(Bai Dich Tai Chinh Tien Te) Dau Tu Nuoc Ngoai The Gioi

The Institute of International Finance, Inc.
Capital Flows to Emerging Market Economies
Capital Flows to Emerging Market Economies

September 24, 2005 Page 1
September 24, 2005
Overview
The strong recovery in net private capital flows to emerging Table 1
markets that began in 2003 has continued this year. Although a Emerging Market Economies' External Financing
(billions of U.S. dollars)
moderation in the pace of flows is anticipated in the next several 2003 2004 2005f 2006f
quarters, the overall level envisaged for 2006 remains relatively
elevated. Downside risks have increased, however, in the face of Current account balance 118.0 151.9 194.4 180.7
rising concerns and unease about a potentially less hospitable External financing, net:
global economic environment going forward. Private flows, net 213.7 317.4 345.2 317.8
Equity investment, net 128.9 167.5 191.3 184.4
Private flows are projected to reach a record high Direct investment, net 95.9 132.2 148.9 145.8
$345 billion this year before slowing to $318 billion in 2006 Portfolio investment, net 33.0 35.3 42.3 38.7
(Table 1, Chart 1). This year’s expected flows surpass the Private creditors, net 84.8 149.8 153.9 133.3
previous record of $323 billion reached in 1996 prior to the Commercial banks, net 25.4 61.1 63.5 57.8
Nonbanks, net 59.4 88.7 90.4 75.5
Asian crisis. The continued robustness in flows is being supported
by a further pickup in direct investment and a record pace of bond Official flows, net -21.4 -30.6 -50.4 -24.2
IFIs -6.6 -16.4 -23.9 -12.4
issuance as sovereign and private borrowers endeavor to stay ahead Bilateral creditors -14.8 -14.2 -26.5 -11.8
of the curve before the tightening policy interest rate cycle starts to
hit bond markets visibly. With many debtors having already taken Resident lending/other, net1 -37.6 -38.6 -87.7 -72.3
the opportunity to pre-finance obligations due in 2006, the current Reserves (- = increase) -272.6 -400.0 -401.4 -402.0
pace of bond issuance is unlikely to be sustained next year,
contributing to an overall slowdown in private capital flows to f = IIF forecast
1
Including net lending, monetary gold, and errors and omissions.
emerging markets. This forecasted slowdown could become more
pronounced if downside risks from a further jump in oil prices,
unanticipated policy slippage or other problems in a major emerging
market economy, or a sudden shift in investor risk aversion
stemming, inter alia, from concerns over global imbalances or the
fragility of global growth were to materialize.
The strong private capital flows to emerging markets in Chart 1: Capital Flows to Emerging Markets
2005 has occurred against a backdrop of strong global economic (billions of U.S. dollars)
expansion, which has been supported by strong corporate
400
profitability and buoyant housing markets in the United States
and elsewhere. The measured but sustained monetary tightening in
300
the United States has yet to dampen growth, as bond yields have
tended to drift down. Neither have sharply higher oil prices begun
200
to visibly affect the forward momentum of global activity, although
this could now change in the aftermath of Hurricane Katrina.
100
Low yields on U.S. Treasury bonds and a flat yield curve

have pushed investors to purchase lower rated credits, 0
compressing credit spreads, including those on emerging market

bonds. Despite the historically high price of emerging market -100
94 95 96 97 98 99 00 01 02 03 04 05f 06f
assets, investor demand remains strong, reflecting both the
Official lending Private equity Private credit
search for yield and the improving fundamentals in many key
countries. Most of these countries have experienced robust growth
with relatively little inflation while accumulating substantial
international reserves as a result of current account surpluses and
large capital inflows. Growing confidence on the part of investors
in the policy performance of some of the key emerging market
© 2005. The Institute of International Finance, Inc. All rights reserved. The contents of this report may be neither reproduced nor distributed in whole or in
part outside the membership without the prior written approval of the Institute of International Finance, Inc.
The Institute of International Finance, Inc. Capital Flows to Emerging Market Economies
countries has contributed to both direct and portfolio investment

inflows as well as bond flows. “Although the general conditions in emerging markets
as a whole remain broadly conducive to growth and
Although the general conditions in emerging markets as a
stability, less favorable economic performance and
whole remain broadly conducive to growth and stability, less
troublesome developments, including the persistence
favorable economic performance and troublesome
of high debt ratios and a tendency to hold back on
developments, including the persistence of high debt ratios and
structural reforms, have been observed in some
a tendency to hold back on structural reforms, have been
countries.”
observed in some countries. These problems could be exacerbated
by a possible deterioration in global macroeconomic fundamentals
stemming, for example, from high oil prices. A possible weakening
of global financial market stability in the face of progressive
monetary tightening could also work to magnify and propagate
problems associated with inadequate policy performance of
individual emerging market economies. Such possibilities are real
as the default rates of sub-investment grade borrowers are likely to
increase—partly because of the wave of high yield issuance in
previous years—and as credit derivatives, which have proliferated
in recent years and whose pricing has depended on relatively
untested models and default correlation assumptions, are vulnerable
to corrections.
None of the circumstances mentioned above necessarily “The United States has continued to be the engine of
points to major market disturbances or credit events in the growth for the world economy with projected growth
period immediately ahead. Nevertheless, in conjunction with for this year the highest in the G7.”
gradual increases in risk aversion in world financial markets that are
likely to occur, the risk of disorderly exchange rate movements
among major currencies stemming from global current account
imbalances, and a bunching of key elections in emerging market
countries in the next 15 months, such possibilities are a cause for
concern.
Global Economic Environment

Global recovery has continued in 2005, albeit at a more
moderate pace than in 2004 (Chart 2). Strong balance sheets and
favorable profit margins have been supportive of investment activity
while consumption has held up well in the face of higher energy
costs. Global growth is expected to moderate further in 2006. The
pattern of uneven growth and the policies responsible for such a Chart 2: Industrial Countries’ Real GDP Growth
pattern, which together have contributed to a widening in global (percent change from previous year)
current account imbalances, remain a risk going forward.
5
• The United States has continued to be the engine of growth for 4

the world economy with projected growth for this year the 3
highest in the G7. Although GDP growth slowed to an
2
annualized rate of 3.3 percent in the second quarter, the strength
of final demand in that quarter and subsequent activity 1
indicators suggest that, even after allowing for the effects of 0
Katrina, full-year GDP growth in the vicinity of 3½ percent is
-1
well within reach. Growth momentum is expected to slow
somewhat next year on an annual average basis as high oil -2
prices finally bite into consumption in the situation where the 00 01 02 03 04 05f 06f
savings rate has hit rock bottom. Business fixed investment is U.S. Japan Eurozone
likely to continue to play a key role as a source of growth.
• The narrowing of the output gap that has taken place in the
United States this year is not being replicated in other major “Japan seems poised to register its first sustained
industrial countries, except perhaps in Japan. Indeed, recovery economic recovery since the bursting of the bubble,
in the Eurozone has faltered with real GDP growth projected at albeit with wide gyrations in quarterly growth, which
1.3 percent in 2005. While the employment situation has may reflect in part problems with seasonal
improved a little, the same cannot be said for consumption, adjustment.”
which has been held back in part by higher oil prices, which
have not been attenuated of late by a strengthening euro.
Growth next year is projected to reach 1.6 percent—with
Germany showing some strength—supported by export volume
growth that should benefit from the lagged effects of earlier
exchange rate developments. A major strengthening of
domestic demand growth is not expected, however.
• Japan seems poised to register its first sustained economic

recovery since the bursting of the bubble, albeit with wide
gyrations in quarterly growth, which may reflect in part
problems with seasonal adjustment. With signs of
Chart 3: Emerging Market Economies’
strengthening in the jobs market and in wages and salaries,
Real GDP Growth
growth this year is expected to reach 2¼ percent, underpinned (percent change from previous year)
by moderately strong private consumption and business 7
investment. Forward-looking indicators suggest that economic
growth next year will continue at this year’s pace. Survey data 6
show that business confidence is increasing and that export 5
growth is likely to rebound as the manufacturing sector reacts
4
favorably to global IT sector adjustment. If the current
reduction in deflation continues, it should come to an end in 3
2006, if not earlier. 2
1
Emerging market growth this year is projected at 5.9 percent
(Chart 3). This is nearly one percentage point lower than in 2004, 0
when growth reached a 20-year high. 98 99 2000
00 01 02 2003
03 04 05f 2006f
06f
• Emerging Europe is likely to experience the most visible fall-

off in growth to 4.9 percent from 6.8 percent in 2004, reflecting
slower export growth to the euro area and some moderation in
domestic demand, most noticeably in Turkey (Table 2). In
2006, real GDP growth is expected to remain nearly unchanged
from this year’s pace.
• Growth in Latin America is projected to decline to 4.3 percent

