Washington DC & Zurich, January 23, 2012 — The Euro Area crisis is having a negative impact on net private capital flows to emerging markets, as new forecasts from the Institute of International Finance (IIF) point to a substantial slowing of flows into these markets in 2012 following a significant reduction in the second half of 2011.

The IIF said net private capital flows to emerging markets this year are likely to total $746 billion, down from an estimated $910 billion in 2011, which in turn is a decline from the 2010 level of $1,040 billion. On the assumption of a gradual stabilization of the European economic situation in the course of this year and a revival of albeit subdued growth in Europe in 2013, the IIF projects a recovery in flows next year to around $900 billion.

The IIF is the global association of financial services firms with more than 450 member institutions. IIF Managing Director Charles Dallara said, “The Euro Area crisis is a major factor in the slowing of capital flows to emerging markets. The component of the overall net private flows to show the largest decline in the second half of 2011 was bank lending and we expect that net flows from banks to emerging markets will be quite weak for 2012 as a whole.”

Mr. Dallara added, “The sovereign debt difficulties in a number of European countries are having a growing impact on the global economy and on sentiment in financial markets. The crisis is contributing to bank deleveraging, which is damaging the prospects for both growth in Europe and for capital flows to emerging markets.”

IIF Chief Economist and Deputy Managing Director Philip Suttle said, “Our expectation of a protracted adjustment process in the Euro Area leads us to think that outward investments are likely to remain weak. This is the main driver behind our downward revision in capital flows to emerging economies for 2011 and our new forecasts for 2012. We anticipate that tensions in Europe will subside only gradually. We currently forecast a mild recession for the region, with output contracting at a 1.5-2% annualized pace from the final quarter of 2011 through the first half of 2012, followed by a sluggish resumption of growth.”

The IIF said it estimates that net commercial bank flows to emerging markets declined to $137 billion in 2011 from $162 billion in the previous year. For 2012, the IIF projects a sharp further fall in bank flows to a total of $38 billion, but a recovery is seen next year with a volume of $96 billion. The new forecasts show declines in net non-bank (mostly bonds) flows in 2011 to $301 billion from $319 billion in 2010, and a substantial drop in the total is now seen for this year to $211 billion, while a moderate upswing is projected in 2013 to $240 billion. Although there was a strong decline in net portfolio equity flows last year to $44 billion from $193 billion in 2010, the IIF forecast a 2012 recovery to $76 billion and a further advance to $116 billion in 2013.

Commenting on the EuroArea crisis at an IIF press conference in Zurich, Mr. Dallara said, “Progress has been made by Euro Area leaders toward stabilizing the sovereign debt market. However, the leaders, who are due to meet next week, need to do still more at the national and regional levels to restore market confidence on a sustained basis.”

Mr. Walter Kielholz, Vice Chairman of the IIF Board of Directors and Chairman of Swiss Re, speaking at the press conference noted that, “The IIF’s report underscores that 2012 will be a testing and uncertain year for private capital flows to emerging markets. Indeed, the 2012 forecast is for a volume of such flows that will be more than 25 percent below the one trillion dollar level seen in 2010. Notwithstanding this significant reduction, the report today highlights the underlying strengths of many of the emerging market economies, which as a group are seen as continuing to have stronger economic growth than the mature industrial economies.”

The IIF report pointed out that foreign direct investment is holding up with a projected 2012 volume of $420 billion after a 2011 total of $428 billion. FDI in 2013 is seen at $441 billion and Mr. Dallara noted, “In the longer term, the overall superior growth prospects for emerging economies are most likely to drive greater flows of private investment capital into emerging economies.”

The Institute said increased perceptions of counterparty risk have led to funding difficulties for banks in Europe, increasing their need for liquid assets. This has prompted European investors and lenders to drastically cut back outward capital flows and sell assets held in emerging markets. This in turn reduced the supply of external financing in emerging economies and weighed on financial confidence. Mr. Suttle pointed out that, “This deleveraging was accelerated by measures taken by the European Banking Authority (EBA) in an attempt to shore up Euro Area banks by requiring them to achieve a 9% core Tier 1 capital ratio by the middle of 2012. These new requirements have added further pressure on banks’ sovereign exposures. In an environment where raising new capital was extremely expensive, Euro Area banks responded by accelerating asset shedding, especially in foreign markets.”
The IIF report stated that flows to two regions were most affected by the cutbacks. It said that not surprisingly, flows to Emerging Europe were reduced, and these cutbacks are likely to be extended through 2012. Perhaps more surprisingly, however, flows into Emerging Asia were much reduced as well. Among other factors, interbank lending from European banks to banks across Emerging Asia seems to have fallen substantially. This development was corroborated by the IIF’s Emerging Market Bank Lending Conditions Survey, which it also published today and which is now conducted on a quarterly basis.

