OVERVIEW AND POLICY MESSAGES creditworthiness concerns, and, for some, relieving consequences are very real, as countries reach the upward pressure on a fixed exchange rate to help limit of their ability to sterilize the impact of large maintain trade competitiveness reserve accumulations Although these motives are justifiable under some conditions, one outcome is that current Clear policy challenges are emerging reserve levels in several countries exceed by a large For developing countries, the greatest challenge margin the conventional measures of reserve ade- is to continue taking advantage of current favor quacy. That excess leads to concerns over the cost able financing conditions, while pursuing the and the sustainability of current policies, particu- necessary domestic macroeconomic and struc larly () the quasi-fiscal cost associated with central tural reforms necessary to promote long-term banks'sterilized intervention operations to offset stability in their external financing sources. This the expansionary monetary impact of higher re- would involve rves,and (i)potential capital losses on dollar dominated reserve assets(chapter 3) Renewed commitment to macro stabilization The quasi-fiscal burden reflects the differenc and structural reforms that have laid the foun between what the foreign-currency reserve asset dation for the recovery and vigorous expan- earn and what the central bank must pay sion of capital flows since 2002 domestic securities issued to offset their expan In high-reserve countries, reevaluation of sionary monetary impact. This burden can be the sustainability and costs of rapid reserve substantial-the gap between the two rates, under accumulation, both in terms of domestic prevailing market conditions, can be as high as macroeconomic management and increased 6-8 percent, with each percentage point costing vulnerability to changing external conditions. the central bank an additional S100 million annu- These countries need to consider how to man- ally for each S10 billion in reserves. Moreover, age appreciation of their currencies against where domestic financial markets are still under- the major currencies, to share the global developed, there are institutional limits on cen- adjustment burden. tral bank capacity to pursue such sterilized market Continuing efforts to improve asset and liabil- operations. India has a shortage of available in- ity management, especially by lengthening bor- struments to use in sterilization operations rowing maturity, retiring high-cost debt, diver Korea has run up against limits on the amount of sifying the currency composition of debt, and securities it can issue. and state-owned banks in hedging currency exposure as much as possible China have reached the limits of their capacity to Pushing forward with efforts to strengthen purchase additional securities at below-market the health and soundness of the domestic rates financial system through measures to improve The capital loss costs relate to the valuation prudential regulations, enhance banks' capi and management of the central bank,s portfolio talization, develop local bond markets, and of reserve assets. while most central banks are remove incentives for excessive foreign cur engaging professional asset managers, an esti- rency intermediation mated 70 percent of reserves are held in dollar- denominated assets (individual country estimate are generally not available), implying that a sharp drop in the dollar could translate into a corre- The complexity of developing sponding drop in the domestic value of the reserve country debt poses new challenges holdings uch has changed since the wave of financial Looking ahead, countries accumulating sub- crises rocked emerging market economies stantial excess reserves will have to reconcile the and disrupted global financial markets from the benefits of higher reserves with the potential for mid-1990s up until 2002. Many countries that capital losses and growing quasi-fiscal carrying were at the center of earlier crises have made signif costs. Even when costs are hidden(for example, by icant progress in improving prudential and regula requiring banks to hold domestic assets at below- tory policies and structures whose weaknesses con- market yields), the domestic macroeconomic tributed to the crisis. Fiscal policies have generally
OVERVIEW AND POLICY MESSAGES creditworthiness concerns, and, for some, relieving upward pressure on a fixed exchange rate to help maintain trade competitiveness. Although these motives are justifiable under some conditions, one outcome is that current reserve levels in several countries exceed by a large margin the conventional measures of reserve adequacy. That excess leads to concerns over the cost and the sustainability of current policies, particularly (i) the quasi-fiscal cost associated with central banks’ sterilized intervention operations to offset the expansionary monetary impact of higher reserves, and (ii) potential capital losses on dollardominated reserve assets (chapter 3). The quasi-fiscal burden reflects the difference between what the foreign-currency reserve assets earn and what the central bank must pay on domestic securities issued to offset their expansionary monetary impact. This burden can be substantial—the gap between the two rates, under prevailing market conditions, can be as high as 6–8 percent, with each percentage point costing the central bank an additional $100 million annually for each $10 billion in reserves. Moreover, where domestic financial markets are still underdeveloped, there are institutional limits on