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iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved. OCTOBER 1, 2015 Capital Flows to Emerging Markets Capital flows to emerging markets have weakened sharply in recent months. With non-resident inflows looking likely to fall below 2008 levels and rising resident outflows, we now expect that net capital flows to EMs in 2015 will be negative for the first time since 1988 (Chart 1). Unlike the 2008 crisis, the pullback from EMs has been driven primarily by internal factors, basically reflecting a sustained slowdown in EM growth and amplified by rising uncertainty about China’s economy and policies. We project only a moderate rebound of EM capital flows in 2016 as structural factors continue to weigh on EM growth prospects. Monetary policy divergence in mature markets could contribute to market volatility as the Fed starts to raise rates. The possibility of further RMB weakening is another potential source of risk. Countries most in jeopardy from EM turbulence include those with large current account deficits, questionable macro policy frameworks, large corporate FX liabilities, and acute political uncertainties. Brazil and Turkey combine these features. From a markets perspective, EM equity valuations have fallen to very low levels, but near-term downside risks are high enough to keep investors cautious, absent a clear catalyst for re-entry. Risks for EM corporate bond markets remain elevated, especially given substantial corporate foreign currency exposures as well as pressure on earnings. DEEPENING DROUGHT IN 2015 Capital flows to emerging markets have weakened markedly this year, after a substantial decline in 2014. We estimate that net non-resident inflows will reach only $548 billion in 2015 down from $1,074 billion last year, sinking below levels recorded in 2008/09. As a share of EM GDP, such inflows have fallen to about 2% Chart 1 As a share of EM GDP, capital inflows have fallen to about 2% from a record high of almost 8% in 2007 This report is the result of the collective efforts of the IIF Economics and Capital Markets staff. All contributors are listed on the back cover. Questions and data requests can be submitted to [email protected]. -1300 -1100 -900 -700 -500 -300 -100 100 300 500 700 900 1100 1300 1995 2000 2005 2010 2015 Non-Resident Capital Inflows Resident Capital Outflows Source: IIF. Net Capital Flows (Financial Account Balance) Capital Flows to Emerging Markets, Annual Data $ billion; resident capital outflows exclude reserves IIF Forecast Deepening Drought 1 Prospects for 2016 7 EM Equity Valuations 11 EM Corporate Debt 16 Concept of “EM” 20 Emerging Asia 23 Emerging Europe 25 Latin America 27 Middle East 29 Sub-Saharan Africa 30 Tables and Annex 31 Contributors 38 Table of Contents

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Page 1: Capital Flows to Emerging Markets - ValueWalk€¦ · Latin America Emerging Asia Total Portfolio Flows $ billion Source: National Sources, Bloomberg, IIF.-1.5 0.0 1.5 3.0 4.5 6.0

iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

OCTOBER 1, 2015

Capital Flows to Emerging Markets

Capital flows to emerging markets have weakened sharply in recent months. With non-resident inflows looking likely to fall below 2008 levels and rising resident outflows, we now expect that net capital flows to EMs in 2015 will be negative for the first time since 1988 (Chart 1).

Unlike the 2008 crisis, the pullback from EMs has been driven primarily by internal factors, basically reflecting a sustained slowdown in EM growth and amplified by rising uncertainty about China’s economy and policies.

We project only a moderate rebound of EM capital flows in 2016 as structural factors continue to weigh on EM growth prospects.

Monetary policy divergence in mature markets could contribute to market volatility as the Fed starts to raise rates. The possibility of further RMB weakening is another potential source of risk.

Countries most in jeopardy from EM turbulence include those with large current account deficits, questionable macro policy frameworks, large corporate FX liabilities, and acute political uncertainties. Brazil and Turkey combine these features.

From a markets perspective, EM equity valuations have fallen to very low levels, but near-term downside risks are high enough to keep investors cautious, absent a clear catalyst for re-entry. Risks for EM corporate bond markets remain elevated, especially given substantial corporate foreign currency exposures as well as pressure on earnings.

DEEPENING DROUGHT IN 2015

Capital flows to emerging markets have weakened markedly this year, after a substantial decline in 2014. We estimate that net non-resident inflows will reach only $548 billion in 2015 down from $1,074 billion last year, sinking below levels recorded in 2008/09. As a share of EM GDP, such inflows have fallen to about 2%

Chart 1

As a share of EM

GDP, capital

inflows have fallen

to about 2% from

a record high of

almost 8% in 2007

This report is the result of the collective efforts of the IIF Economics and Capital Markets staff. All contributors are listed on the back cover. Questions and data requests can be submitted to [email protected].

-1300-1100-900-700-500-300-100100300500700900

11001300

1995 2000 2005 2010 2015

Non-Resident Capital InflowsResident Capital Outflows

Source: IIF.

Net Capital Flows (Financial Account Balance)

Capital Flows to Emerging Markets, Annual Data$ billion; resident capital outflows exclude reserves

IIF Forecast

Deepening Drought 1 Prospects for 2016 7 EM Equity Valuations 11 EM Corporate Debt 16 Concept of “EM” 20 Emerging Asia 23 Emerging Europe 25 Latin America 27 Middle East 29 Sub-Saharan Africa 30 Tables and Annex 31 Contributors 38

Table of Contents

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page 2 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

from a record high of almost 8% in 2007. Moreover, resident outward investment flows have also accelerated amid the recent turbulence in global financial markets, putting further downward pressure on EM reserves, exchange rates and asset prices (see our September 2015 Global Economic Monitor and Capital Markets Monitor). Taken together, we expect net capital flows1 for our group of 30 EM economies to be negative—on a calendar year basis—for the first time in since 1988, with net outflows projected at $540 billion (Table 1).

On the face of it, the sharp decline in nonresident capital inflows is reminiscent of the 2008/09 financial crisis. However, the underlying factors leading to the pullback are fundamentally different. This year’s decline has been driven by a sustained slowdown in EM growth, and in particular by uncertainty about China’s economy amid continuing concerns about the impact of the Fed’s eventual turn to raise U.S. interest rates. By contrast, back then the collapse in capital flows reflected a sudden financial crisis and deep recession in mature economies that spilled over rapidly to emerging markets. The 2008/09 crisis triggered a broad-based “sudden stop” event after years of strong capital inflows, expressed in a massive reversal of banking and portfolio flows. By contrast, this year’s slowdown represents a marked intensification of trends that have been underway since 2012, making the current episode feel more like a lengthening drought rather than a crisis event (Chart 2).

While all regions have experienced weaker inflows, it is noteworthy that a large part of the decline in overall flows this year is attributable to flows out of China (Chart 4), which intensified after the PBOC announced a mini-devaluation of the RMB and a shift to a more market-oriented exchange rate fixing regime in August.

Chart 2

Capital outflows in

2015 feel more

like a lengthening

drought than a

classic sudden

stop

1 Net capital flows as measured by the financial account balance of the balance of payments, i.e. ex-cluding official reserve accumulation.

-150-100-50

050

100150200250300350400450

2012Q1 2013Q1 2014Q1 2015Q1 2016Q1

Inward - OtherInward Portfolio DebtInward Portfolio EquityInward FDI

IIF EM 30: Non-Resident Capital Inflows by Component$ billion

IIF Forecast

Source: National Sources, IMF, IIF.

Page 3: Capital Flows to Emerging Markets - ValueWalk€¦ · Latin America Emerging Asia Total Portfolio Flows $ billion Source: National Sources, Bloomberg, IIF.-1.5 0.0 1.5 3.0 4.5 6.0

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page 3 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

On a component basis, portfolio flows account for a significant portion of the recent drop in EM capital flows. Portfolio equity and debt flows saw a sharp reversal over the summer in the context of a precipitous EM stock market selloff (Chart 3). We estimate that outflows of portfolio capital in 2015Q3 amounted to $40 billion, the worst quarter since 2008Q4 at the height of the global financial crisis (Charts 4 to 6, see also our September 2015 Portfolio Flows Tracker and Flows Alert). But even before this recent turbulence, portfolio flows had been on a downward trend for several months. In light of these developments, we have slashed our projections for 2015 portfolio flows to $26 billion for equity flows (from $144 billion projected in May) and $109 billion for debt flows (from $193 billion).

However, the component that has been most affected by recent market volatility is bank lending. Our latest projections look for commercial banks to reduce cross-border exposure to EMs by $134 billion on net in 2015, led by repayments of dollar-denominated loans by Chinese corporates after years of heavy offshore borrowing. In addition, Russia is projected to see a further reduction in foreign bank credit to the tune of $22 billion this year, after years of heavier retrenchment. Meanwhile, after being resilient since the crisis, FDI inflows are also showing signs of a modest decline, and are projected to dip to $535 billion this year from $586

Table 1 Emerging Market Economies: Capital Flows $ billion 2013 2014 2015 Est. 2016 Proj. Non-Resident Capital Inflows 1305 1074 548 776

Private Inflows 1273 1032 484 727

Equity Investment 663 683 561 599

Direct Investment 579 586 535 503

Portfolio Investment 84 98 26 96

Private Creditors 610 349 -77 129

Commercial Banks 173 164 -134 17

Nonbanks 437 185 57 112

Official Inflows 33 42 65 48

International Financial Institutions -3 13 28 24

Bilateral Creditors 36 29 37 24

Resident Capital Outflows -1527 -1164 -748 -1013

Private Outflows -986 -1043 -1089 -1082

Equity Investment Abroad -421 -403 -409 -434

Resident Lending/Other -566 -640 -680 -648

Reserves (- = Increase) -541 -121 341 68

-222 -89 -199 -238

Memo: Net Errors and Omissions -9 -137 0 0

Current Account Balance 231 226 199 238

Source: IIF. See page 37 for guidance on how to interpret these data.

Net Capital Flows incl. Reserves Net Capital Flows excl. Reserves (Financial Account Balance) 319 32 -540 -306

4

6

8

10

12

14

6

8

10

12

14

16

18

2007 2013

EM vs. Mature Equitiesindex (in 100), both scales

EM

Mature

Source: MSCI, Bloomberg, IIF.

Chart 3

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page 4 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

billion in 2014, in part reflecting cutbacks in spending on commodity-related infrastructure projects in the wake of steep commodity price declines.

The factors that are driving inflows lower this year are not new, but rather reflect an intensification of recent trends. Both pull and push factors have had an adverse effect on EM capital flows. On the pull side, weaker growth in emerging economies has rendered their asset markets a less attractive investment destination. Over the past few years, EM growth has declined, both in absolute terms and relative to growth in mature economies, but that trend has intensified this year with the China slowdown and the downturn in the commodity price cycle deepening (Chart 7).

On the push side, concern about spillover effects from Fed liftoff has contributed to uncertainty and market volatility as U.S. labor markets tighten progressively, notwithstanding continued dovish messages from the Fed that policy rate increases would be gradual and data dependent. These messages have

Chart 4 Chart 5

Chart 7 Chart 6

-25

-15

-5

5

15

25

35

45

55

Sep 13 Jan 14 May 14 Sep 14 Jan 15 May 15 Sep 15

Africa & Middle EastEmerging EuropeLatin AmericaEmerging Asia

Total Portfolio Flows$ billion

Source: National Sources, Bloomberg, IIF.

-1.5

0.0

1.5

3.0

4.5

6.0

7.5

9.0

10.5

-300

0

300

600

900

1200

1500

2005 2010 2015

China EM Asia ex. ChinaMENA Latin AmericaEM Europe

Total, Percent of EM GDP

IIF Forecast

Non-Resident Capital Inflows to Emerging Markets$ billion percent

Source: IIF.

-125-100-75-50-25

0255075

100125150

2008 2009 2010 2011 2012 2013 2014 2015

Debt Equity

Source: IIF.

