After the crisis, private lenders close the purse

News Analysis: The worst of the turmoil is over, but private capital flows to emerging economies have dried up

THE EFFECTS of the global financial crisis, which began in July 1997 with the devaluation of the Thai baht and reached a climax last August with Russia's default and the near-collapse of Long-Term Capital Management, are still working through the financial markets.

One of the most worrying was highlighted in a report published yesterday by the prestigious Institute for International Finance (IIF). This association of the world's biggest banks predicts a further year of subdued capital flows to emerging economies in 1999, with signs that lenders and investors are more than ever discriminating in favour of just a few countries.

The total net private capital flow to emerging economies was just over $140bn (pounds 86bn) in 1998, a sharp drop from 1997's $263bn total and the previous year's record $328bn. The IIF expects this year's figure to be about the same as last year's.

Within that total there will be some shifts. Direct investment held up extremely well last year at $120bn, thanks to bargain prices. But slower growth in the world economy will take its toll, reducing this year's figure to an estimated $103bn.

The IIF expects nothing less than a catastrophic drop in bank lending to emerging markets. Net flows from commercial banks fell by $29bn in 1998 and are expected to drop by another $11.8bn this year. Flows via non-bank creditors - mainly bonds - are expected to total $28bn after $49bn in 1998.

Taken together, private credit flows will be just $16bn in 1999, somewhat less than in 1998 and down from nearly $200bn in 1996. With much of the new lending involuntary - the result of interest arrears in Russia and Indonesia - voluntary lending will be a meagre $7bn.

There is one bright spot. Portfolio equity flows have begun to recover and should rise. The forecast is for $20bn, on 1998's tiny $2bn, as emerging equity markets continue to recover.

And, in another signal that the crisis is abating, official flows are likely to decline. They totalled a whopping $51bn last year, but are forecast to dip to $33.5bn this year, with no new financial emergency on the cards.

Charles Dallara, IIF managing director, reckons the flow of private credit is improving slowly. "A pick-up in flows appears possible as the year goes on, assuming key economies remain on track," he said.

John Bond, chairman of the IIF board and chairman of HSBC Holdings, said there were some encouraging trends. "Fundamentally, the sustained recovery of portfolio equity flows will depend on the ability of emerging market economies to perform well."

But the report notes there is evidence that lenders and investors are restricting new lending and investment to just a handful of countries. William Rhodes, vice-chairman of Citigroup, said: "There is growing evidence that lenders and investors are differentiating more carefully between emerging markets."

The evidence lies in the range of spreads on bonds in different markets. All spreads between emerging market bonds and safe assets, such as US Treasury bonds, exploded last August and remain high by past standards, even though they have since narrowed.

But Asian spreads are lower by far than those for Latin American and East European bonds, and much of the recovery in net new investment reflects an end to the disinvestment in Asia that characterised 1998.

On the other hand, flows to central and eastern Europe are still in decline. So, for example, Brazil still pays around 8.2 percentage points above the odds to borrow on the international capital markets, down from a peak of 11.25 percentage points. This compares with a 2.5 per cent premium for Asian bonds, down from 9.6 points in August and 3.6 points at the end of 1998. Korea and Thailand are actually in a better position now than before the August crisis.

The report concludes that there has been real improvement for just a limited number of high-quality borrowers. And investor sentiment remains cautious. The report says: "Serious policy slippage in a key economy could have a major impact on sentiment." So, too, could further slowing of growth in developed economies. Low growth in the G7 would erode prospects and creditworthiness in the emerging markets.

The report also contains a special warning about the dangers of creeping protectionism, especially in the US market so crucial to emerging economies. The EU banana dispute, the passage of a bill in the House of Representatives imposing steel quotas, deferral of China's entry into the World Trade Organisation - all are ominous signs of protectionism.

The experts' verdict is that the worst of the crisis is over and signs of normalisation are evident. But the note of caution expressed by the IIF is unmistakable.