The Institute of International Finance, Inc.

Capital Flows to Emerging Market Economies

Update
March 30, 2006
on Capital Flows Page 1
to Emerging Market Economies
March 30, 2006

Overview
This brief update of our January report confirms a surge in Table 1
private capital flows to emerging market economies in 2005. Emerging Market Economies' External Financing
(billions of U.S. dollars)
Indeed, the momentum has proved stronger than suggested by the 2003 2004 2005e 2006f
data available at that time. As a result, the estimate for 2005 and the
projections for this year have been revised upwards to $400 billion Current account balance 117.0 144.1 231.9 233.3

and $357 billion, respectively, from the January report’s figures of External financing, net:
$358 billion and $322 billion (Table 1, Chart 1). The deceleration Private flows, net 228.8 329.3 399.6 356.8
that is projected from last year’s record flows reflects in part the Equity investment, net 134.7 182.1 219.6 240.3
Direct investment, net 97.6 143.8 157.9 169.8
prevalence of prefinancing in 2005. Downside risks stemming from Portfolio investment, net 37.1 38.3 61.7 70.5
an unanticipated slowdown in global growth and potential shocks Private creditors, net 94.0 147.2 180.0 116.5
associated with continuing large global current account imbalances Commercial banks, net 26.9 63.9 88.7 51.6
could reduce net private capital flows in a more substantive way. Nonbanks, net 67.2 83.2 91.3 64.9
Official flows, net -20.1 -24.8 -66.8 -25.9
The stronger pace of net private capital flows to emerging IFIs -6.4 -16.2 -40.2 -12.5
Bilateral creditors -13.8 -8.7 -26.6 -13.4
markets continued in the first two months of this year with large
amounts of both bond and equity issuance. Emerging market bond Resident lending/other, net1 -57.7 -51.4 -148.5 -164.2
spreads continue to hover near record low levels as investors remain Reserves (- = increase) -267.9 -397.1 -416.2 -400.0
enthusiastic about the asset class. This is reflected in market
discussion of a shortage of foreign currency denominated bonds as 1
e = estimate, f = IIF forecast
Including net lending, monetary gold, and errors and omissions.
several major emerging market countries have announced or are
already engaged in significant buybacks of outstanding bonds.
Many emerging market countries have already significantly reduced
the ratio of public debt to GDP and that of external debt to exports,
reflecting strong output and export growth, improving fiscal
balances, and improved competitiveness. In addition, for some
countries, external financing requirements have become more
manageable because of increased remittances from overseas Chart 1: Capital Flows to Emerging Markets
workers and, for the time being, higher commodity prices. (billions of U.S. dollars)
400
The positive outlook for further strong capital flows to
emerging markets is also supported by favorable growth prospects 300
for industrial countries. Well-contained inflation and long-term
inflationary expectations continue to provide the basis for financial 200
market conditions that are favorable to the maintenance of forward
momentum in industrialized countries’ economies. Growth in the 100
United States in 2006 is now projected again to exceed its potential
rate, albeit slightly, while growth in the Eurozone is expected to
0
gather some traction and the recovery in Japan seems set to become
more broad-based and more sustainable.
-100
94 95 96 97 98 99 00 01 02 03 04 05e 06f
After several years of outsized returns (bringing the average per Official lending Private equity Private credit
annum return over the past decade to 16 percent), the sustainability
of the favorable environment that has supported the emerging
market debt asset class might be at more risk now. The sharply
higher valuation itself might start acting as a deterrent. Adverse
developments associated with a possible spike in energy prices or a
sudden unwinding of global imbalances could affect global growth,
interest rates, and exchange rates with negative consequences for

© 2006. The Institute of International Finance, Inc. All rights reserved. The contents of this report may be neither reproduced nor distributed in whole or in
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The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies
March 30, 2006 Page 2

emerging markets. Moreover, risk aversion could increase as global

liquidity becomes progressively tighter. “Global recovery is expected to continue in 2006 at a
marginally faster pace than last year, despite facing
In light of this, and given the underlying strains in the global headwinds from high energy prices.”
economy beneath its rather benign surface at the moment, it is
important for emerging market governments to pursue policies that
sustain market confidence. With emerging markets in the throes of
a high-profile election cycle, there is need for countries to adhere to
prudent macroeconomic policies and to re-invigorate structural
reforms that foster the productivity gains required to achieve higher
potential growth. There will be temptation to adopt expansionary
policies in the run-up to elections. Such temptation can be
compounded by generally favorable market conditions. However,
continued discipline is in order given that market sentiment could
turn quickly.

