93992 Global Volume 2 | July 2013 Economic Prospects FINANCIAL MARKET OUTLOOK The World Bank GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 Global Economic Prospects Financial Market Outlook Global financial markets were largely stable during the past year, notwith- standing the recent uptick in volatility amid uncertainty over the timing of an eventual tapering off of quantitative easing. Yields for high-spread European sovereign debt have declined to around 400 basis points, and despite recent losses, developed country stock markets have rebounded and U.S. stock market indices have recovered their pre-crisis levels — even as Euro Area and Japanese stock market indexes remain some 30 percent lower than in 2007. Improved financial conditions are reflected in a strong rebound in gross capital flows (international bond issuance, cross-border syndicated bank loans and new equity placements) to developing countries, which were 63 percent higher in the first five months of 2013 than during the same period in 2012. Flows strengthened in every region except the Middle East and North Africa, with the sharpest increase in Europe and Central Asia. All types of flows posted an increase of around 60 percent increase, while record levels of interna- tional bond issuance recorded by developing countries as a group. Syndicated bank lending increased by almost 70 percent versus a year ago. Despite the rela- tive weakness in April, bank lending has been on the rebound since the second quarter of 2012. While many factors were at play, an slowing of the deleveraging process by European banks has been the key. Foreign direct investment (FDI) inflows to developing countries in- creased by 9 percent during the first quarter of 2013 on a year-on-year ba- sis, with a mixed picture across countries. FDI flows for 2013 as a whole are expected to reach $719 billion in 2013, an increase of 7 percent. The rebound will come after the 5 percent decline in 2012 following increased uncertainty in global financial markets. The impact of the uncertainty was comparatively pro- found for high-income economies, where FDI inflows declined by 30 percent. The relative resilience of FDI in developing countries mostly reflects stable lev- els of re-invested earnings. Since late May, financial market volatility has increased, with increased ex- pectations about possible tapering of U.S. quantitative easing in coming months Dilek Aykut and uncertainty over its impacts. Although there have been some large stock Development Prospects market corrections in some Asian countries, so far the overall impact has been Group moderate. Bond yields on developing country debt are also on the rise as base The World Bank rates and spreads increase. 1818 H St, NW Washington DC 20433 Net private capital flows to developing countries are set to rise through Tel: +1(202) 473-1674 2015. A 5.7 percent increase, to $1.25 trillion, is expected in 2013. While flows daykut@worldbank.org will rise in nominal terms, they are projected to ease when expressed as a percent of developing country GDP. The mixed result reflects on one hand projected Eung Ju Kim improvements in developing country growth prospects over the medium-term Development Prospects and improved risk profiles, both of which should boost flows, and on the other Group a transition toward monetary policy tightening in the United States. Though the The World Bank likelihood of a major crisis emanating from high-income countries has receded, 1818 H St, NW the eventual tapering off of quantitative easing in the United States is likely to Washington DC 20433 cause global financial conditions to tighten. As a result, the quantity of capital Tel: +1(202) 458-5804 flows to developing countries is likely to decline as a percentage of their GDP ekim@worldbank.org even as the cost of capital rises. 2 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 Recent developments Some level of volatility has returned in global financial markets since late May as expectations in financial markets about possible tapering of U.S. quantitative easing in coming months have increased. As investors have started to reposition themselves, there has been a considerable amount of sell-off in global stock markets (see discussion below). Though international bond yields for developing countries had already started to widen earlier in the year, the The “risk-off” phase in global financial uptick has been sharper since May. The increase in borrowing costs seems to have limited the bond markets continued until June flows so far in June after a record number issuances during the first five months of the year. Global financial markets have been mostly calm Most markets have experienced a moderate since the beginning of the year following the correction thus far, but the impact may intensify in substantial improvements during the second half of the coming months. 