Part 1

External finance for developing countries

Back to Contents
Overview

It was a rollercoaster year for emerging markets in 1997. During the first three quarters external finance from private sources rose strongly, as low international interest rates and high stock market valuations in some countries encouraged creditors to seek out higher yields (and accept higher risks) in emerging market debt instruments. Stock market booms in Latin America and Eastern Europe were accompanied by substantial portfolio equity flows. But the onset of the East Asian financial crisis in July and its effects on other regions later in the year led to a general retreat from new investments in emerging markets. Bond issues and loan commitments fell (on a year-over-year basis) in the third quarter to East Asia and in the fourth quarter to most major borrowers. At the same time stock markets fell sharply in many countries and loan spreads widened, though they remained well below the levels that followed the Mexican peso crisis in early 1995. The same forces that led to pronounced swings in flows induced large changes in secondary market spreads. Spreads fell sharply from early 1995 to mid-1997 and then shot up in late 1997 in response to the turmoil in financial and currency markets.

Net long-term flows from private sources are estimated at $256 billion for the year, up slightly from $247 billion in 1996 (table 1). However, these estimates do not reflect short-term flows or asset transactions (such as changes in foreign deposits held by developing country residents), which probably recorded significant capital outflows during the second half of the year owing to the East Asian financial crisis.

Table 1 Net long-term resource flows to developing countries, 1990–97
(billions of U.S. dollars)

Note: Developing countries are defined as low- and middle-income countries with 1995 per capita incomes of less than $765 (low) and $9,385 (middle).
a. Preliminary.
Source: World Bank Debtor Reporting System.

Net flows of foreign direct investment again touched record levels, but growth rates were down markedly from recent years. Net foreign direct investment (FDI) flows to developing countries reached $120 billion in 1997, five times their level in 1990, but not much higher than in 1996. Privatization transactions accounted for some $15 billion of this amount. FDI was down in East Asia, as FDI in China and Indonesia fell from the highs of 1996. The fall in East Asia was offset by a rise in Latin America in response to privatization transactions (notably in Brazil), improved economic performance, and continued progress in liberalization programs. Medium-term prospects for FDI are favorable, as growth in developing countries is projected to remain strong (at almost twice the rate in high-income economies), world trade buoyant, and the liberalization of investment rules to continue. Macroeconomic policies that enhance stability and an enabling environment for private sector development should also contribute.

Before the turmoil in emerging markets that erupted in October, developing countries’ participation in international capital markets was marked by significant financial innovation. Emerging market bond issues became more diversified as countries expanded their use of non-U.S. dollar issues and Argentina and South Africa issued local currency–denominated bonds on international markets. New instruments, such as collateralized bond and loan obligations, were introduced to attract institutional investors. Corporate debt issuance jumped from $23 billion in 1996 to an estimated $36 billion in 1997, and subsovereign borrowers also increased their participation in the markets. The number of mutual funds dedicated to emerging markets and the use of depository receipts continued to rise. And the availability of financial and equity derivative products increased.

This deepening of markets has the potential to increase capital flows to developing countries while enhancing the ability to hedge against risks. But the greater availability of derivatives and other financial innovations can also pose risks in countries that lack robust financial systems and appropriate regulatory policies. Balancing the potential and the risks through proper pacing and sequencing of financial reforms and financial innovations will continue to be a significant challenge for policymakers in emerging market economies.

Back to top
Back to Contents

Private capital flows to developing countries are likely to decline in the near term. The deterioration in confidence resulting from the East Asian crisis has already affected the supply of funds to emerging markets. At the same time, measures to maintain currency values and control external deficits, including tighter fiscal and monetary policies, will reduce growth rates in many developing countries and lower their demand for foreign finance. Provided that countries implement strong adjustment programs and that market confidence is restored soon, the decline in private flows in 1998 is expected to be moderate. And even with moderate declines, flows to developing countries would still remain very high compared with flows in the late 1980s and early 1990s.

Despite the significantly adverse effects of the crisis in East Asia, the international capital market environment is expected to remain broadly favorable in 1998, with continued low interest rates and strong growth of world output and trade. Once the initial shock of the currency crisis has worn off, countries with strong economic fundamentals may quickly regain full access to international capital markets (as occurred after the initial contagion effects of the Mexican peso crisis). However, without concerted efforts of the international community, strong reform programs by developing countries (especially in East Asia), and a return of confidence the crisis could deepen and become more widespread. In that case a generalized sharp fall in private capital flows to developing countries is possible.

