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 that 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 jumpstart 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 (BofA-ML), 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 that its current account
deficit is almost triple 2005 levels.
But FDI halved in this period to $9bn this year to cover 16%
of Turkey’s deficit versus 50% in 2005.
Poland has seen its current account deficit double in the
past six years.
Back in 2005, like other central European countries it was a
key investment destination for German manufacturing giants looking to
capitalise on lower labour costs. That FDI then covered almost the entire
Polish deficit.
This year Poland should receive $2bn in FDI, or just over 6%
of its financing needs, BofA-ML data show.
"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 the 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% to the dollar while the zloty fell
10%, 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 said.
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%, IMF data show.
"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 said.
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 $3bn, half of last year's levels and down from over
$14bn 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 short-term relief
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 labour costs in dollar terms to $1
290 a month - 25% 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 $100bn 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,
prioritising share buybacks and retiring debt. US buybacks rose 63% 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.