Reversal of Capital Flows to Emerging Markets Poses Risks

With super low interest rates available in the U.S. and the rest of the developed world, investors may be tempted to chase the juicy yields available on emerging market (EM) debt.

The World Bank estimates that in 2009, 104 of 129 developing countries will have current account surpluses inadequate to cover private debt coming due. For these countries, total financing needs are expected to amount to more than US$1.4 trillion during the year. External financing needs are expected to exceed private sources of financing (equity flows and private debt disbursements) in 98 of the 104 countries, implying a financing gap in 98 countries of about US$268 bn. Should bank rollover rates be lower than expected, or should capital flight significantly increase, this figure could rise to almost US$700 bn. Well over US$1 trillion in EM corporate debt and US$2½-3 trillion in total EM debt matures in 2009, the majority of which reflects claims of major international banks extended cross-border or through their affiliates and branches located in emerging markets.

The outlook for the flow of portfolio investments is even less encouraging. Redemptions of US$41.2 bn out of EM equity funds in 2008 have fully reversed the record US$40.8 bn inflow of 2007. About half of the EM fund purchases that have occurred since 2003 have now been withdrawn. According to the Institute for International Finance (IIF), net private capital flows to emerging markets are estimated to have declined to US$467 bn in 2008, half of their 2007 level. A further sharp decline to US$165 bn is forecast for 2009, with just over three-quarters of the decline due to deterioration in net flows from commercial banks. Moreover, net lending of international banks to emerging countries (excluding Gulf countries) is expected to fall to US$135 bn in 2009 from US$401 bn in 2007 and US$245 bn in 2008.

Expect capital controls, defaults and social unrest caused by austerity measures dictated by the multi-lateral organizations supplying financial rescue packages.