Reversal of Capital Flows in the Emerging World

The reversal of capital inflows due to deleveraging or losses in financial markets has been one of the most significant effects of the financial crisis on emerging and frontier economies.

After a period in 2007 and 2008 when many emerging markets faced the problem of dealing with extensive capital inflows, now capital flows have reversed. Private capital flows in 2009 are expected to be less than half of their 2007 levels, posing pressure on emerging market currencies, asset markets and economies. Countries that relied on readily available capital to finance their current account deficits are particularly vulnerable. Furthermore, capital outflows pose the risk that governments may react with some type of capital controls or barriers to the exit of foreign investments.

Foreign direct investment (FDI) is considered by many to be a major and more stable source of financing for many developing countries. FDIs slowed down sharply in recent quarters due to two major factors affecting domestic as well as international investment. First, the capability of firms to invest has been reduced by a fall in access to financial resources, both internally (due to a decline in corporate profits) and externally (due to lower availability and higher cost of finance). Second, the propensity to invest has been affected negatively by economic prospects, especially in cases involving corporations with operations in the developed countries which are hit by a severe recession. In addition, a very high level of perceived risk is leading companies to extensively curtail their costs and investment programmes to become more resilient to any further deterioration of the business environment and their balance sheets. The fact that many multinational enterprises can easily shift financial resources from one country to another, adds another degree of uncertainty, contributing to the growing macroeconomic instability in developing countries.

The outlook for the flow of portfolio investments is even less encouraging. Redemptions of US$41.2 billion out of EM equity funds in 2008 have fully reversed the record US$40.8 billion inflow of 2007. About half of the EM fund purchases that have occurred since 2003 have now been withdrawn. According to the Institute for International Finance (IIF), net private capital flows to emerging markets are estimated to have declined to US$467 billion in 2008, half of their 2007 level. A further sharp decline to US$165 billion is forecast for 2009, with just over three-quarters of the decline due to deterioration in net flows from commercial banks. Moreover, net lending of international banks to emerging countries (excluding Gulf countries) is expected to fall to US$135 billion in 2009 from US$401 billion in 2007 and US$245 billion in 2008.

The World Bank estimates that in 2009, 104 of 129 developing countries will have current account surpluses inadequate to cover private debt coming due. For these countries, total financing needs are expected to amount to more than US$1.4 trillion during the year. External financing needs are expected to exceed private sources of financing (equity flows and private debt disbursements) in 98 of the 104 countries, implying a financing gap in 98 countries of about US$268 billion. Should bank rollover rates be lower than expected, or should capital flight significantly increase, this figure could rise to almost US$700 billion. Well over US$1 trillion in EM corporate debt and US$2½-3 trillion in total EM debt matures in 2009, the majority of which reflects claims of major international banks extended cross-border or through their affiliates and branches located in emerging markets.

For most of the reasons presented above, a number of emerging economies have recently imposed controls on capital outflows as a way of managing financial crises. Iceland, Ukraine, Argentina, Indonesia and Russia, among others, have resorted to a number of restrictions on the availability of foreign exchange as a way of dealing with the collapse in global risk appetite. Although those are frequently used as a way of rationing forex during a crisis, there is a risk that capital controls might become a normal part of policymakers’ tool-kits well beyond strict emergency needs. In principle, capital controls permit monetary and fiscal policy to be directed to the stabilization of economic activity without having to worry about a collapse of the currency and its deleterious effects on the sectoral and national balance sheets. The imposition of capital controls should be viewed as temporary, with a gradual relaxation as economic conditions improve and global financial stability returns. Such controls might restrict the ability to attract capital in the future as foreign investors fear that they will be unable to repatriate their profits

With rising unemployment and falling real wages, remittances will also subside with pressure on the standard of living, growth and external balances of labor-sending countries. In addition to these private capital flows the reduction of official flows, including development assistance is also set to slow as donors scale back their funding in the face of greater domestic needs. However funds available from multilateral institutions like the IMF and regional development banks may partly offset the decline in other funds and withdrawal of private capital. The G20 seems to have neared an agreement on doubling or tripling the IMF’s lending capacity and regional development banks like the EBRD, ADB and others are boosting their capital base and scaling up their lending to support regional banks.