The IIF said net private capital flows to Emerging Asia, which reached a volume of $490 billion in 2010, saw a most considerable 2011 decline to $370 billion and now a further large reduction to $290 billion is in prospect for 2012. A moderate recovery to $320 billion is projected for 2013. The share of Emerging Asia in total private capital flows to emerging markets also slips from a record 59% in 2009 to 40% this year. While the region has witnessed a rebound in capital flows after the global crisis, this has been below the trend seen in the years leading up to the crisis. The turmoil brought on by the European debt crisis precipitated a sudden stop in capital flows to this region in late 2011. In addition to rising risk aversion contributing to the pullback from regional equity and bond markets, the tightening in funding conditions encouraged foreign banks to shed assets. Asia was particularly vulnerable because of the prominent role played by European banks and large inflows leading up to the crisis.

Another factor contributing to the softness in flows to Emerging Asia is the apparent sharp decline in “hot money” flows to China, which generally occurred through debt inflows from non-bank sources. This decline reflects a reduction in expectations for Chinese currency appreciation.

Nevertheless, the IIF added that the outlook for the dissipation of the global turmoil, a return to search for yields and relatively strong regional economic performance, should result in a gradual upturn in capital inflows by 2013. Moreover, the leading emerging markets in the region, China and India, are rightly set to continue gradual liberalization of the capital account, for both inflows and outflows. Real GDP growth for the seven countries constituting Emerging Asia is set to moderate from 9.1% in 2010 to 7.7% in 2011 and 7.4% in 2012, due to the global headwinds along with the earlier policy tightening. The IIF sees growth reviving to 7.9% in 2013, with Asia continuing to outperform the rest of the world.

In Emerging Europe, the uncertainty surrounding the European sovereign debt crisis and the deteriorated global growth outlook caused private capital inflows to the region to slow sharply or reverse in some countries after July. Portfolio equity inflows have reversed, and IPOs and bond issues have been postponed. Sharply intensified funding constraints, including by foreign parents, have led domestic banking operations of these firms to repay external debt in most countries. Nonresident purchases of local currency-denominated bonds have fallen sharply. These developments largely offset a steady, even if moderate, increase in capital inflows through July, leaving the full-year total at $208 billion, only slightly higher than the $201 billion reported in 2010. The deteriorated global growth outlook has caused private capital inflows to Emerging Europe to slow sharply since August. Moreover, exceptional taxes charged against banking institutions in some countries in the region have also weighed on lending.

With financial market pressures likely to remain elevated and risk aversion high this year as European banks strive to meet additional capital requirements mandated by the recent EBA stress test, capital inflows to Emerging Europe look set to slow by one-third to $146 billion. Except for direct equity investment, which is likely to remain little changed from last year, all other types of inflows are likely to register steep declines. Borrowing from banks is likely to suffer the most, with the region as a whole making net repayments as in 2009.

Borrowing by foreign-owned domestic banks from their offshore parents will be cut as well, as the latter are forced by their home regulators to cut exposures. Borrowing from nonbank creditors is likely to decline sharply as well, by more than 30 percent from last year, thanks to smaller Eurobond issues and reduced foreign purchases of local currency denominated government bonds. Portfolio equity inflows will be smaller as well. While capital inflows will be smaller across the region, countries deemed to have weaker fundamentals and those with large external borrowing needs will be hit the hardest. Ukraine and Hungary stand out as most vulnerable in the region. Turkey, with its outsized current account deficit and large external borrowing needs, could come under pressure as well.

Net private capital inflows to Latin America have, by contrast with other emerging market regions, been quite stable and, as a result, their share of total inflows has gained. Total net private capital flows to the region, which were an estimated $260 billion in 2011, are forecast to total $250 billion this year and $270 billion in 2013. The underlying capital flow dynamics in 2012 reflect: (1) a moderate recovery of portfolio equity inflows following a sharp drop last year, (2) a reduction of net trade financing as regional real GDP growth weakens, and (3) flat net inflows by commercial banks. We expect the accumulation of international reserves to slow this year as current account deficits widen and risk aversion remains relatively high. Reserves increased more than $100 billion in 2011 driven by carry trade and equity investment inflows; we expect them to rise to about $25 billion in 2012.

Aggregated capital flows in 2011 and 2012 to the seven Africa/Middle East countries included in the IIF’s capital flows report disguise some sharp differences in both the economic performance and financing requirements of individual countries as well as the composition of the aggregated flows. High oil prices have boosted oil exporting countries (Saudi Arabia, the UAE and Nigeria), ongoing political uncertainty continues to adversely affect some MENA economies (Egypt and to a lesser extent Lebanon and Morocco), and global capital market developments and the crisis in Europe have tended to impact the more mature economies (especially South Africa).

Net private capital inflows to the region are projected to slow for the second consecutive year, from an estimated $72.5 billion in 2011 to $63.7 billion in 2012. The slowdown is mainly due to lower, but still robust, inflows into South Africa whose capital markets are more integrated into the global economy. In contrast to private flows, official flows to the region are forecast to be the highest in over a decade. The projected $9.9 billion of net inflows in 2012 compares with $5.5 billion in net repayments last year, and assumes that multilateral institutions and bilateral creditors rally to support countries in transition such as Egypt (and Tunisia) that are experiencing growing financing difficulties.