2012 (World Bank 2013). Investor confidence, as proxied by risk premia and credit default swap (CDS) rates, has remained relatively strong despite Despite the recent weakness, negative developments in Euro Area (box FIN.1): continued economic weakness, political gridlock in developed country stock markets Italy that has stalled reforms, and the financial have outperformed those of crisis in Cyprus that culminated in the imposition of capital controls—a first in the Euro Area. developing countries in 2013 Developing-country CDS rates have in general The developed country stock market indexes rose remained at low levels (figure FIN.1), although significantly during the first five months of 2013 Argentina and Egypt are exceptions to this trend before losing some value in June. Nevertheless, the (figure FIN.2). Egyptian spreads rose due to the year-to-date gain for the developed country rising deficit and debt tied to the economic composite index was 10.9 percent as of mid-June consequences of political turmoil, while (figure FIN.3). Argentinean rates increased due to the uncertainty generated by a U.S. court decision concerning the Among developed countries, the benchmark S&P repayment to creditors that did not participate in 500 index for the United States reached a record the 2005 and 2010 restructuring of Argentina’s level in late May as improving economic data debt following its sovereign default in 2001.1 reports seemed to confirm that the U.S. economy Fig FIN.1 CDS rates for most developing regions re- Fig FIN.2 Argentina’s CDS rates surged in March mained stable despite the events in March from already very high levels 5-year sovereign CDS rates, basis points 500 4000 5-year sovereign CDS rates, basis points Middle East & N. Africa 3500 400 3000 300 2500 Europe & Central Asia 2000 200 Latin America & Caribbean 1500 100 1000 500 East Asia & Pacific 0 0 Jan '12 Apr '12 Jul '12 Oct '12 Jan '13 Apr '13 Apr '11 Sep '11 Feb '12 Jul '12 Dec '12 May '13 Source: World Bank; Bloomberg. Source: Bloomberg. 3 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 Box FIN.1 Recent developments in the Euro Area A range of significant steps taken in 2012 and 2013 has calmed investors and led to a significant rebound in key markets:  European Central Bank (ECB) President Mario Draghi’s forceful “whatever it takes” speech on July 26, 2012;  Introduction of a new Outright Monetary Transactions (OMT) facility  Widespread fiscal consolidation that has brought down Euro Area government deficits from 6.4 percent of GDP in 2009 to an estimated 2.9 percent in 2012 (IMF 2013), although the deficits of Ireland, Poland, and Spain still exceed 5 percent of GDP;  Euro Area-wide agreements to establish a banking union, to reinforce monitoring and respect of budgetary rules, to require countries to enter into binding reform contracts, and proposals to increase democratic legitimacy through direct election of European Commission President in 2014;  Early repayment of more than 25 percent of ECB crisis loans by Euro Area banks during the first quarter of 2013 (the loans were not due until 2014 and 2015). Other developments in 2013 have tested the resilience of this improved climate, however:  Inconclusive elections in Italy and weak polls for other leaders, underscoring ongoing political risks;  Uncertainty about governments’ willingness to accept conditionality if the OMT were activated;  Fears that the bailing in of bank depositors during the Cyprus rescue would lead to deposit flight in other European jurisdictions. While these developments led to some widening of CDS rates and yields on high -spread Euro Area countries’ debt, the in- creases were modest compared with earlier declines, and yields for high -spread countries except Portugal have remained Italy 2012 levels (box figure around their December Italy FIN 1.1). Ireland Spain Ireland Portugal Box Figure Italy 1.1 FIN Spain Ireland Portugal Portugal Ireland 5-year sovereign CDS rates, basis points Yields on 10-year sovereign debt, basis points 1800 60 Portugal 1600 40 Between January-March Spain Portugal Since March 1400 20 1200 1000 0 rtugal Ireland 800 -20 600 Italy -40 400 200 Spain -60 Italy 0 Spain Jan '10 Jul '10 Jan '11 Jul '11 Jan '12 Jul '12 Jan '13 -80 Italy Portugal Spain Italy Source: World Bank; Bloomberg Ireland Fig FIN.3 Developed country equities are outper- was gaining momentum (figure FIN.4). forming developing country Similarly, the Japan’s Nikkei gained almost 50 MSCI Equity Index (Jan.2011 = 100) percent between January and May, reflecting 125 the expectations related to the monetary 120 easing program announced by the Bank of 115 MSCI Emerging Markets Japan. The Nikkei has experienced a sharp 110 MSCI Developed Markets 105 decline of 15 percent since then, however, 100 reducing the year-to- date gain to 25 percent. 95 Equity market returns in Europe have been 90 positive as well, though less robust due to the 85 region’s weak economic outlook. After a 80 downward adjustment since May, the year- to 75 -date gain of the Stoxx Europe 600 was only Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 4.8 percent. Overall, equity markets in Europe Source: Bloomberg. 4 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 and Japan have recovered around 70 percent of the riskiness of high- income countries’ their 2007 value, versus a more than full recovery financial assets and growing concerns about in the United States. asset prices bubbles and growth prospects in some middle-income countries. Such In contrast with the strong performance in high- sentiment is likely to encourage investors to income markets earlier in the year, developing shift their portfolios away from developing to country stock market performance has been weak developed markets, and may help explain why since the beginning of 2013, with the MSCI yields on developing country debt are rising Emerging Markets index losing 6.4 percent of its (see discussion below). value (figure FIN.3). Stock market indexes declined in Brazil (-19.1 percent), Russia (-11.9 percent), and China (-4.7 