Official QuarterlyBalance of Payments Data Through Q4 2014

Equity and Debt Non-Resident Portfolio Flows to EMs$ billion

Monthly Tracker (Quarterly Aggregate, Q3 = Preliminary Estimate)

100

150

200

250

300

3.0

3.5

4.0

4.5

5.0

12Q4 13Q4 14Q4 15Q4f 16Q4f

EM GDP Growth 4-Quarter MA

Total Capital Inflows 4-Quarter MA

IIF Forecast

Source: National Sources, IMF, IIF.

EM GDP Growth and EM Non-Resident Capital Inflowspercent, q/q, saar $ billion

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page 5 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

-55

-40

-25

-10

Bra

zil

Ukra

ine

Turk

ey

Col

omb

ia

Ma

lays

ia

S. A

frica

Indo

Chi

le

Mex

ico

Arg

entin

a

Tha

iland

Kore

a

Egyp

t

YTD Change in Spot FX Rates vis-à-vis the USDpercent

Source: Bloomberg, IIF.

contributed to repeated downward revisions in market expectations of the Fed’s policy trajectory (Chart 8). At the same time, the ECB’s launch of full-scale quantitative easing has provided some offset, particularly for EM Europe borrowers with established access to euro funding.

Turbulence From China

These fundamental factors weighing against capital flows to emerging markets were exacerbated by a sharp increase in risk aversion in financial markets over the summer months (Chart 9). Unlike the 2013 “taper tantrum” that was triggered by a shift in perceptions about the Fed’s policy trajectory, this episode originated in the announcement by the PBOC that it would shift to a more market-oriented approach to setting the exchange rate, along with a 2% devaluation of the RMB/$ exchange rate fix. This unexpected policy shift followed months of weakening Chinese activity data and a stock market crash, all of which raised serious question marks about China’s growth path and policy reactions. As well as prompting an intensification of capital outflows from China itself—particularly by corporates overexposed to dollar liabilities—EMs suffered more broadly, particularly China’s closest trading partners and commodity producers reliant on Chinese demand.

For some countries at least, recent movements in asset prices are approaching crisis dimensions. For example, EM exchange rates have dropped sharply—and total currency depreciation since the start of the year for countries including Brazil, Ukraine, Turkey, and Colombia now exceed the 25% threshold commonly used to identify an external crisis (Chart 10).1 These movements have raised concerns about stress levels for corporates with heavy FX exposure. However, in general EMs look more resilient to a classic capital account crisis given flexible exchange rates, higher reserve levels, and improved public sector balance sheets.

Chart 9

Chart 10 Chart 11

0.50

0.75

1.00

1.25

1.50

1.75

2.00

Jan 14 Nov 14 Sep 15

Dec 2016 Fed Funds Futurespercent per annum

Source: Bloomberg, IIF.

Chart 8

1 Frankel, Jeffrey A. and Andrew K. Rose. 1996. “Currency Crashes in Emerging Markets: An Empirical Treat-ment," Journal of International Economics, November 1996, 41 (3-4), 351-366.

0.4

0.5

0.6

0.7

0.8

0.9

2008 2009 2010 2011 2012 2013 2014 2015

Pre-2008Crisis Average

Post-2008Crisis Average

Source: Bloomberg, IIF.

Correlation across EM Sovereign Bond Spreadsaverage 30-day rolling correlation between percentage change in EMBIG EM spreads and country-specific spreads for 17 EMs

50

250

450

650

850

0102030405060708090

2006 2010 2014

Market Volatilityindex basis points

Source: Bloomberg, IIF.

VIX

BBB Spread

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During recent months, correlations across EM bond markets increased sharply (Chart 11), suggesting a low degree of investor differentiation as is typical during surges in risk aversion. Taking a somewhat longer perspective, however, signs of investor discrimination become more visible. For example, in the bond market the increase in individual countries’ EMBIG spreads over the past four months shows a high correlation with EM vulnerability as measured by our September 2015 Heat Map (Chart 12). Investors have focused in particular on countries’ external vulnerabilities as well as domestic leverage (not least reflecting concerns about high corporate indebtedness, see page 16) and political strains in several countries.

Rising Resident Outflows, Falling Reserves

Adding to the gloom, lower nonresident inflows to EMs have been coupled with sharply rising outflows by residents. We project “private” outflows (i.e. excluding reserves) to increase to $1,089 bn this year, a historical high. The rise in outflows is mainly in the form of portfolio equity and, in particular, resident lending, notably out of China. On a net basis, lower inflows and rising outflows imply that private capital is leaving EMs for the first time since the early 1980s.

Negative net capital flows have been coupled with a sharp swing in EM reserves. After having accumulated reserves to the tune of $500 bn per year on average over the last five years, we project that 2015 will see a decline in the aggregate EM reserve position by $342 bn. The swing reflects the fact that many countries are selling reserves to support depreciating currencies in the face of rising private capital outflows. The shift is particularly large in China, after years of heavy reserve accumulation (Chart 13). The MENA countries have also begun to sell FX reserves as current account positions are turning into deficit amidst lower oil prices (Chart 14; see page 29).

-400

-200

0

200

400

600

800

1,000

1,200

1,400

2000 2002 2004 2006 2008 2010 2012 2014 2016

EM EuropeLatin AmericaMiddle East/AfricaEM Asia excl. ChinaChina

EM FX Reserve Accumulation by Region$ billion

Source: IIF.

IIF Forecast

EM

Resident capital outflows have also risen sharply

0255075

100125150175200225250275

0.3 0.4 0.5 0.6 0.7

avg. of domestic, external, policy vulnerability indices in April*

IIF Heat Map Vulnerability Measures vs. EMBIG Spreadschange in EMBIG spreads since mid-May 2015

IDZA

COMY

PE

TR

HUROIN

RU

CL

MX

PH PL

CN

BR

*A higher value implies higher vulnerability. Source: IIF, Bloomberg.

Chart 12 Chart 13

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page 7 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

Chart 15

PROSPECTS FOR 2016—ONLY A SLOW TURNAROUND

Looking ahead, an important implication of our analysis is that flows are unlikely to rebound swiftly, as they did in 2010. Instead, the recent drought is likely to be protracted as EM growth remains well below trend and monetary policy divergences remain a concern. In sum, we expect only a moderate recovery in flows next year, with risk remaining on the downside.

End of an EM Growth Supercycle

Emerging market growth performance has deteriorated markedly over the past five years, reflecting a weakening of fundamental drivers as well as cyclical factors. In our September 2015 Global Economic Monitor, we projected EM growth to reach only 3.5% this year—less than half of that of 2010, and the lowest since the 2008/09 financial crisis—with only a modest revival to 4.2 % in 2016, a rate still well below the average of the past ten years—notwithstanding solid growth momentum in the mature economies (Charts 15 and 16). As a result, we have marked down our forecasts for EM growth significantly relative to our May 2015 Capital Flows Report, by almost 0.5pp this year and 1pp for 2016 (Chart 17).

As discussed in the September GEM, a number of structural developments are now weighing on EM growth performance, implying a likely end to the “EM growth supercycle” that we have witnessed over the past twenty years or so. At the core of the problem are diminishing returns from an export oriented growth model, in which reduction of trade barriers and introduction of new technologies allowed rapid growth through integration of EMs labor forces in global manufacturing supply chains. The rising importance of the less easily tradable services sector in the mature economies has further dampened world trade and EM export opportunities, while the onset of population aging in many EMs implies less favorable demographics.

Chart 14

-400

0

400

800

1,200

1,600

2,000

2000 2002 2004 2006 2008 2010 2012 2014 2016

Resident LendingEquity Investment AbroadReserve Accumulation

EM Resident Capital Outflows Composition$ billion

Source: IIF.

The recent

drought in capital

flows is likely to

be protracted

EM growth

supercycle—

coming to an end?

0

2

4

6

8

2000 2002 2004 2006 2008 2010 2012 2014 2016

GDP Growth: Emerging Marketspercent y/y

Source: IIF.

2004-2014Average

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page 8 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

China has been notably affected by this shifting dynamic. Chinese growth has slowed markedly since 2011, and while policy makers have developed an ambitious agenda to transform their economy, they have struggled to advance reforms while also meeting growth targets. Fears of a rapid slowdown or even a hard landing have been exacerbated by the volatile correction in the stock market over the summer, weakening growth indicators and the surprise “mini-devaluation” of the currency in mid-August. The government increasingly faces a policy trilemma—as it tries to stabilize its exchange rate and ease monetary policy with an increasingly open capital account—and this has raised concerns about how tensions will be resolved (see our September 2015 Update from Beijing).

The many emerging market commodity exporters have also faced particular strains as their exports have been damaged by sharp price corrections as global demand prospects have been scaled back. Commodity prices remain at very low levels and, importantly, there is a growing sense that oversupply is likely to keep prices low for the foreseeable future. Many countries will need to go through difficult adjustments, to rein in fiscal accounts and to foster more diversified economies. The sharp downward revision of our projections for Latin America is a case in point.

Living With Monetary Policy Divergence

In recent years, monetary policy divergence across the major advanced economies has been a key driver of movements in mature market exchange and interest rates. Next year is likely to see increasing divergence as the Fed and BOE raise policy rates, while the ECB and BOJ are likely to extend their QE programs to ensure that inflation rises towards their targets. Against this background, in 2016 we expect to see continued market volatility and cautious investor appetite for EM assets, which could be further exacerbated by uncertainty about China’s exchange rate management.

Chart 16 Chart 17

0

1

2

3

4

5

6

2000 2002 2004 2006 2008 2010 2012 2014 2016f

Growth differential: Emerging Markets - Mature Economiespercentage points

Source: IIF.

IIF Forecast

Weak commodity

prices will require

more countries to

go through

difficult

adjustments

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

2015 2016

Forecast Revisions to GDP Growth Relative to May CFRpercentage points

Source: IIF.

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page 9 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

Specifically for the Fed, our baseline is for the first rate hike to occur in December this year, followed by a gradual path of subsequent rate increases that should bring the federal funds rate to around 1%-1.25% by the end of next year (Chart 18). In the initial stages, we expect a moderate negative impact from the Fed’s rate increases on EM capital flows, notably portfolio flows. However, once the initial two rate hikes are out of the way, the adverse impact from Fed tightening should moderate as uncertainty diminishes.

Our capital flows forecasts assume that the FOMC’s approach will continue to be very dovish. However, we remain concerned that as the U.S. cycle matures, inflation pressures may start to build and a more rapid pace of rate increases will be called for. An abrupt upward adjustment in the market’s expectation of the Fed’s trajectory could lead to sharp movements in rates that could be very disruptive for emerging markets and would likely spark a further retrenchment of portfolio investment.

Gradual Recovery But Risks Continue to Loom

Based on this analysis of the global environment as well as our country-by-country assessments, we project a moderate recovery of capital flows to emerging markets in 2016. Total net capital flows would remain negative at $306 billion for the year, while non-resident inflows would pick up to around $776 billion. These figures represent a substantial reduction relative to our May CFR, but is noteworthy that net non-resident inflows would remain positive and thus a source of EM external financing even in these volatile times.

The modest uptick in private inflows for 2016 is visible across all regions, in line with our projection of a slight rebound in EM growth. Banking flows as well as both portfolio equity and debt are envisaged to benefit, while FDI inflows may see a

Chart 18

2015 2016 2017 2018-1

0

1

2

3

4

5

6 FOMC Dot Plot as of 9/2015IIF Forecast

Latest FOMC Dot Plot, Market Expectations, IIF Forecastpercent

Source: U.S. Federal Reserve, Bloomberg, IIF.

Path of 2004 Hiking Cycle

Market Exp. as of 9/29/2015

Our capital flows

forecasts assume a

dovish Fed

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page 10 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

further small decline, not least because commodity prices are likely to remain at low levels.

