Global Development Finance 2006

May 30, 2006

Managing record surge in capital flows poses challenge for developing countries


Global Development Finance 2006 cites improved policies, trade growth and South-South flows, but warns of risks posed by imbalances and high oil prices


TOKYO, May 30, 2006 — Net private capital flows to developing countries reached a record high of $491 billion in 2005, driven by privatizations, mergers and acquisitions, external debt refinancing, as well as strong investor interest in local-currency bond markets in Asia and Latin America, says the World Bank’s annual 2006 Global Development Finance report. The surging flows, including record bank lending and bond issuance, among others, coincided with 6.4-percent economic growth in the developing world last year, more than double the 2.8-percent growth in developed countries.


“These increased flows suggest that improved economic policies in many developing countries have had a positive impact,” said François Bourguignon, World Bank Chief Economist and Senior Vice President for Development Economics. “Countries are benefiting from improved global market conditions and investment climates, while closer global financial integration is posing difficult challenges to policymakers in developing countries to sustain economic growth and financial stability.”


The sharp rise in private flows to developing countries came despite uncertainties caused by high oil prices, rising global interest rates and growing global payments imbalances. Private debt flows to developing countries rose to an estimated $192 billion, up from $85 billion in 2003, driven by abundant global liquidity, steady improvement in developing-country credit quality, lower yields in rich countries, and expansion of investor interest in emerging market assets. Many developing countries have received credit-rating upgrades to accompany record-low spreads on their bonds, enabling them to raise a record $131 billion in bond issues in 2005, up from $102 billion in 2004.


These gains reflect estimated GDP growth of 6.4 percent in low- and middle-income countries in 2005, buoyed by China and India, whose output grew, respectively, by 9.9 and eight percent. Excluding these two countries, growth in other oil-importing developing countries was 4.3 percent, down from 5.7 percent in 2004. Growth is expected to exceed five percent through 2008 in all developing regions, except Latin America and the Caribbean, where it is projected to reach an average of 3.8 percent.


“High oil prices, rising interest rates and building inflationary pressures are expected to restrain growth in most developing regions over the next two years, but these regions are still expected to outperform high-income economies,” said Hans Timmer, manager of the Bank’s Global Trends team, which produced the economic outlook section of the report. “While current account deficits in developing countries—as a whole—are close to balance, deficits in oil-importing countries have increased substantially, reflecting both higher oil prices and, in several cases, unsustainably rapid growth.”


The surge in capital flows also reflects rising trade flows and financial integration among developing countries. South-South trade rose to $562 billion in 2004, up from $222 billion in 1995, and in 2004 accounted for 26 percent of developing countries’ total trade. South-South foreign direct investment (FDI) also rose, reaching $47 billion in 2003, up from $14 billion in 1995, and in 2003, accounted for 37 percent of developing countries’ total FDI.


While these South-South flows are a relatively small share of total private flows, they have the potential to change the face of development finance, particularly if growth in developing countries continues to outpace that in the developed countries,” said Mansoor Dailami, lead author of the 2006 Global Development Finance report.


Much South-South FDI originates with middle-income country firms, and is invested in the same region, for example, Russian and Hungarian firms investing in Eastern Europe and Central Asia, and South African companies investing elsewhere in southern Africa. About half of China’s FDI, however, went to natural resources projects in Latin America.


While this favorable economic performance was backed by good policies, it also reflects favorable external conditions that are expected to weaken. Many developing countries have exhausted surpluses and other cushions that allowed them to absorb higher oil prices, while growing quickly. As a result, they remain vulnerable to further shocks,” said Uri Dadush, Director of the Bank’s Development Prospects Group, which produces the GDF. “These could include overheating in some economies, a disorderly unwinding of global imbalances, a sudden disruption in global oil supply, and the possibility of a decline in the prices of other commodities which have supported incomes in many developing countries.”


Amid the encouraging trend of increased capital flows to developing countries, a gap in access to credit persists among these countries. One group, including China, Chile, Hungary, Malaysia, Mexico, Poland, Russia and Thailand, have issued bonds since 2002, are rated investment-grade, and enjoy lower bond spreads than the overall developing-country average. A second group has access to bank lending because of well-defined revenue streams such as exports, remittances or extractive industries, but lacks access to bond markets. A third group of low-income countries has no access to private capital except short-term trade finance or FDI, and depend mainly on official financing for their long-term capital needs.


This last group benefited from gains in development aid and debt relief. Donors increased official development assistance (ODA) to 0.33 percent of their gross national income (GNI) in 2005, up from 0.22 percent in 2001, and just below the early-1990s high of 0.34 percent. Most of the record $27-billion increase is due to debt relief provided to just two countries, Iraq and Nigeria. Still, the trend indicates that donors are enhancing their aid effort. ODA likely will decline in 2006–7 as debt relief falls, but rise gradually to reach 0.36 percent of GNI in 2010. Donors plan to allocate at least half of the $50-billion increase in ODA by 2010 to Sub-Saharan Africa, doubling aid to the region. In addition, debt relief provided under the Heavily-Indebted Poor Countries (HIPC) Initiative and the Multilateral Debt Reduction Initiative (MDRI) will significantly reduce the debt service of poor countries that qualify, providing additional finances needed to support progress on the MDGs.