percent), whereas they remained more Developing country bond yields have or less stable in India (-1.3 percent). The weakness risen since January in developing country stock markets reflects declining commodity prices and weak corporate The cost of international bond financing — earnings, together with a collection of country- proxied by 10-year U.S. Treasury bond yield specific factors. Recent curbs on property markets + EMBIG cash bond spread — has gone up to in China, for example, have contributed to the 5.42 percent as of mid-June after reaching a weakness in share values, while easing in record low level of 4.36 percent in early commodity prices have affected stock market January (figure FIN.5). Most of the increase performance in Brazil and Russia. in average borrowing cost has occurred since May, with the 106 basis points (bps) increase After reaching record highs in early 2013, helped the result of a 85 bps widening in EMBIG by strong foreign private capital inflows, equity cash bond spreads and a 22 bps rise in 10- markets in several East Asian countries— year U.S. Treasury bond yields. Indonesia, the Philippines, and Thailand—have experienced sharp sell-offs since late May. Despite Unlike previous episodes of rising yields, the the recent decline, stock market indexes in these rise between February and May did not occur countries were 10.3 percent, 7.4 percent, and 5.3 during a period of heightened global risk percent higher, respectively, on June 14 compared aversion. Moreover, the widening in with the end of 2012. secondary-market bond spreads was not associated with a decline in benchmark U.S. The decoupling in the equity market performance yields. U.S. Treasury yields tend to fall during of developed and developing countries likely the periods of heightened risk-aversion in reflects a decline in the investors’ perceptions of global financial markets, as they are Fig FIN.4 Performance in selected stock markets Fig FIN.5 Cost of bond financing increased in February and March Stock Market Index (Jan. 2011 = 100) Percent 155 7 Nikkei Implicit yield = 145 Yield on US 10 year treasury + EMBIG bond spread 135 6.4 125 S&P500 5.8 115 105 5.2 The record low borrowing cost on Jan 3rd = 4.2% 95 Stoxx 600 85 4.6 75 Apr Jul Oct Jan Apr Jul Oct Jan Apr 4 '11 '11 '11 '12 '12 '12 '12 '13 '13 Sep '11 Jan '12 May '12 Sep '12 Jan '13 May '13 Source: Bloomberg. Source: World Bank; JP Morgan. 5 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 considered safe assets. Over the past few years, developing country bond yields have Fig FIN.7 Gross flows have remained robust since September 2012 tended to remain relatively constant, even as benchmark yields (U.S. 10-year Treasury $billion 75 yield) fluctuated — implying that spreads have risen as benchmark yields fell. During the 60 first half of 2013, developing-country spreads have increased as benchmark U.S. 10-year 45 Treasury yields have risen (figure FIN.6), 30 despite the continued trend toward upgrading of developing country debt by rating 15 agencies. 2 0 These developments could be consistent with Jan '12 Apr '12 Jul '12 Oct '12 Jan '13 Apr '13 the beginning of a new trend where the price Equity Issuance Syndicated Bank Lending of risk returns to levels that are more normal. Bond Issuance The trend decline in spreads for developing Source: World Bank; Dealogic. countries over the last five years has been partly explained by their improved credit quality. The decline also reflects very low policy rates and quantitative easing in major Despite weak performance of their high-income countries (World Bank 2010; stock markets in recent months, IMF 2013), with easy monetary conditions having suppressed the price of risk in both developing countries’ gross capital developed and developing countries. inflows have remained robust The most recent surge in both developing country spreads and high-income yields Gross capital flows (international bond issuance, reflects a forward-looking response of cross-border syndicated bank loans and equity financial markets to talk of an eventual placements) to developing countries rose by 63 tapering off of U.S. quantitative easing. While percent year-on-year during the first five months of these increases are expected to ease in the 2013, reaching a historic high of $306 billion short term as the timing of the Fed becomes (figure FIN.7). All types of flows posted an clearer, over the long term both base rates and increase of around 60 percent, with record levels of developing country yields are likely to rise. international bond issuance. Flows to every region Fig FIN.6 Bonds spreads widened despite “the risk- Fig FIN.8 Syndicated bank lending has risen since off” phase July 2012 due to less deleveraging 3-month moving average, $ billion 500 EMBIG Sovereign Bond Spreads excluding Argentina, basis points 30 450 25 400 20 350 15 Sep 09-May 11 Average 10 300 250 5 2005-07 Average 0 200 Sep '11 Jan '12 May '12 Sep '12 Jan '13 May '13 Jan '11 Jul '11 Jan '12 Jul '12 Jan '13 Source: JP Morgan. Source: World Bank; Dealogic. 