Private Capital Flows in Emerging Markets

(Source Article: Capital Flows in Emerging Markets - WB News)

Developing countries enjoyed record-breaking net private capital flows in 2005— totaling US$ 491 billion. A number of factors fueled the increase in such flows: privatizations, mergers and acquisitions, external debt refinancing, and strong investor interest in local-currency bond markets in Asia and Latin America, according to the World Bank in its annual Global Development Finance Report.

This increase is reflective of an estimated GDP growth of 6.4 percent in low and middle-income countries in 2005, compared to a 2.8 percent growth in developed countries; China and India were largely responsible for such a high average, as their GDPs experienced 9.9 and eight percent growth, respectively.

Despite impressive growth last year, these emerging markets are highly susceptible to the volatility often created by private capital flows. The lead author of the World Bank’s report said, “[t]his moment is so critical to give these countries the time to develop their markets.”

Low level interest rates in the developed world have allowed leveraging for investors who borrow cheaply to pick up higher returns on an offer elsewhere—“[i]f these foreigners withdraw, local market rates go up and that’s an area we’re worried about,” commented the report’s author. (see World Bank alert on emerging markets - FT.com)

India is already being affected by the volatility of private capital flows; since the market there peaked on May 11, foreign funds have sold US$ 2.4 billion of Indian equities in the cash market, with approximately US$ 800 million being withdrawn in just two days. Such rapid withdrawals have caused many to fear that the country will not be able to finance its growing current account deficit. These withdrawals also shake the confidence of potential future investors, making it difficult for the government to attract them. (see Deficit finance fear in India - FT.com)

With a ballooned trade deficit of $4.2 billion in April, JP Morgan expects India’s deficit to reach 3.6 percent of its GDP this year.

The report also shows an increase in capital flows between developing countries (often referred to as “south-south flows”), and that such flows are growing more rapidly than those between developed and developing countries (“north-south” flows). For instance, Foreign Direct Investment between developing countries in 2003 reached $47 billion (37% of total FDI in developing countries), a tremendous increase from the $14 billion in 1995. World Bank officials commented that these developing countries have the potential to change the face of development finance—especially if their growth continues to outpace that of developed countries. (see Changing the face of development finance? - WB News)