Capital Flows To Emerging Market Economies

IIF RESEARCH NOTE
Capital Flows to Emerging

Market Economies
April 15, 2010
Philip Suttle
CHIEF ECONOMIST
1-202-857-3609
psuttle@iif.com
Global growth forecasts revised up, but capital flows projections edged down
Macroeconomic backdrop remains extremely supportive of flows from mature to Catalina Krauss
emerging economies ECONOMIST
Problems from the credit crisis linger in mature economies, however, and will keep Global Macroeconomic Analysis
1-202-857-3639
flows from banks weak into the upturn
ckrauss@iif.com
Synchronized global fiscal tightening in prospect for 2011
Julien Mazzacurati
RESEARCH ASSISTANT
AN UNSPECTACULAR RECOVERY Global Macroeconomic Analysis
1-202-857-3308
The global economy and net private capital flows to emerging economies are now each in a jmazzacurati@iif.com
recovery phase, with both feeding off each other. A return to buoyant local credit market
conditions has been important to the restoration of strong growth in domestic demand in
Emerging Asia, especially China. In turn, this has been the leading edge of the global
recovery. But gains in net private cross-border capital flows have been more limited in this
upswing to date, and are thus not contributing much to the rebound.
This is somewhat of a surprise as there are so many factors promoting private capital flows
to emerging economies. Growth prospects appear bright for emerging economies relative to Gains in net private cross-
border capital flows have
mature economies; short-term interest rates will remain close to zero for an extended period
been more limited in this
in most mature markets; and near-term financial risks remain most evident in mature
upswing to date
markets. In the past three months, these trends have, if anything, intensified, with concern
over Euro Area budget deficits (especially in Greece) coming to the fore.
Chart 1
Emerging Market Private Capital Inflows, Net
$ billion percent of GDP
1400 9
8
1200 Level Percent of GDP
7
1000
6
800 5
600 4
3
400
2
200
1
0 0
1980 1985 1990 1995 2000 2005 2010
IIF.com © Copyright 2010. The Institute of International Finance, Inc. All rights reserved.
page 2
IIF RESEARCH NOTE
Capital Flows to Emerging Market Economies
Table 1 Our estimates of net private

Emerging Market Economies: External Financing
$ billion capital flows to emerging
2008 2009e 2010f 2011f economies have actually
been revised down slightly
Current Account Balance 591.0 351.6 373.0 319.5
for 2010 and, especially,
External Financing, Net:
2011
Private Inflows, Net 588.2 530.8 708.6 746.4
Equity Investment, Net 420.8 465.8 528.8 568.3
Direct Investment, Net 505.5 346.6 434.9 470.2
Portfolio Investment, Net -84.7 119.2 93.9 98.1
Private Creditors, Net 167.5 65.0 179.8 178.1
Commercial Banks, Net 33.1 -31.9 48.9 66.7
Nonbanks, Net 134.4 96.9 130.9 111.4
Official Inflows, Net 61.4 62.4 55.2 35.3

IFIs 27.2 47.5 28.7 12.2
Bilateral Creditors 34.3 14.9 26.5 23.1
Equity Investment Abroad, by Residents, Net -228.0 -183.5 -230.1 -268.6
Resident Lending/Other, Net -535.4 -211.6 -293.2 -297.2
Reserves (- = Increase) -477.2 -549.8 -613.5 -535.4
Memo:
Private Flows, Net (IIF Former Measure) 360.2 347.3 478.5 477.8
It is noteworthy that our estimates of net private capital flows to emerging economies have
actually been revised down slightly for 2010 and, especially, 2011. We now expect net flows
to total $709 billion in 2010 and $746 billion in 2011 (Table 1). In January, these estimates
had been $722 billion and $798 billion, respectively. To an important extent, the relatively
modest nature of this increase over the first two years of this recovery reflects the likely
subdued world of financial flows in the next couple of years (Chart 1), with flows from banks
likely to remain especially weak. For some emerging economies—most notably in Asia—this
relative weakness is not a problem as they have plentiful local financing sources (including
local banks). For other regions, however, the subdued nature of the recovery in flows will
remain an important headwind. This is especially true of Emerging Europe.
Emerging economies
continue to lead the global
FLOWS IN 2010: STRONGER, ALTHOUGH NOT DRAMATICALLY SO expansion and thus seem
Net private capital flows to emerging economies continued to rise in the early months of to offer investors the
prospects of higher returns
2010, judging from high-frequency indicators available (Charts 2 and 3, page 4).
across many asset classes
Three months ago, we described the macroeconomic backdrop as the most propitious
conditions for emerging market flows in history, and developments since then have
supported that view (see next section). Emerging economies continue to lead the global
expansion and thus seem to offer investors the prospects of higher returns across many
asset classes. At the same time, the relative risk characteristics of mature and emerging
economies have rotated fundamentally and seemingly durably in recent years. One key
source of country risk—high public sector budget deficits and debt—is now far more
page 3
IIF RESEARCH NOTE
REVISIONS TO OUR FORECASTS
There have been two main sets of revisions made to the IIF estimates of capital flows to
(and from) a sample of 30 key emerging market economies in the past three months
(see page 20 for a full listing of countries covered).
First, there have been some modest historic revisions, which probably serve to highlight
the short, sharp nature of the 2008-09 cycle for many key emerging economies.
Estimates for net inflows in 2008 have generally been revised down, while those for
2009 have been revised up (the net impact of the revisions over the two years is to add
about $17 billion to inflows; Table 2). While these are annual estimates, these revisions
probably reflect more weakness than we had earlier estimated in the last few months of
2008, and a more healthy revival in flows after March 2009. Note that these revisions are
concentrated on two countries, Poland and Korea, which were hit hard early in the crisis
(i.e., 2008H2) but which recovered better than we had expected in 2009.
Table 2
Revisions to IIF Net Capital Inflows
$ billion
2007 2008 2009e 2010 2011
IIF Capital Flows
April 2010 1277 588 531 709 746
January 2010 1280 667 435 722 798
Difference -3 -79 96 -13 -52
Due to:
Korea
April 2010 79 -63 49 1 11
January 2010 77 -20 9 9 12
Difference 1 -43 41 -9 -1
Poland
April 2010 61 37 33 34 36
January 2010 60 41 12 24 23
Difference 1 -3 21 10 13
Other countries (28)
April 2010 1138 614 449 674 700
January 2010 1143 647 414 688 762
Difference -6 -33 34 -15 -63
Second, our forward-looking projections for increases in net private flows to emerging
economies for 2010-11 have been tempered somewhat relative to January (especially
for 2011). This is unusual, since our forecast revisions have typically been pro-cyclical.
In other words, when flows are rising, revisions tend to be upwards.
page 4
IIF RESEARCH NOTE
Chart 2 Chart 3
Emerging Market External Bond Issuance* Emerging Market Regional Equity Fund Flows*
$ billion $ billion
60 8
Private sector
50 Government 4
40
0
30
20 -4
Emerging Asia
10 Emerging Europe
-8
0 Latin America
07Q1 07Q3 08Q1 08Q3 09Q1 09Q3 10Q1 -12
Source: Thomson Financial; IIF calculat ions. * Includes f oreign currency denominat ed 2008 2008 2009 2009 2010
bonds issued in an ext ernal market, f or the 30 major EM count ries covered in the IIF's * Flows from dedicat ed f unds.
Capital Flows t o EM sreport.
pervasive across the mature world. Indeed, concern and focus on this issue has intensified
in the past few months, especially in the Euro Area.
In this light, it is of note that flows to emerging economies have not been even stronger
than we had expected. Indeed, we have trimmed our estimates for flows to EM in both
2010 and 2011 (by $13 billion and $52 billion, respectively). They still rise relative to the
crisis-depressed levels of 2009, but at a slightly slower pace than we had projected in
January.
A combination of five factors would seem to account for the relatively cautious nature of the
increase to date: Amid the optimism about
EM assets generated by an
Limited supply capacity. Amid the optimism about EM assets generated by an EM led global recovery, it is
emerging market led global recovery, it is important not to lose sight of the fact important not to lose sight
that many financial institutions in mature economies remain firmly in deleveraging of the fact that many
mode. This is undoubtedly reducing debt-related flows that might otherwise be financial institutions in
mature economies remain
associated with relatively large interest rate differentials between mature and some
firmly in deleveraging mode
emerging economies. Foreign direct investment flows are also moderate, held
back by the overall weakness in global investment spending relative to its
pre-crisis peak. In 2010-11, for example, we project net FDI inflows into our
sample of 30 emerging economies to average about $450 billion per year. While
this is an impressive gain on the $347 billion evident in 2009, it remains well below
the $500 billion average net inflow in 2007-08. At the margin, emerging
economies are receiving a higher share of global investment outlays, but the
absolute totals are down.
Valuation. There has been a spectacular increase in emerging market asset

