LONDON: Emerging economies dependent on overseas financing to balance their books look vulnerable to another looming slowdown in bricks-and-mortar investment, as rising deficits in many countries force reliance on volatile financial market flows.
A report last month report by the United Nations agency UNCTAD painted a bleak picture of the outlook for foreign direct investment (FDI), noting a sharp slowdown globally in the third quarter of 2011 after a strong start to the year.
That’s hardly surprising, given the euro crisis threatens to tip the world economy into recession and companies across the West have embarked on a multi-year deleveraging cycle. In this environment, FDI, involving big-ticket investment in factories, mines and land, will inevitably take a harder hit than stock and bond flows as companies scale back long-term commitments.
This is dismaying at a time private investment is urgently needed to jump-start growth and create jobs. But it is in the emerging world an FDI slowdown has big repercussions — above all for the ability to fund balance of payments deficits.
David Hauner, head of EEMEA economics and fixed income strategy at BofA Merrill Lynch Global Research, cites Turkey and Poland as prime examples of emerging countries where FDI has not kept pace with booming economic growth.
Like many developing countries, Turkey’s low interest rates and loose fiscal policy after the 2008 crisis unleashed a growth and credit boom, leading to a massive import surge. The result is its current account deficit is almost triple 2005 levels.
But FDI halved in this period to $9 billion this year to cover 16 percent of Turkey’s deficit versus 50 percent in 2005.
Poland has seen its current account deficit double in the past six years.
Back in 2005 it, like other countries in central Europe, was a key investment destination for German manufacturing giants looking to capitalize on lower labor costs. That FDI then covered almost the entire Polish deficit.
This year, Poland should receive $2 billion in FDI, or just over 6 percent of its financing needs, BofA-ML data shows.
"Growth in these countries will be constrained by a lower rate of investment," Hauner said. "Second, you can see the share of FDI financing…is dramatically down. That means more financing is coming from debt and primarily short term debt, which is making these countries more vulnerable."
FDI is considered safest form of investment as it is long-term focused and generates jobs and tax receipts. Flows to stocks and bonds are volatile and can generate balance of payment crises if investors suddenly decide to pull out.
Investors’ fears over deficit financing were highlighted by the recent global sell-off which hit the Turkish lira and Polish zloty harder than most currencies. The lira has lost 15 percent to dollar while the zloty fell 10 percent, both currencies supported by repeated central bank interventions.
"Both these countries show how the decline in FDI has led to increased volatility in exchange rates," Hauner added.
No FDI, no portfolio cash either
Worries about financing current account deficits are weighing even more heavily in Africa, pushing currencies in Kenya, Uganda and Tanzania to multi-year lows against the dollar and forcing central banks into currency-defending rate hikes.
Kenya, facing a current account deficit that has doubled in the past year, jacked up rates by 550 basis points on Wednesday, threatening a huge hit to economic growth.
These countries, with tiny, illiquid capital markets, have always been more heavily reliant on FDI and aid than peers in Eastern Europe or Latin America. FDI covered a third of Kenya’s deficit in 2008 but now covers 17 percent, IMF data shows.
"Why are we seeing so much FX volatility in Africa?" said Razia Khan, chief Africa economist at Standard Chartered. "These countries relied very heavily on FDI …and that’s one of the flows that would have shown substantial correction."
Egypt may become a test case for the consequences of FDI collapse, Renaissance Capital economist Mert Yildiz says.
Turmoil during the Arab Spring ousting of long-standing leader Hosni Mubarak and lack of clarity over future policies are seen cutting 2011 FDI to a maximum of $3 billion, half of last year’s levels and down from over $14 billion in 2008.
"What happened in 2004-2008 was that unemployment came down and the reason was Egypt was open to FDI. Sectors reliant on FDI and foreign expertise were providing the jobs and exports, others such as retail are at capacity," Yildiz said.
No relief in the short term
As competition for FDI hots up post-crisis, analysts expect competitive devaluations to become frequent. A BofA-ML study found the recent depreciation of the Turkish lira cut average labor costs in dollar terms to $1,290 a month — 25 percent below Poland.
Cost advantages and economies of scale are already helping big fast growing emerging markets grab an increasing share of the pie. China for instance has seen inflows leap above $100 billion a year, almost double 2005 levels.
Many say an FDI rebound is due, citing companies’ need for returns and bumper cash reserves of over $2 trillion globally. But without evidence of an uptick in world growth, firms will prefer to play safe, prioritizing share buybacks and retiring debt. US buybacks rose 63 percent in the first half of 2011.
"It is a structural phenomenon to the extent that we still have excess capacity globally and there is deleveraging in most of the countries where FDI originates," Hauner of BofA-ML said. –Additional reporting by Carolyn Cohn