Global Economic Environment

Growth Prospects
Chart 2: Industrial Countries’ Real GDP Growth
Global recovery is expected to continue in 2006 at a marginally (percent change from previous year)
faster pace than last year, despite facing headwinds from high 5
energy prices (Chart 2). A benign inflation outlook, safeguarded by
a withdrawal of monetary stimulus in line with the strength of 4
economic activity, is keeping long-term interest rates markedly 3
lower than in past cyclical experiences, contributing to the 2
sustainability of growth. Strong balance sheets and favorable profit
margins should be supportive of continued robust investment 1
activity in many parts of the world. However, the continuation of 0
uneven growth in industrial countries and an unsustainable policy
-1
mix, which have contributed to global current account imbalances,
remain a risk going forward. -2
00 01 02 03 04 05e 06f

• The United States is likely to record again the fastest growth U.S. Japan Eurozone
among major industrial economies this year, with real GDP
growth of 3.4 percent. Despite strong consumer sentiment,
private consumption is expected to weaken slightly as the
household savings rate edges toward positive territory in a
situation where sharply weaker gains in housing prices slow the
accumulation of net household wealth. Consumer durable
purchases are already being affected by the significant increase
in short-term interest rates. However, business investment
growth should remain robust amid continued healthy profits
and strong balance sheets. Core inflation is expected to remain
subdued. Costly energy imports and strong growth in non-
energy imports together could push the current account deficit
above 6.5 percent of GDP this year.

• Economic recovery in the Eurozone is likely to gain some

momentum in 2006 as export growth strengthens in lagged
response to the weakness of the euro, with output growth
reaching 2.0 percent. Recent surveys of business confidence
point to a firming in investment demand. Private consumption
is also expected to rebound from a lower level. With the ECB
recently raising its inflation forecast to 2.2 percent for mid-year
“A benign inflation outlook, safeguarded by a
withdrawal of monetary stimulus in line with the
strength of economic activity, is keeping long-term
interest rates markedly lower than in past cyclical
experiences, contributing to the sustainability of
growth.”
The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies
March 30, 2006 Page 3

2007, this could presage further tightening of policy interest Chart 3: Emerging Market Economies’
rates before yearend. Including its possible impact on the euro, Real GDP Growth
such tightening would pose a challenge in maintaining the (percent change from previous year)
momentum toward higher growth. 8
7
• Japan is likely to record positive growth for the fourth 6
consecutive year in 2006 with real GDP growth of 2.8 percent.
5
Core inflation (overall less fresh foods) has settled into positive
territory for the first time in more that a decade. Household 4

consumption is poised to regain some further strength as labor 3

market conditions continue to show improvement. Business 2
investment is expected to remain robust. An upturn in wage 1
growth and a strengthening in employment are not likely to be 0
marked enough to start eroding profits. 98 99 00 01 02 03 04 05e 06f

• Based on our growth outlook for industrialized countries, we

project overall growth of emerging market economies in 2006
of 6.2 percent, unchanged from last year (Chart 3). On a
regional basis, growth in emerging Asia is expected to remain
above 7 percent for the fifth consecutive year. For countries of
emerging Europe, the outlook is mixed across countries, with
overall regional growth expected to be unchanged from 2005 at
about 5 percent. In Latin America, Brazil and Mexico are
expected to register stronger GDP growth this year, boosting
overall regional growth to 4.2 percent, up from 4.0 percent in
2005. In the Africa/Middle East region, growth is projected to Table 2
increase to over 5 percent this year (Table 2). Emerging Market Economies' Output Growth
(percent change from previous year)
2003 2004 2005e 2006f
Downside Risks
Real GDP 5.5 7.0 6.2 6.2

Energy Prices Latin America 1.7 5.9 4.0 4.2

Europe 5.5 6.8 5.1 5.1
Africa/Middle East 4.2 4.6 4.6 5.2
Although the grave concerns prevalent in the wake of the major Asia/Pacific 7.8 7.9 7.8 7.7
hurricanes that struck the United States last fall have faded, the two
fundamental problems relating to oil markets nevertheless persist. e = estimate, f = IIF forecast
The first is the very narrow margin of spare capacity in crude oil
and refining, while the second is a mismatch between the kinds of
oil more abundantly supplied (heavy and sour) and those highly
demanded (light and sweet). If either one of those problems
intensifies in any appreciable way, oil prices could spike markedly
with potential negative consequences for global growth, inflation
and interest rates.