Despite substantial downward revisions to our baseline projections, downside risks remain a concern. As flagged above, a steeper path for rate hikes by the Fed than assumed under our baseline scenario continues to be a tangible risk, as an abrupt adjustment in market expectations could lead to a spike in rates and a surge in risk aversion that would have a sizeable negative impact for the more volatile portfolio flows in particular (see May 2015 Capital Flows Report). This risk has arguably increased after the September Fed meeting, which not only delayed liftoff but also lowered the expected path of future rate hikes by FOMC members. It will thus be important to continue closely monitoring U.S. data for signs of labor market tightening and incipient wage and price pressures.

Countries that would be particularly affected by a sharp jump in rates and accompanying volatility and risk aversion include those with sizeable current account deficits, questionable macroeconomic policy frameworks, large corporate open FX positions, and political uncertainties that could hinder a forceful policy response to rising stress (see our September 2015 Heat Map). Brazil and Turkey are two countries that combine these features.

An alternative scenario, discussed in our May CFR, is that inflation remains muted but in the context of sluggish U.S. demand growth and more in line with current market thinking. In this case, FOMC tightening could be on the slower trajectory now priced in by the market with only two rate hikes priced in before end 2016, but any positive effect from lower rates under such a scenario would be limited by the weaker growth momentum in the U.S. economy.

We also see more downside risks on the EM side. While we expect some overall rebound in EM growth next year, this forecast factors in continued mild further slowing in China and some stabilization in Brazil and Russia. Most worrying, rising concern about a more abrupt slowdown in China or more rapid RMB depreciation would have repercussions for prospects across EMs. Our baseline projections assume that Chinese policymakers are successful in stabilizing expectations about the RMB and can dial back their market intervention accordingly. However, continuing disappointing growth performance in China could lead to rising expectations of a policy shift towards allowing the RMB to depreciate against the dollar. Such a course would have a particularly dampening impact on East Asian trading partners and commodity exporters, particularly if accompanied by another spike in risk aversion as occurred in August this year.

Despite

substantial

downward

revisions to our

baseline

projections,

downside risks

remain a concern

Continuing

disappointing

growth

performance in

China could lead

to rising

expectations of a

policy shift

towards allowing

the RMB to

depreciate against

the dollar

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page 11 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1995 2000 2005 2010 2015

Emerging Markets: Price-to-Book Ratioratio, MXEF index

2005/15 YTD Avg.

Source: Bloomberg, IIF.

Asian Crisis

1995-15 YTD Avg.

Gulf War9/11 2008 Crisis ?

6

7

8

9

10

11

12

13

14

10

12

14

16

18

20

22

2008 2009 2010 2011 2012 2013 2014 2015

Emerging Markets: Fund Portfolio Weights, by Asset Class% of global bond/equity allocations, dashed line: 08-15ytd avg.

Source: EPFR, IIF estimates; includes mutual funds and ETFs.

Bonds

Equities

EM equities are at very low valuation levels...

EMERGING MARKET EQUITY VALUATIONS: CHEAP ENOUGH FOR RE-ENTRY?

The decline in global investors’ appetite for emerging market stocks over the past several years has been quite striking. Indeed, trends in mutual fund and ETF investors’ portfolio allocations suggest that EM stocks today account for just 12% of global investors’ portfolios, more than 8 percentage points lower than in 2010 (Chart 19). Weakening trend growth, disappointing corporate earnings, higher corporate debt levels (see below), falling commodity prices, emerging geopolitical risks and in many cases domestic political tensions have all reduced the appeal of EM equities. This lack of investor appetite has of course also been reflected in lower stock market valuations. A range of valuation metrics suggest that many EM equity markets have become cheaper still in 2015, and are increasingly undervalued compared to 10-year averages.

Price-to-book ratio: The benchmark MSCI EM equity index was trading on a price-to-book ratio of around 1.3x as of mid-September under half of its peak value in 2008 and close to the levels seen during previous stress episodes—though still well above levels seen during the 1997/98 Asian crisis (Chart 20). Perhaps the most striking feature of recent years has been the dramatic de-rating of EM equities relative to their mature market peers (Chart 21). Although price-to-book ratios are typically not seen as a reliable predictor of short-term future returns, lower price-to-book ratios have generally been followed by high nominal returns over a longer-term horizon as suggested by the negative correlation between price-to-book ratios and cumulative returns over the subsequent 5-years (Chart 22).

Trailing and forward price/earning ratios: The trailing 12-month price/earnings ratio of the MSCI EM index is also below its long-term average. However, this metric should be interpreted with caution as indicator of valuation, as higher readings could reflect lower earnings, rather than higher stock prices and vice versa. For instance, the P/E ratio of the MSCI EM index hit record highs during previous EM stress episodes when the decline in earnings was much larger than the decline in equity prices (Chart 23).

Another commonly used metric that reduces this problem somewhat is the forward P/E

Chart 19 Chart 20

...but investors have become increasingly doubtful about earnings growth potential

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page 12 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

-40-30-20-10

0102030405060

2005 2010 2015

EM Forward Earnings Growthpercent, y/y, MSCI index, 12m forward

Source: Bloomberg, IIF.

0

5

10

15

20

25

30

35

40

1995 2000 2005 2010 2015

Emerging Markets: Price/Earnings Ratioratio, MXEF index

95-15 Avg.

-1.5 Std. Dev.

+1.5 Std. Dev.

The sharp rise in P/E ratio during the stress episodes reflects the marked decline in earnings.

Source: Bloomberg, IIF.

-75

-25

25

75

125

175

225

275

0.8 1.2 1.6 2.0 2.4 2.8 3.2

Price to Book Ratio and Cumulative Stock Market Returnsx-axis: price-to-book ratio of MXEF index y-axis: cum. noninal returns on MXEF index over the next 5yrs

Source: Bloomberg, IIF. Based on monthly return data betwen Jan. 2001 and Aug. 2015 .

Low levels of P/B ratio have generally been followed by high nominal returns of the MXEF index over the next five years.

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1995 2000 2005 2010 2015

EM vs MM: Relative Price-to-Book Ratiorelative ratio

EM Relatively More Expensive than MM

1995-2015 Average

2005-2015 YTD Avg.

Source: Bloomberg, IIF.

ratio, based on projections of next year’s earnings. This ratio stands very close to its long–term average—though it has fallen since early summer. Interpretation of this ratio also requires a careful analysis of price and earnings dynamics. The recent decline in the forward P/E ratio has been mainly driven by the drop in stock prices, with a more modest decline in estimated 12-month forward earnings partly offsetting the sharper decline in prices in the numerator. The drop in P/E ratios has been much more modest than the decline in stock prices, implying that adjustment of prices has broadly kept pace with the downgrades to earnings forecasts.

Both variations on the P/E ratio point to growing doubt about EM firms’ earnings capacity in the current environment. In particular, EM earnings growth forecasts have fallen very sharply over the past year (Chart 24), to levels last seen in 2009. Moreover, the EM valuation discount to mature markets is the largest since 2006 (Chart 25), effectively erasing the “re-rating’ that had left them trading roughly in line with mature markets between 2007-2011.

Chart 23 Chart 24

Chart 21 Chart 22

The EM valuation discount to mature markets is the largest since 2006

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page 13 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

-100-80-60-40-20

020406080

100

8 10 12 14 16 18 20 22 24 26 28 30

CAPE Ratio and Cumulative Stock Market Returns x-axis: cyclically adjusted P/E ratio of MXEF index y-axis: cum. real returns on MXEF index over the next 5 years

Low levels of CAPE ratio have generally been followed by high real returns of the MXEF index over the next five years.

Source: Bloomberg, IIF. Based on monthly return data betwen Jan. 2005 and Aug. 2015.

81012141618202224262830

2005 2007 2009 2011 2013 2015

CAPE: Cyclically Adjusted P/E Ratio (Shiller P/E Ratio)ratio, dashed lines show 2005-2015ytd average

Mature Markets

Emerging Markets

Source: Bloomberg, IIF.

0

5

10

15

20

25

30

35

40

2005 2007 2009 2011 2013 2015

Cyclically Adjusted P/E Ratio, by Regionratio

Source: Bloomberg, IIF.

EM Asia

EM Europe

LatAm

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

2005 2010 2015Source: Bloomberg, IIF.

EM vs MM: Relative Forward Price-Earnings Ratiorelative ratio, MXEF vs MXWO index

2005-2015 Average

EM Relatively More Expensive than MM

Cyclically-adjusted price/earning ratio (CAPE): Our newly developed CAPE measure, the ratio of current stock prices to average inflation-adjusted earnings over the previous ten years, highlights that cyclically-adjusted valuations have been steadily declining since early 2011.1 In August 2015, EM CAPE ratios hit their lowest level on record (Chart 26). Although time series data are limited, lower CAPE ratios also appear to be associated with higher returns over subsequent 5-year term (Chart 27). However, CAPE ratios (which aim to smooth over the business cycle) reveal greater differentiation across countries and sectors than do price/book ratios:

Although CAPE valuations are below their historical averages in all emerging market regions, EM Asian stocks have sustained valuations better than other EM regions (Chart 28). This is particularly noticeable relative to Latin American equities, where CAPE valuations had been very similar to EM Asian markets prior to 2013. That said, the decline in real valuations during the summer of 2015 was more

Chart 25 Chart 26

Chart 27 Chart 28

1 Following the same methodology proposed by Campbell and Shiller (2001), we compute the EM CAPE as a ratio of inflation-adjusted stock prices

stocks to the average of inflation-adjusted earnings over the last ten years.

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page 14 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

0

5

10

15

20

25

30

352005-15 Avg.

Latest

Cyclically Adjusted P/E Ratio, by Sectorratio

Source: Bloomberg, IIF.

0

5

10

15

20

25

30

35

Philip

pine

sIn

dia

S. A

frica

Indo

nesia

Ma

lays

iaTh

aila

ndM

exic

oM

oroc

coC

hile

Chi

naKo

rea

Pola

ndC

olom

bia

Peru

Cze

ch R

ep.

Turk

eyH

unga

ryA

rgen

tina

Bra

zilRu

ssia

2005-15 Avg.

Latest

Cyclically Adjusted P/E Ratio, by Countryratio

Source: Bloomberg, IIF.

pronounced in EM Asia, largely driven by the Chinese equity market correction, which brought China’s CAPE ratio from 16.2x to 11.5x.

Across the countries in our sample, the Philippines is the only country where the stocks are more richly valued by the CAPE metric relative to their own historical average (albeit only modestly), and relative to other emerging markets (Chart 29). The CAPE ratio remains close to its historical average in South Africa and Turkey, while for most other countries in our sample, valuations have fallen far below 10-year averages. Notably, the deviation from long-term averages is particularly pronounced in commodity exporting countries, such as Colombia, Chile, and Brazil--reflecting the particular concerns about prospects for earnings and profit margins for their exporters.

On a sectoral basis, valuations are also well below historical averages across all sectors (Chart 30), with the most marked gaps in materials (65% below their long-term average), energy (60%) and financials (50%).

Although on these and other similar metrics, EM equity market valuations are at low levels relative to past values, one key question is whether these valuations are likely to decline further still over the short to medium term. Although investors will focus on firm-specific factors (default history, currency composition of revenues, global exposure of firms, etc.) when deciding on desired exposure to emerging markets, the key drivers will include prospects for better earnings growth performance and for changes in risk evaluation.

