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T H E W O R L D B A N K

GlobalDevelopmentFinanceThe Globalization of Corporate Finance in Developing Countries

GlobalDevelopmentFinance

2007I : R E V I E W, A N A L Y S I S , A N D O U T L O O K

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I: Review, Analysis, and Outlook

T H E W O R L D B A N K


2007I : R E V I E W , A N A L Y S I S , A N D O U T L O O K

© 2007 The International Bank for Reconstruction and Development / The World Bank1818 H Street NWWashington DC 20433Telephone: 202-473-1000Internet: www.worldbank.orgE-mail: [email protected]

All rights reserved

1 2 3 4 10 09 08 07

This volume is a product of the staff of the International Bank for Reconstruction and Development / TheWorld Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflectthe views of the Executive Directors of The World Bank or the governments they represent.

The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors,denominations, and other information shown on any map in this work do not imply any judgement on thepart of The World Bank concerning the legal status of any territory or the endorsement or acceptance of suchboundaries.

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The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work withoutpermission may be a violation of applicable law. The International Bank for Reconstruction and Development /The World Bank encourages dissemination of its work and will normally grant permission to reproduce portionsof the work promptly.

For permission to photocopy or reprint any part of this work, please send a request with completeinformation to the Copyright Clearance Center Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; telephone: 978-750-8400; fax: 978-750-4470; Internet: www.copyright.com.

All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of thePublisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail:[email protected].

Cover art: Charles Arnoldi, “Jumbo,” 2000 (detail).Cover design: Drew Fasick.

ISBN-10: 0-8213-6977-6ISBN-13: 978-0-8213-6977-7eISBN-10: 0-8213-6978-4eISBN-13: 978-0-8213-6978-4DOI: 10.1596/978-0-8213-6977-7ISSN: 1020-5454

The cutoff date for data used in this report was May 15, 2007. Dollars are current U.S. dollars unlessotherwise specified.

v

Table of Contents

Foreword xi

Acknowledgments xiii

Selected Abbreviations xv

Overview 1Strong growth in 2006 probably represents a cyclical peak 2The expansion in capital flows was led by equity, as private sources eclipsed official 2The globalization of corporate finance offers significant benefits for developing countries 2Little progress has been made in scaling up aid 4Good policies need to be sustained and extended in managing the upcoming adjustment 4

Chapter 1 The Outlook for Developing Economies 7Summary of the medium-term outlook 7The global outlook 8Inflation, interest rates, and global imbalances 15World trade 21Commodity markets 23A period of uncertainty 28Notes 32References 33

Chapter 2 Financial Flows to Developing Countries: Recent Trends and Prospects 35Capital market developments in 2006 37Private debt market developments 41Private equity market developments 48Official development assistance 54Low-income countries’ access to private debt markets 58Prospects for capital flows 62Annex 1: Commercial Debt Restructuring 65Developments between April 2006 and March 2007 65Annex 2: Debt Restructuring with Official Creditors 68Notes 69References 69

G L O B A L D E V E L O P M E N T F I N A N C E 2 0 0 7

Chapter 3 The Globalization of Corporate Finance in Developing Countries 73The rapidly evolving corporate sector in emerging economies 75Factors shaping corporate access to international finance 84Prospects and risks 94An agenda for strengthening the transparency of corporate governance 100Annex: Econometric Methodology and Estimation of Corporate Bond Spreads 103Notes 105References 106

Appendix: Regional Outlooks 109East Asia and the Pacific 109Europe and Central Asia 114Latin America and the Caribbean 120Middle East and North Africa 126South Asia 131Sub-Saharan Africa 136Notes 143Reference 144

Tables1.1 The global outlook in summary 91.2 Simulated impact of an increase of 200 basis points in emerging-market spreads 281.3 Simulated impact of a prolonged recession in the United States 301.4 Grain price forecast 301.5 Estimated poverty impact of a 40 percent increase in rice and wheat prices in selected

countries 31

2.1 Net capital flows to developing countries, 1998–2006 372.2 Repayments by selected developing countries to official creditors, 2006 412.3 Private bond flows to developing countries, 1998–2006 422.4 Cross-border bank lending to developing countries, by region, 1998–2006 432. 5 Cross-border loan commitments to developing countries, by region, 2006 432.6 Net short-term debt flows to developing countries, 2006 442.7 Major prepayments to private creditors, 2006 452.8 Net portfolio equity flows to developing countries, 2000–06 482.9 Ten largest cross-border initial public offerings in 2006 492.10 International equity prices, 2004–06 492.11 Net FDI flows to developing countries, 1998–2006 512.12 Major privatizations, mergers, and acquisitions in 2006 512.13 Net disbursements of official development assistance, 1990–2006 552.14 Bilateral ODA disbursements to 10 largest recipient countries, 2003–05 56

3.1 Capital raised through equity issues, bond issues, and syndicated bank borrowing by firms in selected middle-income countries, 1998–2006 77

3.2 Performance indicators of selected developing countries 783.3 Foreign debt contracted by developing-country corporations, 1999–2006 793.4 International borrowing by banks in 10 middle-income countries, 2004–06 803.5 Correlation of mature and developing stock market indexes 903.6 Segmentation of emerging-market equities from world markets 913.7 Performance and vulnerability of top foreign borrowers compared with other banks, selected

aggregates, 2000–05 100

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T A B L E O F C O N T E N T S

3A.1 Regression results of analysis of at-issue corporate bond spreads 104

A.1 East Asia and Pacific forecast summary 109A.2 Net capital flows to East Asia and Pacific 111A.3 East Asia and Pacific country forecasts 113A.4 Europe and Central Asia forecast summary 114A.5 Net capital flows to Europe and Central Asia 116A.6 Europe and Central Asia country forecasts 117A.7 Latin America and the Caribbean forecast summary 120A.8 Net capital flows to Latin America and the Caribbean 123A.9 Latin America and the Caribbean country forecasts 124A.10 Middle East and North Africa forecast summary 127A.11 Net capital flows to the Middle East and North Africa 129A.12 Middle East and North Africa country forecasts 130A.13 South Asia forecast summary 132A.14 Net capital flows to South Asia 134A.15 South Asia country forecasts 134A.16 Sub-Saharan Africa forecast summary 136A.17 Net capital flows to Sub-Saharan Africa 139A.18 Sub-Saharan Africa country forecasts 140

Figures1.1 U.S. industrial production growth 101.2 Regional growth 121.3 Developing-country industrial production grwoth 121.4 Inflation in high-income countries 151.5 Inflation in selected countries 161.6 Real policy interest rates, by region 171.7 Spreads on emerging-market bonds compared with 10-year U.S. Treasuries 171.8 Spreads on emerging-market debt and subprime corporate bonds in 2007 181.9 Emerging-market stock market valuations 181.10 U.S. trade balance is improving 181.11 Growth in domestic demand, by region 191.12 Movements in exchange rates 191.13 Difference between U.S. and Japanese/European interest rates 201.14 Current account balances 201.15 Foreign exchange reserves 211.16 Sources of export growth for high-income countries 221.17 Sources of export revenues for developing countries 221.18 Commodity prices 231.19 Prices of selected metals 231.20 Agricultural prices 241.21 Oil prices 251.22 Spare oil-production capacity within OPEC 261.23 Demand for oil 261.24 Change in sources of oil supply 271.25 Expected growth in non-OPEC oil production 271.26 Housing sector investment 291.27 Simulated impact of a grain-sector supply shock on selected developing countries 31

2.1 Net capital flows to developing countries, 1990–2006 38

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2.2 Net debt and equity flows, 1990–2006 382.3 Foreign exchange reserves relative to GDP in developing countries, 1998–2006 392.4 Changes in credit ratings of sovereign debt issued by emerging-market

economies, 2001–06 392.5 Emerging-market bond spreads, January 2006–March 2007 392.6 Monthly changes in emerging-market bond spreads in select countries since 1990 402.7 Net official debt flows to developing countries, 1998–2006 402.8 Net private debt flows to developing countries, 1994–2006 412.9 Private bond flows to developing countries, 1994–2006 422.10 Concentration of cross-border loan commitments, 1998–2006 432.11 Cross-border syndicated lending to low- and lower-middle-income countries,

by region, 2004–06 442.12 Bond issuance by sovereign and corporate sectors, 1994–2006 452.13 Long-term external debt as a share of GDP in developing countries,

by type of debt, 1994–2006 452.14 Public debt as a share of GDP in 28 largest emerging-market economies, 1998–2006 462.15 Share of domestic debt held by nonresidents, selected countries, 2002 and 2006 472.16 Bond issuance by developing countries by credit grade, 1996–2006 472.17 Loan commitments to developing countries by credit grade, 1990–2006 472.18 Average spread across all loan commitments, 1990–2006 482.19 International equity prices, January 2000–March 2007 492.20 Net FDI inflows to developing countries, 1990–2006 502.21 Concentration of net FDI inflows to developing countries, 1997–2006 532.22 FDI income relative to GDP, 1990–2006 532.23 Net ODA disbursements by DAC donors, 1990–2006 552.24 Net ODA disbursements to Sub-Saharan Africa, 1990–2005 562.25 Emergency relief provided by DAC donors, 1990–2006 572.26 Proportion of developing countries that accessed private debt markets at

least once, 1980–2006 592.27 Proportion of developing countries that accessed private debt markets, 1980–2006 592.28 Emerging-market bond spreads in June 1997, September 1998, and March 2007 622.29 Change in emerging-market equity prices, June 1997–September 1998 622.30 World GDP growth and net equity flows as a percentage of GDP, 1990–2009 632.31 World GDP growth and net debt flows as a percentage of GDP, 1990–2009 63

3.1 Foreign capital raised by developing-country corporations, 1998–2006 763.2 Foreign companies listed on major global stock exchanges, 1998–2006 763.3 Trends in corporate debt and industrial production, 1994–2006 793.4 Foreign borrowing by companies from emerging-market countries, by region, 1990–2006 793.5 International bond issuance by sovereign governments and corporations, 1990–2006 823.6 International bond issuance by public and private corporations, 1990–2006 823.7 Average spread of emerging-market corporate bonds against U.S. Treasury bonds,

by grade, 1993–2006 833.8 Notional value of global credit default swaps, 2002–06 853.9 Five-year spreads on CDSs and ASWs 853.10 Spreads on U.S. credit derivative index, 2005–07 853.11 Distribution of global debt and equity capital, 2005 883.12 Spreads on investment-grade corporate bonds from developing and developed countries,

1996–2005 883.13 Correlation in mature debt and equity markets 893.14 Volatility measures in mature equity markets, 2002–07 89

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T A B L E O F C O N T E N T S

3.15 Correlation of equity returns in emerging markets and world markets, February 1992–January 2007 90

3.16 Capital account openness in developed and developing countries 913.17 Systematic movement of emerging-market equities with world markets 913.18 Effect of selected characteristics of bond issues on at-issue spreads 933.19 Number of listed companies and amount of equity raised on selected stock

exchanges, 2006 943.20 Size of global derivative markets, June 2006 973.21 Implied cost of equity in emerging markets, 1992–2006 983.22 Net debt-to-equity ratios for nonfinancial corporations in emerging markets, 1985–2005 983.23 Average maturity of issues by financial and nonfinancial corporations, 1990–2006 983.24 Foreign borrowing by the banking sector and domestic private credit growth in developing

countries, 2001–05 993.25 Average foreign loan maturity contracted by commercial banks in select developing

countries, 2000–06 993.26 Asset growth of largest foreign borrowers versus country asset growth, 2005 1003.27 Short-term volatility in emerging market currencies, January 2006–April 2007 102

A.1 Chinese industrial production 110A.2 Inflation in Malaysia, the Philippines, and Thailand 110A.3 No permanent impact on inflation of a removal of energy subsidies in Indonesia 111A.4 Building inflationary pressure in Europe and Central Asia 115A.5 Short-term debt in selected countries of Europe and Central Asia, Q3 2006 120A.6 Contribution of consumption, investment, and exports to GDP growth in

Latin America and the Caribbean 121A.7 Rising inflation in selected countries of the Middle East and North Africa 128A.8 Stock market valuations in the Middle East and North Africa 129A.9 Strong workers’ remittances in South Asia 133A.10 Real interest rates in South Asia 133A.11 Ratio of nominal investment to nominal GDP among Sub-Saharan oil

importers 137A.12 ODA (net of debt relief) in selected Sub-Saharan African countries, 2003–05 138

Boxes2.1 Foreign direct investment in the oil and gas sector 522.2 Remittance flows to developing countries 54

3.1 A profile of developing-country companies that access global financial markets 813.2 The relationship between emerging-market sovereign and corporate bond spreads 843.3 Globalization and the growth of transnational companies in the developing world 863.4 Determinants of emerging corporate bond spreads 923.5 Foreign company listings on major financial centers continue to grow 96

A.1 New GDP estimates for Brazil 121

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THE ECONOMIC ENVIRONMENT facing developing countries remained highlyfavorable in 2006. Global gross domestic

product (GDP) expanded by 4 percent, althoughsigns of moderation emerged toward year-end.Developing economies grew by 7.3 percent, and in-ternational financial markets remained supportiveof their financing needs despite several episodes ofheightened volatility. Oil prices appear to havepeaked, while markets for most other commoditiesproduced by developing countries remained high—or rose still further. Combined, these conditionscreated the context for the continued expansion ofprivate capital flows to developing countries, whichreached a record $647 billion in 2006—5.7 percentof the aggregate GDP of these countries.

Strong private capital flows to developingcountries reflect both these cyclical elements andimprovements in the fundamentals of theseeconomies. A wide range of middle-income coun-tries has benefited from these flows, but access toprivate capital in many low-income developingcountries remains limited and is dominated bytrade financing and the resource sector. Sub-Saharan Africa, for example, was the destinationof only 6 percent ($292 billion) of the $4.9 trillionin private capital that flowed to developingeconomies between 1990 and 2006. Low-incomecountries, benefiting from recent internationaldebt-relief initiatives, must face the challenge ofadopting prudent borrowing practices to ensurelong-term growth and debt sustainability. Comple-mentary efforts to increase aid flows havestalled—the amount of official development assis-tance provided by the 22 members of the Develop-ment Assistance Committee of the Organisation forEconomic Co-operation and Development declinedby almost $3 billion in 2006, following a large $27billion increase in 2005. Donors must enrich de-velopment assistance significantly over the nextfew years in order to meet their commitments, no-tably the pledge made by G-8 and other donorcountries to double the amount of aid provided toSub-Saharan Africa by 2010.

Although oil import bills have risen, the pastfive years have presented a highly favorable mix ofeconomic and financial conditions for most devel-oping countries: low international interest rates,ample global liquidity, and strong global demandfor exports. Many middle-income countries havetaken advantage of this opportunity to enhancetheir creditworthiness by accumulating foreign ex-change reserves, improving current account bal-ances, reducing external debt burdens, and improv-ing debt management by issuing longer maturities.Several large borrowers have bought back signifi-cant amounts of outstanding debt using abundantforeign exchange reserves. Many governments haveturned from external to domestic markets, wheremost debt is denominated in local currency. Partlyas a consequence, creditors’ assessment of develop-ing countries is very positive, as reflected in nearrecord-low spreads on emerging-market bonds andbank loans.

These favorable conditions and the gains thathave accrued are not grounds for complacency inassessing future risks. History suggests that marketconditions and sentiment can shift with dizzyingspeed. Sustaining the discipline and sound policythat have contributed to the current favorablephase must remain in the forefront of decisionmakers’ objectives.

The increasing share of corporate finance inemerging-market economies’ external borrowinghas introduced its own risks. For much of thepostwar era, foreign borrowing by sovereigns has been the dominant feature of development finance. Since 2002, however, a different picturehas emerged. The past few years of strong developing-country growth has brought the leading companies of the developing world tothe attention of an ever-wider set of investors. Together with the liberalization of capital controlsand the pressures facing international portfoliomanagers to enhance returns, the globalization ofcorporate finance is now reaching a larger segmentof the developing world. This in turn strengthensthe case for a more coherent and global approach

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Foreword


to regulating cross-border public offerings andsecurities listings. Domestic regulators must paygreater attention to the transparency andstringency of accounting standards, the credibilityof financial reporting, and the integrity of corpo-rate governance. In all cases, there must be abalance between official regulations and marketincentives for enhancing the efficiency of globalcapital allocation.

The globalization of corporate finance alsopoints to other challenges. As emerging-market cor-porations have expanded their international opera-tions, they have increased their exposure to interestrate and currency risks. Concerns are growing thatseveral countries in emerging Europe and CentralAsia are experiencing a credit boom engendered bycross-border borrowing by banks of untested financial health and stamina. Some of these bankshave increased their foreign exchange exposure to worrisome levels, a concern that warrants specialattention from national policymakers. Given banks’critical role in domestic monetary systems, policy-makers should step up their regulation of foreignborrowing by banks.

The projected slowdown in global growth andtighter monetary policy in high-income countriesare expected to make financing conditions for de-veloping countries somewhat less favorable in

coming years. While a soft landing is the mostlikely outcome, there are risks. For example, if theeconomic downturn in the United States is deeperthan forecast, demand for developing economies’exports (and commodity prices) may fall enoughto contribute to reduced confidence and induce financial sector disruption. Conversely, shouldgrowth fail to moderate, financial stability in somefast-growing developing economies could bethreatened by rising inflation and high current ac-count deficits.

Global Development Finance is the WorldBank’s annual review of global financial condi-tions facing developing countries. The currentvolume provides analysis of key trends andprospects, including coverage of capital raised bydeveloping country based corporations. A sepa-rate volume contains detailed standardized exter-nal debt statistics for 136 countries as well assummary data for regions and income groups.More information, including additional material,sources, background papers, and a platform forinteractive dialogue on the key issues, can befound at http://www.worldbank.org/prospects. Acompanion online publication, “Prospects for theGlobal Economy,” is available in English, French,and Spanish at http://www.worldbank.org/globaloutlook.

François BourguignonChief Economist and Senior Vice PresidentThe World Bank

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Acknowledgments

THIS REPORT WAS PREPARED BY THEInternational Finance Team of the WorldBank’s Development Prospects Group

(DECPG). Substantial support was also providedby staff from other parts of the Development Eco-nomics Vice Presidency, World Bank operationalregions and networks, the International FinanceCorporation, and the Multilateral InvestmentGuarantee Agency.

The principal author was Mansoor Dailami,with direction by Uri Dadush. The report was pre-pared under the general guidance of FrançoisBourguignon, World Bank Chief Economist andSenior Vice President. The principal authors ofeach chapter were:

Overview Mansoor Dailami, with contri-butions from the InternationalFinance Team and AndrewBurns

Chapter 1 Andrew BurnsChapter 2 Douglas Hostland, Olga Sulla,

Dilek Aykut, Jacqueline Irving,Neeltje van Horen, and Eung JuKim

Chapter 3 Mansoor Dailami, Dilek Aykut,Jacqueline Irving, Neeltje vanHoren, Eung Ju Kim, HaocongRen, and Valentina Bruno.

Preparation of the commercial and officialdebt restructuring annexes was managed by EungJu Kim, with inputs from Haocong Ren and OlgaSulla. The financial flow and debt estimates weredeveloped in a collaborative effort betweenDECPG and the Financial Data Team of theDevelopment Data Group (DECDG), led byIbrahim Levent and including Nevin Fahmy, Shel-ley Lai Fu, and Gloria R. Moreno. The mainmacroeconomic forecasts were prepared by theGlobal Trends Team of DECPG, led by Hans Tim-mer and including Andrew Burns, Maurizio Bus-solo, Betty Dow, Annette De Kleine, Don Mitchell,Denis Medvedev, Mick Riordan, Cristina Savescu,

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and Shane Streifel. Gauresh Rajadhyaksha man-aged and maintained the modeling and data sys-tems. Shuo Tan and David Horowitz provided re-search assistance and technical support.

The regional outlooks were written byAndrew Burns and Hans Timmer, based on contri-butions from Maurizio Bussolo, Annette DeKleine, Denis Medvedev, Mick Riordan, CristinaSavescu, and the International Finance Team.Contributors from the Bank’s regional side in-cluded Milan Brahmbhatt (East Asia and Pacific),Asad Alam (Europe and Central Asia), ErnestoMay and Guillermo Perry (Latin America and theCaribbean), Carlos Silva–Jauregui (Middle Eastand North Africa), Ejaz Syed Ghani (South Asia),and Delfin Go (Sub-Saharan Africa).

Background notes and papers were preparedby Robert Hauswald (American University, deter-minants of corporate bond spreads); OliverFratzscher (corporate risk management);Anderson Caputo Silva (foreign investor participa-tion in emerging local debt markets); WilliamShaw (prospects for globalization of corporate sec-tor); and Dilip Ratha (workers’ remittances). Theonline companion publication, “Prospects for theGlobal Economy,” was prepared by AndrewBurns, Sarah Crow, Cristina Savescu, and ShuoTan, with the assistance of Roula Yazigi, ShunaliniSarkar, and the Global Trends team. Technicalhelp in the production of that Web site was pro-vided by Saurabh Gupta, David Hobbs, ShahinOutadi, Raja Reddy Komati Reddy, MalarvizhiVeerappan, and Kavita Watsa.

The report also benefited from the commentsof the Bank’s Executive Directors, presented at aninformal board meeting on April 26, 2007.

Many others provided inputs, comments,guidance and support at various stages of thereport’s preparation. Marilou Uy, BarbaraMierau–Klein, Cesar Calderon, Thomas Helbling(IMF), Stijn Claessens (IMF), John Williamson(Institute for International Economics), and JackD. Glen (IFC) were discussants at the Bankwide re-view. In addition, within the Bank, comments and


help were provided by Alan Gelb, Jeff Lewis, LeoraKlapper, Makhtar Diop, Manuela Ferro, Ejaz SyedGhani, Luis Serven, Alan Winters, Nicholas Krafft,Swati Ghosh, Laszlo Lovei, Sanket Moha Patra,Marcelo Giugale, Fernando Montes-Negret,Margret Thalwitz, and Eleanor Fink.

Outside the Bank, many people contributedthrough meetings, shared insights, and correspon-dence on issues addressed in the report. Theseinclude: Anne Miroux and Masataka Fujita(UNCTAD), Patrick Ankpli Akatu, Victor DuarteLledo, Zuzana Murgasova (IMF), Sylvester Akele(Nigeria Securities and Exchange Commission),

Ann Hunter (Standard Bank of South Africa),Dori Flanagan (Bank of New York), YasminAhmad (Development Assistance Committee,OECD), and Lemma Senbert (Robert H. SmithSchool of Business, University of Maryland).

Steven Kennedy edited the report. MariaAmparo Gamboa provided assistance to the team.Araceli Jimeno and Merrell Tuck-Primdahl man-aged production and dissemination activities forDECPG. Book design, editing, and productionwere coordinated by Dana Vorisek and DeniseBergeron of the World Bank’s Office of thePublisher.

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Selected Abbreviations

ADR American Depositary ReceiptASW Asset swapCDS Credit default swapDAC Development Assistance Committee EMBI Global JPMorgan Emerging Markets Bond

Index GlobalEU European UnionFASB Financial Accounting Standards Board FDI Foreign direct investment G-7 Group of Seven (Canada, France,

Germany, Italy, Japan, UnitedKingdom, United States)

GAAP Generally Accepted Accounting Principles

GCC Gulf Cooperation CouncilGDP Gross domestic productGDR Global Depositary ReceiptHIPC Heavily indebted poor countriesIASB International Accounting Standards

BoardICRG International Consulting Resources

Group

IFRS International Financial Reporting Standards

IFS International Financial Statistics (IMF)IMF International Monetary FundIPO Initial public offeringLSE London Stock ExchangeM&A Mergers and acquisitions MDRI Multilateral Debt Relief InitiativeMSCI Morgan Stanley Capital Internationalmbpd Million barrels per dayNYSE New York Stock Exchange ODA Official development assistance OECD Organisation for Economic

Co-operation and DevelopmentOPEC Organization of Petroleum-Exporting

CountriesPPP Purchasing power paritySIC Standard Industrial ClassificationUN United NationsWDI World Development Indicators

(World Bank)WTO World Trade Organization

Overview

WORLD GROWTH IS MODERATING,and financial markets are signaling aturn in the financing conditions facing

the developing world. As these developments makethemselves felt, 2007 is likely to be a year of adjust-ment for capital flows to developing countries.

After recovering from the sharp contraction of2001–02, private flows weathered several episodesof global financial volatility and passed through afull cycle of global monetary easing and tighteningto reach a record level of $647 billion in 2006,up 17 percent from 2005. Total capital flows,including lending by official creditors, leveled offat 5 percent of gross domestic product (GDP) in2005–06, just below the 5.25 percent level reachedin 1995–97, before the East Asian crisis.

Developing countries have come to accountfor a large share of the growth of world outputand trade, a fact that is increasingly recognized byinternational investors. Their economies grewmore than 7 percent in 2006—more than twice the3 percent rate of growth in high-income countries.The expansion was particularly evident in China,where output increased 10.7 percent, and India,which grew 9.2 percent. But the strong perfor-mance was broadly based, with all developing re-gions growing at least 5 percent. Even oil-importingdeveloping countries recorded robust growth ofalmost 5 percent, despite high oil prices for thethird consecutive year.

Most developing countries have taken advan-tage of favorable external conditions to implementdomestic policies designed to reduce their vulnera-bility to financial turmoil and reversals in capitalflows. In particular, countries have reduced their

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external debt burdens and lengthened the maturitystructure of their debt. Several have bought backlarge amounts of outstanding debt, using abun-dant foreign exchange reserves, and refinancedexisting debt on more favorable terms. The marketfor sovereign debt has evolved significantly, asgovernments have turned from borrowing exter-nally to borrowing domestically, usually in localcurrency. Creditors’ assessment of the creditwor-thiness of developing-country borrowers remainspositive, as reflected in spreads on emerging mar-ket bonds and bank loans, which have hoverednear record lows.

