Selected abbreviations AGFUND Arab Gulf Program for United Nations International Country Risk Guide Development Organizations IDA International Development Association AGOA African Growth and Opportunity Act (World Bank (United States IFC International Finance Corporation asean Association of Southeast asian Nations IFF International Finance Facility BADEA Arab Bank for Economic Development IFFIm F for Immunization in Africa International financial institution BIS Bank for International Settlements IMF International Monetary Fund Collective action clause CUS Low-income countries under stress CPIA Country Policy and Institutional JICa Japan International Cooperation Agency Assessment(World Bank LIBOR London interbank offered rate DAC Development Assistance Committee, MDG Millennium Development Goals OECD MFA Multi-Fibre Arrangement Diversified payment rights MIGA Multilateral Investment Guarantee Agency DRS Debtor Reporting System(World Bank) NEPAD New Partnership for Africa's Development EBA Everything But Arms(European Union) NErICa New Rice for Africa EMBI Emerging Markets Bond Index NGO Nongovernmental organization EU European Union O Official development assistance FDI Foreign direct investment OECD Organisation for Economic Co-operation G-3 Group of Three(European Union, Japan, and Development United States) OPEC Organization of Petroleum-Exporting Group of Seven(Canada, France, Germany, Countries Italy, Japan, United Kingdom, Purchasing power parity United States PRSP Poverty reduction strategy paper G-8 G-7 plus Russian Federation Standard and Poor's GAVI lobal Alliance for Vaccines and Special Data Dissemination Standard (IMF) Immunization UN United nations GDP Gross domestic product UNCTAD United Nations Conference on Trade and GNI Gross national income Development GNP Gross national product UNDP United Nations Development Programme HIPC Heavily Indebted Poor Countries Initiative WARDA West Africa Rice Development Association IACD Inter-American Agency for Cooperation World Economic Outlook(IMF) and Development World Trade Organization IBRD ternational Bank for Reconstruction and Development
Selected Abbreviations AGFUND Arab Gulf Program for United Nations Development Organizations AGOA African Growth and Opportunity Act (United States) ASEAN Association of Southeast Asian Nations BADEA Arab Bank for Economic Development in Africa BIS Bank for International Settlements CAC Collective action clause CPIA Country Policy and Institutional Assessment (World Bank) DAC Development Assistance Committee, OECD DPR Diversified payment rights DRS Debtor Reporting System (World Bank) EBA Everything But Arms (European Union) EMBI Emerging Markets Bond Index EU European Union FDI Foreign direct investment G-3 Group of Three (European Union, Japan, United States) G-7 Group of Seven (Canada, France, Germany, Italy, Japan, United Kingdom, United States) G-8 G-7 plus Russian Federation GAVI Global Alliance for Vaccines and Immunization GDP Gross domestic product GNI Gross national income GNP Gross national product HIPC Heavily Indebted Poor Countries Initiative IACD Inter-American Agency for Cooperation and Development IBRD International Bank for Reconstruction and Development xiii . ICRG International Country Risk Guide IDA International Development Association (World Bank) IFC International Finance Corporation IFF International Finance Facility IFFIm IFF for Immunization IFI International financial institution IMF International Monetary Fund LICUS Low-income countries under stress JICA Japan International Cooperation Agency LIBOR London interbank offered rate MDG Millennium Development Goals MFA Multi-Fibre Arrangement MIGA Multilateral Investment Guarantee Agency NEPAD New Partnership for Africa’s Development NERICA New Rice for Africa NGO Nongovernmental organization ODA Official development assistance OECD Organisation for Economic Co-operation and Development OPEC Organization of Petroleum-Exporting Countries PPP Purchasing power parity PRSP Poverty reduction strategy paper S&P Standard and Poor’s SDDS Special Data Dissemination Standard (IMF) UN United Nations UNCTAD United Nations Conference on Trade and Development UNDP United Nations Development Programme WARDA West Africa Rice Development Association WEO World Economic Outlook (IMF) WTO World Trade Organization
Overview and Policy Messages: Mobilizing Finance and Managing Vulnerability 2 004 WAS A ROBUST YEAR FOR THE last two years can be sustained over the medium global economy, especially for developing term. countries, which recorded their fastest growth Emerging market economies with access to in more than three decades. The global recovery global finance are particularly vulnerable to changes strengthened, with much of the momentum coming in interest and exchange rates that may occur as from the United States and Asia(notably China), markets anticipate and adjust to policy measures in- and broadened, with a pickup in Latin America, tended to relieve the yawning imbalances. Countries acceleration in Japan, and modest recovery in the that have accumulated large dollar-denominated European Union(EU). Driven by favorable global reserve holdings face acute pressures and large po conditions and strong domestic performance at tential investment losses from the weakening dollar, home, developing countries continued to attract though their dollar-denominated debt burdens may