. Overview: International Finance and the Poorest Developing Countries T HE INTEGRATION OF DEVELOPING COUN- percent in real terms over the same period. The tries into the global economy increased poor countries now receive about the same level of sharply in the 1990s with improvements in FDI as middle-income countries, relative to the size their economic policies; the massive expansion of of their economies. In addition, the global expan- global trade and finance driven by technological sion of international banks coupled with the liber- innovations in communications, transport, and alization of domestic financial systems in the poor data management; and the lowering of barriers to countries increased the average share of foreign trade and financial transactions. Many of the poor- bank assets to more than 40 percent of total assets, est developing countries1 participated strongly in more than double the share of 1995 and compara- this process despite their limited access to capital ble to that of many middle-income countries that markets. This report analyzes the interaction be- have recently benefited from increased foreign tween the global expansion of finance and im- bank participation (see pages 64­66). provements in domestic policies in the poor coun- tries over the 1990s, and the implications for --good policies and governance, along with growth and poverty reduction. Three main mes- strong institutions, are critical to using private sages are developed: (a) a strong investment cli- flows productively mate is critical to attracting foreign capital and A rise in private flows can have a substantial im- using it productively; (b) poor countries' increas- pact on investment in the poor countries and, if ing integration in the global economy means that productively used, on growth. However, the policy they face similar policy challenges as middle-income framework must be right. Improvements in the in- countries, including how to deal with capital mo- vestment climate (a term that refers to the numer- bility; and (c) achieving the Millennium Develop- ous ways in which government affects the produc- ment Goals will require a substantial rise in aid tivity of investment, including policies, governance, flows, an increased allocation of aid to countries and the strength of institutions) have boosted the with good policies, and improvements in policies impact of international financial transactions on by both developing countries and donors. productivity in the poor countries. Domestic firms in countries with strong investment climates are A greater integration of poor countries more able to absorb the foreign technology and and private capital-- skills that come with FDI (see pages 62­63). Better The surge in foreign direct investment (FDI) flows policies have enabled some poor countries to at- and the decline in aid have transformed external fi- tract more diversified FDI flows--the share of nance to the poor countries. FDI flows to the poor countries that export natural resources in the poor countries rose from 0.4 percent of the gross domes- countries' FDI dropped from half in 1991 to 20 tic product (GDP) in the late 1980s to 2.8 percent percent toward the end of the decade. Countries in the late 1990s in response to the globalization of that established the competitive conditions re- production and improvements in domestic policies quired to attract foreign banks experienced an im- (see pages 59­61). Aid to these countries fell by 20 provement in the efficiency of their domestic banks 1 G L O B A L D E V E L O P M E N T F I N A N C E and thus a decline in the cost of financial interme- Good policies and strong governance diation (see pages 66­69). are also key to improving aid effectiveness E arlier empirical studies consistently found a weak relationship between aid and investment, Poor countries face similar challenges with even less of an impact of aid on growth. How- from globalization as middle-income ever, more recent research shows that aid makes countries an effective contribution to growth and poverty re- T he events of the past year underlined the risks duction in countries with good economic policies, of capital mobility for the middle-income sound institutions, and strong governance, but has emerging markets. The current global economic little effect in countries with poor policies. A dou- slowdown, exacerbated by the bursting of the high- bling of aid flows would help ensure that develop- tech bubble at the end of 2000 and the terrorist at- ing countries achieve the Millennium Development tacks in September 2001, is exceptionally deep and Goals, provided that this aid is allocated to coun- broad (see pages 7­11). Capital market flows once tries with good policies and large numbers of poor again proved to be procyclical: the growth slow- people (pages 99­100). down in