By these measures, most developing countrieshave clearly improved their ability to deal withthe moderate shocks that may accompanychanges in the international credit environment.However, the buoyancy of financial markets,combined with the slowing of growth and thetrend toward continued monetary tightening,provide grounds for caution. In particular, al-though the smooth adjustment toward slower,more sustainable, growth that is outlined in thebaseline projection presented in this report isthe most likely outcome, such turning points arerisky in nature. The extent to which the U.S.housing-sector correction spreads to other sectorsin the economy, the success with which those de-veloping countries that are overheating are ableto contain inflation and reduce current accountimbalances, and the durability of financial mar-kets’ current benign assessment of long-term risksare all areas of uncertainty that could result ina more abrupt and disruptive adjustment towardslower growth.


Strong growth in 2006 probablyrepresents a cyclical peak

Global GDP expanded 4 percent in 2006,despite signs of a moderation of the current

expansion. Tighter monetary policy, furtheremerging capacity constraints in many countries,and a generalized maturation of the investmentcycle contributed to a slowing of industrial pro-duction toward the end of the year in the majorhigh-income countries and China. The moremarked slowdown in the United States has con-tributed to some easing of major tensions. U.S.housing prices have moderated or declined insome parts of the country, without (yet) triggeringa disruptive sell-off. At the same time, U.S. savingshave crept up, as the current account deficit fell to5.9 percent of GDP in the last quarter of 2006.

Short- and long-term international interestrates have risen in response to policy actions andmarket-induced revaluations of long-term risks,while risk premiums, notably on subprime assets,have increased in recent months. Commodityprices also show signs of having reached cyclicalpeaks, with some easing of oil prices from themid-2006 high point and a decline in the prices ofcopper and zinc, two of the metals whose priceshad risen most rapidly. Financial conditions re-main supportive by historical measures, however,and liquidity remains ample. As a result, the tran-sition to slower growth is expected to be rela-tively smooth. The expansion of developingeconomies is projected to moderate gradually,from 7.3 percent in 2006 to about 6 percent in2009, with all regions slowing but continuing torecord strong results. At the same time, growth inthe high-income countries is expected to ease in2007 (mainly reflecting slower U.S. growth) beforestrengthening in 2008 and 2009, as the UnitedStates recovers and the economies of Japan andEurope continue to expand at close to their poten-tial rates.

The expansion in capital flows wasled by equity, as private sourceseclipsed official

The composition of capital flows continues itspronounced shift from debt to equity financ-

ing and from official to private sources of debt.Equity flows totaled $419 billion in 2006, ac-counting for almost three-quarters of capital

flows, up from two-thirds in 2004, with stronggains in both portfolio equity and foreign directinvestment (FDI). Equity prices in emerging mar-kets continued to outperform mature markets by awide margin while also exhibiting greater volatil-ity. Worldwide FDI inflows reached $1.2 trillionin 2006, with about one-quarter of the total($325 billion) going to developing countries.

Net lending from the international financialinstitutions and other official sources in the ParisClub of creditors dropped starkly over the pasttwo years, while private lending surged. Severalcountries drew down abundant foreign exchangereserves to pay off debt owed to official creditorsand to access financing from private sources onfavorable terms. Principal repayments to the ParisClub and multilateral institutions (particularly theInternational Monetary Fund) exceeded disburse-ments by some $146 billion in 2005–06, as netprivate debt flows reached $432 billion.

The development of local and regional bondmarkets in low-income countries, as highlightedby the G-7 finance ministers at their meeting inFebruary 2007, has the potential to improve finan-cial infrastructure and provide an additionalsource of financing. Local bond markets in Kenya,Nigeria, Zambia, and elsewhere have alreadyattracted the interest of foreign investors. Whileparticipation of foreign investors in these marketsoffers significant potential benefits, notably diver-sifying the investor base and enhancing liquidity,it also poses new risks, particularly in cases wheresegments of these markets are dominated by for-eign investors, which makes them more vulnerableto a sudden swing in investor sentiment. Progresson improving the quality of institutions, gover-nance, and economic policies will ultimately havea major influence on how effectively developingcountries manage such risks. Given the highvulnerability of such countries to domestic andexternal shocks, governments are well advised toimprove data collection and procedures for bettermonitoring of foreign investment flows.

The globalization of corporatefinance offers significant benefitsfor developing countries

In the making for many years, the globalizationof corporate finance in the developing world

has accelerated since 2002, as governments have

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O V E R V I E W

liberalized capital controls and international port-folio managers have enhanced returns by diversify-ing into emerging corporate securities. With thesechanges, more companies based in developingcountries have entered world capital markets tobroaden their funding sources, borrowing atlonger maturities and improving risk managementthrough the use of sophisticated financing instru-ments. Private sector companies were behind muchof the increase, accounting for more than 60 per-cent of total bank borrowing and 75 percent ofnew bond issuance during 2002–06. Financialcorporations, particularly commercial banks fromIndia, Kazakhstan, the Russian Federation, andTurkey, have been on the forefront of what maywell be a major foreign-credit boom in the bank-ing industry of these countries. Banks have tappedinternational debt markets to fund growing do-mestic loan portfolios and meet increasing capital-adequacy requirements. Faced with intensifiedcompetitive pressures and highly liquid markets,international banks have been willing to narrowmargins, lengthen maturities, and relax creditstandards.

Growing numbers of firms are opting tocross-list their shares on major world stock ex-changes as a way of facilitating trading by foreigninvestors and building channels through which tomeet future capital needs. Companies often gainvalue by bypassing underdeveloped local capitalmarkets and committing to higher standards ofaccounting, reporting, disclosure, and corporategovernance, as mandated by major financial cen-ters. By meeting these standards, companies canlower their cost of capital. But overreliance on in-ternational sources of capital has drawbacks, too:

• As emerging-market corporations have in-creased in size and expanded their interna-tional operations, they have increased theirexposure to interest-rate and currency risks.Despite advances in risk management by manyfirms, concerns remain in two particular areas.First, growing yen-denominated liabilities heldby some corporations may not be adequatelyhedged against currency movements. Second,in many emerging-market corporations, thecapacity to develop an enterprisewide riskmanagement framework is hampered byunderdeveloped derivatives markets, makingit difficult to measure, aggregate, and hedge

risk. Moreover, credit risk may be substan-tially underestimated at the current phase ofthe credit cycle.

• Banks’ exposure to foreign-currency borrow-ing warrants special attention from policymakers, given banks’ critical role in domesticmonetary systems. Foreign borrowing bydeveloping-country banks can help deepen andmodernize the financial sector if underlyingpolicy and regulatory frameworks promotehealthy banking practices, sound credit alloca-tion, and proper risk management. Where su-pervision is less than stringent, systemic riskscan be considerable—and they are rarely con-fined to the country in which the risky bor-rower is based. Several countries, particularlyin the transition economies of Europe and Cen-tral Asia, are now experiencing a credit boom,spearheaded by banks of untested financialhealth and stamina. Concerns are growing thatsome of these banks—particularly in Estonia,Hungary, Kazakhstan, Latvia, Lithuania,Russia, and Ukraine—are increasing their for-eign exchange exposure to levels that have thepotential to jeopardize financial stability.

Protecting the benefits of globalization fordeveloping countries and their corporations willrequire appropriate policies, both macroeconomicand regulatory, by governments in the developingworld. While corporate decisions to raise capitalon overseas markets should depend primarily onmarket forces, pubic authorities must not shyaway from addressing situations in which corpo-rate financial distress could spill over to the bank-ing sector, raising systemic risk. Policy makersmust keep two realities in sharp focus. The first isthat the globalization of firms based in developingcountries is driven by powerful market forcesand trends that are inseparable from the broaderglobalization of the world economy. This is a secu-lar trend that shows no signs of abating. On bal-ance this is a positive trend, worthy of continuedsupport from policy makers and regulators. Thesecond is that governments must also keep theireyes on managing short-term fluctuations andrisks. Market-determined exchange rates, fargreater corporate transparency, and governmentregulation of foreign borrowing by banks areneeded to reduce the likelihood of excessive corpo-rate foreign borrowing and financial distress.

3


International financial institutions and supra-national organizations (notably those in the securi-ties and accounting fields) can help by establishingclear and consistent rules for access to the finan-cial markets of the industrial world. National andregional systems of securities regulation embracedifferent standards, rules, and systems. For firms,complying with multiple sets of rules can be verycostly. Market pressures and action by interna-tional regulators have brought about some degreeof convergence in certain areas, notably account-ing rules, but the need remains to strike a balancebetween official regulations and market incentivesin managing cross-border offerings and listingson major exchanges. Doing so will require moreprogress in streamlining and harmonizing nationalregulation of corporate governance practices, dis-closure rules, financial accounting standards, andenforcement mechanisms.

Little progress has been made inscaling up aid

The wave of private finance in the developingworld may represent a powerful secular trend,

but it has not reached all shores. Sixty percent ofall developing countries (79 of 135) never accessedthe external bond market between 1980 and 2006;just eight countries did so frequently.

Most low-income countries lack ready accessto private debt markets, and many continue todepend very heavily on concessional loans andgrants to meet their financing needs. At the UNConference on Financing for Development inMonterrey in 2002, official donors pledged to in-crease the amount of new aid they provided, overand above the substantial amounts of debt reliefthen being planned. Donors subsequently madecommitments to enhance aid substantially over thebalance of the decade, particularly to low-incomecountries in Sub-Saharan Africa.

Little progress was made toward meetingthese objectives in 2006. Excluding debt relief, netdisbursements of official development assistancewere static, after growing at an average annualrate of 16 percent over the three previous years.

Several new aid donors have emerged in the pastfew years. Some, such as Brazil, China, India, andRussia, are now both donors and recipients of devel-

opment assistance. Not much is known about theaid provided by most of the new donor countries,because their activities are not reported in a compre-hensive manner. But the emergence of new playerson the aid agenda has increased the need for greatercoordination among donors and better monitoringof aid flows, so that aid can be directed where it ismost needed and most likely to be effective.

Good policies need to be sustainedand extended in managing theupcoming adjustment

Never before have conditions been so wellaligned for a major push toward sustainable

growth and poverty reduction. Developing coun-tries stand to reap substantial benefits from theaccess their enterprises have gained to the world’smajor financial centers, with their deep and liquidfinancial resources, broad investor bases, andmodern trading platforms. For the fourth con-secutive year, growth in developing countries, in-cluding those in Sub-Saharan Africa, was strong.Low-income countries’ ability to access privatedebt markets has been considerably enhanced byrecent debt-relief initiatives, which have signifi-cantly reduced their debt burdens and improvedtheir creditworthiness. These hard-won gains areworth protecting.

The key requirement for doing so is to sustainand extend the solid policies and frameworks thathave provided fertile ground for developing coun-tries’ growth and that have brought emergingmarkets to the attention of an ever-wider set ofinvestors. Underway in many countries since theearly 1990s, these fundamental improvementsinclude progress toward flexible exchange rates; aphased easing of capital controls, in line with im-provements in institutional and regulatory capac-ity; and privatization of public enterprises. Greaterefforts are also needed to spur the development ofwell-regulated and liquid local capital markets,which provide developing countries with soundprotection against external shocks, and to ensureprudential regulation of foreign borrowing by do-mestic banks and other regulated financial entities.Such structural improvements would greatly reducethe likelihood of corporate financial distress andvulnerability while promoting the orderly growth

4

O V E R V I E W

of new market institutions and the regulatorycapacity needed for effective macroeconomicmanagement of the increasingly open economiesof the developing world.

These improvements notwithstanding, thecyclical component of financial flows to devel-oping countries means that the newly enhancedaccess of emerging market sovereigns and corpora-tions to global finance could reverse itself. Globalfinancial markets are notoriously sensitive to badnews during downturns in the global business

cycle, and the possibility of an abrupt marketreaction to unexpected events, economic or politi-cal, cannot be ruled out. The outlook is furtherclouded by large current account deficits in severalmiddle-income developing countries (especiallythose in Europe and Central Asia) and uncertaintysurrounding the functioning of exotically struc-tured financial products and their ability to sustaina major reversal in investor sentiment.

These are the themes and concerns of thisyear’s edition of Global Development Finance.

5

1The Outlook for Developing Economies

Summary of the medium-termoutlook

Growth in the developing countries came in at7.3 percent in 2006, the fourth year that their

economies expanded by more than 5.5 percent.Very fast-growing countries, such as China(10.7 percent) and India (9.2 percent), contributedstrongly to this overall result. But even excludingthese countries, low- and middle-income countriesgrew 5.9 percent and gross domestic product(GDP) in every developing region expanded bymore than 5 percent. This robust developing-country demand was reflected in stronger high-income country export growth, which was themain factor behind the acceleration of GDP inthose countries to 3.1 percent. Overall, global out-put increased by 4 percent (5.3 percent usingpurchasing power parity [PPP] weights).

Despite these strong figures, 2006 was likely acyclical peak, as both GDP and industrial produc-tion began slowing in mid-2006 and into 2007.This moderation of growth among developingcountries is welcome, however, because it shouldhelp reduce the chance that the current growthboom could be followed by a bust.

The past few years of very strong growth havegenerated a number of tensions in the global econ-omy, including increased commodity and assetprices (notably those of oil, metals, and housing)and a buildup of inflationary pressures.

The moderation of growth reflects the influ-ence of a number of economic adjustment mecha-nisms that are in part a self-correcting reaction tothese tensions.

Rising interest rates and tighter fiscal policyform a central part of the re-equilibrating process.Both policy action and market-induced revalua-

7

.

tions of long-term risk have caused short-term in-terest rates to rise. Among developing countries,monetary tightening is most advanced in EastAsia, where it has both slowed growth and con-tained inflationary pressures in a number of coun-tries. In other developing economies, interest rateshave risen and fiscal policy has been less procycli-cal than in the past, but the overall stance ofmacroeconomic policy in many of these countriesis still relatively accommodating—leaving openthe possibility of a much bumpier return to poten-tial growth rates than is laid out in the baselineprojection.

Growth in many developing countries contin-ues to exceed potential. Partly as a consequence,there are clear signs of overheating in several mid-dle-income countries, and inflation, which hadbeen easing in 2005, stabilized or picked up overthe past 12 months in four of six developingregions. Among high-income countries, slowergrowth (especially in the United States) and loweroil prices have brought down headline inflation.But core inflation is high in the United States andrising in Europe, causing monetary authorities toremain cautious.

Another factor contributing to a slowing ingrowth is the apparent stabilization of capitalflows to developing countries. While inflows re-main high, they have stabilized as a share of GDPand are no longer making a significant contribu-tion to growth. Partly as a result, most developingcountries have stopped accumulating reserves atrapid rates—although China and Russia constituteimportant exceptions in this regard.

Commodity prices also show signs of havingreached cyclical peaks. Oil prices have eased fromhigh points in mid-2006, as have the prices of


copper and zinc, two of the metals whose priceshave risen most rapidly. As growth eases, commod-ity prices are projected to decline further, whichshould support real incomes in importing countrieseven as output growth moderates. While a gradualdecline in oil and other commodity prices is themost likely scenario, supplies remain very tight. Anoil-sector supply shock could be extremely disrup-tive, driving up oil prices even farther while simul-taneously slowing growth and weakening theprices of most nonoil commodities to the detrimentof oil-importing developing countries.

These developments are also working to allevi-ate the global imbalances that have been buildingover the past nine years. Indeed, very strong do-mestic demand in developing countries, the recov-ery in Europe, rising interest rates, lower commod-ity prices, and an increase in U.S. savings as thehousing boom recedes have brought an end to thetrend rise in the U.S. current account deficit, whichdeclined to 5.8 percent of GDP in the fourth quar-ter of 2006. While cyclical factors are at play, theincrease in U.S. savings, the decline in commodityprices, and the shift in global growth toward devel-oping countries reflect important structuralchanges that likely signal a beginning of an orderlyresolution to the trend rise in global imbalances.Nevertheless, imbalances remain large, and there isa continuing low-probability risk that they will beresolved in a disruptive manner.

Although interest rates have increased, finan-cial conditions remain supportive by historicalmeasures, and liquidity is ample.1 As a result, thetransition to slower growth is expected to be rela-tively smooth. The expansion in developing coun-tries is projected to moderate gradually, to about6 percent in 2009, with all regions slowing butcontinuing to record strong results. At the sametime, growth in the high-income countries is ex-pected to ease in 2007 (mainly reflecting slowerU.S. growth) before strengthening in 2008 and2009, as the United States recovers and theeconomies of Europe and Japan continue to ex-pand at close to their potential rates.

This positive outlook is subject to significanttensions and uncertainties. Overheating (high in-flation and large current account deficits) in anumber of middle-income countries increases therisk of a hard landing for at least some of them.Should financial markets react to a sudden policy-induced slowdown (or an increase in internal or

external imbalances) in one or more of these coun-tries by re-evaluating the riskiness of emergingmarket assets, there could be a sharp reversal incapital flows. This, in turn, could provoke signifi-cant real-side adjustments among those countrieswith the largest current account deficits.

The risk of a steep recession in the UnitedStates appears to have declined, but the effects ofweakness in the housing sector are increasinglybeing felt in other sectors, and a much sharperthan projected slowdown cannot be ruled out.Such a slowdown would have consequences fordeveloping countries, through traditional tradechannels but also potentially via financial markets.If, for example, difficulties in the U.S. subprimemarket were to deepen or spread to other sectors,investors might be forced to close positions inemerging markets to meet obligations in theUnited States, with adverse effects on developing-market valuations.

For the poorest countries, significantly slowergrowth could cause commodity prices to weakenmore rapidly than projected, potentially placingmany developing countries that have so faravoided current account problems in difficulty.Private sector funding of resource-based projectswould likely dry up, and lower revenues mightmake it difficult for some countries to repay someof the private sector and short-term lending thathas accounted for much of the increase in financialflows to developing countries in recent years.

The diversion of land and produce into theproduction of biofuels has greatly reduced globalstocks of wheat, rice, and maize. Should 2007 bea poor crop year, the prices of these basic foodscould rise by as much as 100 percent. This couldhave serious near-term consequences for the urbanpoor in those developing countries where theseproducts represent a large share of total consump-tion. Estimates suggest that a 40 percent increasein the price of one of these grains could reduce realincomes among the poor in some countries by6 percent or more.

The global outlook

Despite oil prices that topped $75 a barrel duringthe course of 2006, world GDP rose 4 percent

(5.3 percent in PPP terms), up from 3.5 percentin 2005 (table 1.1). This strong global per-formance reflects the very rapid expansion of

8

T H E O U T L O O K F O R D E V E L O P I N G E C O N O M I E S

9

Table 1.1 The global outlook in summary% change from previous year, except interest rates and oil price

1960–80 1980–2000 2005 2006e 2007f 2008f 2009f

Global conditionsWorld trade volume — 5.8 7.6 10.2 7.5 8.2 7.9Consumer prices

G-7 countriesa,b — 3.6 2.5 2.6 1.6 1.7 1.7United States — 3.8 3.4 3.2 1.9 1.5 1.9

Commodity prices ($ terms)Non-oil commodities 6.0 �1.8 13.4 24.7 6.3 �8.6 �8.4

Oil price ($ per barrel)c 7.1 22.2 53.4 64.3 60.4 58.4 55.2Oil price (percent change) 16.9 �1.3 41.5 20.4 �6.0 �3.4 �5.4

Manufactures unit export valued 6.3 1.1 0 1.6 0.8 0.8 0.8Interest rates

$, 6-month (percent) — 7.9 3.6 5.2 5.4 4.8 4.7€, 6-month (percent) — 6.9 2.2 3.1 3.8 4.3 4.3

Real GDP growthe

World 4.7 3.0 3.5 4.0 3.3 3.6 3.5Memo item: World (PPP weights)f 4.7 3.0 4.7 5.3 4.7 4.8 4.7High-income countries 4.5 2.9 2.6 3.1 2.4 2.8 2.8

OECD 4.4 2.8 2.5 2.9 2.3 2.7 2.7Euro Area 4.3 2.3 1.3 2.7 2.5 2.2 2.0Japan 7.4 2.6 2.6 2.2 2.3 2.4 2.1United States 3.5 3.3 3.2 3.3 1.9 3.0 3.1Non-OECD 4.5 2.9 5.8 5.7 4.9 5.1 5.0

Developing countries 6.2 3.3 6.7 7.3 6.7 6.2 6.1East Asia and Pacific 5.6 8.0 9.0 9.5 8.7 8.0 7.9

China 4.9 9.9 10.2 10.7 9.6 8.7 8.5Indonesia 6.0 5.3 5.7 5.5 6.3 6.5 6.4Thailand 7.5 6.1 4.5 5.3 4.5 4.5 5.0

Europe and Central Asia — — 6.0 6.8 6.0 5.7 5.8Russia — — 6.4 6.7 6.3 5.6 5.8Turkey 3.6 4.4 7.4 6.0 4.5 5.5 5.4Poland 5.8 1.7 3.5 6.1 6.5 5.7 5.0

Latin America and the Caribbean 5.5 2.2 4.7 5.6 4.8 4.3 3.9Brazil 7.3 2.1 2.9 3.7 4.2 4.1 3.9Mexico 6.7 2.6 2.8 4.8 3.5 3.7 3.6Argentina 3.4 1.5 9.2 8.5 7.5 5.6 3.8

Middle East and North Africa 6.0 3.9 4.3 5.0 4.5 4.6 4.8Egypt, Arab Rep. of 6.0 4.9 4.6 6.9 5.3 5.4 6.0Iran, Islamic Rep. of 6.5 2.9 4.4 5.8 5.0 4.7 4.5Algeria 4.8 2.2 5.3 1.4 2.5 3.5 4.0

South Asia 3.7 5.4 8.7 8.6 7.9 7.5 7.2India 3.5 5.6 9.2 9.2 8.4 7.8 7.5Pakistan 5.9 5.1 7.8 6.6 6.4 6.3 6.1Bangladesh 2.4 4.3 6.0 6.2 6.0 6.1 6.4

Sub-Saharan Africa 4.3 2.1 5.8 5.6 5.8 5.8 5.4South Africa 4.7 1.7 5.1 5.0 4.4 5.2 4.9Nigeria 4.6 1.9 6.9 5.6 6.4 6.6 5.9Kenya 6.2 3.0 5.8 5.9 5.1 5.2 4.9

Memorandum itemsDeveloping countries

excluding transition countries 5.2 4.1 6.9 7.4 6.7 6.3 6.1excluding China and India 6.5 2.2 5.2 5.9 5.3 5.0 4.9

Source: World Bank.Note: PPP � purchasing power parity; e � estimate; f � forecast; — � not available.a. Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.b. In local currency, aggregated using 2000 GDP weights.c. Simple average of Dubai, Brent, and West Texas Intermediate.d. Unit value index of manufactured exports from major economies, expressed in U.S. dollars.e. GDP in 2000 constant dollars; 2000 prices and market exchange rates.f. GDP measured at 2000 PPP weights.


developing economies, which grew 7.3 percent—more than twice the rate in high-income countries(3.1 percent).

Robust growth in China (10.7 percent) andIndia (9.2 percent) played a significant role in therecent strength of developing countries. Neverthe-less, the pickup was broadly based. Even exclud-ing these two countries, developing countriesgrew 5.9 percent (5.2 percent for small oilexporters), and all regions grew by more than5 percent.

The outlook for high-income countriesIn the United States, GDP expanded 3.3 percentin 2006. Output grew very rapidly at the begin-ning of the year, before higher short-term interestrates, brought on by tighter monetary policy,prompted a sharp correction in the housing mar-ket. The ensuing sectoral recession caused eco-nomic activity in the housing sector to begin con-tracting in the second quarter. Residentialinvestment fell 17 percent during the six quartersending March 2007, contributing to significantlyslower GDP growth. Preliminary estimates indi-cate that the U.S. economy expanded only 1.3 per-cent in the first quarter of 2007, as weakness in thehousing sector weighed upon investment expendi-tures elsewhere in the economy and falling residen-tial investment slowed orders and industrialproduction in related sectors (figure 1.1).

These developments were concentrated in thegoods sector (including structures, computers, andvehicles), whose contribution to growth fell to zeroin both the final quarter of 2006 and the first quar-ter of 2007 and was reflected in very weak importdemand. Consumer demand and production ofservices have remained robust, partly because thejobs picture remains good and inflation is falling.Export volumes rose 6.6 percent in the six monthsending in the first quarter of 2007, rising sharplyin the fourth quarter of 2006 before falling in thefirst quarter of 2007 (seasonally-adjusted annual-ized rates). In contrast, imports rose just 0.6 per-cent over this period. Coupled with lower fuelprices, these developments helped reduce the U.S.current account deficit to 5.8 percent of GDP inthe fourth quarter of 2006, down from an averageof 6.7 percent in the preceding three quarters.

In Europe GDP grew 2.8 percent in 2006, dri-ven by strong export growth and a resurgence indomestic demand toward the end of the year.2

After slowing during the third quarter, GDP accel-erated in the fourth quarter, to a 3.1 percent annu-alized pace, as falling unemployment and strongprofitability boosted consumer demand and in-vestment activity. A pickup in private consumptionin Germany before a 3 percent hike in the valueadded tax (VAT) in January 2007 provided an ad-ditional fillip to growth, while robust exports tothe countries of the former Soviet bloc helped pro-pel economic activity throughout the year.

Data for the first quarter of 2007 indicate thatGerman industrial production was up strongly inthe first two months of the year but that retailsales declined 4.5 percent on an annualized basisin response to the increased VAT rate. Neverthe-less, consumer confidence improved. Private con-sumption in France was robust during the firstquarter. In contrast to the United States, industrialproduction in Europe picked up in the finalmonths of 2006 and into 2007. Business sentimentand orders point to continued strong growth in themonths to come. Overall, GDP decelerated some-what, although excluding Germany it picked up inthe first quarter of 2007.

In Japan GDP increased 2.2 percent in 2006,boosted by investment spending and a modest re-covery in consumer demand. As in Europe, growthstarted the year very strong, weakened toward thethird quarter, and strengthened in the fourth quar-ter. Reflecting falling unemployment and rising

10

Quarterly growth rate

Monthly growth rate

�15

�10

�5

Jan.

1995

Jan.

1996

Jan.

1997

Jan.

1998

Jan.

1999

Jan.

2000

Jan.

2001

Jan.

2002

Jan.

2003

Jan.

2004

Jan.