Growth expectations: Disappointing corporate earnings have been a striking feature of emerging markets over the past four years, suggesting that this year’s decline in prices broadly brought them back in line with the underlying loss of earnings momentum. Relative to mature markets, where valuations rose sharply between 2012-2015, emerging market P/E ratios had not seen the same runup—meaning less need for a correction in valuations. Thus, a positive change in the outlook for corporate earnings—whether

Chart 29 Chart 30

One key question is whether EM equity valuations are likely to decline further still over the short to medium term

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page 15 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

-0.6-0.4 -0.2 0 0.2 0.4 0.6 0.8 1

FC debt/EBITDAGross debt/EBITDA

LC debt/EBITDAUSD, REER, %q/qNet debt/EBITDA

Consumer prices, %y/yReal interest rates

P/E ratioIndustrial production, %q/q

EBITDA, %q/qProfit Margin

Nominal interest ratesROEROCROA

Price-to-Book

Statistically Significant at 0.01 LevelStatistically Significant at 0.1 LevelStatistically Insignificant

Correlation Between EM CAPE and Selected Variablesratio

Source: Bloomberg, IIF.

through better export prospects on the back of stronger demand from China or mature markets, some recovery in commodity prices, or positive structural change—will be needed to prompt improvement in valuations.

Relative valuation as U.S. rates normalize: As low rates boost the present value of expected cash flows and thus the price of underlying assets, ultra-low global rates have been supportive for stock prices and thus valuations since 2008. However, as the relevant risk-free discount rate (say U.S. 10yr bond yields) for global equities rises, it will weigh against valuations across the board. Moreover, currency weakness has already prompted many central banks in emerging markets to raise policy rates (Chart 31), particularly in Latin America and to a lesser extent in Emerging Europe—another headwind to EM equity prices. That said, while rising U.S. rates will of course have an impact across asset classes, EM equity valuations are sufficiently low relative to alternative assets (e.g., mature markets or HY bonds) that there may be less downside.

Emerging risks and uncertainties: Dollar strength and rising risk premia are likely to constrain the upside for EM valuations in the near term:

As U.S. dollar appreciation is typically associated with lower cyclically-adjusted EM valuations, the prospect of weaker EM currencies in the context of rising U.S. interest rates could prompt further downward pressure (Chart 32).

Given the sharp buildup in EM corporate indebtedness in recent years, both in local currency and foreign currency, investors could demand higher risk premiums (see page 16). As still-higher risk premia would also feed through into higher risk-adjusted discount rates, this would be another headwind to the present value of future cash flows, weighing on equity prices and valuations.

In sum, EM equity valuations are at low levels compared to past values, but near-term downside risks are high enough to keep investors cautious about re-entry.

Chart 32

3456789

10111213

2007 2011 2015

EM Policy Ratespercent

Source: Bloomberg, IIF.

EM Asia

LatAm

EM Europe

Chart 31

A positive change in the outlook for corporate earnings will be needed to prompt improvement in valuations

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page 16 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

0

20

40

60

80

100

120

140

1995 1999 2003 2007 2011 2015

Emerging Markets: Non-Financial Corporate Debtpercent of GDP

Source: BIS, IIF.

LatAmMENA

EM Asia

EM Europe

10

20

30

40

50

60

70

80

90

1995 2000 2005 2010 2015

Emerging Markets: Non-Financial Sector Debtpercent of GDP

Source: BIS, IIF.

Government

Non-Fin Corporates

Households

0102030405060708090

100

2005 2010 2015

BondsCross-border loansDomestic credit

Type of Creditpercent of total

Source: BIS, IIF.

NON-FINANCIAL CORPORATE DEBT IN EMERGING MARKETS: RISING STRAINS

Since our May CFR report, we have enhanced our EM non-financial corporate debt database by adding more countries with longer historical data series. Our new database comprises 18 emerging market economies and tracks the debt figures on a quarterly basis starting from 1995Q1. Increasing concerns about FX-denominated debt have also prompted us to dig more deeply into the currency breakdown of corporate debt figures, mainly based on national sources on domestic bank lending and the BIS’s newly extended series on debt securities and cross-border bank lending. This special section describes our new EM non-financial corporate database.

Non-financial corporate indebtedness has increased more than five-fold over the past decade, surpassing $23.7 trillion (nearly 90% of GDP) in early 2015 (Chart 33).1

The debt buildup has been particularly pronounced since the 2008/9 crisis as many emerging market corporates took advantage of monetary policy easing and ultra-low interest rates to raise debt in both local and foreign currency.

Almost all of the countries in our sample have seen an increase in debt-to-GDP ratios, but the increase has been mostly concentrated in emerging Asia, with the debt-to-GDP ratio increasing to 125% in 2015Q1 from around 100% in 2010Q4 (Chart 34).

The development of EM corporate bond markets and greater accessibility of bond market financing has contributed to the buildup in debt. Indeed, the share of bond market financing in total corporate funding has risen from below 10% a decade ago to 16% in 2015Q1 (Chart 35).

1 Our sample includes Argentina, Brazil, China, Czech Republic, Hong Kong, Hungary, India, Indonesia,

Korea, Malaysia, Mexico, Poland, Russia, Saudi Arabia, Singapore, South Africa, Thailand, and Turkey.

Chart 35

Chart 33 Chart 34

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page 17 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

-1012345678

Bra

zilTu

rkey

Sing

apo

reM

ala

ysia EM

Mex

ico

S. A

frica

Indo

nesia

Tha

iland

Russ

iaS.

Kor

eaH

unga

ryIn

dia

Arg

entin

aC

hina

Cze

ch R

ep.

Pola

ndS.

Ara

bia

Hon

g Ko

ng

EM Non-Financial Corporate Debt and the U.S. Dollar percentage point change in debt-to-GDP ratio reflecting bilateral exchange rate movements since end -2014

Source: BIS, IIF.

2 Based on an annual firm-level data on about 600 non-financial corporates listed in MSCI EM index from 18 emerging market countries.

Corporate sectors in Hong Kong, Singapore, China, Turkey and Brazil have recorded the largest increases (Chart 36). Hungary is the only country in our sample witnessing a decline in its corporate-debt-to-GDP ratio during this time period.

While the currency breakdown of debt differs significantly across countries, the rise in foreign currency-denominated debt has been marked in the aftermath of the global financial crisis. Foreign currency-denominated debt rose from 12% of GDP in 2008 to 16% of GDP in 2015Q1, and now accounts for close to 18% of all non-financial corporate debt in emerging markets. Of note, the bulk of the rise in foreign currency-denominated debt was attributable to USD debt--which has reached 12% of GDP (or $3.3 trillion) in 2015, up from 8% in 2008 (Charts 37 and 38).

The sharp depreciation of EM currencies against the U.S. dollar so far this year has implied a considerable deterioration of corporate balance sheets with open FX positions. To give a sense of the magnitude, Chart 39 shows the gross increase in non-financial corporate debt relative to GDP due solely to bilateral exchange movements against the dollar this year (although this does not take into account that to some extent corporates may have hedged some of their exposure). The largest increases in USD debt relative to GDP include: Brazil (up 7.3 percentage points of GDP), Turkey (up 6.2pp), Singapore (up 4.1pp) and Malaysia (2.9pp).

Looking at the rise in corporate debt relative to earnings using firm-level data for large non-financial EM corporates confirms the substantial increase in total debt burdens in the aftermath of the 2008 crisis.2 In particular, for the firms in our sample, total debt has more than doubled close to $3 trillion while corporate earnings (EBITDA) have only increased by around 68% during the same time period (Chart 40).

Across the large EM corporates, firms in Hong Kong, Brazil, and China have recorded the largest increases in debt levels relative to earnings, while corporates

Chart 39

Foreign currency-denominated debt now accounts for close to 18% of all non-financial corporate debt in emerging markets

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page 18 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

0

1

2

3

4

5

6

7

Sept. 2015

2008

Non-Financial Corporates' Total Debt-to-EBITDA, by Sectorratio, total debt-to-EBITDA

Source: Bloomberg, IIF.

0

1

2

3

4

5

6

Chi

naBr

azil

Chi

leH

ong

Kong

Philip

pine

sTu

rkey

Col

omb

iaTh

aila

ndM

ala

ysia

Kore

aC

zech

Rep

.M

exic

oIn

dia

S. A

frica

Hun

gary

Pola

ndIn

done

siaRu

ssia

Sept. 2015

2008

Non-Financial Corporates' Total Debt-to-EBITDA, by Countryratio, total debt-to-EBITDA

Source: Bloomberg, IIF.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1.0

1.5

2.0

2.5

3.0

2008 2009 2010 2011 2012 2013 2014 2015

Foreign Currency Debt-to-EBITDALocal Currency Debt-to-EBITDAEBITDA (Trailing 12-months, rhs)Total Debt (rhs)

Total-Debt-to-EBITDAratio $ trillion

Source: Bloomberg, IIF.

0102030405060708090

100

Hon

g Ko

ngM

exic

oTu

rkey

Hun

gary

Sing

apo

reRu

ssia

Indo

nesia

Sout

h A

frica

Arg

entin

aBr

azil

Pola

ndC

zech

Ma

lays

iaSa

udi A

rabi

aTh

aila

nd EMIn

dia

Sout

h Ko

rea

Chi

na

Other EURO USD LC

Currency Breakdown of Non-Financial Corporate Debtpercent, Q1 2015

Source: BIS, IIF.

0 50 100 150 200 250

ArgentinaMexico

IndonesiaRussia

South AfricaSaudi Arabia

PolandBrazilIndia

ThailandTurkeyCzech

MalaysiaHungary

EMSouth Korea

SingaporeChina

Hong Kong

LC

USD

EURO

Other

Non-Financial Corporate Debt, Q1 2015percent of GDP

Source: BIS, IIF.

Chart 41

-15 0 15 30 45 60 75

Hong KongChina

SingaporeTurkey

BrazilIndonesia

ThailandPolandMexico

RussiaSouth Africa

CzechMalaysia

KoreaSaudi Arabia

IndiaArgentina

Hungary

Change in Non-financial Corporate Indebtednesspercentage point change in debt-to-GDP ratio since 2010

Source: BIS, IIF.

Chart 36

Chart 40 Chart 38

Chart 42

Chart 37

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page 19 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

in Hungary, Korea and Malaysia have seen a decline in their debt-to-EBITDA ratios (Chart 41).

Firm-level data also reveal that the buildup in debt has been most pronounced in the industrial, energy and materials sectors, while companies in the information technology sector have been able to manage their debt relatively well compared to other sectors (Chart 42).

Details on firm-level debt statistics indicate that Hong Kong’s consumer staples sector is the most indebted sector in our sample, with the debt-to-EBITDA ratio increasing from 2.2 in 2008 to 11.8 in September 2015 (Tables 2 and 3). By region, firms from Hong Kong, China and Chile dominate our Top 15 Debt Raisers list, while non-financial corporates from materials and industrials sectors take over 50% of the total slots in the Top 15 Debt Raisers list (Table 3).

Table 2 Top 15 Total Debt Raisers change in total debt-to-EBITDA ratio, in levels

Change Since 2008 1 Hong Kong Consumer Staples 9.6 2 Hong Kong Materials 8.4 3 Turkey Energy 8.3 4 South Korea Industrials 8.2 5 Thailand Consumer Staples 6.2 6 Brazil Energy 4.6 7 China Materials 4.2 8 China Energy 4.1 9 China Industrials 3.8 10 Hong Kong Industrials 3.5 11 Chile Industrials 2.8 12 Chile Telecommunication Services 2.8 13 India Utilities 2.6 14 Chile Materials 2.6 15 Brazil Materials 1.9 Source: Blloomberg, IIF.

Table 2 Top 15 Indebted Sectors, by Country total debt-to-EBITDA ratio As of Sept. 2015 1 Hong Kong Consumer Staples 11.8 2 Colombia Materials 11.4 3 South Korea Industrials 11.3 4 Hong Kong Materials 9.7 5 China Energy 9.7 6 Turkey Energy 8.7 7 Hong Kong Industrials 7.8 8 Thailand Consumer Staples 7.7 9 China Materials 6.8 10 China Industrials 6.7 11 Hong Kong Information Technology 6.2

12 Chile Industrials 5.7 13 China Utilities 5.5 14 Chile Consumer Discretionary 5.5 15 Brazil Energy 5.3 Source: Bloomberg, IIF.