6 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 Box FIN.2 Regional gross capital flows Gross capital flows to developing countries have rebounded in all regions, except the Middle East and North Africa. A surge in bank lending to firms in the Russia Federation helped to boost flows to the European and Central Asia region to about $105 billion during the first five months of 2013, more than twice their $46 billion level of last year. Bank lending to Russia increased more than threefold from last year as syndicated loans from European lenders more than doubled. All types of capital inflows to the East Asia and Pacific region increased, totaling $92 billion during the first five months of 2013, compared with $55 billion the same period in 2012. Syndicated bank lending in the region almost doubled, reaching $27 billion compared with $14 billion in 2012. Flows to South Asia strengthened mainly due to strong bond issuance by India. Meanwhile, Sub-Saharan Africa saw a marked strengthening in bank lending (led by South Africa and Nigeria) and an increase in bond flows, which together much more than offset a small decline in equity flows. Notably, Rwanda came to the international bond market for the first time with a $400 million 10 -year Eurobond in April 2013, capitalizing on investors’ growing appetite for developing-country debt. In contrast, gross capital flows to Latin America and the Caribbean increased by 23 percent, to $79 billion, in the first five months of 2013 versus a year prior. Equity placement rose by 154 percent due to a strong issuance activity by Brazilian firms, including the largest developing -country corporate bond issuance on record ($11 billion) by the oil company Petrobras. In contrast, bank lending to the region fell by 34 percent. Capital flows to the Middle East and North Africa have been weak so far in 2013, with only one syndicated loan deal for Jordan ($288 million) and two bond issues for Lebanon and Morocco ($1.1 billion and $750 million, respectively). Only Tuni- sia was able was able to raise capital through equity issuance, through four transactions valued totaling $119 million. Box Figure FIN 2.1 Regional gross capital flows ($ billions) East Asia & Pacific Europe & Central Asia Latin America & Caribbean 30 35 Equity Bond Bank 35 25 30 30 25 25 20 20 20 15 15 15 10 10 10 5 5 5 0 0 0 Jan-12 May-12 Sep-12 Jan-13 May-13 Jan-12 May-12 Sep-12 Jan-13 May-13 Jan-12 May-12 Sep-12 Jan-13 May-13 Middle East & North Africa South Asia Sub-Saharan Africa 7 7 7 6 6 6 5 5 5 4 4 4 3 3 3 2 2 2 1 1 1 0 0 0 Jan-12 May-12 Sep-12 Jan-13 May-13 Jan-12 May-12 Sep-12 Jan-13 May-13 Jan-12 May-12 Sep-12 Jan-13 May-13 Source: World Bank; Dealogic. except the Middle East and North Africa European banks has been key. As of early June strengthened (box FIN.2). The sharpest increase 2012, three quarters of European banks had experienced by Europe and Central Asia, where complied with the ECB’s capital ratio the flows more than doubled. requirements. Moreover, according to the April ECB Bank Lending Survey, Euro Area banks have Syndicated bank lending to developing countries eased the pace at which they are tightening credit totaled $91 billion during the first five months of standards.3 Euro Area banks have also begun 2013, 69 percent higher compared with a year ago. repaying ECB crisis loans; some have repaid loans Despite the relative weakness in April, bank well in advance (box FIN.1). lending has been on a rebound since the second quarter of 2012 (figure FIN.8). While many factors More than 50 percent of the bank lending to were at play, an easing of deleveraging by developing countries during the first five months 7 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 The increase in equity flows to developing Fig FIN.9 The average spread and term of bank loans have remained relatively stable in recent countries—initial public offering (IPO) and follow- months on issuance—was due to the strong follow-on Basis points Years issuance in East Asia, Europe and Central Asia, and Latin America and the recovery of the overall 350 7 IPO activity from last year’s low level. While China 300 6 still dominates overall equity volume, equity 250 5 issuance also increased in other countries, including 4 Brazil, Chile, Indonesia, Malaysia, Mexico, the 200 3 Philippines, Russia, and Thailand. 150 2 Average Spread International bond flows to developing countries 100 1 Average Term of Loans (RHS) have been particularly robust thus far in 2013, 50 0 reaching a historical high of $158 billion for the 2005 2007 2009 2011 2013* first five months of the year, including the record *as of May monthly issuance of $45 billion in April. Source: World Bank; Dealogic. Developing countries issued more than $20 billion per month between September 2012 and May of 2013 went to resource-related companies, 2013, with the exceptions of December and mostly for refinancing (26 percent), acquisition (22 February, the latter of which was when the percent), and trade finance purposes (17 percent). Chinese Lunar New Year fell this year (figure FIN.11). The average maturity of the bank loans declined slightly to 5.3 years, with the share of long-term Investor appetite for developing-country debt has syndicated bank lending (minimum maturity of five been driven up by the low yield environment years) falling to 35 percent from 55 percent in 2012 created by quantitative easing in high-income (figure FIN.9). countries. This created an opportunity for several non-investment-grade (non-IG) companies to tap The average cost of bank financing increased by 8 into international bond markets. In fact, the share bps to 3.4 percent as average bank spreads rose by of non-investment grade corporate issuance has 16 bps (figure FIN.9), while the benchmark 6- risen to 31 percent of the value of bonds issued by month U.S. dollar LIBOR has eased in 2013. All of developing countries (compared