Capital Flows to Emerging Market Economies

Capital Flows to Emerging Market Economies September 24, 2005

© 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.

September 24, 2005

Overview

The strong recovery in net private capital flows to emerging

markets that began in 2003 has continued this year Although a

moderation in the pace of flows is anticipated in the next several

quarters, the overall level envisaged for 2006 remains relatively

elevated Downside risks have increased, however, in the face of

rising concerns and unease about a potentially less hospitable

global economic environment going forward

Private flows are projected to reach a record high

$345 billion this year before slowing to $318 billion in 2006

(Table 1, Chart 1) This year’s expected flows surpass the

previous record of $323 billion reached in 1996 prior to the

Asian crisis The continued robustness in flows is being supported

by a further pickup in direct investment and a record pace of bond

issuance as sovereign and private borrowers endeavor to stay ahead

of the curve before the tightening policy interest rate cycle starts to

hit bond markets visibly With many debtors having already taken

the opportunity to pre-finance obligations due in 2006, the current

pace of bond issuance is unlikely to be sustained next year,

contributing to an overall slowdown in private capital flows to

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

2005 has occurred against a backdrop of strong global economic

expansion, which has been supported by strong corporate

profitability and buoyant housing markets in the United States

and elsewhere The measured but sustained monetary tightening in

the United States has yet to dampen growth, as bond yields have

tended to drift down Neither have sharply higher oil prices begun

to visibly affect the forward momentum of global activity, although

this could now change in the aftermath of Hurricane Katrina

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

have pushed investors to purchase lower rated credits,

compressing credit spreads, including those on emerging market

bonds Despite the historically high price of emerging market

assets, investor demand remains strong, reflecting both the

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

Table 1 Emerging Market Economies' External Financing

(billions of U.S dollars)

2003 2004 2005f 2006f Current account balance 118.0 151.9 194.4 180.7 External financing, net:

Equity investment, net 128.9 167.5 191.3 184.4 Direct investment, net 95.9 132.2 148.9 145.8 Portfolio investment, net 33.0 35.3 42.3 38.7 Private creditors, net 84.8 149.8 153.9 133.3 Commercial banks, net 25.4 61.1 63.5 57.8

Bilateral creditors -14.8 -14.2 -26.5 -11.8 Resident lending/other, net 1 -37.6 -38.6 -87.7 -72.3 Reserves (- = increase) -272.6 -400.0 -401.4 -402.0

f = IIF forecast 1

Including net lending, monetary gold, and errors and omissions.

Chart 1: Capital Flows to Emerging Markets

(billions of U.S dollars)

-100 0 100 200 300 400

94 95 96 97 98 99 00 01 02 03 04 05f 06f Official lending Private equity Private credit

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 stability, less

favorable economic performance and troublesome

developments, including the persistence of high debt ratios and

a tendency to hold back on structural reforms, have been

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

points to major market disturbances or credit events in the

period immediately ahead Nevertheless, in conjunction with

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

pattern, which together have contributed to a widening in global

current account imbalances, remain a risk going forward

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

the world economy with projected growth for this year the

highest in the G7 Although GDP growth slowed to an

annualized rate of 3.3 percent in the second quarter, the strength

of final demand in that quarter and subsequent activity

indicators suggest that, even after allowing for the effects of

Katrina, full-year GDP growth in the vicinity of 3½ percent is

well within reach Growth momentum is expected to slow

somewhat next year on an annual average basis as high oil

prices finally bite into consumption in the situation where the

savings rate has hit rock bottom Business fixed investment is

likely to continue to play a key role as a source of growth

“Although the general conditions in emerging markets

as a whole remain broadly conducive to growth and stability, less favorable economic performance and troublesome developments, including the persistence

of high debt ratios and a tendency to hold back on structural reforms, have been observed in some countries.”

“The United States has continued to be the engine of growth for the world economy with projected growth for this year the highest in the G7.”