The buildup in debt has been most pronounced in the industrial, energy and materials sectors

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page 20 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

IS THE CONCEPT OF “EMERGING MARKETS” STILL MEANINGFUL?

When the term was coined at the end of the 1980s, the group of countries referred to as “emerging markets” shared a number of distinctive characteristics that made it appealing, in particular for investors, to think of them as a single group that could be contrasted with developed markets (DMs). Some of these characteristics included having relatively low per capita income, strong growth prospects (and thus high expected returns), weaker institutions and governmance, less developed financial markets, and greater propensity to volatile performance.

Twenty-five years later, “emerging markets” is now used for a large array of countries that are vastly different in their economic, governance and financial market structures. This has led some observers to argue that these economies are too different to be usefully lumped into one bucket. Others argue that the countries thought of as emerging markets still have important characteristics in common, if only in contrast to the DM group.

One important commonality is that emerging markets have their own benchmarks for asset allocation, so that many investors perceive and treat EMs as an asset class in making investment decisions. Mutual funds and ETFs track the country weights of EM benchmark indices to a significant, but varying, extent, which means that EM portfolio flows and asset

Table 4 Indicators Used for EM-DM ranking higher value associated with mature economies, unless otherwise indicated Unit Source Comments Macroeconomic Indicators GDP per Capita USD Haver, IMF Average of PPP-based and market-based

exchange rates Growth percent change Haver, World

Bank Higher growth associated with EMs, lower growth with DMs

Headline Inflation percent change, y/y Haver, World Bank

Higher inflation associated with EMs, lower inflation with DMs

Non-FDI Inflows percent of GDP Haver, IIF, IMF Sum of portfolio and other invesment inflow as a share of GDP

Exports: Share of Mining/Fuel percent of total export WTO Higher share associated with EMs, lower share with DMs

Financial/Governance Indicators DM MSCI Correlation percent change Bloomberg Correlation of the country's MSCI index with the

MSCI World Fin. Market Development aggregated score World Economic

Forum Measures efficiency, trustworthiness and confidence of the financial system

Capital Account Openness index Chinn-Ito Index Based on restrictions on cross-border financial transactions reported in the IMF's AREAER database

Worldwide Governance Indicators

avg of 6 sub-indicators World Bank Six indicators: voice & accountability, political stability & absence of violence, government effectiveness, regulatory quality, rule of law, control of corruption

Institutions aggregated score World Economic Forum

Measures efficiency & transparency of public administration, business ethics, corporate governance

Ease of Doing Business rank World Bank Measures regulations directly affecting businesses

Source: IIF.

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page 21 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

0102030405060708090

100

IND

IDN

NG

AEC

UEG

YPH

LRU

SA

RG SAU

PER

CH

NV

ENC

OL

MYS

BRA

THA

UKR

CH

LZA

FRO

UM

AR

MEX TUR

KOR

BGR

HUN ES

PLB

NA

USPO

LUA

EPR

TG

BRC

AN

GRC US

AD

EU ITA CZE

FRA EA

SWE

JPN

CH

EIR

L

2010-2014 Ranking by Macro Indicatorsaverage of percentile

Source: IIF.

EMDMEuro Area Periphery Countries

0102030405060708090

100

VEN

ECU

UKR

NG

AA

RG LBN

EGY

PHL

RUS

MA

RID

NC

HN

IND

CO

LG

RC BGR

ROU

TUR

BRA

THA ITA M

EXH

UN PER

SAU

CZE

KOR

POL

ZAF

ESP

MYS PR

TUA

EJP

NC

HL

IRL

EA FRA

AUS

DEU

USA

CH

EG

BRC

AN

SWE

2010-2014 Ranking by Financial and Governance Indicatorsaverage of percentile

Source: IIF.

EMDMEuro Area Periphery Countries

price movements are more correlated than they would otherwise be. This “benchmark effect” is confirmed in a recent World Bank study.2

In order to address how meaningful the EM-DM divide is today, we compare the 30 countries that constitute the IIF EM-30 group and contrast them with a group of 15 mature economies, comprised of the G7 and other major core and periphery countries in the Euro Area. We rank the 45 countries along a number of macroeconomic, governance and financial indicators that are often used to separate EM and mature economies (Table 4). For each indicator, we then assign a percentile score from 0 to 100 to each country (e.g., the median country will receive a score of 50). We average the percentile scores among all macroeconomic and among all financial/governance indicators to get two overall rankings on the degree to which a country has the typical characteristics associated with an emerging market.

We find that for most countries, the EM-DM divide holds reasonably well. Ranking all the countries by their aggregate macroeconomic and governance/financial scores shows

Chart 43

Chart 44

2 Raddatz, Claudio E., Sergio L. Schmukler, and Tomás Williams. 2015. "International Asset Allocations and Capital Flows: the Benchmark Effect." Policy Research Working Paper 6866. World Bank.

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page 22 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

Chart 45

very limited overlap between the EM and DM groups (Charts 43 and 44). To the extent that there is overlap, the DMs in question largely comprise the Euro Area periphery countries, which arguably are in a category of their own. When considering both the macroeconomic and the governance/financial ranking at the same time, there are only three countries that rank above the 50th percentile in both categories: the Czech Republic, Poland, and Hungary (Chart 45, top right quadrant), all members of the European Union.

Our analysis thus suggests that the EM-DM classification is not obsolete. However, our results also show a significant degree of heterogeneity among emerging markets, as illustrated by the wide dispersion of EM scores in the scatterplot.

In addition, it is important to note that while the term EM may provide some information about a country’s stage of development, different groups of emerging markets may respond very differently to different types of external shocks, depending on their economic structures. For example, the recent decline in commodity prices, notably oil, will weigh on commodity exporting countries while benefitting commodity importers. Similarly, emerging markets with current account deficits would likely suffer more from a Fed tightening shock than surplus countries.

Hence, while there are good reasons to think of emerging markets as an asset class, it remains important for investors to understand country characteristics and country-specific vulnerabilities and to make decisions on investment allocation accordingly. The detailed country ranking is provided on page 37.

IRL

CHE

JPN

SWE

EA

FRA

CZE

ITA

DEU

USA

GRC

CAN

GBR

PRT

UAE

POL

AUS

LBN

ESP

HUN

BGR

KOR

TUR

MEX

MAR

ROU

ZAF

CHL

UKR

THA

BRA

MYS

COL

VEN

CHN

PER

SAU

ARG

RUS

PHL

EGY

ECUNGA

IDN

IND

0

20

40

60

80

100

0 20 40 60 80 100

2010-2014 Financial & Governance Indicators vs. Macro Indicators average of percentile

Macro

Financial & Governance

Source: IIF.

EMDMEuro Area Periphery Countries

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page 23 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

-250-200-150-100-50

050

100150200

13Q1 13Q3 14Q1 14Q3 15Q1 15Q3 16Q1 16Q3

Other Inflows Other OutflowsPortfolio Debt Inflows Portfolio Debt OutflowsPortfolio Equity Inflows Portfolio Equity OutflowsFDI ODI

China: Capital Flows and Current Account Balance$ billion

Source: SAFE, IIF.

IIF Forecast

Reserves (- = Increase)

Current Account Balance

0

1

2

3

4

5

6

7

-200-100

0100200300400500600700800

2008 2009 2010 2011 2012 2013 2014 2015 2016

Nonbank Debt Bank LendingPortfolio Equity FDI

EM Asia: Non-Resident Private Capital Inflows $ billion percent of GDP

Source: IIF.

% of GDPIIF Forecast

EMERGING ASIA: HIT BY CHINA CONCERNS AND GLOBAL WOES

We project non-resident private capital flows to Emerging Asia to plunge in 2015 to lows unseen since the global financial crisis, before a tepid revival in 2016 (Chart 46). Much of the drop reflects reduced offshore borrowing by Chinese corporates responding to shifting perceptions about RMB management. In Asia, heightened risk aversion towards EMs is amplified by China-related uncertainty triggered by the slowdown in China along with its surprise depreciation and stock market meltdown, as well as large foreign holdings and relatively liquid markets. The result has been a sharp selloff of domestic stocks and bonds from mid-year. Moreover, in several Asian EMs, delayed public investment programs and structural reforms have had a negative impact, as have fractious politics and weakness in commodity prices.

While the adverse factors are expected to dissipate somewhat over the next year, continuing concerns about China’s growth trajectory and policy responses pose a key downside risk and market volatility is likely to continue to dampen inflows in 2016, although not to the same extent as this year. Parallels have been drawn with the Asian crisis, although fundamentals have improved, and moderate public debt, large reserves, exchange rate flexibility and stronger banks in most countries should protect against another full-blown crisis.

The slump in private capital inflows is most dramatic for China (Chart 47). Slowing growth due to excess industrial capacity, correction in the property sector and export weakness, together with monetary easing and the stock market bust have discouraged inflows. The biggest shift is that there has been a decline in non-resident inflows and rising resident outflows related to corporations seeking to reduce their open FX positions, after building up dollar debt, on expectations of continuing RMB depreciation. Heavy outflows and volatile market conditions following the August 11 move to provide more of a role for market forces in FX fixing and trading prompted heavy intervention to support the RMB.

Bejoy Das Gupta Chief Economist Asia/Pacific 1-202-857-3649 [email protected]

Chart 46 Chart 47

Non-resident private capital flows to Emerging Asia to plunge in 2015 to lows unseen since the global financial crisis, before a tepid revival in 2016

Slump most dramatic for China

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page 24 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

0 10 20 30 40 50

CH*IN

KOTH

MYID

LCY GovBondsEquity

Foreign Holdings ofDomestic Securitiespercent of total

Source: National Sources, ADB, CEIC, IIF. *Includes gov and corp bonds.

05

1015202530

2013 2014 2015

EM Asia: External Bond Issuance$ billion

Source: ThomsonOne. *15Q3 through Sep 17.

*

Overall, capital outflows from China should stabilize in the fourth quarter of 2015 and into 2016 and the pace of intervention should moderate, although an intensification of growth concerns could add to pressures if markets start to anticipate a renewed policy shift to let the RMB depreciate further. We also expect policymakers to be more cautious on capital account liberalization out of concern that it contributes to further outflows and adds to RMB weakness.

Elsewhere in the region, countries with large foreign portfolio holdings have been adversely affected by shifts in investor sentiment (Charts 48 and 49). Malaysia has been hard hit by nervousness triggered by the plunge in energy prices and heightened political concerns, contributing to sizeable withdrawal of non-resident portfolio investments. We expect some moderation in non-resident portfolio outflows in 2016, while the stepped-up use of reserves and government-linked entities reducing their investments abroad should support the external position and contain pressure on the ringgit. Non-resident capital inflows to Indonesia have been impacted by weak energy and coal prices, slowing China and EM risk aversion. Nevertheless, resilient FDI and large issuance of sovereign external bonds are providing support along with moderately tight monetary policy, fiscal discipline and efforts to advance reforms (Chart 50).

While Thailand has not been immune to the portfolio selloff and the government has liberalized resident capital outflows, sizeable inward FDI and a large current account surplus have supported the external position. Meanwhile, the fall in capital inflows has been less prominent in Korea and the Philippines. For Korea, inward FDI, participation of long-term foreign institutional investors in debt markets and a diversified equity investor base along with the large current account surplus are bolstering the balance of payments. In the Philippines, a relatively insulated capital account, both on the portfolio equity and debt sides, has help shield the external position against EM stress, combined with large workers’ remittances underpinning the current account surplus, positive growth outlook and moderate FDI.