2005

Jan.

2007

Jan.

2006

0

5

10

15

20

Percent

Sources: World Bank; Datastream.Note: Quarterly and monthly percentages are seasonally-adjustedannualized rates.

Figure 1.1 U.S. industrial production growth


wages, consumer demand rose 4.2 percent in thefourth quarter, with private investment also in-creasing rapidly (these data may be revised). Ex-port growth, which had led the expansion earlierin the year, eased in the fourth quarter, reflecting astagnant high-tech market and weaker importdemand from the United States and the MiddleEast. Data for the first few months of 2007 sug-gest that exports have picked up, while indicatorsfor consumer demand and imports suggest thatdomestic demand has stagnated.

Order books and business sector confidenceare strong in both Europe and Japan, suggestingthat industrial activity should remain robust forthe remainder of the year. In the United States,however, these leading indicators suggest furtherweakening in investment and industrial activity.Short-term forecasting models based on these datasuggest that output in the United States will growat a less than 2 percent annual pace during the sec-ond quarter of 2007. Annualized growth ratescould average 2.5 percent in the European Unionand 2 percent in Japan during the first half of theyear.3

Solid growth in Europe and Japan is expectedto compensate for slower U.S. growth

In the United States, the sharp decline in hous-ing-sector activity, which has already reduced in-vestment in other sectors, is projected to continueto slow economic activity in the second quarter of2007. However, as activity in the housing sectorgradually stabilizes in the second half of the year,growth should pick up, even though knock-on ef-fects in the construction and manufacturing sectorsmay continue to be felt. Going into 2008, lowerstocks, the elimination of the drag on growth fromthe housing sector, and relatively accommodativeinterest rates are expected to prompt a recoveryin investment, and growth should accelerate to3 percent in 2008 and 3.1 percent in 2009.

Lower oil prices, slower growth, and higherinterest rates in many countries are expected tocontain inflationary pressures, obviating the needfor further increases in policy interest rates. How-ever, the recent tendency for long-term interestrates to rise in the United States is expected tocontinue, as expectations for a depreciation of thedollar firm. This should help promote domesticsavings, which, along with the weaker conditionof the economy in 2007, should be reflected in

slower import growth and a further decline in thetrade and current account deficits, with the cur-rent account deficit reaching about 5.3 percent ofGDP in 2009.

Prospects for Europe appear increasinglyrobust. Improved consumer confidence, lower un-employment, high capacity utilization rates, andstill-strong order books should translate into soliddomestic demand growth, while continued integra-tion of new member states into the EuropeanUnion should fuel exports. While inflationary pres-sures are present, lower commodity prices and agradual tightening of monetary conditions by theEuropean Central Bank should contain them with-out endangering the expansion. As a result, GDPamong European countries is projected to moder-ate only modestly, to about 2.6 percent (2.5 percentfor the Euro Area) in 2007, before easing towardmore sustainable growth rates of about 2.2 percent(2 percent for the Euro Area) by 2009.

In Japan vigorous growth in developing EastAsia, strong business confidence indicators, andreduced drag from corporate consolidation areexpected to help maintain growth at 2.3 percent in2007. Very low interest rates are projected to sus-tain investment and industrial production as themain drivers of the economy, while tighteninglabor market conditions should boost consumerdemand, permitting the economy to accelerate toa 2.4 percent annual pace in 2008.

Still-modest consumer demand is expected tobolster Japan’s current account surplus in 2007.As private spending increases in 2008 and 2009,however, the current account surplus is projectedto ease toward 3.1 percent of GDP by 2009. Therecent return to positive inflation is expected topersist, allowing short-term interest rates to gradu-ally rise to about 2 percent by the end of 2008.

The outlook for developing countriesBuoyant external demand (as a result of strongerEuropean and continued robust Japanese growth),low real interest rates, and low bond market inter-est-rate spreads helped the developing worldexpand by 7.3 percent in 2006, the fourth consec-utive year in which growth exceeded 5 percent.

Growth was particularly strong in China,which grew 10.7 percent, and India, where outputrose 9.2 percent. But the strong performancewas broadly based, with all developing regionsgrowing more than 5 percent (figure 1.2). Despite

11


the substantial increases in the price of oil duringthe first half of 2006, growth among the remain-ing oil-importing developing countries actuallystrengthened, reaching 5.3 percent for the year asa whole.

While industrial production and growth in de-veloping countries eased during the third quarterof 2006, activity recovered somewhat in the finalquarter and into the early months of 2007 in EastAsia and Pacific, South Asia, and Europe and Cen-tral Asia (figure 1.3). For the moment, the knock-on effects of the slowdown in U.S. imports havebeen concentrated in Latin America (the slow-down in the Middle East and North Africa regionmainly reflects reduced oil production resultingfrom OPEC quotas and capacity constraints).

Slower import demand from high-incomecountries, a weakening of commodity revenues,capacity constraints, and an expected increase ininterest rates in response to rising inflation in somecountries are expected to ease the pace of growthof developing countries through 2009. As a group,however, low- and middle-income countries shouldcontinue to outperform high-income economies bya wide margin. Their strong performance will con-tinue to be a critical driver of global growth.

Administrative restrictions on investment andreduced import demand from the United States areexpected to bring Chinese growth down to a moresustainable 8.5 percent by 2009. Higher interestrates and some further fiscal tightening are expectedto slow the expansion in India to about 7.5 percent.

Prospects for the remaining oil importers arevaried. Many economies, particularly in Eastern

and Central Europe, have overheated (or areoverheating) and have entered a phase of policytightening. Economic activity in these countries isprojected to slow. Notwithstanding weaker importdemand from the United States, growth in otherdeveloping countries, including Brazil and Mexico,is projected to accelerate or stabilize at high rates,as they continue to benefit from a favorable

12

Source: World Bank.

2

4

5

7

8

9

10

6

3

Figure 1.2 Regional growth

Percent

East Asiaand Pacific

Europe andCentral Asia

Latin America andthe Caribbean

Middle East andNorth Africa

South Asia Sub-SaharanAfrica

Oil exporters Oil importers(excluding China)

2005 2006 20082007 2009

�10

�5

0

Jan.

2005

Mar

. 200

5

May

200

5

Jul. 2

005

Sep. 2

005

Nov. 2

005

Jan.

2006

Mar

. 200

6

May

200

6

Jul. 2

006

Sep. 2

006

Mar

. 200

7

Jan.

2007

Nov. 2

006

5

10

15

25

35

30

20

Percent

Sources: World Bank; Datastream.

Note: Percentages are 3-month/3-month seasonally-adjustedannualized rates.

Figure 1.3 Developing-country industrialproduction growth

East Asia and Pacific

Europe and Central Asia

World

South Asia

Sub-SaharanAfricaLatin America and the Caribbean

Middle East and North Africa


external climate, including low long-term real in-terest rates and interest-rate spreads. Overall,growth in developing oil importers, excludingChina and India, is projected to slow only gradu-ally, falling from 5.3 percent in 2006 to 4.9 per-cent in 2009.

For oil exporters (and other large commodityexporters), strong revenue inflows should continueto fuel domestic demand, despite lower prices.These inflows are projected to result in rapidgrowth of both imports and the noncommoditysectors of these economies.

Meanwhile, capacity constraints (particularlyfor oil exporters) are projected to limit volume in-creases in the export sector. As a result, while2007–09 are expected to be solid years for com-modity exporters, the combination of weaker ex-port growth, lower commodity prices, and strongimport demand should result in declining currentaccount surpluses and a gradual slowing ofgrowth toward more sustainable long-termrates (4.9 percent for developing-country oilexporters).

Regional outlooks

In the East Asia and Pacific region, growth,led by China, was once again very strong. Whileefforts to contain investment and credit growth insome sectors moderated the pace of the expansiontoward midyear, it has since picked up. Growth inother countries in the region strengthened, in partbecause of a relaxation of monetary policy in sev-eral countries following the successful dampeningof emerging inflationary pressures.

Countries in the region have continued tobenefit from strong inflows of foreign direct in-vestment (FDI), with the bulk of FDI going toChina. Nevertheless, FDI inflows were down forthe year, having been partially replaced by largerequity and portfolio inflows, with the regionattracting more than half of all portfolio flows todeveloping countries. Net capital inflows to East

The regional appendix describes economicdevelopments in low- and middle-incomecountries in more detail, providing regionalforecast summaries and country-specific fore-casts (see also http://www.worldbank.org/globaloutlook).

Asia totaled $167 billion in 2006, almost un-changed from 2005.

Partly as a reaction to these strong inflowsover the past four to five years, policy makers inthe region have adopted increasingly flexible ex-change rate regimes. The Chinese authorities haveallowed the renminbi to appreciate steadily againstthe U.S. dollar and appear to have increased theunderlying rate of appreciation of the currencyfrom 3 percent to 6 percent during the course of2006.

Regional growth is projected to slow through2009, reflecting a tighter policy environment inChina and weaker U.S. import demand, especiallyin 2007. While currencies are expected to appreci-ate modestly over the forecast period, recent largecurrent account surpluses are expected to declineonly marginally.

Economic activity in Europe and Central Asiacontinues to reflect very strong capital inflowsinto countries that have acceded or expect toaccede to the European Union and the directand indirect effects of very strong spending by re-gional oil exporters. This very buoyant environ-ment exacerbated internal and external imbal-ances in a number of countries, with inflationexceeding 5 percent and current account deficitsreaching more than 5 percent of GDP in manycountries.

Net capital inflows to the region surged in2006, reaching a record $241 billion, dominatedby private flows (both FDI and equity), as coun-tries continued to prepay Soviet-era debts. Corpo-rations headquartered in the region contracted$135 billion in foreign debt in 2006, with mostof the funds going into the finance and oil andgas sectors. Significant bank borrowing in severalcountries has financed a surge in credit growth,accompanied by mounting inflationary pressuresand concerns about exchange rate risk. While re-serve ratios in most countries have stabilized, inRussia they increased by $120 billion.

Lower oil prices, a diminishing stimulus togrowth from EU accession, and a tightening ofmacroeconomic policy should result in slower butstill-robust growth in 2009 of about 6.8 percentfor regional oil exporters and 5.2 percent for oilimporters.

The expansion in the Latin America and theCaribbean region entered its fourth year in 2006,with most economies growing at 4 percent or

13


more. A relaxation of monetary policy in Braziland Mexico saw output in the region’s two largesteconomies pick up, even as growth in Argentinaand República Bolivariana de Venezuela eased to-ward more sustainable rates.

Net capital inflows to the region increasedslightly in 2006, although they fell from 2.8 per-cent to 2.5 percent of GDP. The decline reflectedan absolute decrease in private inflows and an off-setting reduction in the extent to which countriesin the region paid off official debt. Net FDI in-flows also declined as a percentage of GDP. Largedebt buybacks have reduced the average cost ofcapital of many countries and significantly im-proved their debt-servicing profiles. Despite im-proved external debt statistics, uncertainty overthe ownership of locally issued bonds makes theextent to which dependence on foreign capital hasdeclined unclear.

Weak import demand in the United States isexpected to moderate regional export growth in2007, but high prices for metals and mineralsshould sustain the expansion at close to potentialrates through 2009. However, a number of coun-tries in the region have recently introduced policymeasures that could undermine longer-termgrowth prospects.

The developing economies of the Middle Eastand North Africa also enjoyed strong growth,despite the conflict in Lebanon, which saw GDP inthat country decline by 5.5 percent. While OPECcut oil output during the course of the year, slow-ing GDP growth among oil exporters, a 20 percenthike in oil prices fueled domestic demand and im-ports. This boosted exports of goods and servicesamong the diversified countries of the region,which, along with a rebound in agricultural pro-duction following a severe drought in 2005,propelled their GDP growth to 5.6 percent—a 10-year record. Several years of very rapid growthand the removal of some price subsidies have con-tributed to an uptick in inflation in several coun-tries and a decline in the current account andgovernment balances of oil exporters (which nev-ertheless remain in surplus).

Booming oil revenues have fueled strong fi-nancial flows within the region. FDI flows, whichreached 3 percent of regional GDP in 2006, havebeen associated with a revival in privatizationactivity and cross-border mergers and acquisitions,

particularly in the banking sector. Equity prices inIraq and the Islamic Republic of Iran remain de-pressed following global turbulence in May andJune 2006, but they have recovered in other mar-kets in the region. Official development assistanceto the region has surged, but more than 40 percentof the total went to Iraq.

Increased output by non–OPEC oil producersis expected to keep OPEC quotas tight (see below),which should restrain GDP growth among oil ex-porters through 2009. However, even if prices andproduction decline, oil revenues will remain high,fueling domestic demand and contributing to anexpected decline in the current account and gov-ernment surpluses of oil exporters. Spillovers fromthis strong demand, in the form of investment andremittance inflows, coupled with robust Europeandemand for goods and tourist services should helpsustain strong growth among the region’s diversi-fied economies.

South Asia also recorded vigorous GDPgrowth in 2006, propelled by strong exports andburgeoning domestic demand, caused in part bylow real interest rates and strong capital and re-mittance inflows. Central banks in the regionreacted to strong growth and rising inflation by in-creasing nominal interest rates. However, realrates remain negative or close to zero in severalcountries.

Net capital inflows to the region reached$40.1 billion (3.6 percent of GDP) in 2006, withmost of the funds going to India. Net private debtflows were responsible for more than 100 percentof the $11.8 billion dollar increase, as prepaymentof public sector debt reduced the overall total. FDIwas up (particularly in the Indian service sector, inresponse to new legislation), as were FDI outflowsfrom India, which reflected an increase in cross-border merger and acquisition purchases by Indiancompanies, mainly in advanced economies. Port-folio inflows fell by more than the increase in netFDI, causing net equity flows to decline, althoughthey still represent almost 60 percent of net privateinflows to the region. Despite a sharp increase inthe dollar value of reserves, import cover declinedas a result of exchange rate movements and robustincreases in import volumes.

While falling oil prices should contribute toa stabilization of the region’s current accountbalance and a reduction in government deficits,

14


they are expected to offer only limited inflationrelief, because much of the initial hike in oil priceshas yet to be passed through to consumers. WeakerU.S. import demand, the removal of temporary re-strictions on Chinese exports of selected clothingand textiles, and rising interest rates are projectedto reduce GDP growth in the region from 8.6 per-cent in 2006 to about 7.2 percent in 2009.

Sub-Saharan Africa also benefited from strongglobal growth. High oil prices have fueled an in-vestment boom among regional oil exporters, sup-porting a 6.9 percent increase in their GDP.Increased aid flows over the past several years,strong commodity prices, a period of relativepeace, improved macroeconomic policies, and thecumulative effects of several years of microeco-nomic policy reform have combined to yield threeyears of growth of 5 percent or more among oilimporters. This robust performance has beenbroadly based, with more than half the countriesin the region growing by 5 percent or more andonly six growing by less than 2 percent.

Net capital inflows to Sub-Saharan Africareached $39.8 billion, or 5.6 percent of GDP, in2006. Reflecting high commodity prices and im-proved fundamentals, net private capital inflowsexceeded bilateral aid grants for the first time since1999. Aid, at $13.2 billion (excluding debt relief)in 2005, remains important, representing morethan 5 percent of GDP for 80 percent of countriesin the region and exceeding 10 percent in several.

The increase in private flows reflects increasedFDI (principally into extractive sectors), portfolioinvestment, and bank lending (particularlyfrom other developing-country banks). Despiteimproved fundamentals, only two countries (theSeychelles and South Africa) have accessed the in-ternational bond market in the past two decades,although several are expected to issue bonds in2007 and there has been growing investor interestin local currency bond markets.

Several countries in the region show signs ofoverheating. While the higher investment rates ofthe past few years are expected to boost supply,infrastructural weaknesses and capacity con-straints in the energy sector are endemic. As a re-sult, while growth is expected to remain robustand per capita incomes should continue to rise,growth is projected to ease to about 5.4 percentby 2009.

Inflation, interest rates, and globalimbalances

The uninterrupted growth of the past severalyears has been reflected in growing capacity

constraints, rising prices in commodity markets(see below), and significant internal and externalimbalances in a number of countries. At the sametime, a main contributor to the longevity of thecurrent expansion has been the muted response ofinflation to high oil prices—particularly in high-income countries—which has allowed monetarypolicy to remain relatively relaxed and interestrates low.

However, headline inflation is above the com-fort levels of central banks in high-income coun-tries, and notwithstanding some easing as a resultof the recent decline in oil prices, core inflationremains high in the United States and is rising inEurope (figure 1.4). As a consequence, monetaryauthorities remain vigilant, and additional hikes ofpolicy rates are expected in both Europe and Japan.

Inflation in low- and middle-income countrieshas also been generally muted, although recenttrends raise some concerns. While inflation indeveloping countries picked up in response tothe initial hike in oil prices in 2003, it began de-clining soon afterward, in response to monetarypolicy tightening and limited pass-through. Morerecently, there are signs that price pressures are

15

0.0

0.5

Jan.

2002

Jul. 2

002

Jan.

2003

Jul. 2

003

Jan.

2004

Jul. 2

004

Jan.

2005

Jul. 2

005

Jan.

2006

Jul. 2

006

Jan.

2007

1.0

1.5

2.5

4.5

5.0

3.5

3.0

4.0

2.0

% change, year-over-year


Figure 1.4 Inflation in high-income countries

U.S. all goodsand services

U.S. coreinflation

EU all goodsand services

EU core inflation


building in several regions and in a number ofcountries that have been growing very rapidly(figure 1.5). These increases likely reflect the directimpact of higher oil prices during the first half of2006, but they may not yet show the full impact ofthe decline in the second half. Indeed, though year-over-year inflation is up compared with last year,rates are declining in several countries that haveexperienced an uptick. Higher inflation does ap-pear to reflect overheating in several middle-income countries, including Argentina, India,South Africa, and República Bolivariana deVenezuela, as well as several smaller countries inEurope and Central Asia, the Middle East andNorth Africa, and South Asia.

At the regional level, inflation has increased ineach of the past three years in the Middle East andNorth Africa and in each of the past six years inSouth Asia. Developments in Sub-Saharan Africaare also worrisome, though the large weight of foodprices in the consumer price basket in that regionmakes it difficult to determine whether recent in-creases represent a trend. In Europe and CentralAsia, some countries have combated rising inflationwith tighter monetary policies, while in others pol-icy has either been neutralized by capital inflows ortoo timid in response to increased price pressures.

The trend toward higher inflation over the past fewyears is of concern, because it may result in a signif-icant increase in inflation expectations, whichcan—given the blunt instruments available to mon-etary authorities—be difficult to lower without asharp deceleration in economic growth.

Financial conditions for developing countriesremain favorableThe pickup in inflation over the past several years,coupled with very rapid growth, has contributedto rising short-term interest rates and the gradualremoval of monetary policy stimulus in manycountries, most notably in high-income countries,where short-term real interest rates have increasedsome 200 basis points since mid-2005.4 Manydeveloping countries have also acted to restraincredit and contain inflation. Policy rates have risensharply and appear to be slowing inflation inBulgaria, Indonesia, Thailand, and Turkey. Inother countries (Argentina, India, Pakistan, SouthAfrica, and República Bolivariana de Venezuela),the tightening cycle is less advanced. As a result,real interest rates remain low and inflation high.

Despite increases in inflation, real short-terminterest rates in most regions are low by historicalstandards and have been relatively stable or even

16

% change in consumer price index, year-over-year

Source: World Bank.

Burkina Faso

Chile

Malaysia

Morocco

Lithuania

Estonia

Barbados

South Africa

India

Kazakhstan

Botswana

Pakistan

Turkey

Uganda

Argentina

Ukraine

Mauritius

Egypt, Arab Rep. of

Paraguay

Kenya

Figure 1.5 Inflation in selected countries

10�1 3 5 7 9 11 13 15 17

2004 inflation

End-2006 inflation


falling (notably in South Asia) in recent months(figure 1.6). Long-term interest rates are also low.Yields on U.S. government bonds remain about4.5 percent, and spreads on emerging-market debtare near record lows (figure 1.7).

The extended period of low interest rates andlow spreads on emerging-market and subprime

corporate bonds has led many observers to worrythat global liquidity levels are too high—or inter-est rates too low. Several factors help explain whyinterest rates are lower than in the past (see WorldBank 2005, pp. 11–13). One is the relative stabil-ity of inflation, especially in the face of higher oilprices, caused partly by more credible monetarypolicy and partly by the entrance of China and theformer Soviet Union into the world trading sys-tem. The extended period of very accommodativemonetary policy in high-income countries and therecycling of oil revenues have also had a dampen-ing effect on interest rates. While there is no uni-versally accepted measure of liquidity, measuresproduced by the OECD (2006) based on globalmoney supply or bank lending suggest that liquid-ity may be as much as 15 percent higher than nor-mal given the current level of economic activity.

Many observers worry that, should the expec-tations of investors change rapidly or their evalua-tions of underlying risk change, interest ratescould increase rapidly and capital inflows, whichhave been strong, could reverse (see chapter 2).Indeed, the sensitivity of financial markets tochanges in perceptions was illustrated in May andJune 2006, when markets became uncertain of thefuture conduct of U.S. monetary policy, and morerecently in February and March 2007, followingthe recognition of problems in the U.S. subprimemortgage market and concerns of currency under-valuation in some Asian markets.

While developing-country bond markets wereshaken and volatility in both bond and equitymarkets increased (particularly among the mostvulnerable countries and those with large currentaccount deficits, such as Turkey), emerging mar-kets suffered relatively minor ill effects from theseepisodes. Indeed, the 21–basis point increase inemerging-market spreads in February and March2007 compares favorably with the 39–basis pointincrease in the yield on high-income country sub-prime corporate debt (emerging-market spreadsremain 100 basis points higher than those ofsubprime corporates) (figure 1.8). Moreover, whileemerging-market spreads have fallen below theirprevious levels, subprime spreads remain elevated.

If the increase in spreads reflected investors’revaluation of risk, the smaller upward adjustmentfor emerging-market debt (and its subsequentdecline) supports the view that improved funda-mentals explain at least part of the decline in

17

Figure 1.6 Real policy interest rates, by region

�2

0

2

4

6

8

10

12

14

16

Percent

Jan.

2002

Jul. 2

002

Jan.

2003

Jul. 2

003

Jan.

2004

Jul. 2

004

Jan.

2005

Jul. 2

005

Jan.

2006

Jul. 2

006

Jan.

2007

South Asia


East Asia and Pacific

Sources: World Bank; Datastream.Note: Percentages are GDP-weighted averages, deflated by CPIinflation.

Sub-Saharan Africa

High-income countries

Latin America andthe Caribbean

0

200

400

600

800

1,000

1,200

1,400

1,600

Basis points

Jan.

1998

Feb. 1

999

Mar

. 200

0

Apr. 2

001

May

200

2

Jun.

2003

Jul. 2

004

Aug. 2

005

Sep. 2

006

Turkey

Global

South Africa

Figure 1.7 Spreads on emerging-market bondscompared with 10-year U.S. Treasuries

Sources: Datastream; JPMorgan Chase; World Bank.


emerging-market spreads over the past severalyears. Despite the increase in volatility in emergingstock markets, valuations remain very high, up100–400 percent since 2003 (figure 1.9). Emerg-ing-market spreads are at very low levels, and fi-nancial conditions for developing countries remainvery favorable, factors reflected in the strong capi-tal inflows (see chapter 2) that have been fuelingthese countries’ growth.

Global imbalances begin to narrowThe imbalances in global spending patterns thathave characterized the world economy over thepast five years showed signs of stabilizing in 2006.Following several years of steady increases, theU.S. current account deficit declined in the fourthquarter of 2006, coming in at 5.8 percent of GDP,down considerably from the 7 percent levelrecorded in the same quarter of 2005, when oilprices were lower.5 Preliminary data for the firstthree months of 2007 suggest that the current ac-count deficit has fallen even farther, to about5.7 percent of GDP. Indeed, the nonoil tradedeficit, which had been broadly stable, at about4.4 percent of GDP since 2004, has been decliningsince early 2006 and stood at 4 percent of GDP inthe first quarter of 2007 (figure 1.10).

While the cyclical slowdown in U.S. growthwas a factor in the improvement in the nonoil bal-ance, structural adjustments are also at work. Thepattern in the nonoil balance mirrors the stabiliza-tion of the savings rate in the United States thatbegan in 2004 and its subsequent rise beginning in2006.6 Overall, the savings rate has increased by1 percent of GDP. This is likely a permanent in-crease in savings, reflecting a return to more nor-mal levels following the artificial decline in savingscaused by higher consumer spending fromincreased wealth during the housing boom. Theincrease in savings also reflected the decline in thegovernment deficit, from 3.7 percent of GDPin 2005 to 2.4 percent of GDP in 2006.

18

Figure 1.8 Spreads on emerging-marketdebt and subprime corporate bonds in 2007

250

Jan.

02, 2

007

Jan.

14, 2

007

Jan.

26, 2

007

Feb.

07, 2

007

Feb.

19, 2

007

Mar

. 03,

200

7

Mar

. 15,

200

7

Mar

. 27,

200

7

Apr. 0

8, 2

007

Apr. 2

0, 2

007

270

290

310

330

350

160

170

180

190

200

U.S. high-yieldspreads (left scale)

EM bond spreads(right scale)

Merrill Lynch bond index (basis points) EMBI Global (basis points)

Sources: World Bank; JPMorgan Chase.

50

100

150

200

250

300

350

400

Index, Jan. 2004 � 100

Figure 1.9 Emerging-market stock marketvaluations

Sources: Datastream; Standard & Poors; World Bank.

South Africa


Middle East andNorth Africa

Thailand

Latin America and theCaribbean

India

May

200

4

Oct.

200

4

Feb

. 200

5

Jul. 2

005

Nov. 2

005

Apr. 2

006

Sep. 2

006

Jan.

2007

Apr. 2

007

Figure 1.10 U.S. trade balance is improving

�7

�6

�5

�4

�3

Sources: U.S. Department of Commerce; World Bank.Note: e � estimate.

