The reversal of capital inflows due to deleveraging or losses in financial markets has been one of the most significant effects of the financial crisis on emerging and frontier economies. After a period in 2007 and 2008 when many emerging markets faced the problem of dealing with extensive capital inflows, now capital flows have reversed. Private capital flows in 2009 are expected to be less than half of their 2007 levels, posing pressure on emerging market currencies, asset markets and economies. Countries that relied on readily available capital to finance their current account deficits are particularly vulnerable. Furthermore, capital outflows pose the risk that governments may react with some type of capital controls or barriers to the exit of foreign investments.

Foreign direct investment (FDI) is considered by many to be a major and more stable source of financing for many developing countries. FDIs slowed down sharply in recent quarters due to two major factors affecting domestic as well as international investment. First, the capability of firms to invest has been reduced by a fall in access to financial resources, both internally (due to a decline in corporate profits) and externally (due to lower availability and higher cost of finance). Second, the propensity to invest has been affected negatively by economic prospects, especially in cases involving corporations with operations in the developed countries which are hit by a severe recession. In addition, a very high level of perceived risk is leading companies to extensively curtail their costs and investment programs to become more resilient to any further deterioration of the business environment and their balance sheets. The fact that many multinational enterprises can easily shift financial resources from one country to another, adds another degree of uncertainty, contributing to the growing macroeconomic instability in developing countries.

The outlook for the flow of portfolio investments is even less encouraging. Redemptions of US$41.2 bn out of EM equity funds in 2008 have fully reversed the record US$40.8 bn inflow of 2007. About half of the EM fund purchases that have occurred since 2003 have now been withdrawn. According to the Institute for International Finance (IIF), net private capital flows to emerging markets are estimated to have declined to US$467 bn in 2008, half of their 2007 level. A further sharp decline to US$165 bn is forecast for 2009, with just over three-quarters of the decline due to deterioration in net flows from commercial banks. Moreover, net lending of international banks to emerging countries (excluding Gulf countries) is expected to fall to US$135 bn in 2009 from US$401 bn in 2007 and US$245 bn in 2008.

The World Bank estimates that in 2009, 104 of 129 developing countries will have current account surpluses inadequate to cover private debt coming due. For these countries, total financing needs are expected to amount to more than US$1.4 trillion during the year. External financing needs are expected to exceed private sources of financing (equity flows and private debt disbursements) in 98 of the 104 countries, implying a financing gap in 98 countries of about US$268 bn. Should bank rollover rates be lower than expected, or should capital flight significantly increase, this figure could rise to almost US$700 bn. Well over US$1 trillion in EM corporate debt and US$2½-3 trillion in total EM debt matures in 2009, the majority of which reflects claims of major international banks extended cross-border or through their affiliates and branches located in emerging markets.

For most of the reasons presented above, a number of emerging economies have recently imposed controls on capital outflows as a way of managing financial crises. Iceland, Ukraine, Argentina, Indonesia and Russia, among others, have resorted to a number of restrictions on the availability of foreign exchange as a way of dealing with the collapse in global risk appetite. Although those are frequently used as a way of rationing forex during a crisis, there is a risk that capital controls might become a normal part of policymakers’ tool-kits well beyond strict emergency needs. In principle, capital controls permit monetary and fiscal policy to be directed to the stabilization of economic activity without having to worry about a collapse of the currency and its deleterious effects on the sectoral and national balance sheets. The imposition of capital controls should be viewed as temporary, with a gradual relaxation as economic conditions improve and global financial stability returns. Such controls might restrict the ability to attract capital in the future as foreign investors fear that they will be unable to repatriate their profits

With rising unemployment and falling real wages, remittances will also subside with pressure on the standard of living, growth and external balances of labor-sending countries. In addition to these private capital flows the reduction of official flows, including development assistance is also set to slow as donors scale back their funding in the face of greater domestic needs. However funds available from multilateral institutions like the IMF and regional development banks may partly offset the decline in other funds and withdrawal of private capital. The G20 seems to have neared an agreement on doubling or tripling the IMF’s lending capacity and regional development banks like the EBRD, ADB and others are boosting their capital base and scaling up their lending to support regional banks.

The fall in the price of oil (and the reduction in oil revenues) has eroded the surpluses of oil exporting nations, lowering the funds they have to invest abroad in advanced economies and in emerging markets. Furthermore the need for capital at home (to support domestic banks, finance fiscal stimulus packages, stabilize asset markets) and losses on past investments are leading sovereign investors to privilege liquid assets rather than the riskier assets like equity, corporate bonds and alternatives – which they tended to invest in until mid 2008. The reduction in funds entrusted to the international banking system by countries like Russia and African oil exporters, some of which, the IMF suggests, were re-lent to Eastern European countries, provide further pressure on bank lending. Governments of commodity rich countries are now having to take on a larger role in financing infrastructure projects that had been earmarked as public-private partnerships rather than making significant investments overseas. However, other investors like some of Chinese government institutions may be emerging to take up some of the slack. China recently extended loans to several cash-strapped resource companies and may also be emerging as a source of investment to countries like Pakistan and Kazakhstan.