Chart 2: Industrial Countries’ Real GDP Growth (percent change from previous year)

-2 -1 0 1 2 3 4 5

• The narrowing of the output gap that has taken place in the

United States this year is not being replicated in other major

industrial countries, except perhaps in Japan Indeed, recovery

in the Eurozone has faltered with real GDP growth projected at

1.3 percent in 2005 While the employment situation has

improved a little, the same cannot be said for consumption,

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

strengthening in the jobs market and in wages and salaries,

growth this year is expected to reach 2¼ percent, underpinned

by moderately strong private consumption and business

investment Forward-looking indicators suggest that economic

growth next year will continue at this year’s pace Survey data

show that business confidence is increasing and that export

growth is likely to rebound as the manufacturing sector reacts

favorably to global IT sector adjustment If the current

reduction in deflation continues, it should come to an end in

2006, if not earlier

Emerging market growth this year is projected at 5.9 percent

(Chart 3) This is nearly one percentage point lower than in 2004,

when growth reached a 20-year high

• 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

terms-of-trade gains With the exception of Brazil, all countries

in Latin America are likely to experience a moderation in

growth in 2006

this year at 7.2 percent, marginally lower than 7.5 percent last

year Korea and Malaysia are projected to have the weakest

growth in the region (at 3.5 percent and 4.3 percent,

respectively) while China is likely to register growth of

9.3 percent, down slightly from a rapid pace of 9.5 percent last

year Regional growth next year is projected to fall below

Table 2 Emerging Market Economies' Output Growth

(percent change from previous year)

0 1 2 3 4 5 6 7

98 99 2000 01 02 2003 04 05f 2006f

“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.”

Chart 3: Emerging Market Economies’

Real GDP Growth (percent change from previous year)

0 1 2 3 4 5 6 7

7 percent for the first time since 2002 with China’s growth

slowing to 8.5 percent

grow at 4.2 percent, the same as last year, and step up to

4.5 percent next year

Interest Rates

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

bonds have not begun a clear upward trend, although there

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

pension funds to increase their holdings in long-term bonds to

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

lead to a deterioration in the financial condition of emerging market

countries, particularly those with lower credit ratings and in need of

external financing

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

recent movement in unit labor costs and several components of

producer prices, this assumption is not without risks

5.0 percent by the second half of 2006, and to a 5¼-5½ percent

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

of this year, the lack of prospects for coordinated policy action by

major economies raises the possibility of a disorderly depreciation

of the dollar in due course Such a depreciation could push U.S

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

Chart 4: 10-year U.S Treasury Bond Yields

(percentage points)

3.5 4 4.5 5

the Eurozone and Japan while higher U.S interest rates would

dampen U.S domestic demand Both of these developments would

reduce growth of exports and output in emerging markets Wider

EMBIG spreads and weaker growth would have a negative impact

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

capital flows exercise is projected to reach 2.4 percent of GDP

this year, up from 2.1 percent in 2004 Double-digit export

growth is expected for the third consecutive year Growth of

remittances is likely to remain strong, constituting the

single-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

power of companies, adequate labor supply and benign inflation

expectations

In looking at the possible future trend of oil prices, a number of

factors need to be considered The increasing concentration of

global growth on several oil-intensive economies in Asia has

already noticeably accelerated the growth of global oil demand

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,

despite increased production by non-OPEC countries, the global oil

supply has become progressively tighter, reflecting a long period in

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

the Middle East and recurrent production disturbances in non-OPEC

Chart 6: Real Oil Prices (2004 U.S dollars)

“Adjustment in U.S fiscal policy is but one component

of what is needed to reduce the current global payments imbalance.”

countries Temporary refinery constraints have also contributed to

oil market jitters

• Brent crude oil prices are expected to fall to about $60 a

barrel by end-2005 and average $60 a barrel in 2006 This

forecast assumes that the increase in world demand for oil will

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

Since our last update on capital flows to emerging market

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 nine-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

rely on debt financing In 2006, positive net lending to Latin

America is projected to take place for the first time since 2000

nonbank credit flows are likely to reach an all-time high of

more than $90 billion Net flows are expected to recede next

“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.”

“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.”

“China will remain the largest recipient of foreign direct investment among emerging market economies, accounting for one-third of net flows.”

