. Overview and Policy Messages: Striving for Stability in Development Finance A LTHOUGH 2002 WAS A YEAR OF HESITANT the disruptive effects of sharp reversals in financ- global recovery, financial conditions facing ing? These are the central concerns of this year's many developing countries were once again Global Development Finance. challenging, especially for those countries (mainly On the bright side, the steady drop in external middle-income countries) dependent on interna- debt financing has been cushioned by resilience in tional financial markets. Conditions have im- foreign direct investment (FDI). A further positive proved a little in the early months of 2003, al- sign is the growth of local-currency bond markets though the uncertainties surrounding Iraq have cast in several emerging economies and the development a shadow over both the global economy and finan- of several promising innovations to manage credit cial markets. risk. These issues, too, are covered in this report. Concern over the recent pattern of financial flows for global development that has prevailed in recent years is widespread--and understandably so. Since 1998, developing countries have repaid The developing world is learning external debt to private creditors in developed to live with less external debt T countries. In some cases these net repayments of he supply of debt capital to the developing debt have been required by timorous capital mar- world, which swelled in the early 1990s, was kets grown wary of overexposure to developing- first reduced by the shock of the East Asian crisis country debt. In others they reflect reduced de- of 1997­98, then by the turmoil in global fixed- mand for debt by countries that have either found income markets in the summer of 1998, and most alternative forms of external finance or have re- recently by the problems in global high-yield mar- duced their overall demand for external invest- kets in the aftermath of the 2001 slowdown. How- ment funds. Combined with developing countries' ever, this broad-based decline in debt flows, first steady accumulation of financial assets in high- evident in East Asia and the Russian Federation, is income economies, however, these debt repayments now focused on Latin America. mean that the developing world has become a net Some early signs of improvement in the external- capital exporter to the developed world. debt market cropped up as 2002 came to a close. On a net basis, therefore, capital is no longer The forecasts in this publication point to a further, flowing from high-income countries to economies gradual rise in debt flows in 2003 and 2004 (see that need it to sustain their progress toward the chapters 1 and 3). It is unlikely, however, that pri- Millennium Development Goals. The shortage is vate debt flows to developing countries will return compounded in the poorest countries by a signifi- to the levels of the 1990s. Nor would such a re- cant drop in official development assistance from bound necessarily be desirable. bilateral donors. While external bond and bank financing should What can or should be done to promote access continue to play an important role in the financing by developing countries to external capital? What strategies of governments and private-sector can be done to prevent growing economies from borrowers in developing countries, the fixed 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 2 0 0 3 commitments of debt service are not well suited to that depends critically on improvements in the in- the swings in nominal income experienced by vestment climate. A healthy operating environ- many developing countries, especially those de- ment for the corporate sector--including a sound pendent on primary commodities. Market reac- domestic institutional framework--is a necessary tions to debt-servicing strains add a whole new condition for profitable investment and the mitiga- layer of volatility that can be severely damaging to tion of risk, and therefore for the attraction of FDI growth and poverty reduction. (see chapter 5). It is also required to promote pro- The movement from debt to equity has been ductivity, entrepreneurship, and investment for do- underway in private financial markets since 1998. mestic firms and farms, the sources of 90 percent Policymakers should recognize the consequences of developing-country investment and the main of this important shift--and respond to the oppor- drivers of growth. Finally, it is the key determinant tunities and policy challenges it poses. of whether domestic capital stays at home or flees abroad. Measures to promote the inflow of foreign equity capital are critical Growth and poverty reduction F DI is less volatile than external debt. Its focus on depend on prudent management long-term returns makes it clearly more appro- of sovereign financial risks F priate for developing countries. And it can bring inancial markets react swiftly to adverse news, advantages both in technology and in operational making it all the more important to plan care- and financial management. In this context, the re- fully to mitigate risk. Fortunately, bond markets in silience of FDI in the face of the sustained weakness developing countries have moved in recent years in debt flows is a hopeful sign (see chapter 4). toward issues denominated in local currency, al- In contrast to debt investors, companies have though such issues tend to have shorter maturities, been willing to raise their exposures in the develop- at least in the early years of market development. ing world, in part because their holdings in devel- During such a transition, it is all too easy for a sov- oping countries are a relatively small part of their ereign borrower to shift, rather than mitigate, its overall capital stock, and in part because many ma- risk, with currency risks giving way to the rollover ture companies now expect a large portion of their risks that occur when domestic debt is linked to a revenue growth and cost reduction (and thus their foreign currency (see chapter 3). The fact that the profit growth) to come from operations in develop- epicenter of most middle-income debt problems in ing countries, whether they are producing for ex- recent years has been the local short-term money port or for local sale. and bond markets serves as a graphic reminder of FDI usually brings with it important benefits the case for prudent debt management. such as access to markets and transfers of technol- ogy and skills. In a world of volatile private capital flows, however, it is the financial aspects of FDI Workers' remittances are an that are particularly desirable. Companies tend to increasingly important source invest in developing countries for the long haul. of external financing A They see their returns rise and fall with the overall n under-recognized trend in the external fi- performance of the host economy and generally nances of developing countries--especially keep a significant share of earnings in the country. some of the smallest and poorest--is the steadily A solid flow of FDI to