A new report launched today by the World Bank examines the range of challenges developing countries face in managing recent surges in private capital flows. The report explores the nature of the changes that are leading to the integration of developing countries into world financial markets, analyzes the benefits and problems that these countries are likely to encounter, and examines the experiences of those economies that are managing this process successfully to see what policy lessons can be learned.
"We are at a critical time in the history of economic development. Developing countries have taken the first step toward long-term economic growth by implementing important economic reforms and opening their markets to global competition. And the global economy is responding to these changes. But to ensure that the accomplishments of recent years take root, these countries must maintain macroeconomic vigilance and take the next step of strengthening the network of financial institutions that support economic activity," says World Bank Chief Economist Joseph Stiglitz.
The report, Private Capital Flows to Developing Countries: The Road to Financial Integration, presents compelling evidence that while lower global interest rates provided an important impetus to the surge in private capital flows to developing countries in the early 1990s, these flows have entered a new phase, reflecting structural forces that are leading to progressive financial integration of developing countries into world financial markets.
On the international side, integration is being driven by advances in communications and information technology, deregulation of financial markets, and the rising importance of institutional investors that are able and willing to invest internationally. In developing countries too, the environment is changing rapidly as a growing number of countries have embarked on reforms that have boosted creditworthiness and returns, and made their markets more accessible to foreign investment.
Financial integration is expected to deepen further and encompass a growing number of countries. Given the continuing decline in investment risks, the higher expected rates of return, opportunities for portfolio diversification, and the growing interest of investors in emerging markets, net private capital flows to developing countries are likely to be sustained at the high levels of the 1990s. But there are likely to be sizable year-to-year fluctuations and large variations across countries.
The report makes clear that financial integration has significant benefits for developing countries. In addition to the direct gains of access to a growing pool of global capital and opportunities for risk diversification, there are indirect rewards from the transfer of knowledge and technology, higher productivity growth, and improved depth and efficiency of financial markets. Indeed, it is these indirect benefits that may be critically important in the long-term.
But as the Mexican peso crisis demonstrated, these gains are not guaranteed. International capital flows can act like a magnifying glass on the domestic economy, multiplying the benefits of well-structured reform programs, but also increasing the costs of poor economic fundamentals and unsound policies. The challenge for developing countries, therefore, is to take advantage of growing investor interest in their markets.
Lessons for Macroeconomic Management
The initial manifestation of growing financial integration in many developing countries in the 1990s has been large surges of capital inflows. Since these flows have often been very large in relation to the size of their economies, authorities have had to contend with the pressures of macroeconomic overheating an overexpansion of aggregate demand and the vulnerabilities associated with potential reversals.
In contrast to the commercial lending boom of the early 1980s, virtually all recipient countries have avoided increases in inflation and unstable imbalances in their current accounts. There are some common elements in the response of countries as well as some important differences.
Based on its review of cross-country experience, the report concludes that the policy mix used to combat overheating also has a major effect on the performance of the real economy and its ability to benefit in the long term from capital flows. In particular, a heavy reliance on fiscal policy, supported by monetary tightening to offset the expansionary impact of the capital inflows, and some nominal exchange rate flexibility and in more extreme cases, by temporary taxes or controls on inflows while an effective response to overheating, can also improve the balance between domestic investment and consumption and reduce risks of large reversals. More generally, countries are likely to suffer a loss of investor confidence when the real exchange rate is perceived to be out of line, if the government-debt obligations are large in relation to its earnings capacity and external reserve position, if fiscal adjustment is perceived to be politically or administratively infeasible, or if the country's growth prospects are bleak.
Central Role of the Banking System
The report argues that a country's ability to maintain a healthy banking system will determine, to a large extent, whether it will be able to realize the benefits of financial integration and avoid its pitfalls. The banking system dominates financial intermediation in developing countries, but the health of these systems is generally weaker than in industrial countries, as many have only been recently deregulated.
Addressing the underlying weaknesses of the banking system becomes more urgent in a globally integrated environment, because banks can increase lending more easily and incur greater risks, and because circumstances can change more swiftly. The report shows that lending booms associated with the early stages of financial integration can, if unchecked, lead to costly banking crises.
Since banking system reforms take time to implement, the report argues that it may be necessary to curb lending booms associated with capital inflows by using macroeconomic policies, as well as more targeted restrictions, such as raising reserve requirements or adopting risk-weighted capital adequacy requirements.
Preparing Capital Markets for Financial Integration
With a growing proportion of flows making their way to developing countries in the form of portfolio capital, the stakes are high for strengthening capital markets. The report points out that developing country capital markets must be made more attractive to foreign investors by addressing three concerns in the market and regulatory structure: market inefficiencies that cause higher costs and failed trades, lack of protection for property rights, and information shortcomings that impair an investor's ability to assess market risks and identify potential profits.
The good news is that some developing countries, especially in Asia, have been able to rapidly improve their market infrastructure by leapfrogging the state-of-the-art systems. But balanced progress in developing the three legs of an efficient capital market market infrastructure, property rights, and the regulatory system is needed to enhance the beneficial impact of these efforts. And promoting institutional investors that can mobilize large pools of dedicated money becomes even more important with financial integration to assuage fears of excessive foreign presence and potential volatility.