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

by countries in emerging Europe, one of which, Poland, used

the bond market extensively this year to finance large

prepayments of debt to Paris Club members

Net repayments to official creditors are projected to reach a

record high this year of more than $50 billion, with Poland and

Russia together accounting for $31 billion of the total Net

repayments are projected to be cut in half in 2006

From a geographical perspective, net private capital flows to

Asia are expected to account for 42 percent of total flows to

emerging markets this year, down from 52 percent in 2004

(Table 3) An increase to 46 percent is projected for next year as

flows to China pick up after a moderate dip this year In terms of

other regions:

• 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

remain in the range of 13-16 percent through 2006, with

Mexico continuing to garner the largest share of net inflows to

the region while Brazil closes the gap as it attracts increasing

investor interest

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

performance, has attracted increasing amounts of direct equity

investment Thus, after falling to a seven-year low of $96 billion in

2003, direct investment is expected to rise for the second

consecutive year, reaching $149 billion in 2005—the highest level

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

investment inflows Larger amounts of cross-border transactions

between the related entities within the ownership structures of

multinational corporations also appear to be taking place In

looking for investment opportunities there is an increasing tendency

for companies to search in the more populous emerging market

countries in the belief that these countries will provide an expanding

customer base in addition to a cost advantage needed as an export

“After falling to a seven-year low of $96 billion in

2003, direct investment is expected to rise for the second consecutive year, reaching $149 billion in 2005—the highest level since 1999.”

Table 3 Financial Flows to Emerging Market Economies by Region, Net

(billions of U.S dollars)

Chart 7: Net Direct Investment by Region

(billions of U.S dollars)

0 40 80 120 160

Emerging Europe

A continued strengthening of foreign direct investment and

nonbank creditor flows should help raise net private capital

flows to a record high $132 billion this year before slowing

to an expected $111 billion in 2006

• With the exception of Bulgaria, all countries in the region

are likely to experience a slowdown in economic growth

this year, primarily because of a weakening in the net

for-eign balance of most countries In 2006, real GDP in

emerging Europe is expected to grow 4.8 percent, nearly

identical to this year’s projected outcome

• Privatization activity in the Czech Republic and Turkey is

largely behind the expected pickup in direct investment

this year Proximity to major markets in Western Europe

and still relatively low labor costs are attracting direct

in-vestment in the region Direct inin-vestment is forecast to

hold steady next year at $34 billion

• Reserve accumulation is slated to accelerate in 2005 as a

rise in net private capital flows is augmented by a

reduc-tion in net resident lending abroad Reserve accumulareduc-tion

is projected to reach a record high $73 billion this year,

bringing the stock of reserves to nearly $335 billion,

rep-resenting 5.8 months of imports of goods, services and

transfers A smaller, expected current account surplus

next year, along with a reduction in net private capital

in-flows, will hold down reserve accumulation to less than

$62 billion

Asia/Pacific

Net private capital inflows are set to moderate to $146 billion this year from $166 billion in 2004 as flows in all categories

of investment are likely to recede Capital flows are expected

to remain at this year’s level in 2006

• Regional growth is likely to stay above 7 percent for the third consecutive year with China once again expected to experience the fastest growth among our survey countries

at 9.3 percent A tapering off of activity in China next year will limit regional growth to a projected 6.8 percent

• Capital flows to the region continue to be dominated by direct investment, which is expected to account for more than 40 percent of flows this year China remains the major recipient of direct investment in emerging Asia as these flows, along with the mobilization of the labor force, have transformed the country into a regional export base

• Despite a slowdown in capital flows to the region this year, reserve accumulation is expected to exceed $280 billion for the second consecutive year as the aggregate current account surplus reaches 3.7 percent of GDP, up from 3.2 percent in 2004 Reserve accumulation is projected to hit a record high $312 billion in 2006, bringing the region’s stock of reserves to $1.7 trillion (See separate box on page 10 for details of China’s external financing.)

Table 4

Europe: External Financing

(billions of U.S dollars)

External financing, net:

(billions of U.S dollars)

External financing, net:

Latin America

Increases in equity investment for the third consecutive year

and a reduction in net outflows to commercial banks will

contribute to a significant expansion of net private flows this

year to an expected $46 billion from $31 billion in 2004 A

further moderate increase in flows is projected for 2006

• All countries in the region are likely to experience some

degree of a slowdown in economic activity this year with

Uruguay and Venezuela expected to see the biggest

declines in growth rates, following significant rebounds in

activity in 2004 Regional growth is projected to dip to

4.3 percent in 2005 from 5.9 percent last year and slow

further to 3.9 percent in 2006

• Net nonbank creditor inflows are expected to increase for

the second consecutive year to $11 billion from $9.5

billion in 2004 Reduced financing needs and improved

public balance sheets should limit nonbank creditor

flows—mostly bonds—to less than $9 billion next year

with an increasing likelihood of more local

currency-denominated global bond issuance

• A significant increase in net resident lending, particularly

from Mexico and Venezuela, is projected to limit reserve

accumulation in the region to about $17 billion this year,

down from more than $22 billion in 2004 A further

decrease in reserve accumulation is expected next year as

the current account surplus shrinks to only 0.3 percent of

GDP, down from 1.1 percent in 2005

Africa/Middle East

Net private capital flows to the region are expected to approach nearly $22 billion this year, nearly double the amount received in 2004 A surge in direct investment is responsible for a significant portion of the overall increase in flows