industrial countries reduced both emerg- Aid continued to decline in 2001, and the pros- ing markets' export revenues and their access to ex- pects for a substantial rise in the medium term are ternal finance (see pages 32­36). By contrast, the limited (pages 90­94). Most countries with good level of FDI in 2001 was virtually unchanged from policies can continue to absorb additional aid re- the previous year despite adverse global conditions, sources without seriously impairing the effective- including a drop in global FDI flows (see pages ness of that aid (see pages 96­99). Aid does not, in 37­40). The crisis in Argentina illustrates how general, increase the volatility of government re- open capital accounts can compound the effects of sources, and appropriate policies can ensure that unsustainable macroeconomic policies and high aid does not contribute to inflationary pressures or public sector debt, thus seriously complicating sta- cause excessive exchange-rate appreciation. It is bilization efforts (see pages 43­47). true that even in many countries with good poli- The poor countries are also vulnerable to capi- cies, lack of administrative capacity lowers the tal mobility. While most still impose restrictions on marginal productivity of aid as aid levels rise. capital account transactions, controls have had However, recent research indicates that aid levels only limited success in controlling capital outflows to most countries with strong economic programs in the context of a weak investment climate, where are well below the threshold where aid becomes domestic investment opportunities are limited and ineffective. fears of confiscation or reduction in the value of assets provide considerable incentive to put money abroad (see pages 69­78). Poor countries with bet- ter than average policies (as measured by the Better aid policies by donors also World Bank) had more success in retaining domes- contribute to poverty reduction tic capital: a rough estimate of the stock of their here is evidence that donors have made pro- capital outflows relative to GDP was about one- T gress in improving their own policies, through sixth the size in poor countries with worse than av- increasing resources to debt relief for good per- erage policies. Capital outflows have been more formers, easing complex administrative require- volatile in the poor countries than in the middle-in- ments that can strain limited government capacity, come countries, while volatility can be more costly and reducing the share of tied aid (see pages (in terms of welfare) in poor countries because 101­104). Modifications of adjustment assistance more people live close to subsistence and have little have helped to preserve the use of conditionality in private insurance or public safety nets. Thus poli- channeling aid resources to good performers and cymakers in poor countries need to recognize the supporting the credibility of government policies, potential impact of capital mobility on both stabi- while ensuring adequate government flexibility lization policies and long-term development. and domestic stakeholder commitment to the pro- 2 O V E R V I E W : I N T E R N A T I O N A L F I N A N C E A N D T H E P O O R E S T D E V E L O P I N G C O U N T R I E S gram. Here also, recipient government policies are Cambodia, Cameroon, Cape Verde, Central African Repub- key: strong leadership and effective administration lic, Chad, Comoros, the Democratic Republic of Congo, the by the government can help promote aid coordina- Republic of Congo, Côte d'Ivoire, Djibouti, Eritrea, Ethi- opia, The Gambia, Georgia, Ghana, Guinea, Guinea-Bissau, tion and make it easier for donors to adopt more Guyana, Haiti, Honduras, Kenya, Kiribati, the Kyrgyz Re- flexible policies. public, the Lao People's Democratic Republic, Lesotho, Liberia, Madagascar, Malawi, Maldives, Mali, Mauritania, Moldova, Mongolia, Mozambique, Myanmar, Nepal, Nicaragua, Niger, Nigeria, Pakistan, Rwanda, Samoa, São Tomé and Principe, Senegal, Sierra Leone, Solomon Islands, Note Somalia, Sri Lanka, Sudan, Tajikistan, Tanzania, Togo, 1. The poor countries are defined to represent developing Tonga, Uganda, Vanuatu, Vietnam, Republic of Yemen, countries with relatively low per capita income and almost Zambia, and Zimbabwe. These countries' average per capita no access to international capital markets. The group in- income is under $500 per year compared with $2,900 for cludes all IDA-only countries plus a few blend countries that other developing countries. And most of them are small; only have had few IBRD loans over the past few years. The coun- Pakistan, Bangladesh, Nigeria, Vietnam, Ethiopia, and the tries included are Afghanistan, Albania, Angola, Armenia, Democratic Republic of Congo have more than 50 million Bangladesh, Benin, Bhutan, Bolivia, Burkina Faso, Burundi, people. 3