prices over the past year, taking prices of publicly-traded assets to rich levels, at
least when judged relative to historic standards (Charts 4 and 5). With many
emerging market assets thus no longer quite so attractive from a valuation
page 5
IIF RESEARCH NOTE
Chart 4 Chart 5
Emerging Market Sovereign Bonds Emerging Markets: Equity Prices and P/E Ratio
basis points over UST MSCI Indices, $ terms, end-1999=100 ratio
1800 300 25
1500
250 Price to Earnings Ratio
20
1200
200
900 15
150
600
10
100 Equity Prices
300
0 50 5
1998 2000 2002 2004 2006 2008 2010 2000 2003 2006 2009
standpoint, it is understandable that flows would moderate. This is most evident in

net inflows of portfolio equity capital, which posted a remarkable rebound in 2009,
when they were $119 billion, net, following a net outflow of $85 billion in 2008. This
year and next, net portfolio equity inflows are projected to moderate to about
$96 billion per year. Our estimate for 2010 is about $10 billion less than it was in
January.
Fear of tighter controls on capital inflows. A few years ago, many emerging
economies were described as having a “fear of floating”. They had notionally
introduced flexible exchange rate regimes, but were reluctant to allow for a clean
There is much more solid
float. Such fear of floating persists, although the main worry of the earlier period—
case for emerging market
the risk of undue depreciation—has given way to a new worry of undue central banks to move away
appreciation. This concern led to the introduction of the expanded IOF tax in Brazil from a relatively easy
in October 2009 (see the IIF’s Capital Flows to Emerging Market Economies, monetary stance
January 2010, for details of this tax). Although Brazil’s move has not been followed
by any other major country, it seemed to serve to dampen market enthusiasm.
Since the tax was introduced, Brazil’s currency has been relatively stable and
equity-related inflows into emerging economies have been muted.
Fear of tightening. In order to assure the recovery, emerging market central banks
generally followed their peers in the mature markets and positioned monetary policy
to be unprecedentedly easy. This was an understandable response during the
panic phase. But the longer-term damage done in emerging economies by the
crisis was (thankfully) limited. In particular, the degree of economic slack opened up
during the downturn was limited (Charts 6 and 8). As a result, there is much more
solid case for emerging market central banks to move away from an easy monetary
stance, and it has been somewhat surprising how slow, in aggregate, EM central
banks have been to begin the tightening process, especially in Emerging Asia
(Chart 7). Once again, concern over attracting undue short-term capital inflows with
attendant pressure for currency appreciation may have been behind this response,
page 6
IIF RESEARCH NOTE
Chart 6 Chart 7
Global GDP Growth Trends in Official Interest Rates
index, 1982=100, dotted lines =trend percent, GDP-weighted regional averages
400 205 12
11
350 195 10 Latin America
Emerging
Economies 9
300 185 8 Emerging Europe