Balance on goods, oil and nonoil (% of GDP)

Q1 20

01

Q2 20

01

Q3 20

01

Q4 20

01

Q1 20

02

Q2 20

02

Q3 20

02

Q4 20

02

Q1 20

03

Q2 20

03

Q3 20

03

Q4 20

03

Q1 20

04

Q2 20

04

Q3 20

04

Q4 20

04

Q1 20

05

Q2 20

05

Q3 20

05

Q4 20

05

Q1 20

06

Q1 20

07e

Q220

06

Non oil balance

Nonoil balance

Oil balance


Residential investment spending declinedsharply, from a peak of 6.3 percent of nominal GDPin the fourth quarter of 2005 to 5 percent of GDPin the first quarter of 2007. Assuming a return tothe long-term average of 4.6 percent of GDP, in-vestment is likely to fall farther, resulting in a con-comitant reduction in the current account balance.

The decline in oil prices during the second halfof 2006 also helped reduce the U.S. current ac-count deficit. This decline was probably also struc-tural in nature, because the lower oil prices reflecta natural response to earlier price hikes thatslowed demand growth and induced additionalsupply (see the discussion of the commodity mar-ket below). Over the medium term, energy pricesare expected to fall farther, which should provideadditional relief to global imbalances by reducingboth the U.S. trade deficit and the surpluses of oil-exporting countries.7

While higher savings in the United States re-mains a critical component of any long-term solu-tion to global imbalances, demand elsewhere willhave to pick up the slack. In this regard, the recov-ery of demand in Europe and Japan, their returntoward potential output, and strong growth in thedeveloping world should help sustain world outputand reduce global imbalances (figure 1.11). Thisshift in growth is expected to continue into theforecast period, although it will be more moderatein 2008 and 2009, as growth in the U.S. recovers.

The rapid increase in import demand by oil ex-porters should also help reduce global imbalances.In dollar terms, the export revenues of oil exporters

are up $1.8 trillion since 2003, and their importsare up $1.5 trillion. As oil prices decline and domes-tic demand catches up with the increase in revenues,these trade surpluses are projected to decline.

Exchange rate movements are playing a lim-ited role in the overall adjustment process. Since2003 the U.S. dollar has depreciated by 10 percentin real effective terms, and the euro has appreci-ated by 9 percent (figure 1.12). Along with in-creased savings, these shifts have likely played arole in the relative strength of exports and weak-ness of imports in the United States over the pastyear. By increasing the competitiveness of U.S.exports, such shifts, which are projected to con-tinue, should facilitate a reduction of global imbal-ances as long as domestic savings continue toadjust (Obstfeld and Rogoff 2004).

Exchange rates in China, Japan, and oil-exporting nations have not appreciated in real-effective terms, and, as a result, their movementshave not served to support a smooth adjustment inthe same way. Notwithstanding an acceleration inthe steady rate at which the renminbi appreciatedagainst the dollar to a 6 percent annual rate, theChinese currency has remained broadly stable inreal effective terms since 2003,8 while the curren-cies of many oil exporters that maintain a fixedexchange rate with respect to the dollar have actu-ally depreciated in real effective terms.

Partly as a result, China’s current accountsurplus continues to grow, reaching $230 billionin 2006 (9.3 percent of GDP). A reinforcement ofmeasures being introduced to stimulate domestic

19

Source: World Bank.

UnitedStates

Europe Japan Developingoil

exporters

Developingoil

importers

Figure 1.11 Growth in domestic demand, byregion

Percent

0

1

2

3

4

5

6

7

8

92004 2005

2006 2007

App

reci

atio

nD

epre

ciat

ion

Source: World Bank. Note: All figures in graph are real effective exchange rates.

85

95

100

105

110

90

Jan.

200

3

May

200

3

Sep. 2

003

Jan.

200

4

May

200

4

Sep. 2

004

Jan.

200

5

May

200

5

Sep. 2

005

May

200

6

Sep. 2

006

Jan.

200

6

Jan.

200

7

Index Jan. 2003 � 100

Figure 1.12 Movements in exchange rates

Euro Area

United States

SaudiArabia

Japan

China


demand, supported by a more flexible exchangerate regime, may be necessary before China’s sur-plus begins to decline. In addition to contributing toa reduction in global imbalances, such steps wouldalso distribute some of the economic fruits of itsvery strong growth more broadly within China.

Low interest rates in Japan (and to a lesser ex-tent in Europe) and the carry trade that they haveinduced partially explain the relative strength ofthe dollar. As of early May 2007, the interest-ratedifferential in favor of the dollar was some 400basis points at the short end of the market and 300basis points at the longer end (figure 1.13). WithU.S. monetary policy near or at the end of its tight-ening cycle, these differences are expected to nar-row. In the baseline forecast, this narrowing andslower growth in the United States are projected tocause the dollar to depreciate by about 5 percent ayear against the euro through 2009, which shouldfurther facilitate the unwinding of global imbal-ances. Should downward pressures be more se-vere, however, the depreciation could be larger orthe rise in U.S. interest rates greater.

Taken together, these factors suggest that acontinued narrowing of global imbalances is to beexpected. Nevertheless, imbalances remain large,and there are several countervailing pressures.

First, the size of the imbalance—in both Chinaand the United States—is very large. The value ofU.S. imports is 50 percent larger than the valueof U.S. exports, implying that even if exports andimports were to grow at the same rate, the tradedeficit would continue to widen. Therefore, forprogress to be made, exports will have to increaseat a substantially faster rate than imports.

Second, with each year of additional currentaccount deficit, the stock of U.S. financial liabili-ties increases, as do the interest payments due onthem. Thus, the longer imbalances remain at cur-rent levels, the more difficult it will be to over-come them, even if the trade balance improves.Here, two factors work in favor of reducing globalimbalances. The first is the large gap between therates the United States pays on its external debtand the returns it earns on investments abroad.The second is the fact that currency depreciationtends to increase the value of U.S. assets abroadrelative to foreign-owned U.S. assets. Over themedium term, both factors are expected to con-tinue to hold sway, improving global imbalancesmodestly (figure 1.14).

20

�3�2�1

0123

45

�3

�2

�1

0

1

2

U.S.-Japan interestrate differential

U.S.-Japan interestrate differential

U.S.-Euro interestrate differential

U.S.-Euro interestrate differential

3

4

5

Apr. 2

002

Figure 1.13 Difference between U.S. andJapanese/European interest rates

a. 3-month interbank rates

b. 10-year government yields

Percentage points

Percentage points

Apr. 2

007

Oct. 2

002

Apr. 2

003

Oct. 2

003

Apr. 2

004

Oct. 2

004

Apr. 2

005

Oct.20

05

Apr. 2

006

Oct. 2

006


Apr. 2

002

Apr. 2

007

Oct. 2

002

Apr. 2

003

Oct. 2

003

Apr. 2

004

Oct. 2

004

Apr. 2

005

Oct.20

05

Apr. 2

006

Oct. 2

006

Source: World Bank.

Figure 1.14 Current account balances

$ billions

2002 2006 2009

�1,000

�800

�600

�400

�200

0

200

400

Oil exportersOil importers

Low-in

com

e

High-in

com

e

Other

dev

elopin

g

Europ

e an

d Cen

tral A

siaChin

a

East A

sia a

nd P

acific

(exc

luding

Chin

a)

Other

high

-inco

me

Japa

n

Europ

e

United

Sta

tes


However, as discussed in past editionsof Global Development Finance and GlobalEconomic Prospects, the possibility of a disruptiveadjustment to these still-large global imbalances isreal. Were global investors to revise their expecta-tions about the future value of the U.S. currency,they could demand a significantly higher return ondollar-denominated assets. Such an increase wouldserve to slow U.S. growth, with serious knock-oneffects on commodity prices and growth in devel-oping economies (see the analysis surroundingtable 1.6 in World Bank 2005).

Partly reflecting the stabilization of global im-balances, the rapid accumulation of reserves bydeveloping countries during the first few years ofthis decade has changed character. Although devel-oping-country reserves increased by some $630 bil-lion in 2006 (see chapter 2), the vast majority ofcountries increased reserves only in line with risingimports, keeping the number of months of importsthat their reserves could finance broadly stable(figure 1.15). Oil-importing countries saw theirimport cover ratios remain stable or decline andthe import cover ratios of most countries remainwell above the normally accepted benchmark ofthree months. Reserves among oil exporters havenot risen as might have been expected becausemost of them have put the bulk of their surplus

revenues into investment trusts, which do notcount as reserves.

In contrast, China and Russia accumulated atotal of $366 billion in additional reserves in2006, 40 percent more than the total for all otherdeveloping countries, including other oil ex-porters. The level of reserves they currently hold—14 months of imports in China and almost 17months of imports in Russia—exceeds normalprudential levels by a wide margin.

World trade

Much like industrial production, the growthin the volume of global merchandise trade

slowed in the third quarter of 2006, before pickingup toward the end of the year to reach year-over-year growth of 11 percent. Most of the decelera-tion occurred in China, Japan, and Europe. U.S.exports were relatively strong, increasing 10.5 per-cent for the year as a whole, while U.S. importsrose just 5.8 percent.

Weaker consumption and investment growthin the United States, combined with rising incomesamong oil exporters and other developing countriesboosted U.S. export volumes, which expanded atdouble-digit rates in the last two quarters of 2006.9

Similar strength was observed in Europe.

21

0

2

4

6

8

10

12

14

16

18

Figure 1.15 Foreign exchange reserves

Number of months of imports that can be financed by reserves

Oil exp

orte

rs

(exc

luding

Rus

sian

Fede

ratio

n)

Russia

n Fe

dera

tion

East A

sia a

nd P

acific

(exc

luding

China) Chin

a

Latin

Amer

ica a

nd

the

Caribb

ean

Midd

le Eas

t and

North

Afri

ca

Europ

e an

d

Centra

l Asia

South

Asia

Sub-S

ahra

n Afri

ca

(exc

luding

Sou

th A

frica

)

South

Afri

ca

Source: World Bank.

2000 2001 20042002 2003 20062005

3 months of importcover—normally

considered a prudent level


Much of the demand for these exports origi-nated in developing countries. Over the pastthree years, the average contribution of demandfrom oil exporters and low-income oil importersto U.S. export growth was 8.7 percentage points(5.2 percentage points for low-income countriesalone). This is more than double the incrementto demand from high-income countries (4 per-centage points) and compares favorably with the1990s, when these countries’ contribution to U.S.exports rarely exceeded 5 percent (figure 1.16).

Oil exporters and low-income oil importersare boosting exports in Europe by even more, re-flecting the expansion of trade between Europeand countries of the former Soviet bloc.

Notwithstanding the rapid rise in commod-ity prices over the past several years, manufac-turing remains the main source of export revenuefor developing countries, even when China isexcluded from the data (figure 1.17). If oil ex-porters are excluded, the result is even stronger,with the overall weight of nonoil commodities

falling from 24 percent to 12 percent of develop-ing-country (excluding China) exports between1990 and 2005.

22

Low-income oil exporters Low-income oil importers High-income oil exporters High-income oil importers

Total

�10

�5

0

5

10

15

20

1980

1982

1983

1981

1984

1985

1986

1987

1988

1989

1990

199

119

9219

9319

9419

9519

9619

9719

9819

9920

0020

0120

0220

0320

0420

0520

06

1980

1982

1983

1981

1984

1985

1986

1987

1988

1989

1990

199

119

9219

9319

9419

9519

9619

9719

9819

9920

0020

0120

0220

0320

0420

0520

06

25

a. Destination of high-income European country exports

Percent

Percent

b. Destination of U.S. exports

�15�10

�505

101520

2530

Sources: World Bank; IMF.Note: Figures show contribution to dollar value of export growth, by aggregate.

Figure 1.16 Sources of export growth for high-income countries

Total

Figure 1.17 Sources of export revenues fordeveloping countries

Sources: World Bank; Comtrade.

Note: Figure shows share of commodities in total merchandise exportvalues of developing countries (excluding China).

0

10

20

30

40

50

60

Percent

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Other commodities

Metals and minerals

Petroleum products


On the trade policy front, the Doha Roundnegotiations resumed at the beginning of 2007,following a six-month suspension, partly becauseof concerns that the United States’ fast-track au-thority would expire and not be renewed. Progresstoward sketching an outline of an accord remainslimited, however, and a serious risk exists that ne-gotiations will last several years, underminingconfidence in the multilateral system. The prolifer-ation of bilateral and regional trade agreements ofthe kind currently being signed is not a substitutefor a multilateral accord, especially because manyof the smaller and poorer developing countriesare among the least likely to take effective partin them.

For developing countries with a strong spe-cialization in the textiles and clothing sector, theremoval of partial restrictions on Chinese exportsof these goods to the European Union and theUnited States in 2008 is expected to dampenexport volumes and prices in 2008 and 2009.However, many of these countries have succeededsurprisingly well in the face of the earlier liberal-ization of the sector in 2006. To the extent thatthey continue to achieve the kind of efficiency im-provement that has underpinned this strong per-formance, they can be expected to survive this ad-ditional pressure relatively well—and indeed, maybe well placed to exploit further scale efficiencies.

Commodity markets

Strong global growth, especially the rapid ex-pansion of output in developing countries, is

largely responsible for the rise in commodityprices over the past several years. Weaker indus-trial production and output growth toward theend of 2006 and into 2007 contributed to a level-ing off and decline in some metals prices, as wellas the more widely followed decline in oil prices.Agricultural commodity prices remain robust, inpart because high oil prices have pushed up fertil-izer and other production costs and increased in-terest in biofuels has boosted demand for manyagricultural products.

While increases in oil prices received the bulkof media attention, the price of metals and miner-als rose much more rapidly in 2006 (figure 1.18).Continued strong growth in global output, lowstocks, numerous supply disruptions, and specula-tive demand pushed the prices of metals and

minerals up 47 percent. Agricultural prices alsoposted gains in dollar terms, rising 13 percent in2006, but they were broadly stable (up 1.3 per-cent) expressed in euros.

Metals and minerals prices level offThe prices of copper and zinc, two of the metalswhose prices rose most markedly in recent years,fell sharply in late 2006 and early 2007, as demandweakened and stocks increased (figure 1.19). Both

23

Figure 1.18 Commodity prices

Index, Jan. 2003 � 100

Source: World Bank.

50

Jan.

2000

Nov. 2

000

Sep. 2

001

May

200

3

Jul. 2

002

Mar

. 200

4

Jan.

2005

Nov. 2

005

Sep. 2

006

100

150

200

250

300

350

Agriculture

Metals and minerals

Energy

Figure 1.19 Prices of selected metals

0

100

200

Jan.

2003

Jul. 2

003

Jan.

2004

Jul. 2

004

Jan.

2005

Jul. 2

005

Jan.

2006

Jul. 2

006

Jan.

2007

300

400

500

600

Zinc

AluminumCopper

Index, Jan. 2003 � 100

Source: World Bank.


substitution away from these products, as a resultof the sharp rise in their prices during 2006, andcyclical factors, notably the decline in demand forcopper from the U.S. housing sector and reduceddemand for steel from the auto sector, playeda role.

Destocking in China, which accounts for22 percent of world demand for copper, and theresulting decline in import demand also causedprices to fall. A boost in Chinese exports explainsmuch of the 26 percent drop in the price of zinc inthe early months of 2007. After strong demandand weak supply pushed the global price of zincup 137 percent in 2006 (26 percent in the fourthquarter), China (the world’s largest miner) steppedinto the market, increasing apparent supply andnearly eliminating the price gains of the previousthree quarters. The rising role of China may alsobe seen in the behavior of aluminum prices, which,unlike those of zinc and copper, rose by much less,despite rapid growth in demand, principallybecause China has been steadily expanding itsexports.

The prices of many other metals continued torise, as a result of low stocks, strong demand, ris-ing costs, and supply shortfalls. Nickel prices, inparticular, have soared, reflecting very strong de-mand for stainless steel, supply disruptions, anddelays in the start-up of new projects. Stocks ofother products, such as aluminum and copper,have increased, suggesting an easing of their pricesgoing forward.

Coupled with slower global growth, notablyin the U.S. housing and auto sectors, metals pricesare projected to peak during 2007 (copper in2006). They are likely to decline in 2008 and2009, as additional supply comes on stream andcapacity constraints ease, with the global supplyof copper rising 7 percent, to about 1 million tons,and the supply of zinc rising 9 percent, to about0.8 million tons (7 and 9 percent), with a 10 per-cent increase expected in African output. In con-trast, nickel prices are not projected to ease, be-cause no significant new supply is expected in theimmediate term.

Some uncertainty remains as to the speed atwhich metals prices will decline, both becauseglobal growth is projected to remain relativelyrapid and because supply problems that have chal-lenged the industry over the past few years maypersist.

Agricultural prices continue to riseAgricultural prices rose 12 percent in 2006, reflect-ing a weaker dollar, higher energy and fertilizerprices, crop-specific supply shortfalls, droughts,low carryover stocks, and strong increases in de-mand, especially for biofuels. While real agricul-tural prices have increased substantially since theircyclical lows in 2001, the increase has done little toreverse the longer-term downward trend that hasseen real agricultural prices fall 56 percent over thelast 46 years (figure 1.20).10

High energy prices contributed directly to asurge in the price of some agricultural commoditiesthat are either used as energy crops (biofuels) orcompete with synthetic products made from petro-leum. The price of sugar, which is being diverted toethanol production for automotive fuel in Brazil,rose 50 percent, while that of natural rubber (a sub-stitute for synthetics produced from petroleumproducts) was up 40 percent. The price of maize,which is used as the feedstock for ethanol produc-tion in the United States, rose 23 percent in 2006.

High energy prices also increased the price offertilizer, raising farmers’ cost of production andreducing yields as farmers use less of it. The offset-ting increase in world prices likely benefitsdeveloping-country producers disproportionately,because they use less fertilizer and machinery perhectare. As a result, their overall production costsare likely to have increased by less than those ofproducers in high-income countries. However,

24

Figure 1.20 Agricultural prices

0

50

100

150

200

250

300

350

400

450

500

Sources: World Bank; Datastream.Note: Figure shows real prices deflated by U.S. CPI.

Index, Jan. 2000 � 100

Jan.

1960

Jan.

1965

Jan.

1970

Jan.

1975

Jan.

1980

Jan.

1985

Jan.

1990

Jan.

1995

Jan.

2000

Jan.

2005


higher food prices work to the detriment of thepoorest households, for whom basic foodstuffs ac-count for a significant share of total spending (seesection on risk).

Lower petroleum (and fertilizer) prices shouldhelp increase agricultural yields and contribute tothe weakening of agricultural prices over the nextseveral years. Dollar prices of agricultural goodsare expected to rise by about 5 percent in 2007and to decline 1.5 percent in 2008. Commoditiessuch as natural rubber and sugar, which saw thelargest price increases during 2006, are expectedto suffer the largest declines, with the price ofnatural rubber falling 5 percent and the price ofsugar tumbling 20 percent. If it were not for con-tinued increases in the demand for the agriculturalraw materials used in the production of biofuels,the expected decline in agricultural prices wouldlikely be more pronounced.

Although lower fuel prices should reduce theeconomic viability of these alternatives, govern-ment subsidies and other policy measures are ex-pected to keep expanding, sustaining pressure onsuch inputs as maize and sugar cane. Twenty per-cent of the U.S. maize crop is already being used toproduce ethanol, and the figure is expected to riseto 30 percent over the projection period. Fifty per-cent of Brazilian sugar cane is being diverted toethanol production, and demand for soybean andrapeseed oils, which are used to produce biodieselfuel, is rising.

As more land is shifted into production of bio-fuel inputs, price pressures on other agriculturalcommodities will build. Partly as a result of thisprocess, stocks of many grains are extremely low,which could result in a sharp increase in theirprices should demand rise more than expected orweather or other supply disruptions cause a poorcrop year (see section on risk). Increased use ofmaize for ethanol production in the United Stateshas already led to higher maize prices, which havebeen reflected in higher meat prices in the UnitedStates and higher tortilla prices in Mexico.

Among other agricultural commodities, coffeeprices are expected to increase in 2007 (withrobusta prices rising 11 percent), as demand in-creases in developing countries and Vietnamcontinues to have difficulties increasing supply. Incontrast, tea prices should decline, as output inKenya rises following last year’s drought. Timberprices are expected to increase 15 percent in 2007and an additional 5 percent in 2008, as a result ofstrong demand (especially from China and India)and limits on timber exports from developingcountries, motivated by environmental concernsand efforts to control illegal logging.

Oil market After shooting up in the first half of 2006, the priceof oil declined in the second half of the year, fallingto less than $51 a barrel during January 2007(figure 1.21). Oil prices have since rebounded,

25

15

25

35

45

55

65

75

Jan.

200

0

May

200

0

Sep. 2

000

May

200

1

Jan.

200

1

Sep. 2

001

Jan.

200

2

May

200

2

Sep. 2

002

Jan.

200

3

May

200

3

Sep. 2

003

Jan.

200

4

May

200

4

Sep. 2

004

Jan.

200

5

May

200

5

Sep. 2

005

Jan.

200

6

May

200

6

Sep. 2

006

Jan.

200

7


Unit price per barrel, World Bank average

Figure 1.21 Oil prices

U.S. dollars

Euros


reaching about $65 a barrel in early May 2007—almost $5 less than a year before.

The decline in the price of oil in the secondhalf of 2006 and early 2007 was consistent withan end of the trend rise in oil prices. However, lowlevels of spare capacity continue to make pricessensitive to small changes in the external environ-ment (figure 1.22). Indeed, the decline in pricesin January 2007 was associated with a relativelywarm early winter. Prices reversed when colderweather arrived in February. While weather clearlyaffects demand, the swings observed appear to beout of step with changes in stocks and demandlevels. The rise in prices toward the end of Marchmainly reflected concerns that supply would bedisrupted because of the buildup of politicaltensions in the Persian Gulf. As these tensionsdissipate, the price of oil is expected to begin togradually decline.

Looking forward, the recent period of veryweak growth in demand for oil shows signs ofending, suggesting that the moderating influencethat higher oil prices have had on additional de-mand may be weakening. Energy demand haspicked up somewhat, rising from 0.8 additionalbarrels a day in the four quarters ending the firstquarter of 2006 to 1.1 additional barrels a day inthe fourth quarter (figure 1.23). Nevertheless, thepace of increased demand at the end of 2006remains well below the increase that would be

expected given the growth of output during thisperiod and well below the peak of 2.4 million bar-rels a day in 2004, suggesting that high pricescontinue to induce significant substitution andconservation efforts.

At the same time, supply is accelerating. Afteran extended period during which supply showedonly limited responsiveness to higher prices, out-put among non–OPEC producers accelerated inthe second half of 2006. The main change was sig-nificant increases in Canada and the United States(in particular from oil sands in Canada and deep-water Gulf fields in the United States) followingtwo years of steady declines, as well as smallerdeclines in North Sea production and increasedproduction in Australia. These changes augmentedcontinued gains elsewhere, notably in the formerSoviet Union, West Africa, and Brazil (figure 1.24).OPEC responded by agreeing in November 2006to cut production by 1.2 million barrels a dayand agreeing to an additional 0.5 million barrelsa day cut in early 2007 (about 1 million barrels aday had been cut by early March 2007), reinforc-ing the sense that the supply constraints that un-derpinned the earlier rise in oil prices have easedsubstantially.

Over the medium-term, supply fromnon–OPEC countries (including new OPECmember Angola, which is not subject to produc-tion restraints this year) is projected to rise by

26

�3

�2

�1

0

1

2

3

4

5

Millions of barrels per day, year-over-year

Source: International Energy Agency.

Q1 20

02

Q2 20

02

Q3 20

02

Q4 20

02

Q1 20

03

Q2 20

03

Q3 20

03

Q4 20

03

Q1 20

04

Q2 20

04

Q3 20

04

Q4 20

04

Q1 20

05

Q2 20

05

Q3 20

05

Q4 20

05

Q1 20

06

Q2 20

06

Q3 20

06

Q4 20

06

Q1 20

07

Figure 1.23 Demand for oil

Total

OECD China Other Asia Other

Hurricane Katrina

0

1

2

3

4

5

6

7

Jan.

2002

Jul. 2

002

Jan.

2003

Jul. 2

003

Jan.

2004

Jul. 2

004

Jan.

2005

Jul. 2

005

Jan.

2006

Jul. 2

006

Jan.

2007

Sources: World Bank; International Energy Agency.

Millions of barrels per day

Figure 1.22 Spare oil-production capacitywithin OPEC

Total

Excluding Iraq


1.4–1.6 million barrels a day during 2007 and2008. This contrasts with an annual average ofonly 0.5 million barrels day per between 1985 and2006, when output gains were held back by aging

fields and low investment rates caused by weakprices.

The anticipated pickup in supply reflects up-stream investment projects that are already wellunder way (figure 1.25). Among OECD countries,new fields are expected to yield only modest netgains in production, as a result of the depletionof old fields in the North Sea, the United States,and Mexico. Production in Canada is expected tocontinue its climb, with additional output concen-trated in oil sands.

The largest increase in production is likely tocome from the former Soviet Union, with Azerbai-jan and Russia each expected to increase annualoutput by 0.2 million barrels a day. The increaseby Azerbaijan reflects the opening of the Baku-Tiblisi-Ceyhan pipeline to the Mediterranean.Production in Kazakhstan is unlikely to rise sub-stantially before 2009, given transport capacityconstraints.

Increased production in Africa is projected toyield the second-largest increment to supply, withthe bulk of the additional output emanating from

27

World

�3

�2

�1

0

1

2

3

4

5

Millions of barrels per day, year-over-year

Source: International Energy Agency.Note: Figure shows change in oil deliveries.

Q1 20

02

Q2 20

02

Q3 20

02

Q4 20

02

Q1 20

03

Q2 20

03

Q3 20

03

Q4 20

03

Q1 20

04

Q2 20

04

Q3 20

04

Q4 20

04

Q1 20

05

Q2 20

05

Q3 20

05

Q4 20

05

Q1 20

06

Q2 20

06

Q3 20

06

Q4 20

06

Q1 20

07

Figure 1.24 Change in sources of oil supply

Former Soviet Union OPEC Other

Millions of barrels per day

Sources: World Bank; International Energy Agency.

