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Flow of Capital Soars To 'Emerging' Nations

Private Investment Surge Echoes 1990s

By Paul Blustein
Washington Post Staff Writer
Thursday, January 20, 2005; Page E05

Private investment is pouring into developing countries at the fastest rate since just before the Asian financial crisis of the late 1990s, according to a report released yesterday by the leading international association of financial institutions.

The trend has some of the features of a "bubble" that could lead to market turmoil in the future, the group's director acknowledged.

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The Institute of International Finance Inc., which represents more than 300 banks, investment firms and other major financial companies, said the flow of private money to 29 "emerging market" nations reached $279 billion last year. That is more than double the 2002 level, and close to the $287 billion posted in 1997, the year that Thailand's currency collapsed, sparking a flight of capital from Asia. The record was in 1996, when $322 billion flowed into emerging markets.

The flow of capital has been especially strong in recent months to China and Russia, but was also up last year in Latin America, Eastern Europe, Asia and the Pacific, and Africa and the Middle East.

The pace will continue this year, according to the group's forecast. Net flows of private capital -- the amount of new private investment and loans less outflows and repayments -- will be $276 billion in 2005, the institute predicted.

The figures are the latest evidence suggesting to some economists that global financial markets have been pumped up to dangerous heights thanks in part to the low-interest rate policy pursued by the U.S. Federal Reserve and other major central banks. The enormous amount of capital flooding into developing countries has stirred concern that the boom could turn to bust if market conditions change and investors prove as panic-prone as they did during the late 1990s. The flight of investors that began in Thailand spread through much of the developing world, and triggered recessions or sharp economic slowdowns in such countries as South Korea, Russia and Brazil.

Charles H. Dallara, the institute's managing director, said at a news conference that he doesn't like comparing the current figures to 1997's, because "we don't want to suggest we're on the precipice of a crisis. But these numbers do raise some important questions."

The surge of money into emerging markets in 2004 stemmed in part from improved policies and economic fundamentals in major countries such as Brazil and Turkey, he said. Bolstering that point, the report noted that there has been a "marked improvement" since 2001 in the average credit rating of emerging market countries that issue bonds to private investors, meaning they are considered better credit risks.

But the flood of capital can also be attributed to "strong liquidity growth" worldwide and "relatively low returns on fixed income and equity" investments in the United States, Europe and Japan, Dallara said. The Federal Reserve has pumped large amounts of cash into the U.S. banking system in recent years, resulting in low yields on U.S. Treasury bonds and other securities. That prompted some investors eager for extra returns to accept yields on emerging-market bonds that are relatively modest in relation to the risks involved with investing in countries with less stable economies.

The report noted that the average "spread" on emerging market bonds -- the extra yield that investors demand above U.S. Treasurys -- fell to a seven-year low of 3.46 percentage points on Dec. 27.

"There could be a dimension of a bubble" in the current situation, Dallara said in response to a question. He issued similar warnings early last year, when emerging-market bond spreads plunged. The concern abated somewhat in the middle of the year, when the average spread rose as high as 5.69 percentage points, but now the spreads are very low again.

"It would be naive for us to think that the benign environment will continue in 2005," Dallara said, noting that investors will almost certainly turn more cautious once it becomes clear that the Fed is pushing U.S. rates up.

An investment surge in the fourth quarter was mainly the result of sharply increased flows into China, where investors are betting that the government will abandon its fixed exchange rate and allow the nation's currency to rise. Russia was another major recipient, because Russian banks have been borrowing abroad to speculate on a rise in the ruble, Dallara said.

On the positive side, nearly half the private money flowing into emerging markets last year consisted of direct investment -- that is, investment in plants, equipment and businesses rather than portfolio investment in stocks and bonds, said Yusuke Horiguchi, the institute's chief economist.

The report showed that the Asia-Pacific region was, as usual, the biggest recipient of private investment, with $146 billion in net capital flow. Next were the emerging markets of Europe, at $97 billion, followed by Latin America at $26 billion and Africa and the Middle East at $9.2 billion.

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