central bank capacity to pursue such sterilized market operations. India has a shortage of available instruments to use in sterilization operations, Korea has run up against limits on the amount of securities it can issue, and state-owned banks in China have reached the limits of their capacity to purchase additional securities at below-market rates. The capital loss costs relate to the valuation and management of the central bank’s portfolio of reserve assets. While most central banks are engaging professional asset managers, an estimated 70 percent of reserves are held in dollardenominated assets (individual country estimates are generally not available), implying that a sharp drop in the dollar could translate into a corresponding drop in the domestic value of the reserve holdings. Looking ahead, countries accumulating substantial excess reserves will have to reconcile the benefits of higher reserves with the potential for capital losses and growing quasi-fiscal carrying costs. Even when costs are hidden (for example, by requiring banks to hold domestic assets at belowmarket yields), the domestic macroeconomic consequences are very real, as countries reach the limit of their ability to sterilize the impact of large reserve accumulations. Clear policy challenges are emerging For developing countries, the greatest challenge is to continue taking advantage of current favorable financing conditions, while pursuing the necessary domestic macroeconomic and structural reforms necessary to promote long-term stability in their external financing sources. This would involve: • Renewed commitment to macro stabilization and structural reforms that have laid the foundation for the recovery and vigorous expansion of capital flows since 2002. • In high-reserve countries, reevaluation of the sustainability and costs of rapid reserve accumulation, both in terms of domestic macroeconomic management and increased vulnerability to changing external conditions. These countries need to consider how to manage appreciation of their currencies against the major currencies, to share the global adjustment burden. • Continuing efforts to improve asset and liability management, especially by lengthening borrowing maturity, retiring high-cost debt, diversifying the currency composition of debt, and hedging currency exposure as much as possible. • Pushing forward with efforts to strengthen the health and soundness of the domestic financial system through measures to improve prudential regulations, enhance banks’ capitalization, develop local bond markets, and remove incentives for excessive foreign currency intermediation. The complexity of developingcountry debt poses new challenges Much has changed since the wave of financial crises rocked emerging market economies and disrupted global financial markets from the mid-1990s up until 2002. Many countries that were at the center of earlier crises have made significant progress in improving prudential and regulatory policies and structures whose weaknesses contributed to the crisis. Fiscal policies have generally 5
GLOBAL DEVELOPMENT FINANCE 2005 been more prudent, although concerns persist strengthen the banking sector and enhance the about the sustainability of public debt in several ability of banks to take on and sustain riskier lend- countries. Inflation has fallen. Greater exchange ing, through measures to mitigate and manage rate flexibility has reduced the likelihood that an risk. Joint international efforts on statistics and exchange-rate crisis will become a debt crisis and monitoring are improving the quality and quantity raised awareness of the risks inherent in currency of information available for use in managing ap- mismatches. Since 1996, 19 developing countries proaching crises have shifted to floating exchange-rate regimes But while efforts to strengthen the interna Overall, the improved disposition of investors to- tional framework for dealing with financial dis- ward developing countries has been reflected in the tress have started to yield results, much remains to ends in average credit quality, which has risen be done. For example, the adoption of collective steadily since early 2002. The number of countries action clauses can help facilitate debt restructur- carrying formal credit risk ratings (around 60)is ing, but their impact is still quite limited, as they now almost four times higher than in the mid- apply only to bond debt, are not adopted in all 1990s new issues, and do not apply to pre-2002 debt The dynamics of external debt have been External debt burdens have eased for some transformed but not for most The debt-related crises of the 1990s, which were Developing countries' burden of external debt concentrated in a small group of emerging market (public and private) declined from a peak of 45 per- economies, have induced changes in debt dynam- cent of GN in 1999 to an estimated 39 percent in ics in many developing countries. A rapid expan- 2003. This improvement occurred despite an in- sion in bond finance, pursued most aggressively in crease of almost $207 billion in the nominal value countries that experienced severe debt pressures or of external debt. It therefore reflects the impact of crises in the 1990s, has increased vulnerability to stronger developing country performance: since the changing market conditions in global markets late-1990s, GNI has grown three times faster than (over which individual countries can exercise little external debt. Other indicators of developing coun- control) and domestic circumstances, which can tries vulnerability to interest and