Last week, the World Bank published its report on Global Development Finance, 2008, which has a chapter on Financial Flows to Developing Countries: Recent Trends and Prospects. The trend of rapidly rising fund flows to emerging markets in the last four years is well-known, but what’s on every investor’s mind is whether that trend is going to be reversed. The World Bank is sure that it will.
But, the current high level of uncertainty makes forecasting very difficult, so the bank outlines two scenarios for the rest of this year and for 2009. Under its base case or soft-landing scenario, it says private fund flows to developing countries will decline from $1.03 trillion (more than Rs44 trillion) in 2007 to $850 billion in 2009. But, flows in 2009 will continue to be much higher than in the mid-1990s, before the Asian crisis.
Under its second or hard landing scenario, private fund flows will fall to $550 billion in 2009, which, as a proportion of developing countries’ gross domestic product, is slightly above the average of fund flows between 1993 and 2002. Lower global growth and tighter financing conditions are expected to lower capital flows.
The bank underlines its belief that emerging markets will continue to attract strong capital inflows over the longer term. It says: “Institutional investors’ holdings of emerging-market assets are well below levels implied by their capitalization value and hence are expected to rise significantly over the medium term.” However, the prospects are not so good in the short term. The report says, “Given concerns about overvaluation in some emerging equity markets along with the risk of an abrupt slowdown in global growth, fund managers may prefer to postpone taking on more exposure to emerging-market assets until global economic and financial conditions have improved.”
The base case implies a 17.4% drop in inflows from the lofty heights reached in 2007. That’s not such a big deal, when you consider net private flows to developing countries (both debt and equity) rose from $760 billion in 2006 to $1.03 trillion in the next year. Under this scenario, therefore, all that will happen is a minor pullback in inflows and they would still be well above the levels of 2006. Under the hard landing scenario, however, inflows would be around the 2005 level of $551 billion. That would still be double the inflows of $274 billion notched up in 2003. In other words, despite the credit crisis, despite the troubles of the big banks and in spite of the rise in risk aversion, the World Bank does not believe that all of the surge in fund flows to emerging markets will be reversed.
The bank probably has at the back of its mind the experience of the last downturn, when fund flows to developing countries dropped from $196 billion in 1999 to $165 billion in 2001, a drop of 16%.
But, private fund flows include equity as well as debt flows and equity flows are further divided into foreign direct equity and portfolio flows. During the last downturn, while FDI flows remained stable, debt as well as equity portfolio flows fell dramatically. Net medium- and long-term debt flows fell from $18.9 billion in 1999 to $0.7 billion in 2002. Net portfolio equity inflows fell from $13.5 billion in 2000 to $5.6 billion in 2001 and $5.5 billion in 2002, a drop of 59%. In short, while net inflows were propped up by stable FDI flows, both the debt as well as the equity markets took a beating. The same trend is likely to be seen this time as well.
While the World Bank’s figures for overall fund flows remain relatively benign, the same is unlikely to be the case for portfolio equity as well as debt inflows, although the bank doesn’t give separate projections for FDI and portfolio flows. For the Indian market, the impact of the high levels of portfolio inflows last year is now being seen in the net FII outflows of Rs21,800 crore from the cash market so far this year.
This month (till 12 June) , despite the much more reasonable valuations, FIIs sold a net Rs6,717 crore in the cash market and Rs2,402 crore in the futures market.
The trend of stable FDI propping up net inflows is likely to benefit countries such as China, Russia and Brazil, which received FDI worth $84 billion, $52.5 billion and $34.6 billion, respectively, in 2007, according to the bank’s estimates. In contrast, India’s share was $21 billion. On the other hand, portfolio investment was much higher in India last year, at $34 billion, only marginally less than top recipient China’s $35 billion. In short, India’s dependence on volatile portfolio flows could lead to lower overall net inflows compared to its peers, which means that the impact on the current account deficit, liquidity, interest rates and the currency will be greater compared to its peers. Unless, of course, lower equity prices lead to more FDI through takeovers of Indian companies, on the lines of Daiichi Sankyo Co. Ltd’s acquisition of Ranbaxy Laboratories Ltd.
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