Mature
7
Economies
250 175 6
5 Emerging Asia
200 165 4
2000 2005 2010 2000 2005 2010 2006 2007 2008 2009 2010
but a local monetary stance that remains too easy for too long risks promoting
excessive domestic credit growth (see pages 14-16).
The lack of need for external borrowing. The flip side of relatively low EM local
policy rates, which have tended to hold other domestic rates down, is that local
markets become an attractive means of financing for local businesses. This is
especially true in Emerging Asia, where excess local liquidity remains ample even
after measures taken by China and India to raise bank reserve requirements.
THE GLOBAL RECOVERY TAKES HOLD: THE EURO AREA IS THE LAGGARD
The global economy continues to recover from the steep declines of 2008Q4-2009Q1. U.S. and Japanese growth
estimates for 2010 have
Emerging economies continue to lead, with growth in Emerging Asia remaining strong (led
been raised by over a half
by China). There was a strengthening in growth in mature economies at the end of 2009.
percentage point each
Our forecasts continue to project significant accelerations now underway in other emerging since January….the Euro
regions (Table 3). Area 2010 growth forecast
has been trimmed by about
Our aggregate global growth forecast for 2010 has been revised up slightly since January, ¾ of a percentage point
by a tenth, to 3.3 percent (Table 4). But this disguises an important rotation in fortunes within
the major economies. On the one hand, U.S. and Japanese growth estimates for 2010 have
been raised by over a half percentage point each since January; on the other, the Euro Area
2010 growth forecast has been trimmed by about ¾ of a percentage point. The Euro Area
(and Europe more broadly) are in a recovery phase, but that recovery is, so far, lagging the
rest of the global economy.
The U.S. economy had been expected to post solid growth readings in late 2009 and
through the early months of 2010, as the continued support from expansionary fiscal (and
monetary) policies combined with a turn in the inventory cycle. These factors have indeed
delivered on schedule. What has been surprising, however, has been the strengthening in
final private demand—equipment investment in particular, but consumption as well. As a
page 7
IIF RESEARCH NOTE
Table 3 Chart 8
Global Output Growth Global Unemployment Rates
percent, q/q saar percent of labor force
09Q1 09Q2 09Q3 09Q4
10
Mature Economies -8.8 0.5 1.6 3.4 Mature Economies
United States -6.4 -0.7 2.2 5.6 9
Euro Area -9.6 -0.5 1.7 0.5 8