The current lack of spare capacity is not likely to change in the

near term, as non-OPEC production is at its capacity with declining
yields observed in some existing fields. Moreover, many places
with potential exploration opportunities are wracked either by
political instability, terrorism, or policies that limit foreign
investment. With the exception of Saudi Arabia, there is little
leeway for OPEC countries to increase their production capacity in
any significant way in the short term. In the meantime, with
demand for oil remaining strong, even a moderate disruption in “With the exception of Saudi Arabia, there is little
supply could have an appreciable impact on prices. Iran and leeway for OPEC countries to increase their
Nigeria are clear sources of concern in that regard. The reaction to production capacity in any significant way in the short
the failed attack on oil facilities in Saudi Arabia in February attests term.”
to how quickly market participants can bid up prices.
The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies
March 30, 2006 Page 4

The mismatch between the various kinds of oil supplied and

refined and those demanded is not likely to be resolved soon. Oil “The mismatch between the various kinds of oil
companies, in general, have been slow to undertake investment to supplied and refined and those demanded is not likely
improve refining capacity with flexibility to refine various products to be resolved soon.”
using various kinds of crude. Such investment is expensive,
requiring long-term assumptions about trends in oil prices reaching
certain thresholds in order for this type of investment to make
economic sense. Oil company executives have not been easily
convinced of the durability of higher prices. As a consequence, the
supply/demand balance remains precarious with natural disasters
such as Hurricane Katrina creating significant imbalances that
produce volatile price fluctuations. It should also be noted that the
spare capacity of Saudi Arabia—which is estimated at between
1.0-2.0 million barrels per day—is mostly comprised of heavy and
sour oil.

To date, the impact of oil price increases for the past two years
has not been very marked relative to expectations based on
simulations of many kinds, all of which are based on historical
experience. The reasons for this limited effect include:

• High oil prices this time around, unlike earlier episodes, have
been triggered by unexpectedly strong demand, partly related to “Growing signs of a lessening of momentum in the
strong global growth rather than to a supply shock. U.S. housing market might prove to be a precursor of
a considerably sharper slowing in housing price
• Unlike in the past, the strong credibility of monetary authorities
increases, with a correspondingly large impact on U.S.
has alleviated the need for higher policy rates.
consumption and residential investment with
implications for global growth.”
This year, however, a supply shock could push prices up with
different consequences.

U.S. Housing Market

Growing signs of a lessening of momentum in the U.S. housing

market might prove to be a precursor of a considerably sharper
slowing in housing price increases, with a correspondingly large
impact on U.S. consumption and residential investment with
implications for global growth. Although a firm trend is not yet
evident, most recent data show a drop in both existing and new
home sales. In addition, the inventory of new homes has risen to its
highest level on record. The various data series on housing prices
could be interpreted as not giving a clear-cut picture of the situation,
but most series do show signs of softening.

A key series on affordability for the first-time house buyer has

deteriorated to levels not seen since the end of the housing boom in
the late 1980s. The lack of affordability this time around stems
mainly from the level of home prices as opposed to previous periods
when it resulted from high interest rates. This situation has been
accompanied by a decline in the average credit quality of
mortgages, with regulators in the United States warning borrowers
of the potential risks they are assuming while cautioning lenders to “The share of sub-prime (low quality) mortgages as a
avoid making lower credit quality loans. The share of sub-prime share of total mortgages rose to more than 35 percent
(low quality) mortgages as a share of total mortgages rose to more last year from about 28 percent in 2004 and far above
than 35 percent last year from about 28 percent in 2004 and far the average of roughly 10 percent for the period 2000-
above the average of roughly 10 percent for the period 2000-2003. 2003.”
The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies
March 30, 2006 Page 5

So far, an unusually low number of defaults have occurred, but this

could change if interest rates rise further. “Despite a stronger momentum of net private capital
flows into the United States in the final months of last
A slowdown in housing activity would negatively impact year (influenced in part by the Homeland Investment
economic growth, both directly and indirectly. It would impact Act and interest rate differentials), a heavy reliance on
directly both residential construction activity (characterized in GDP official flows for the financing of the current account
accounts as residential investment) and housing-related highlights the precariousness of the situation.”
employment. A weak housing sector could be extremely
detrimental for employment as it is estimated that 40-50 percent of
the net new jobs created in the private sector during this recovery
has been in housing-related industries. However, the indirect effects
could have an even more severe impact on economic growth.
According to one estimate, the wealth effect and the cash-outs from
refinancing added nearly two full percentage points to GDP growth
in 2005. Freddie Mac forecasts that cash-outs are likely to drop by
almost 50 percent this year to $114 billion from a record
$204 billion in 2005. This alone reduces the contribution from
cash-outs to real GDP growth by about 0.4 percentage points.

Current Account Imbalances

Chart 4: U.S. Current Account Balance
(percent of GDP)
Large global current account imbalances persist. The continued
disparity in growth prospects for the United States relative to the -7.5
Eurozone and Japan implies underlying forces working toward an
even further widening of the U.S. current account deficit (Chart 4).
-6.5
Investors have been expressing concern over the sustainability of
the flows needed to finance the outsized current account deficit.
Despite a stronger momentum of net private capital flows into the -5.5
United States in the final months of last year (influenced in part by
the Homeland Investment Act and interest rate differentials), a
-4.5
heavy reliance on official flows for the financing of the current
account highlights the precariousness of the situation.
-3.5
The lack of prospects for coordinated policy action by major 2000 2001 2002 2003 2004 2005e 2006f
economies aimed at adjustment raises the possibility of a disorderly
depreciation of the dollar. Such a depreciation could push up the
U.S. interest rate curve well beyond the current expectations with
adverse consequences for EMBIG spreads. A sharp fall in the dollar
would also weaken output growth in the Eurozone and Japan while
higher U.S. interest rates would dampen U.S. domestic demand
growth. This would have a negative impact on the growth of
emerging markets’ exports and output. Wider EMBIG spreads and
weaker growth would affect the debt dynamics of those emerging
market economies with high debt levels.