capital in 2004, although more slowly than in 2003. ease. Those that have failed to take advantage of Favorable global economic and financial con- recent favorable conditions to lighten their debt ditions over the past few years, along with domes- burden may face debt-servicing difficulties as tic policy initiatives, have improved economic conditions worsen. All countries, whatever their fundamentals in most developing countries, circumstances, stand to benefit from a better under strengthening their external positions and making standing of the complex challenges that are chang them less susceptible to external pressures. But sig- ing the borrowing environment(both external and nificant global financial imbalances suggest the domestic)and the options open to policymakers need for adjustment. History has shown time and The risks are somewhat different for low. again that financial crises often take markets and income countries that are more reliant on official policymakers by surprise. The Asian crisis that and concessional sources of external finance. Offi- erupted in mid-1997 offers a striking example- cial aid flows are vulnerable to growing fiscal pres large exchange-rate exposures on balance sheets in sures in donor countries, while private flows will the corporate, financial, and public sectors were come to reflect tightening global conditions. Keep not widely recognized until after the fact ing growth on a sustainable path as the global Valuable lessons can be learned from these recovery evolves will therefore be a major factor in past episodes. One is that there is a tendency for attaining the Millennium Development Goals financial markets and policymakers to miss the embraced by the worlds leaders at the UN Millen- warning signs and overshoot, making the neces- nium Summit in 2000 sary adjustment larger when it does occur. Over The theme of this year's edition of Global shooting has contributed to" boom-bust"cycles Development Finance--mobilizing finance and in global financial markets, which have impeded managing vulnerability-embraces three key economic development in many regions. In the challenge current context, the memory of past mistakes raises the question of whether the strong pickup Managing the vulnerability inherent in global in capital flows to developing countries over the economic and financial imbalances
Overview and Policy Messages: Mobilizing Finance and Managing Vulnerability 2004 WAS A ROBUST YEAR FOR THE global economy, especially for developing countries, which recorded their fastest growth in more than three decades. The global recovery strengthened, with much of the momentum coming from the United States and Asia (notably China), and broadened, with a pickup in Latin America, acceleration in Japan, and modest recovery in the European Union (EU). Driven by favorable global conditions and strong domestic performance at home, developing countries continued to attract capital in 2004, although more slowly than in 2003. Favorable global economic and financial conditions over the past few years, along with domestic policy initiatives, have improved economic fundamentals in most developing countries, strengthening their external positions and making them less susceptible to external pressures. But significant global financial imbalances suggest the need for adjustment. History has shown time and again that financial crises often take markets and policymakers by surprise. The Asian crisis that erupted in mid-1997 offers a striking example— large exchange-rate exposures on balance sheets in the corporate, financial, and public sectors were not widely recognized until after the fact. Valuable lessons can be learned from these past episodes. One is that there is a tendency for financial markets and policymakers to miss the warning signs and overshoot, making the necessary adjustment larger when it does occur. Overshooting has contributed to “boom-bust” cycles in global financial markets, which have impeded economic development in many regions. In the current context, the memory of past mistakes raises the question of whether the strong pickup in capital flows to developing countries over the 1 . last two years can be sustained over the medium term. Emerging market economies with access to global finance are particularly vulnerable to changes in interest and exchange rates that may occur as markets anticipate and adjust to policy measures intended to relieve the yawning imbalances. Countries that have accumulated large dollar-denominated reserve holdings face acute pressures and large potential investment losses from the weakening dollar, though their dollar-denominated debt burdens may ease. Those that have failed to take advantage of recent favorable conditions to lighten their debt burden may face debt-servicing difficulties as conditions worsen. All countries, whatever their circumstances, stand to benefit from a better understanding of the complex challenges that are changing the borrowing environment (both external and domestic) and the options open to policymakers. The risks are somewhat different for lowincome countries that are more reliant on official and concessional sources of external finance. Official aid flows are vulnerable to growing fiscal pressures in donor countries, while private flows will come to reflect tightening global conditions. Keeping growth on a sustainable path as the global recovery evolves will therefore be a major factor in attaining the Millennium Development Goals embraced by the world’s leaders at the UN Millennium Summit in 2000. The theme of this year’s edition of Global Development Finance—mobilizing finance and managing vulnerability—embraces three key challenges: • Managing the vulnerability inherent in global economic and financial imbalances