developing countries growing importance of workers' remittances (see should not be taken for granted, however. Indeed, chapter 7). Such flows now rank second in impor- net FDI to developing countries has already fallen tance only to FDI in the overall external financing from its peak of $179 billion in 1999 to $143 bil- of developing countries (see chapter 1). At $80 bil- lion in 2002. With the bulk of net cross-border lion in 2002, remittances were about double the capital flows now coming in this form, it becomes level of official aid­related inflows and showed a increasingly important for policymakers and mar- remarkably steady growth through the 1990s. The ket participants to focus on sustaining FDI--and strong U.S. labor market was especially important 2 O V E R V I E W A N D P O L I C Y M E S S A G E S in fueling the growth of remittances, and the United Policymakers in the industrial States is now by far the largest source of remittance countries can help stabilize flows. development financing-- Demographic trends suggest that remittance flows from high-income countries will grow over --by improving aid and trade policies-- the medium term, with the demographic depen- Although much of the policy and many of the insti- dency ratio falling in poor countries and rising in tutional reforms needed to stabilize development rich ones. However, heightened security concerns financing must come from governments in devel- and a softening labor market in the high-income oping countries, the authorities in the developed economies will probably check these flows over world can play an important role. The major the next year or two. This prospect highlights the economies can support development most directly importance of the issues of trade in services and through coherent aid and trade policies that pro- migration. mote development. The commitments made in advance of the United Nations Conference on Fi- nancing for Development in Monterrey in March The international community must 2002 promised a modest increase in aid flows. help borrowers manage pressures These point to a welcome reversal of the downward to reduce debt trend through most of the 1990s, but their scale is I ntense pressures to pay down external debt have incommensurate with the commitment to reach the placed many countries under severe stress in re- Millennium Development Goals by 2015. cent years, usually with particularly adverse conse- The effectiveness of aid can be improved by re- quences for poor people. There is now a growing allocating funds to poorer countries that have the consensus that the mechanisms available to cush- policies, institutions, and governance that can be ion these debt pressures are in need of reform. expected to reduce poverty. In those same coun- For low-income economies, significant progress tries, aid is also likely to be more productive if has been made in providing debt relief under the channeled through government institutions, with Heavily Indebted Poor Countries Initiative. How- the close involvement of civil society, rather than ever, continued weakness in commodity prices, through project-oriented institutions with intru- and thus in the export earnings of many poor sive management by donors. countries, means that several countries will require Most important of all, industrial countries can additional resources before their debt can be con- spur development by reducing agricultural subsi- sidered sustainable (see chapter 6). dies and trade barriers that discriminate against For highly indebted middle-income countries, developing countries' exports. Industrial countries the International Monetary Fund (IMF) has pro- spend more than $300 billion each year in agricul- posed the creation of a sovereign debt restructur- tural subsidies, about six times the amount they ing mechanism that would provide an orderly spend on foreign aid. Unless progress is made on framework for restructuring external sovereign agricultural protection and subsidies, negotiations bond debt (see chapter 3). within the World Trade Organization (WTO) are The proposed framework is intended to be use- likely to be stalled, to the detriment of growth and ful not only after a sovereign default, but also development. ahead of such an event, as its existence would make both debtors and creditors act in a more --and by ensuring broader macroeconomic measured fashion, avoiding some of the extreme stability actions that have complicated recent defaults on The major economies also play an important role sovereign debt. through their macroeconomic policies and perfor- The discussion of this proposal reminds us that mances, which shape the global opportunities the current set-up has not worked well and that open to developing countries (see chapter 2). De- the debt difficulties of middle-income countries are veloping countries benefit most when the major likely to persist in a world of low nominal income economies achieve steady, sustainable growth, growth (see chapter 2). avoiding booms and busts. Central banks in the 3 G L O B A L D E V E L O P M E N T F I N A N C E 2 0 0 3 major economies have established conditions fa- sustained downturn in capital spending, but also vorable for the growth of global liquidity. With to a rise in spreads in high-yield debt markets. nominal interest rates within the Organisation for Given the large number of investors who are ac- Economic Co-operation and Development (OECD) tive in both industrial and emerging markets, the at their lowest levels in 50 years and real short- rise in spreads on high-yield debt helped lift inter- term interest rates generally close to zero, the core est-rate spreads in markets for the external debt of condition for reversing the flow of capital from developing countries (see chapter 3). In Japan, developing to developed countries is in place. corporate-debt woes and their effects on the bank- Through the 1990s, the countries of the OECD ing system held back growth throughout the made important gains in reducing budget deficits, 1990s and added to deflationary pressures but much of this progress has been reversed in the throughout the economy. past two years. The expectation of large, continu- Japan serves as a graphic example of the costs ing budget deficits may further reduce developing of delaying necessary corporate adjustments. By countries' access to funds, while fiscal stimulus contrast, the high-profile corporate bankruptcies packages, which provided an important near-term in other mature economies--especially the United boost to growth, have now generally reached their States--in 2002 can be seen as a mixed blessing. limits of effectiveness. On the one hand, they underlined the severity of The widespread debt difficulties of the corpo- the downturn and the magnitudes of the necessary rate sector in the United States and Europe were adjustments in corporate spending. On the other, an important feature of the global downturn in they served to highlight that corporate restructur- 2001, contributing not only to a pronounced, ing is proceeding. 4