this year after reaching nearly 6 percent in 2004. A tightening
of monetary policy in both Brazil and Mexico has dampened
demand growth. Growth momentum, however, has been
supported in countries dependent on commodity exports by Table 2
terms-of-trade gains. With the exception of Brazil, all countries Emerging Market Economies' Output Growth
in Latin America are likely to experience a moderation in (percent change from previous year)
2003 2004 2005f 2006f
growth in 2006.
Real GDP 5.3 6.7 5.9 5.5
• Output growth in emerging Asia is expected to remain robust Latin America 1.7 5.9 4.3 3.9
this year at 7.2 percent, marginally lower than 7.5 percent last Europe 5.5 6.8 4.9 4.8
year. Korea and Malaysia are projected to have the weakest Africa/Middle East 4.1 4.2 4.2 4.5
Asia/Pacific 7.4 7.5 7.2 6.8
growth in the region (at 3.5 percent and 4.3 percent,
respectively) while China is likely to register growth of f = IIF forecast
9.3 percent, down slightly from a rapid pace of 9.5 percent last
year. Regional growth next year is projected to fall below
7 percent for the first time since 2002 with China’s growth
slowing to 8.5 percent. Chart 4: 10-year U.S. Treasury Bond Yields
(percentage points)
• Output in the Africa/Middle East region in 2005 is likely to 5
grow at 4.2 percent, the same as last year, and step up to
4.5 percent next year.
4.5
Interest Rates
Somewhat surprisingly, yields on 10-year U.S. Treasury

bonds have not begun a clear upward trend, although there 4
have been a few episodes of visible but temporary spikes (Chart
4). This pattern seems to indicate the lack of conviction on the part
of market participants about the robustness of U.S. growth. Foreign
official demand as well as the demand of insurance companies and 3.5
pension funds to increase their holdings in long-term bonds to Jan-04 Jul-04 Jan-05 Jul-05
reduce duration mismatches is also considered as a factor
contributing to the absence of sustained upward pressure on bond
yields. However, a sudden rise in inflation expectations or a
weakening in foreign demand for U.S. securities, resulting from a
change in policy by China or other Asian countries, could prompt
significant financial market deleveraging and downward adjustment
in asset prices, especially those of riskier assets. This in turn could Chart 5: U.S. Current Account Balance
lead to a deterioration in the financial condition of emerging market (percent of GDP)
countries, particularly those with lower credit ratings and in need of -7.0
external financing.
• Our base case scenario sees the federal funds rate rising -6.0
toward a 4.0-4.25 percent range in the course of the first half of
2006, assuming that the increase in the core personal consump-
tion expenditure deflator hovers around 2.0 percent. Given the -5.0
recent movement in unit labor costs and several components of
producer prices, this assumption is not without risks.
-4.0
• The yield on 10-year Treasury bonds is seen as rising to the
5.0 percent by the second half of 2006, and to a 5¼-5½ percent 2000 2001 2002 2003 2004 2005
range by mid-2007 in step with a progressive narrowing in the
margin of economic slack.
• Market interest rates in Japan are projected to remain broadly

unchanged while rates in the Eurozone are likely to show a
slight upward trend.
Current Account Balance
The continued disparity in growth prospects for the United

States relative to the Eurozone and Japan implies underlying
forces working toward a further widening of the U.S. current
account deficit (Chart 5). While the dollar has been firm for most “The continued disparity in growth prospects for the
of this year, the lack of prospects for coordinated policy action by United States relative to the Eurozone and Japan
major economies raises the possibility of a disorderly depreciation implies underlying forces working toward a further
of the dollar in due course. Such a depreciation could push U.S. widening of the U.S. current account deficit.”
interest rates—both the federal funds rate and market rates—well
beyond current expectations with adverse consequences for EMBIG
spreads. Such a depreciation would also weaken output growth in
the Eurozone and Japan while higher U.S. interest rates would
dampen U.S. domestic demand. Both of these developments would “Adjustment in U.S. fiscal policy is but one component
reduce growth of exports and output in emerging markets. Wider of what is needed to reduce the current global
EMBIG spreads and weaker growth would have a negative impact payments imbalance.”
on the debt dynamics of those emerging market economies with
high debt levels.
• Adjustment in U.S. fiscal policy is but one component of

what is needed to reduce the current global payments
imbalance. Improving growth prospects for the Eurozone
depends critically on structural reforms—particularly those
pertaining to labor markets—that promote more flexible and
responsive economies. In Japan, further structural reforms,
building on those that have helped improve balance sheets of
the corporate sector and banking system, are needed to boost
growth prospects.
• Emerging markets will need to do their part as well, for

example, through corporate and banking reform in Asia, better
financial regulation and supervision in central Europe, and a
more user-friendly investment and corporate governance
environment in Latin America. In the meantime, the aggregate
current account surplus of emerging markets included in this “Second-round effects of higher oil prices on inflation
capital flows exercise is projected to reach 2.4 percent of GDP have so far been held in check by several factors,
this year, up from 2.1 percent in 2004. Double-digit export including limited pricing power of companies,
growth is expected for the third consecutive year. Growth of adequate labor supply and benign inflation
remittances is likely to remain strong, constituting the single- expectations.”
largest source of foreign exchange, excluding merchandise
exports, in a number of countries. Remittances are expected to
remain resilient next year despite a projected decline in the
overall current account surplus to 2.1 percent of GDP.
Oil Prices
The impact of higher oil prices on global activity and
inflation so far has been relatively mild compared to earlier
episodes in the 1970s and 80s. Oil prices in real terms are still
below those reached during the past three decades (Chart 6).
Second-round effects of higher oil prices on inflation have so far
been held in check by several factors, including limited pricing Chart 6: Real Oil Prices
power of companies, adequate labor supply and benign inflation (2004 U.S. dollars)
expectations. $100
In looking at the possible future trend of oil prices, a number of
factors need to be considered. The increasing concentration of $80
global growth on several oil-intensive economies in Asia has
already noticeably accelerated the growth of global oil demand.
$60
Although the International Energy Agency (IEA) and others are
forecasting slower growth in demand for oil in the coming year, this
market has been known to surprise analysts. On the supply side, $40
despite increased production by non-OPEC countries, the global oil
supply has become progressively tighter, reflecting a long period in
$20
which there has been low investment in the sector. The lowest level
of OPEC’s spare capacity in 25 years has accentuated market
participants’ reaction to possible terrorist threats to oil supplies from $0
the Middle East and recurrent production disturbances in non-OPEC 70 75 80 85 90 95 00 05
countries. Temporary refinery constraints have also contributed to

oil market jitters.
“As has been pointed out by the IEA and others, a
sharp rise in oil prices could have a significant and
• Brent crude oil prices are expected to fall to about $60 a
disproportionate negative impact on the growth
barrel by end-2005 and average $60 a barrel in 2006. This
prospects for key importing emerging market
forecast assumes that the increase in world demand for oil will
countries.”
hover around 2 percent next year, following an increase of
1.6 percent in 2005 as expected by the IEA. Our price
assumption also depends on OPEC increasing its output by
roughly 0.4 million barrels per day in 2006 with an increase of
1.4 million barrels per day from non-OPEC producers.
• A further rise in oil prices could lead to a drag on growth.

The IEA estimates that every $10 a barrel rise in the price of
oil, sustained for one year, would subtract roughly 0.5 percent
from world GDP as its direct impact. As has been pointed out
by the IEA and others, a sharp rise in oil prices could have a
significant and disproportionate negative impact on the growth
prospects for key importing emerging market countries.
Outlook for Major Components

of Capital Flows “China will remain the largest recipient of foreign
direct investment among emerging market economies,
Since our last update on capital flows to emerging market accounting for one-third of net flows.”
economies at the end of March, we have revised our projection
for net private capital flows in 2005 to $345 billion from
$311 billion. The most notable change in the composition of this
external financing is that commercial bank net lending has been
revised upward by $17 billion with nearly all of it going to Asia.
Net nonbank credit flows—mostly bonds—have also been revised
upward by $11 billion as borrowers have taken advantage of low
spreads to prefinance obligations due in 2006. Portfolio equity
flows are also more robust than previously expected.
Key features of the main categories of net private capital flows

to emerging market economies this year and next are as follows:
• Net direct investment (projected at $149 billion this year and