Outlook for Major Components

of Capital Flows
Since our last report in January on capital flows to emerging
market economies, we have revised our projections for net private
flows in 2006 to $357 billion from $322 billion. This is due to our “The lack of prospects for coordinated policy action
expectation for larger net inflows of direct equity and portfolio by major economies aimed at adjustment raises the
equity investment following upward revisions of these flows for possibility of a disorderly depreciation of the dollar.”
2005. At the same time, we have revised downward our forecast for
The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies
March 30, 2006 Page 6

net nonbank private sector lending as several major countries have

decided to buy back select outstanding bonds before they reach “Prospects for direct equity investment remain
maturity. favorable, reflecting the broadly positive outlook for
economic growth in emerging market countries as well
These revisions reinforce our view that a variety of forces are at as improving confidence on the part of long-term
work to support a continuation of strong flows, including robust investors in emerging markets’ policy performance.”
economic growth and a generally favorable balance sheet position
of many emerging market countries. Nevertheless, there is a risk
that the high level of flows into some emerging market assets
(particularly those that are non-investment grade) has pushed up
valuations that are not commensurate with underlying fundamentals.
A change in investors’ expectations for a number of key factors that
have supported these valuations could result in an appreciable
contraction in net private capital flows to emerging markets.

Direct Investment

Prospects for direct equity investment remain favorable,

reflecting the broadly positive outlook for economic growth in
emerging market countries as well as improving confidence on the
part of long-term investors in emerging markets’ policy Chart 5: Net Direct Investment by Region
performance. Continued liberalization of investment rules and (billions of U.S. dollars)
regulations in a number of countries should alleviate many of the
180
remaining roadblocks faced by corporate investors as they seek new
opportunities. Thus, direct investment is projected to rise to
$170 billion this year from $158 billion in 2005 and represent the 120
highest level of flows since our survey began (Chart 5).

The favorable outlook for direct investment has come at a time 60

when stronger demand in a range of industries has improved
corporate profits and the availability of investible funds. In looking
for investment opportunities, there seems to be an increasing 0
tendency for companies to search for those in the largest emerging EME LA A/ME Asia Europe
market countries as part of a strategy to service local clients or to
2003 2004 2005e 2006f
acquire a strategic position that could become prosperous as market
development takes place. Industries expected to be at the forefront
of direct investment growth are computing and internet technology,
public utilities, transportation- and tourism-related services,
electrical products, machinery and metals, and mining and
petroleum.

• On a regional basis, the only significant increase in direct

investment is expected to take place in emerging Europe, where
countries like Poland and Romania are likely to see an
appreciable pickup in direct investment flows as foreign
companies seek to solidify their positions. Russia is projected
to experience a sharp positive reversal in flows this year, but
the $5.6 billion in flows forecast will still fall short of those
received by half the countries in the region. China will
continue to receive the vast majority of direct investment in the
Asia/Pacific region. The large pipeline of commitments “Industries expected to be at the forefront of direct
suggests that net inflows could increase to $51 billion this year investment growth are computing and internet
from $50 billion in 2005. This nonetheless signifies a tapering technology, public utilities, transportation- and
off of these flows, albeit at an overwhelmingly high level tourism-related services, electrical products,
relative to other emerging market economies. In Latin machinery and metals, and mining and petroleum.”
The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies
March 30, 2006 Page 7

America, only Mexico is expected to see any noticeable

increase in net direct investment this year, accounting for about
one-third of such flows to the region. In the case of Brazil,
while gross inflows of foreign direct investment are rising
visibly, this is being offset by direct investment of Brazilian
companies in a number of other countries.
“Total equity issuance this year is likely to exceed the
$50 billion recorded in 2005, which was the highest in
a decade.”

Portfolio Investment

After reaching a record high of almost $62 billion in 2005,

emerging market portfolio equity investment is projected to
accelerate further this year to nearly $71 billion. This figure is more
than $20 billion higher than the forecast in our January report as
investors continue to see value in emerging market stocks.
Although the price of stocks has risen substantially in a large
number of emerging market countries, positive structural trends are
likely to keep emerging market equities relatively attractive in the
eyes of investors. These include:

• Improved domestic and external economic fundamentals with

more than 50 percent of MSCI Emerging Market Index Chart 6: Net Portfolio Investment by Region
countries rated investment grade. (billions of U.S. dollars)
80
• Sustainable growth in capital expenditures and credit flows to
firms.
50
• Fundamentally sound balance sheet positions of firms.