exchange rates quickly translate into higher borrowing costs have improved as well: ratios of debt to exports through their impact on spreads(chapter 3)or re- dropped from 135 percent in 1997 to 125 percent duced capital availability. Furthermore, the enor- in 2003 mous increase in the number of stakeholders that Amid the overall improvement, the debt cir- has accompanied the shift into bonds has compli- cumstances of individual countries differ consider cated the resolution and management of crises. ably. The reduction in aggregate debt burden has nternational capital markets today are more been driven by large improvements in a few coun- attuned to, and more discriminating about, devel- tries(representing about 30 percent of outstanding opment finance than in the past. This in turn im- debt). But in two-thirds of middle-income coun- poses a degree of discipline on borrowing through tries, the debt burden increased between 1997 and greater transparency, a more substantial flow of 2002. For nine emerging market economies in this information, increased market research, and finer group(Argentina, Brazil, Indonesia, Philippines, distinctions in credit risk. Overall, these develop- Poland, Russian Federation, South Africa, and ments have reduced the systemic risk in market urkey), the average deterioration in the debt/GNI based emerging market finance ratio was 21 percentage points. Currency evalua- Similarly, the international financial architec- tion effects also loom large for countries with large ture, which aims to prevent defaults and facilitate dollar-denominated debts(chapter 3), more than orderly debt restructuring, has been strengthened. offsetting the underlying reduction in debt stocks ollective action clauses have been introduced in through repayment for some countries some bond financing transactions, and discussions The share of foreign direct investment (FDi over a code of conduct continue. The Capital and portfolio equity in the finance mix of many Adequacy Accord(Basel ID offers the potential to developing countries has grown in recent years-a
GLOBAL DEVELOPMENT FINANCE 2005 been more prudent, although concerns persist about the sustainability of public debt in several countries. Inflation has fallen. Greater exchange rate flexibility has reduced the likelihood that an exchange-rate crisis will become a debt crisis and raised awareness of the risks inherent in currency mismatches. Since 1996, 19 developing countries have shifted to floating exchange-rate regimes. Overall, the improved disposition of investors toward developing countries has been reflected in the trends in average credit quality, which has risen steadily since early 2002. The number of countries carrying formal credit risk ratings (around 60) is now almost four times higher than in the mid- 1990s. The dynamics of external debt have been transformed The debt-related crises of the 1990s, which were concentrated in a small group of emerging market economies, have induced changes in debt dynamics in many developing countries. A rapid expansion in bond finance, pursued most aggressively in countries that experienced severe debt pressures or crises in the 1990s, has increased vulnerability to changing market conditions in global markets (over which individual countries can exercise little control) and domestic circumstances, which can quickly translate into higher borrowing costs through their impact on spreads (chapter 3) or reduced capital availability. Furthermore, the enormous increase in the number of stakeholders that has accompanied the shift into bonds has complicated the resolution and management of crises. International capital markets today are more attuned to, and more discriminating about, development finance than in the past. This in turn imposes a degree of discipline on borrowing through greater transparency, a more substantial flow of information, increased market research, and finer distinctions in credit risk. Overall, these developments have reduced the systemic risk in marketbased emerging market finance. Similarly, the international financial architecture, which aims to prevent defaults and facilitate orderly debt restructuring, has been strengthened. Collective action clauses have been introduced in some bond financing transactions, and discussions over a code of conduct continue. The Capital Adequacy Accord (Basel II) offers the potential to strengthen the banking sector and enhance the ability of banks to take on and sustain riskier lending, through measures to mitigate and manage risk. Joint international efforts on statistics and monitoring are improving the quality and quantity of information available for use in managing approaching crises. But while efforts to strengthen the international framework for dealing with financial distress have started to yield results, much remains to be done. For example, the adoption of collective action clauses can help facilitate debt restructuring, but their impact is still quite limited, as they apply only to bond debt, are not adopted in all new issues, and do not apply to pre-2002 debt. External debt burdens have eased for some, but not for most Developing countries’ burden of external debt (public and private) declined from a peak of 45 percent of GNI in 1999 to an estimated 39 percent in 2003. This improvement occurred despite an increase of almost $207 billion in the nominal value of external debt. It therefore reflects the impact of stronger developing country performance: since the late-1990s, GNI has grown three times faster than external debt. Other indicators of developing