$146 billion next year) is expected to account for 43 percent of
all private capital flows to emerging markets in 2005 and
slightly more in 2006. China will remain the largest recipient
of foreign direct investment among emerging market
economies, accounting for one-third of net flows.
• Commercial bank net lending is projected to reach a nine-

year high of $63 billion this year before slowing down to
$59 billion in 2006. Emerging Europe is likely to be the major
recipient of commercial bank funding as companies continue to “Commercial bank net lending is projected to reach a
rely on debt financing. In 2006, positive net lending to Latin nine-year high of $63 billion this year before slowing
America is projected to take place for the first time since 2000. down to $59 billion in 2006.”
• Despite an increase in amortization payments this year, net
nonbank credit flows are likely to reach an all-time high of
more than $90 billion. Net flows are expected to recede next
year to $76 billion in large part because of reduced borrowing

by countries in emerging Europe, one of which, Poland, used Table 3
the bond market extensively this year to finance large Financial Flows to Emerging Market Economies by Region, Net
prepayments of debt to Paris Club members. (billions of U.S. dollars)
2003 2004 2005f 2006f
Net repayments to official creditors are projected to reach a Private flows 213.7 317.4 345.2 317.8
record high this year of more than $50 billion, with Poland and Latin America 26.8 31.0 46.2 49.9
Russia together accounting for $31 billion of the total. Net Europe 65.1 108.9 131.5 110.8
repayments are projected to be cut in half in 2006. Africa/Middle East 3.6 11.0 21.6 12.3
Asia/Pacific 118.2 166.4 145.9 144.8
From a geographical perspective, net private capital flows to Official flows -21.4 -30.6 -50.4 -24.2
Asia are expected to account for 42 percent of total flows to Latin America -0.6 -10.3 -14.0 -9.0
emerging markets this year, down from 52 percent in 2004 Europe -3.4 -9.1 -34.6 -15.0
(Table 3). An increase to 46 percent is projected for next year as Africa/Middle East -2.6 -2.5 -1.7 -2.4
Asia/Pacific -14.9 -8.7 -0.1 2.2
flows to China pick up after a moderate dip this year. In terms of
other regions: f = IIF forecast
• Private capital flows to emerging Europe are expected to reach

nearly $132 billion in 2005, representing 38 percent of total net
capital flows to emerging markets. This share is likely to
decline to 35 percent in 2006, but remain substantially above
the 10-year average of 24 percent.
• Latin America’s share of total net private flows is expected to “After falling to a seven-year low of $96 billion in
remain in the range of 13-16 percent through 2006, with 2003, direct investment is expected to rise for the
Mexico continuing to garner the largest share of net inflows to second consecutive year, reaching $149 billion in
the region while Brazil closes the gap as it attracts increasing 2005—the highest level since 1999.”
investor interest.
• Private flows to the Africa/Middle East region are likely to

remain small at 4-6 percent of total flows, with much of it
accounted for by South Africa.
Regional notes on pages 8 and 9 provide greater details, including

key features of the composition of net private capital flows as well
as total amounts.
Direct Investment
The generally favorable 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 7: Net Direct Investment by Region
performance, has attracted increasing amounts of direct equity (billions of U.S. dollars)
investment. Thus, after falling to a seven-year low of $96 billion in 160
2003, direct investment is expected to rise for the second
consecutive year, reaching $149 billion in 2005—the highest level
120
since 1999 (Chart 7). Direct investment is projected to remain
nearly unchanged in 2006 at $146 billion. Traditional mergers and
acquisitions and green investment will constitute the bulk of 80
investment inflows. Larger amounts of cross-border transactions
between the related entities within the ownership structures of 40
multinational corporations also appear to be taking place. In
looking for investment opportunities there is an increasing tendency 0
for companies to search in the more populous emerging market EME LA A/ME Asia Europe
countries in the belief that these countries will provide an expanding 2003 2004 2005f 2006f
customer base in addition to a cost advantage needed as an export
Emerging Europe Asia/Pacific
A continued strengthening of foreign direct investment and Net private capital inflows are set to moderate to $146 billion
nonbank creditor flows should help raise net private capital this year from $166 billion in 2004 as flows in all categories
flows to a record high $132 billion this year before slowing of investment are likely to recede. Capital flows are expected
to an expected $111 billion in 2006. to remain at this year’s level in 2006.
• With the exception of Bulgaria, all countries in the region • Regional growth is likely to stay above 7 percent for the
are likely to experience a slowdown in economic growth third consecutive year with China once again expected to
this year, primarily because of a weakening in the net for- experience the fastest growth among our survey countries
eign balance of most countries. In 2006, real GDP in at 9.3 percent. A tapering off of activity in China next
emerging Europe is expected to grow 4.8 percent, nearly year will limit regional growth to a projected 6.8 percent.
identical to this year’s projected outcome.
• Capital flows to the region continue to be dominated by
• Privatization activity in the Czech Republic and Turkey is direct investment, which is expected to account for more
largely behind the expected pickup in direct investment than 40 percent of flows this year. China remains the
this year. Proximity to major markets in Western Europe major recipient of direct investment in emerging Asia as
and still relatively low labor costs are attracting direct in- these flows, along with the mobilization of the labor
vestment in the region. Direct investment is forecast to force, have transformed the country into a regional export
hold steady next year at $34 billion. base.
• Reserve accumulation is slated to accelerate in 2005 as a • Despite a slowdown in capital flows to the region this
rise in net private capital flows is augmented by a reduc- year, reserve accumulation is expected to exceed $280
tion in net resident lending abroad. Reserve accumulation billion for the second consecutive year as the aggregate
is projected to reach a record high $73 billion this year, current account surplus reaches 3.7 percent of GDP, up
bringing the stock of reserves to nearly $335 billion, rep- from 3.2 percent in 2004. Reserve accumulation is
resenting 5.8 months of imports of goods, services and projected to hit a record high $312 billion in 2006,
transfers. A smaller, expected current account surplus bringing the region’s stock of reserves to $1.7 trillion.
next year, along with a reduction in net private capital in-
flows, will hold down reserve accumulation to less than (See separate box on page 10 for details of China’s external
$62 billion. financing.)
Table 4 Table 5
Europe: External Financing Asia/Pacific: External Financing
(billions of U.S. dollars) (billions of U.S. dollars)
2003 2004 2005f 2006f 2003 2004 2005f 2006f
Current account balance -1.3 6.3 7.9 2.6 Current account balance 99.2 117.3 151.0 164.5
External financing, net: External financing, net:

Private flows, net 65.1 108.9 131.5 110.8 Private flows, net 118.2 166.4 145.9 144.8
Equity investment, net 8.1 28.1 41.7 41.4 Equity investment, net 91.6 95.9 93.8 96.4
Direct investment, net 6.0 23.3 34.5 34.5 Direct investment, net 55.8 64.2 63.9 64.0
Portfolio investment, net 2.0 4.8 7.2 6.9 Portfolio investment, net 35.8 31.8 29.9 32.4
Private creditors, net 57.0 80.9 89.8 69.4 Private creditors, net 26.6 70.5 52.2 48.4
Commercial banks, net 27.3 37.9 39.2 31.1 Commercial banks, net 13.8 37.5 28.2 22.6
Nonbanks, net 29.7 43.0 50.6 38.3 Nonbanks, net 12.8 32.9 24.0 25.8
Official flows, net -3.4 -9.1 -34.6 -15.0 Official flows, net -14.9 -8.7 -0.1 2.2
IFIs -0.1 -2.9 -7.5 -2.7 IFIs -10.1 -4.7 -2.7 -0.8
Bilateral creditors -3.3 -6.2 -27.1 -12.3 Bilateral creditors -4.8 -4.0 2.5 2.9
Resident lending/other, net1 -24.3 -47.8 -32.0 -36.8 Resident lending/other, net1 -12.1 25.9 -14.8 1.1
Reserves (- = increase) -36.1 -58.4 -72.8 -61.6 Reserves (- = increase) -190.4 -300.9 -282.0 -312.5
f = IIF forecast f = IIF forecast

1 1
Including net lending, monetary gold, and errors and omissions. Including net lending, monetary gold, and errors and omissions.
Latin America Africa/Middle East
Increases in equity investment for the third consecutive year Net private capital flows to the region are expected to
and a reduction in net outflows to commercial banks will approach nearly $22 billion this year, nearly double the
contribute to a significant expansion of net private flows this amount received in 2004. A surge in direct investment is
year to an expected $46 billion from $31 billion in 2004. A responsible for a significant portion of the overall increase in
further moderate increase in flows is projected for 2006. flows.
• All countries in the region are likely to experience some • Growth in the region will hold up at relatively high levels
degree of a slowdown in economic activity this year with this year with a further acceleration in regional growth
Uruguay and Venezuela expected to see the biggest expected next year. Egypt should see the sharpest
declines in growth rates, following significant rebounds in increase in growth, reflecting improved policy
activity in 2004. Regional growth is projected to dip to implementation and a rebound in tourism.
4.3 percent in 2005 from 5.9 percent last year and slow
further to 3.9 percent in 2006. • The acquisition of one of South Africa’s major banks, as
well as foreign interest in the natural resource sector, has
• Net nonbank creditor inflows are expected to increase for been pivotal to the significant pickup in equity investment
the second consecutive year to $11 billion from $9.5 in the region this year. Bond flows as well as commercial
billion in 2004. Reduced financing needs and improved bank lending are also expected to rise this year before
public balance sheets should limit nonbank creditor dropping in 2006.
flows—mostly bonds—to less than $9 billion next year
with an increasing likelihood of more local currency- • The region’s current account is forecast to remain healthy
denominated global bond issuance. in 2005 with a surplus of 2.5 percent of GDP. An
expected shift in the terms of trade is projected to result in
• A significant increase in net resident lending, particularly a smaller current account surplus in 2006. Reserve
from Mexico and Venezuela, is projected to limit reserve accumulation is likely to reach $29 billion this year, up
accumulation in the region to about $17 billion this year, from $18 billion in 2004. Reduced capital flows and a
down from more than $22 billion in 2004. A further smaller current account surplus will limit reserve
decrease in reserve accumulation is expected next year as accumulation next year to less than $16 billion.
the current account surplus shrinks to only 0.3 percent of
GDP, down from 1.1 percent in 2005.
Table 6 Table 7
Latin America: External Financing Africa/Middle East: External Financing
(billions of U.S. dollars) (billions of U.S. dollars)
2003 2004 2005f 2006f 2003 2004 2005f 2006f
Current account balance 10.9 20.2 23.2 6.9 Current account balance 9.1 8.0 12.3 6.7
External financing, net: External financing, net:

Private flows, net 26.8 31.0 46.2 49.9 Private flows, net 3.6 11.0 21.6 12.3
Equity investment, net 24.8 36.4 39.8 37.8 Equity investment, net 4.4 7.1 16.0 8.9
Direct investment, net 30.1 43.3 41.1 41.8 Direct investment, net 3.9 1.5 9.5 5.6
Portfolio investment, net -5.3 -6.9 -1.3 -3.9 Portfolio investment, net 0.5 5.6 6.5 3.3
Private creditors, net 1.9 -5.4 6.4 12.1 Private creditors, net -0.8 3.9 5.6 3.5
Commercial banks, net -13.2 -14.9 -4.8 3.4 Commercial banks, net -2.5 0.5 0.9 0.7
Nonbanks, net 15.1 9.5 11.2 8.6 Nonbanks, net 1.8 3.3 4.7 2.8
Official flows, net -0.6 -10.3 -14.0 -9.0 Official flows, net -2.6 -2.5 -1.7 -2.4
IFIs 4.8 -7.6 -12.9 -8.1 IFIs -1.3 -1.2 -0.8 -0.8
Bilateral creditors -5.4 -2.7 -1.0 -0.9 Bilateral creditors -1.3 -1.3 -0.9 -1.5
1
Resident lending/other, net1 -3.7 -18.6 -38.0 -35.5 Resident lending/other, net 2.5 1.8 -2.9 -1.0
Reserves (- = increase) -33.4 -22.4 -17.4 -12.2 Reserves (- = increase) -12.7 -18.3 -29.2 -15.6
f = IIF forecast f = IIF forecast

1 1
Including net lending, monetary gold, and errors and omissions. Including net lending, monetary gold, and errors and omissions.
China: Economic Outlook and Prospects for Capital Flows

• Real GDP growth is likely to remain robust this year at Table 8
9.3 percent following 9.5 percent in 2004. We expect a China's External Financing
moderation to 8.5 percent next year. (billions of U.S. dollars)
2003 2004 2005f 2006f
• Continued strong export growth will push this year’s current
Current account balance 45.9 68.7 130.0 160.0
account surplus to 6.7 percent of GDP and to more than
7 percent in 2006. External financing, net:
Private flows, net 71.0 101.1 87.2 93.2
• Net private capital flows are expected to decline to Equity investment, net 54.7 64.1 67.0 68.0
$87 billion this year from $101 billion in 2004 as commer- Direct investment, net 46.9 53.1 52.0 53.0
cial bank borrowing and nonbank inflows retreat in the face Portfolio investment, net 7.7 10.9 15.0 15.0
of pressure by the authorities to limit overseas borrowing. Private creditors, net 16.4 37.0 20.2 25.2
Commercial banks, net 9.6 16.0 6.1 9.3
• Net direct investment in 2005 and 2006 is forecast to remain Nonbanks, net 6.8 21.0 14.1 15.9
near last year’s level of $53 billion, accounting for one-third
Official flows, net -0.9 0.5 1.1 0.8
of all direct investment to emerging markets.
IFIs -1.6 1.0 0.9 0.8
Bilateral creditors 0.7 -0.4 0.1 0.0
• As a result of the continued widening of China’s current ac-
count surplus, reserve accumulation is likely to reach an all- Resident lending/other, net
1
1.0 36.1 12.0 24.0
time high of nearly $230 billion this year, bringing reserves
to nearly $840 billion by yearend. Reserves (- = increase) -117.0 -206.4 -230.3 -278.0
f = IIF forecast
1
Including net lending, monetary gold, and errors and omissions.
base. Direct investment is also being attracted to areas

undergoing regulatory and administrative reforms. WTO
accession and the termination of the Multi-Fiber Arrangement
have provided impetus for new investment.
One aspect of direct investment that seems to be

gaining more prominence but is not readily quantifiable
because of the lack of reliable data is outward investment
by emerging market investors. Companies in relatively more
advanced economies like Korea, South Africa, Brazil and Chile
“Increasingly, emerging market based companies are
have taken the lead in searching for opportunities outside of
seeking to integrate corporate entities in advanced
their home base. Some estimates suggest that “south-south”
industrial countries into their developing global network.”
investment between emerging market economies could account
for as much as one-third of global foreign direct investment
flows. Increasingly, emerging market based companies are
seeking to integrate corporate entities in advanced industrial
countries into their developing global network. Some of this
activity is being driven by a desire to acquire high technology
and management expertise. The rapid rise in commodity prices
is also spurring efforts to secure natural resource based
companies.
On a regional basis, emerging Europe and the Africa/

Middle East region are expected to see a marked increase in
direct investment.
Emerging Europe is likely to see direct equity investment

increase to $34 billion this year from $23 billion in 2004.
Direct investment is projected to hold steady at this year’s level in

2006. Several EU accession countries are seeing a further pickup in
direct investment flows this year as foreign companies seek to “Several EU accession countries are seeing a further
expand into higher value-added activities. pickup in direct investment flows this year as foreign
companies seek to expand into higher value-added
activities.”
• Direct investment in the Czech Republic is poised to jump to
$7 billion this year from $3.6 billion in 2004 as the sale of
Césky Telecom and other firms boost privatization receipts.
• In Turkey, as of mid-August, privatization implementations,

including the transfer of operating rights of Istanbul airport,
totaled $12.7 billion, equal to about 3.5 percent of estimated
GDP. The impending sales of the country’s iron and steel plant
Erdemir and oil refiner Tupras could push privatization to
$16 billion this year, or 4.6 percent of GDP. Net direct
investment inflows could reach $9.6 billion in 2005, up from
only $1.5 billion last year. In 2006, the privatization of 20
regional electricity distribution networks worth between $3.5-
5.0 billion could result in overall net direct equity investment of
$9.5 billion.
• In Russia, direct investment is reported to have risen 31 percent

in the first half of 2005 from a year earlier with the bulk of
investment going to manufacturing and trade, and not in natural “Trade frictions have encouraged some manufacturers
resources as might be expected. With no major privatization to diversify production away from China, and the
deals on the horizon, direct investment is expected to be held to recent revaluation, albeit small, has signaled a more
$3.2 billion in 2006, up only marginally from $3 billion this significant appreciation over time.”
year.
Direct investment in the Asia/Pacific region continues to be

dominated by investment in China.
• At an annualized rate of $55 billion, actual inflows to China in

the first eight months of 2005 were 3 percent below the level of
a year earlier, according to Chinese official statistics. Trade
frictions have encouraged some manufacturers to diversify
production away from China, and the recent revaluation, albeit
small, has signaled a more significant appreciation over time.
While inflows of direct investment probably have peaked after
a five-year run-up, the large pipeline of new commitments
suggests that net inflows should be sustained at about
$53 billion in 2006.
• India remains one of the top recipients of direct investment in

the region although investment has not met government
expectations because of bureaucratic hurdles and the slow
lifting of ownership restrictions in services activities. The
government’s plans to hike foreign investment ceilings in
insurance and banking have been delayed for over a year by
strong political opposition, which may also hamper the opening “India remains one of the top recipients of direct
of the retail sector to foreign companies like WalMart. investment in the region although investment has not
Moreover, services liberalization and market openings are part met government expectations because of bureaucratic
of the ongoing Doha Round of the WTO, which is making slow hurdles and the slow lifting of ownership restrictions
progress. in services activities.”
Net direct investment in Latin America is likely to slip to

$41 billion this year after achieving a three-year high of $43 billion
in 2004. “While gross inflows are rising significantly, this is
offset to an important extent by foreign direct
investment of Brazilian companies in a number of
• Mexico is the only country in the region that is expected to see a
countries abroad.”
noticeable increase in net direct investment this year,
accounting for more than one-third of such flows to the region.
• In the case of Brazil, direct investment in the first seven months

of 2005 was almost double the amount in the same period last
year. While gross inflows are rising significantly, this is offset
to an important extent by foreign direct investment of Brazilian
companies in a number of countries abroad. For the full year,
net direct equity investment in Brazil is projected to decline to
$10 billion from nearly $12 billion in 2004. A slight increase in
flows is expected in 2006.
• Direct investment in Argentina is likely to amount to