with 18 percent in the increase in average spreads was on loans for 2012) and 46 percent of the number of bonds acquisition purposes, while spreads on loans for (versus 34 percent in 2012). In addition, there was other purposes fell (figure FIN.10). a long line of first-time international sovereign bond issuers, including Honduras ($500 million) and Rwanda ($400 million). Fig FIN.10 Spreads on loans for acquisition pur- Fig FIN.11 Corporates dominated bond flows poses rose $ billion Acquisitions 45 Basis points Ref inancing 40 500 Working capital 35 Trade f inance 450 Project f inance 30 400 25 350 20 15 300 10 250 5 200 0 Sep Oct Nov Dec Jan Feb Mar Apr May 150 '12 '12 '12 '12 '13 '13 '13 '13 '13 100 2008 2009 2010 2011 2012 2013* Corporate (IG) Corporate (non-IG) Sovereign (non-IG) Sovereign (IG) *as of May 2013. Simple averages of each loans. Source: World Bank; Dealogic. Source: World Bank; Dealogic. 8 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 The heavy issuance trend may now be coming to percent (figure FIN.13). Most developed countries an end, however. During the first two weeks of experienced declines compared to 2011. Belgium, June there were only five sovereign issuances from Finland, and the Netherlands experienced net Chile, Russia, Turkey, and Brazil, raising just $1 disinvestments in 2012, while FDI inflows to billion in the first two weeks of June (versus an Denmark and Germany declined by almost 90 average of approximately $30 billion of debt percent. The relative resilience of FDI in issuance per month by developing countries since developing countries mostly reflects stable re- September 2012). While the increase in borrowing invested earnings and intra-company loans. The costs since May has likely held back bond issuance share of global FDI flows going to developing in recent weeks, there may be other contributing countries reached a historical high of 45 percent in factors, in particular the prospect of a change in 2012. monetary policy stance in the United States. Among developing regions, the largest contraction in FDI flows for 2012 as a while was in South Foreign direct investment inflows to Asia, which experienced a 20 percent decline due to slow growth and regulatory uncertainties in developing countries were robust in India and Pakistan. Most Eastern European the second half of 2012 following a economies also experienced a drop in FDI inflows, reflecting economic weakness in high- weak first half of the year income Europe. Latvia, Lithuania, and Serbia faced the largest declines. Flows to East Asia, as After slowing during the first half of 2012, the well, dropped, with China, Malaysia, and Thailand pace of foreign direct investment (FDI) inflows to all experiencing contractions. Despite the 8 developing countries picked up considerably in the percent reduction in inflows to China, largely final quarter of the year. Nevertheless, inflows resulting from ongoing structural changes in the declined by 5 percent for the year as a whole, to country’s economy, the country was the top FDI $670 billion, from $701 billion in 2011 (figure recipient in the world in 2012. FIN.12).4 The weakness in the flows earlier in the year was mostly the result of increased uncertainty In contrast, FDI inflows to Latin American in global financial markets due to Euro Area economies rose by 10 percent in 2012, supported problems. by still high (though weakening) commodity prices and increased investment from the United States. The impact of the market uncertainty on FDI Argentina, Chile, and Colombia, in particular, flows was more profound for high-income experienced significant increases. economies, where FDI inflows declined by 32 Fig FIN.12 FDI inflows to developing countries Fig FIN.13 Almost half of the global FDI inflows in 2012 went to developing countries $ billion $ billion 350 180 300 160 Developing Countries High-Income OECD 250 140 200 120 150 100 100 80 50 60 2009Q1 2010Q1 2011Q1 2012Q1 2013Q1* 0 2010Q1 2010Q3 2011Q1 2011Q3 2012Q1 2012Q3 *Value for 2013Q1 is an estimate. Source: World Bank; Central banks of selected countries. Source: World Bank; Central banks of selected countries. 9 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 For 2013, high-frequency data indicate a 9 percent result some countries have introduced special rise in FDI flows to developing regions during the measures, including capital controls. first quarter on a year-over-year basis, with a mixed picture across countries. Flows eased in most Asian Recent data on portfolio investment flows for economies, including Malaysia and Thailand, while major middle-income countries presents a mixed flows to Chile, India, and Russia were robust. picture (figure FIN.14). Despite the current Particularly strong FDI flows to Russia during the relatively low risk environment and high levels of first quarter of the year reflect the closing of a market liquidity, flows to local stock and bond special acquisition deal.5 markets have moderated for Turkey but have picked up in Brazil, while flows to Mexico surged FDI flows to developing countries as a whole will in the last quarter of 2012 and were at record high likely rebound in the second half of the year. levels for the year. Several countries in emerging Europe, including Russia and Serbia, have announced plans to As an alternative measure, high-frequency data on accelerate privatization efforts this year. FDI flows flows to emerging market mutual funds indicate a to developing