In India, non-resident capital inflows have been dampened somewhat by recent foreign portfolio equity and debt net sales along with a slippage in bank lending because of slow investment recovery and falling imports, but inward FDI is on an upward trajectory, accompanied by rising Non-Resident Indian (NRI) deposits in the banking system and sizeable external bond issuance. The failure so far to push through legislation for the Goods and Services Tax (GST) and land reforms due to opposition in the upper house of parliament has taken off some of the shine from the India story, but other reforms to tackle supply-side impediments are advancing, the legacy tax dispute for foreign portfolio investors has been recently resolved and lower inflation is allowing room for monetary easing to support growth.

-30-20-10

01020

2013 2014 2015

Equity Debt

Portfolio Flows to EM Asia$ billion

Source: National Sources, IIF. Includes India, Indonesia, Malaysia, Philippines, South Korea, and Thailand. *Through Aug. 2015

Total

*

Chart 49

Chart 48

Chart 50

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page 25 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

-70-60-50-40-30-20-10

0102030

14Q1 14Q2 14Q3 14Q4 15Q1 15Q2

CEE Russia

Turkey Ukraine

Source: IIF.

Emerging Europe: Resident Private Capital Outflows, Net$ billion

-30

-10

10

30

50

14Q1 14Q2 14Q3 14Q4 15Q1 15Q2

CEE Russia

Turkey Ukraine

Source: IIF.

Emerging Europe: Non-resident Private Capital Inflows, Net $billion

Total

EMERGING EUROPE: RISKS REMAIN TILTED TO THE DOWNSIDE

Emerging Europe has experienced substantial net capital outflows since the start of 2014, both through non-resident capital withdrawals and heavy resident outflows. Net outflows from the region continued to be driven primarily by Russia, although the anticipation of Fed rate hikes as well as political uncertainty in some countries in the region (such as Turkey) also depressed non-resident private capital outflows. Excluding Russia, net inflows of non-resident private capital declined from $20 billion per quarter on average during the second half of 2014 to $9 billion in the second quarter of 2015 (Chart 51). Resident capital outflows slowed to $7 billion in the second quarter from $23 billion in the first, thanks to a marked slowdown in outflows from Russia, the Czech Republic and Turkey (Chart 52).

With global risk aversion amid concerns about a growth slowdown in China, as well as expectations of Fed liftoff in late 2015, market sentiment towards emerging markets turned more negative in the second quarter, especially for commodity exporters and those with large external financing needs. In Emerging Europe, major commodity exporters of Russia and Ukraine suffered the most. CEE and Turkey, by contrast, benefited somewhat from a pick-up in economic activity in the Euro Area during the first half of 2015. Indeed, Turkey received the lion’s share of net inflows of foreign private capital in the second quarter of 2015, as a sharp shift to direct foreign borrowing by Turkish companies offset the decline in net foreign borrowing by Turkish banks. Even so, political concerns in Turkey have led to broader policy uncertainty. With credit demand weak, CEE banks continued to make net foreign debt repayments in the second quarter.

Ukraine returned to the international bond markets in the second quarter with a $1 billion government bond with a U.S. sovereign guarantee and plans to issue another $1 billion before year-end. Ukrainian state-owned Oschadbank issued a new $1.2 billion bond in the third quarter to swap the bank's two bonds maturing in 2016 and 2018 as part of a debt restructuring deal agreed in June with private creditors under the framework of the IMF-supported program. However, overall international bond issuance declined from $19 billion in the first quarter to $5 billion in the third

Chart 51 Chart 52

Ugras Ulku Senior Economist Emerging Europe 1-202-857-3617 [email protected]

Net outflows from the region continued to be driven primarily by Russia

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page 26 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

-100

-50

0

50

100

150

200

250

300

2011 2012 2013 2014 2015 2016

Nonbanks, NetDirect Investment, NetCommercial Banks, NetPortfolio Investment, Net

Source: IIF.

Emerging Europe: Non-resident Private Capital Inflows$ billion

IIF ForecastTotal

0

10

20

30

14Q1 14Q2 14Q3 14Q4 15Q1 15Q2 15Q3

CEE Russia Turkey Ukraine

Source: IIF.

Emerging Europe: Eurobond Issuance, Gross$ billion

quarter, driven mainly by lower issuance by Russia and Turkey (Chart 53).

Looking ahead, we project a modest recovery of inflows, but the outlook will crucially depend on the timing and path of Fed rate hikes as well as political uncertainty in Turkey. Even though the ECB’s QE program should ensure abundant liquidity in European markets, the anticipated Fed rate hikes as well as China-related uncertainty should keep global risk appetite weak. U.S. and EU sanctions are likely to remain in place, leading to further, but smaller, net outflows of non-resident private capital from Russia during the remainder of 2015 and into 2016. Net inflows of non-resident private capital elsewhere in the region should remain broadly unchanged during the rest of the year from their second-quarter level before picking up slightly next year. As a result, for the region as a whole (including Russia), non-resident private capital will likely shift to a modest inflow of $43 billion in 2016 from a projected outflow of $20 billion this year (Chart 54). Part of the shift would reflect moderate portfolio equity inflows in 2016 and domestic banks shifting back to net foreign borrowing in 2016. FDI inflows should remain subdued in 2016, as output growth looks likely to remain soft across the region.

Risks remain tilted to the downside, mainly related to the political uncertainty in Turkey and the potential impact of divergent G3 monetary policy stances. Should Fed tightening trigger a sharp rise in risk aversion, Turkey would be particularly vulnerable given its sizable current account deficit and reliance on short-term foreign bank borrowing to fund its deficit. Such risks could be reduced if the November 1 elections yield an effective government, but higher interest rates and continued political instability could imply tighter external financing conditions for Turkish banks, and corporate balance sheets would be further damaged by continuing depreciation of the Turkish lira. Despite a large current account surplus and ample foreign exchange reserves, Hungary also looks vulnerable to the Fed’s rate hikes, with U.S. investors holding a large share of Hungary’s government debt. Additionally, an escalation in the Ukraine conflict would likely result in tighter sanctions, which would lead to a renewed intensification of capital outflows from Russia.

Chart 53 Chart 54

The near-term outlook for the region will depend on the timing and path of Fed rate hikes as well as political uncertainty in Turkey

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page 27 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

-2

-1

0

1

2

3

4

-175

-100

-25

50

125

200

275

350

2012 2013 2014 2015 2016

Private Inflows

Latin America: Private Capital Inflows and GDP Growth $ billion percent y/y

IIF Forecast

DownwardForecast Revisions*

Previous Growth Forecasts*

GDP Growth

Source: IIF; *Since May 2015 CFR.

LATIN AMERICA: UNDER PRESSURE

Continued commodity price weakening, heightened global risk aversion, and domestic policy shortcomings have put sustained downward pressure on local currencies, weighed on real GDP growth and held down private capital inflows this year. Conditions have deteriorated since our last capital flows report in May, leading to substantial downward revisions in both our regional growth outlook as well as capital flow projections (Chart 55). We project Latin America’s output will contract almost 1.0% in 2015 and non-resident capital inflows will fall by $42 billion vis-à-vis 2014. Brazil’s worsening performance has been a major drag on the region. Flows are expected to pick up somewhat next year, but remain subdued, consistent with slower growth momentum and the impact of Fed interest rate liftoff.

In Brazil, the political crisis has, thus far, precluded the implementation of an effective confidence-enhancing fiscal adjustment, triggering the loss of its investment grade credit rating by Standard and Poor’s in early September. Deteriorating domestic conditions have been reflected in relentless market pressure and capital outflows. The real has weakened close to 50% to 4.2 reais/$ since the beginning of the year (its weakest level in over two decades), prompting the central bank to step up intervention in the spot as well as the FX derivatives market (Chart 56). EMBIG spreads have widened over 225 basis points to some 500 bps. Overall portfolio flows (equity and debt) turned negative in July and August (Chart 57). We expect this trend to continue in the coming months and possibly intensify as the economy contracts further and expectations of real depreciation persist. With little political leverage and a hostile Congress, we are skeptical that the government will be able to deliver on its newly proposed fiscal package aimed at restoring confidence. Thus, we expect market stress and subpar growth to continue throughout 2016. Inflows are projected to decline again in 2016 compared to 2015 and the local currency to depreciate further to around 4.5 reais/$.

Chart 55 Chart 56

Ramón Aracena Chief Economist Latin America 1-202-857-3630 [email protected]

Julia Smearman Research Analyst Latin America 1-202-682-7451 [email protected]

We project Latin America’s output will contract almost 1.0% and private capital inflows will fall 13% this year vis-à-vis 2014

60

80

100

120

140

160

180

2001 2003 2005 2007 2009 2011 2013 2015

Latin America: Local Currency vs. U.S. Dollarindex (2001=100), inverted

Source: Bloomberg.

Brazil

Mexico

ColombiaChile

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page 28 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

60

70

80

90

100

110

Dec 14 Jun 15

Stock Market Indices index (end-2014=100)

Peru

Chile

Colombia

Source: Bloomberg.

0

10

20

30

40

50

60

70

2007 2008 2009 2010 2011 2012 2013 2014 2015

Mexico: Foreign Holdings of Local Currency Debt percent of total

Bonos Total

Cetes

Source: Central Bank of Mexico.

-10

-5

0

5

10

15

Jun 14 Sep 14 Dec 14 Mar 15 Jun 15

DebtEquity

Brazil: Portfolio Inflows $ billion

Source: Central Bank of Brazil.

Despite global jitters and peso depreciation, portfolio inflows to Mexico have remained relatively stable, albeit at a lower level than last year. The stock of foreign holdings of local public debt has held around 36% of total with a shift in portfolio composition away from short-term instruments (Chart 58). We have moderated our expectations for a pick up in private capital inflows next year due to a downward growth revision and the impact of low oil prices on foreign direct investment in the newly opened energy sector. Below-trend growth and weak commodity prices have also taken a toll on our outlook for capital flows to the other Pacific Alliance members (Chart 59).

Private inflows to Argentina have remained minimal as the holdout creditors’ saga remains to be resolved. The central bank has relied heavily on a currency swap from China to support an artificially strong peso. Given that litigation has halted local law dollar issuance, international reserves will likely be reduced by $6 billion to service a maturing bond in October, declining to $15 billion (excluding the China currency swap) by this December, the lowest level in over a decade. We expect the next administration, due to take office in December, will give priority to resolving the holdout creditors’ issue to regain access to global capital markets. However, we do not anticipate a quick return to robust private capital inflows unless a comprehensive and front-loaded policy shift to restore macroeconomic balance is also implemented.

Unwilling to adjust policies ahead of legislative elections in December, Venezuela has continued to tap unconventional sources and draw down external assets to finance its foreign exchange needs. We estimate the government has managed to raise about $20 billion in financing so far this year by borrowing heavily from China, withdrawing its Special Drawing Rights from the IMF, and issuing debt through Citgo. Private capital inflows have been virtually nonexistent. With a looming financing gap projected for next year and uncertain political dynamics, a credit event remains a clear risk.

Chart 57 Chart 58

Chart 59

We do not anticipate a quick return to robust private capital inflows unless a comprehensive and front-loaded policy shift is also implemented

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page 29 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

MENA: END OF AN ERA FOR LARGE CAPITAL OUTFLOWS

Until recently, MENA oil-exporting countries (Saudi Arabia, the UAE, Qatar, Kuwait, Oman, Bahrain, Algeria, Iran, Iraq and Libya) were major exporters of capital (Chart 60), recycling their combined current account surplus, which peaked at $467 billion in 2012. The drop in oil prices since mid-2014, however, is shifting the aggregate current account to a projected deficit of $82 billion in 2015 from a surplus of $233 billion in 2014. Accordingly, we project a dramatic shift from resi-dent capital outflows of $212 billion in 2014 to a small net inflow of $15 billion in 2015. Resident capital outflows will increase slightly in 2016, assuming oil prices re-cover to $63/bbl.

