Global Capital Flows to Ebb in 2006

Written by Stephen Poloz

There is an old saying that love makes the world go ’round. But those who deal with everyday commerce know differently — ’tis money that makes the world go ’round.

Every dollar spent in the world is received by someone. Those with surpluses become investors while those who accumulate deficits become debtors. The U.S. economy is one of the latter, because it is carrying a massive balance of payments deficit.

Countries with payments surpluses must put the money somewhere, and the money will find its way ultimately to countries with deficits. For example, Japan has an international payments surplus, so Japan is lending to the rest of the world. These flows of funds between countries can take two forms. One is financial investment, as Japanese investors purchase U.S. bonds and stocks. The other is called foreign direct investment (FDI), and occurs when Japanese investors purchase or build real assets in the U.S. — factories, real estate and so on.

Global capital flows are a good gauge of investor sentiment. When global conditions are uncertain, such as during the recessionary period of 2001-02, investors move their funds to safe markets, like the U.S, and interest rate spreads between U.S. bonds and bonds in developing markets tend to widen. In better times, they invest in riskier markets, and bond spreads narrow.

FDI flows in all directions declined during 2001-02, and flows to the major economies continued to decline in 2003-04. In contrast, FDI flows to developing countries began to recover in 2003, and then rose by 40% in 2004, to US$233 billion. By all indications, FDI to developing markets remained strong in 2005, because interest spreads continued to narrow.

But economists are looking for a moderation in global economic growth in 2006. The OECD’s leading economic indicator is pointing to a significant slowdown. The U.K. and Australia have slowed, led down by their formerly booming housing sectors, and the U.S. economy appears to be following suit. World economic growth will remain solid at 4.1% in 2006, but this is well below the rates in excess of 5% observed during 2004 and into the first part of 2005.

Accordingly, it is likely that FDI flows to the developing economies have peaked for this cycle. Slower economic growth, continuing high debt, the stresses of high oil prices and a busy electoral calendar will cause investors to increase the share of low-risk assets in their portfolios — and a widening of interest rate spreads and a stronger U.S. dollar will be the natural result.

The bottom line? Global capital flows are an essential mechanism for maintaining world economic growth, and FDI flows to developing markets probably hit a record in 2005. But 2006 will see slower growth and rising risks, so global investors should prepare for more volatility.

The views expressed here are those of the author, and not necessarily of Export Development Canada.

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