GLOBAL DEVELOPMENT FINANCE 2005 Confronting the risks posed by e new com the previous two years. While the concentration plexities in developing country debt, and of FDI flows remains high(five emerging market Mobilizing and diversifying sources of finance economies account for 60 percent of FDI and for low-income countries with more limited 88 percent of the increase), the share flowing to access to international capital markets low-income countries reached 11 percent, the highest in 15 years. Reported FDI outflows from developing countries surged dramatically, reach ing an estimated $40 billion in 2004(from only Capital flows to developing S3 billion in 1991). The bulk of the FDi outflows countries continued to recover. originated in countries that have been major re- but at a slower pace cipients of inflows in recent years. In response to he strong recovery of capital flows to devel- greater foreign competition, domestic firms in oping countries that began in 2003 carried those countries have launched an aggressive over to 2004, albeit at a reduced pace. Total pri- search for markets abroad-often elsewhere in vate and official net debt flows totaled a record the developing world high of almost S325 billion, up significantly from S200 billion during 2000-2. The pickup is more Private debt flows showed strong gains from modest after taking into account factors such record levels of bond issuance as inflation, economic growth, and the sizable Net international bank lending continued to depreciation of the dollar against most major decline as net bond flows rebounded sharply currencies. Net capital flows to developing coun- reaching a record high in 2004. Gross bond is- tries equaled 4.5 percent of their gross domestic stance surpassed gross bank lending for the first product(GDP)in 2004, up slightly from 4.3 per- time, although bank lending remains available to cent in 2003, but significantly below highs ex- a larger group of countries. The strong gains in ceeding 6 percent reached in the mid-1990s bond issuance over the past two years reflect both (chapter 1) supply and demand factors-ample global liquid ity, low advanced-country interest rates promoting Developing countries continued to export a"search for yield, "and a broad-based improve capital and accumulate reserves ment in credit fundamentals in many emerging Drawing on healthy trade balances, developing markets. Apart from some short-lived volatility in countries have continued to generate large current April-May (as the tightening of U.S. monetary account surpluses, a dramatic turnaround from policy began), emerging-market bond spreads fell ast decades. Combined with expanding capital steadily during 2004, reaching a near-record low flows, the growing surpluses contributed to accel- by the end of the year rating accumulation of foreign reserves by devel oping countries-from S292 billion during 2003 Official aid continued to shift from to S378 billion during 2004. Although the largest loans to grant reserve accumulation was concentrated in Asia, Recent figures confirm the continuing structural the phenomenon was widespread. More than shift in official development assistance(ODA) from three-quarters of developing countries reporting loans to grants over the last several years. While bi- reserve changes(101 of 132)accumulated reserves lateral aid grants have risen annually since 2001,net during the year. A sizable portion of this new accu- official lending, largely multilateral, has declined mulation is invested in U.S. Treasuries, indicative dramatically, falling from S27 billion in net inflows of the growing stake of developing countries in the to developing countries, to S25 in net outflows in global financial system 2004. The largest factor underlying this shift has been a $30 billion net decline in lending by the Inter- FDI inflows increased modestly, but outflows national Monetary Fund (IMF), reflecting repay surged ment of sizable crisis-related disbursements made in FDI inflows to developing countries increased 2001. But net lending by the World Bank also fell by during 2004, partly offsetting the decline during s9 billion over the period, as several countries
GLOBAL DEVELOPMENT FINANCE 2005 • Confronting the risks posed by the new complexities in developing country debt, and • Mobilizing and diversifying sources of finance for low-income countries with more limited access to international capital markets. Capital flows to developing countries continued to recover, but at a slower pace The strong recovery of capital flows to developing countries that began in 2003 carried over to 2004, albeit at a reduced pace. Total private and official net debt flows totaled a record high of almost $325 billion, up significantly from $200 billion during 2000–2. The pickup is more modest after taking into account factors such as inflation, economic growth, and the sizable depreciation of the dollar against most major currencies. Net capital flows to developing countries equaled 4.5 percent of