�0.3

�0.2

�0.1

0

0.1

0.2

0.3

0.4

0.5

0.62007 2008 2009

Figure 1.25 Expected growth in non-OPEC oil production

NorthAmerica

OECD

High-incomeEurope

PacificFormerSovietUnion

Easternand Central

Europe

ChinaOtherAsia

LatinAmerica

MiddleEast

AfricaProcessinggains

Biofuels


Angola. Significant increases in output are also ex-pected from relatively new producers Mauritaniaand Sudan, each of which will produce an esti-mated 0.2 million barrels a day.

Most of the anticipated increase in LatinAmerica reflects the coming on stream of Brazil’sdeepwater fields, which will produce an additional0.7 million barrels a day by 2008 and 1 millionbarrels a day by 2009. Output from other produc-ers (notably Argentina, Colombia, Ecuador,Mexico, and República Bolivariana de Venezuela)is expected to stagnate or decline, because of pro-duction inefficiencies and underinvestment. Thesupply of biofuels is projected to double, fromabout 0.8 million barrels a day in 2006 to 1.5 mil-lion barrels a day in 2009, with the cumulativeincrease in supply equivalent to about 18 percentof the expected gains from traditional non–OPECsources during the same period.

Over the near term, high oil prices shouldcontinue to moderate demand for petroleum prod-ucts and sustain incentives to invest in new capac-ity. Projects already underway are expected toincrease gross oil production by about 15 millionbarrels a day by 2010 (9.2 million barrels a daynet), with annual expected increases in demandof 1.5–2 million barrels a day. Spare capacity canthus be expected to increase by 1–3 million barrelsa day by 2010. Over the medium term, the recentbuildup in additional spare capacity, additionalnon–OPEC supply, and slower growth shouldkeep supply-side constraints at a minimum. As aresult, the price of oil is projected to decline mod-estly over the next two years, reaching an averagelevel of $55 a barrel in 2009.11

Supply conditions in the oil market, althoughrelaxing, remain tight. A 2 million barrel a daysupply disruption—an event whose likelihood inthe next 10 years is estimated at 70 percent (Beccueand Huntington 2005)—could send oil prices ashigh as $100 a barrel, reducing global growth by asmuch as 1 percent (1.7 percent for developingcountries) (see the discussion surrounding table 1.5in World Bank 2005 for more details).

A period of uncertainty

Anumber of factors suggest that the soft-landing scenario outlined above is the most

likely outcome. Tighter monetary policy in high-income and a number of developing countries isslowing growth, which is easing commodity pricesand inflationary tensions in high-income coun-tries. Meanwhile, interest rates and emerging-market spreads remain low. These favorable exter-nal conditions for developing countries shouldallow them to grow at a slower but still-robustpace of 6.1 percent in 2009.

However, the global economy is at a turningpoint, following several years of very stronggrowth. Such periods imply higher risk. As anextreme example, the period immediately preced-ing the Asian financial crisis in 1997 wascharacterized by strong growth, robust capitalflows, and generalized optimism.

In the current context, the extended periodof very rapid growth (particularly in developingcountries) has generated a number of tensions. Ithas contributed to a surge in commodity prices,

28

Table 1.2 Simulated impact of an increase of 200 basis points in emerging-market spreads

2007 2008 2009 2010 2011

Interest rates (percentage point change in fourth-quarter level from baseline)World 0.3 0.3 �0.1 �0.1 0High-income 0 �0.3 �0.4 �0.4 �0.2Low- and middle-income 1.6 2.7 1.3 1.3 0.8

Real GDP (% change from baseline)World �0.2 �0.9 �0.4 0 0.7High-income �0.1 �0.6 �0.2 0 0.8Low- and middle-income �0.6 �1.7 �0.9 �0.3 0.6

Inflation (change in inflation rate)World 0 0.3 �0.6 �0.6 �0.6High-income 0 �0.2 �0.7 �0.7 �0.6Low- and middle-income �0.1 �0.6 �0.3 �0.3 �0.4

Source: World Bank.


higher consumer price inflation, and increasedprices in a number of asset markets (notablyemerging-market equities and real estate marketsin high-income countries). It has also been accom-panied by unprecedentedly large imbalances in thebalance of payments.

The projected slowdown in growth that hasalready begun in some of the world’s largesteconomies is helping dampen these tensions in arelatively smooth manner. Oil and metals pricesare declining, inflation is down in high-incomecountries, equity and home prices are no longerrising at unsustainable rates, and external imbal-ances are beginning to stabilize. Nevertheless, ten-sions persist and remain significant.

The rest of this chapter explores the implica-tions for developing economies of three alternativescenarios in which these tensions resolve them-selves in a more turbulent manner than projectedin the baseline scenario.

Overheating in some developing countriescould reverse favorable financial marketconditionsThe very rapid growth of developing economieshas generated significant internal and external im-balances (rising inflation and rising current ac-count imbalances) in a number of countries. Whilea generalized tightening of macroeconomic policyis projected to slow growth in many economies,policy remains relatively relaxed in others, whereimbalances are either growing or receding onlyslowly.

Should these imbalances continue to grow orinternational investors’ tolerance (or expectations)for them change abruptly, significant financialmarket turmoil could ensue. Both the May 2006and February–March 2007 episodes of increasedfinancial volatility offer insights into the possibleconsequences. In each case, valuations in equitymarkets declined abruptly and risk premiums indebt markets jumped, with countries with largedebt burdens and current account deficits sufferingthe largest declines. While in both instances theturmoil proved short-lived and currency adjust-ments were largely limited to unwinding earlier(arguably excessive) appreciations, a futureshock could be more severe, with longer-termconsequences.

Table 1.2 outlines the impact of a scenario inwhich some event (political or economic) under-

mines confidence in a large emerging-marketeconomy, generating a generalized flight of capitaltoward “quality.” The scenario is assumed toboost average spreads by some 200 basis points,with more-heavily indebted countries affectedmost severely. Increased perceptions of risk causelong-term interest rates in high-income countriesto rise by 100 basis points.

The overall impact of this scenario is to reduceglobal output by 0.9 percent compared with the

29

�25

�20

�15

�10

�5

0

5

10

15

20

25

% seasonally-adjusted annualized growth

Percent

Figure 1.26 Housing sector investment

a. Quarterly growth of residential investment inconstant prices

Q119

99

Q120

00

Q120

01

Q120

02

Q120

03

Q120

04

Q120

05

Q120

06

Q1 20

07

3

4

5

6

7

1970 1975 1980 1985 1990 1995 2000 2005

b. Residential investment as share ofnominal GDP

Source: World Bank.


baseline by 2008. Developing countries are moreseverely affected, with output down an estimated1.7 percent. Slower growth eases inflationarypressures in developing countries, which meansthat nominal interest rates decline relativelyquickly, although real rates remain elevated.Weaker global growth lowers commodity prices ascompared with the baseline, which causes the cur-rent account balances of developing countries as awhole to deteriorate by 0.1 percent of GDP.

In general, lower debt-to-GDP ratios, the pre-payment of sovereign debt obligations, and theadoption of more flexible exchange rate regimesshould make most developing countries less sensi-tive to such a scenario than they would have beenin the past. As a result, the contagion and real-sideconsequences are expected to be more moderatethan they were during the Asian crisis. However,impacts on more-heavily indebted countries, suchas Brazil and Turkey, are more marked, with in-creased debt-servicing charges causing the currentaccount to deteriorate by 0.4 percent of GDP inBrazil and 0.9 of GDP in Turkey.

Housing-sector adjustment in the UnitedStates could be more severe A significant uncertainty for the outlook concernsthe depth and durability of the adjustment in theU.S. housing sector. While the adjustment processis already well advanced (housing starts increasedin February 2007, following several months ofdecline), the stock of unsold homes remains large.Current inventories currently represent about sixmonths of sales—much more than the normallevel of two to four months. Moreover, while thepace at which residential investment is declininghas stabilized, both real and nominal investmentlevels remain high suggesting that a prolonged pe-riod of rapidly falling housing-sector investmentand prices cannot be ruled out.

Should residential investment continue to de-cline, bringing it back to levels (as a percent ofGDP) consistent with long-term averages (fig-ure 1.26), spillovers to other parts of the economyare likely to intensify. Indeed, there are already in-creasing signs of spillover from the constructionsector to other parts of the economy, notablydurable goods consumption and investment.

Table 1.3 outlines the expected impact of ascenario in which spillovers from the constructionsector to other parts of the economy intensify.Under this scenario, the United States experiencesa prolonged recession. The recession in residentialinvestment, which in the baseline is expected tobegin easing in the third quarter of 2007, deepensand extends to other investments. As a result, ag-gregate investment declines at a 5 percent annual-ized rate throughout 2007 and 2008, with GDP inthe United States increasing by only 1 percent a

30

Table 1.4 Grain price forecast

2006 2007

Baseline High scenario

Wheat $192 $220 $275 Maize $122 $140 $175 Rice $305 $320 $400

% increaseWheat 14.6 43.2Maize 14.8 43.4Rice 4.9 31.1

Source: World Bank.

Table 1.3 Simulated impact of a prolonged recession in the United States

2007 2008 2009 2010 2011

Interest rates (percentage point change from baseline)World 0 �0.2 �0.1 �0.1 �0.2High-income 0 �0.2 �0.3 �0.3 �0.3Low- and middle-income �0.1 �0.1 0.5 0.5 0.4

Real GDP (% change from baseline)World �0.2 �1.0 �1.5 �1.6 �1.5High-income �0.3 �1.1 �1.7 �1.8 �1.7Low- and middle-income �0.1 �0.6 �1.0 �1.0 �0.9

Inflation (change in inflation rate)World 0 �0.4 �1.1 �1.1 �1.4High-income 0 �0.4 �1.3 �1.3 �1.6Low- and middle-income 0 �0.4 �0.4 �0.4 �0.5

Source: World Bank.


year during this period. Slower import growth inthe United States transmits to the rest of the worldas reduced export demand. It also generates a de-cline in interest rates, which has a positive effecton global output.

For heavily indebted countries, the slowergrowth and larger current account deficits trans-late into increased risk perceptions and higher in-terest rates beginning in 2009, intensifying theslowdown in growth in these countries. Consistentwith the results recently produced by the Interna-tional Monetary Fund (IMF 2006), those coun-tries, such as China and Mexico, that have theclosest trade ties with the United States experiencethe sharpest declines in growth. These declines areabout half as intense as in the United States itself,and in the case of China they are minor comparedwith its baseline growth rate of 8–9 percent. Theimpact on other developing countries is weakerand takes longer to materialize, partly becausethe slowdown in these economies reflects the sec-ondary impacts of import demand in China.

Low grain stocks pose a risk for the poorin developing countriesPartly because of the diversion of a substantialproportion of maize to the production of biofuels,stocks of and supply conditions for a number ofgrains are very low. In the United States, theworld’s largest producer and exporter of maize,ethanol production in 2007 is projected to con-sume 25 percent more maize than in 2006, when

31

Income loss (% of GDP)

Source: World Bank.

�3.0 �2.5 �2.0 �1.5 �1.0 �0.5 0

EritreaTajikistanKiribatiLesothoGambia, TheYemen, Republic ofSenegalHaitiArmeniaCape VerdeMozambiqueSierra LeoneNigeriaSwazilandBhutanHondurasJordanMongoliaPapua New GuineaDjiboutiAlgeriaTogoEgypt, Arab Rep. ofSão Tomé and PrincipeAzerbaijanGhanaMoroccoFijiVanuatuNigerEthiopiaPalauTunisiaMicronesia, Fed. States ofBosnia and HerzegovinaSri LankaSeychellesGuineaMauritaniaNicaraguaCôte d'IvoireMauritiusKenya

Figure 1.27 Simulated impact of a grain-sectorsupply shock on selected developing countries

Table 1.5 Estimated poverty impact of a 40 percent increase in rice and wheat pricesin selected countries

Initial poverty Change in poverty Percent change in the headcount headcount incomes of the poor

Rice Wheat Rice Wheat

Rural populationPakistan 16.4 �0.1 0.6 0.1 �2.4Vietnam 2.4 �0.1 0 0.2 �0.2Nicaragua 61.1 1.9 0 �3.7 0Zambia 80.0 0.1 0.1 �0.4 �1.0

Urban populationPakistan 8.0 0.1 0.9 �0.4 �3.8Vietnam 0.9 0.1 0 �6.3 �0.3Nicaragua 32.1 1.5 0 �3.6 0Zambia 46.9 0.3 0 �0.6 �0.1

Source: World Bank.Note: Poverty defined as $1.08 per day in PPP terms.


32

20 percent of the crop was used for this purpose.Although plantings are expected to rise another15 percent (at the expense of other crops, notablysoybeans), supply remains constrained As result,maize prices are up 75 percent since the summerof 2006.

This reorientation of agricultural output to-ward biofuels, together with a change in stockingpolicy in China, has reduced global grain stocksto 16 percent of annual consumption. Low stocksare a principal factor behind the 15 percent in-crease in wheat and maize prices incorporatedinto the baseline. But supply conditions are sotight that a major supply shock could result in theprice of these grains rising much more rapidly,with wheat and maize prices possibly rising morethan 40 percent (table 1.4). Indeed, stocks are cur-rently only slightly higher than the levels observedbefore the more than doubling of grain pricesin 1972–74 and the roughly 40 percent increase in1994–96.

A hike of 40 percent or more, such as outlinedin table 1.4, would have serious consequences formajor importing countries. Simulations suggestthat the first-round income effects (before substitu-tion effects) would be more than 0.5 percent ofGDP for a wide range of developing countries,with as many as 13 enduring a loss of 1 percent ofGDP or more (figure 1.27). Among these countries,Armenia, Cape Verde, Eritrea, Mozambique,Senegal, and Sierra Leone already have current ac-count deficits that exceed 5 percent of GDP. Forthese countries, the additional import costs may beparticularly disruptive, requiring substantial real-side adjustments.

The impacts would be much more pro-nounced for nonfarm poor families, because of theimportance of grain products in their consump-tion.12 In Kenya, for example, maize accounts for36 percent of households’ caloric intake (58 per-cent for the poorest households) and 28 percent oftotal food expenditures.

Calculations based on estimates of the shareof various grains in the overall expenditures ofpoor households suggest that a 40 percent increasein grain prices could reduce real incomes amonghouseholds living at or below the extreme povertyline of $1 a day by as much as 6.3 percent forsome urban populations (table 1.5). In countriessuch as Nicaragua, a 40 percent increase in grain

prices could be enough to push an additional2 percent of the population into extreme poverty.

Notes1. The Organisation for Economic Co-operation and

Development (OECD 2006) estimates liquidity, as measuredby the sum of global M3 or outstanding loans, to be about15 percent above normal levels.

2. For the purposes of this publication, “Europe” in-cludes only high-income European countries. Developmentsamong middle-income European countries are discussed inthe context of the Europe and Central Asia Region.

3. The European Commission publishes quarterly fore-casts based on such indicators every month (see http://ec.europa.eu/economy_finance/indicators/euroareagdp_en.htm). The OECD does so on a quarterly basis.

4. As of early May 2007, real policy interest rates wereabout 3 percent in the United States, about 2 percent inEurope, and about 2 percent in Japan.

5. Crude oil prices averaged $69 a barrel in the fourthquarter of 2006, up from $56 in the same period of 2005(although the comparison is skewed by the disruptionscaused by Hurricane Katrina). The rise boosted importsof gasoline while slowing imports of crude oil. Net importvolume growth was probably about 2 percent higher thannormal in the fourth quarter of 2005.

6. Low interest rates in the wake of the bursting ofthe Internet bubble and the subsequent housing boom con-tributed to a sharp decline in the national net savings rate inthe United States, from an average of 6.2 percent in 1999 toless than 1 percent in 2004. During most of 2004 and 2005,it remained at about 1 percent. In 2006 it rose again, to anaverage of 2 percent, as a result of higher interest rates andthe ending of the housing-market boom.

7. Assuming oil prices decline as projected, the U.S.current account deficit could fall by another 0.2 percent ofGDP.

8. Relatively low inflation in China and the fact thatthe currencies of its other trading partners appreciated withrespect to the dollar explain this result.

9. Preliminary data suggest that U.S. export growth inthe first quarter of 2007 was much weaker. Unfortunately,direction of trade is not yet available to extend the analysisto cover this period.

10. Agricultural prices are quoted in U.S. dollars andhave therefore been deflated by U.S. inflation.

11. For the past few years, the World Bank has used atechnical assumption for its oil forecasts, because, given lowstocks, a wide range of short-term outcomes was judged tobe consistent with fundamentals. Accordingly, the price ofoil is assumed here to decline gradually toward a long-termreal price of $40 a barrel (2006 dollars) in 2015. This realprice is then converted into a nominal price using long-termprojections for the unit value of manufactures.

12. To the extent that they produce more than theyconsume, farm households benefit from the higher costs offood products.


References

Beccue, Phillip C., and Hillard G. Huntington. 2005. “AnAssessment of Oil Market Disruption Risks.” FinalReport of Energy Modeling Forum & SR 8, EnergyModeling Forum. October.

IMF (International Monetary Fund). 2006. World Eco-nomic Outlook: Financial Systems and EconomicCycles. Washington, DC: IMF.

Obstfeld, Maurice, and Kenneth Rogoff. 2004. “The Unsus-tainable U.S. Current Account Position Revisited.”

NBER Working Paper 10869, National Bureau ofEconomic Research, Cambridge, MA.

OECD (Organisation for Economic Co-operation andDevelopment). 2006. OECD Economic OutlookNo. 80, December, Paris.

World Bank. 2005. Global Economic Prospects 2006:Economic Implications of Remittances and Migration.Washington, DC: World Bank.

———. 2006. Global Development Finance 2006: TheDevelopment Potential of Surging Capital Flows.Washington, DC: World Bank.

33

2Financial Flows to Developing Countries:Recent Trends and Prospects

CAPITAL INFLOWS TO DEVELOPINGcountries continued to expand in 2006,albeit at a more modest pace than in the

previous three years. Total private and officialflows reached a record $571 billion, up 19 percentfrom 2005, following three years of strong gainsaveraging 40 percent. In a year characterized byheightened uncertainty over the course of globaleconomic growth, inflationary pressures, and in-terest rates, episodes of turbulence in financialmarkets were telling reminders of the risks facedby borrowers and lenders. The expansion in capi-tal flows over the year as a whole speaks well forthe resiliency of developing economies and for theability of international financial markets to man-age risks, though the outcomes so far should notbe grounds for complacency.

Private sector flows rebounded from the sharpcontraction of 2001–02, with four consecutiveyears of strong gains supported by a combinationof cyclical and structural factors. Global factors—low interest rates and ample liquidity—teamedwith robust growth to sustain strong foreign inter-est in debt and equity investments in emergingmarkets and other developing countries. Investorconfidence in emerging markets was not shaken bythe turbulence that buffeted financial marketsfrom time to time. Bond spreads widened in thewake of such episodes but quickly recovered, andcredit ratings continued to improve, indicating thatfinancial markets continue to take a favorable viewof the fundamentals underlying most emerging-market economies. The swelling demand foremerging-market assets received an additionalboost from innovative derivative products (notablycredit default swaps), which have greatly expandedthe menu of options available for managing risk,

35

.

and from new sources of lending and equity invest-ment (notably hedge funds and private equityfirms).

For their part, developing countries have con-tinued to take advantage of favorable externalconditions by implementing domestic policies de-signed to reduce their vulnerability to large fluctu-ations in interest rates, exchange rates, and privatecapital flows—fluctuations that have triggered somany of the financial crises of the past fewdecades. Countries have reduced their externaldebt burdens and lengthened the maturity struc-ture of their debt. Several have bought back largeamounts of outstanding debt using abundant for-eign exchange reserves, refinancing existing debtby issuing longer maturities on more favorableterms. The market for sovereign debt has evolvedsignificantly, as governments have turned from theexternal to the domestic market, where debt is typ-ically denominated in local currency. Most devel-oping countries continue to hold abundant foreignexchange reserves; few have acute current accountimbalances. Creditors’ assessment of their credit-worthiness remains very positive, as reflected inthe near-record low spreads on emerging-marketbonds and bank loans. Lenders appear to be in-creasingly willing to take on greater risk in theform of unsecured bank loans and bonds issued byunrated borrowers.

As global growth recedes to more sustainablerates, the probability of a turn in the credit cyclerises. Looking ahead, the key challenge facing de-veloping countries is to manage the transition bytaking preemptive measures aimed at lessening therisk of a sharp, unexpected reversal in capital flows.The repercussions of such a reversal would be feltmost acutely in countries that have experienced


large capital inflows, unsustainably rapid economicand credit growth, mounting inflationary pressures,and growing fiscal and external imbalances. Theseconditions have been made possible in part by cir-cumstances in the industrial world, where long-term interest rates have remained low by historicalstandards and ample liquidity has sent investorsin search of higher yields. Aggressive competitionamong lenders has made them more willing to takeon riskier positions. Many of the factors supportingthe expansion in capital flows over the past fewyears could turn out to have strong cyclical compo-nents, which could create strong headwinds foreven the most resilient countries.

These conditions, familiar from previousepisodes, are cause for concern. But some featuresof the current landscape are new. Development fi-nance has evolved in ways that alter the conven-tional assessment of risks. Sovereign borrowers aremeeting a growing portion of their financing needsby issuing bonds in domestic markets, while cor-porate borrowing in the external debt market hasexpanded considerably. These developments havechanged the nature of the risks in internationaland domestic financial markets, increasing the im-portance of sound monetary, fiscal, and exchangerate policies; a well-regulated domestic financialsystem; and effective standards of corporate gover-nance and accounting. Data on sovereign borrow-ing in domestic markets and corporate borrowingabroad are scarce and spotty, making it muchmore difficult for investors and multilateral insti-tutions to monitor developments and assess therisks posed by the significant new trends in devel-opment finance.

This chapter reviews financial flows to devel-oping countries, analyzing recent developmentsand assessing short-term prospects. The key mes-sages are highlighted below.

• Capital inflows to developing countries havecontinued to keep pace with these countries’robust rates of growth. Developing economieshave showed impressive resilience to turbu-lence in international financial markets; mostare well placed to withstand an abrupt deterio-ration in economic and financial conditions, akey risk in the current phase of the credit cycle.There are exceptions, however. Some countriesappear particularly vulnerable to a suddendeterioration in global economic conditions,

especially when accompanied by wide fluctua-tions in interest rates, exchange rates, and eq-uity prices, or an abrupt fall in commodityprices, in the case of exporting countries.

• Equity continues to account for the bulk ofcapital inflows to developing countries, asequity prices in emerging markets continue tooutperform those in mature markets, despiteepisodes of turbulence. The higher volatilityhas not suppressed investors’ interest inemerging-market assets. Portfolio equity flowsto developing countries have continued theirsurge, reaching a record $94 billion in 2006,up from less than $6 billion in 2001–02. Thestrength of investors’ interest was well demon-strated by initial public offerings (IPOs) bytwo Chinese banks (the Industrial and Com-mercial Bank of China and the Bank of China)totaling $21 billion. Both issues were greatlyoversubscribed, despite being launched in themidst of the turbulence that gripped financialmarkets in May–June 2006.

• The surge in private capital inflows to devel-oping countries over the past few years hascoincided with a dramatic decline in net offi-cial lending. Repayments on loans owed togovernments and multilateral institutions out-stripped lending by a wide margin ($145 bil-lion) in 2005–06, as middle-income countriesmade voluntary prepayments to the ParisClub of creditors and multilateral institutions,especially the International Monetary Fund(IMF). High oil prices have enabled severalmajor oil-exporting countries (led by Algeria,Nigeria, and Russia) to prepay such debt.Favorable economic and financial conditionshave virtually eliminated IMF lending tocountries in need of emergency financing, per-mitting several countries (notably Argentina,Indonesia, and Turkey) to repay their out-standing debt ahead of schedule. As a resultof these repayments, the IMF’s outstandingcredit has fallen to levels not seen since beforethe Latin American debt crisis of the 1980s.

• Despite favorable financing conditions, manydeveloping countries have not accessed pri-vate debt markets over the past few years andremain heavily dependent on development as-sistance to meet their financing needs. Officialdevelopment assistance (ODA) decreased byalmost $3 billion in 2006, following a record

36

F I N A N C I A L F L O W S T O D E V E L O P I N G C O U N T R I E S : R E C E N T T R E N D S A N D P R O S P E C T S

$27 billion increase in 2005. The changelargely reflects an extraordinary amount ofdebt relief provided to Iraq and Nigeria bytheir Paris Club creditors, totaling more than$19 billion in 2005 and $14 billion in 2006.At the UN Conference on Financing for Devel-opment in Monterrey in 2002, donors pledgedthat debt relief would not displace other com-ponents of ODA. Donors subsequently madecommitments to enhance aid substantially overthe balance of the decade, particularly to low-income countries in Sub-Saharan Africa. Littleprogress was made toward meeting thesecommitments in 2006: excluding debt relief,net ODA disbursements were static.

• Uncertain whether donors will meet theircommitments to enhance development assis-tance, some low-income countries may opt tomeet their financing needs by borrowing on

nonconcessional terms. Doing so could erodedebt sustainability over the long term anderase the benefits of recent debt-relief initia-tives. Because such borrowing is not reportedin a comprehensive and timely manner, credi-tors and policy makers have difficulty assess-ing its potential impact on debt sustainability.

Capital market developments in 2006The expansion in capital flows continues . . .

The expansion in net capital flows to develop-ing countries continues to keep pace with

economic growth, with total (private and official)flows increasing slightly, from about 5 percentof GDP in 2005 to 5.1 percent in 2006, up from3 percent in 2001 and equal to the level reachedin 1995 before the Asian crisis (table 2.1 andfigure 2.1).

