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Capital Flows to Emerging Markets Rise – Supporting Growth, But Adding to Policy Challenges. IIF Stresses Concerns About Use of Capital Controls.

New Forecasts for 2011 and 2012.

Washington D.C., June 1, 2011 — The Institute of International Finance is projecting further increases in overall net private capital flows to emerging markets this year to more than $1 trillion, following a 54% rise to $990 billion in 2010. While high inflows contribute to economic growth in emerging economies, they also present policy challenges to those countries already facing inflation pressures, strong credit growth and asset price gains.

The IIF forecast that total net private capital flows to emerging markets are likely to reach $ 1,041 billion this year and amount to $1,056 billion in 2012. Inflows to both Emerging Asia and Latin America, which rose sharply in 2010, are likely to fall modestly below that level in 2011 and in 2012. Net private flows to the Middle East – Africa region are expected to be significantly below the 2010 level this year, but to recover next year. Total 2011 flows into Emerging Europe are projected to be almost $100 billion above the 2010 total and a further significant advance is seen for 2012.

The IIF is the leading global association of financial services firms with over 430 member institutions headquartered in over 70 countries. IIF Managing Director Charles Dallara said, “The high level of capital flows to emerging markets reflects the rising weight of these economies in the global economy and their very strong performance relative to the mature economies in recent years. Overall, these inflows make a very positive contribution to global growth and it is important to note that approximately 40% of the total is accounted for by foreign direct investment.”

Mr. Dallara added, “Inflationary pressures, rather than high capital inflows is the largest threat to sustained growth in most emerging economies. We believe that the appropriate response by governments in general is to allow their exchange rates to adjust over time, tighten monetary policy as necessary, as well as make greater use of fiscal and macroprudential policy measures.”

In its report today on the outlook for net private capital flows to emerging markets, the IIF stressed that countries should be cautious about introducing capital controls in response to high inflows. Mr. Philip Suttle, IIF Deputy Managing Director and Chief Economist, said, “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 aggregate credit growth and inflation.”

Mr. Suttle stressed that, “Although total credit growth is strong and rising as a share of GDP in a number of key emerging economies, the ratio of foreign lending to total credit growth has been mostly 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 real interest rates remain close to zero in many emerging economies and that no large economy has plans to tighten fiscal policy significantly in 2011, even though most are running sizable budget deficits.”

Mr. Jeremy Lawson, the IIF’s Deputy Director of Global Macroeconomic Analysis, told a press conference here, “Our forecast for capital flows to remain strong this year and next, but not to accelerate significantly, reflects the Institute’s perspectives on underlying fundamental economic developments. Emerging markets’ GDP growth is expected to moderate from 7.2% in 2010 to 6.1% in 2012. This remains well above growth rates in mature economies, although the gap is seen as narrowing. We expect that interest rate differentials with the mature economies will widen in the near-term as the emerging markets combat overheating, but then stabilize next year as policy normalization in the mature economies gathers pace.”

Today’s report showed a continuing overall upward trend in foreign direct investment flows to emerging markets. Portfolio equity investment flows slowed somewhat in the earlier months of this year as the froth came off equity markets, but an upswing is projected for 2012 as growth remains solid and global asset reallocation in favor of emerging markets resumes. Bank lending is seen as continuing to recover, attracted by higher short-term interest rates. Strong flows into emerging market bond funds are also seen as likely, supported by perceptions that many of these economies have sounder public finances than some mature economies.

Regional Trends

Emerging Asia: After plunging from around $410 billion in 2007 to a five-year low of $119 billion in 2008 due to the global financial crisis, private capital inflows to this region rebounded to a record $500 billion last year. Inflows this year are likely to amount to around $484 billion before moderating only slightly to around $446 billion in 2012. Emerging 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.

Latin America: Net private capital inflows to Latin America are forecast at $255 billion in 2011, slightly lower than in 2010. Robust inflows reflect strengthening foreign direct investment (FDI) driven by prospects of a permanent increase in commodity prices and comparatively stronger growth prospects. The IIF projected net FDI inflows to around $100 billion this year, up from $90 billion in 2010 and $60 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 rising inflation. 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, said the Institute.

Emerging Europe: For 2011 as a whole, net 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. Today’s reported noted that 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. Despite macroprudential measures aimed at discouraging short-term inflows, Turkey will remain the country most exposed to such inflows in the region.

Middle East-Africa: Sharp divergences in capital flows are projected between the leading oil exporting countries and those countries in the Middle East that experienced political upheaval – particularly Egypt – when it comes to capital flows. Overall, net private capital inflows to the region are projected at $56 billion this year from $77 billion in 2010. 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.

Egypt has suffered large capital outflows following the political turmoil earlier in the year. Reserves fell by about $8 billion between December 2010 and April 2011 and the central bank has also run down its foreign exchange deposits at banks to provide dollar liquidity to the market. This, together with sharply lower foreign direct investment and a deterioration in the current account as a result of the slump in tourism, suggests that nearly $18 billion has already flowed out of the country this year.

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