity Commercial

Banks

Nonbanks Total

Chart 3

Revisions to Private Capital Inflow Estimates for 2011 by Component

$ billion, change between January 2011 and latest (June 2011) estimates

All flows categories except

portfolio equity investment

have been revised up



IIF RESEARCH NOTE

page 5



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

Global Output Growth

percent change over previous year

2009 2010 2011f 2012f

Mature Economies -3.9 2.5 1.9 2.6

United States -2.6 2.9 2.8 3.4

Euro Area -4.1 1.7 1.9 1.6

Japan -6.3 4.0 -0.7 3.2

Emerging Economies 1.6 7.2 6.4 6.1

Latin America -2.4 6.2 4.4 4.3

Argentina -2.6 8.8 5.5 4.4

Brazil -0.6 7.5 4.0 4.2

Mexico -6.1 5.5 5.0 4.5

Emerging Europe -5.8 4.5 4.1 3.7Russia -7.8 4.0 4.5 3.8

Turkey -4.8 8.9 5.0 4.0

Asia/Pacific 6.8 9.3 8.2 8.1

China 9.2 10.7 9.4 9.0

India 8.0 8.6 7.8 8.2

Africa/Middle East 0.6 4.0 4.7 3.9

South Africa -1.7 2.8 3.6 4.2

World -2.0 4.3 3.6 4.0

Table 3

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 non-manufacturing 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



IIF RESEARCH NOTE

page 6



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.

Japan’s 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 Japan’s 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

Consumer Prices

percent change over previous year, end of period2009 2010 2011f 2012f

Mature Economies -0.1 1.5 2.4 1.2

United States -0.3 1.2 3.2 1.0

Euro Area 0.3 2.0 2.4 1.7

Japan -1.4 0.1 -0.3 0.0

Emerging Economies 5.0 6.2 6.4 5.3

Latin America 6.2 8.1 8.4 6.6

Argentina 17.4 22.9 25.8 11.2

Brazil 4.3 5.9 6.6 5.3

Mexico 3.6 4.4 3.1 3.9

Emerging Europe 6.8 6.8 7.1 6.3

Russia 8.8 8.8 9.4 8.0

Turkey 6.5 6.4 7.2 6.4

Asia/Pacific 3.6 5.2 5.1 4.1

China 1.9 4.6 4.9 3.7

India 10.4 9.0 6.3 5.0

Africa/Middle East 5.9 5.4 6.9 6.6

South Africa 6.3 3.5 5.5 5.6

World 1.7 3.2 3.9 2.8

Table 4



IIF RESEARCH NOTE

page 7



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 world’s

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 Russia’s, 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.

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.

Global Current Account Balance

$ billion

2009 2010 2011f 2012f

United States -378 -470 -612 -548

Euro Area -43 -49 -28 0

Japan 142 196 136 148

Other Mature Economies 25 33 81 57

Emerging Economies (IIF 30) 358 358 395 294

Africa / Middle East 24 46 161 122

Latin America -15 -42 -47 -88

Emerging Europe 20 7 -21 -70

of which Russia 49 71 74 35

Emerging Asia 328 347 301 330

of which China 261 305 280 328

Other Countries* -104 -67 28 49

Table 5

Global current account

imbalances widened a little

in 2010

* Includes global discrepancy

Capital inflows to EMs still

represent only a tiny

fraction of the global stock

of financial assets



IIF RESEARCH NOTE

page 8



0

5

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15

20

25

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35

00 01 02 03 04 05 06 07 08

Share of Global Output

Share of Global Financial Assets

Weight in Global Equity Benchmark Portfolio*

Chart 5

Emerging Markets: Measures of Underinvestment

ercent

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 greaterand 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.

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 stil l 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 India’s is

95.4% lower.

0

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150

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350

400

90 95 00 01 02 03 04 05 06 07 08

Mature Emerging

Chart 4

EM vs. Mature Economies: Stock of Financial Assets

ercent of GDP

Financial deepening in EMs

is still at an early stage, but

is proceeding rapidly

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



IIF RESEARCH NOTE

page 9



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 country’s

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 capitalinflows 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 country’s 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 fewdomestic investment opportunities and that foreign investment is not crowding out

investment by domestic residents.

