Global Economic Turmoil Having Dramatic Effects on Capital Flows to Developing Countries

June 22, 2009

SEOUL, Korea, June 22, 2009 – Amidst global economic recession and financial-market fragility, net private capital inflows to developing countries fell to $707 billion in 2008, a sharp drop from a peak of $1.2 trillion in 2007. International capital flows are projected to fall further in 2009, to $363 billion.

Global Development Finance 2009: Charting a Global Recovery, warns that the world is entering an era of slower growth that will require tighter and more effective oversight of the financial system. Developing countries are expected to grow by only 1.2% this year, after 8.1% growth in 2007 and 5.9% growth in 2008. When China and India are excluded, GDP in the remaining developing countries is projected to fall by 1.6%, causing continued job losses and throwing more people into poverty. Global growth is also expected to be negative, with an expected 2.9% contraction of global GDP in 2009.

Global GDP growth is expected to rebound to 2% in 2010 and 3.2% by 2011. In developing countries growth is expected to be higher, at 4.4 % in 2010 and 5.7 % in 2011, albeit subdued relative to the robust performance prior to the current crisis.

“The need to restructure the banking system, combined with emerging limits to expansionary policies in high-income countries, will prevent a global rebound from gaining traction,” said Justin Lin, World Bank Chief Economist and Senior Vice President, Development Economics, “Developing countries can become a key driving force in the recovery, assuming their domestic investments rebound with international support, including a resumption in the flow of international credit.”

While the authors note that extraordinary policy responses by a number of big economies have prevented systemic collapse, they stress the importance of concerted global action while the crisis is still underway.

“To prevent a second wave of instability, policies have to focus rapidly on financial sector reform and support for the poorest countries,” said Hans Timmer, Director of the Bank’s Prospects Group.

Global integration and the expanding role of private actors in international finance have brought huge benefits, but have also widened the scope for turmoil. Today, developing countries rely heavily on private flows and many countries are being hit by a collapse in corporate finance, with big companies and banks that were powering growth now in distress.

“Many corporations will be hard pressed to service their foreign currency liabilities with revenues earned in depreciating domestic currencies at the same time that export demand has plummeted,” noted Mansoor Dailami, Manager of International Finance in the Prospects Group and lead GDF author.

The risk of balance-of-payments crises and corporate debt restructurings in many countries warrant special attention, the report cautions.

Charting a worldwide recovery will require quick implementation of detailed reforms and an eventual shift away from governments having high stakes in the financial system to a resumption of private sector control of the banking system, the report says. In addition, the big expansion of the money supply in advanced countries will need to be unwound and fiscal deficits will need to be cut in the medium term, to maintain debt sustainability and avoid another debt crisis as seen in the 1970s and 1980s.

Outlook for the Developing Regions

East Asia and Pacific The East Asia and Pacific region has felt the full brunt of the crisis because of its close trade links with high-income countries and because of declining investment as well as a drop in exports and industrial production. Growth for the region is projected to be 5% this year, although several EAP countries are projected to see GDP decline. Recovery across the region is expected to begin in the second half of 2009 and into 2010, reflecting substantial fiscal stimulus in China and a modest recovery of export demand in rich countries. However, the turnaround is expected to be gradual, with regional GDP forecast to increase by 6.6 percent in 2010 and 7.8 percent by 2011.

Europe and Central Asia has been the region most adversely affected by recent developments, in large part because many countries in the region entered the crisis period suffering from substantial imbalances. Large current account deficits and domestic overheating made many countries vulnerable to the abrupt reversal of capital flows and weaker export demand that the crisis generated. GDP is projected to fall by 4.7 percent in 2009, recovering to grow by about 1.6 percent in 2010.

Latin America and the Caribbean entered the crisis supported by stronger fiscal, currency, and financial fundamentals than in the past. However, it too is feeling the crisis in part because of falling commodity prices, but also on the financial side as foreign funds were withdrawn quickly. Flexible exchange rates in many countries in the region were able to absorb much of the initial shock and avoid systemic problems even as equity markets tumbled. Regional GDP is expected to decline by 2.3 percent in 2009, and to reach 2 percent growth in 2010.

The Middle East and North Africa region has been less directly affected by the credit crunch than other regions, but local equity and property markets have come under intense pressure, and developing countries in the region have suffered from much weaker conditions in the high-income countries in the region. Remittances, services exports and FDI flows from these countries and high-income Europe are expected to fall in 2009 – cutting into incomes. Growth is projected to halve to 3.1 percent in 2009, then edge up to 3.8 percent in 2010 and 4.6 percent in 2011, partly because the slowdown has been less pronounced in MENA than in other regions and oil demand and prices are expected to remain low.

South Asia has witnessed considerably diminished capital inflows and a falloff in investment growth. GDP is projected to expand 4.6 percent in 2009, down from 6.1 percent in 2008. Regional output is then expected to increase by 7 percent in 2010 and 7.8 percent in 2011. However, threats to long-term growth include the possibility of heightened fiscal pressures if the global recession is prolonged, and large fiscal deficits.

Sub-Saharan Africa has been hit hard by reduced external demand, plunging export prices, weaker remittances and tourism revenues, and sharply lower capital inflows, notably FDI. Growth is expected to decelerate sharply this year to 1 percent, down from 5.7 percent on average over the past three years. By 2010, growth is forecast to rise by 3.7 percent. Sharp cuts in remittances and official aid flows also represent a risk for the region, because many Sub-Saharan countries rely on aid flows for budget support and because remittances are a vital cushion against poverty.

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