Japan -13.7 6.0 -0.6 3.8
7
Emerging Economies -5.4 8.1 7.6 7.0
Latin America -11.7 0.9 5.8 7.1 6
Emerging Europe -21.3 6.0 4.1 8.5
5 Emerging Economies
Asia/Pacific 3.4 12.6 10.0 6.5
4
World -8.1 2.2 2.9 4.2
1996 1999 2002 2005 2008
result, we have revised up our U.S. growth estimates for the first half of 2010. Similarly,
recent Japanese indicators have been much stronger than we had expected, with the
rebound most visible in the industrial sector. While much of this represents a rebound in
exports from their very depressed level early in 2009, Japanese consumer spending has also
been far stronger than we had expected.
The outlier in this cyclical pattern has been the Euro Area. Euro Area industry has responded
to improving global conditions and regional business surveys do not look particularly bad
when compared to other regions (Chart 9). But Euro Area domestic demand indicators are
relatively weak (Chart 10).
Table 4
Global Output Growth
percent change over previous year
2008 2009e 2010f 2011f
Mature Economies 0.2 -3.5 2.5 2.0
United States 0.4 -2.4 3.6 2.6
Euro Area 0.5 -4.0 1.0 1.5
Japan -1.2 -5.2 2.6 1.3
Emerging Economies 5.6 1.4 6.3 5.9
Latin America 4.0 -2.3 4.7 3.9
Argentina 7.0 -2.6 4.4 3.2
Brazil 5.1 -0.2 6.2 4.0
Mexico 1.4 -6.4 4.4 3.5
Emerging Europe 4.0 -5.8 4.1 3.2
Russia 5.6 -7.9 4.2 2.7
Turkey 0.7 -4.7 6.5 4.7
Asia/Pacific 7.3 6.3 8.4 8.0
China 9.6 8.7 10.0 9.0
India 6.7 7.2 8.5 9.0
Africa/Middle East 5.2 0.7 3.7 4.6
South Africa 3.7 -1.8 3.1 4.0
World 1.4 -2.4 3.3 2.9
page 8
IIF RESEARCH NOTE
Chart 9 Chart 10
Purchasing Managers' Indices G3: Real Retail Sales
manufacturing index, 50=breakeven percent, 3m/3m saar
65 6 Japan
U.S. Euro
60
Area 3
55
0
50
45 -3 Euro Area
40 Emerging
-6
Economies U.S. (ex. Auto Dealers,
35
-9 Building Materials and
30 Gas Stations)
Japan
25 -12
2003 2005 2007 2009 2007 2008 2009 2010
Aggregate Euro Area domestic demand has weakened since the onset of the global credit
crisis, as previously rapidly growing parts of the region have seen a sharp slump in domestic
demand, related to weakness in both previously-booming property markets and domestic
credit supply. These regions have also seen sharp increases in unemployment rates. This
has not been offset by any meaningful acceleration in demand in other parts of the Euro
Area, where growth remains generally moribund. In the first year of the global downturn,
weakness was buffered somewhat by an expansion in budget deficits, some of which was
discretionary (counter-cyclical fiscal policy), but most of which was cyclical. Although the
strict rules of the Stability and Growth Pact have not been applied, countries within the
region—led most graphically by Greece—are now under considerable pressure to tighten
fiscal policy in order to lower budget deficits to 3 percent of GDP or below by 2012 (Greece
and Italy); 2013 (France, Germany, Portugal and Spain); and 2014 (Ireland).
SYNCHRONIZED FISCAL TIGHTENING IN MATURE ECONOMIES IN 2011
The Euro Area is leading the shift to tighter fiscal policies among the major economies.
Heading into 2011, however, there will be an unusually synchronized shift to a more
Fiscal thrust in mature
contractionary fiscal policy among the major economies. The American Recovery and
markets is shifting from
Reinvestment Act will have largely played out in 2010H2 and the President’s FY2011 budget boosting activity by about
projects a shift to spending restraint. The new U.K. government is likely to tighten policy 1 ¼ percent of GDP in 2010
quite aggressively, especially as market pressures for tighter policy would likely build if the to restraining activity by a
key rating agencies were to downgrade the U.K. from its AAA status. The recent experience similar amount in 2011 (and
beyond)
of Greece is a salutary reminder that mature economies are not immune from being forced
to tighten fiscal policy aggressively by financial market pressures. Euro Area tightening will
spread to France and Germany in 2011 and, in aggregate, will be more severe than in 2010.
The outlook for Japan is less certain, but Japan’s high debt levels make it unlikely that this
year’s degree of stimulus (about 1 percent of GDP) can be matched in 2011.
page 9
IIF RESEARCH NOTE
Fiscal thrust in mature markets is thus shifting from boosting activity by about 1 ¼ percent of
For the major economies,
GDP in 2010 to restraining activity by a similar amount in 2011 (and beyond). Even though
deflation is more of a near-
the private sector will be better placed to sustain global activity into 2011, it seems highly
term threat than inflation
likely that this policy shift will lead to slower growth in mature economies in 2011 (Table 4).
Global headline consumer price inflation accelerated in the last few months of 2009 and the
early months of 2010. This acceleration does not look to be too concerning, and mainly
reflected base effects, with the lows in oil and other commodity prices in 2008Q4-2009Q1
being compared with recovery-related levels a year later. Importantly, core consumer price
inflation is very moderate and falling in the United States and Euro Area and already negative
in Japan. For the major economies, deflation is more of a near-term threat than inflation
(Table 5).
Food prices have recently risen in a number of Emerging Asian economies. While this mainly
reflects supply disruptions, it is a reminder that growing regional prosperity will likely add to
simmering global commodity price pressures. In this context, it should be noted that the
current level of the oil price is above our assumed forecast for 2010H2 ($75 per barrel) and
2011 ($80 per barrel). Our forecast is based on the assumption that OPEC would increase
production in 2010 to meet recovering global demand, thus reversing some of the
production cuts made during the downturn. This has not yet occurred, however, and we
would see the possibility of oil prices once again rising towards $100 per barrel, acting as
another downside risk facing the global economy heading into 2011.
As with fiscal policy, the current stance of G7 monetary policy is extreme. With the exception
of Japan, which has learned to live with short-term interest rates close to zero for the past
decade, the major central banks are all liable to re-think their monetary policy in the year
Table 5
Consumer Prices
percent change over previous year, end of period
2008 2009e 2010f 2011f
Mature Economies 0.6 1.4 1.2 0.9
United States -0.1 2.8 2.2 2.0
Euro Area 1.6 0.9 0.8 0.3
Japan 0.4 -1.7 -0.8 -0.9
Emerging Economies 6.2 4.8 5.4 5.0
Latin America 8.2 5.5 8.3 6.6
Argentina 7.2 7.7 10.2 10.0
Brazil 5.9 4.3 5.5 5.0
Mexico 6.5 3.6 5.6 3.6
Emerging Europe 10.2 6.8 6.8 5.4
Russia 13.3 8.9 7.8 6.8
Turkey 10.1 6.5 8.3 5.8
Asia/Pacific 2.5 3.5 3.3 4.1
China 1.2 1.9 2.7 3.5
India 1.2 10.0 4.0 5.8
Africa/Middle East 10.9 5.2 6.6 5.7
South Africa 9.5 6.3 5.8 4.7
World 1.9 2.1 2.1 1.8
page 10
IIF RESEARCH NOTE
ahead, with the bias towards removing what is widely seen as an emergency stance. A fiscal
Our current forecast is for
contraction combined with a growing concern about deflation is unlikely to produce much in
U.S. short rates to rise to
the way of aggregate monetary tightening, however. Our current forecast is for U.S. short
50 basis points at the end
rates to rise to 50 basis points at the end of 2010 and to 1 percent at the end of 2001; the of 2010 and to 1 percent at
European Central Bank is forecast to remain on hold (at 1 percent) in 2010 and raise rates the end of 2011
by just 25 basis points next year.
These low rates are liable to keep emerging market currencies under some upward pressure
against mature market currencies, although these appreciation pressures will continue to be
resisted by emerging market policy makers, especially in China. While we do not envisage
much in the way of movement for the major currencies against each other, it seems likely
that relative under-performance on the part of Europe will lead to some near-term softness in
the euro through 2010Q2. We expect any weakness in the euro to be made up in 2011,
however, as Euro Area growth quickens slightly and moderates elsewhere.
There was a significant narrowing in global current account imbalances in 2009 relative to
2008 (Table 6). Most significantly, there was a sharp reduction in both the U.S. current
account deficit and China’s current account surplus. While the recovery in U.S. domestic
demand, including some modest restocking of inventories, will lead to a renewed rise in the
U.S. deficit in 2010, the likely persistent strength in U.S. exports will probably push the U.S.
current account deficit to below 2 percent of GDP in 2011. China’s current account deficit
will likely similarly fall as a share of GDP, although it will edge back up in nominal terms.
CROWDING OUT RISKS IN PERSPECTIVE
High budget imbalances have thus replaced high external imbalances as the key global
financial concern. For emerging economies, the budget imbalances in mature markets carry
three, related sources of risk. First, they represent a significant downside risk to external
Table 6
Global Current Account Balance
$ billion
2008 2009e 2010f 2011f
United States -706 -420 -440 -323
Euro Area -207 -82 2 22
Japan 160 142 151 127
Other Mature Economies 44 -7 -8 3

Emerging Economies (IIF 30) 591 352 373 320
Africa / Middle East 185 -19 38 51
Latin America -13 -26 -62 -83
Emerging Europe -17 25 30 7
o/w Russia 102 49 74 67