37

Table 2.1 Net capital flows to developing countries, 1998–2006$ billions

1998 1999 2000 2001 2002 2003 2004 2005 2006e

Current account balance �96.7 �19.1 34.4 12.1 60.5 101.9 113.6 256.4 348.5as % of GDP �1.7 �0.3 0.6 0.2 1.0 1.5 1.4 2.7 3.1

Financial flowsNet private and official flows 228.9 209.6 181.1 191.1 174.2 262.0 385.9 480.7 571.0Net private flows (debt � equity) 193.4 195.6 187.0 164.5 169.2 274.1 412.5 551.4 646.8Net equity flows 175.8 189.6 179.9 176.6 162.9 184.3 257.7 347.5 418.8

Net FDI inflows 170.0 178.0 166.5 171.0 157.1 160.0 217.8 280.8 324.7Net portfolio equity inflows 5.8 11.6 13.4 5.6 5.8 24.3 39.9 66.7 94.1

Net debt flows 53.1 20.0 1.2 14.5 11.3 77.7 128.2 133.2 152.2

Official creditors 35.5 14.0 �5.9 26.6 5.0 �12.1 �26.6 �70.7 �75.8World Bank 8.7 8.8 7.9 7.5 �0.2 �0.8 1.4 2.5 �2.4IMF 14.1 �2.2 �10.7 19.5 14.0 2.4 �14.7 �40.2 �25.1Others 12.7 7.4 �3.1 �0.4 �8.8 �13.7 �13.3 �33.0 �48.3

Private creditors 17.6 6.0 7.1 �12.1 6.3 89.8 154.8 203.9 228.0Net medium- and long-term 82.9 23.3 13.4 11.6 5.8 34.8 86.4 136.2 156.0

debt flowsBonds 38.8 30.1 20.9 10.3 10.4 24.7 39.8 55.1 49.3Banks 49.4 �5.3 �3.8 7.8 2.3 14.5 50.6 86.0 112.2Others �5.3 �1.5 �3.7 �6.5 �6.9 �4.4 �4.0 �4.9 �5.5

Net short-term debt flows �65.3 �17.3 �6.3 �23.7 0.5 55.0 68.4 67.7 72.0

Balancing itema �114.6 �158.1 �170.4 �122.4 �60.2 �69.1 �95.5 �345.4 �286.5

Change in reserves �17.6 �32.4 �45.1 �80.8 �174.4 �294.7 �404.0 �391.7 �633.1(� � increase)

Memo items:Bilateral aid grants 42.5 44.4 43.3 43.7 50.6 63.6 70.5 71.3 70.6of which:

Technical cooperation grants 15.8 16.0 14.7 15.8 18.2 20.1 20.4 19.3 19.9Other 26.7 28.4 28.6 27.9 32.4 43.5 50.1 52 50.7

Net official flows (aid � debt) 78.0 58.4 37.4 70.3 55.6 51.5 43.9 0.6 �5.2

Workers’ remittances 72.7 76.6 83.8 95.3 116.2 143.8 163.7 189.5 199.0Repatriated earnings on FDI 28.7 27.8 34.6 43.8 43.2 53.4 73.8 107.0 125.0

Sources: World Bank Debt Reporting System and staff estimates.Note: e � estimate.a. Combination of errors and omissions and net acquisition of foreign assets (including FDI) by developing countries.


The composition of capital flows continues toshift from official to private sources, as net capitalinflows from private creditors continue to expand,partially offset by net capital outflows to officialcreditors. Private debt and equity inflows reacheda record $647 billion in 2006, up 17 percent from2005, following three years of gains averaging al-most 50 percent. Meanwhile, net official lendingdeclined sharply over the past two years, as princi-pal repayments to official creditors exceeded dis-bursements by $70 billion in 2005 and $75 billionin 2006. Net capital outflows to official creditorstotaled $185 billion between 2003 and 2006,while net capital inflows from private creditorsreached $1.9 trillion.

. . . led by a surge in equity flows . . .Equity continued to account for the bulk of capitalflows, averaging 70 percent of the total during2004–06. Foreign direct and portfolio equity flowsincreased by $235 billion over this period, whilenet private and official debt flows increased by just$75 billion (figure 2.2). The expansion in equityflows kept pace with economic growth, increasingslightly from 3.6 percent of GDP in 2005 to a record3.8 percent, above the previous peak (3.35 percent)attained in 1999.

. . . supported by favorable external anddomestic conditionsThe continued expansion in capital flows has beenbuoyed by a benign economic and financial

environment. Demand from industrial countrieshas remained strong, with GDP growth of 3.1 per-cent in 2006 (up from 2.6 percent in 2005) boost-ing developing countries’ exports. High commodityprices have continued to benefit exporting coun-tries. Although world oil prices eased in the secondhalf of 2006, they remained well above the levels ofprevious years (figure 1.21). Prices for metals andminerals surged to record levels in 2006, whilethose of agricultural products continued to risesteadily (figure 1.20). Although short-term interestrates increased in many countries in response tostrong growth and mounting inflationary pres-sures, long-term rates remained relatively low,holding down borrowing costs for developingcountries while fueling investors’ search for yield inemerging-market assets.

Current account balances for developingcountries as a group continued to improve in2006, reaching a record 3.1 percent of GDP, upfrom 2.7 percent in 2005. These balances rose by$247 billion between 2003 and 2006, with mostof the increase concentrated in China ($162 bil-lion) and Russia ($63 billion). World oil pricescontinued to have a major influence, with currentaccount balances as a share of GDP rising morethan three percentage points in 11 of the 24 oil-exporting countries and declining more than threepercentage points in 33 of 96 oil-importing coun-tries during this period. Two-thirds of oil-importingcountries ran current account deficits of more

38

600

700

500

400

300

200

100

0

�100

6

5

7

4

3

2

1

0

�1

1990

1991

1993

1995

1997

1999

1992

1994

1996

1998

2000

2001

2003

2005

2002

2004

2006

e

Total flows/GDP(right scale)

$ billions Percent

Figure 2.1 Net capital flows to developingcountries, 1990–2006

Private Official

Sources: World Bank Debt Reporting System and staff estimates.Note: e � estimate.

0

100

1990

1992

1994

1996

1998

2000

2002

2004

1991

1993

1995

1997

1999

2001

2003

2005

2006

e

200

300

400

500

4

5

0

1

2

3

$ billions Percent

Figure 2.2 Net debt and equity flows, 1990–2006

Net debt flows Equity flows


Equity flows/GDP(right scale)


than 3 percent of GDP in 2006, while half of oil-exporting countries ran surpluses of more than3 percent of GDP.

The pace of reserve accumulation by develop-ing countries picked up significantly in 2006. For-eign exchange reserves rose by $633 billion, upfrom about $400 billion in 2004 and 2005. TheBRICs (Brazil, Russia, India, and China) accountedfor 70 percent of the increase, with reserves risingby $247 billion in China, $120 billion in Russia,$39 billion in India, and $32 billion in Brazil. In-ternational reserves held by all developing coun-tries increased from less than 10 percent to almost25 percent of their GDP over the past 10 years(figure 2.3).1 China’s share rose from 25 percent inthe late 1990s to 40 percent in 2006, while theshare held by Russia increased from under 2 per-cent to 11 percent.

Markets maintain favorable view onemerging-market assetsFinancial markets’ assessment of emerging-markets’creditworthiness has remained positive for the mostpart, despite turbulence in May–June 2006 and inlate February and early March 2007. Credit ratingsof sovereign debt issued by emerging-marketeconomies continued to improve in 2006, with up-grades exceeding downgrades by an increasingmargin (figure 2.4). Average spreads on emerging-market sovereign bonds remained near recordlows. The EMBI Global declined to 175 basispoints in early May 2006 before widening to about

225 basis points in late June, as investors sold offemerging-market debt and equity (figure 2.5).The turbulence encountered in May–June wassparked by heightened uncertainty about thecourse of interest rates, growth, and inflationarypressures in advanced countries—and the effect acontraction would have on emerging markets. Inresponse, international investors reduced theirholdings of emerging-market assets. Bond spreadswere most affected in the countries deemed to bemost vulnerable, such as Turkey, where spreads

39

02001 2002 20042003 2005 2006

10

20

30

40

50

60

Number of rating changes

Upgrades Downgrades

Figure 2.4 Changes in credit ratings of sovereigndebt issued by emerging-market economies,2001–06

Sources: World Bank staff calculations based on ratings by Fitch,Moody’s, and Standard & Poor’s.

150

Jan.

2006

Feb.

2007

Oct. 2

006

Dec. 2

006

Sept. 2

006

Jul. 2

006

May

200

6

Mar

. 200

6

200

250

300

350

Basis points, EMBI Global

Source: JPMorgan Chase.

Figure 2.5 Emerging-market bond spreads,January 2006–March 2007

Turkey

Composite index

01997 1998 1999 2000 2001 2002 20042003 2005 2006

5

10

15

20

25Brazil India

China

Russia

Other

Source: IMF International Financial Statistics.

Percent

Figure 2.3 Foreign exchange reserves relative toGDP in developing countries, 1998–2006


widened by about 150 basis points, three times theincrease for the composite index.

The sell-off turned out to be short-lived,demonstrating the resiliency of the emerging-market asset class. Spreads recovered quickly. Thecomposite index narrowed to 170 basis points inearly 2007. In late February 2007, spreadsabruptly widened again in the midst of more tur-bulence in financial markets, increasing 25 basispoints before quickly recovering, reaching recordlows below 165 basis points in April 2007. Theseevents must be viewed in perspective. In 2002 onlyone in five countries in the index had bond spreadsbelow 200 basis points; by April 2007 the propor-tion had risen to three in four.

Emerging-market bond spreads have also be-come much less volatile. The daily standard devia-tion of the EMBI Global was less than 15 basispoints in 2006 and 7.5 basis points in the first quar-ter of 2007, down from almost 200 basis pointsover the 2000–05 period. The volatility of month-to-month changes in bond spreads also declinedconsiderably in several countries. In Mexico, for ex-ample, the standard deviation of monthly changesin bond spreads (measured using the EMBI Global)fell from more than 100 basis points in 1994–2004to less than 10 basis points in 2005–06 (figure 2.6).Thus, from a historical perspective, the volatilityobserved over the past few years has been relativelyminor.

Official capital flows continue their sharpdeclineThe continued decline in net official lending in2006 reflects substantial repayments by developing-country borrowers to their Paris Club creditorsand the IMF (figure 2.7 and table 2.2). Such re-payments totaled $65 billion in 2006, up from$50 billion in 2005. Plentiful oil revenues enabledRussia to finish paying off its Soviet-era debtswith a $22 billion prepayment to Paris Club cred-itors in 2006, following a $15 billion prepaymentin 2005. Oil revenues enabled Algeria to prepay$8 billion to the Paris Club and Nigeria to prepay$6 billion to Paris Club creditors and $1.5 billionto London Club creditors, following a $6.4 bil-lion repayment to the Paris Club in 2005.2

Most countries making these large prepaymentsnevertheless managed to accumulate substantial for-eign exchange reserves and to reduce their externaldebt burdens, indicating that the prepayments madeto official creditors were not financed by additionalborrowing from private creditors. In 2006, for ex-ample, Russia accumulated $120 billion in interna-tional reserves, providing 17 months of import coverat the end of 2006, up from 13 months at the end of2005. The country’s external debt declined from30 percent of GDP in December 2005 to 25 percentin December 2006. Exceptions are Turkey, whereexternal debt rose from from 48 to 57 percent ofGDP, and Uruguay, where the reserve import coverdeclined from over 8 months to less than 7 months.

Repayments to the IMF continued to outstriplending by a wide margin, reflecting a marked

40

0

25

50

75

100

150

125

Basis points, standard deviation

1990�2004 2005�06


Figure 2.6 Monthly changes in emerging-marketbond spreads in select countries since 1990

Domini

can

Repub

licBrazil

Bulgar

ia

Mex

ico

Colom

bia

Turk

eyPer

u

Philipp

ines

Poland

Panam

aChil

e

China

Figure 2.7 Net official debt flows to developingcountries, 1998–2006

Sources: World Bank Debt Reporting System and staff estimates.

$ billions

�50

0

10

20

30

�10

�20

�30

�40

World Bank Paris Club and othersIMF

1998 1999 2000 2001 2002 2003 2004 2005 2006


improvement in international financial stability.Lending by the IMF (purchases) declined from anaverage of $32 billion in 2001–03, during themajor financial crises in Argentina, Brazil, andTurkey, to an average of $5 billion in 2004–06.Repayments totaled $28 billion in 2006, largelyas a result of sizable prepayments by Argentina($9.6 billion), and Indonesia ($8 billion), and alarge repayment by Turkey ($4.5 billion), followinga record $44 billion in repayments in 2005. IMFcredit outstanding declined to under $18 billion atend-March 2007, down from a high of just under$100 billion in 2003. With such a low level of creditoutstanding, it is unlikely that repayments will con-tinue to exceed disbursements in the coming years.

Most of the large repayments made to officialcreditors over the past few years involve nonconces-sional loans to middle-income countries. Conces-sional loans and grants to low-income countries—a better measure of development assistance—arereviewed later in this chapter.

Private debt market developments

Net private debt flows increased by $24 billion(12 percent) in 2006, led by a $26 billion

expansion in net bank lending, partly offset by adecline in net bond flows (figure 2.8)

Private bond flows declinedNet private bond flows (bond issuance less princi-pal repayments) declined by $6 billion (10 percent)in 2006, to $49 billion (figure 2.9). The declinefollowed three years of strong expansion in netbond flows. The 2006 figure was still higher thanthe level reached in 1996, just before the Asiancrisis. Private bond flows averaged just 0.5 percent

of GDP in 2004–06, however, well below thepeak of 0.9 percent attained in 1996. The declinein 2006 was driven by an estimated $30 billionin sovereign debt buybacks ($27 billion in LatinAmerica), although some of the buybacks werefinanced by other issues and thus did not affectnet bond flows.3 In Latin America, principal re-payments on sovereign bonds increased by almost$20 billion in 2006, while sovereign bond issuancedeclined by $2 billion. The decline in net flowsto Latin America was balanced by a $20 billionrise in Europe and Central Asia. Other regionsrecorded relatively small changes in net flows(table 2.3).

41

�75

1994

1996

1998

2000

2002

2004

2006

�50

�25

0

25

50

75

100


125

$ billions

Figure 2.8 Net private debt flows to developingcountries, 1994–2006

1995

1997

1999

2001

2003

2005

Bond flows

Short-term debt flows

Bank lending

Table 2.2 Repayments by selected developing countries to official creditors, 2006

External debt/GDP Foreign reserves Reserve import cover Repayment (percent) ($ billions) (months)

in 2006 ($ billions) Official creditor 2005 2006 Dec. 2005 Dec. 2006 Dec. 2005 Dec. 2006

Russian Federation 22.0 Paris Club 30.0 25.4 175.9 295.6 15.4 18.2Argentina 9.6 IMF 60.2 45.6 27.2 30.9 10.6 11.0Mexico 9.0 IDB/World Bank 22.1 19.1 74.1 76.3 3.7 3.5Algeria 8.0 Paris Club 22.3 21.8 56.3 77.9 27.7 28.7Indonesia 8.0 IMF 50.6 37.9 33.0 40.9 6.8 8.4Turkey 7.5 IMF 48.0 56.7 50.6 61.1 4.6 4.9Nigeria 7.5 Paris/London Club 22.5 5.9 28.3 42.4 12.0 16.2Uruguay 2.5 IMF 90.5 64.5 3.1 3.1 8.7 8.7Brazil 2.0 Paris Club 25.6 22.4 53.6 85.6 6.7 11.3



occurred in Latin America and the Caribbean,largely as a result of the record $17.6 billionbridge loan contracted by the Brazilian miningcompany Compania Vale do Rio Doce (CVRD) toacquire the Canadian mining company Inco. Thebridge loan involves substantial repayments overthe next few years, to be financed through theissuance of global bonds, which will change thecomposition of private debt flows in the region(through a shift from bank to bond lending).

Net bank lending to Europe and Central Asiadeclined by $10 billion in 2006. The region stillaccounted for 60 percent of the total, down from90 percent in 2005. Relative to GDP, net banklending increased to a record 1 percent, surpassingthe previous high of 0.9 percent in 1998.

Syndicated bank loan commitments to devel-oping countries totaled $246 billion in 2006, up$47 billion from 2005 (table 2.5).4 The CVRDloan accounted for most of the increase. The num-ber of loan commitments increased from 1,261 in2005 to 1,469 in 2006, while the average loan sizeincreased from $158 million to $167 million.

42

Table 2.3 Private bond flows to developing countries, 1998–2006$ billions

1998 1999 2000 2001 2002 2003 2004 2005 2006e

Bond issuance All developing countries: 71.4 64.8 71.0 55.1 51.2 73.6 102.0 118.8 122.5By region

East Asia and Pacific 3.5 7.4 5.6 6.7 8.0 6.8 16.4 16.5 14.3Europe and Central Asia 20.7 12.5 12.2 7.7 11.7 22.1 35.2 46.0 61.3Latin America and the Caribbean 40.7 41.6 43.9 33.0 21.2 34.7 35.0 43.5 38.2Middle East and North Africa .. 1.6 2.1 5.1 6.2 2.9 6.6 4.7 1.2South Asia 4.6 .. .. .. .. 1.5 7.1 6.2 3.3Sub-Saharan Africa 0.4 1.6 1.5 2.5 4.1 5.6 1.8 1.7 4.3

Principal repaymentsAll developing countries: 32.5 34.7 50.1 44.8 40.8 48.9 62.1 63.7 73.3By region

East Asia and Pacific 2.5 6.6 6.4 6.3 7.9 4.8 6.7 6.6 7.2Europe and Central Asia 6.3 4.7 6.6 6.5 8.0 12.6 11.8 17.6 12.9Latin America and the Caribbean 23.0 21.6 35.5 30.2 21.6 23.7 36.9 26.9 45.3Middle East and North Africa 0.1 0.2 1.0 0.7 1.2 2.2 3.2 2.2 3.5South Asia 0.4 1.2 0.1 0.5 0.8 4.7 3.0 9.1 1.3Sub-Saharan Africa 0.1 0.5 0.5 0.5 1.3 1.1 0.5 1.3 2.9

Net bond flows (bond issuance less principal repayments)

All developing countries: 38.8 30.1 20.9 10.3 10.4 24.8 39.8 55.1 49.3By region

East Asia and Pacific 0.9 0.9 �0.8 0.4 0.1 2.0 9.7 9.9 7.0Europe and Central Asia 14.3 7.8 5.7 1.2 3.6 9.5 23.3 28.4 48.3Latin America and the Caribbean 17.7 20.0 8.4 2.9 �0.4 11.0 �1.9 16.6 �7.1Middle East and North Africa 1.3 1.4 1.2 4.4 5.0 0.7 3.3 2.6 �2.3South Asia 4.2 �1.2 5.5 �0.5 �0.7 �3.1 4.1 �2.9 2.0Sub-Saharan Africa 0.3 1.1 1.0 1.9 2.7 4.5 1.2 0.4 1.4

Sources: World Bank Debt Reporting System and staff estimates.Note: .. � negligible. e � estimate.

Net flows

Figure 2.9 Private bond flows to developingcountries, 1994–2006


$ billions

0

75

125

50

25

Issuance Principal repayments

100

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Bank lending continues to expand . . .Net commercial bank lending rose by $26 billionin 2006, reaching a record $112 billion (table 2.4).The greatest increase (more than $12 billion)


Large middle-income countries continue todominate cross-border loan commitments. Lendingbecame more concentrated over the past two years,with just 10 countries accounting for almost three-quarters of all borrowing in 2006, up from 60 per-cent in 2002–04 (figure 2.10).

Significant shifts also occurred in the alloca-tion of loan commitments across sectors. Com-mitments to the oil and gas sector declined, fromalmost $60 billion in 2005 to $30 billion in 2006,while commitments to the mining sector increased,from $5 billion to $25 billion (reflecting the

43

Table 2.4 Cross-border bank lending to developing countries, by region, 1998–2006$ billions

1998 1999 2000 2001 2002 2003 2004 2005 2006e

Gross bank lendingTotal 130.4 120.3 116.9 147.6 150.0 176.5 237.1 290.8 313.1By region


Principal repaymentsTotal 81.0 125.6 120.7 139.8 147.7 162.0 186.5 204.8 200.9By region


Net bank lending (gross lending less principal repayments)

Total 49.4 �5.3 �3.8 7.8 2.3 14.5 50.6 86.0 112.2By region

East Asia and Pacific �4.8 �11.9 �11.3 �11.7 �10.2 �8.4 0.2 �0.6 3.4Europe and Central Asia 13.8 11.9 9.3 7.3 17.0 21.8 48.7 76.7 66.9Latin America and the Caribbean 39.1 �1.4 0.4 15.1 �2.7 �1.1 0.9 0.1 12.4Middle East and North Africa 2.0 �1.7 0.5 �0.1 �0.2 �1.0 �0.8 3.4 4.4South Asia 0.7 �0.6 �2.0 �1.1 1.0 4.4 1.1 4.2 9.9Sub-Saharan Africa �1.3 �1.7 �0.7 �1.6 �2.6 �1.4 0.4 2.2 6.4


Table 2.5 Cross-border loan commitments todeveloping countries, by region, 2006

Share Average loan Amount of total Number amount

($ billions) (percent) of loans ($ millions)

Total 245.8 100.0 1,469 167By region

East Asia and Pacific 37.3 15.2 207 180Europe and Central Asia 93.6 38.1 410 228Latin America and

the Caribbean 59.2 24.1 577 103Middle East and

North Africa 10.3 4.2 67 153South Asia 26.6 10.8 121 219Sub-Saharan Africa 18.8 7.6 87 216

Source: World Bank staff calculations based on data from DealogicLoanware.

Figure 2.10 Concentration of cross-border loancommitments, 1998–2006

Source: World Bank staff estimates based on Dealogic Loanware.

$ billions

0

150

200

50

100

250Other borrowers

Top 5 borrowers

Top 6–10 borrowers

1998 1999 2000 2001 2002 2003 2004 2005 2006


CVRD bridge loan). Loan commitments to thebanking sector totaled $32 billion in 2006, ex-ceeding for the first time the value of commitmentsto the oil and gas sector.

Short-term debt flows (bank loans and bond is-sues coming due within a year) increased by $4 bil-lion (6 percent) in 2006, reaching $72 billion, justunder one-third of private debt flows (table 2.6).Short-term debt flows are highly concentrated inthe East Asia and Pacific region and in Europe andCentral Asia, which accounted for 85 percent of thetotal in 2006, equal to the average over the threeprevious years.

Banks from developing countries are playingan active roleBanks in developing countries continue to be ac-tively involved in syndicated lending to other de-veloping countries (so-called “South–South” banklending—see World Bank 2006, pp. 118–23). Be-cause South–South cross-border bank lending isoften dominated by a few large transactions, re-gional and country allocations tend to vary widelyfrom year to year. In 2004–06 banks in developingcountries accounted for just 4.5 percent of cross-border syndicated loan commitments to borrowersdomiciled in low- and lower-middle-income coun-tries. Half of the amount loaned went to borrow-ers in East Asia and Pacific and Europe and Cen-tral Asia, with more than half going to borrowersin resource-rich countries. Four oil-producingcountries—Angola, the Arab Republic of Egypt,Indonesia, and Kazakhstan—received almost halfof the total amount.

Although South–South lending makes up lessthan 5 percent of bank lending to the developingworld, it is prominent in some regions, particularlySub-Saharan Africa, which received 20 percent of

all such loan commitments by banks fromdeveloping countries in 2004–06. About three-quarters of these loans were made by Chinesebanks. In contrast, Sub-Saharan Africa receivedjust 6 percent of such commitments made by bankslocated in high-income countries (figure 2.11).5

Banks in developing countries made an esti-mated $5.3 billion in syndicated loan commit-ments to low- and lower-middle-income countriesin 2006. Banks in China, India, Malaysia, andSouth Africa accounted for nearly three-quartersof the amount loaned. About half of the loans($2.2 billion) financed oil and gas projects, withChinese banks providing $2 billion. Overall,Chinese banks provided $2.4 billion in loan com-mitments to low- and lower-middle-income coun-tries, with nearly two-thirds of these commitments

44

Table 2.6 Net short-term debt flows to developing countries, 2006$ billions

1998 1999 2000 2001 2002 2003 2004 2005 2006e

Total �65.3 �17.3 �6.3 �23.7 0.5 55.0 68.4 67.7 72.0By region

East Asia and Pacific �44.7 �13.3 �9.9 1.7 6.8 18.5 32.6 39.5 31.8Europe and Central Asia 6.1 0.5 8.4 �5.9 4.7 31.0 19.9 23.0 30.1Latin America and the Caribbean �28.3 �4.9 �0.9 �14.6 �10.5 2.6 7.3 �2.8 2.1Middle East and North Africa 3.3 1.0 �1.9 �1.8 �0.6 3.1 4.5 3.2 1.9South Asia �1.3 0.1 �0.9 �0.9 1.8 0.7 2.6 1.6 2.8Sub-Saharan Africa �0.5 �0.6 �1.1 �2.1 �1.8 �1.0 1.6 3.2 3.3


Figure 2.11 Cross-border syndicated lending to low- and lower-middle-income countries,by region, 2004–06

Sources: Dealogic Loanware and World Bank staff estimates.

Percentage of all loan commitments by each group of banks

0

20

30

5

10

15

25

Midd

le Eas

t and

North

Afri

ca

Latin

Amer

ica

and

the

Caribb

ean

South

Asia

Sub-S

ahar

an

Africa

Europ

e an

d

Centra

l Asia

East A

sia

and

Pacific

Banks from high-income countries

Banks from developing countries


($1.3 billion) involving two Chinese policy banks(Export-Import Bank of China and the ChinaDevelopment Bank). The Chinese commitmentsincluded $700 million in syndicated loan commit-ments to Angola ($405 million from China’spolicy banks) and $326 million to Kazakhstan(all but $4 million from the policy banks). Theseamounts refer only to syndicated loan commit-ments and do not include bilateral loancommitments; hence, they understate the totalamount of lending by banks located in develop-ing countries.6

Bond issuance is shifting toward the privatesectorThe private sector has emerged as the majorsource of developing countries’ borrowing overthe past few years (figure 2.12). In 2005–06 cor-porate bond issues (including corporate bondsguaranteed by the public sector) accounted forover half of the value of all issues, up from less

than one-quarter percent in 2000. The corporateshare of long-term external debt has increasedfrom less than 20 percent in the late 1990s to overhalf in 2006 (figure 2.13).