The fall in the price of oil (and the reduction in oil revenues) has eroded the surpluses of oil exporting nations, lowering the funds they have to invest abroad in advanced economies and in emerging markets. Furthermore the need for capital at home (to support domestic banks, finance fiscal stimulus packages, stabilize asset markets) and losses on past investments are leading sovereign investors to privilege liquid assets rather than the riskier assets like equity, corporate bonds and alternatives – which they tended to invest in until mid 2008. The reduction in funds entrusted to the international banking system by countries like Russia and African oil exporters, some of which, the IMF suggests, were re-lent to Eastern European countries, provide further pressure on bank lending. Governments of commodity rich countries are now having to take on a larger role in financing infrastructure projects that had been earmarked as public-private partnerships rather than making significant investments overseas. However, other investors like some of Chinese government institutions may be emerging to take up some of the slack. China recently extended loans to several cash-strapped resource companies and may also be emerging as a source of investment to countries like Pakistan and Kazakhstan.

Eastern Europe

Eastern Europe’s heavy reliance on external financing may be its Achilles Heel, as it looks set to be the hardest hit of emerging market regions as such financing dries up. Almost every country in the region is either in or close to recession, and the sharp drop-off in capital flows is both a reflection of, and a contributor to, the region’s deteriorating growth prospects.

For the last decade, a bonanza of foreign financing has helped the region grow faster than the world average. The region’s capital account liberalization, financial sector reforms and its prospects for convergence with the EU made it an attractive destination for inflows. But that ‘attractive’ status is changing, given the current environment of global credit tightening and given investors’ waning EUphoria. Net private capital flows to the CEE-6 (Poland, Czech Republic, Hungary, Romania, Bulgaria, Turkey) are forecast to fall to around $60 billion in 2009, less than half that received in 2008, according to the Institute of International Finance (IIF).

Besides boosting growth, the stream of foreign capital inflows contributed to a build-up of external imbalances in recent years, specifically high current-account deficits. Such deficits are the norm in the region, but the Baltics (Estonia, Latvia, Lithuania), Bulgaria, and Romania stand out for their sky-high deficits (in the double-digits as a % of GDP in 2008), making them particularly vulnerable to a drop-off in capital inflows. While current-account deficits are expected to narrow across the board in Eastern European countries in 2009, the adjustment is painful and has led to concerns over a full-blown balance of payments crisis. Latvia and Hungary have already turned to the IMF for financing.

While the region’s heavy dependence on foreign financing has been apparent for years, alarm bells were muted. The rationale was two-fold. One, the region was playing catch-up to the EU and current-account deficits were seen as a normal part of that process. Two, the inflows to the region consisted of relatively ‘safe’ forms of financing. That is, FDI – generally considered more stable and less susceptible to rapid outflows than other capital flows, like portfolio investment – accounted for the majority of inflows, although that is now changing. FDI inflows covered almost 100% of the EU newcomers’ current-account deficits from 2003-2007. However, in 2008, FDI coverage dropped to an estimated 55%, according to the Economist. The recession in Western Europe, the source of the bulk of the region’s FDI inflows, is not helping matters.

With the drop-off in FDI, debt – particularly intra-bank lending – has been financing an increasing portion of these countries’ current-account deficits. Nevertheless, intra-bank lending – that is, lending between foreign parent banks and their subsidiaries in the region – is also set to drop off sharply in 2009. Net bank lending to emerging Europe, excluding Russia, is projected to be a meager $22 billion in 2009, down from $95 billion in 2008, according to the IIF. Foreign parent banks, who dominate the region’s banking systems, have pledged to continue to support their CEE subsidiaries, but the global credit crisis has made it difficult for them to maintain previous levels of lending. With the slowdown in both FDI and intra-bank lending, central banks in the region are increasingly being forced to tap their foreign reserves. As for growth, the sharper the decline in capital flows, the sharper the contraction in growth. Future growth prospects hinge on a recovery in capital inflows to the region.