Emerging Asia 436 371 368 346
o/w China 426 284 310 320
Other Countries* 118 15 -78 -148
*Includes global discrepancy
page 11
IIF RESEARCH NOTE
demand. Second, they represent a potentially significant wealth loss, given the substantial
Persistently high budget
holdings of mature market bonds in the assets of emerging market central banks. Finally,
deficits in mature
persistently high budget deficits in mature economies raise concerns about credit market
economies raise concerns
“crowding out”, especially when it is the United States that is a key culprit when it comes to (in emerging markets)
large, extended net government borrowing needs. about credit market
“crowding out”
From an emerging market perspective, the main episode that sparks concern is the middle
years of the 1980s, which is the last time that the U.S. economy staged a solid recovery
from a deep recession. The Reagan expansion was accompanied by what (at the time)
seemed like a dramatic increase in the budget deficit. The Federal deficit doubled from 2.5
percent of GDP in 1977-81, to 5 percent of GDP in 1985-86. With private sector net
borrowing needs strong through the recovery, the rise in the Federal deficit was matched by
a rise in the current account deficit. In order to equilibrate these various net borrowing
needs, real interest rates soared, from an average of 0.2 percent in 1977-81 to about 6
percent in 1983-86 (Chart 11)¹.
This sharp rise in real yields had a significantly restraining effect on capital flows to emerging
economies (Chart 12). In that period, the effect was not an instantaneous one: the lag
seemed to vary between one and two years. The low point in real U.S. yields came in 1980,
and the resulting high point in net flows to emerging economies was in 1981. At the other
end of this rate cycle, the peak in real U.S. yields came in 1984, while the trough in flows to
emerging economies came two years later.
Comparing this crowding out experience of the mid-1980s to the current (and prospective)
period, a few important differences stand out. First, the recent (and prospective) level of the
U.S. budget deficit is far higher than anything seen in the 1980s. Back then, the Federal
deficit averaged 5 percent of GDP in its three peak years (1984-86); in the current cycle, the
U.S. Federal deficit is projected to average 10 percent of GDP in the three peak years
¹Rising budget deficits were not the only factor pushing bond yields up. The unanticipated inflation of the later 1970s
made bond investors far more wary about buying volatile long-term debt, thus leading to an increased required risk
premium.
Chart 11 Chart 12
United States: Budget Deficit and Real Yields Real U.S. Bond Yields and Capital Flows to EM
percent, deflated by core CPI % GDP, inv. scale percent, deflated by core CPI % GDP, inv. scale
8 -7 8 0
Real 10-year Real 10-year
7 Bond Yield -6 7 Bond Yield 1
6 -5 6
5 5 2
-4
4 4 3
-3
3 3
-2 4
2 2
1 -1 1
U.S. Federal Budget Balance Capital Flows to EM, 5
0 0 0 Advanced 2 Years
1 6
-1 -1
-2 2 -2 7
1977 1981 1985 1989 1993 1997 1977 1981 1985 1989 1993 1997
page 12
IIF RESEARCH NOTE
(2009-11). Second, U.S. real bond yields are shaping up to be dramatically lower in the
current period than in the mid-1980s, despite the substantially higher budget deficit. As While higher U.S. (and
noted, real bond yields averaged 6 percent in 1983-86; in 2009-11, they seem more likely to mature economies’) budget
deficits may raise concerns
average about 1.5 to 2 percent. Third, the dollar was much stronger in the 1980s than it is at
about crowding out, the
present, pulled up (at least temporarily) by the attraction of relatively high real interest rates. likely persistence of low G3
Once again the opposite is true today. A high dollar was burdensome in the 1980s for bond yields suggests that
indebted emerging economies, since their external debts were generally denominated in this concern is unlikely to
dollars and thus rose in real terms when the dollar was strong. be realized, at least for the
foreseeable future
From the current perspective of the emerging markets, it is the second of these
developments that is the most important. While higher U.S. (and mature economies’) budget
deficits may raise legitimate concerns about crowding out, the likely persistence of low G3
bond yields suggests that this concern is unlikely to be realized, at least for the foreseeable
future.
Should private sector net borrowing demands in mature economies revive in a meaningful
way in the years ahead and combine with still high budget deficits in mature economies, the
resulting spike in real interest rates could then have serious crowding out effects for
emerging market borrowers. But, unless and until that private sector recovery develops, the
main headache facing emerging market policy makers, especially those of well-performing
countries, will probably continue to be the provision of too much capital by international
investors, not too little.
SELF-INSURANCE POLICIES ON THE RISE
One factor that is widely held to account for the low level of U.S. bond yields is the support
provided by foreign buyers, especially foreign central banks in emerging economies. While
foreign support for the U.S. bond market has been a long-established development, one
underappreciated development of the past two years is that this support has become even
more relevant as U.S. government debt supply has spiraled.
One way of illustrating this is to note that the share of the publicly traded Treasury papers
held by foreign central banks (mainly, but not exclusively in emerging economies) has risen
from 28 percent at the end of 2007 to 30 percent at the end of September 2009. For this to
occur foreign central banks have bought, at the margin, about 36 percent of the soaring total
of net U.S. public debt issued to the public between the end of 2007 and September 2009
(Chart 13).
Two developments have promoted such strong emerging market central bank demand for
U.S. Treasuries. First, foreign central banks have been understandably much more cautious
about holding what was previously seen as a good alternative—U.S. agency debt—since
2008Q4. They have run down holdings of the agencies and replaced them with Treasuries
(Chart 14).
Second, the turmoil in financial markets that occurred after September 2008 led many
emerging market central banks (or national reserve management agencies) to conclude that
what might previously have been viewed a sufficiently large stock of international reserves
page 13
IIF RESEARCH NOTE
Chart 13 Chart 14
U.S. Treasury Debt Foreign Central Bank Holdings of U.S. Gov Securities
$ trillion (both scales) $ trillion (both scales)
7 2.2 2.2 1.2
GSE Debt
2.0
6 1.0
1.8
1.6 0.8
5 1.6
1.4 0.6
4 Total Privately Held
Foreign Central 1.2
1.0 0.4
Bank Holdings 1.0 Treasury Securities
3 0.2
0.8
2 0.4 0.6 0.0
2000 2003 2006 2009 2003 2005 2007 2009
was insufficient to meet possible demands at times of severe stress. The need to provide
international liquidity rapidly and on a large scale to local financial institutions and
internationally-active non-financial corporates became extreme after mid-September 2008.
Some of these strains were relieved when the IMF established the Flexible Credit Line and
the Federal Reserve created or expanded swap lines with a number of leading emerging
market central banks. But the suddenness and severity of the shock of 2008Q4, and the
observation that it was China (with its vast stock of international reserves) that was best able
to ride out the turmoil of 2008Q4-2009Q1, has led many emerging market policy makers to Many EM policy makers
have resolved to build
resolve to build reserves aggressively in the recovery phase as a form a “self-insurance,” so
reserves aggressively in the
that they can provide a credible source of not just domestic but also international liquidity at
recovery phase as a form a
times of acute financial difficulty. “self-insurance,” so that
For our sample of 30 countries, foreign exchange reserve accumulation is projected to they can provide a credible
source of international
average about $570 billion a year in 2010-11, with China accounting for about two-thirds of
liquidity at times of acute
this gain (Chart 15). While the currency composition of foreign exchange reserves is one of
financial difficulty
least reported economic statistics, it would seem that most marginal reserve accumulation
continues to flow into dollars (Chart 16).
In buying foreign exchange—especially dollars—emerging market central banks are able to