countries are expected to increase by decline in recent months (figure FIN.15). The drop 7 percent reaching $719 billion in 2013. has been particularly sharp for emerging market equity funds, which showed net outflows in March and May. The fall partly reflects weak corporate Hot money flows: a new heat wave earnings and country specific factors (discussed earlier). In addition, downside risks for returns on from the East? emerging market mutual funds assets have risen, in particular due to the possibility that U.S. Treasuries The loose monetary policy environment in high- will rise earlier and higher than expected. income countries since the 2008/09 global financial crisis has prompted a trend among investors to Looking forward, Japan’s recently-begun borrow cheaply and invest in high-yielding foreign quantitative easing program may contribute to an markets. Investors have been attracted to increase inflows to developing countries (box developing country local currency assets (equity FIN.3). The Bank of Japan’s commitment to and bonds) because of their stronger growth purchase $75 billion of government bonds a month potential, and interest rate differentials. This has (just short of the Fed’s monthly purchase of $85 led to significant levels of the flows (hot money billion) is likely to weaken returns in Japanese flows) to equity and local currency debt securities. markets, making developing-country assets Flows to a few large middle-income countries were relatively more attractive. While Japanese investors particularly strong in 2010. Managing the volatility tend to have a stronger home bias than U.S. in these flows can be quite challenging, and as a investors, Japan’s domestic market is smaller than Fig FIN.14 A mixed picture for hot money flows Fig FIN.15 The flows to emerging market mutual funds declined sharply after January Foreign investment in equity and local currency bond markets (% of GDP) $ billions 9 40 8 7 30 Brazil Mexico Turkey 6 5 20 4 10 3 2 0 1 0 -10 -1 Jan '12 Apr '12 Jul '12 Oct '12 Jan '13 Apr '13 -2 2009Q1 2010Q1 2011Q1 2012 Q1 2013 Q1 EM Fixed-Income Funds EM Equity Funds Source: World Bank; Central banks of selected countries. Source: World Bank; Haver. 10 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 Box FIN.3 Japan’s monetary easing and developing countries In November 2012, the Bank of Japan (BoJ) signaled that it would undertake monetary easing measures to combat deflation. Specific quantitative and qualitative easing measures, subsequently announced in April 2013, include the monthly purchase of ¥7.5 trillion ($75 billion) of Japanese government bonds. The aim is to double the monetary base in two years. The BoJ will also increase the average maturity of bonds that it pur- chases from three to seven years, and will continue these measures “as long as necessary.” At $75 billion in monthly purchases, the BoJ’s quantitative easing (QE) program is similar in size to the QE3 program in the United States, under which the Federal Reserve is currently purchasing $85 billion of U.S. gov- ernment bonds each month. Both programs seek to depress the return on low - risk assets in order to push in- vestors into riskier assets. While the immediate beneficiary of quantitative easing is domestic assets, spillover into international capital markets is inevitable. In the case of Japan’s program, the level of the outflows may be larger, in part because at $8.8 trillion for bonds and $3.3 trillion for equities, the Japanese market is only 22 and 8 percent, respec- tively, the size of U.S. markets. Though the bulk of these flows are likely to go to other high - income coun- tries—only 2.4 percent of Japanese external holdings are in developing countries —Japanese investors have recently shown greater interest in local currency bond and equity markets in several developing countries (box table FIN 3.1) via Uridashi funds (typically foreign currency bonds) and larger Toshin investment trust funds (predominantly equity). According to the Investment Trusts Association of Japan, Japanese portfolio invest- ment in local debt securities increased in Mexico (by 34 percent), Turkey (28 percent), and Thailand (17 per- cent) during the first two months of 2013. A less pronounced increase was seen in the Philippines (5.9 per- cent) and South Africa (4.4 percent). Although the depreciation of yen will make Japanese investors’ holding of foreign assets relatively more ex- pensive, it is possible that Japan’s QE program may bring about an increase Japanese multinationals’ direct investment in developing countries by lowering their cost of capital. Among East Asian developing countries, rising outward FDI flows from Japan in recent years have been particularly important for Thailand, accounting for 40 percent of the latter country’s FDI inflows in 2012, up from 28 percent in 2009. Box Table FIN 3.1 Japanese outward investment position by destination, 2011 ($ billions) FDI Portfolio Investment Total PI: Equity PI: Debt Total 935.4 3,279 647 2,632 Developed Countries 742.5 3,203.5 618.6 2,584.9 Developing Countries 192.8 75.6 28.3 47.3 P.R.China 73.5 10.3 9.8 0.5 Thailand 31.0 2.3 1.5 0.9 Indonesia 13.9 5.8 3.3 2.6 Malaysia 9.9 4.3 1.6 2.7 Philippines 9.0 2.7 0.3 2.5 Viet Nam 5.6 0.1 0.1 0.0 India 13.6 5.0 3.4 1.6 Mexico 2.6 11.6 0.5 11.1 Brazil 30.0 28.1 5.6 22.4 Russia 1.5 2.0 1.2 0.8 R.South Africa 2.2 3.2 0.9 2.3 ASEAN 107.6 27.2 13.3 13.9 Source: Bank of Japan. 