Total equity issuance this year is likely to exceed the $50 billion 20
recorded in 2005, which was the highest in a decade. Issuance in
the first two months of this year already reached $10 billion, with
more than two-thirds of it coming from Asia. IPOs seem likely to -10
become a bigger share of the issuance in 2006 as privatization EME LA A/ME Asia Europe
moves forward in several countries and more state-owned
companies in China list their shares overseas. 2003 2004 2005e 2006f

• The Asia/Pacific region is expected to account for about

60 percent of total net equity portfolio flows to emerging
market countries this year (Chart 6). In China, planned
overseas listings by a spate of state-owned companies and
banks should help to generate $25 billion in net inflows this
year, up from $21 billion in 2005. An easing in new issues
from the surge of the past and a more discriminatory investor
community are likely to limit net portfolio equity investment in
India to $8 billion this year, following $12.5 billion in 2005.

• In emerging Europe, net portfolio equity investment is expected

to increase to more than $19 billion in 2006 from $9.2 billion
last year, reflecting a sharp rise in net inflows to Russia. The
surge to Russia stems from the planned IPO of a minority stake
in Rosneft and the removal of restrictions on foreign purchases “IPOs seem likely to become a bigger share of the
of Gazprom shares traded domestically. issuance in 2006 as privatization moves forward in
several countries and more state-owned companies in
• In Latin America, net inflows of portfolio equity investment in China list their shares overseas.”
2006 are projected to be cut in half from last year’s $5.5 billion
The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies
March 30, 2006 Page 8

Emerging Europe Asia/Pacific

Even though a record level of net equity investment is
expected in 2006, a significant decline in net commercial
bank lending should lead to an easing in overall net private
capital flows from last year’s all-time high to $157 billion
this year.
• While the growth outlook for the countries of emerging
Europe appears mixed this year, real GDP growth for the
region is expected to be 5.1 percent in 2006. This is the
same as last year but well below the rapid pace seen in
2004.
• Both direct equity investment and portfolio investment
are expected to reach record levels this year. Direct
equity flows are spread relatively evenly throughout the
region, with five of the eight countries in emerging
Europe expected to receive at least $5 billion in net
direct investment flows in 2006. Meanwhile, portfolio
equity flows are projected to reach in excess of
$19 billion, well above an average level of net flows of
less than $3 billion in the 2000-2005 period.
After approaching $170 billion in 2004, net private capital
flows slipped some last year and are expected to edge slightly
lower again in 2006. With a slowdown in net commercial
bank lending not quite offset by a pickup in portfolio equity
investment flows, net private capital flows to emerging Asia
are projected to be $143 billion this year, about $4 billion
less than last year.
• At 7.7 percent, projected growth in emerging Asia in
2006 should surpass 7 percent for the fifth consecutive
year, and make emerging Asia the fastest growing region
for the eighth straight year. While slowing somewhat
from its 2005 pace, China is expected to be the fastest
growing economy in our survey in 2006.
• Direct equity investment remains the most significant
segment of capital flows to the region, with China
expected to receive nearly 80 percent of such flows in
2006. Nonetheless, a small downturn in net direct equity
flows to China this year and last from the record level in
2004 might signal a leveling off of the trend.

• Even with the current account projected to decline to
near balance, reserve accumulation is projected to reach
$84 billion in 2006, second only to last year’s record
level of reserve accumulation. As a result, the stock of
reserves in the region is projected to exceed $460 billion
this year, providing over 6½ months of import cover.
• Buoyed by a widening trade surplus, the aggregate
current account surplus in 2006 is expected to be
3.8 percent of GDP for the second consecutive year.
Reserve accumulation is projected to be $274 billion this
year, bringing the region’s stock of reserves to over
$1.6 trillion—about 3.5 times greater than just five years
ago.