$4.2 billion in 2005, up from $3.7 billion last year, but far
below the annual average of flows of nearly $9 billion between
1995 and 2000.
In the Africa/Middle East region, net direct equity investment

is expected to jump to $9.5 billion this year from a six-year low of “Emerging market portfolio equity investment is
$1.5 billion in 2004. Roughly one-half of this year’s net inflow will projected to strengthen this year with net inflows
be accounted for by the 60 percent purchase of South African bank amounting to $42 billion, up from about $35 billion in
ABSA by Barclays. This marks the largest ever single direct 2004, and representing the highest level since 1993.”
investment transaction in the country. In 2006, net direct
investment in the region is projected to decline to $5.6 billion.
Portfolio Investment
Emerging market portfolio equity investment is projected to

strengthen this year with net inflows amounting to $42 billion,
up from about $35 billion in 2004, and representing the highest
level since 1993 (Chart 8). Emerging Asia is expected to account
for roughly three-fourths of total net inflows to emerging markets.
Net portfolio investment is likely to decline next year partly as a
result of a narrowing in the emerging market’s discount to
developed markets. A number of factors could negatively affect the Chart 8: Net Portfolio Investment by Region
asset class, including continued high oil prices, which would (billions of U.S. dollars)
inevitably cause overall earnings to slow in emerging markets,
particularly in Asia. High valuations in the United States and 50
elsewhere could lead in time to significant corrections in light of
40
slower earnings stemming from higher input costs to which
emerging market equities, albeit being considered by many to be 30
near fair valuations, would not be immune.
20
The Asia/Pacific region’s portfolio equity flows are expected to 10

fall back to $29.9 billion this year from $31.8 billion in 2004. A
pickup in flows to $32.4 billion is projected for next year. 0
-10
• China is likely to account for one-half of total flows to the EME LA A/ME Asia Europe
region this year. Overseas share listings by Chinese companies
2003 2004 2005f 2006f
generated $6.2 billion in equity inflows in the first six months
of 2005, up moderately from $5.6 billion a year earlier.

Planned overseas listings by a spate of state-owned companies
and banks, including the upcoming IPOs of Bank of China and “Planned overseas listings by a spate of state-owned
the Construction Bank, should lift net inflows of portfolio companies and banks, including the upcoming IPOs of
equity to $15 billion annually in the next two years from Bank of China and the Construction Bank, should lift
$11 billion in 2004. net inflows of portfolio equity to $15 billion annually
in the next two years from $11 billion in 2004.”
• In India, despite a slowdown in privatization, the growing
profitability of private sector firms as well as a large volume of
funding for expansion is likely to help maintain net inflows of
portfolio equity at $9-10 billion a year. Increasingly,
institutional investors, including venture capital and private
equity funds, are stepping up their exposure to India.
In emerging Europe, net portfolio equity investment is

expected to increase to more than $7 billion in 2005 from
$4.8 billion last year. A slight decline in flows is projected for next
year.
• In Turkey, net portfolio equity investment amounted to $1.6

billion during January-May, four times as much as a year
earlier. This partly reflected the floatation of minority shares of
two large state-owned companies. It was also in response to the
rebound in corporate earnings and increased interest among “Increasingly, institutional investors, including
foreign portfolio investors following the EU’s decision to begin venture capital and private equity funds, are stepping
accession negotiations. For the full year, net inflows should up their exposure to India.”
reach $3 billion before rising in 2006 to $3.2 billion.
• Poland is expected to see net portfolio equity inflows of

$2 billion this year. Investors are being attracted by higher
corporate earnings, rising equity prices and a large number of
initial public offerings, thanks to the use of the stock exchange
to privatize state-owned share holdings.
• Despite record high prices on the Russian stock exchange and a

record amount of IPOs ($3.3 billion) floated on the London
market in the first seven months of this year, net portfolio
equity inflows for the entire year are projected to amount to
only $1 billion as money taken offshore in the wake of the
Yukos affair has yet to fully return. A pickup in net inflows is
expected next year.
Net portfolio equity investment in Latin America is likely to

show an outflow of $1.3 billion in 2005, following an outflow of
nearly $7 billion last year.
• Brazil is expected to be the largest recipient of net portfolio

equity inflows in the region this year. Net inflows gained
momentum in July exceeding $1 billion, representing the
largest gain in five months. Although recent political events “Poland is expected to see net portfolio equity inflows
could have a dampening effect on inflows, we nonetheless of $2 billion this year. Investors are being attracted
project that net portfolio equity investment will reach by higher corporate earnings, rising equity prices and
$2.5 billion this year before declining to $1.0 billion in 2006. a large number of initial public offerings, thanks to the
use of the stock exchange to privatize state-owned
• Mexico is likely to have a positive reversal in flows this year share holdings.”
despite the fact that domestic pension funds are now allowed to
invest in foreign stocks. For the year, net inflows are projected
to reach $1 billion, following net outflows of $2.5 billion in
2004. “Total equity issuance this year seems likely to exceed
the nearly $33 billion recorded in 2004, which was the
• For the fifth consecutive year, Chile will account for the bulk of highest in a decade.”
net outflows in the region as pension fund managers look to
continue to diversify their portfolios. This year’s projected
outflow of $4.3 billion is expected to be repeated in 2006.
In the Africa/Middle East region, portfolio equity investment

is likely to increase to $6.5 billion in 2005 from $5.6 billion last
year.
• South Africa is expected to be the recipient of more than

90 percent of these flows. A large portion of the $6 billion in
portfolio equity investment that is projected to flow into South
Africa this year will go to firms connected with natural resource
Chart 9: Emerging Market Equities
exploration, spurred by the run-up in global commodity prices (January 2002 = 100, MSCI, US$ terms)
and demand for diamonds, gold, platinum and palladium.
300
• Net portfolio equity investment in Egypt is expected to shift
from an outflow of $0.1 billion last year to an inflow of 250
$0.5 billion in 2005.
200
Equity prices and issuance: Following a correction in March
and April, emerging market equity prices as measured by the MSCI 150
Emerging Markets Free Index resumed an upward climb in the latter
part of the second quarter, albeit at a much slower pace than the 100
8 percent recorded for the first two months of the year. In the
second quarter, the stock index rose 3 percent. For the year to
50
September 15, the MSCI increased 17.6 percent, bringing the index 2003 2004 2005
level to an all-time high. On a geographical basis, the emerging
Asia
Europe region equity index has risen 35 percent so far this year, Emerging Europe
followed by Latin America with a 30 percent gain (Chart 9). The Latin America
Asia region has been the worst performing with its index rising at
less than half the rate of Latin America. Markets in several
countries, including Indonesia, have experienced declines. After
languishing during the first five months of the year, Chinese equity
prices have risen sharply as investors have gained confidence that
the government will be able to properly manage the “gradual”
conversion of non-tradable state-owned shares into tradable shares.
Total equity issuance this year seems likely to exceed the nearly Chart 10: Emerging Market Equity Issues
$33 billion recorded in 2004, which was the highest in a decade (billions of U.S. dollars)
(Chart 10). A significant portion of this issuance has occurred in
Asia with 48 offerings coming from China totaling more than 8
$10 billion. In Latin America, only six offerings have taken place,
with five of them in Brazil amounting to $0.9 billion. Issuance in
6
emerging Europe has been dominated by Russia, with five offerings
totaling $2.8 billion in the first eight months of the year compared
with $0.3 billion a year earlier. In the Africa/Middle East region, 4
the amount of issuance is running at only about two-thirds of last
year’s level. For emerging markets as a whole, IPOs have become a
2
bigger share of total issuance this year as privatization moves
forward in several countries and more state-owned companies in
China list their shares overseas. 0
2001 2002 2003 2004 2005
Nonbank Private Sector Lending

Chart 11: Net Nonbank Lending by Region
Investors’ continued willingness to purchase emerging (billions of U.S. dollars)
market bonds is projected to push net nonbank private sector 100
lending this year to $90 billion, surpassing the record high in
1997 (Chart 11). Emerging market debt spreads have proven 80
resilient so far this year to bouts of financial market volatility.
Indeed, spreads decoupled from their traditional relationship to U.S. 60
corporate high-yield spreads during the auto-sector related sell-off,
remaining relatively steady as U.S. high yield spreads widened thus 40
leading to a reduced differential between the two. Better economic
policies and improved performance by an increasing number of 20
emerging market economies have been accompanied by a
continuing trend toward higher credit ratings of emerging market 0
issuers (Chart 12). This has been supportive of a reduction in EME LA A/ME Asia Europe
spreads. The emerging debt market has also benefited from more
2003 2004 2005f 2006f
investor-friendly instruments that include collective action clauses
as well as from growing recognition by investors that this asset class
has delivered on a risk-adjusted basis higher returns than all other
traditional asset classes in the last ten-year period. For now, the
supply of bonds coming on stream is likely to be readily absorbed as
emerging market bonds remain a diversification play for
institutional and crossover investors (the latter estimated to now
hold more than three-fourths of assets under management in
emerging market bonds) given the relatively low correlations with Chart 12: EMBI+ Credit Ratings
other asset classes. BB+/Ba1
In 2006, net nonbank private sector lending is expected to