resist the upward pressure on their currencies, most extremely in the case of China which (at
the time of writing) still adheres to its de facto dollar peg. And as noted above, foreign central
bank buying of U.S. Treasuries is helping keep U.S. bond yields lower than they would
otherwise be.
For emerging market borrowers, this would seem to hurt borrowers in local markets relative
to borrowers in international markets (i.e., the external dollar market) since most foreign
exchange accumulation is funded through the issuance of local currency debt, which would
thus raise the cost of the latter. In the absence of intervention, local rates would probably be
lower as inflation might be lower as a result of, and central bank monetary policy easier in
response to, a stronger currency, which also would moderate economic activity.
page 14
IIF RESEARCH NOTE
Chart 15 Chart 16
Foreign Exchange Reserve Accumulation Emerging Economies: Composition of FX Reserves
$ billion percent of allocated reserves, net of valuation effects
700 80
USD
600 70
60
500
Total ex. China
50
400
China
40
300 EUR
30
200
20
100 10 GBP
0 0
1995 1998 2001 2004 2007 2010 1999 2001 2003 2005 2007 2009
Finally, it is important not to lose sight of the medium-term stability considerations associated
with the accumulation of an ever-larger stock of (primarily) dollar reserves in the hands of
emerging market central banks. For one thing, these stocks are coming to dominate the
asset side of many central bank balance sheets, leaving those institutions (or their owners)
with large unhedged foreign exchange positions. Sometimes, unhedged exposure gives rise
to gains. In the 2008-09 crisis, for example, the net public external debt of a number of key
emerging countries—most notably Brazil—actually fell as the gains from dollar reserve
holdings offset the increase in the value of the external debt. But, as these unhedged
positions become more skewed, they will leave EM central banks—most obviously the
People’s Bank of China—exposed to sizeable losses from appreciation of their own
currency. Second, the existence of such large and rising dollar holdings accumulated mainly
for non profit maximizing reasons would appear to leave the U.S. dollar open to substantial
selling pressure at just the wrong time (i.e., when confidence in dollar holdings was falling).
Such “wrong-way” risk is precisely the kind of exposure that supervisors have been urging
financial institutions to avoid in recent years.
BUOYANCY IN EMERGING ASIAN LOCAL CREDIT MARKETS
One important factor shaping the demand for net external financing is the availability of In Emerging Asia—and
China specifically—local
cheap local financing. In Emerging Asia—and China specifically—local bank lending is
bank lending is plentiful. It
plentiful. It is providing important fuel to the current expansion, and obviating the need for
is providing important fuel
external financing (Chart 17). to the current expansion,
and obviating the need for
Emerging Asia is a contrast to other major emerging market regions, especially Emerging external financing
Europe, where local credit cycles have generally been an exaggerated version of that in the
mature economies (Chart 18). Some of the weakness in local bank lending in Emerging
Europe and, especially, Latin America in the past 18 months will have reflected more
cautious demand from local borrowers. But much of the weakness reflected a squeeze on
the local lending capacity of banks based in Emerging Europe and Latin America caused by
the sudden evaporation of external financing from banks based in mature countries. There
page 15
IIF RESEARCH NOTE
Chart 17 Chart 18
Global Bank Lending to Private Sector Emerging Economies: Bank Lending to Private Sector
percent change over a year ago percent change over a year ago (both scales)
30 26 50
Emerging Europe
25
40
Emerging Economies 22
20
15 30
Latin America
Mature Economies 18
10 20
5 Emerging
14
Asia 10
0
-5 10 0
2003 2005 2007 2009 2001 2003 2005 2007 2009
were also some countries—Mexico, for example—where problems for foreign-owned banks
led to a retrenchment that spilled over to local bank lending.
There are global implications of Chinese banks becoming the major marginal providers of
global credit, even though this credit is being supplied almost exclusively into the local
economy. First, and most obviously, it stimulates demand in China which is increasingly
spilling over to the rest of the world. Second, indirect financing is provided to the rest of the
world to the extent that Chinese banks buy the local debt issued by the Chinese government
in their efforts to sterilize their purchases of U.S. (and other government) securities, and
when Chinese banks provide financing to Chinese companies to finance their increasingly
large purchases of assets (especially FDI assets) held abroad. Finally, swings in Chinese
credit conditions will thus matter more to participants in global financial markets, both as a
source of opportunity and risk.
EMERGING ASIA: SLOW DECLINE IN EXTERNAL SURPLUS
The aggregate current account surplus of the seven countries making up our Emerging
Asian sample fell from a peak of $436 billion in 2008 to $371 billion in 2009, and modest
further reductions are in prospect for 2010 and 2011. There are some notable differences External surpluses in Korea
and Thailand rose quite
between China and some of the other countries, however. China’s surplus fell conspicuously
sharply in 2009
in 2009, but continued to account for about three quarters of the regional total. By contrast,
external surpluses in Korea and Thailand rose quite sharply in 2009 (by $50 billion and $18
billion, respectively). In 2010-11, China’s surplus is projected to edge back up, while external
balances generally deteriorate elsewhere.
Flows of foreign direct investment continue to dominate the overall flows of private capital to
(and from) the region. Net inward FDI will average $207 billion in 2010-11, of which about
$135 billion will be accounted for by China. The region has also become a major exporter of
FDI, and these flows should average $115 billion in 2010-11, with China exporting an
average of $75 billion, net.
page 16
IIF RESEARCH NOTE
Table 7
Emerging Asia: External Financing
$ billion
2008 2009e 2010f 2011f
Current Account Balance 435.9 370.6 367.9 345.6
Private Creditors, Net -51.3 51.9 29.0 19.3
Commercial Banks, Net -57.9 18.0 13.9 7.1
Nonbanks, Net 6.6 33.8 15.1 12.2