Table 3 Table 4
Europe: External Financing Asia/Pacific: External Financing
(billions of U.S. dollars) (billions of U.S. dollars)
2003 2004 2005e 2006f 2003 2004 2005e 2006f

Current account balance -1.6 -1.4 19.4 6.7 Current account balance 99.2 117.9 170.6 196.8

External financing, net: External financing, net:

Private flows, net 68.1 121.0 172.7 157.2 Private flows, net 124.4 168.6 147.7 143.4
Equity investment, net 8.9 34.7 45.8 67.8 Equity investment, net 92.9 97.7 103.0 105.8
Direct investment, net 7.0 29.9 36.6 48.6 Direct investment, net 55.9 65.3 64.0 64.2
Portfolio investment, net 1.9 4.8 9.2 19.2 Portfolio investment, net 37.0 32.5 39.0 41.6
Private creditors, net 59.2 86.3 126.9 89.4 Private creditors, net 31.5 70.9 44.7 37.6
Commercial banks, net 26.2 39.6 67.0 34.9 Commercial banks, net 15.5 37.0 21.4 15.3
Nonbanks, net 33.0 46.7 59.9 54.5 Nonbanks, net 15.9 33.9 23.2 22.3
Official flows, net -3.7 -9.0 -35.2 -18.6 Official flows, net -15.3 -4.8 1.5 1.2
IFIs -0.1 -3.2 -9.1 -3.8 IFIs -10.0 -4.6 -2.0 -0.3
Bilateral creditors -3.6 -5.8 -26.1 -14.8 Bilateral creditors -5.3 -0.2 3.5 1.5

Resident lending/other, net1 -26.7 -52.2 -53.3 -61.2 Resident lending/other, net1 -22.9 15.9 -59.2 -67.5

Reserves (- = increase) -36.1 -58.4 -103.5 -84.2 Reserves (- = increase) -185.4 -297.5 -260.6 -273.8

e = estimate, f = IIF forecast e = estimate, f = IIF forecast

1 1
Including net lending, monetary gold, and errors and omissions. Including net lending, monetary gold, and errors and omissions.
The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies
March 30, 2006 Page 9

Latin America Africa/Middle East

Net private capital flows to Latin America in 2006 are
expected to decline to about $28 billion—some $22 billion
less than last year. A significant reversal in nonbank creditor
flows accounts for over 80 percent of the decline, with net
equity flows only slightly lower compared to 2005.
• Growth in Latin America is projected to be 4.2 percent
in 2006, well above the region’s average growth rate
over the past decade. While only Brazil and Mexico are
expected to register improved growth in 2006, of the
remaining countries in the region, only Ecuador is
projected see growth below 4 percent this year.
• With a number of debt buyback programs planned, net
nonbank creditor flows are expected to shift from an
inflow of $4 billion in 2005 to a net outflow of nearly
$15 billion this year. Brazil alone is expected to see a
net nonbank outflow of more than $13 billion, with
Mexico and Venezuela together accounting for almost an
additional $7 billion in outflows.
• Behind a weakening trade surplus, the region’s current
account surplus is expected to decline to less than 1
percent of GDP in 2006. With a smaller current account
surplus and lower net capital inflows, reserve
accumulation should fall to about $12 billion this year—
leading to a decline in the region’s stock of reserves (in
terms of import cover) for the third consecutive year.
Net private capital flows to the region are expected to be
nearly $29 billion in 2006, only slightly off last year’s record
pace. Behind strength in equity flows—including a likely
record level of direct equity flows in 2006—net private flows
this year and last are more than the sum of net flows in the
preceding seven years.
• Regional growth is projected to increase to 5.2 percent in
2006, the fastest growth rate since 1996. Growth rates
should improve, compared to 2005, in every country in
the region this year, with Morocco expected to see a
significant improvement after a poor agricultural outturn
last year.
• Following a record level of net equity investment in
2005, the region should experience a slight decline this
year. With the exception of South Africa, all countries
in the region should see a pickup in direct equity
investment in 2006. Net private creditor flows are
projected to be little changed, as an increase in
commercial bank lending to Egypt should help offset a
decline in net creditor flows to South Africa.
• With support from the terms of trade, the region’s
current account surplus is expected to increase to about 2
percent of GDP in 2006. Reserve accumulation is
projected to reach $30 billion this year, pushing the
region’s stock of reserves to a record high (in both
import cover and nominal terms).

Table 5 Table 6
Latin America: External Financing Africa/Middle East: External Financing
(billions of U.S. dollars) (billions of U.S. dollars)
2003 2004 2005e 2006f 2003 2004 2005e 2006f

Current account balance 11.9 21.7 34.7 18.6 Current account balance 7.4 6.0 7.2 11.2

External financing, net: External financing, net:

Private flows, net 31.1 29.1 50.1 27.7 Private flows, net 5.2 10.6 29.1 28.5
Equity investment, net 27.9 39.5 46.7 43.3 Equity investment, net 4.9 10.1 24.1 23.5
Direct investment, net 30.3 44.9 41.2 40.5 Direct investment, net 4.5 3.7 16.1 16.5
Portfolio investment, net -2.3 -5.3 5.5 2.7 Portfolio investment, net 0.5 6.4 8.0 7.0
Private creditors, net 3.2 -10.5 3.4 -15.6 Private creditors, net 0.2 0.5 5.0 5.0
Commercial banks, net -12.7 -13.5 -0.7 -0.9 Commercial banks, net -2.2 0.9 1.0 2.4
Nonbanks, net 15.8 3.0 4.1 -14.7 Nonbanks, net 2.4 -0.4 4.0 2.7
Official flows, net 0.2 -8.0 -30.1 -8.5 Official flows, net -1.4 -3.1 -3.0 0.1
IFIs 4.8 -7.1 -28.8 -9.3 IFIs -1.1 -1.3 -0.3 0.9
Bilateral creditors -4.6 -0.9 -1.3 0.8 Bilateral creditors -0.2 -1.8 -2.7 -0.9