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.

Capital inflows have a more

benevolent effect in

countries with higher levels

of institutional developmen

and human capital

-40

-20

0

20

40

60

80

2000 2002 2004 2006 2008 2010

-300

0

300

600

Net Acquisition ofEquity byForeigners

Equity

Issuance*

Portfolio

Inflows

(Inward)

Chart 7

EM: Equity Issuance and Porfolio Inflows

ercent of total $ billion

0

1

2

3

4

5

6

7

2002 2004 2006 2008 2010

0

100

200

300

400

500

600

700Inward FDI (rhs)

Chart 6

EM: Productivity Growth and Volume of Inward FDI

ercent $ billion

Productivity

Growth*

Source: Datastream; IIF calculations. * Productivity is proxied by Real GDP per worker forthe 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.



IIF RESEARCH NOTE

page 10



0

10

20

30

40

50

2001 2003 2005 2007 2009 2011

Chart 9

Emerging Economies: Bank Lending to Private Sector

ercent change over a year ago

EM Asia

EM Europe

Latin America

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 theauthorities 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 exception—Turkey—where

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 changein 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

10

14

18

22

26

30

2001 2003 2005 2007 2009 2011

2

3

4

5

6

7

8

9

10

Chart 8

Emerging Economies: Bank Lending and Inflation

ercent change over a year ago (both scales), 20 EMs

Bank Credit to

Private Sector

Headline Inflation



IIF RESEARCH NOTE

page 11



BOX 2: IIF EMERGING MARKETS BANK LENDING CONDITIONS SURVEY

The IIF’s quarterly Emerging Markets Bank Lending Conditions Survey of 45 memberbanks 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.

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.

44

47

50

53

56

EM Fed ECB

Corporate Loans

Consumer Loans

Mortgages

Net Easing

Chart X

Global Bank Lending Conditionsdiffusion index; 50 = breakeven (both charts)

Credit Standards

40

45

50

55

60

65

EM Fed ECB BoJ

Corporate Loans

Consumer Loans

Mortgages

Net Increase

Demand for Loans

10



IIF RESEARCH NOTE

page 12



$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. Thiswill 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

In the current cycle

domestic lending has been

increasing at a much faster

pace than all types of debt

flows

0

10

20

30

40

50

60

70

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

Financial Sector

Other Private Sector

Government

Chart 12

Emerging Market External Bond Issuance*

$ billionThrough

May 20

0.06

0.08

0.10

0.12

0.14

0.16

0.18

0.20

0.22

2000 2002 2004 2006 2008 2010

Chart 11

EM: Debt Flows Funded by Private Creditors*

ratio

Total Debt

Flows toNominal GDP

Commercial Banks to

Domestic Bank Credit

Other Private Creditors to

Domestic Bank Credit

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

* 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 RESEARCH NOTE

page 13



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 fundingopportunities 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, China’s 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 f lows, 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

EM investments in mature

economies are mainly low-

yielding debt flows, while

inflows to EMs are primarily

equity flows

0.0

0.1

0.2

0.3

0.4

0.5

0.6

00 02 04 06 08 10 12

Chart 13

Emerging Markets: Net Capital Inflows and Outflows

$ trillionDebt & ReservesEquity

Inflows

Outflows

0.0

0.4

0.8

1.2

1.6

00 02 04 06 08 10 12

Inflows

Outflows

0

200

400

600

800

1000

1200

1400

16001800

2000

98 00 02 04 06 08 10 12

FX Reserves

Resident Lending

Portfolio Equity

FDI

Chart 14

Net Capital Exports by Emerging Economies

$ billion



IIF RESEARCH NOTE

page 14



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 countriesshould 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 IMF’s 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 matureeconomies 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

Historically, capital control

measures have been

unsuccessful in stemming

aggregate capital flows,

especially when driven by

fundamentals



IIF RESEARCH NOTE

page 15



Monetary and fiscal policy

settings are too

accommodative in many

EMs

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.