countries’ vulnerability to interest and exchange rates have improved as well: ratios of debt to exports dropped from 135 percent in 1997 to 125 percent in 2003. Amid the overall improvement, the debt circumstances of individual countries differ considerably. The reduction in aggregate debt burden has been driven by large improvements in a few countries (representing about 30 percent of outstanding debt). But in two-thirds of middle-income countries, the debt burden increased between 1997 and 2002. For nine emerging market economies in this group (Argentina, Brazil, Indonesia, Philippines, Poland, Russian Federation, South Africa, and Turkey), the average deterioration in the debt/GNI ratio was 21 percentage points. Currency revaluation effects also loom large for countries with large dollar-denominated debts (chapter 3), more than offsetting the underlying reduction in debt stocks through repayment for some countries. The share of foreign direct investment (FDI) and portfolio equity in the finance mix of many developing countries has grown in recent years—a 6
OVERVIEW AND POLICY MESSAGES trend that enhances stability. Equity flows ac- 1999 has not been matched by as large an increase counted for 80 percent of total external financing in domestic financing during 1999-2003, compared with just 60 percent Greater domestic borrowing by the private during 1993-98 sector also poses dangers. High levels of domestic credit to the private sector have been the precursor he composition of external debt has changed, to many financial crises. The risk is particularly with an increase in private borrowing great when perceptions of risk motivate swift Developments in international capital markets and changes in global asset allocations, beyond what is developing countries, as well as expansion in the warranted by underlying fundamentals. The bur- investor base, have helped facilitate the private den imposed by private sector bailouts, especially sectors access to international capital markets. as in the financial sector, can lead to a buildup of debt a result of greater private borrowing, the share of for the public sector as well. In addition, the corpo- public sector debt in total external debt declined rate sector's engagement in derivative-type transac- from 82 percent during 1990-95 to 69 percent tions can pose contingent liabilities that are at during 1996-2003. At the same time, the public times unanticipated, often for lack of information. sectors emphasis on domestic sources of financing But the deepening of local bond markets has increased brings many benefits. Local bond markets help The reduction in the public debt share might finance government deficits, compensate for the appear to lower sovereign vulnerability, but as the effects of holding large, low-yield reserves, and fa Asian crisis demonstrated, excessively risky pri- cilitate domestic monetary policy by providing a vate sector behavior can precipitate a crisis-and liquid debt market to facilitate operational aspects the subsequent cleanup often blurs the lines be- of monetary policy. They also strengthen the do- tween public and private mestic financial system-bond markets comple ment structured financing and stimulate competi- The rise in domestic debt partly offsets the tion, while the infrastructure required to support reduced burden of external debt them(clearing and settlement systems, regulatory Debt from domestic sources has grown rapidly in and legal frameworks) makes the entire financial emerging market economies, largely through the system more efficient Domestic debt markets also development of domestic bond markets. In many offer an increasingly attractive destination for for countries where external debt burdens have stabi- eign investors and have encouraged an important lized or fallen, domestic public debt burdens have catalytic role for international financial institu increased(chapter 4). As a result, in many devel- tions, which have often taken the lead in initiating oping countries, the burden of public sector debt borrowing in developing-country currencies remains high, calling into question the apparent improvement associated with falling external The need to balance external and domestically indebtedness financed debt has created new challenges The extent of the shift from external to do- with the shift in the balance of external and do- mestic debt has varied across regions. In Asia, fol- mestic debt, new challenges have emerged On the lowing the market-forced retrenchment of credit positive side, lower external debt reduces vulnera that occurred during the crisis, the switch was bility to external shocks (related to exchange rates rapid and intentional-the ratio of domestic to r interest rates), which in turn builds confidence ternal debt rose from close to parity in 1997 to 3 among international investors. It also can relieve to 1 in 2002. Initial domestic debt buildup was pressure on exchange rates and raise credit ratings driven by crisis responses(often bailouts or recap- leading to lower external borrowing costs and talizations of failing banks), while more recent in- even increased asset demand as the economy creases have been driven by conscious policies to moves into a risk class more open to institutional reduce reliance on external debt(and, for many, a investors buildup in foreign exchange reserves). Elsewhere, But the switch to domestic debt heightens other the picture is more mixed-in Latin America, for risks-notably the uncertainties of rolling over example, the decline in external financing since short-term debt(because maturities of domestic