amount to about $76 billion. The projected reduction from this
year’s likely near record level reflects the fact that many debtors BB/Ba2
have already taken the opportunity to pre-finance obligations due
next year. The anticipated decline in net lending could be even
more pronounced if downside risk from higher oil prices, a belated BB-/Ba3
rise in U.S. bond yields to levels more consistent with past cyclical
experiences, or a sudden shift in investor risk aversion were to
materialize. A number of recent empirical studies have pointed to
the prominent role that developments in mature economies play in B+/B1
accounting for changes in emerging market bond spreads. One in- 1993 1996 1999 2002 2005
depth study showed that about two-fifths of the change in spreads in
the past two years could be explained by better domestic
fundamentals with the remainder of the change explained almost
equally by stronger global growth, greater global liquidity, and
lower risk aversion. These findings suggest that a reversion to the
mean for factors mentioned above could easily cause emerging
market bond spreads to rise by 100 to 150 basis points.
The extremely favorable environment for emerging market

bonds has allowed sovereign authorities and, to a lesser extent,
corporate treasurers to actively manage debt to improve their credit
profiles. Debt managers have taken the opportunity to broaden the
investor base by issuing in different currencies and increasing the “The extremely favorable environment for emerging
share of financing from domestic sources. Efforts have been made market bonds has allowed sovereign authorities and,
to issue global bonds denominated in local currencies in to a lesser extent, corporate treasurers to actively
international capital markets to overcome what has been termed the manage debt to improve their credit profiles.”
“original sin” of emerging markets—the inability to issue
international bonds in local currency. Several countries, including
Poland, were able to tap the private capital market at attractive

spreads in order to prepay obligations to members of the Paris Club.
Also, debt restructuring operations have improved the debt profile “Debt restructuring operations have improved the
of several issuers, including the Dominican Republic where efforts debt profile of several issuers, including the
were made to utilize the Principles for Stable Capital Flows and Fair Dominican Republic where efforts were made to utilize
Debt Restructuring in Emerging Markets in discussions with the Principles for Stable Capital Flows and Fair Debt
creditors. Restructuring in Emerging Markets in discussions with
creditors.”
Emerging Europe is projected to account for more than one-
half of nonbank private creditor flows to emerging markets this
year. The total amount projected for this year of more than
$50 billion is nearly eight times higher than the low point of 2002.
• As in 2004, Russia will account for the largest amount of

borrowing in the region followed by Poland and Turkey.
Russian corporate Eurobond issues amounted to $7 billion in
the first eight months of this year with issuance largely spread
among financial, telecommunication and natural resource
companies. The largest single issue to date has been from
Gazprom, which was worth $1.25 billion.
• Net nonbank lending to Poland this year is expected to exceed

$14 billion, up from $8.3 billion in 2004. Government foreign
bond issuance has reached $10 billion in conjunction with “Emerging Europe is projected to account for more
efforts to prepay Paris Club debt. Issuance has been done in than one-half of nonbank private creditor flows to
several currencies and at maturities of 15, 30, and 50 years. emerging markets this year. The total amount
Non-residents have also been attracted to the domestic market projected for this year of more than $50 billion is
making net purchases of $3 billion of zloty-denominated nearly eight times higher than the low point of 2002.”
government bonds in the first five months of 2005.
• Net nonbank lending to Turkey is on pace to slightly exceed last

year’s $10.5 billion. Government issuance in the international
capital market in the first eight months of this year reached
$5.3 billion and is set to top $7 billion by yearend. Non-
residents remain significant purchasers of domestic government
securities with net purchases this year projected at more than
$6 billion. Non-residents as of mid-year held 20 percent of lira-
denominated debt, almost twice that of a year earlier.
Net nonbank private creditor flows to Latin America are likely

to rise to $11 billion in 2005 from $9.5 billion last year. A
slowdown in economic growth in the region as well as political
tensions in some countries do not appear to be having an impact on
lending as of now.
• After experiencing a net outflow of $3 billion last year, Brazil

is expected to receive a similar-sized inflow of nonbank private
credit this year. The Brazilian government has been an active
participant in the bond market, exchanging $4.4 billion of
C-bonds for new A-bonds in July. This followed issuance of
$3.7 billion earlier in the year. The participation rate for the “After experiencing a net outflow of $3 billion last
C-bond exchange was high at nearly 80 percent. By carrying year, Brazil is expected to receive a similar-sized
out the exchange, the government has been able to smooth the inflow of nonbank private credit this year.”
amortization profile of public sector external debt. Following
the exchange, it was announced that the government would roll
over only 80 percent of its external debt due in 2006-2007.

This implies that Brazil will come to the market for $9 billion
of the $11.8 billion in debt maturing in the next two years. “The combination of low risk aversion by investors
and a still relatively benign interest rate environment
has led to large inflows into the emerging markets
• Mexico is likely to see net inflows of $3.8 billion this year,
asset class, providing a favorable environment for
down from $4.6 billion in 2004. Pemex has been active in the
bond issuance.”
international market issuing $2.8 billion in bonds. In mid-July,
the Mexican government announced that it had completed the
raising of the foreign exchange needed to meet all external debt
amortizations due in 2006-2007. This includes $1.9 billion
from previous pre-funding operations.
• In July, Uruguay began pre-financing its 2006 external needs

by placing €300 million in bonds due in 2016. This was the
first bond issue in euros by the government.
After reaching an eight-year high of more than $33 billion in Chart 13: Foreign Currency-Denominated Bond Issuance
2004, net nonbank creditor inflows to the Asia/Pacific region are in Emerging Markets
expected to decline to less than $24 billion this year with China, (billions of U.S. dollars)
Korea, and Malaysia all likely to experience a decrease in net 10
inflows.
9
• China is projected to receive about 60 percent of the net inflows 8

7
to the region. New international bond issuance by Chinese
entities raised only $1.2 billion in the first seven months of 6
2005, which was far below the $5.2 billion received in the same 5
period last year. Borrowing by Chinese companies from 4
foreign suppliers also appears to have slowed. 3
2
• Korea is expected to see a sharp drop in borrowing from 1
nonbank private creditors while Indonesia is projected to 0
experience net outflows for the eighth consecutive year. 2001 2002 2003 2004 2005
Bond issuance and spreads: Overall issuance in the first eight

months of this year far outpaced that for the same period in 2004
with corporate and sovereign issuance amounting to $85 billion
(Chart 13). The combination of low risk aversion by investors and a
still relatively benign interest rate environment has led to large
inflows into the emerging markets asset class, providing a favorable
environment for bond issuance. Indeed, a record-high amount Chart 14: Sovereign versus Corporate Bond Issuance
seems likely to take place this year as many issuers have accelerated (percent of total)
their 2006 and in some cases 2007 borrowing programs in
anticipation of higher global bond yields. Corporate entities have 70
accounted for slightly more than half of total issuance so far this
year with these issuers on balance having higher credit ratings than
sovereigns (Chart 14). Nevertheless, the credit quality of sovereigns 50
has been edging up again this year to the equivalent of a BB rating
on average. The strong demand for emerging market bonds among
a variety of institutional investors has enabled issuers to sharply 30
increase the share of bonds issued in non-dollar currencies,
particularly euros. Momentum is also building for sovereign global
bond issues denominated in local currencies. Supranational
10
borrowers have also begun to tap local emerging markets. For
2001 2002 2003 2004 2005
example, German development bank KfW sold 500 million pesos of
2009 bonds in Mexico in August. Sovereign Corporate
The rapid pace of emerging market bond issuance this year has
coincided with an overall compression in bond spreads. Following Chart 15: EMBIG Spreads
our last capital flows update at the end of March, the spread on the (basis points)
EMBIG index peaked for the year on April 15 at 395 basis points 1200
(Chart 15). Subsequently, spreads held in a trading range of 365-
385 through the beginning of June as market participants sorted out
950
the impact of the downgrading of GM and Ford on the U.S. high-
yield market. Since early June, EMBIG spreads have fallen about
120 basis points, of which approximately 50 basis points were 700
accounted for by the replacement of defaulted securities of
Argentina with new bonds issued following the completion of the 450
debt exchange at end-May. Even adjusting for the Argentina effect,
the spread on the EMBIG index reached an all-time low in mid-
September. Concerns about potential higher inflation and U.S. in- 200
2002 2003 2004 2005
terest rates do not seem to be having an effect on spreads and indeed
for the past few months emerging market bond spreads have largely
decoupled from the movement in long-term U.S. interest rates.
On a regional basis, emerging Europe has outperformed the

other sub-indices. After widening 55 basis points from early March
to mid-April, the spread on the emerging Europe sub-index of the
EMBIG declined 85 basis points to reach a low of 151 basis points
in mid-September (Chart 16). Chart 16: EMBIG Regional Spreads
(basis points)
• Russian bonds have had the best performance in the region with 1600
a total return for the country sub-index of more than 13 percent
so far this year. Investors seem to have put aside for the time
being concerns about property rights and the slowdown in 1200
structural reforms in favor of the rapid accumulation of

international reserves and pro-active debt management 800
operations.
• Despite solid policy performance in Turkey, which has resulted 400

in an impressive decline in inflation and domestic interest rates,
sovereign external bonds have underperformed the emerging
0
Europe sub-index in part because of concerns about the 2001 2002 2003 2004 2005
widening current account deficit. In terms of issuance activity, Asia Europe Latin
Turkey and Russia so far this year have accounted for about
40 percent of the $33 billion of issuance in the region.
Although Latin America’s EMBIG spread has shown the