Emerging Asia

Private capital flows to Asia slowed sharply from US$315 billion in 2007 to around US$96 billion in 2008. Risk aversion, de-leveraging and redemption by investors to offset losses in developed markets contributed to portfolio outflows of US$55 billion in 2008 and foreign bank borrowing slowed from US$156 billion in 2007 to just US$30 billion in 2008. While these trends will continue to erode capital flows to Asia in 2009, albeit at a slower pace, even more resilient flows like FDI and debt inflows will take a hit also. South Korea, India and Indonesia are most vulnerable to capital outflows, however foreign capital fueled credit growth and lending to firms and households even in countries like Hong Kong, Taiwan, Singapore and Vietnam. Therefore, the ongoing liquidity crunch will hit fixed investment, consumer spending, raise credit costs and bank delinquencies as well as undermine asset markets.

After emerging Europe, emerging Asia has been most severely hit by the decline in foreign bank borrowing especially firms and banks in South Korea, India, China and Indonesia which relied heavily on foreign capital to drive investment and consumer spending. But despite having high external debt and short-term debt relative to foreign exchange reserves, countries like South Korea, India and Indonesia will be able to meet the debt obligations due in 2009 (over 50% of it to Western European banks) or even roll over debt. After 2008 reversed the portfolio inflows of 2007, outflows might continue even in 2009 led by India, Taiwan and South Korea. The main drivers will likely be domestic risks (GDP growth and export slowdown, lower corporate earnings, easing fiscal and external balances), not just global factors. This might exacerbate equity market sell-offs in India, Thailand, Philippines, China, Vietnam, Singapore and Hong Kong so that valuations, in spite of being attractive in markets like Hong Kong, Indonesia, Singapore and Vietnam, might trend down further.

Fiscal stimulus and subsidy spending are affecting fiscal balances and raising external financing needs of countries like Malaysia, Philippines, India, Vietnam and Indonesia. Others like China will boost domestic bond issuance. While yields will go up, bond issuance might continue to face a tepid response due to risk aversion in EMs, flight to safe-haven (the U.S.!), narrowing interest rate differential with the U.S., risk of ratings downgrade, and expectations of limited currency appreciation in the near term.

The global credit crunch, high credit costs and export contraction have also taken a toll on FDI into Asia, a large share of which is export-related. China, Indonesia, Malaysia and Vietnam where FDI accounts for a large share of total fixed investment, are most affected. FDI to China began slowing in the second half of 2008, and has been declining for the last five months as the global outlook began to worsen, and revaluation expectations were reversed. The decline in corporate profits though poses a bigger risk to investment as retained earnings are the biggest contributor to investment. Moreover, large lay-offs across the world, especially in the West and the GCC will impact countries dependent on remittances such as Philippines, Vietnam and India, challenging the financing of current account balances and also domestic demand in some countries.

