Washington-based IIF reports a worsening of the environment for capital flows to EMEs in the context of a surge in global risk aversion amid concerns about the duration of ultra-easy monetary policy and this, it notes, has already been sending ripples through the emerging markets. Their currencies have also plummeted in recent months, driven in part by a reversal of portfolio equity flows and reduced bond inflows since March this year.

Unctad’s annual publication, World Investment Report 2013, records a decline in FDI flows worldwide to 1.35 trillion dollars in 2012 - by 18 per cent over 2011 - due in general to caution on the part of investors, given economic fragility and policy uncertainty in many of major economies. Its projections for 2013 and 2014 are not strikingly better than possibly a modest rise up to 1.45 trillion dollars in 2013.

The road to FDI recovery remains “bumpy” and as macroeconomic conditions improve and investors regain confidence in the medium term, Unctad says, TNCs may convert their “record levels of cash holdings into new investments”. If global prospects improve, FDI flows may then reach the level of $1.6 trillion in 2014 and $1.8 trillion in 2015.

A notable feature in FDI in 2012 was larger flows to developing countries, for the first time, at 703 billion dollars or 58 per cent of total flows, with an increase of 142 billion over the share of developed countries of 561 billion dollars (42 per cent down from 50 per cent in 2011). Developing countries also generated almost one-third of global FDI outflows continuing an uptrend for some years now.

FDI outflows from developed economies dropped to a low of 909 billion dollars while outflows from developing countries had risen to 426 billion, despite global downturn, with corporates continuing an expansion trend that is set to continue. The uncertain economic outlook led transnational corporations (TNCs) to maintain their ‘wait-and-see’ approach towards new investments or to divest foreign assets, rather than undertake major international expansion, Unctad reports.

Out of 38 developed countries, 22 experienced a decline in outward FDI in 2012 leading to a 23 per cent overall decline in their outflows. Apart from Euro-zone situation, the decline is also attributed to political transition in some countries and TNC putting in place “complex structures” often with the aim of reducing tax liabilities or to respond to varying national tax systems by transferring profits and loans across borders.

According to IIF, net private capital flows to emerging market economies (including FDI, portfolio, commercial bank, and other official and non-official flows) are projected to decline from 1212 billion dollars in 2012 to 1187 billion and 1167 billion in 2013 and 2014 respectively. Of these, direct investments are projected at 541 billion in 2013, (slightly less than in 2012), and 523 billion in 2014.

The fall in these flows is related by IIF to weaker growth in emerging economies, some of which seem “vulnerable to a retrenchment of foreign capital”. But other EMEs have become important sources of external financing in the global economy. Both UNCTAD and IIF have highlighted significant risks in the world scenario, such as structural weaknesses in the global financial system, possible deterioration of the macroeconomic environment, and policy uncertainty in areas crucial for investor confidence.

IIF says loose monetary policies in mature economies had driven capital inflows into emerging market countries with strong growth “pulling” money, but investors have now become increasingly concerned about an exit from easy monetary conditions. Additionally, growth in emerging economies has lost some momentum recently while growth prospects in mature economies have brightened somewhat, thus reducing the relative attractiveness for developed market investors to move capital abroad.

IIF’s baseline forecast for capital flows assumes that volatility in bond markets will remain a feature going forward. While an increase in policy rates by the Federal Reserve may still be some time away – not least because the U.S. unemployment rate may decline more slowly and core inflation remains low – a process of normalization would be in line with the fact that U.S. growth has recovered from the extraordinary weakness during the Great Recession.

World GDP growth is expected to be 2.5% this year and 3.3% in 2014, IIF estimates, as against a historical average of 3.1% over 1996 - 2007. With mature economies performing better and emerging markets on slower growth, the global outlook has become less supportive for capital flows.

Emerging market currencies in aggregate are down almost 7% since early May, with the Brazilian real, the South African rand, the Indian rupee and the Indonesian rupiah hit particularly hard. The marked divergence in developed and emerging market equity prices, IIF review adds, is also a worrying signal of investor concern about EM growth prospects broadly.

With the pre-crisis “engine of growth” status of EM “appearing worn”, IIF forecasts look for under 5% growth in 2013, with only a modest pick-up to 5.4% in 2014. Normalisation of monetary easing poses risks to EMEs which tend to be affected disproportionately because foreign capital movements can be huge relative to their domestic financial markets. A narrowing of interest rate differential between EM and mature economies should reduce the search for yield by global investors, if the monetary exit progresses in a smooth fashion, IIF adds.

India remained the largest FDI recipient, despite decline to 26 billion dollars, in South Asia whose FDI share had also fallen to 34 billion dollars. Unctad sees prospect of FDI growing in India for services and manufacturing with the ongoing efforts to open up more economic sectors and the proposed establishment of country or industry-specific industrial zones. Like the Delhi-Mumbai Industrial Corridor, with Japan’s assistance, bilateral efforts may result in an increasing amount of FDI inflows to industries in the years to come. Outflows from India also decreased in 2012 to 8.6 billion dollars.

IIF projects Asian region’s share in total emerging market inflows to average 43% this year and next, down slightly from 50% in 2010 and 2011. Calibrated policies to stimulate the economy in China along with support from domestic demand in Southeast Asia and policy efforts to revive the Indian economy suggest that real GDP growth for Emerging Asia should remain at around 7% in 2013 and 2014. Inward FDI to the region is set to remain around $270-290 billion a year.

China will continue to dominate (FDI of 121 billion in 2012) but its share may progressively slip from a recent high of 76% in 2011 to 72% in 2014 because of factors like rising labor costs, some diversification of manufacturing to other countries in the region and Sino-Japanese geopolitical tensions.

For India, IIF says, the gradual opening up of previously closed sectors and the withdrawal of controversial tax plans should help lift FDI inflows to $35 billion in the fiscal year ending March 2015 from $28 billion in 2012/13, “although dampened by infrastructural deficiencies and administrative hurdles”.

Portfolio flows to Emerging Asia would fall from 58 billion dollars in 2012 to $46 billion in 2013 before reviving to $60 billion in 2014. Notwithstanding periodic swings, India will continue to lead the region in portfolio flows at around 24 billion dollars a year on the back of expected GDP recovery along with investor-friendly measures. (IPA Service)