11 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 the U.S. market and thus the impact on domestic relatively faster than developed economies and asset prices is likely to be larger and the incentive their credit quality has improved, the growth to invest abroad stronger. Japanese investors have differential is expected to narrow as growth in high already shown increased interest in developing -income countries picks up. Perceptions of the countries’ local currency debt markets. In addition, riskiness of high-income country investments have portfolio investment by Japanese investor interest also declined, which should lead to a portfolio shift in developing countries tends to be geographically in their favor over the medium term. diverse, with a significant presence in Brazil, Mexico, and Turkey. In addition, the uniformly accommodative stance of monetary policy in high-income countries may Should the momentum in capital flows to begin to diverge as the United States looks toward developing countries increase in the coming scaling back on quantitative easing and Japan months, some countries may face challenges in expands it. A gradual transition toward U.S. managing the impact of these flows on their monetary policy tightening is likely to increase the economies. cost of capital for developing countries; expectations of such a move may lead to an easing of flows even earlier. The shift in U.S. policy stance may be partially offset by quantitative easing in Prospects Japan, however, if investors there substantially increase their demand for developing country assets. The overall effect is likely to be tighter external financial conditions with considerable implications for developing countries. Following a strong start to 2013 (figure FIN.16 and table FIN.1), net capital flows to the developing Tighter external financial conditions can be world are expected to increase to $1.3 trillion, up expected to impact bond flows to developing from $1.2 trillion in 2012, with another record level countries—both international issuance within the of bond flows, rebounding bank lending, and countries and foreign investment into local robust FDI inflows. As a share of developing currency bond markets. After reaching record countries’ aggregate GDP, however, inflows appear highs in 2012 and 2013, bond flows are expected to set to ease slightly, from 4.9 percent to 4.7 percent. fall gradually in 2014 and 2015. While the prospects for capital flows to developing Bank lending, on the other hand, is expected to countries remain positive in the medium term, rise, particularly now that intense deleveraging some of the factors that have been in play over the pressures have eased—although the extent of the last few years are expected to weaken. For example, bounce-back may be limited by an increasingly while developing economies will continue to grow strict regulatory environment. FDI inflows to developing countries are projected Fig FIN.16 Net private capital flows are set to rise to increase through the forecast period, reaching in nominal terms $758 billion (2.4 percent of GDP) by 2015. Despite 1.4 $ trillion Percent 9 considerable real-side uncertainties in the short 1.2 8 term, multinational corporations continue to be 1 7 attracted to developing countries’ medium-term 0.8 6 growth prospects, large and growing consumer 0.6 5 base, natural resources, and still low labor costs. In 0.4 4 addition, many developing countries are removing 3 0.2 barriers to foreign investment. For example, 2 0 1 following its recent World Trade Organization -0.2 0 accession, Russia has committed to reducing 2004 2006 2008 2010 2012 2014 2016 restrictions on foreign investors in a number of As a share of GDP(RHS) Bank lending Portfolio Equity service industries. Other countries in Eastern STdebt Bond flows FDI Inflows Europe have been pursuing services sector Source: World Bank. privatization. Similarly, India may attract an influx 12 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 of investment in the coming years now that the offset, though, by the market-seeking FDI flows cap on foreign ownership in multi-brand retail and by multinationals interested in serving China’s aviation businesses has been raised. As long as growing middle-income population. Japanese monetary easing reduces the cost of capital for its multinationals, it should also support Despite the expectation that private capital flows FDI flows to Asian economies, particularly to developing countries will increase, the outlook Thailand and Vietnam in the short term. is subject to significant downside risks. First, despite the recent progress towards a resolution of While China continues to be the predominant the Euro Area debt crisis, considerable destination of FDI flows among developing uncertainties remain and, as highlighted by the countries, FDI inflows to the country are expected Cyprus bailout, event risk persists. Any major to ease over the medium term. The Chinese setback could lead to a renewed crisis of economy is in the midst of significant structural confidence. Similarly, lack of progress in dealing adjustments, among these rising wages and with fiscal challenges in the United States has a production costs, which will continue to limit the similar potential to diminish confidence. efficiency-seeking FDI. The decline will be partly Table FIN1. Net capital flows to developing countries ($ billions) 2008 2009 2010 2011 2012e 2013f 2014f 2015f Current account balance 409.4 233.0 173.3 129.6 -16.7 -74.9 -108.2 -126.3 Capital