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Capital flows and risks in developing countries

Extract from GEP January 2014 - Chapter 3

The past two decades have seen dramatic changes in private capital inflows to developing countries. These flows have increased substantially both in absolute terms and as a share of developing-country GDP, and have been characterized by large fluctuations in response to changing global financial and economic conditions.

In the post-crisis period, financial inflows have averaged around 6 percent of GDP in developing countries, supported by historically low interest rates in high-income countries and stronger growth prospects across emerging and developing regions.

As the recovery in high-income countries firms amid a gradual withdrawal of extraordinary monetary stimulus, the global conditions prevailing in previous years will evolve in significant ways. Developing countries can expect in this context stronger demand for their exports as global trade regains momentum, but also rising interest rates and potentially weaker capital inflows.

In the most likely scenario, this process of normalization of activity and policy in high-income countries should follow a relatively orderly trajectory, with global interest rates rising only slowly to reach 3.6 percent by mid-2016. The analysis presented in this chapter show that such gradual tightening would imply limited disruption to developing countries, with a slowdown in capital inflows amounting to 0.6 percent of developing-country GDP between 2013 and 2016, driven in particularly by weaker portfolio investments.

However, the risk of more abrupt adjustments remains significant, especially if increased market volatility accompanies the actual unwinding of unprecedented central bank interventions. According to simulations, abrupt changes in market expectations, resulting in global bond yields increasing by 100 to 200 basis points within a couple of quarters, could lead to a sharp reduction in capital inflows to developing countries by between 50 and 80 percent for several months.

Some developing countries could face crisis risks should such scenario unfold. Focusing on an assessment of prevalent factors in past banking crises, evidence suggests that countries having seen a substantial expansion of domestic credit over the last five years, deteriorating current account balances, high levels of foreign and short-term debt and over-valued exchange rates could be more at risk in current circumstances.

In any event, policy makers need to consider how they would respond to a tightening of global financing conditions, and assess their specific vulnerabilities. Countries with adequate policy buffers and investor confidence may be able to rely on market mechanisms, counter-cyclical macroeconomic and prudential policies to deal with a retrenchment of foreign capital. In other cases, where the scope for maneuver is more limited, countries may be forced to tighten fiscal and monetary policy to reduce financing needs and attract additional inflows. Where adequate foreign reserves exist, these can be used to moderate the pace of exchange rate depreciation, while a loosening of capital inflow regulation and incentives for foreign direct investment might help smooth adjustments. Eventually, reforming domestic economies by improving the efficiency of labor markets, fiscal management, the breadth and depth of institutions, governance and infrastructure will be the most effective way to restore confidence and spur stability.

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FIGURE 1 Private capital inflows to developing countries
Source: World Bank, based on IMF Balance of Payments Statistics
FIGURE 2 Estimated decline in capital flows relative to no policy change baseline by type
Source: World Bank
FIGURE 3Capital inflows to developing countriesDownload the chart data
Source: World Bank
FIGURE 4 Capital inflow surges, stops and frequency of financial crises in developing countries
Source: Iaeven and Valencia (2012), World Bank
FIGURE 5 Policy options to cope with a sudden deceleration in capital inflows
Source: World Bank