The dramatic decline in external sovereigndebt in recent years is partly the result of fiscal re-straint, as reflected in the modest decline in theratio of public sector debt to GDP. But lower ex-ternal sovereign debt also reflects massive buy-backs of external debt and a shift in public sectorborrowing to the domestic bond market.

Brazil, Colombia, Mexico, and RepúblicaBolivariana de Venezuela bought back almost$30 billion in sovereign debt in 2006 (table 2.7).Brazil accounted for $15 billion, an amount equalto more than 60 percent of its external debt at theend of 2005. These debt-management operationsreduced Brazil’s average cost of capital, substan-tially improving its debt-servicing profile in theprocess. Brady bonds, once the mainstay of theemerging-market asset class, have been almostcompletely retired: less than $6 billion remains

45

Figure 2.12 Bond issuance by sovereign andcorporate sectors, 1994–2006


$ billions

0

100

125

50

25

75

Sovereign Corporate

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Figure 2.13 Long-term external debt as a shareof GDP in developing countries, by type of debt, 1994–2006


Percent

0

30

40

10

20

Corporate Sovereign

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Table 2.7 Major prepayments to private creditors, 2006

External debt/GDP Foreign reserves Reserve import cover (percent) ($ billions) (months)

Prepayment 2005 2006 Dec. 2005 Dec. 2006 Dec. 2005 Dec. 2006

Brazil 15.0 25.6 22.4 53.6 85.6 6.7 8.7Mexico 5.4 22.1 19.1 74.1 76.3 3.6 3.2Venezuela, R. B. de 4.6 32.1 20.7 23.9 29.4 9.2 8.4Colombia 4.3 33.0 29.9 14.8 15.3 7.5 5.9



outstanding, an amount equal to about 4 percentof the original value issued in the early 1990s.

The increase in domestic debt since the mid-1990s has been more prominent in middle-incomecountries than in low-income countries. The aver-age level of domestic debt as a share of GDP in 33low-income countries increased from 17 to 20 per-cent over the period 1995 to 2005, compared to20 to 29 percent in 28 middle-income countries.7

The growth of developing countries’ domesticdebt markets and the newfound ability of severalgovernments to issue long-term bonds in local cur-rency have provided an alternative source tomeet public sector borrowing requirements. For the28 largest emerging-market economies, the domes-tic portion of the outstanding stock of public debtrose from a little more than half in 1998 to three-quarters in 2006 (figure 2.14).8 External publicdebt declined from 16 percent of GDP in 1998–99to an estimated 10 percent in 2006, while domesticpublic debt climbed from 18 percent to 28 percent.

Foreign investors continue to purchasedomestic bondsThe rise in sovereign demand for financing hasbeen partially met by foreign investors in the sov-ereigns’ domestic debt markets. Foreign investorshave been attracted by a combination of factors,including higher yields, opportunities for portfoliodiversification, improved economic fundamentalsin most emerging-market economies, and the per-ception of lower currency risk.

Returns on emerging-market sovereign bondsissued in local markets (measured by JPMorgan’sGBI-EM composite index) averaged 13 percent in2006 (in dollar terms), about 3 percentage pointsabove the average return on emerging-market sover-eign bonds issued in external markets (measured byJPMorgan’s EMBI Global composite index) and6 percentage points above sovereign bonds issuedby advanced countries (measured by JPMorgan’sGBI composite index). Country returns rangedfrom 46 percent in Indonesia to –5 percent in SouthAfrica (in dollar terms). Returns on local currencybonds in commodity-exporting countries (notablyNigeria and Zambia) have been supported by highcommodity prices, which have raised expectationsof currency appreciations.

Foreign investors have gained more confidencein several countries that have improved their mone-tary and fiscal policy frameworks and adoptedmore flexible exchange rate regimes. Confidence inother countries rose after substantial declines intheir debt burdens owing to major debt-relief ini-tiatives (the Heavily Indebted Poor Countries[HIPC] Initiative and the Multilateral Debt ReliefInitiative [MDRI]) as well as additional debt relieffrom Paris Club creditors.

Comprehensive data on the extent of foreignparticipation in domestic debt markets are notavailable, making it difficult to draw general con-clusions. The available data indicate that nonresi-dents purchased about $9 billion in domestic debtin 2006. About two-thirds of this debt was ac-quired by foreign institutional investors (includingpension funds, central banks, and governmentagencies), with the rest purchased by foreign retailinvestors. In many countries, foreign participationhas been overshadowed by growing demand fromdomestic institutional investors. But the extent offoreign participation varies widely across countries,ranging from less than 1 percent in China, India,Kenya, and the Republic of Korea to more than20 percent in Hungary and Poland (figure 2.15). Arecent address by the managing director of theMonetary Authority of Singapore indicated that onaverage, nonresident investors hold less than 5 per-cent of local bonds in Asia.

Foreign participation has risen substantiallyover the past few years in some countries. InMexico, for example, foreign holdings of domesticdebt increased from less than 2 percent in 2002 tomore than 10 percent in 2006. In Brazil foreign

46

Figure 2.14 Public debt as a share of GDP in 28largest emerging-market economies, 1998–2006

Source: JPMorgan Chase (2007).

Percent

0

30

50

10

20

40

1998 1999 2000 2001 2002 2003 2004 2005 2006

ExternalDomestic


purchases increased in response to the removal ofwithholding taxes on foreign investors in February2006. However, foreign investment in Brazil’s localmarkets remains limited by the country’s issuanceof local currency bonds in international markets.

Despite their small share, foreign investorshave played an important role in certain segmentsof domestic debt markets. Nonresidents held84 percent of 20-year bonds during the early stageof their introduction in Mexico; more than 40 per-cent of 20-year bonds and at least 80 percent ofinflation-indexed securities in Poland; and a sub-stantial share of longer maturities in Brazil. The in-troduction of derivatives and structured products(such as credit-linked notes) by foreign investorshas also reduced the interest rate risk borne by localfinancial intermediaries, contributing to the sound-ness of the domestic financial system. Nonresidentinvestors have been active in providing domesticBrazilian institutions with derivative products tohedge interest rate risk.

Credit quality appears to have declinedAs private debt flows swell, riskier borrowers maybe taking a larger share of the market. The shareof bonds issued by unrated (sovereign and corpo-rate) borrowers rose from 10 percent in 2000 to37 percent in 2006 (figure 2.16), and the share ofunsecured loans in total bank lending rose from

50 percent in 2002 to almost 80 percent in 2006(figure 2.17). While the profile of bank borrowersappeared to become more risky, average spreadsacross all loan commitments (measured relative tobenchmark LIBOR interest rates) fell from morethan 200 basis points in 2002 to 125 in 2006 (fig-ure 2.18). Average loan maturities lengthened, evenafter taking into account shifts in sector, purpose,and country of borrower.

The shift to ostensibly more risky borrowersin the context of falling spreads and lengtheningmaturities may indicate that lenders are failing toprice risk adequately. But other explanations are

47

Figure 2.15 Share of domestic debt held by nonresidents, selected countries, 2002 and 2006

Source: World Bank staff estimates.

Percent

0

20

30

10

Kenya

Korea

, Rep

. of

Mala

ysia

Mex

ico

Indo

nesia

Zambia

Poland

Hunga

ry

Brazil

June 2002 June 2006

Source: World Bank staff estimates based on data fromDealogic Bondware.

0

50

75

100

125

25

199819971996 1999 2000 2001 2002 2003 2004 2005 2006

Figure 2.16 Bond issuance by developing countriesby credit grade, 1996–2006

$ billions

Unrated borrowers

Noninvestment grade

Investment grade

Source: World Bank staff estimates based on data fromDealogic Loanware.

0

100

150

200

250

50

1990

1999

1998

1997

1996

1995

1994

1993

1992

1991

2000

2001

2002

2003

2004

2005

2006

$ billions

Figure 2.17 Loan commitments to developingcountries by credit grade, 1990–2006

Secured loans

Unsecured loans to rated companies

Unsecured loans to unrated companies


also possible. The trend may reflect a significantimprovement in the creditworthiness of corporateand sovereign borrowers. It may also reflect abroadening of the investor base as a result of therapid growth of derivatives and the increasing par-ticipation of institutional investors (hedge funds,in particular). These developments have reducedthe cost of intermediation for issuing bonds andequity, as well as the cost of capital to banks (thusreducing the price of risk). The extent to which theoverall composition of private lending to developingcountries has become riskier over the past fewyears is thus not clear.

Private equity market developmentsPortfolio equity flows to developing countriesreach record levels

Portfolio equity inflows to developing countriesrose to $94 billion in 2006—15 times their

2002 level—led by strong gains in the East Asiaand Pacific region (table 2.8). IPOs by twoChinese banks accounted for $21 billion of thetotal (table 2.9), increasing China’s share from 30percent to 35 percent. Although the number ofIPOs declined, from 160 to 140, the value of IPOtransactions reached a record $53 billion in 2006,accounting for some two-thirds of portfolio equityflows, up from $37 billion in 2005. Four of the 10largest IPOs were by Chinese companies, account-ing for almost two-thirds of total IPO value.Russian companies issued 3 of the 10 largest IPOs,accounting for 22 percent of the total.

The record volume of international equity is-sues over the past few years has been supportedby growing demand on the part of institutionalinvestors. Hedge funds have been playing an in-creasingly prominent role in the primary issuancemarket, to the point where their involvement oftenhas a major bearing on the success of an IPO.

Emerging-market equities continue to performwell, despite turbulenceEquity prices in emerging markets outperformedthose in mature markets in 2006, despite sharpdeclines in May–June 2006 and in February–March2007 (figure 2.19). Net inflows to emerging-market

48

Source: World Bank staff estimates based on data fromDealogic Loanware.

0

100

150

250

300

200

50

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Figure 2.18 Average spread across all loancommitments, 1990–2006

Basis points

Table 2.8 Net portfolio equity flows to developing countries, 2000–06$ billions

2000 2001 2002 2003 2004 2005 2006e

Total 13.4 5.6 5.8 24.3 39.9 66.7 94.1

East Asia and Pacific 6.6 1.8 3.8 12.5 19.0 26.1 48.4China 6.9 0.8 2.2 7.7 10.9 20.3 32.0Thailand 0.9 0.4 0.5 1.8 1.3 5.7 5.4

Europe and Central Asia 0.6 �0.4 0.1 �0.6 5.3 6.3 10.5Russian Federation 0.2 0.5 2.6 0.4 0.2 �0.2 9.2

Latin America and the Caribbean �0.6 2.5 1.4 3.4 �0.6 12.4 11.1Brazil 3.1 2.5 2.0 3.0 2.1 6.5 7.7Mexico 0.4 0.2 �0.1 �0.1 �2.5 3.4 3.9

Middle East and North Africa 0.2 �0.1 �0.3 0.3 0.7 2.3 1.6

South Asia 2.4 2.7 1.0 8.0 8.8 12.2 10.0India 2.3 2.9 1.0 8.2 9.1 12.2 8.7

Sub-Saharan Africa 4.2 �0.9 �0.4 0.7 6.7 7.4 12.5South Africa 4.2 �1.0 �0.4 0.7 6.7 6.9 12.4



equity funds totaled $30 billion in the first fourmonths of 2006, almost twice the total for the en-tire previous year. The S&P/IFCI Composite Indexfor emerging markets rose 16 percent in the sameperiod.

Flows reversed abruptly in May–June, in thewake of turbulence that gripped international fi-nancial markets. The S&P/IFCI Composite Indexfell 19 points between the beginning of May andmid-June, with most emerging equity markets suf-fering dramatic drops and emerging-market equityfunds seeing a net outflow of about $17 billion(table 2.10). China was an important exception:equity prices there fell just 8 percent in May–June,and the Bank of China’s $9 billion equity issue inMay was oversubscribed. The markets recoveredquickly, however, ending the year with an average

gain of 32 percent, led by Russia (92 percent),Peru (60 percent), and Brazil (53 percent). Net in-flows to emerging-market equity funds recoveredover the balance of the year, more than offsettingthe outflows in May–June.

Equities in several emerging-market economiesoutperformed those in mature markets by a widemargin over the past few years, while exhibitingmuch greater volatility. The S&P/IFCI Equity PriceIndex for Russia rose at an average annual rate of60 percent over the past three years, well above theindex for the United States (21.5 percent) or thecountries in the euro area (12.7 percent). However,

49

100

150

250

350

300

200

50

Jan.

2000

Jan.

2001

Jan.

2002

Jan.

2003

Jan.

2004

Jan.

2005

Jan.

2006

Mar

. 200

7

Figure 2.19 International equity prices,January 2000–March 2007

Sources: Standard & Poor’s and International Finance Corporationcomposite indexes (S&P/IFCI).

Index (2000 � 100)

India

Developing countries

China

Euro Area

UnitedStates

Table 2.9 Ten largest cross-border initial public offerings in 2006

Issuer Country Sector Exchange Value ($ billions)

Industrial and Commercial Bank of China China Banking Hong Kong Stock Exchange 12.1Bank of China Ltd China Banking Hong Kong Stock Exchange 8.9Rosneft Russian Federation Oil and gas London Stock Exchange 5.5KazMunaiGas Exploration and Production Kazakhstan Oil and gas London Stock Exchange 2.3TMK Russian Federation Materials London Stock Exchange 1.1Comstar UTS OAO Russian Federation Telecommunications London Stock Exchange 1.1Grupo Aeroportuario del Pacifico SA Mexico Transportation New York Stock Exchange 1.0Thai Beverage PCL Thailand Food and beverage Stock Exchange of Singapore 1.0Shui On Land Ltd China Real estate Hong Kong Stock Exchange 0.9Shimao Property Holdings Ltd China Real estate Hong Kong Stock Exchange 0.6

Sources: Economist Intelligence Unit Country Reports; Financial Times, and other news media.

Table 2.10 International equity prices, 2004–06Percent change in equity price index (S&P/IFCI)

Average rate Standardof changeb deviationc

May–June, 2006a 2006 2004–06 2004–06

All developing countries �18.9 32.6 33.3 4.6United States �7.1 22.4 21.5 2.2Euro Area �10.3 10.6 12.7 2.8

Developing countries with strongest gains in 2006Russian Federation �26.7 92.0 60.0 8.9Peru �10.7 59.6 39.2 7.2Brazil �27.0 53.3 54.6 8.4Colombia �48.2 49.2 75.1 10.1India �27.8 46.5 45.0 9.5China �8.0 43.7 17.0 5.8Argentina �24.7 43.4 48.5 9.3Mexico �20.1 43.2 42.5 5.3Indonesia �23.4 42.5 39.5 7.2Nigeria 9.7 41.9 35.0 7.9

Source: Standard & Poor’s/International Finance Corporationcomposite indexes (S&P/IFCI).a. Percent change between early May and mid-June 2006.b. Year-end to year-end.c. Standard deviation of monthly changes over the period 2004–06.


the standard deviation of monthly changes wasfour times that for the United States and threetimes that for the Euro Area countries.

There has been an ongoing shift in new equitylistings away from exchanges in the United Statestoward exchanges in London and Hong Kong(China). Only 1 of the 10 largest cross-border IPOsin 2006 was issued in New York, while four werelisted in Hong Kong and four in London. The valueof new listings by emerging-market companies onU.S. exchanges declined about 7 percent, from $2.9billion in 2004 to $2.7 billion in 2006.

Meanwhile, the value of listings issued inLondon increased by a factor of 14 (from $0.7 bil-lion to $9.6 billion) and the value of listings issuedin Hong Kong (China) quadrupled (from $7.2to $30.4 billion). The $20 billion raised by twoChinese banks through IPOs in Hong Kongrepresents a major breakthrough and perhaps,with the encouragement of the Chinese govern-ment, the beginning of a new era. By electing to listin Hong Kong, the two Chinese banks have defiedthe long-held belief that large corporations mustlist on a New York or London exchange to gainaccess to global capital. A steady stream of IPOtransactions is expected in Hong Kong, as morestate-owned enterprises in China are privatized.

FDI inflows continue to expand, keeping pacewith strong growthForeign direct investment (FDI) inflows to devel-oping countries reached a record $325 billion in2006 (figure 2.20), up $44 billion from 2005. Vir-tually all of the gains occurred in Eastern Europeand Central Asia (table 2.11). FDI inflows stabi-lized at 2.9 percent of GDP in 2006, up from thelow of 2.3 percent in 2003 but still below the peakof 3.1 percent reached in 1999.

As of 2004 (the most recent year for whichdata on the sectoral composition of FDI are avail-able), half of the FDI stock in developing countrieswas in the services sector. Various indicators sug-gest that this trend has continued over the pasttwo years, particularly in banking, telecommuni-cations, and real estate. The trend has been sup-ported by developing countries’ improvements inpolicies designed to attract FDI, particularly in theservices sector, where several countries have re-laxed restrictions on foreign ownership and under-taken major privatizations.

Most of the 10 largest privatizations, mergers,and acquisitions in 2006 (with a total value of$18 billion) occurred in the banking ($7.3 billion)and telecommunications ($5.6 billion) sectors(table 2.12). China was conspicuously active in thisarea, providing foreigners with greater access to in-vestment opportunities in banking and insurance,in compliance with the membership requirementsof the World Trade Organization. There has alsobeen an increase in FDI in real estate over the pastfew years, notably in India, Turkey, and severalcountries in the Middle East and North Africa, dri-ven by private equity firms and the recycling ofpetrodollars by the Gulf countries (notably Kuwait,Saudi Arabia, and the United Arab Emirates).

Global FDI flows reached a record $1.1 tril-lion in 2006, with mergers and acquisitions valuedat a record $1.25 trillion worldwide. About a quar-ter of these transactions involved purchases ofassets in developing countries, consistent with thehistorical average.

The continuing rise in FDI inflows to develop-ing countries has been driven by a combination ofexternal and domestic factors. Favorable globaleconomic conditions boosted investor confidence.Along with strong global economic growth (4 per-cent in 2006), corporate profits as a share of GDProse worldwide, reaching a 50-year high in theUnited States. Low long-term interest rates andrising stock market valuations make it easier forcompanies to finance investments.

50


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51

Table 2.11 Net FDI flows to developing countries, 1998–2006$ billions

2000 2001 2002 2003 2004 2005 2006e

Total 166.5 171.0 157.1 160.0 217.8 280.8 324.7

East Asia and Pacific 45.1 47.7 57.0 53.5 65.8 96.4 88.3China 38.4 44.2 49.3 53.5 54.9 79.1 76.0Indonesia �4.6 �3.0 0.1 �0.6 1.0 5.2 2.0Malaysia 3.8 0.6 3.2 2.5 4.6 4.0 4.0Philippines 1.3 1.0 1.8 0.3 0.5 1.1 0.9Thailand 3.4 3.9 1.0 1.9 1.4 4.0 5.5Vietnam 1.3 1.3 1.4 1.5 1.6 2.0 2.0

Europe and Central Asia 25.2 25.4 26.4 34.2 62.7 73.2 116.4Bulgaria 1.0 0.8 0.9 2.1 2.0 2.6 5.0Croatia 1.1 1.3 1.2 2.1 1.2 1.6 2.9Hungary 2.8 3.9 3.0 2.2 4.6 6.4 9.0Kazakhstan 1.3 2.8 2.6 2.1 4.1 1.7 5.0Poland 9.3 5.7 4.1 4.6 12.9 9.6 12.6Russian Federation 2.7 2.7 3.5 8.0 15.4 15.2 28.0Romania 1.0 1.2 1.1 1.8 5.4 6.6 7.0Slovak Republic 1.9 1.6 4.1 0.6 1.3 1.9 3.0Ukraine 0.6 0.8 0.7 1.4 1.7 7.8 4.0Turkey 1.0 3.3 1.1 1.8 2.7 9.7 19.0

Latin America and the Caribbean 79.8 70.6 51.0 43.0 62.5 70.0 69.4Argentina 10.4 2.2 2.1 1.7 4.1 4.7 4.0Brazil 32.8 22.5 16.6 10.1 18.2 15.2 18.8Chile 4.9 4.2 2.6 4.4 7.6 6.7 8.5Colombia 2.4 2.5 2.1 1.8 3.1 10.4 5.0Mexico 17.1 27.7 15.5 12.3 17.4 18.1 18.9Peru 0.8 1.1 2.2 1.3 1.8 2.5 3.5Venezuela, R. B. de 4.7 3.7 0.8 2.7 1.5 3.0 �0.5

Middle East and North Africa 4.8 4.1 4.9 8.1 6.8 13.8 19.2Algeria 0.4 1.2 1.1 0.6 0.9 1.1 1.1Egypt, Arab Rep. of 1.2 0.5 0.6 0.2 1.3 5.4 6.3Morocco 0.2 0.1 0.1 2.3 0.8 2.9 2.5Tunusia 0.8 0.5 0.8 0.5 0.6 0.7 2.8

South Asia 4.4 6.1 6.7 5.6 7.3 9.9 12.9India 3.6 5.5 5.6 4.6 5.3 6.6 8.0Pakistan 0.3 0.4 0.8 0.5 1.1 2.2 3.5

Sub-Saharan Africa 3.5 12.1 5.3 9.1 7.1 13.8 12.5Angola 0.9 2.1 1.7 3.5 1.4 0 1.5Equatorial Guinea 0.1 0.9 0.3 1.4 1.7 1.9 2.0Nigeria 1.1 1.2 1.9 2.0 1.9 3.4 4.0South Africa 1.0 7.3 0.7 0.8 0.6 6.3 2.5Sudan 0.4 0.6 0.7 1.3 1.5 2.3 2.5


Table 2.12 Major privatizations, mergers, and acquisitions in 2006

Seller Country Buyer Country Sector Value ($ billions)

Akbank Turkey Citigroup United States Banking 3.1Guangdong Development Bank China Citigroup-led consortium United States Banking 3.0Vodacom South Africa Vodafone United Kingdom Telecommunications 2.4Tunisie Télécom Tunisia TECOM-DIG United Arab Emirates Telecommunications 2.2Kazakh Oil Kazakhstan CITIC China Oil and gas 1.9MOL Foldgazellato Hungary E.ON Ruhrgas Int. AG Germany Oil and gas 1.3Ukrsotsbank Ukraine Intesa Bank Italy Banking 1.2Petrol Ofisi Turkey OMV Austria Oil and gas 1.1Vee Networks Ltd Nigeria Celtel International BV Netherlands Telecommunications 1.0Omimex de Colombia Colombia ONGC & Sinopec China and India Oil and gas 0.8



Although world oil prices declined over thesecond half of 2006, average prices for the yearwere 20 percent above 2005 prices (see fig-ure 1.21). High prices continued to attract FDI inthe oil and gas sector (box 2.1). Energy-related in-vestments led a major increase in FDI inflows toRussia, from $15 billion in 2004–05 to $28 billionin 2006. FDI inflows to four major oil-producingcountries in Sub-Saharan Africa (Angola, Equator-ial Guinea, Nigeria, and Sudan) were estimated at$10 billion in 2006, half of all FDI to low-incomecountries.

The tremendous expansion in oil revenues inoil-exporting countries has altered the profile ofFDI in developing countries. FDI inflows to theMiddle East and North Africa increased by almost

52

Oil and gas was one of the first sectors in developingcountries to become tightly integrated with other

countries, through both trade and FDI. In 2005, 73 per-cent of production took place in developing countries,55 percent of which was consumed by industrial countries(International Energy Agency 2006).

Oil exploration and production occur in developingcountries. But downstream activities, notably refining anddistribution, are concentrated in industrial countries, re-flecting the importance of proximity to major markets andefficient infrastructure. The countries of the Organisationfor Economic Co-operation and Development account for54 percent of global refinery capacity but only 27 percentof global oil production. Industrial countries are netproviders of FDI in exploration and production and net recipients of FDI in refining and distribution.

Developing countries receive about half of worldwideFDI flows into the oil and gas sector. The share fluctuatesconsiderably from year to year, mainly because of largemergers and acquisitions. In 2006 FDI in the oil and gassector was estimated at $25 billion, accounting for 7.5 percent of total FDI. In 1999 FDI in the sector reached a record $29.5 billion (about 16 percent of all FDI that year), when an Argentinean company (YPF) was acquired by a Spanish company (Repsol) for $13 billion.

Many oil-producing developing countries have liberal-ized regulations on FDI in the oil and gas sector as a wayof modernizing technology and attracting equity capitalfrom abroad. Foreign-owned companies operate under

various arrangements, including direct ownership, jointventures, and product-sharing agreements.

Some of these arrangements do not entail foreignownership and hence are not included in conventionalmeasures of FDI. (Because of this, official data on foreignparticipation in the oil and gas sector of developing coun-tries are understated.) The nature of investment agree-ments can also influence the composition of FDI flows. Forinstance, when restrictions on foreign ownership are bind-ing, foreign companies seek additional financing throughintracompany loans. In Angola all FDI in the oil and gassector takes this form.

State-owned enterprises play an important role in theoil and gas sector, because they hold exclusive access tonearly 90 percent of proven oil reserves in the developingworld. High oil prices over the past few years have consid-erably increased the earnings of such enterprises. Manyhave expanded their operations abroad by investing in ex-ploration and production activities in other countries in aneffort to diversify their reserves. State-owned enterpriseshave also expanded their investments in refining, distribu-tion, and petrochemicals. In addition, some countries—including Bolivia, Ecuador, and República Bolivariana deVenezuela—have passed legislation that gives state-ownedenterprises majority ownership of all oil and gas opera-tions, reducing foreign participation in the sector. Otherdeveloping countries (notably Kazakhstan and Russia), aswell as the United Kingdom, the United States, and otherdeveloped countries, have revised tax policies to raise thegovernments’ share of rents in the oil and gas sector.

Box 2.1 Foreign direct investment in the oil and gas sector

$10 billion in 2006, fueled mainly by foreign in-vestments from oil-exporting Gulf countries(chiefly the Islamic Republic of Iran and the UnitedArab Emirates) in the energy, infrastructure, realestate, and tourism sectors. Private equity firmshave also played a more prominent role as a sourceof FDI in developing countries. At the same time,FDI outflows from developing countries increased,from $63 billion in 2005 to an estimated $110 bil-lion in 2006.9 Part of the growth came as multina-tionals based in developing countries made majorinvestments in developed countries, a growing phe-nomenon known as South–North FDI. Since 2004FDI flows from India into the United Kingdom, forexample, have exceeded flows from the UnitedKingdom to India.