Capital outflows have pulled down most Asian currencies since 2008 led by South Korea, Malaysia, Singapore, India, Indonesia and Taiwan. In response, many central banks like India, South Korea, Thailand, Philippines, Vietnam and Indonesia have run down foreign exchange reserves to defend their currencies. And even Chinese reserve growth has been much more subdued, with the most recent numbers suggesting that China may have experienced capital outflows in several months in Q42008 and Q12009. Amid dollar squeeze, countries like Indonesia have imposed restrictions on currency conversion and US$ outflows, while others like India have eased foreign investment rules to attract the much needed capital. Waning capital inflows will put pressure on the BOP as shrinking exports affect the current account, especially for those running trade and/or current account deficits – South Korea, India, Thailand, Vietnam, Indonesia and Philippines and those running surpluses like China and Taiwan will run narrower surpluses. Nevertheless, large foreign reserve accumulation and current account balances will contain risks of BOP and currency crises like in 1997-98. Asian central banks have also been actively injecting dollar liquidity, entering swap agreements (South Korea, Indonesia, Singapore, Hong Kong), easing credit costs for firms, and expanding Asian reserve pooling under the Chiang Mai Initiative to relieve selling pressure on their currencies. The expansion of Asian Development Bank’s resources, as advocated by the G20 will provide further financing to avert the reversal of other development assistance and avoid balance of payments pressure.

Commonwealth of Independent States

While Russia’s current account has yet to sink into deficit as the sharp fall in the rouble and lack of credit led imports to contract more than exports, a deficit is likely in 2009 if the oil price stays below $50 a barrel. Furthermore portfolio and direct inflows have been reduced, leaving Russian corporates to seek funds from the government to meet their outstanding liabilities accrued when credit was cheap. With the global IPO and bond markets frozen, Russia is trying to raise funds at home. The government is stepping back from its plans to implicitly guarantee all the foreign liabilities, but it has provided significant funds to the banking sector and will increase spending to offset the withdrawal of foreign investment. Some Russian officials find the ideal of capital controlsvery attractive, though Putin worries that it will offset the opportunity for the rouble to become a regional currency.

Like Russia, banks in countries like Kazakhstan and Ukraine borrowed heavily while international capital was cheap and have accumulated large foreign debts, many of which are coming due in 2009 and 2010. This has put pressure on the banking system that has been frozen out of international credit markets and is facing domestic liquidity shortages and the rising domestic costs of external debts after currency depreciation , which might increase defaults and lead to a pattern of non-payments. The Ukraine with its wide current account deficit is particularly vulnerable and has turned to the IMF to avoid a balance of payments crisis. Kazakhstan by contrast will rely on its past savings and may seek Chinese funds.

Remittances are the largest source of external financing for many Central Asian countries, accounting for at least 20% of the regions GDP in total – they account for over 30% of the GDP of Kyrgystan and Tajikistan. The deteriorating economic situation in Russia, rising unemployment and the quota cuts for foreign workers have reversed migration trends and drastically reduced remittances flows to many CIS countries, in the face of current account deterioration as well as the social and political unrest that an influx of returning labor could trigger.

Latin America

Historically, Latin America was poorly placed to handle external capital market shocks, as it typically did little to save in expansion phases, remaining quickly vulnerable to deterioration in both real and financial external conditions. Key parts of the region remain prone to these problems: both Argentina and Venezuela are now facing much more challenging conditions in an environment of lower commodity prices. Ecuador has already defaulted. By contrast, other countries in the region appear relatively well placed to handle global difficulties, in large part because of their relative prudence in the post 2002 global credit boom. Foreign currency borrowing by the public sector was sharply curtailed (although not that by the private sector). Owing mainly to a fall in commodity prices, the region’s aggregate current account will be in deficit of about $65 billion in 2009. The accumulation of substantial foreign exchange reserves provides some leeway t
o finance the deficit, while reduced levels of dollar-denominated public debt allow currency depreciation to occur without raising solvency concerns.

In Brazil, the balance of payments printed only a slight surplus in 2008, US$2.9 billion compared to a huge surplus of US$87.4 billion in 2007. For 2009, the data so far suggest a much weaker reading as well. In fact total flow of FDI of only US$11 billion is expected in 2009, down from US$45 billion in 2008 reflecting the sluggishness of capital markets and the sharp contraction in the advanced economies, the main sources of those flows in the past. At the same time, some recovery of portfolio flows is likely if there is a marginal bounce back in risk appetite vis-à-vis 2008. Total capital and financial accounts inflow might amount to around US$17 billion, nearly matching the estimated current account deficit of US$19.2 billion, characterizing a nearly zero balance of payments for 2009.