OVERVIEW AND POLICY MESSAGES trend that enhances stability. Equity flows accounted for 80 percent of total external financing during 1999–2003, compared with just 60 percent during 1993–98. The composition of external debt has changed, with an increase in private borrowing Developments in international capital markets and developing countries, as well as expansion in the investor base, have helped facilitate the private sector’s access to international capital markets. As a result of greater private borrowing, the share of public sector debt in total external debt declined from 82 percent during 1990–95 to 69 percent during 1996–2003. At the same time, the public sector’s emphasis on domestic sources of financing has increased. The reduction in the public debt share might appear to lower sovereign vulnerability, but as the Asian crisis demonstrated, excessively risky private sector behavior can precipitate a crisis—and the subsequent cleanup often blurs the lines between public and private. The rise in domestic debt partly offsets the reduced burden of external debt Debt from domestic sources has grown rapidly in emerging market economies, largely through the development of domestic bond markets. In many countries where external debt burdens have stabilized or fallen, domestic public debt burdens have increased (chapter 4). As a result, in many developing countries, the burden of public sector debt remains high, calling into question the apparent improvement associated with falling external indebtedness. The extent of the shift from external to domestic debt has varied across regions. In Asia, following the market-forced retrenchment of credit that occurred during the crisis, the switch was rapid and intentional—the ratio of domestic to external debt rose from close to parity in 1997 to 3 to 1 in 2002. Initial domestic debt buildup was driven by crisis responses (often bailouts or recapitalizations of failing banks), while more recent increases have been driven by conscious policies to reduce reliance on external debt (and, for many, a buildup in foreign exchange reserves). Elsewhere, the picture is more mixed—in Latin America, for example, the decline in external financing since 1999 has not been matched by as large an increase in domestic financing. Greater domestic borrowing by the private sector also poses dangers. High levels of domestic credit to the private sector have been the precursor to many financial crises. The risk is particularly great when perceptions of risk motivate swift changes in global asset allocations, beyond what is warranted by underlying fundamentals. The burden imposed by private sector bailouts, especially in the financial sector, can lead to a buildup of debt for the public sector as well. In addition, the corporate sector’s engagement in derivative-type transactions can pose contingent liabilities that are at times unanticipated, often for lack of information. But the deepening of local bond markets brings many benefits. Local bond markets help finance government deficits, compensate for the effects of holding large, low-yield reserves, and facilitate domestic monetary policy by providing a liquid debt market to facilitate operational aspects of monetary policy. They also strengthen the domestic financial system—bond markets complement structured financing and stimulate competition, while the infrastructure required to support them (clearing and settlement systems, regulatory and legal frameworks) makes the entire financial system more efficient. Domestic debt markets also offer an increasingly attractive destination for foreign investors and have encouraged an important catalytic role for international financial institutions, which have often taken the lead in initiating borrowing in developing-country currencies. The need to balance external and domestically financed debt has created new challenges With the shift in the balance of external and domestic debt, new challenges have emerged. On the positive side, lower external debt reduces vulnerability to external shocks (related to exchange rates or interest rates), which in turn builds confidence among international investors. It also can relieve pressure on exchange rates and raise credit ratings, leading to lower external borrowing costs and even increased asset demand as the economy moves into a risk class more open to institutional investors. But the switch to domestic debt heightens other risks—notably the uncertainties of rolling over short-term debt (because maturities of domestic 7
GLOBAL DEVELOPMENT FINANCE 2005 debt are generally shorter than those of external Sources of external finance have changed debt), and associated interest-rate risks. To mini- Since the early 1990s, the relative importance of mize risk, domestic borrowing, like external bor- ODA as a source of external financing for poor rowing, must be based on sound measures for countries has declined, in part due to the end of managing public debt, a capable tax system, and the Cold War and waning support for client states, effective regulatory and legal environment for but also because of growing global integration domestic financial activity. Exchange-rate manage- through the liberalization of financial flows, trade, ment remains particularly crucial, because interna- and migration. Aggregate figures mask enormous tional demand for domestic assets will be critically variation among the 28 countries considered in affected by perceptions of the soundness of ex- this study: ODA dependence ranges from a high of change- rate policy and concerns over volatility and 36 percent of GDP in Mozambique to 2.2 percent convertibility. Finally, any temptation to borrow in Bangladesh. xcessively from domestic sources needs to be re- But other forces were at work as well. while sisted. A debt crisis sparked by excessive domestic ODA was declining, other sources were rising: FDI borrowing can be just as devastating as one created rose from only 0. 