IFIs 2.0 3.6 2.5 2.5

Memo:
EMERGING EUROPE: UKRAINE REMAINS THE WEAK LINK
Economic recovery and higher (commodity) import prices will tend to widen current account
deficits in Central Europe and Turkey, despite improving export performance. Deficits will
also widen as investment earnings recover (offset by larger retained earnings inflows under
FDI) but (for EU members) will be contained by larger inflows of EU budget transfers.
Russia's surplus will widen due to higher oil prices.
Privatization may boost flows somewhat in Poland and Turkey. Portfolio equity inflows will
rise to Russia, Turkey and Poland, the only countries with sizable domestic equity markets,
but be partly offset by increased buying of foreign equities by residents throughout the
region.
Governments in Central
Governments in Central Europe, Russia and Turkey are taking advantage of favorable capital Europe, Russia and Turkey
market conditions to issue foreign currency bonds. Nonresident investors have stepped up are taking advantage of
net purchases of local currency government bonds in response to improved risk profiles and favorable capital market
stronger risk appetite. Greece's problems may have had a more positive than negative conditions to issue foreign
currency bonds
spillover effect for those countries such as Poland, Hungary and Romania that have IMF
programs already in effect and those such as the Czech Republic, Turkey and Bulgaria with
more manageable levels of government debt and without recent legacies of large fiscal
shortfalls. Ukraine will remain shut off from most private credit, however, as will many
Russian banks and corporates.
Net repayments by banks should taper off as deleveraging moderates. Borrowing from
foreign banks should be buoyed by the larger amounts of trade-related financing but still be
page 17
IIF RESEARCH NOTE
Table 8
Emerging Europe: External Financing
$ billion
2008 2009e 2010f 2011f
Current Account Balance -16.9 25.3 29.7 6.7
Private Creditors, Net 152.0 -25.7 73.2 91.4
Nonbanks, Net 71.8 21.5 55.4 61.1

IFIs 19.7 31.3 17.1 2.6
Bilateral Creditors 1.7 -5.5 2.7 -2.6

Reserves (- = Increase) 33.0 -10.6 -61.6 -38.0
Memo:
Private Flows, Net (IIF Former Measure) 194.6 -0.5 130.4 149.9
constrained by generally weak borrowing demand and tightened lending standards among
banks whose foreign parents are striving to retain capital and bolster liquidity in anticipation
of regulatory reform proposals. Russian and Ukrainian banks will remain burdened by the
substantial increases in NPLs seen to date and consequent shortages of capital.
LATIN AMERICA: EARTHQUAKE REBUILDING TO MAKE CHILE MODEST NET

CAPITAL IMPORTER
Net private capital flows to Latin America should continue to pick up momentum, led by
Brazil. Equity flows should continue to lead the way, although there will also be a rise in debt-
related flows, encouraged by sizeable increases in flows from non-bank private creditors
(Table 9).
Argentina is making determined efforts to settle long-standing arrears with private creditors.
Even a high participation rate on the part of the holdouts may not restore government's Argentina is making
determined efforts to settle
access to global capital markets, however, because of lingering legal challenges and
long-standing arrears with
associated attachment risk. The exchange will likely increase private capital flows to
private creditors
Argentina in 2010-11 through two channels, however. First, Argentine corporations as well
as state and local governments will have an easier (cheaper) access to foreign capital.
Second, foreign investors will likely increase participation in the local capital market. In
addition, the exchange itself is expected to bring the government extra cash of up to $1.0
billion upfront.
Increased external financing requirements to cover reconstruction costs triggered by the

earthquake and tsunami of February 27 will shift Chile’s external position from capital
page 18
IIF RESEARCH NOTE
Table 9
Latin America: External Financing
$ billion
2008 2009e 2010f 2011f
Current Account Balance -12.9 -25.5 -62.1 -83.3
Private Creditors, Net 40.3 41.7 67.1 54.1
Commercial Banks, Net 8.7 0.8 12.1 20.8
Nonbanks, Net 31.5 40.8 55.0 33.3

IFIs 4.2 9.3 5.7 4.4

Memo:
exporter in 2009 (largely the result of its dynamic private pension system) to capital importer
this year and next. The cost of this natural catastrophe, estimated at $29.7 billion
(18 percent of GDP) by the Chilean government, splits evenly between the public and private
sectors, and is to be absorbed over the next three-four years. The catastrophe has raised
the financing requirements of the public sector by $9.3 billion (5.7 percent of GDP) for 2010- Increased external
2013. Financing needs, however, are likely to be higher in 2010 and 2011 as the bulk of financing requirements to
reconstruction effort is to be carried out during these years. cover reconstruction costs
triggered by the earthquake
Notwithstanding copper savings for $11.3 billion (7.0 percent of GDP) in the Economic and and tsunami of February 27
Social Stabilization Fund (ESSF), the financing mix chosen by the government is likely to limit will shift Chile’s external
ESSF withdrawals , with judicious reliance on the deep local bond market to finance part of position from capital
the reconstruction through peso debt issuance. This is partly to avoid a disruptive sharp exporter in 2009, to capital
importer this year and next
currency appreciation. The public financing mix is also likely to include expenditure
reallocation, sale of assets and a selective increase of taxes.
While implementation of a balanced financing mix will allow rebuilding the economy’s
productive capacity without compromising stability, we expect this catastrophe to have the
following impact on the balance of payments:
Shift the current account into deficit: Despite a higher price of copper, which
account for half of total exports, we expect a surge in imports to shift the current
account from a surplus of 2.6 percent of GDP in 2009 to a small deficit this year.
The catastrophe is set to boost imports of machinery and equipment and other
industrial goods needed to substitute a temporary decline in national production.
page 19
IIF RESEARCH NOTE
Repatriation of ESSF funds: We expect earthquake-related capital repatriation of

