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Financial market conditions have improved over the past year

The improvement reflects progress toward fiscal sustainability in the Euro Area, reinforced assurances that the European Central Bank (ECB) will do whatever it takes to save the Euro Area, and concrete steps toward reinforcing those aspects of institutional weakness that contributed to Euro Area difficulties (box 1).

These improved financial market conditions have persisted for almost a whole year, despite being subjected to stresses, including elections in several economies, concerns about a potential banking crisis in Slovenia, the Cyprus rescue package, and an extended period of very slow or negative growth. The durability of the improved indicators attests to the improvement in conditions. Nevertheless, concerns remain, particularly among banks in high-spread countries, which continue to be burdened by relatively large quantities of underperforming loans and relatively weak levels of capitalization (IMF 2013b).

The better financial conditions in the Euro Area, in tandem with the extraordinary monetary policy steps undertaken by the Federal Reserve Bank in the United States, the Bank of England, the ECB, and most recently the Bank of Japan, have flooded markets with liquidity. This in turn has reduced yields on long-term debt and the price of riskier assets—including developing-country equities, bonds, and bank loans. As a result, by May gross capital flows to developing countries, which were weak for most of the post-crisis period, have recovered to close-to-peak levels. Bank lending and equity issuance has doubled relative to the same period a year ago (figure 2). Nevertheless, as a percent of developing-country GDP, capital flows remain well below pre-crisis levels.

Figure 2
Gross capital flows to developing countries have recovered in nominal terms

Source: World Bank, Dealogic

The recovery in bank flows is especially important, because it suggests that the most acute effects on developing countries of the deleveraging among high-income banks have passed. Most of the recent recovery in banking flows has benefitted developing Europe and Central Asia, which was the developing region hardest-hit by the crisis and by the Euro Area deleveraging process. Flows in most regions, except the Middle East & North Africa,FN1 were significantly higher than in 2012, with Europe & Central Asia (mainly banking and bond), and East Asia & Pacific (mainly bond and equity) recording the biggest increases.

Despite the improvement in gross flows and in financial indicators among high-income countries, developing-country financial-market prices have been weak. Thus, while stock markets in high-income countries surged in the post–June 2012 period (the Stoxx Europe 600, Standard & Poor’s 500 Index, and Nikkei 225 are up 17.5, 18.1, and 44.5 percent, respectively), overall indexes for developing countries have declined. This said, some developing-country stock markets have shown strong gains, raising concerns about overvaluation. Equity market indexes in Indonesia, Malaysia, the Philippines, and Thailand all recorded highs in 2013, partly reflecting strong inflows of foreign private capital. Indeed, stock markets in these countries have declined lately as concerns about high valuations and prospects of scaling back of the U.S. stimulus program weighed in on investor sentiment.The generally better performance of high-income stock markets in the recent period reflects both a difference in timing (developing-country stocks recovered earlier in the cycle), and the relatively high valuations that developing-country stock markets had at the start of the crisis. Currently price-earnings ratios of major developing-country firms remain much lower (between 12 and 18) than in high-income countries (where they are between 16 and 24).

Overall, net capital flows (inflows + outflows) to developing countries fell by about 7 percent in 2012, reflecting broadly stable net inflows (1.5 percent) and a 28.4 percent increase in outflows, roughly proportionately distributed across foreign direct investment (FDI), equity, debt, and other outflows (table 2). Both net inflows and outflows are projected to rise. Overall net capital inflows should rise by about 5.7 percent in 2013, with much of the increase reflecting the stronger flows toward the end of 2012. They are expected to rise by 2.9 percent in 2014 and 7.5 percent in 2015, reaching $1.4 trillion or about 4.3 percent of developing-country GDP in 2015.

Table 2
Net financial flows to developing countries ($ billions)
Source: World Bank
Notes: e = estimate, f = forecast
/a Combination of errors and omissions, unidentified capital inflows to and outflows from developing countries

1. Equity flows to the Middle-East & North Africa completely dried up in the first four months of 2013, with just one bond issue from Lebanon ($1.1 billion) and two syndicated bank deals worth about $643 million.

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