their gross domestic product (GDP) in 2004, up slightly from 4.3 percent in 2003, but significantly below highs exceeding 6 percent reached in the mid-1990s (chapter 1). Developing countries continued to export capital and accumulate reserves Drawing on healthy trade balances, developing countries have continued to generate large current account surpluses, a dramatic turnaround from past decades. Combined with expanding capital flows, the growing surpluses contributed to accelerating accumulation of foreign reserves by developing countries—from $292 billion during 2003 to $378 billion during 2004. Although the largest reserve accumulation was concentrated in Asia, the phenomenon was widespread. More than three-quarters of developing countries reporting reserve changes (101 of 132) accumulated reserves during the year. A sizable portion of this new accumulation is invested in U.S. Treasuries, indicative of the growing stake of developing countries in the global financial system. FDI inflows increased modestly, but outflows surged FDI inflows to developing countries increased during 2004, partly offsetting the decline during the previous two years. While the concentration of FDI flows remains high (five emerging market economies account for 60 percent of FDI and 88 percent of the increase), the share flowing to low-income countries reached 11 percent, the highest in 15 years. Reported FDI outflows from developing countries surged dramatically, reaching an estimated $40 billion in 2004 (from only $3 billion in 1991). The bulk of the FDI outflows originated in countries that have been major recipients of inflows in recent years. In response to greater foreign competition, domestic firms in those countries have launched an aggressive search for markets abroad—often elsewhere in the developing world. Private debt flows showed strong gains from record levels of bond issuance Net international bank lending continued to decline as net bond flows rebounded sharply, reaching a record high in 2004. Gross bond issuance surpassed gross bank lending for the first time, although bank lending remains available to a larger group of countries. The strong gains in bond issuance over the past two years reflect both supply and demand factors—ample global liquidity, low advanced-country interest rates promoting a “search for yield,” and a broad-based improvement in credit fundamentals in many emerging markets. Apart from some short-lived volatility in April–May (as the tightening of U.S. monetary policy began), emerging-market bond spreads fell steadily during 2004, reaching a near-record low by the end of the year. Official aid continued to shift from loans to grants Recent figures confirm the continuing structural shift in official development assistance (ODA) from loans to grants over the last several years. While bilateral aid grants have risen annually since 2001, net official lending, largely multilateral, has declined dramatically, falling from $27 billion in net inflows to developing countries, to $25 in net outflows in 2004. The largest factor underlying this shift has been a $30 billion net decline in lending by the International Monetary Fund (IMF), reflecting repayment of sizable crisis-related disbursements made in 2001. But net lending by the World Bank also fell by $9 billion over the period, as several countries 2
OVERVIEW AND POLICY MESSAGES paid large structural adjustment loans, and other will remain above the rising trend for much of the Bank loans were repaid ahead of schedule past two decades. As a result, commodity prices are While ODA figures for 2004 are not yet avail- expected to ease only slowly, and inflation pres- able, promising signs of expansion since the sures will continue to build in a number of develop March 2002 Monterrey Conference on Financing ing countries for Development are evident, with an increase in 2003 of around s10 billion to S69 billion(although Global imbalances and major currencies after accounting for inflation and exchange rate are stabilizing changes, the real increase was only 5 percent). A combination of a somewhat tighter fiscal policy Sub-Saharan Africa has received 60 percent of the and higher interest rates in the United States is pro- increases in ODa disbursements over the five-year jected to halt and even reverse the widening current period from 1998 to 2003. However, with most of account deficit. Higher U.S. interest rates will in- these funds allocated to postconflict situations, the crease the willingness of private-sector investors to ncrease in development aid has been small. hold dollars. and the two effects should slow the Five bilateral donors have increased disburse- currency's tendency to depreciate. Co-movements ments to levels exceeding the United Nations (UN) among the currencies of developing countries and target of 0.7 percent of GNl; four additional donors the compensating effect of an appreciation of the have specified explicit time tables for meeting the euro have left the real effective exchange rate of UN target over the next few years. ODA as a share most developing countries broadly stable. However, of gross national income(GND) in donor countries the large swings in the bilateral exchange rates of the is projected to rise from 0.25 percent in 2003 to major industrialized economies impose adjustment 0 30 percent in 2006-implying a 9 percent annual costs on firms