largest absolute decline among the regions since reaching a peak of
486 basis points in mid-April, once this is adjusted for the change in
Argentine bonds in the sub-index, Latin America’s total return falls
below the overall index (7.5 percent versus 7.8 percent).
• The Dominican Republic’s restructuring has paid off well for

investors with a total return on the country index so far this year
of nearly 27 percent—the best among all countries included in
the EMBIG. “The Dominican Republic’s restructuring has paid off
well for investors with a total return on the country
• Uruguay has had the second best performance in the region index so far this year of 27 percent—the best among
with a total return of 11 percent. all countries included in the EMBIG.”
• Despite strong economic performance in Brazil, political

scandal has weighed on investors, which has resulted in the
“Although economic fundamentals on balance
country index underperforming the regional index.
continue to improve in emerging market countries, the
nagging question of whether or not the current level of
• The worst performer in the region has been Argentina, with a
spreads is sustainable continues to persist.”
total return of 0.4 percent. Argentina has the lowest total return
so far this year of all the countries in the EMBIG index.
In terms of issuance activity, political scandal and policy missteps

that have had a negative impact on bond spreads of some countries
in the region have not deterred issuance, which is on track to exceed
the $29 billion recorded in 2004. In the first eight months of 2005,
issuance in Latin America amounted to more than $25 billion, with
Mexico and Brazil accounting for two-thirds of the total.
Issuance activity so far in 2005 for the Asia/Pacific region is on

a pace to match last year’s placements, which totaled nearly
$38 billion, the largest amount since 1997.
• Korea remains the biggest issuer in the region, accounting for

40 percent of $24 billion of bonds issued in January-August
2005.
• Issuance in Indonesia and Thailand has already exceeded that “The improvement in fundamentals, widely
for the entire year of 2004. The EMBIG spread for Asia as of acknowledged by market participants and analysts, is
mid-September was 262 basis points, down 46 basis points not totally independent of the substantial capital that
from its peak in early July. has flowed into emerging markets since 2004 and the
global circumstances that have been behind the
Although economic fundamentals on balance continue to resurgence of these flows.”
improve in emerging market countries, the nagging question of
whether or not the current level of spreads is sustainable continues
to persist. At present, it does not appear that a possible episode of
bad market technicals would turn into bad credit fundamentals,
which sometimes jolted the asset class in the past. Nevertheless, the
improvement in fundamentals, widely acknowledged by market par-
ticipants and analysts, is not totally independent of the substantial
capital that has flowed into emerging markets since 2004 and the
global circumstances that have been behind the resurgence of these
flows. This does not diminish the policy accomplishments that con-
tributed to stronger fundamentals in emerging markets, but it does
suggest that borrowers could become complacent about policy in the
face of the favorable reception that their new bonds have received in
the international capital market. Moreover, with elections looming
in a number of emerging market economies, this could tempt
governments to pause from further measures to secure sound fiscal
and monetary policies and pursue structural reforms. Although
emerging markets have weathered the tightening of policy interest
rates so far, the latitude for policy mistakes will necessarily narrow
as the global economy adjusts to a period of tighter global liquidity. “Although emerging markets have weathered the
tightening of policy interest rates so far, the latitude
Commercial Bank Lending for policy mistakes will necessarily narrow as the
global economy adjusts to a period of tighter global
Net commercial bank lending in 2005 is expected to be liquidity.”
positive for the third consecutive year after having been largely
negative for the period 1998-2002. Net lending is projected to be
more than $63 billion this year, representing the highest level since
1996. Emerging Europe is likely to attract nearly two-thirds of the
Chart 17: Net Commercial Bank Lending by Region
total net lending to emerging markets this year. Net commercial (billions of U.S. dollars)
bank lending to emerging markets in 2006 is projected to hold near
80
this year’s level, with positive net flows to Latin America expected
to take place for the first time since 2000 (Chart 17). 60
The continued revival of cross-border lending by commercial 40

banks reflects in part efforts to build relationships with emerging
market countries in order to expand business opportunities in other 20
fee-generating areas. Loan pricing on balance has been competitive
with other sources of financing and indeed loan margins have been 0
almost continuously under downward pressure because of abundant
liquidity. Some of the activity in the global syndicated loan market -20
this year is related to the refinancing of previous projects. Banks EME LA A/ME Asia Europe
are sometimes recycling the same money with the same clients at 2003 2004 2005f 2006f
lower margins and a longer tenor.
Net commercial bank lending to emerging Europe is

forecasted to rise this year to more than $39 billion from $38 billion
last year.
• The largest portion of this will take place in Russia where net
inflows are projected to increase to $17.7 billion from
$13 billion in 2004. Despite the rapid run-up in stock prices,
many Russian companies continue their financing through
syndicated loans.
“Some of the activity in the global syndicated loan
• In Turkey, net borrowing from commercial banks in 2005 is market this year is related to the refinancing of
expected to decrease to $6.7 billion from $8.9 billion last year. previous projects. Banks are sometimes recycling the
This borrowing is likely to be distributed fairly evenly between same money with the same clients at lower margins
short-term trade credits and medium-term loans. A large and a longer tenor.”
amount of corporate borrowing is taking place from the foreign
branches of Turkish banks, which mostly represent round-
tripped domestic lending cycled through offshore branches to
avoid transaction taxes and regulatory barriers against domestic
foreign exchange lending to firms with insufficient export
proceeds.
Net commercial bank lending to the Asia/Pacific region is

expected to decline to $28 billion this year from nearly $38 billion
in 2004.
• China will likely account for most of the decline, reflecting

administrative measures taken by the authorities to impose
quotas on banks’ overseas borrowing.
• After reaching a record high of $8.3 billion in 2004, net

commercial bank lending in India is projected to remain strong
at $7.5 billion this year as robust investment demand, “A large amount of corporate borrowing is taking
expanding trade and low international interest rates relative to place from the foreign branches of Turkish banks,
domestic rates continue to attract borrowers. which mostly represent round-tripped domestic
lending cycled through offshore branches to avoid
• Commercial banks are likely to receive net repayments from the transaction taxes and regulatory barriers against
Philippines this year as they continue to scale back their domestic foreign exchange lending to firms with
insufficient export proceeds.”
medium- and long-term exposure, but continue extending net

new short-term credits over the near term.
Chart 18: Net Official Lending by Region
(billions of U.S. dollars)
Latin America is expected to be the only region in aggregate to
10
experience net outflows to commercial banks this year. However,
net outflows are projected to amount to $4.8 billion, down sharply 0
from nearly $15 billion in 2004. -10
-20
• Net outflows to commercial banks are likely to decrease from
Brazil in 2005 as gross disbursements rise sharply from last -30
year and net short-term credit inflows take place for the first -40
time in more than five years. Brazil is projected to see net
-50
commercial bank lending next year for the first time since 2001
as companies draw on liquidity facilities being set up ahead of -60
next year’s election. EME LA A/ME Asia Europe
2003 2004 2005f 2006f

• In Mexico, net outflows to commercial banks are expected to
decline to $0.2 billion in 2005 from more than $3 billion last
year as repayments drop significantly.
• Following six years of net outflows, Colombia is likely to see

-500
net lending from commercial banks for the second consecutive
year, with
-400 net inflows reaching $0.9 billion in 2005. A
continuing improvement in economic performance has given
-300
banks comfort in increasing their exposure to the country.
-200
Official Flows “On the creditor side, official bilateral conditions are
-100 expected to receive net repayments of nearly $27
Net repayments to official creditors from emerging market billion in 2005, following $14 billion last year. The
0
countries are expected to reach a record high of $50 billion this increase is almost entirely accounted for by the
year, up from 100 $31 billion in 2004 (Chart 18). On a geographic prepayment of a significant portion of Paris Club debt
basis, the Asia/Pacific
1996 region
1998 is 2000
the only2002
one that2004will 2006f
see a by Poland and Russia.”
substantial decline in net outflows,
Reservewhich are projected to shrink
Accumulation
from nearly $9 billion in 2004Resident
to onlyLending
$0.1 Abroad,
billion net1
this year. In
contrast, for emerging1Europe, net repayments are expected
Including net lending, monetary gold, and
to jump
from $9 billion last yearerrors
to almost $35 billion in 2005, with Poland
and oissions.
and Russia together accounting for $31 billion in outflows. Despite
the fact that Egypt, South Africa and Tunisia are expected to receive
net inflows this year, the Africa/Middle East region in aggregate is
likely to experience net outflows of $1.7 billion.
On the creditor side, official bilateral conditions are expected to

receive net repayments of nearly $27 billion in 2005, following
$14 billion last year. The increase is almost entirely accounted for
by the prepayment of a significant portion of Paris Club debt by
Poland and Russia. One-half of the countries included in our survey
are projected to obtain net lending from official bilateral creditors
this year, with India receiving the largest amount of net inflow at
$1.5 billion. In terms of international financial institutions (IFIs),
the three largest recipients of financing from the International
Monetary Fund—Argentina, Brazil and Turkey—are slated to make “One-half of the countries included in our survey are
total net repayments to the IMF of $13 billion in 2005, following projected to obtain net lending from official bilateral
about $10 billion last year. India and China are expected to receive creditors this year, with India receiving the largest
$1.6 billion and $0.9 billion, respectively, from IFIs this year, far amount of net inflow at $1.5 billion.”
more than any other country in our survey.
In 2005, net repayments to official creditors from countries in

emerging Europe are projected to increase to nearly $35 billion
from $9 billion last year. “Russia is expected to make net repayments to official
creditors of $21 billion, including $17.6 billion that
• Russia is expected to make net repayments to official creditors comprises mostly prepayments to members of the Paris
of $21 billion, including $17.6 billion that comprises mostly Club.”
prepayments to members of the Paris Club. Reflecting the
country’s strong balance of payments position and large reserve
holdings, the Russian government also decided to repay its
remaining obligation to the IMF, totaling $3.3 billion. Poland
also negotiated large prepayments to the Paris Club, which for
the year will reach $10 billion.
In 2006, net outflows from the region are projected to decline to