Mexico experienced a significant decrease in FDI and portfolio inflows in Q42008 (-US$ 3.6 billion vs. US$ 11.9 billion in Q42007) as growth expectations for the U.S. and Mexico were revised significantly lower, credit conditions abroad tightened (deleveraging), and global risk appetite dried up. However, assets held abroad increased sharply (by US$ 8.1 billion vs. a decrease of US$ 3.7 billion in 4Q07), thus compensating for the shortage in capital inflows. Overall, the capital account ended up with a slightly wider surplus in 2008 (US$ 20.9 billion vs. +US$ 20.8 billion in 2007) and was enough to finance the much larger current account deficit (of US$ 15.5 billion vs. US$ 8.2 billion in 2007). Although workers’ remittances are considered part of the current account, they are an important source of capital inflows and for the first time since 1995 they declined to US$25.1 billion in 2008 (US$ 26 billion in 2007). In 2009, the current account deficit will most likely widen (US$ 25 billion). Pairing this with a flat capital account result in 2009 (US$ 21 billion), the balance of payment deficit should amount to roughly US$4 billion.

In Colombia, unfriendly growth and financial external conditions are impacting capital flows. The most recent data (to February 2009) suggest an outflow of US$ 140 million vs. an inflow of US$ 1.75 billion in the first two months of 2008. The central bank stated that the outflow was mainly explained by ‘other special operations’ (US$ 1.7 billion), which are most likely related to transfers to the treasury and the central bank intervention mechanism in the FX market (options) to control for volatility, among others. Moreover, capital flows were impacted by a decline in FDI (32% to US$ 1.2 billion) and in remittances (7% y/y to US$ 800mn).


The reduction in capital flows, especially private capital and the fall in commodity prices is undermining Africa’s recent high growth rates. With investors now fleeing to safe assets rather than seeking out yields, exotic investments like African equities and government bonds are finding it difficult to attract capital even as official sector flows also seem to be scaled back. Official development assistance, FDI inflows and remittances that have contributed to financing current account imbalances in a number of African economies in recent years are set to drastically decline in 2009 threatening to offset economic gains they helped to achieve. Furthermore commodity exporters like Nigeria who recently ran surpluses are now facing the prospect of current account deficits even as the reduction in energy and metals prices reduces FDI to the continent including in Southern Africa’s mining sector.

Estimates suggest that FDI to Sub-Saharan Africa fell sharply by about 21% in 2008, a trend likely to worsen in 2009. This means that governments with ambitious investment and development programs will need to revise their current spending and financing plans downwards. Furthermore with contraction in credit, and risk aversion, portfolio flows are increasingly difficult to attract, with outflows reported from most African exchanges. Most of the region’s equity markets are dominated by domestic investors though but the reduction in global liquidity and bank lending has created vulnerabilities for banks, especially in Nigeria. Overall, there were no international bond issues by African countries in 2008 compared with US$ 6.5 billion in 2007.

Remittance inflows from Africans working abroad, estimated at US$3 billion in 2007, are bound to fall because they originate from advanced economies that are experiencing deteriorating economic situations and rising unemployment. Remittances between African countries (eg from South Africa to others) have also fallen along with the contraction in the mining sector.

The UN estimates that aid flows will need to double by 2010 to meet the cost of financing the Millennium Development Goals. Yet core development aid has declined by 4% since industrialized nations committed to increasing it at the Gleneagles summit in 2005. France and Ireland are considering cutting aid budgets as the cost of the recession rises and while President Obama pledged to double the country’s aid budget eventually the timeline is unclear. According to the IMF a 1% drop in global growth leads to a 0.5% fall in growth in Sub-Saharan Africa but given the freezing of capital flows the effects could be more pronounced with the region likely to grow less than 3% in 2009.