that are expected to augment trade increase in ODA in real terms, well above that growth. achieved over the past two years(6 percent) Significant downside risks persist A reduction in the pace at which central banks are The world economy is slowing accumulating dollars, a weakening in investors The growth cycle is peaking appetite for risk, or a greater than anticipated e year 2004 was a record year for developing pickup in inflationary pressures could cause inter- countries, with aggregate growth of 6.6 per- est rates to rise farther than projected, provoking a cent. While very strong growth in China(and to a deeper-than-expected slowdown or even a global lesser extent in Russia and India) contributed im- recession. If the dollar were to depreciate by more portantly to this result, growth was strong through- than projected, it would likely undershoot its long out the developing world. However, high-frequency run equilibrium level. Should it remain low for an data suggest that global growth began slowing in extended period, this could induce a costly restruc the second half of the year, and this trend is pro- turing of world industry that would have to be un- jected to continue into 2005 and 2006. Persistently done in following years as the dollar returned to high oil prices, rising interest rates as a result of its equilibrium level. Finally, the slowdown in monetary tightening, and a waning fiscal stimulus global growth could sap policymakers' desire to from efforts to address the 2000/01 recession are pursue further trade liberalization, which has been projected to dampen domestic demand and slow a major motor of the improved performance of de- growth among high-income countries. These same veloping countries over the past half decade forces, plus softening import demand in the devel- ensible policy can reduce the probability oped world, are expected to slow the pace of and severity of such adverse scenarios. Tighter ansion in low-and middle-income countries. Nev- U.S. monetary and fiscal policy, a relaxation of ertheless, their growth should continue to outpace European monetary policy(relative to the United industrial economies by a wide margin-partly States), and a managed appreciation of some Asian because of continued strong growth in China and currencies would reduce the likelihood of a sharp India. Indeed, notwithstanding the slowdown, eco- depreciation in the dollar or an abrupt hike in nomic growth in low-and middle-income countries interest rates by reducing global imbalances
OVERVIEW AND POLICY MESSAGES repaid large structural adjustment loans, and other Bank loans were repaid ahead of schedule. While ODA figures for 2004 are not yet available, promising signs of expansion since the March 2002 Monterrey Conference on Financing for Development are evident, with an increase in 2003 of around $10 billion to $69 billion (although after accounting for inflation and exchange rate changes, the real increase was only 5 percent). Sub-Saharan Africa has received 60 percent of the increases in ODA disbursements over the five-year period from 1998 to 2003. However, with most of these funds allocated to postconflict situations, the increase in development aid has been small. Five bilateral donors have increased disbursements to levels exceeding the United Nations (UN) target of 0.7 percent of GNI; four additional donors have specified explicit time tables for meeting the UN target over the next few years. ODA as a share of gross national income (GNI) in donor countries is projected to rise from 0.25 percent in 2003 to 0.30 percent in 2006—implying a 9 percent annual increase in ODA in real terms, well above that achieved over the past two years (6 percent). The world economy is slowing The growth cycle is peaking The year 2004 was a record year for developing countries, with aggregate growth of 6.6 percent. While very strong growth in China (and to a lesser extent in Russia and India) contributed importantly to this result, growth was strong throughout the developing world. However, high-frequency data suggest that global growth began slowing in the second half of the year, and this trend is projected to continue into 2005 and 2006. Persistently high oil prices, rising interest rates as a result of monetary tightening, and a waning fiscal stimulus from efforts to address the 2000/01 recession are projected to dampen domestic demand and slow growth among high-income countries. These same forces, plus softening import demand in the developed world, are expected to slow the pace of expansion in low- and middle-income countries. Nevertheless, their growth should continue to outpace industrial economies by a wide margin—partly because of continued strong growth in China and India. Indeed, notwithstanding the slowdown, economic growth in low- and middle-income countries will remain above the rising trend for much of the past two decades. As a result, commodity prices are expected to ease only slowly, and inflation pressures will continue to build in a number of developing countries. Global imbalances and major currencies are stabilizing A combination of a somewhat tighter fiscal policy and higher interest rates in the United States is projected to halt and even reverse the widening current account deficit. Higher U.S. interest rates will increase the willingness of private-sector investors to hold dollars, and the two effects should