In consequence, net foreign assets of MENA exporting countries are expected to decline by about $165 billion to $2.5 trillion in 2015, about half of which is managed by SWFs (Chart 61). The other 45% is in official reserves, mostly of Saudi Arabia and Algeria. The projected decline in official reserves will lead to lower deposits with foreign banks and debt securities, while the smaller accumulations in SWFs will be reflected in less FDI and portfolio investment abroad.

Capital inflows to the five MENA countries in our universe (the UAE, Saudi Arabia, Egypt, Morocco, and Lebanon) are projected to decrease in 2015 as FDI and bank inflows decrease in Saudi Arabia and the UAE (Chart 62). In the UAE, the strong U.S. dollar has made the real estate market more expensive and may ad-versely affect FDI. In Egypt, the previously expected strong pick-up in FDI has not yet materialized due partly to the slow pace of structural reforms. In Morocco, the capital and financial accounts are expected to improve further, particularly FDI, as political stability and improvement in the business environment make Morocco a more attractive destination. In Lebanon, the modest decline in FDI is being offset by the continued strong growth in nonresident deposits in domestic banks (Chart 63).

Garbis Iradian Chief Economist Middle East and North Africa 1-202-857-3304 [email protected]

0369

1215182124273033

2014

2015

2016

2014

2015

2016

2014

2015

2016

2014

2015

2016

2014

2015

2016

Private CreditorsPortfolio InvestmentDirect Investment

Private Inflows to Selected MENA Economies$ billion

UAE Saudi A. Egypt Morocco LebanonSource: IIF.

Chart 63

-400

-300

-200

-100

0

100

200

300

400

500

2008 2009 2010 2011 2012 2013 2014 2015 2016

Resident Capital OutflowsCurrent Account

MENA Oil Exporters: Capital Outflows and Current Account$ billion

Source: IIF.

IIF Forecast

Chart 60

0

15

30

45

60

75

2014 2015 2016

OtherPortfolioFDI

MENA: Private Inflows$ billion

Source: IIF.

Chart 62

600900

120015001800210024002700

2006 2011 2017

MENA Oil Exporters:Net Foreign Assets$ billion

IIF Forecast

Source: IIF.

Chart 61

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page 30 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

-2

-1

0

1

2

3

4

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2013

2015

2012

Source: South African Reserve Bank

2014

South Africa: Nonresidents' Purchases/Sales of Equities$ billion, cumulative YTD

-3

-2

-1

0

1

2

3

4

5

6

Jun 10 Sep 11 Dec 12 Mar 14 Jun 15

Equity Debt

Nigeria: Net Portfolio Investment$ billion

Source: Central Bank of Nigeria.

SUB SAHARAN AFRICA: BUFFETED BY GLOBAL HEADWINDS

Lower oil and metal prices, concerns over China and anxiety over Fed liftoff have adversely impacted capital flows to Sub Saharan Africa this year. This has resulted in accelerated currency depreciation in a number of countries, requiring policy tightening to control inflation. Growth has slowed, which in turn has made countries less attractive investment destinations. Eurobond yields have increased and issues have slowed. Nigeria has been out of the market, reflecting the extended political transition, and Kenya is not issuing this year after its successful debut in 2014. By contrast, Zambia and Ghana, have or are about to come to market to help finance large budget deficits and to reduce heavy pressure on their balance of payments.

The drop in oil prices and political uncertainty in Nigeria have had a major impact on capital flows (Chart 64). Despite two de facto devaluations, the naira has remained under pressure and the central bank has introduced measures to ration the supply of foreign currency to preserve its international reserves. Under these circumstances, and with Nigeria being removed from the JP Morgan Government Bond index due to reduced FX liquidity, we expect portfolio flows to remain sidelined. While there is scope for external borrowing, given Nigeria’s relatively low debt ratios, the new government may be reluctant to tap international markets in current circumstances. The extended political transition has added to uncertainty and is taking a toll on confidence, causing FDI decisions to be postponed.

Portfolio flows into South Africa, especially equity (Chart 65), have fared a little better this year, despite a deterioration in domestic economic conditions and increased global financial market volatility. Inflation fell earlier in the year, but is now on an upward trajectory again and will likely breach the top of its 3-6% target range by year-end. This, together with steady currency depreciation, prompted the Reserve Bank to tighten monetary policy in July. Despite bond yields edging higher, foreign appetite for fixed income securities has remained weak, dampening total portfolio flows. We expect this to remain the case while uncertainty persists over the timing of Fed liftoff.

Chart 64 Chart 65

David Hedley Chief Economist Sub-Saharan Africa 1-202-857-3605 [email protected]

The drop in oil prices and political uncertainty have had a major impact on capital flows to Nigeria

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page 31 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

Table 5 Emerging Asia: Capital Flows $ billion 2013 2014 2015 Est. 2016 Proj.

Non-Resident Capital Inflows 676 619 191 350

Private Inflows 668 613 185 344

Equity Investment 396 442 378 375

Direct Investment 349 372 364 313

Portfolio Investment 47 70 14 62

Private Creditors 272 171 -193 -31

Commercial Banks 127 73 -165 -38

Nonbanks 145 99 -29 6

Official Inflows 8 6 6 7

International Financial Institutions 3 4 4 3

Bilateral Creditors 5 2 2 3

Resident Capital Outflows -961 -801 -543 -719

Private Outflows -506 -609 -746 -741

Equity Investment Abroad -211 -219 -248 -274

Resident Lending/Other -295 -390 -498 -467

Reserves (- = Increase) -455 -192 203 23

-285 -182 -352 -368

Memo: Net Errors and Omissions 64 -83 0 0

Current Account Balance 221 265 352 368

Source: IIF. See page 37 for guidance on how to interpret these data.

Net Capital Flows incl. Reserves

Net Capital Flows excl. Reserves (Financial Account Balance) 170 10 -555 -391

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page 32 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

Table 6 Emerging Europe: Capital Flows $ billion 2013 2014 2015 Est. 2016 Proj.

Non-Resident Capital Inflows 214 38 -4 51

Private Inflows 218 31 -20 43

Equity Investment 64 52 17 44

Direct Investment 66 59 33 42

Portfolio Investment -2 -7 -16 2

Private Creditors 154 -22 -37 -1

Commercial Banks 20 32 -14 10

Nonbanks 134 -54 -23 -11

Official Inflows -4 7 17 8

International Financial Institutions -12 3 14 10

Bilateral Creditors 8 4 3 -2

Resident Capital Outflows -178 -55 -64 -100

Private Outflows -179 -163 -50 -87

Equity Investment Abroad -101 -57 -50 -48

Resident Lending/Other -78 -106 0 -39

Reserves (- = Increase) 1 107 -14 -13

36 -18 -67 -50

Memo: Net Errors and Omissions -10 -3 0 0

Current Account Balance -27 20 67 50

Source: IIF. See page 37 for guidance on how to interpret these data.

Net Capital Flows incl. Reserves

Net Capital Flows excl. Reserves (Financial Account Balance) 35 -125 -54 -37

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page 33 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

Table 7 Latin America: Capital Flows $ billion 2013 2014 2015 Est. 2016 Proj.

Non-Resident Capital Inflows 323 316 274 282

Private Inflows 304 291 239 257

Equity Investment 145 138 120 128

Direct Investment 125 116 103 110

Portfolio Investment 20 22 17 18

Private Creditors 159 153 120 129

Commercial Banks 23 32 21 27

Nonbanks 135 122 98 102

Official Inflows 19 25 34 25

International Financial Institutions 3 5 7 8

Bilateral Creditors 16 20 27 17

Resident Capital Outflows -151 -142 -113 -148

Private Outflows -154 -119 -127 -150

Equity Investment Abroad -63 -63 -64 -62

Resident Lending/Other -92 -56 -63 -89

Reserves (- = Increase) 4 -23 14 3

172 174 161 135

Memo: Net Errors and Omissions -30 -11 0 0

Current Account Balance -143 -163 -161 -135

Source: IIF. See page 37 for guidance on how to interpret these data.

Net Capital Flows incl. Reserves

Net Capital Flows excl. Reserves (Financial Account Balance) 169 197 147 132

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Table 8 Africa/Middle East: Capital Flows $ billion 2013 2014 2015 Est. 2016 Proj.

Non-Resident Capital Inflows 92 102 87 93

Private Inflows 83 97 79 84

Equity Investment 58 51 46 52

Direct Investment 38 39 36 37

Portfolio Investment 20 12 10 15

Private Creditors 25 46 34 32

Commercial Banks 2 28 23 17

Nonbanks 22 18 11 15

Official Inflows 10 5 8 9

International Financial Institutions 3 1 3 3

Bilateral Creditors 7 4 5 6

Resident Capital Outflows -238 -165 -28 -47

Private Outflows -147 -151 -165 -103

Equity Investment Abroad -46 -63 -46 -50

Resident Lending/Other -101 -88 -119 -53

Reserves (- = Increase) -91 -14 138 56

-146 -64 59 46

Memo: Net Errors and Omissions -34 -40 0 0

Current Account Balance 179 104 -59 -46

Source: IIF. See page 37 for guidance on how to interpret these data.

Net Capital Flows incl. Reserves

Net Capital Flows excl. Reserves (Financial Account Balance) -55 -50 -78 -10

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page 35 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

RGDP per capita

Growth Rate

RGDP Growth Rate

Headline Inflation

Non-FDI Inflows

Exports: Share of

Mining/FuelUnit % change % change % change, y/y % of GDP % of exportYear(s)Source Hav er Hav er IIF, Hav er IIF, Hav er WTOOther Metadata PPP market