Resident lending/other, net1 -9.8 -20.3 -28.1 -26.1 Resident lending/other, net1 1.8 5.2 -7.9 -9.4

Reserves (- = increase) -33.4 -22.5 -26.7 -11.6 Reserves (- = increase) -13.0 -18.7 -25.4 -30.4

e = estimate, f = IIF forecast e = estimate, f = IIF forecast

1 1
Including net lending, monetary gold, and errors and omissions. Including net lending, monetary gold, and errors and omissions.
The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies
March 30, 2006 Page 10

with marked reductions in Colombia and Mexico. A substantial Chart 7: Net Nonbank Lending by Region
portion of the net inflows will go to Brazil. (billions of U.S. dollars)
100
Nonbank Private Sector Lending

After exceeding $91 billion last year, net nonbank private sector 80
lending, mostly in the form of bond purchases, is expected to
decrease in 2006 to about $65 billion (Chart 7). Despite continued 60
strong bond issuance in the first two months of this year, gross
issuance for the full year is likely to fall below the more than 40
$127 billion recorded in 2005, as front-loading by sovereign and
corporate borrowers has taken place in anticipation of higher global 20
interest rates. According to one estimate, emerging market
sovereigns by the end of February had already completed nearly 0
50 percent of planned issuance for this year. In addition, a number EME LA A/ME Asia Europe
of important emerging market countries, including Brazil,
2003 2004 2005e 2006f
Colombia, Ecuador, Mexico, Peru, and Turkey, have stated that they
will undertake buybacks of external debt in 2006, which will further
reduce net nonbank lending.

The trend in recent years toward higher credit ratings of

emerging market issuers has been supportive of a significant
compression in spreads since the latter part of 2002 to recent record
lows. However, the limited dispersion of bond spreads across
countries, with different credit ratings, included in the EMBIG
index suggests that investors are not discriminating sufficiently
among borrowers. Indeed, sovereign spreads this year are clustered “The higher overall credit quality of emerging market
more closely together than ever before. debt and risk-adjusted returns of the asset class have
attracted a broader investor base to absorb the
The higher overall credit quality of emerging market debt and explosion of bond issuance since 2003.”
risk-adjusted returns of the asset class have attracted a broader
investor base to absorb the explosion of bond issuance since 2003.
The supply of bonds coming on stream this year should be absorbed
as they remain a diversification play for institutional and crossover
investors given the relatively low correlation with other asset
classes. A broadening of the investor base has had a significant
impact on emerging market bonds and, according to one study, has
accounted for almost one-fourth of the spread compression in these
bonds in the past two years.

The broadening of the investor base has given borrowers more

leeway to issue in different currencies and to increase the share of
financing from domestic resources as part of a more active asset-
liability management process. Stepped-up efforts have been made
to issue global bonds denominated in local currencies in
international capital markets. For U.S. dollar-based investors, gains
on local currency emerging market debt instruments have been
enhanced by exchange rate movements. Emerging market
currencies appreciated by more than 2 percent against the U.S.
dollar in the first two months of 2006.
“Stepped-up efforts have been made to issue global
• Emerging Europe is projected to account for roughly two-thirds bonds denominated in local currencies in international
of nonbank private creditor flows to emerging markets this capital markets. For U.S. dollar-based investors,
year. Net nonbank flows to Turkey will likely fall moderately gains on local currency emerging market debt
below last year’s $17 billion, but nonetheless remain the instruments have been enhanced by exchange rate
highest in the region. Net nonbank lending to the Asia/Pacific movements.”
The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies
March 30, 2006 Page 11

region is expected to decrease for the second consecutive year, “Net commercial bank lending is projected at about
with all countries except India and Malaysia likely to $52 billion in 2006, the fourth consecutive year of
experience a reduction in net inflows. positive flows.”
• In Latin America, Brazil is projected to see a net outflow to
nonbank creditors of more than $13 billion this year, after net
inflows of nearly $2 billion in 2005 as the government has
decided to pay down its external debt obligations. Mexico and
Venezuela are also expected to register net outflows as part of
liability management operations. In Africa/Middle East, South
Africa is likely to account for the bulk of net nonbank lending
to the region.