slow the currency’s tendency to depreciate. Co-movements among the currencies of developing countries and the compensating effect of an appreciation of the euro have left the real effective exchange rate of most developing countries broadly stable. However, the large swings in the bilateral exchange rates of the major industrialized economies impose adjustment costs on firms that are expected to augment trade growth. Significant downside risks persist A reduction in the pace at which central banks are accumulating dollars, a weakening in investors’ appetite for risk, or a greater than anticipated pickup in inflationary pressures could cause interest rates to rise farther than projected, provoking a deeper-than-expected slowdown or even a global recession. If the dollar were to depreciate by more than projected, it would likely undershoot its longrun equilibrium level. Should it remain low for an extended period, this could induce a costly restructuring of world industry that would have to be undone in following years as the dollar returned to its equilibrium level. Finally, the slowdown in global growth could sap policymakers’ desire to pursue further trade liberalization, which has been a major motor of the improved performance of developing countries over the past half decade. Sensible policy can reduce the probability and severity of such adverse scenarios. Tighter U.S. monetary and fiscal policy, a relaxation of European monetary policy (relative to the United States), and a managed appreciation of some Asian currencies would reduce the likelihood of a sharp depreciation in the dollar or an abrupt hike in interest rates by reducing global imbalances, 3
GLOBAL DEVELOPMENT FINANCE 2005 increasing demand for dollars, and lowering infla- U.S. dollar, the dollar's slide since 2002 has re- ionary pressure in developing countries. To mini- duced average ratios of debt to gross national mize the impact of a weaker-than-projected out- product (GNP)and debt service to exports by come, developing countries should ensure that debt about 1 percentage point. and spending obligations will remain affordable Global tightening of monetary policy as major even if output and tax revenues slow substantially industrial economies move to a neutral stance will and interest rates rise. While a coordinated re- have an impact on market interest rates. Rising in- onse would be ideal, the policies described above terest rates, in turn, will likely slow global eco- would be beneficial for each economic grouping- nomic growth, as increases in short-term policy even if adopted unilaterally rates lead to higher borrowing costs(although this effect has been modest to date, as long-term yields in the United States have not increased as in previ- G g global imbalances ous monetary tightenings) risks for emerging market economies How market interest rates respond to future D espite recent strong performance, developing changes in monetary policy-particularly in the countries face substantial risks from trends in United States-and how such reactions spill over the global economy. The channels through which to emerging bond markets is taking on consider- events in global financial markets affect develop- able significance. With emerging-market bond ing countries reflect the changing character and spreads at record lows(which suggests that mar growing significance of developing countries'in- kets may be underestimating credit risks), an un- ternational financial relationships. Not only is expected deterioration in global conditions could there concern about the traditional sensitivity of lead to a precipitous widening of those spreads as emerging-market finance to cyclical developments investors adapt their expectations and reduce their in international capital markets, but, for some risk appetite. With gross bond financing surpass countries, the carrying costs of large accumula- ing bank financing in 2004 for the first time, the tions of foreign exchange reserves raise new impact of sharply higher spreads on emerging challenges. Looking ahead, the possibility of"dis- markets would be substantial orderly"adjustments of external payments imbal Borrowing costs would rise if such pre ances in the global economy could pose acute risks lead credit-rating agencies to downgrade their rat to emerging markets ing of emerging-market borrowers. It is estimated for example, that for the "typical"low-investment Exchange-rate volatility and higher interest grade borrower, a one-notch downgrade raises rates could affect the cost and availability borrowing costs an average of 80 basis points f capital This effect could be accentuated for more vulnera. While the baseline outlook for the global economy ble countries. For example, for countries with (chapter 2)is for an orderly adjustment in global high external debt levels, a 200-basis-point in- imbalances in external payments, less salutary out- crease in U.S. rates(the approximate increase cur comes are possible. One key implication of a more rently anticipated) would bring an additional in disorderly adjustment scenario for emerging mar- crease of 65 basis points(on top of the 200). Fc ket economies is that it would likely bring an end countries with low debt, the incremental impact is to the favorable economic and financial environ- only around 6 basis points ment that has supported a strong rebound in capi tal flows