The financial crisis in East Asia stemmed from a buildup of vulnerabilities during the 1990s and a self-perpetuating loss of confidence. The East Asian crisis differed from previous developing country crises in that the source of difficulties lay in private sector financial decisions (public sector borrowing played no significant role), and it occurred within a benign international environment with low interest rates and solid growth in output and exports. Despite impressive macroeconomic performance and prudent fiscal policies, East Asian economies experienced a buildup of vulnerabilities during the 1990s.

The key problem was in the financial sector, where poorly managed financial liberalization, distorted incentives, inadequate disclosure, lax regulatory standards, and inadequate supervision encouraged excessive risk taking, particularly through maturity and currency mismatches. Financial sector weaknesses permitted a misallocation of investment in the economy and a buildup of nonperforming loans. Large capital inflows amplified the problems of the financial sector and contributed to domestic demand pressures, which coupled with the depreciation of the yen against the dollar (to which these countries’ currencies were closely tied) caused real exchange rates to appreciate. And the magnitude of current account deficits increased the difficulties these economies faced once confidence was lost.

The increase in vulnerabilities does not fully account for the spread and subsequent depth of the crisis in East Asia. The severity of the currency and stock market declines, coupled with the limited forewarning of the crisis from market participants, is strong evidence that a self-fulfilling loss of confidence played an important role. Currency depreciation in the context of a loss of confidence and substantial uncovered foreign exchange exposure was self-perpetuating, as the rise in the local currency value of liabilities impaired balance sheets, lowered stock prices, and further increased demand for foreign exchange to cover open positions. Increased demand for foreign exchange led to further currency depreciation, and so on. Healthy firms suffered along with insolvent ones because of the lack of transparency (which made it difficult for investors to tell the healthy from the infirm, causing them to withdraw from all firms), the increases in interest rates in defense of currencies, the contraction in credit with the rapid fall in the equity of highly leveraged financial institutions (due to their own losses and the insolvency of their borrowers), and the economic downturn and increased uncertainty, which reduced demand.

There are difficult issues for both governments and international agencies to deal with in responding to the crisis. Governments must reestablish confidence in their macroeconomic management and in the domestic financial system. They should avoid indiscriminate bailouts of insolvent financial institutions that would reinforce a tendency toward excessive risk taking and impair market confidence. But with the origins of the crisis in the private sector, governments also must guard against overly restrictive fiscal and monetary policies, which would compound the recessionary effects of widespread banking and corporate failures. International agencies can help to restore market confidence by providing finance, but if support from official sources is always anticipated in times of difficulty, investors may again take on more risk than is warranted. Moral hazard can be mitigated if financing is accompanied by strong policy reform and if lenders and investors (domestic and foreign) can be made to share in the losses as they have previously shared in the gains.

Official development finance is changing in response to budgetary constraints in donor countries and the surge in private flows to developing countries. Net concessional flows to developing countries continued their decline during the 1990s due to constraints on the availability of concessional resources, decisions to reduce direct lending activities as private flows to developing countries increased, and a shift by some developing countries to borrowing in international capital markets rather than from official sources. The decline in net concessional flows has been accompanied by donor measures to identify more realistic objectives and demands for better use of more limited resources.

Efforts to channel scarce aid resources to countries with more effective economic policies and good governance are continuing. Further improvements in aid effectiveness will be critical to the poorest developing economies and may constitute the most convincing argument for maintaining or increasing the availability of resources. The Heavily Indebted Poor Countries Debt Initiative is a major expansion of previous efforts to reduce the debt burdens of the poorest developing countries. The initiative aims to encourage better economic and social policies and ultimately to enable successful countries to graduate from repeated debt rescheduling.

Official agencies also are adopting a number of innovations to support long-term private capital flows to developing countries, such as increased use of guarantees, as reflected in the rise in export credit commitments and in the provision of investment insurance and other guarantee structures for project finance. These innovative approaches to guarantees, along with the increased volumes, are strengthening the private sector in developing countries and increasing their integration with the global economy.

Back to top
Back to Contents