32.0% EM 1 Argentina 47.7% 45.4% 18.2% 27.3% 2.3% 27.2% 61.4%36.6% EM 1 Brazil 29.5% 29.5% 38.7% 41.0% 18.2% 59.0% 36.4%46.4% EM 1 Bulgaria 31.8% 27.2% 52.3% 79.6% 66.0% 36.3% 34.1%42.1% EM 1 Chile 45.4% 52.2% 16.0% 25.0% 36.4% 90.9% 13.7%35.0% EM 1 Colombia 22.7% 25.0% 20.5% 22.8% 52.3% 65.9% 11.4%21.9% EM 1 Ecuador 13.6% 20.4% 22.8% 20.5% 31.9% 22.7% 16.0%15.2% EM 1 Indonesia 11.3% 9.0% 6.9% 6.9% 20.5% 18.1% 20.5%58.9% EM 1 Lebanon 36.3% 43.1% 54.6% 45.5% 38.7% 95.4% 70.5%32.5% EM 1 Peru 18.1% 22.7% 4.6% 11.4% 47.8% 68.1% 18.2%43.9% EM 1 South Africa 25.0% 34.0% 77.3% 56.9% 22.8% 72.7% 27.3%40.5% EM 1 Ukraine 9.0% 11.3% 47.8% 91.0% 16.0% 56.8% 50.0%44.3% EM 2 Morocco 6.8% 13.6% 43.2% 34.1% 91.0% 34.0% 47.8%16.8% EM 2 Nigeria 2.2% 0.0% 34.1% 13.7% 4.6% 52.2% 2.3%29.8% EM 2 Russia 56.8% 38.6% 36.4% 47.8% 13.7% 38.6% 6.9%32.0% EM 2 Saudi Arabia 93.1% 61.3% 25.0% 18.2% 27.3% 29.5% 4.6%59.8% EM 2 UAE 100.0% 70.4% 88.7% 29.6% 88.7% 40.9% 25.0%33.6% EM 2 Venezuela 40.9% 36.3% 91.0% 81.9% 0.0% 43.1% 0.0%23.0% EM 3 Egypt 15.9% 6.8% 70.5% 50.0% 6.9% 6.8% 29.6%14.3% EM 3 India 0.0% 2.2% 2.3% 2.3% 9.1% 20.4% 38.7%45.2% EM 3 Mexico 34.0% 47.7% 45.5% 38.7% 29.6% 70.4% 43.2%59.5% EM 3 Poland 52.2% 54.5% 31.9% 43.2% 61.4% 77.2% 68.2%44.1% EM 3 Romania 38.6% 31.8% 50.0% 75.0% 25.0% 31.8% 66.0%45.3% EM 3 Turkey 43.1% 50.0% 11.4% 16.0% 11.4% 81.8% 72.8%33.4% EM 4 China 20.4% 18.1% 0.0% 0.0% 43.2% 9.0% 95.5%74.1% EM 4 Czech Republic 63.6% 59.0% 81.9% 86.4% 77.3% 63.6% 84.1%51.6% EM 4 Hungary 54.5% 56.8% 59.1% 77.3% 41.0% 2.2% 91.0%45.9% EM 4 Korea 65.9% 68.1% 29.6% 31.9% 59.1% 13.6% 59.1%36.0% EM 4 Malaysia 50.0% 40.9% 13.7% 9.1% 56.9% 25.0% 41.0%26.4% EM 4 Philippines 4.5% 4.5% 9.1% 4.6% 34.1% 11.3% 75.0%39.3% EM 4 Thailand 27.2% 15.9% 27.3% 36.4% 50.0% 15.9% 77.3%59.3% DM Australia 86.3% 81.8% 72.8% 52.3% 54.6% 86.3% 9.1%66.2% DM Canada 81.8% 84.0% 63.7% 54.6% 68.2% 88.6% 31.9%77.9% DM Eurozone 77.2% 86.3% 86.4% 88.7% 75.0% 45.4% 100.0%77.1% DM France 79.5% 77.2% 84.1% 84.1% 86.4% 54.5% 81.9%70.9% DM Germany 84.0% 88.6% 41.0% 63.7% 81.9% 47.7% 86.4%66.4% DM Greece 61.3% 65.9% 100.0% 100.0% 84.1% 61.3% 22.8%91.2% DM Ireland 90.9% 97.7% 68.2% 72.8% 95.5% 97.7% 97.8%73.9% DM Italy 70.4% 75.0% 97.8% 95.5% 70.5% 50.0% 79.6%86.2% DM Japan 72.7% 79.5% 56.9% 70.5% 97.8% 100.0% 93.2%61.2% DM Portugal 59.0% 63.6% 95.5% 97.8% 79.6% 4.5% 63.7%58.2% DM Spain 68.1% 72.7% 93.2% 93.2% 72.8% 0.0% 54.6%78.2% DM Sweden 88.6% 95.4% 61.4% 59.1% 93.2% 93.1% 52.3%88.9% DM Switzerland 97.7% 100.0% 79.6% 66.0% 100.0% 84.0% 88.7%65.0% DM United Kingdom 75.0% 90.9% 75.0% 68.2% 45.5% 79.5% 45.5%70.7% DM United States 95.4% 93.1% 66.0% 61.4% 63.7% 75.0% 56.9%

Table 92010-2014 Percentile Rank: Macro Indicators

Hav er, IMF

Average Category

RGDP per capita

USD2010-2014 av erage

0-20% 20-40% 40-60% 60-80% 80-100%

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page 36 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

DM MSCI Correlation

Capital Account

Openness

Worldwide Governance

IndicatorsInstitutions

Financial Market Devt

Ease of Doing

BusinessUnit % change z-score RankYear(s)Source Bloomberg Chinn-Ito Hav er, WB WEF WEF Hav er, WBOther Metadata MSCI, S&P av erage

18.0% EM 1 Argentina 53.4% 4.5% 27.2% 4.5% 4.5% 13.7%41.9% EM 1 Brazil 74.4% 27.2% 43.1% 36.3% 59.0% 11.4%36.4% EM 1 Bulgaria 16.2% 59.0% 47.7% 15.9% 31.8% 47.8%66.9% EM 1 Chile 62.7% 54.5% 77.2% 77.2% 70.4% 59.1%35.0% EM 1 Colombia 51.1% 25.0% 22.7% 18.1% 40.9% 52.3%9.5% EM 1 Ecuador 0.0% 40.9% 4.5% 2.2% 0.0% 9.1%

32.2% EM 1 Indonesia 23.2% 34.0% 20.4% 52.2% 45.4% 18.2%20.8% EM 1 Lebanon 6.9% 45.4% 11.3% 9.0% 29.5% 22.8%50.6% EM 1 Peru 60.4% 59.0% 36.3% 20.4% 63.6% 63.7%55.9% EM 1 South Africa 55.8% 6.8% 50.0% 65.9% 100.0% 56.9%10.7% EM 1 Ukraine 25.5% 0.0% 13.6% 6.8% 11.3% 6.9%28.4% EM 2 Morocco 4.6% 6.8% 31.8% 54.5% 43.1% 29.6%13.6% EM 2 Nigeria 9.3% 22.7% 2.2% 11.3% 34.0% 2.3%26.7% EM 2 Russia 69.7% 36.3% 6.8% 13.6% 9.0% 25.0%50.6% EM 2 Saudi Arabia 1.2% 45.4% 25.0% 81.8% 81.8% 68.2%61.8% EM 2 UAE 13.9% 59.0% 59.0% 93.1% 75.0% 70.5%0.8% EM 2 Venezuela 2.3% 0.0% 0.0% 0.0% 2.2% 0.0%

21.6% EM 3 Egypt 11.6% 38.6% 9.0% 34.0% 15.9% 20.5%35.0% EM 3 India 41.8% 6.8% 29.5% 50.0% 77.2% 4.6%46.1% EM 3 Mexico 81.3% 45.4% 38.6% 22.7% 38.6% 50.0%55.2% EM 3 Poland 67.4% 29.5% 65.9% 56.8% 65.9% 45.5%39.9% EM 3 Romania 44.1% 59.0% 45.4% 25.0% 27.2% 38.7%41.8% EM 3 Turkey 48.8% 29.5% 40.9% 45.4% 50.0% 36.4%33.5% EM 4 China 37.2% 6.8% 15.9% 61.3% 52.2% 27.3%50.9% EM 4 Czech Republic 39.5% 59.0% 70.4% 40.9% 54.5% 41.0%49.4% EM 4 Hungary 58.1% 59.0% 61.3% 38.6% 36.3% 43.2%51.2% EM 4 Korea 34.8% 43.1% 63.6% 47.7% 22.7% 95.5%58.0% EM 4 Malaysia 20.9% 18.1% 52.2% 75.0% 97.7% 84.1%25.0% EM 4 Philippines 18.6% 20.4% 18.1% 27.2% 47.7% 18.2%42.5% EM 4 Thailand 30.2% 6.8% 34.0% 43.1% 61.3% 79.6%77.8% DM Australia 46.5% 52.2% 93.1% 86.3% 95.4% 93.2%85.5% DM Canada 86.0% 59.0% 95.4% 95.4% 88.6% 88.7%69.3% DM Eurozone 97.6% 56.8% 75.0% 68.1% 56.8% 61.4%75.3% DM France 95.3% 59.0% 79.5% 72.7% 79.5% 66.0%80.3% DM Germany 93.0% 59.0% 90.9% 88.6% 68.1% 81.9%36.1% DM Greece 32.5% 59.0% 54.5% 31.8% 6.8% 31.9%68.4% DM Ireland 72.0% 59.0% 88.6% 84.0% 18.1% 88.7%45.3% DM Italy 79.0% 59.0% 56.8% 29.5% 13.6% 34.1%66.7% DM Japan 27.9% 59.0% 84.0% 79.5% 72.7% 77.3%58.9% DM Portugal 65.1% 59.0% 72.7% 63.6% 20.4% 72.8%57.1% DM Spain 76.7% 59.0% 68.1% 59.0% 25.0% 54.6%88.2% DM Sweden 88.3% 59.0% 100.0% 100.0% 90.9% 91.0%84.4% DM Switzerland 83.7% 59.0% 97.7% 97.7% 93.1% 75.0%84.8% DM United Kingdom 90.6% 59.0% 86.3% 90.9% 84.0% 97.8%82.9% DM United States 100.0% 59.0% 81.8% 70.4% 86.3% 100.0%

Table 102010-2014 Percentile Rank: Financial & Governance Indicators

Average Category2010-2014 av erage

0-20% 20-40% 40-60% 60-80% 80-100%

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page 37 CAPITAL FLOWS TO EMERGING MARKETS | OCTOBER 1, 2015

IIF CAPITAL FLOWS REPORT COUNTRY SAMPLE (30)

Emerging Europe Bulgaria Latin America Argentina

(8) Czech Republic (8) Brazil

Hungary Chile

Poland Colombia

Romania Ecuador

Russian Federation Mexico

Turkey Peru

Ukraine Venezuela

Emerging Asia China Africa/Middle East Egypt

(7) India (7) Lebanon

Indonesia Morocco

Malaysia Nigeria

Philippines Saudi Arabia

South Korea South Africa

Thailand UAE

ANNEX 1: IIF CAPITAL FLOWS DATA – A LAYMAN’S GUIDE

Capital flows arise through the transfer of ownership of assets from one country to another. When analyzing capital flows, we care about who buys an asset and who sells it. If a foreign investor buys an emerging market asset, we typically refer to this as a non-resident capital flow (or inflow) in our terminology. We report capital flows on a net basis. For example, if foreign investors buy $10 billion of assets in a particular country and sell $2 billion of that country’s assets during the same period, we show this as a (net) capital inflow of $8 billion. Note that non-resident capital flows can be negative, namely if foreign investors sell more assets of a country than they buy in a given period. Our “non-resident private capital flows to emerging markets” measure is the sum of all net purchases of EM assets by private foreign investors.

Correspondingly, if an investor from an emerging market country buys a foreign asset, we call this a resident capital flow (or outflow). Non-resident capital flows can also be positive or negative. Following standard balance of payments conventions, we show a net increase in the assets of EM residents with a negative sign.

For further details regarding terminology, concepts and compilation of our data, please consult our User Guide located on our website at www.iif.com/emr/global/capflows.

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GLOBAL MACROECONOMIC ANALYSIS

Charles Collyns, Managing Director & Chief Economist

Felix Huefner, Chief Economist, GMA Department

Robin Koepke, Economist

Arpitha Bykere, Associate Economist

Scott Farnham, Research Analyst

Alli Schultz, Senior Program Assistant

AFRICA/MIDDLE EAST DEPARTMENT

David Hedley, Chief Economist, Sub-Saharan Africa

Garbis Iradian, Chief Economist, MENA

Hussein Anooshah, Associate Economist

Amanda Preston, Senior Program Assistant

EUROPEAN DEPARTMENT

Clay Berry, Chief Economist

Ondrej Schneider, Senior Economist

Ugras Ulku, Senior Economist

Brent Harrison, Program Assistant

GLOBAL CAPITAL MARKETS

Hung Tran, Executive Managing Director

Sonja Gibbs, Director, GCM Department

Emre Tiftik, Financial Economist

Mohammed Assim, Policy Advisor

ASIA/PACIFIC DEPARTMENT

J. C. Sambor, Director

Bejoy Das Gupta, Chief Economist

Feng Guo, Chief Representative, Beijing

Kevin Sanker, Associate Economist

LATIN AMERICA DEPARTMENT

Ramon Aracena, Chief Economist

Martin Castellano, Senior Economist

Maria Paola Figueroa, Economist

Julia Smearman, Research Analyst