4 percent of GDP to 2.7 percent of through external borrowing, and a domestic debt GDP in 2003, reflecting improving performance problem can quickly grow to affect external debt. and a sounder investment climate. FDI has been of Despite the growing sophistication of interna- considerable importance for many poor countries tional capital markets and a steady growth in the including Lesotho, Mauritania. Moldova. and capacity of central banks and monetary authori- Mozambique. Nonetheless, much FDI to poor ties in developing countries, significant weak- countries still flows to enclave mining and natural nesses remain both in the international architec- resources projects, which may limit benefits and ture that has evolved to regulate those markets add to volatility and in the quality of data available on the fast- While not technically a capital flow, private growing domestic debt markets in many emerging transfers(including NGO grants and workers're- market economies. Improving the monitoring mittances) have become relatively more important and dissemination of information on public and in poor countries than in other developing coun- private domestic debt flows should remain a pri- tries. Both are large, stable sources of foreign ex ty for international institutions and national change for poor countries and may be more likely than other capital flows to reach poor households In addition, the size and stability of such current account flows(especially workers' remittances) over time may facilitate poor countries access to Meeting poor countries' financing capital markets through securitization. leeds requires recognition of the countries' special challenges Flows from other developing countries PE oor countries are operating in an external fi- have grown nancing environment of growing complexity. The traditional view of developing countries Although ODA is still the major resource flow for as reliant solely on financing from industrial many countries, many others now receive growing economies is increasingly outdated. While the orivate capital flows(FDI and private debt flows, final report from Monterrey mentioned the ometimes originating in other developing coun- importance of cooperation between developing ries)or other nontraditional private resource countries only briefly, the available data suggest a flows(workers'remittances and grants from non- different perspective: with respect to poor cour governmental organizations [NGOsD Understand- tries, other developing countries(especially larger ing the differential availability of the new mix of ones such as Brazil, China, India, Saudi Arabia financing resources to individual poor countries and South Africa) are increasingly important will be essential to efforts to maximize aid effec- financial players tiveness and achieve development objectives- With wealth increasing and administrative cap- notably the Mdgs(chapter 5) ital controls being eased in the 1990s, developing
GLOBAL DEVELOPMENT FINANCE 2005 debt are generally shorter than those of external debt), and associated interest-rate risks. To minimize risk, domestic borrowing, like external borrowing, must be based on sound measures for managing public debt, a capable tax system, and effective regulatory and legal environment for domestic financial activity. Exchange-rate management remains particularly crucial, because international demand for domestic assets will be critically affected by perceptions of the soundness of exchange-rate policy and concerns over volatility and convertibility. Finally, any temptation to borrow excessively from domestic sources needs to be resisted. A debt crisis sparked by excessive domestic borrowing can be just as devastating as one created through external borrowing, and a domestic debt problem can quickly grow to affect external debt. Despite the growing sophistication of international capital markets and a steady growth in the capacity of central banks and monetary authorities in developing countries, significant weaknesses remain both in the international architecture that has evolved to regulate those markets and in the quality of data available on the fastgrowing domestic debt markets in many emerging market economies. Improving the monitoring and dissemination of information on public and private domestic debt flows should remain a priority for international institutions and national authorities. Meeting poor countries’ financing needs requires recognition of the countries’ special challenges Poor countries are operating in an external financing environment of growing complexity. Although ODA is still the major resource flow for many countries, many others now receive growing private capital flows (FDI and private debt flows, sometimes originating in other developing countries) or other nontraditional private resource flows (workers’ remittances and grants from nongovernmental organizations [NGOs]). Understanding the differential availability of the new mix of financing resources to individual poor countries will be essential to efforts to maximize aid effectiveness and achieve development objectives— notably the MDGs (chapter 5). Sources of external finance have changed Since the early 1990s, the