over the last two years. The most likely Excessive reserve accumulation has costs onsequence would be a widening of credit Not all of the increase in capital inflows has been spreads on emerging-market bonds, which in turn directed to productive domestic investment or could adversely affect the flow of debt. consumption. Some has been channeled into foreign On the positive side, a weaker dollar reduces exchange reserves. Recent record levels of reserve he net external debt burden (measured in local accumulation across a broad range of developing currency)of countries with dollar-denominated countries reflect several motives: insuring against debt. For example, in the 100 or so developing abrupt reversals of capital flows, liquidity consider- countries whose exchange rate is not pegged to the ations related to exchange-rate management and
GLOBAL DEVELOPMENT FINANCE 2005 increasing demand for dollars, and lowering inflationary pressure in developing countries. To minimize the impact of a weaker-than-projected outcome, developing countries should ensure that debt and spending obligations will remain affordable, even if output and tax revenues slow substantially and interest rates rise. While a coordinated response would be ideal, the policies described above would be beneficial for each economic grouping— even if adopted unilaterally. Growing global imbalances pose risks for emerging market economies Despite recent strong performance, developing countries face substantial risks from trends in the global economy. The channels through which events in global financial markets affect developing countries reflect the changing character and growing significance of developing countries’ international financial relationships. Not only is there concern about the traditional sensitivity of emerging-market finance to cyclical developments in international capital markets, but, for some countries, the carrying costs of large accumulations of foreign exchange reserves raise new challenges. Looking ahead, the possibility of “disorderly” adjustments of external payments imbalances in the global economy could pose acute risks to emerging markets. Exchange-rate volatility and higher interest rates could affect the cost and availability of capital While the baseline outlook for the global economy (chapter 2) is for an orderly adjustment in global imbalances in external payments, less salutary outcomes are possible. One key implication of a more disorderly adjustment scenario for emerging market economies is that it would likely bring an end to the favorable economic and financial environment that has supported a strong rebound in capital flows over the last two years. The most likely consequence would be a widening of credit spreads on emerging-market bonds, which in turn could adversely affect the flow of debt. On the positive side, a weaker dollar reduces the net external debt burden (measured in local currency) of countries with dollar-denominated debt. For example, in the 100 or so developing countries whose exchange rate is not pegged to the U.S. dollar, the dollar’s slide since 2002 has reduced average ratios of debt to gross national product (GNP) and debt service to exports by about 1 percentage point. Global tightening of monetary policy as major industrial economies move to a neutral stance will have an impact on market interest rates. Rising interest rates, in turn, will likely slow global economic growth, as increases in short-term policy rates lead to higher borrowing costs (although this effect has been modest to date, as long-term yields in the United States have not increased as in previous monetary tightenings). How market interest rates respond to future changes in monetary policy—particularly in the United States—and how such reactions spill over to emerging bond markets is taking on considerable significance. With emerging-market bond spreads at record lows (which suggests that markets may be underestimating credit risks), an unexpected deterioration in global conditions could lead to a precipitous widening of those spreads as investors adapt their expectations and reduce their risk appetite. With gross bond financing surpassing bank financing in 2004 for the first time, the impact of sharply higher spreads on emerging markets would be substantial. Borrowing costs would rise if such pressures lead credit-rating agencies to downgrade their rating of emerging-market borrowers. It is estimated, for example, that for the “typical” low-investmentgrade borrower, a one-notch downgrade raises borrowing costs an average of 80 basis points. This effect could be accentuated for more vulnerable countries. For example, for countries with high external debt levels, a 200-basis-point increase in U.S. rates (the approximate increase currently anticipated) would bring an additional increase of 65 basis points (on top of the 200). For countries with low debt, the incremental impact is only around 6 basis points. Excessive reserve accumulation has costs Not all of the increase in capital inflows has been directed to productive domestic investment or consumption. Some has been channeled into foreign exchange reserves. Recent record levels of reserve accumulation across a broad range of developing countries reflect several motives: insuring against abrupt reversals of capital flows, liquidity considerations related to exchange-rate management and 4