ESSF foreign currency savings of $1.0-1.5 billion this year.
A surge in net private capital inflows: Two factors will boost private inflows this
year. (1) The sovereign is likely to issue a long-term global bond for about $1.0
billion as part of its reconstruction financing mix in order to provide a benchmark for
potential borrowing by private corporates and (2) substantial capital transfers
stemming from reinsurance claims (in accordance with IMF guidelines, these
payments are accounted for in the capital account). Including claims for damaged
productive capital stock as well as for lost profits, reinsurance inflows are estimated
to be in the range of $5 to $8 billion.
AFRICA AND MIDDLE EAST: DUBAI WORLD RESTRUCTURES DEBT
Net private capital flows to the Africa and Middle East region fell from a peak of $185 billion
in 2007 to just $48 billion in 2009. Much of the decline was accounted for by the UAE and
Net private capital flows to
Saudi Arabia, and this was only partly offset by an increase in flows into Nigeria and Africa and Middle East fell
Lebanon. Flows into South Africa were broadly unchanged at $13 billion. A modest increase from a peak of $185 billion
in flows into the region as a whole is likely in 2010-2011 in line with a steady recovery in in 2007 to just $48 billion in
economic activity. 2009. Much of the decline
was accounted for by the
The debt default by two family-owned Saudi conglomerates and Dubai World in 2009 UAE and Saudi Arabia
exacerbated what had already been a plunge in inflows to the Middle East in 2008. The debt
restructuring plan of Dubai World announced on March 25 is a step in the right direction. The
plan states that creditors will be paid in full on both principal and interest, albeit with a
Table 9
Africa and Middle East: External Financing
$ billion
2008 2009e 2010f 2011f
Current Account Balance 184.9 -18.7 37.6 50.5
Private Creditors, Net 26.5 -2.9 10.5 13.3
Nonbanks, Net 24.5 0.8 5.4 4.9

IFIs 1.3 3.4 3.4 2.7
Bilateral Creditors 2.3 -0.9 1.5 1.1

Reserves (- = Increase) -118.9 21.4 -56.4 -58.1
Memo:
page 20
IIF RESEARCH NOTE
maturity extension of 5 to 8 years. Agreement on the plan is expected in coming weeks. The debt default by two
While these corporate debt issues are thus likely to be settled in 2010, it is evident that a Saudi conglomerates and
regime shift in risk assessment has already taken place. Market participants will increasingly Dubai World in 2009
differentiate more critically between entities explicitly supported by sovereigns and those that exacerbated what had
already been a plunge in
do not enjoy such support, and will be more diligent and discriminatory in lending to the
inflows to the Middle East
region. However, the region will maintain its ability to attract funds, especially in light of huge
in 2008….but the region will
infrastructure and energy projects that are already on course. An oil price close to $80 per maintain its ability to attract
barrel is also supportive for inflows. funds, especially in light of
huge infrastructure and
For South Africa, a positive interest rate differential is likely to encourage carry trade related
energy projects that are
private flows. Nonresident purchases of equities remain positive, with resource-based stocks
already on course
doing well thanks to a revival in commodity and precious metals prices. Flows from official
sources will rise as the infrastructure programs of the major utilities will need a foreign
financing component. The World Bank, for example, last week approved a $3.75 billion loan
to Eskom.
IIF CAPITAL FLOW REPORT COUNTRY SAMPLE (30)
Emerging Europe Bulgaria Latin America Argentina

(8) Czech Republic (8) Brazil
Hungary Chile
Poland 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 Arabia
South Korea South Africa
Thailand UAE

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Capital Flows to Emerging

Table 1 Our estimates of net private

Official Inflows, Net 61.4 62.4 55.2 35.3

REVISIONS TO OUR FORECASTS

Valuation. There has been a spectacular increase in emerging market asset

standpoint, it is understandable that flows would moderate. This is most evident in

300 185 8 Emerging Europe

Euro Area -9.6 -0.5 1.7 0.5 8

SYNCHRONIZED FISCAL TIGHTENING IN MATURE ECONOMIES IN 2011

CROWDING OUT RISKS IN PERSPECTIVE

Other Mature Economies 44 -7 -8 3

Emerging Europe -17 25 30 7

o/w Russia 102 49 74 67

SELF-INSURANCE POLICIES ON THE RISE

In buying foreign exchange—especially dollars—emerging market central banks are able to

BUOYANCY IN EMERGING ASIAN LOCAL CREDIT MARKETS

EMERGING ASIA: SLOW DECLINE IN EXTERNAL SURPLUS

Official Inflows, Net 22.5 10.4 15.4 14.2

Resident Lending/Other, Net -122.0 -65.6 -77.8 -70.9

EMERGING EUROPE: UKRAINE REMAINS THE WEAK LINK

Official Inflows, Net 21.4 25.8 19.9 0.0

Resident Lending/Other, Net -232.0 -40.1 -118.4 -118.6

LATIN AMERICA: EARTHQUAKE REBUILDING TO MAKE CHILE MODEST NET

Increased external financing requirements to cover reconstruction costs triggered by the

Official Inflows, Net 14.0 23.7 14.9 17.4

Resident Lending/Other, Net -54.0 -68.8 -61.8 -49.4

Repatriation of ESSF funds: We expect earthquake-related capital repatriation of

AFRICA AND MIDDLE EAST: DUBAI WORLD RESTRUCTURES DEBT

Official Inflows, Net 3.6 2.5 4.9 3.7

Resident Lending/Other, Net -127.3 -37.2 -35.2 -58.2

IIF CAPITAL FLOW REPORT COUNTRY SAMPLE (30)

Emerging Europe Bulgaria Latin America Argentina

Emerging Asia China Africa/Middle East Egypt

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