relative importance of ODA as a source of external financing for poor countries has declined, in part due to the end of the Cold War and waning support for client states, but also because of growing global integration through the liberalization of financial flows, trade, and migration. Aggregate figures mask enormous variation among the 28 countries considered in this study: ODA dependence ranges from a high of 36 percent of GDP in Mozambique to 2.2 percent in Bangladesh. But other forces were at work as well. While ODA was declining, other sources were rising: FDI rose from only 0.4 percent of GDP to 2.7 percent of GDP in 2003, reflecting improving performance and a sounder investment climate. FDI has been of considerable importance for many poor countries— including Lesotho, Mauritania, Moldova, and Mozambique. Nonetheless, much FDI to poor countries still flows to enclave mining and natural resources projects, which may limit benefits and add to volatility. While not technically a capital flow, private transfers (including NGO grants and workers’ remittances) have become relatively more important in poor countries than in other developing countries. Both are large, stable sources of foreign exchange for poor countries and may be more likely than other capital flows to reach poor households. In addition, the size and stability of such current account flows (especially workers’ remittances) over time may facilitate poor countries’ access to capital markets through securitization. Flows from other developing countries have grown The traditional view of developing countries as reliant solely on financing from industrial economies is increasingly outdated. While the final report from Monterrey mentioned the importance of cooperation between developing countries only briefly, the available data suggest a different perspective: with respect to poor countries, other developing countries (especially larger ones such as Brazil, China, India, Saudi Arabia, and South Africa) are increasingly important financial players. With wealth increasing and administrative capital controls being eased in the 1990s, developing 8
OVERVIEW AND POLICY MESSAGES countries have also emerged as significant will only be met by 2015 if rates of progress in- sources of FDI outflows, in the form of invest- crease considerably. The Commission for Africa ments by developing country firms-usually in recently urged a doubling of aid to Sub-Saharan other developing countries. Because of proximity, Africa. And in February 2005, the G-7 finance cultural similarities. and similar cost structures. ministers reaffirmed their countries' commitments developing country firms may have advantages in to helping the developing world, particularl certain FDI projects. Companies from other de- Africa, achieve the MDGs by 2015. That goal is veloping countries bought assets in a broad one of two main themes for discussion at the G-8 range of privatization deals during the 1990s, in leaders' summit scheduled for July 2005 sectors ranging from mining to agro-business to Second, donors should pursue efforts to make telecommunications aid flows more reliable. Recognizing that aid is Similarly, although aggregate numbers are still more effective when it is allocated preferentially small (and available data limited), ODA providers to countries that demonstrate a capacity to absorb are becoming more diverse. With the emergence of additional aid and to use it well, and that aid can- new donors such as China, Brazil, South Africa, not be expected to stabilize economic fluctuations and India, the scope of South-South development in recipient countries, volatility per se is inimical assistance is growing, with innovative approaches to aid effectiveness. Aid has been observed to be such as triangular cooperation(developed-country more volatile than GDP in recipient countries financing of South-South technical cooperation) and more volatile than some other sources of receiving greater emphasis foreign exchange. Efforts to make it less volatile Finally, the South is the primary destination (through vehicles such as the International Fi for poor-country migrants-a large portion of nancing Facility, for example) could enhance its poor-country migrants in Africa and South Asia effectiveness migrate to another developing country. As a re- Third, donors(both developed and develop sult, other developing countries (not industrial ing) and recipients should press for better donor economies)are the major source of workers' re- coordination, selectivity, and country ownership mittances to the poor countries. The countries to improve the effectiveness of aid, and increase with the highest remittance shares are all adjacent the focus on results. Significant progress has been to larger, wealthier developing countries, an inter- made on this agenda over the last decade, but dependence that creates both opportunities and there is still enormous duplication among donors del and a wide variation among them in terms of se- lectivity. As efforts are made to scale up interven- An agenda for financing the millennium tions to achieve the mdgs, the relevance of initia opment tives targeting coordination and effectiveness will As other sources of finance grow, the development grow even further. community must continue to play the leading role Fourth, the development community should in mobilizing the external resources on which de- support policies that could facilitate better market veloping countries are depending to achieve the access for poor countries and encourage invest MDGs. Action is needed on four fronts