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 andlenders 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)

5

6

7

8

2006 2008 2010

6

10

14

18

22

Policy

Rate

Reserve Requirements

Chart 16

China and Turkey: Monetary Policy Instruments

ercent (all scales)China

6

10

14

18

2006 2008 2010

4

6

8

10

12

14

16

Policy

Rate*

Reserve

Requirements

Turkey

*Turkey’s target rate changed to the one-week repo lending rate in June 2010*FEER = fundamental equilibrium exchange rate

-60

-40

-20

0

20

40

60

B r a z i l

C h i

n a I n

d i a

R

u s s i a

S . A f

r i c a

T h a i l a n

d

T u r k e

y

IMF WEO

Peterson Institute FEER*

Chart 15

EM: Exchange Rate Overvaluation Estimates

ercent overvalued vis-à-vis USD



IIF RESEARCH NOTE

page 16



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

Table 6

Reserve Requirements by Type of Deposit

percent

May 07 May 08 May 09 May 10 May 11

Chile ¹ — — — — 6.6

China ¹ 11.5 16.5 15.5 17.0 21.0

India ¹ 6.5 8.3 5.0 6.0 6.0

Indonesia ¹ 7.3 9.1 5.0 7.5 10.5

Korea ¹ — 7.0 7.0 7.0 7.0

Mexico ¹ 0.0 0.0 0.0 0.0 0.0

Poland ¹ 3.5 3.5 3.5 3.0 3.5

Brazil ²

Time 18.0 18.0 23.0 18.0 32.0

Demand 48.0 48.0 53.0 47.0 55.0

Colombia

Current Account 13.0 8.3 11.5 11.0 11.0

Savings Account 6.0 8.3 11.5 11.0 11.0

Russia

Time 3.5 4.5 1.0 2.5 4.0

Demand 3.5 4.5 1.0 2.5 4.0

FX 4 3.5 5.0 to 5.5 1.0 2.0 4.0 to 5.5

Turkey 5

Time 6.0 6.0 6.0 5.0 5 to 16

Demand 6.0 6.0 6.0 5.0 16.0

FX 11.0 11.0 9.0 9.5 11 to 121 Single ratio on different types of deposits

2 Includes the “additional requirements” that are remunerated at the SELIC rate.

4 Reserve requirement depends on residency of depositor 5 Depending on time length of the deposit

CD ³ 2.5 6.0 4.5 4.5 4.5

3 With maturity > 18 months



IIF RESEARCH NOTE

page 17



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 risinginflation, rising credit growth and strong capital flows.

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 theregion 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 eco-

nomic growth and ample

global liquidity

Among the large emergingeconomies, RRRs are being

relied on most heavily in

China and Turkey

Table 7Emerging Asia: Capital Flows

$ billion

2009 2010 2011f 2012f

Total Inflows, Net: 393.9 513.1 498.5 456.3

Private Inflows, Net 377.5 499.5 484.1 446.0

Equity Investment, Net 257.6 290.1 269.5 275.3

Direct Investment, Net 168.2 161.8 162.2 162.4

Portfolio Investment, Net 89.4 128.3 107.3 112.9

Private Creditors, Net 119.9 209.3 214.6 170.7

Commercial Banks, Net 62.8 128.1 117.6 97.4

Nonbanks, Net 57.1 81.2 97.0 73.3

Official Inflows, Net 16.5 13.6 14.3 10.3

International Financial Institutions 3.9 5.4 2.8 2.1

Bilateral Creditors 12.6 8.2 11.5 8.2

Total Outflows, Net -722.2 -859.8 -799.4 -785.9

Private Outflows, Net -140.7 -251.0 -252.8 -294.8

Equity Investment Abroad, Net -156.6 -140.2 -176.0 -202.9

Resident Lending/Other, Net 16.0 -110.8 -76.8 -91.9

Reserves (- = Increase) -581.5 -608.7 -546.6 -491.1

Current Account Balance 328.2 346.7 300.9 329.8

Memo:



IIF RESEARCH NOTE

page 18



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. China’s manufacturing prowess means that its share will

continue to exceed 60% of EM Asia’s 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 l ifted 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 year’s 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 China’s

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 fiscaltightening 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. China’s 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

Along with large capital

inflows, Emerging Asia is

set to maintain an

aggregate current account

surplus of $300-330 billion

this year and next



IIF RESEARCH NOTE

page 19



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 short-

term 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.