Commercial Bank Lending

Net commercial bank lending is projected at about $52 billion

in 2006, the fourth consecutive year of positive flows. Albeit down
from nearly $89 billion in 2005, the level projected for this year Chart 8: Net Commercial Bank Lending by Region
represents a sizable sum in light of the $132 billion cumulative net (billions of U.S. dollars)
outflow during 1998-2002. Loan pricing on balance is likely to 90
remain competitive with other sources of financing.
60
• Net commercial bank lending to emerging Europe is forecast to
decline to about $35 billion this year from $67 billion in 2005 xxxxxxxxxxxxxxxxxxxx
30
(Chart 8). The bulk of the falloff in net lending will take place
in Russia, where a large repayment of funds used to finance the
purchase by Rosneft of a stake in Gazprom and the latter’s 0
acquisition of Sibneft is scheduled to take place. Net lending to
the Asia/Pacific region is expected to decline to about -30
$15 billion this year from more than $21 billion in 2005. China EME LA A/ME Asia Europe
will remain one of the largest recipients in the region, but net
inflows will continue to be affected by administrative measures 2003 2004 2005e 2006f
taken by the authorities to impose quotas on banks’ overseas
borrowing.

• Latin America is the only region likely to experience net

outflows to commercial banks this year. Although total net
outflows are projected to be less than $1 billion, this would
nevertheless be the sixth consecutive year of net repayments,
with Brazil and Mexico accounting for nearly all of the net
outflows. Net commercial bank lending to Africa/Middle East
Chart 9: Net Official Lending by Region
could exceed $2.3 billion this year, representing the highest (billions of U.S. dollars)
level of net inflows since 1997, as Egypt is expected to
10
experience a sharp positive reversal in flows.
0

Official Flows -10

-20
After reaching a record high of $67 billion in 2005, net -30
repayments to official creditors from emerging market countries are
-40
expected to drop to $26 billion this year (Chart 9). In terms of the
-50
breakdown in flows by creditor group, official bilateral creditors are
projected to see net repayments of $13.4 billion in 2006, down -60
sharply from nearly $27 billion last year, when countries like Poland -70
and Russia made prepayments of a significant portion of their Paris EME LA A/ME Asia Europe
Club debt. For the second consecutive year, Russia will make the 2003 2004 2005e 2006f
The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies
March 30, 2006 Page 12

largest amount of net repayments to official bilateral creditors,

amounting to $11.5 billion in 2006. The next largest repayment of “Even with the slowdown in reserve accumulation, the
$2.6 billion is expected to come from Poland. stock of emerging market reserves will edge up to
eight months of imports of goods, services, and interest
International financial institutions (IFIs) as a creditor group are payments.”
likely to receive net repayments this year of $12.5 billion, with
Argentina accounting for more than one-half of all net repayments.
Turkey is expected to make large net repayments for the second
consecutive year totaling more than $4.5 billion. China, India and
Egypt are projected to obtain the largest net inflows from IFIs in
2006.

Resident Net Lending and International Reserve Accumulation

Net lending abroad by emerging market residents is expected to

increase to $164 billion in 2006 from $149 billion last year. As
regards reserve accumulation, despite a sharp reduction in net
repayments to official creditors, the combination of smaller net Chart 10: International Reserves
and Resident Net Lending
private capital inflows and larger net resident lending abroad will (billions of U.S. dollars)
result in a reduction in the pace of buildup to $400 billion, down
-500
from a record high of $416 billion last year (Chart 10). Even with
the slowdown in reserve accumulation, the stock of emerging -400
market reserves will edge up to eight months of imports of goods,
services, and interest payments. -300

-200
• On a regional basis, the Asia/Pacific region as a whole is
expected to account for 70 percent of total emerging market -100
reserve accumulation this year. Reserve accumulation in
emerging Europe is likely to slow down to $84 billion this year 0
after reaching a record high of nearly $104 billion in 2005. In
100
the Africa/Middle East region, reserve accumulation is 1996 1998 2000 2002 2004 2006f
projected to climb to a record high $30 billion in 2006,
following an increase of $25 billion last year. High energy Reserve Accumulation
prices in hydrocarbon-based economies like Algeria, which Resident Lending Abroad, net1
have pushed up its current account surplus to nearly 20 percent 1
Including net lending, monetary gold and
of GDP, are the principal factor in the sharp run-up in reserves errors and omissions.
since 2004.

Questions or comments regarding this report may be directed to Keith Savard or Joshua Smith
via telephone (202-857-3619), fax (202-775-1430), or e-mail (jsmith@iif.com).

Asia/Pacific Latin America Europe Africa/Middle East

China Argentina Bulgaria Algeria
India Brazil Czech Republic Egypt
Indonesia Chile Hungary Morocco
Malaysia Colombia Poland South Africa
Philippines Ecuador Romania Tunisia
South Korea Mexico Russian Federation
Thailand Peru Slovakia
Uruguay Turkey
Venezuela