$15 billion, with Russia accounting for nearly 85 percent of the
region’s outflows as the government continues to make prepayments
to the Paris Club.
In Latin America, repayments to official creditors are likely to

rise to $14 billion this year from $10.3 billion in 2004 as Brazil’s
repayments to the IMF have ratcheted up significantly.
• Argentina is also slated to increase its net repayments to IFIs.
• Colombia is expected to see a reversal from net inflows of “Colombia is expected to see a reversal from net
$0.4 billion last year to net outflows of $0.9 billion in 2005. inflows of $0.4 billion last year to net outflows of $0.9
This reflects the prepayment of a $1.25 billion loan that the billion in 2005. This reflects the prepayment of a
Inter-American Development Bank made in 2003 for the $1.25 billion loan that the Inter-American
country’s Social Emergency Program. Development Bank made in 2003 for the country’s
Social Emergency Program.”
Next year, Latin America is likely to experience an appreciable
reduction in net outflows to official creditors as net repayments to
IFIs from both Argentina and Brazil decline from this year’s record
levels.
In the Asia/Pacific region, net repayments to official creditors

are expected to decline substantially from last year’s nearly $9 bil-
lion as net outflows from Indonesia and Thailand drop sharply while at
the same time a pickup in net inflows takes place in China and India.
• In Indonesia, the reduction in net outflows this year to only

$0.9 billion from $4.0 billion last year reflects the commitment
of official creditors known as the Consultative Group for
Indonesia to extend in the wake of the tsunami $5.1 billion in
external assistance this year in loans and grants with
$1.7 billion earmarked for Aceh. The reduction in net outflows
from Thailand is also connected with tsunami assistance efforts.
• The pickup in net lending from official creditors to China this

year stems from increased net disbursements from the World “In Indonesia, the reduction in net outflows this year
Bank and official bilateral creditors. to only $0.9 billion from $4.0 billion last year reflects
the commitment of official creditors known as the
• In India, net lending from official creditors is projected to rise Consultative Group for Indonesia to extend in the
to more than $3 billion this year from $2 billion in 2004 as the wake of the tsunami $5.1 billion in external assistance
government increases borrowing to fund its expanded capital this year in loans and grants with $1.7 billion
investment program. earmarked for Aceh.”
In 2006, the Asia/Pacific region is likely to experience net inflows

from official creditors for the first time in six years.
“China is expected to experience a drop in net inflows
Resident Net Lending and International Reserve Accumulation to $12 billion this year from $36 billion last year as
speculative money flowing into the country in
Net lending abroad by emerging market residents is anticipation of further currency appreciation
expected to increase to $88 billion in 2005 from $39 billion last diminishes.”
year. The pickup in net resident lending is concentrated in Latin
America and the Asia/Pacific region. In Latin America, Venezuela
could see net lending abroad exceed $19 billion this year, following
$6.1 billion of net outflows in 2004. The movement of private
capital offshore by residents reflects several factors: an increase in
nonreserve assets held abroad by the public sector, more widespread
overinvoicing of imports, higher foreign exchange supply to the
private sector from CADIVI, and the periodic issuance by the
government of dollar-linked instruments in the domestic capital
market. These bonds are then sold to nonresidents and the proceeds
are kept abroad. In Asia, net outflows are projected to reach nearly Chart 19: International Reserves
$15 billion in 2005, following net inflows of $25 billion in 2004. and Resident Net Lending
China is expected to experience a drop in net inflows to $12 billion (billions of U.S. dollars)
this year from $36 billion last year as speculative money flowing -500
into the country in anticipation of further currency appreciation
diminishes. -400
-300
Despite a likely significant increase in net resident lending
abroad this year, an expected increase in the aggregate current -200
account surplus will result in reserve accumulation in 2005 that
equals last year’s $400 billion (Chart 19). Reserve accumulation is -100
projected to again reach $400 billion in 2006.
0
• Overall, the Asia/Pacific region is expected to account for 100

70 percent of the total emerging market reserve accumulation 1996 1998 2000 2002 2004 2006f
this year and 78 percent in 2006. China alone will likely Reserve Accumulation
account for more than 80 percent of the region’s reserve Resident Lending Abroad, net1
accumulation of $282 billion this year and 89 percent of next 1 Including net lending, monetary gold, and
year’s projected accumulation of nearly $313 billion. errors and oissions.
• Reserve accumulation in emerging Europe is likely to climb to

a record high of nearly $73 billion this year, following an
increase of $58 billion in 2004. Russia is expected to account
for three-fourths of the reserve accumulation in the region as
high oil prices push the current account surplus to more than
9 percent of GDP. Next year’s reserve buildup in emerging
Europe is projected to be nearly $62 billion.
• In Latin America, reserve accumulation is expected to be held

to about $17 billion in 2005, down from more than $22 billion
last year as a substantial increase in net resident lending abroad
more than offsets a pickup in net private capital inflows. A
projected sharp reduction in the region’s aggregate current
account surplus next year is expected to more than offset an “Russia is expected to account for three-fourths of the
acceleration in net private capital inflows. This will limit reserve accumulation in the region as high oil prices
reserve accumulation to about $12 billion—the smallest push the current account surplus to more than 9
increase since 2002. percent of GDP.”
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

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Capital Flows to Emerging Market Economies

Capital Flows to Emerging Market Economies

September 24, 2005

Low yields on U.S. Treasury bonds and a flat yield curve

compressing credit spreads, including those on emerging market

countries has contributed to both direct and portfolio investment

Global Economic Environment

• The United States has continued to be the engine of growth for 4

• Japan seems poised to register its first sustained economic

• Emerging Europe is likely to experience the most visible fall-

• Growth in Latin America is projected to decline to 4.3 percent

Somewhat surprisingly, yields on 10-year U.S. Treasury

• Market interest rates in Japan are projected to remain broadly

Current Account Balance

The continued disparity in growth prospects for the United

• Adjustment in U.S. fiscal policy is but one component of

• Emerging markets will need to do their part as well, for

countries. Temporary refinery constraints have also contributed to

• A further rise in oil prices could lead to a drag on growth.

Outlook for Major Components

Key features of the main categories of net private capital flows

• Net direct investment (projected at $149 billion this year and

• Commercial bank net lending is projected to reach a nine-

year to $76 billion in large part because of reduced borrowing

• Private capital flows to emerging Europe are expected to reach

• Private flows to the Africa/Middle East region are likely to

Regional notes on pages 8 and 9 provide greater details, including

The generally favorable outlook for economic growth in

Emerging Europe Asia/Pacific

External financing, net: External financing, net:

f = IIF forecast f = IIF forecast

Latin America Africa/Middle East

External financing, net: External financing, net:

f = IIF forecast f = IIF forecast

China: Economic Outlook and Prospects for Capital Flows

base. Direct investment is also being attracted to areas

One aspect of direct investment that seems to be

On a regional basis, emerging Europe and the Africa/

Emerging Europe is likely to see direct equity investment

Direct investment is projected to hold steady at this year’s level in

• In Turkey, as of mid-August, privatization implementations,

• In Russia, direct investment is reported to have risen 31 percent

Direct investment in the Asia/Pacific region continues to be

• At an annualized rate of $55 billion, actual inflows to China in

• India remains one of the top recipients of direct investment in

Net direct investment in Latin America is likely to slip to

• In the case of Brazil, direct investment in the first seven months

• Direct investment in Argentina is likely to amount to

In the Africa/Middle East region, net direct equity investment

Emerging market portfolio equity investment is projected to

The Asia/Pacific region’s portfolio equity flows are expected to 10

of 2005, up moderately from $5.6 billion a year earlier.

In emerging Europe, net portfolio equity investment is

• In Turkey, net portfolio equity investment amounted to $1.6

• Poland is expected to see net portfolio equity inflows of

• Despite record high prices on the Russian stock exchange and a

Net portfolio equity investment in Latin America is likely to

• Brazil is expected to be the largest recipient of net portfolio

In the Africa/Middle East region, portfolio equity investment

• South Africa is expected to be the recipient of more than

Nonbank Private Sector Lending