ment through expanding risk-mitigation instru- First, donors must fulfill commitments al- ments to stimulate and build on private-sector ready made(at Monterrey and afterwards) to sub- participation. Most important, poor countries stantially increase ODA and other resources themselves need to pursue effective economic and needed to achieve internationally agreed develop- pro-poor policies. There is clear and growing evi ment goals. Meeting those commitments will re- dence of a link between reforms in governance, an quire overcoming mounting fiscal pressures in improved investment climate, and growth in re many donor countries and avoiding distractions source inflows of all types-FDI, official flows, surrounding shifting strategic considerations- and even remittances. Poor countries should con- so that aid can be channeled to the places that tinue their efforts to improve the investment cli need it most. Much of the enhanced aid effort mate not only to attract more resources, but also must be directed toward africa. where the mdgs to ensure their effective use
OVERVIEW AND POLICY MESSAGES countries have also emerged as significant sources of FDI outflows, in the form of investments by developing country firms—usually in other developing countries. Because of proximity, cultural similarities, and similar cost structures, developing country firms may have advantages in certain FDI projects. Companies from other developing countries bought assets in a broad range of privatization deals during the 1990s, in sectors ranging from mining to agro-business to telecommunications. Similarly, although aggregate numbers are still small (and available data limited), ODA providers are becoming more diverse. With the emergence of new donors such as China, Brazil, South Africa, and India, the scope of South-South development assistance is growing, with innovative approaches such as triangular cooperation (developed-country financing of South-South technical cooperation) receiving greater emphasis. Finally, the South is the primary destination for poor-country migrants—a large portion of poor-country migrants in Africa and South Asia migrate to another developing country. As a result, other developing countries (not industrial economies) are the major source of workers’ remittances to the poor countries. The countries with the highest remittance shares are all adjacent to larger, wealthier developing countries, an interdependence that creates both opportunities and risks. An agenda for financing the Millennium Development Goals As other sources of finance grow, the development community must continue to play the leading role in mobilizing the external resources on which developing countries are depending to achieve the MDGs. Action is needed on four fronts. First, donors must fulfill commitments already made (at Monterrey and afterwards) to substantially increase ODA and other resources needed to achieve internationally agreed development goals. Meeting those commitments will require overcoming mounting fiscal pressures in many donor countries and avoiding distractions surrounding shifting strategic considerations— so that aid can be channeled to the places that need it most. Much of the enhanced aid effort must be directed toward Africa, where the MDGs will only be met by 2015 if rates of progress increase considerably. The Commission for Africa recently urged a doubling of aid to Sub-Saharan Africa. And in February 2005, the G-7 finance ministers reaffirmed their countries’ commitments to helping the developing world, particularly Africa, achieve the MDGs by 2015. That goal is one of two main themes for discussion at the G-8 leaders’ summit scheduled for July 2005. Second, donors should pursue efforts to make aid flows more reliable. Recognizing that aid is more effective when it is allocated preferentially to countries that demonstrate a capacity to absorb additional aid and to use it well, and that aid cannot be expected to stabilize economic fluctuations in recipient countries, volatility per se is inimical to aid effectiveness. Aid has been observed to be more volatile than GDP in recipient countries, and more volatile than some other sources of foreign exchange. Efforts to make it less volatile (through vehicles such as the International Financing Facility, for example) could enhance its effectiveness. Third, donors (both developed and developing) and recipients should press for better donor coordination, selectivity, and country ownership to improve the effectiveness of aid, and increase the focus on results. Significant progress has been made on this agenda over the last decade, but there is still enormous duplication among donors and a wide variation among them in terms of selectivity. As efforts are made to scale up interventions to achieve the MDGs, the relevance of initiatives targeting coordination and effectiveness will grow even further. Fourth, the development community should support policies that could facilitate better market access for poor countries and encourage investment through expanding risk-mitigation instruments to stimulate and build on private-sector participation. Most important, poor countries themselves need to pursue effective economic and pro-poor policies. There is clear and growing evidence of a link between reforms in governance, an improved investment climate, and growth in resource inflows of all types—FDI, official flows, and even remittances. Poor countries should continue their efforts to improve the investment climate not only to attract more resources, but also to ensure their effective use. 9