Private capital flows to Asia slowed sharply from US$315 bn in 2007 to around US$96 bn in 2008. Risk aversion, de-leveraging and redemption by investors to offset losses in developed markets contributed to portfolio outflows of US$55 bn in 2008 and foreign bank borrowing slowed from US$156 bn in 2007 to just US$30 bn in 2008. While these trends will continue to erode capital flows to Asia in 2009, albeit at a slower pace, even more resilient flows like FDI and debt inflows will take a hit also. South Korea, India and Indonesia are most vulnerable to capital outflows, however foreign capital fueled credit growth and lending to firms and households even in countries like Hong Kong, Taiwan, Singapore and Vietnam. Therefore, the ongoing liquidity crunch will hit fixed investment, consumer spending, raise credit costs and bank delinquencies as well as undermine asset markets.

After emerging Europe, emerging Asia has been most severely hit by the decline in foreign bank borrowing especially firms and banks in South Korea, India, China and Indonesia which relied heavily on foreign capital to drive investment and consumer spending. But despite having high external debt and short-term debt relative to foreign exchange reserves, countries like South Korea, India and Indonesia will be able to meet the debt obligations due in 2009 (over 50% of it to Western European banks) or even roll over debt. After 2008 reversed the portfolio inflows of 2007, outflows might continue even in 2009 led by India, Taiwan and South Korea. The main drivers will likely be domestic risks (GDP growth and export slowdown, lower corporate earnings, easing fiscal and external balances), not just global factors. This might exacerbate equity market sell-offs in India, Thailand, Philippines, China, Vietnam, Singapore and Hong Kong so that valuations, in spite of being attractive in markets like Hong Kong, Indonesia, Singapore and Vietnam, might trend down further.

Fiscal stimulus and subsidy spending are affecting fiscal balances and raising external financing needs of countries like Malaysia, Philippines, India, Vietnam and Indonesia. Others like China will boost domestic bond issuance. While yields will go up, bond issuance might continue to face a tepid response due to risk aversion in EMs, flight to safe-haven (the U.S.!), narrowing interest rate differential with the U.S., risk of ratings downgrade, and expectations of limited currency appreciation in the near term.

The global credit crunch, high credit costs and export contraction have also taken a toll on FDI into Asia, a large share of which is export-related. China, Indonesia, Malaysia and Vietnam where FDI accounts for a large share of total fixed investment, are most affected. FDI to China began slowing in the second half of 2008, and has been declining for the last five months as the global outlook began to worsen, and revaluation expectations were reversed. The decline in corporate profits though poses a bigger risk to investment as retained earnings are the biggest contributor to investment. Moreover, large lay-offs across the world, especially in the West and the GCC will impact countries dependent on remittances such as Philippines, Vietnam and India, challenging the financing of current account balances and also domestic demand in some countries.

Capital outflows have pulled down most Asian currencies since 2008 led by South Korea, Malaysia, Singapore, India, Indonesia and Taiwan. In response, many central banks like India, South Korea, Thailand, Philippines, Vietnam and Indonesia have run down foreign exchange reserves to defend their currencies. And even Chinese reserve growth has been much more subdued, with the most recent numbers suggesting that China may have experienced capital outflows in several months in Q42008 and Q12009. Amid dollar squeeze, countries like Indonesia have imposed restrictions on currency conversion and US$ outflows, while others like India have eased foreign investment rules to attract the much needed capital. Waning capital inflows will put pressure on the BOP as shrinking exports affect the current account, especially for those running trade and/or current account deficits – South Korea, India, Thailand, Vietnam, Indonesia and Philippines and those running surpluses like China and Taiwan will run narrower surpluses. Nevertheless, large foreign reserve accumulation and current account balances will contain risks of BOP and currency crises like in 1997-98. Asian central banks have also been actively injecting dollar liquidity, entering swap agreements (South Korea, Indonesia, Singapore, Hong Kong), easing credit costs for firms, and expanding Asian reserve pooling under the Chiang Mai Initiative to relieve selling pressure on their currencies. The expansion of Asian Development Bank’s resources, as advocated by the G20 will provide further financing to avert the reversal of other development assistance and avoid balance of payments pressure.