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 sectorinflows 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.

Official reserves

accumulation in Emerging Asia should slow from

$609 billion in 2010 to

$491 billion in 2012

Capital flows to Emerging

Europe increased at a solid

pace in early 2011



IIF RESEARCH NOTE

page 20



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 l ikely 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 short-

term 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 $7.5billion 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



IIF RESEARCH NOTE

page 21



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 one-third 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.

Table 8Emerging Europe: Capital Flows

$ billion2009 2010 2011f 2012f






Private Creditors, Net -7.1 77.0 138.4 174.5

Commercial Banks, Net -73.2 4.1 43.3 60.1

Nonbanks, Net 66.1 72.9 95.1 114.4


International Financial Institutions 30.1 20.2 11.4 -1.9

Bilateral Creditors -2.3 3.5 -2.5 2.9




Resident Lending/Other, Net -36.4 -43.5 -114.5 -132.5


Current Account Balance 20.5 6.6 -20.6 -69.9

Memo:

This year as a whole,

inflows of private capital

will increase by more than

half to $245 billion



IIF RESEARCH NOTE

page 22



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, short-

term inflows are likely to remain modest, discouraged by low interbank rates, considerableruble 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 andRomania could be affected as well, but vulnerabilities in both should be contained by the

former’s 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 near-

term growth outlook for central Europe and Turkey, helping accelerate FDI inflows.

LATIN AMERICA: STRONG CAPITAL INFLOWS WILL CONTINUE TO CHALLENGE

POLICY MAKINGPrivate 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.

Capital inflows will be the

strongest in Poland and

Turkey, but are likely to

remain constrained in

Russia



IIF RESEARCH NOTE

page 23



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.

Table 9Latin America: Capital Flows

$ billion2009 2010 2011f 2012f








Nonbanks, Net 39.3 80.7 74.1 59.7



Bilateral Creditors 14.5 13.0 18.9 17.8






Current Account Balance -15.0 -42.1 -46.5 -87.9

Memo:

Robust inflows and further

terms of trade gains will

most likely continue to put

upward pressure on local

currencies, thereby

complicating policymaking



IIF RESEARCH NOTE

page 24



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 l iquidity to

the market. This, together with sharply lower foreign direct investment and deterioration in

Sharply higher oil prices

have resulted in a more

than doubling in the current

account surpluses in Saudi

Arabia and the UAE this

year.

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.



IIF RESEARCH NOTE

page 25



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 anestimate 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

Table 10 Africa and Middle East: Capital Flows

$ billion2009 2010 2011f 2012f





Portfolio Investment, Net -22.4 0.7 -16.1 -6.2



Nonbanks, Net 1.5 11.8 6.6 8.2



Bilateral Creditors -0.1 0.4 0.5 2.3





Reserves (- = Increase) 23.6 -54.1 -98.6 -68.8

Current Account Balance 24.2 46.3 161.3 122.1

Memo:



IIF RESEARCH NOTE

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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 high-

yielding 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.

IIF CAPITAL FLOW REPORT COUNTRY SAMPLE (30)

Emerging Europe Bulgaria Latin America Argentina

(8) Czech Republic (8) Brazil

Hungary ChilePoland Colombia

Romania Ecuador

Russian Federation Mexico

Turkey Peru

Ukraine Venezuela

Emerging Asia China Africa/Middle East Egypt

(7) India (7) Lebanon

Indonesia Morocco

Malaysia Nigeria

Philippines Saudi ArabiaSouth Korea South Africa

Thailand UAE

South Africa is likely to

continue to benefit from

robust private capital

inflows this year and in

2012

IIF - Capital Flows to Emerging Markets

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