• Growth in the region will hold up at relatively high levels this year with a further acceleration in regional growth expected next year Egypt should see the sharpest increase in growth, reflecting improved policy implementation and a rebound in tourism

• The acquisition of one of South Africa’s major banks, as well as foreign interest in the natural resource sector, has been pivotal to the significant pickup in equity investment

in the region this year Bond flows as well as commercial bank lending are also expected to rise this year before dropping in 2006

• The region’s current account is forecast to remain healthy

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 smaller current account surplus in 2006 Reserve accumulation is likely to reach $29 billion this year, up from $18 billion in 2004 Reduced capital flows and a smaller current account surplus will limit reserve accumulation next year to less than $16 billion

Table 6

Latin America: External Financing

(billions of U.S dollars)

External financing, net:

(billions of U.S dollars)

External financing, net:

China: Economic Outlook and Prospects for Capital Flows

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

have taken the lead in searching for opportunities outside of

their home base Some estimates suggest that “south-south”

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

“Increasingly, emerging market based companies are seeking to integrate corporate entities in advanced industrial countries into their developing global network.”

• Real GDP growth is likely to remain robust this year at

9.3 percent following 9.5 percent in 2004 We expect a

moderation to 8.5 percent next year

• Continued strong export growth will push this year’s current

account surplus to 6.7 percent of GDP and to more than

7 percent in 2006

• Net private capital flows are expected to decline to

$87 billion this year from $101 billion in 2004 as

commer-cial bank borrowing and nonbank inflows retreat in the face

of pressure by the authorities to limit overseas borrowing

• Net direct investment in 2005 and 2006 is forecast to remain

near last year’s level of $53 billion, accounting for one-third

of all direct investment to emerging markets

• As a result of the continued widening of China’s current

ac-count surplus, reserve accumulation is likely to reach an

all-time high of nearly $230 billion this year, bringing reserves

to nearly $840 billion by yearend

Table 8 China's External Financing

(billions of U.S dollars)

Bilateral creditors 0.7 -0.4 0.1 0.0 Resident lending/other, net1 1.0 36.1 12.0 24.0 Reserves (- = increase) -117.0 -206.4 -230.3 -278.0

f = IIF forecast

1 Including net lending, monetary gold, and errors and omissions.

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

expand into higher value-added activities

$7 billion this year from $3.6 billion in 2004 as the sale of

Césky Telecom and other firms boost privatization receipts

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

resources as might be expected With no major privatization

deals on the horizon, direct investment is expected to be held to

$3.2 billion in 2006, up only marginally from $3 billion this

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

of the retail sector to foreign companies like WalMart

Moreover, services liberalization and market openings are part

of the ongoing Doha Round of the WTO, which is making slow

progress

“Several EU accession countries are seeing a further pickup in direct investment flows this year as foreign companies seek to expand into higher value-added activities.”

“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.”

“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.”

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

• Mexico is the only country in the region that is expected to see a

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

$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

$1.5 billion in 2004 Roughly one-half of this year’s net inflow will

be accounted for by the 60 percent purchase of South African bank

ABSA by Barclays This marks the largest ever single direct

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

asset class, including continued high oil prices, which would

inevitably cause overall earnings to slow in emerging markets,

particularly in Asia High valuations in the United States and

elsewhere could lead in time to significant corrections in light of

slower earnings stemming from higher input costs to which

emerging market equities, albeit being considered by many to be

near fair valuations, would not be immune

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

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

• China is likely to account for one-half of total flows to the

region this year Overseas share listings by Chinese companies

generated $6.2 billion in equity inflows in the first six months

Chart 8: Net Portfolio Investment by Region

(billions of U.S dollars)

-10 0 10 20 30 40 50

“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.”

“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.”