The Institute of International Finance raised its projections for capital flows to emerging markets this year on the back of stronger macroeconomic fundamentals and increased risk appetite.
But flows are still likely to remain around 10% below the peak they reached in 2007 just before the financial crisis, as Western banks are still deleveraging.
The IIF increased its overall estimate for 2012 by $54 billion to $1.080 trillion total capital flows into emerging markets compared with projections it made last October. But this was a slight dip from 2011, when flows totaled $1.084 trillion.
The IIF – which reunites more than 470 financial institutions globally – said that because of the “exceptionally easy” monetary conditions in mature economies and favourable growth conditions in emerging economies, capital flows are expected to increase this year to $1.118 trillion – an upwards revision of $18 billion from last October’s prediction.
Another factor pushing capital flows towards emerging markets is the fact that risk aversion has fallen “significantly” over the past months in financial markets, resulting in strong rises in stock markets and reductions in risk spreads, according to the IFF report.
The macroeconomic outlook for 2013 and 2014 “seems to favour equity investments” which benefit from the better growth outlook in emerging markets.
“Indeed, the projected increase in private capital flows both this year and next is solely accounted for by increased equity inflows,” the IIF’s report said.
“Debt inflows are projected to decline this year and be broadly stable in 2014 as declining flows from nonbank sources mostly offset modest increases in inflows from commercial banks (from a low starting level).”
RISKS BEHIND THE SURFACE
Portfolio equity inflows, which the IIF says “have surged” in recent months, are forecast to increase by 50% to $110 billion by 2014, but still below the $150 billion they reached in 2009 and 2010. By contrast, the strong inflows into bond markets over the recent months are expected to level off, it said.
Direct investment represents about half of all inflows of private capital to emerging markets and are expected to grow by around 3.5% this year and the next, reaching a historic high of $536 billion in 2014. Capital inflows to Latin American and Emerging Asian countries are now more than 30% above their 2007 level, while in Central and Eastern Europe, hard hit by the effects of the financial crisis, they are still a third less than the amount of flows seen in the boom years between 2005 and 2007.
The report identified three sources of volatility: uncertainties about the eurozone – such as whether there will be a bailout for Cyprus and the results of the Italian and German elections – the discussions about the US fiscal situation, and risks in emerging markets themselves, such as the situation in Egypt or deep recessions in Eastern European countries like Hungary and Ukraine.
“On the more distant horizon, as far as risk is concerned, is the direction of interest rate policy by the US Federal Reserve. Investors may be unprepared for a reversal of interest rates. This needs to be seriously considered to avoid disruption,” Charles Dallara, Managing Director of the IIF, said in a statement.
The report pointed to events in 1994, when markets did not anticipate interest rate increases by the Fed, as important case studies for what could happen when eventually the Fed does change course on monetary policy.
The results of the Fed hikes in 1994 were “stunning,” as many market participants had locked into “low for long” trades; there was a scramble to the exit which dragged down all major bond markets and emerging market asset prices slumped in 1994 and early 1995.
“Most importantly, private capital flows to Turkey and to Latin America – especially Mexico – collapsed, culminating in the near default of Mexico in 1995,” the IIF report warned.