Inflows 812.7 701.0 1,218.8 1,175.0 1,192.4 1,260.9 1,297.4 1,394.8 Private inflows, net 782.3 620.0 1,145.6 1,145.1 1,178.3 1,250.2 1,290.7 1,391.7 Equity Inflows, net 583.4 541.3 710.5 710.4 758.1 791.1 803.5 863.5 Net FDI inflows 637.0 427.1 582.3 701.5 670.0 719.3 715.7 758.2 Net portfolio equity inflows -53.6 114.2 128.2 8.9 88.1 71.8 87.8 105.3 Private creditors. Net 198.8 78.7 435.1 434.6 420.2 459.1 487.2 528.2 Bonds -8.6 61.0 129.7 123.8 190.3 187.3 164.4 151.9 Banks 223.3 -11.9 37.2 108.2 82.0 104.7 125.3 146.9 Short-term debt flows -17.1 17.8 257.6 189.3 141.0 158.5 188.2 221.1 Other private 1.3 11.7 10.7 13.3 7.1 9.2 10.4 9.8 Official inflows, net 30.4 81.0 73.2 30.0 14.1 10.7 6.7 3.1 World Bank 7.2 18.3 22.4 6.6 4.6 IMF 10.8 26.8 13.8 0.5 -3.9 Other official 12.4 35.9 36.9 22.8 13.4 Capital outflows -321.2 -175.2 -314.1 -284.7 -365.4 -371.3 -416.3 -464.4 FDI outflows -211.8 -144.3 -213.9 -198.0 -238.0 -275.0 -325.0 -370.0 Portfolio equity outflows -32.1 -75.9 -50.6 4.3 -12.4 -17.3 -24.3 -29.4 Private debt outflows -78.3 50.7 -57.3 -81.0 -103.0 -72.0 -61.0 -56.0 Other outflows 1.0 -5.7 7.7 -10.0 -12.0 -7.0 -6.0 -9.0 Net capital flows (inflows + outflows) 491.5 525.8 904.7 890.4 827.1 889.6 881.1 930.4 Net unidentified Flows/a -82.1 -292.8 -731.3 -760.8 -843.8 -964.5 -989.3 -1,056.7 Source: The World Bank Note: e = estimate, f = forecast 2 /a Combination of errors and omissions, unidentified capital inflows to and outflows from developing countries 13 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 Another factor that might generate volatility in global financial markets is the process of Fig FIN.17 Net private capital flows are set to rise in nominal terms unwinding of monetary easing in the United States. As discussed earlier, expectations External Private Debt (% GDP) related to a possible easing in the pace of Albania quantitative easing recently led to an increase Zimbabwe El Salvador in U.S. 10-year Treasury yields, accompanied Guatemala by a widening of spreads. A rapid shift in Malaysia expectations related to monetary policy in the Guyana Turkey coming months could generate sharp Belarus adjustments in financial markets and capital Chile Bosnia and Herzegovina flows to developing countries. Armenia Macedonia, FYR Jamaica In such a scenario, vulnerabilities that have built up Jordan during periods of sustained low borrowing costs Lao PDR Serbia may be exposed. In this respect, 18 developing Georgia countries have private external debt exposures in Lithuania Kyrgyz Republic excess of 30 percent of GDP (figure FIN.17). Nicaragua Three-quarters of these are in developing Europe Romania and Central Asia, reflecting strong banking and Moldova Ukraine inter-company linkages with high-income Europe. Kazakhstan In the case of Seychelles and Papua New Guinea, Bulgaria Papua New Guinea the gross private sector debt reflects a thriving Latvia offshore-banking system. Though the presence of Seychelles offshore banking changes the nature of the 0 20 40 60 80 100 120 associated risk, it does not eliminate it, as the Note 1: External private debt include private nonguaranteed external debt with short- and long-term maturity. recent experiences of Cyprus, Iceland, and Ireland Note 2.Orange bars indicate low income countries. illustrate. Source: World Bank. 14 GLOBAL ECONOMIC PROSPECTS Financial Market Outlook June 2013 Notes 1. Argentina defaulted a record $95 billion in sovereign debt in 2001. Although the country managed to restructure 92 percent of the debt in 2005 and 2010, Argentina remained in a drawn-out legal battle with bondholders who did not enter into the debt swaps. In the fall of 2012, a U.S. court ruled that Argentina was obliged to repay the unrestructured debt, prompting fears that the country may default once again. As of mid-2013 the issue remains unresolved. A recent IMF (2013b) report indicates that ongoing litigation against Argentina could have significant implications for future sovereign debt restructurings by increasing the leverage of holdout creditors. 2. Since January 2013, the sovereign ratings of 11 developing countries have been upgraded, while only five have been downgraded. 3. According to the April ECB report, net tightening of credit standards declined for loans to businesses in the Euro area. Net tightening for firms is now below its historical average. Credit standards also declined for households, although they remain higher than the historical average. 4. Historical FDI data has been revised given that several countries have started reporting according to the Balance of Payments and International Investment Position Manual (BPM6). 5. FDI flows to Russia surged in the first quarter of 2013 as the deal between Rosneft and BP around the TNK-BP sale eventually resulted in the acquisition of 18.5 percent of Rosneft, worth almost $15 billon, was closed. Adjusted for this one-off event, FDI inflows to Russia remained fairly stable during the first quarter of 2013. References IMF. 2013. Global Financial Stability Report: Old Risks, New Challenges. Washington, DC: IMF. ______. 2013b. “Sovereign Debt Restructuring—Recent Developments and Implications for the Fund’s Legal and Policy Framework.” IMF, Washington, DC. http://www.imf.org/external/np/pp/eng/2013/042613.pdf. World Bank. 2010. Global Economic Prospects: Crisis, Finance, and Growth. Washington, DC: World Bank. ______. 2013. Global Economic Prospects: Less Volatile, but Slower Growth . Washington, DC: World Bank. 15