The portion of FDI earnings that is repatriatedeach year has been relatively stable over the past10 years, averaging 62 percent, down from morethan 80 percent in the early 1990s (figure 2.22).Repatriated earnings increased from $28 billion in2000 to $125 billion in 2006, but they do not rep-resent a significant burden on the balance of pay-ments. Repatriated earnings have representedabout 2 percent of developing countries’ exportrevenues since 2000.

Several factors affect corporate decisions toreinvest or repatriate equity earnings. Corporationsmay seek to smooth dividend payments as a way ofsignaling that profitability can be sustained overthe long term. Firms also have an incentive to repa-triate earnings over time and across countries in away that exploits differences in tax rates and regu-lations. For example, the Homeland InvestmentAct gave many U.S. corporations an incentive torepatriate earnings in 2005 to take advantage oflower tax treatment. As a consequence, repatriatedearnings by U.S. multinationals surged to $260 bil-lion in 2005, well above the annual average of$65 billion over the previous five years. A country’sinvestment climate can also have a major effect: theportion of equity earnings that is repatriated tendsto be lower (and thus the share of reinvestedearnings higher) in countries with better investmentclimates. Sudden shifts in political risk and theimposition (or threat) of capital controls can lead

53

Figure 2.21 Concentration of net FDI inflows todeveloping countries, 1997–2006


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FDI declined in a few countries, for variousreasons. The drop in flows to Latin America andthe Caribbean was concentrated in RepúblicaBolivariana de Venezuela, reflecting the deteriorat-ing investment climate (notably the nationalizationof oil and gas assets), and in Colombia, where FDIreturned to normal levels after several large mergerand acquisition and privatization transactions in2005. The $3 billion decline in South Africa cameon the heels of a $5 billion acquisition in 2005.

FDI continues to be concentrated in a few ofthe largest middle-income countries, although thedegree of concentration has declined somewhatover the past few years. FDI to China declinedslightly in 2006, but China still accounted for al-most one-quarter of FDI inflows to developingcountries, down from almost one-third in 2002.Almost half of FDI inflows went to the five topdestinations in 2005–06, down from almost two-thirds in 2000 (figure 2.21).

Income earned on FDI is risingThe income earned by multinationals on FDI hasrisen in tandem with the surge in flows. The valueof multinationals’ investments in developing coun-tries reached an estimated $2.4 trillion in 2006.The income earned on that stock rose from$74 billion in 2002 to $210 billion in 2006. FDIincome increased from less than 0.5 percent ofGDP in developing countries in the early 1990s toalmost 2 percent in 2006.

Not all of this income represents an outflowfrom developing countries’ balance of payments.


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to abrupt changes in repatriated earnings (WorldBank 2004; Lehmann and Mody 2004; Desai,Foley, and Hines 2004). In the midst of Argentina’sfinancial crisis in 2002, for example, repatriatedearnings outstripped equity earnings by a factor offive, as corporations attempted to evade the intro-duction of controls on outflows and foreign ex-change transactions.

Remittance flows to developing countriescontinue to rise, although at a slower pace After FDI, remittances are the largest source of ex-ternal financing for developing countries (box 2.2).In the 1990s, remittances were less volatile thanother sources of foreign exchange earnings. Unlikeprivate capital flows, remittances tend to rise when

the recipient economy suffers an economic down-turn following a financial crisis, natural disaster, orpolitical conflict. Remittances provide a safety netto migrant households in times of hardship, andthese flows typically do not suffer from the gover-nance problems that may be associated with offi-cial aid flows. Remittances are person-to-personflows that are well targeted to the needs of the re-cipients, who are often poor.

Official development assistance

The many developing countries with little or noaccess to private capital markets depend heav-

ily on grants and concessional loans from officialsources to meet their financing needs.

54

Recorded remittances sent home by migrants from de-veloping countries reached $206 billion in 2006, up

from $193 billion in 2005 and more than double the levelin 2001 (see the table at right). Worldwide flows of remit-tances, including those to high-income countries, are esti-mated to have to grown to $276 billion in 2006. Thisamount, however, reflects only transfers through officialchannels. The true size of remittances, including un-recorded flows through formal and informal channels, isbelieved to be larger (World Bank 2005, chapter 4).

Regionally, Latin America and the Caribbean remainsthe largest recipient of recorded remittances. Due to a lackof data, remittance flows to Sub-Saharan Africa are grosslyunderestimated. Recorded remittance flows have grownrobustly in virtually every region, although most quickly inEurope and Central Asia and in East Asia and Pacific.Growth of remittance flows appears to be slowing in LatinAmerica and the Caribbean region, however, as a result of aslowdown in the housing sector in the United States. In con-trast, remittances to other regions, especially South Asia,have been held up by the strong economy in the migrant-receiving countries in the Persian Gulf region and Europe.

The top recipients of remittances in nominal dollarterms are India, Mexico, China, and the Philippines. As ashare of GDP, however, the top recipients are smaller coun-tries such as Moldova, Tonga, Guyana, and Haiti, whereremittances exceed 20 percent of GDP. Remittances as ashare of GDP amounted to 3.5 percent of GDP in low-income countries in 2005 compared to 1.5 percent inmiddle-income countries.

Recorded remittances have more than doubled since2001. First, remittance flows through informal channels

are being subjected to greater scrutiny since the events ofSeptember 11, 2001. The discovery of the large size ofthese flows has prompted governments worldwide to im-prove the recording of these flows. Second, reduction in re-mittance costs and expansion of remittance networks haveincreased migrants’ disposable incomes and their incentivesto remit. Third, the depreciation of the U.S. dollar hasraised the value of remittances from Europe and Japan.The appreciation of the Euro relative to the U.S. dollarmay account for some 7 percent of the increase in remit-tance flows to developing countries during 2001–05(Mohapatra and others 2006). Finally, growth in migrantstocks (due to falling travel costs and increased globaliza-tion) and an increase in migrant incomes have alsocontributed to higher remittances.

Box 2.2 Remittance flows to developing countriesGlobal flows of international migrant remittances$ billions

2000 2001 2002 2003 2004 2005 2006e

Total 85 96 117 145 165 193 206By region

East Asia and Pacific 17 20 29 35 39 45 47Europe and Central Asia 13 13 14 17 23 31 32Latin America and the Caribbean 20 24 28 35 41 48 53Middle East and North Africa 13 15 16 20 23 24 25South Asia 17 19 24 31 31 36 41Sub-Saharan Africa 5 5 5 6 8 9 9

Source: World Bank staff calculations based on IMF Balance of PaymentsStatistics Yearbook 2007. Remittances are defined as the sum ofworkers’ remittances, compensation of employees, and migrant transfers—see www.worldbank.org/prospects/migrationandremittances for the entiredataset.Note: e � estimate.


Little progress on official aid commitmentsParticipants at the UN Conference on Financingfor Development in Monterrey in 2002 recognizedthat a substantial increase in foreign aid and otherresources would be required if developing countrieswere to achieve internationally agreed develop-ment objectives, including the Millennium Devel-opment Goals (MDGs). Developed countries wereurged to “make concrete efforts” to increase offi-cial development assistance (ODA) to the UN tar-get of 0.7 percent of GNP. The Africa Action Planannounced at the 2002 G-8 Leaders Summit inKananaskis, Canada, suggested that half or moreof new development assistance should go to Africa.At the UN World Summit in 2005, countriesreaffirmed the Monterrey Consensus, recognizingthe importance of enhancing the aid effort, partic-ularly in Africa, the only continent not on track tomeet any of the MDGs by 2015. At the 2005 G-8Summit in Gleneagles, Scotland, G-8 and otherdonors released a “Renewed Commitment toAfrica” that included a pledge to increase theamount of ODA allocated to Sub-Saharan Africaby $25 billion a year by 2010, more than doublingaid to the region from the 2004 level.

Donors have made only modest progresstoward fulfilling these commitments. Net ODAdisbursements by the 22 member countries of theDevelopment Assistance Committee (DAC) of theOrganisation for Economic Co-operation and

55

Figure 2.23 Net ODA disbursements by DAC donors, 1990–2006

Source: OECD Development Assistance Committee.e � estimate.

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Table 2.13 Net disbursements of official development assistance, 1990–2006$ billions

Donor 1990 1995 2000 2001 2002 2003 2004 2005 2006e

DAC donors 54.3 58.8 53.7 52.4 58.3 69.1 79.4 106.8 103.9G-7 countries 42.4 44.7 40.2 38.2 42.6 50.0 57.6 80.5 75.1United States 11.4 7.4 10.0 11.4 13.3 16.3 19.7 27.6 22.7Japan 9.1 14.5 13.5 9.8 9.3 8.9 8.9 13.1 11.6United Kingdom 2.6 3.2 4.5 4.6 4.9 6.3 7.9 10.8 12.6France 7.2 8.4 4.1 4.2 5.5 7.3 8.5 10.0 10.4Germany 6.3 7.5 5.0 5.0 5.3 6.8 7.5 10.1 10.4Canada 2.5 2.1 1.7 1.5 2.0 2.0 2.6 3.8 3.7Italy 3.4 1.6 1.4 1.6 2.3 2.4 2.5 5.1 3.7

Non-DAC donors 0.1 1.0 1.1 1.2 3.2 3.4 3.8 4.2 —Arab countries — 0.6 0.6 0.7 2.7 2.7 2.1 1.7 —Korea, Rep. of 0.1 0.1 0.2 0.3 0.3 0.4 0.4 0.8 —Turkey — 0.1 0.1 0.1 0.1 0.1 0.3 0.6 —

All donors 54.3 59.7 54.9 53.6 61.5 72.5 83.2 120.4 —

Memo itemsEU countries 28.3 31.2 25.3 26.4 30.0 37.1 42.9 55.7 58.9Private NGOs 5.1 6.0 6.9 7.3 8.8 10.3 11.4 14.9 —

Source: OECD Development Assistance Committee.Note: — � not available. e � estimate.

Development (OECD) declined by $3 billion in2006, following a record $27 billion increase in2005 (figure 2.23 and table 2.13). The decreaselargely reflects the return of debt relief to morenormal levels following extraordinary Paris Clubagreements with two countries in 2005, underwhich Iraq and Nigeria received $19.4 billion indebt relief in 2005 and $14.1 billion in 2006.

Debt relief continues to play a critical role inthe development agenda, especially for many of thepoorest countries burdened by heavy debt servicepayments (see World Bank 2006, chapter 3). Debt


relief provided through the HIPC Initiative and theMDRI is estimated to have reduced the debt stocksof 29 countries that have reached the decision pointby almost 90 percent.10 Debt service paid by thesecountries has already declined by about 2 percentof GDP between 1999 and 2005, and is expected todecline further in the medium term, as a result ofMDRI debt relief. Reductions in debt service pay-ments enable countries to channel more resourcesto finance their development objectives, providedthat debt relief does not displace other sources ofdevelopment assistance. At the Monterrey confer-ence, donors pledged that debt relief would be ad-ditional to their commitments to enrich ODA overtime. Despite that commitment, ODA barely heldits own in 2006, after growing at an average an-nual rate of 16 percent over the three previousyears. ODA net of debt relief declined from0.26 percent of gross national income in DACdonor countries in 2005 to 0.25 percent in 2006.This percentage is up from the low of 0.21 percentrecorded in 2001 but well below the 0.33 percentlevel attained in the early 1990s and far short of theUN target of 0.7 percent.

Sub-Saharan Africa received less aidthan expectedODA allocated to Sub-Saharan Africa has increasedsignificantly since the early part of the decade, risingfrom $12.5 billion in 2000 to $32 billion in 2005(figure 2.24). Much of the increase has come in theform of debt relief, however. Excluding debt relief,Sub-Saharan Africa received 35 percent of totalODA in 2005, equal to its average share over the1990–97 period. To meet their pledged increase in

ODA to Sub-Saharan Africa to $50 billion (in realterms) by 2010, donors would have to increase theflow of aid to the region by an average annual rateof 16 percent (in real terms) over the rest of thedecade.

Donors are providing more assistanceto countries affected by conflictThe allocation of aid to countries in or recoveringfrom conflict has risen substantially over the pastfew years. The share of bilateral ODA disburse-ments to Iraq and Afghanistan increased from8 percent in 2003 to 17.5 percent in 2005. An-other 4.5 percent of bilateral ODA was allocatedto Sudan and the Democratic Republic of Congoin 2005, bringing the total share allocated tothese four countries to 22 percent (table 2.14).Emergency and disaster relief also became more

56

Figure 2.24 Net ODA disbursements to Sub-SaharanAfrica, 1990–2005

Source: OECD Development Assistance Committee.

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Table 2.14 Bilateral ODA disbursements to 10 largest recipient countries, 2003–05$ billions

Country 2003 Country 2004 Country 2005

Iraq 2.1 Iraq 4.4 Iraq 7.5Indonesia 1.6 Afghanistan 1.7 Indonesia 2.2Afghanistan 1.2 China 1.6 Afghanistan 2.2China 1.1 Vietnam 1.2 China 1.7Jordan 1.1 Egypt, Arab. Rep. of 1.2 Sudan 1.5Ethiopia 1.0 Congo, Dem. Rep. of 1.2 Vietnam 1.3Russian Federation 1.0 Russian Fed. 1.1 Ethiopia 1.2Vietnam 1.0 Tanzania 1.0 Congo, Dem. Rep. of 1.0Tanzania 1.0 Ethiopia 1.0 Tanzania 0.9Serbia and Montenegro 0.9 Angola 1.0 Sri Lanka 0.9

Source: OECD Development Assistance Committee.Note: Excludes large debt-relief grants provided to Iraq ($13.9 billion) and Nigeria ($5.5 billion) in 2005 and to the Democratic Republic ofCongo ($4.4 billion) in 2003.


prominent, reaching 9 percent of ODA (excludingdebt relief) in 2006, up from less than 4 percent inthe 1990s (figure 2.25).

New donors have emerged . . .ODA provided by the 22 member countries of theOECD’s DAC provides only a partial perspectiveon aid activities, as other countries have emergedas new donors over the past few years. Some (no-tably Brazil, China, India, and Russia) are them-selves developing countries, which are now bothdonors and recipients of development assistance. Itis difficult to quantify the volume, allocation, andcomposition of aid provided by most new donorcountries, because their activities are not reportedin a comprehensive manner.

Fifteen donor countries that are not membersof the OECD DAC report their aid activities toDAC. Net ODA disbursements provided by thesedonors increased from about $1 billion over theperiod 1995–2001 to $4.2 billion in 2005 (themost recent year for which data are available). Thecomposition has shifted substantially over the pastfew years, as ODA provided by the Arab countriesdeclined (from $2.7 billion in 2002–03 to $1.7 bil-lion in 2005) while ODA provided by othernon–DAC donors increased (from $0.5 billion to$2.5 billion in 2005). The increase was led by theRepublic of Korea, which provided $0.75 billionin assistance in 2005, and Turkey, which provided$0.6 billion.

ODA provided by non–DAC donors increasedover the past few years, but it rose by less than

ODA from DAC members. In 2002 ODA bynon–DAC donors totaled $3.2 billion, an amountequal to 5.5 percent of the ODA provided by DACdonors (5.9 percent excluding debt relief). In 2005non–DAC donors provided $4.2 billion, equal tojust 4 percent of the ODA provided by DACdonors (5 percent excluding debt relief).

China’s “Africa Policy,” introduced in January2006, aims to support economic development inAfrica—among other objectives—through a num-ber of channels, including economic assistance anddebt relief (Government of China, 2006). TheChinese government provides concessionary loansand grants to developing countries directly andindirectly through concessional lending by theExport-Import Bank of China. The total amount ofconcessional loans and grants provided by China isnot reported in a comprehensive manner and esti-mates vary considerably.

In an effort to cast more light on the activitiesof new donors, the World Bank, in collaborationwith the OECD DAC, the United Nations Devel-opment Programme (UNDP), and the United Na-tions Department of Economic and Social Affairs(UNDESA), conducted a survey of nine developingcountries (Brazil, Chile, China, India, Malaysia,Russia, South Africa, Thailand, and RepúblicaBolivariana de Venezuela). Only three countries(Chile, Malaysia, and Thailand) have respondedto the survey so far. The information provided bythese countries indicates that almost all of theirdevelopment assistance is provided to countrieswithin their region, largely in the form of techni-cal assistance. Their development assistance isoften leveraged with funds provided by industrialcountries (so-called “triangular cooperation”),notably Japan.

. . . and private organizations are playinga more prominent roleNongovernmental organizations (NGOs) are pro-viding a growing source of financial resources fordeveloping countries. Governments’ contributionsto NGOs active in international development arealready included in ODA tallies, but private contri-butions are not. Private sector aid contributionstotaled $11 billion in 2006, an amount equal to13 percent of the aid provided by DAC donors (ex-cluding debt relief), up from 9 percent in the 1990s.

The amount of development assistance pro-vided by NGOs is difficult to quantify. The

57

Source: OECD Development Assistance Committee.

Debt relief Emergency relief Other

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Figure 2.25 Emergency relief provided by DACdonors, 1990–2006

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measures reported to the OECD DAC are believedto be underestimated by a substantial margin.The reported figures are therefore likely to under-state the growing contribution of NGOs todevelopment.

Private philanthropic foundations attractedmuch attention over the past year, followingWarren Buffet’s $30 billion donation to the Bill &Melinda Gates Foundation. The Gates Foundationis the largest charitable foundation in the world,with an endowment valued at $33 billion at theend of 2006. Its goals are to enhance health careand reduce extreme poverty worldwide and toexpand educational opportunities and access toinformation technology in the United States. TheGates Foundation is projected to disburse about$2.8 billion in 2007 (Brainard 2006), an amountequal to almost 3 percent of projected ODA dis-bursements by DAC donors. These projectionsimply that disbursements by the Gates Foundationwill exceed those of about half of DAC membercountries.

Data limitations make it very difficult to as-sess the overall contribution of private philan-thropic foundations to development. There are nocomprehensive measures of disbursements madeby private foundations to poor countries for devel-opment purposes. The procedures used to collectdata on the activities of private foundations differgreatly over time and across countries, makingcomparisons problematic. The more than 100,000private foundations worldwide have a very diverseset of social, political, charitable, and religiousobjectives, which are often related to, but extendbeyond, economic development.

Most private foundations begin by focusingon domestic initiatives, extending their operationsabroad once they develop sufficient financial andhuman resources and acquire the expertise neededby developing countries. Private U.S. foundationsare believed to be the most active internationally,because they tend to have greater financial re-sources and deeper experience than foundations inother countries.

The data provided by U.S. foundations aremore comprehensive than data from foundationsin most other countries. They reveal that the num-ber of private philanthropic foundations in theUnited States grew from 30,000 in 1993 to 68,000in 2005, while disbursements increased from$10 billion to $33 billion (Foundation Center

2006). About $3.8 billion (11.5 percent) of thesedisbursements went to international initiatives,most of which was channeled through interna-tional organizations (such as the Global Fund toFight AIDS, Tuberculosis and Malaria); NGOs;and private-public partnerships (such as theGlobal Alliance for Vaccines and Immunization).U.S. private foundations provide relatively little de-velopment assistance directly to recipient countries,preferring to provide financial support to institu-tions with well-developed capabilities for deliver-ing aid effectively in specific program areas.

Low-income countries’ accessto private debt markets

Major debt-relief initiatives have significantlyreduced the debt burdens of many low-

income countries, improving their creditworthi-ness and raising concerns among donors that somecountries may seek financing from commercialsources on nonconcessional terms, compromisingtheir hard-won gains in debt sustainability. To ad-dress this concern, donors have stressed the needto monitor borrowing by low-income countriesclosely and continuously and to assess the poten-tial implications of their borrowing for debt sus-tainability (World Bank and IMF 2006).

How likely are low-income countries, particu-larly those with low debt burdens, to gain accessto international debt markets? Two empiricalstudies suggest that debt relief is but one of severalfactors that affect a country’s ability to attainfinancing from commercial sources. Grigorian(2003) examines 38 cases between 1980 and 2002in which countries issued sovereign bonds for thefirst time. His findings suggest that several internaland external factors can help explain first-timebond issuance. Internal factors include the leveland rate of growth of domestic GDP, per capitaGDP, the current account balance, the fiscal bal-ance, the ratio of external debt to exports, theratio of foreign reserves to imports, and inflation.External factors include international interest ratesand the rate of GDP growth in the United States.Gelos, Sahay, and Sandleris (2004) examine bondissuance by and syndicated bank lending to 144developing countries between 1980 and 2000.Their results point to the importance of sound eco-nomic policies and institutions, as well as vulnera-bility to external shocks, in determining whether

58


countries are able to gain access to private bondmarkets and bank loans.

Countries issuing sovereign bonds for the firsttime in the international market have had a widerange of debt burdens. In the early 1980s, the ex-ternal debt to export ratio was less than 40 percentfor three first-time issuers—Botswana (32 percent),China (33 percent), and Panama (37 percent)—andmore than 300 percent for three others—CostaRica (318 percent), the Philippines (302 percent),and Sudan (684 percent). These figures suggest thata country’s debt burden has not been the dominantfactor determining first-time access to the interna-tional bond market.

Most developing countries have accessedbank lending . . .In 1980, 40 percent of developing countries (54 of135 countries) had contracted at least one syndi-cated bank loan (figure 2.26). This number rosesharply in the early 1980s (with 31 countries gain-ing access between 1980 and 2004) and again inthe early 1990s (with 13 countries gaining accessbetween 1991 and 2003). By 2006 the proportionhad increased to almost 90 percent, leaving just13 of 135 developing countries never having con-tracted a syndicated bank loan.

. . . but few have been able to gain accessto the private bond marketFew developing countries issued external bonds be-fore the late 1980s, when the introduction of Brady

bonds gave rise to the emerging-market segment ofthe international bond market. Despite this devel-opment, by 1990 only 12 percent of developingcountries (16 of 135 countries) had issued sover-eign bonds in the external market (see figure 2.26).Thirty more countries gained access to the privatebond market in the 1990s, but in the last fouryears only three new countries joined the pool, de-spite favorable economic and financial conditionsand the strong surge in private bond flows todeveloping countries. This means that as of2006, just 40 percent of developing countries (56of 135 countries) had issued sovereign bonds atsome point over the previous 27 years. Access tothe private bond market could evolve significantlyover the next few years, as four Sub-SaharanAfrican countries—Ghana, Kenya, Nigeria, andZambia—are expected to issue sovereign bonds ininternational markets for the first time.

Few countries access private debt markets on a frequent basisThe number of countries that access either the ex-ternal bond market or syndicated bank lendingvaries substantially from year to year, in responseto the complex interaction of several supply anddemand factors (figure 2.27). In 2006, 46 percentof developing countries contracted syndicatedbank loans, down from the high of 55 percent in2004 but above the 40 percent average level for1980–2005. The number of developing countriesthat issued sovereign bonds in a given year rose

59

Figure 2.26 Proportion of developing countriesthat accessed private debt markets at least once,1980–2006

0

20

40

80

100

Percent

60

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2002

2000

2006

2004

Source: Dealogic Bankware and Loanware.

Bank lending

Bond issuance

Figure 2.27 Proportion of developing countriesthat accessed private debt markets, 1980–2006

0

20

30

50

60

Percent

40

10

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2002

2000

2006

2004

Source: Dealogic Bankware and Loanware.

Bank lending

Bond issuance


substantially in the first half of the 1990s, averag-ing 23 percent since the mid-1990s. But annualbond issuance has been sporadic in most countries.Only 6 percent of developing countries issue ex-ternal bonds on a frequent basis, compared with38 percent for syndicated bank loans.11

Domestic debt has attracted foreigninvestment in some low-income countriesIn countries with limited or no access to externaldebt markets, the domestic debt market is a poten-tially important source of financing for the publicand corporate sectors, one in which nonresidentinvestors have been known to participate.12

Although domestic markets for sovereign bondsare much more advanced in large middle-incomecountries, there has been progress in developingsuch markets in some low-income countries. Mostdomestic debt issued by governments in low-income countries has traditionally been held bylocal commercial banks. Over the past few years,however, local institutional investors have begunto emerge as more prominent participants in somecountries’ markets—particularly countries inwhich private sector pension funds have evolved—raising demand for low-risk, medium- to long-datedmaturities denominated in domestic currency.More recently, foreign investors (hedge funds andspecialty investment funds in particular) have attimes shown interest in some segments of so-called“frontier markets” for sovereign debt. However,local bond markets are still relatively undevelopedin most low-income countries. The acute lack ofliquidity is a major obstacle to broadening the in-vestor base, particularly for corporate bonds.

It is difficult to get accurate and comprehen-sive measures of foreign investors’ participation indomestic debt markets in low-income countries.Data are not compiled or monitored on an ongo-ing basis in most countries; where they are com-piled periodically, nonresident holdings are oftengreatly underreported and aggregated with othercapital flows. The data that are available indicatethat there has been a significant increase in nonres-ident purchases of sovereign bonds issued byKenya, Nigeria, and Zambia. In Zambia the shareof outstanding public debt held by nonresidentsincreased from a negligible amount in 2004 to20 percent by May 2006, before declining to 13 per-cent by the end of 2006. Foreign investor interestwaned in response to lower yields, which reflected

stronger local investor demand, lower inflationrates, and a decline in the local currency’s valuein the wake of heightened uncertainty about theinvestment climate in the run-up to national elec-tions in September 2006.

Foreign investors have been attracted to thesefledgling bond markets by a combination of fac-tors. Economic and financial fundamentals haveimproved significantly in many low-income coun-tries, reducing investors’ perceptions of risk. Thisis reflected in the decline in emerging-marketbond spreads to record lows in early 2007, whichhas spurred investors to search for higher yieldsin frontier debt markets. Frontier markets pro-vide investors with a wider range of options forattaining their desired risk/return trade-off andsimultaneously broadening the scope for portfoliodiversification.

At the same time, improved macroeconomicstability along with the adoption of more flexibleexchange rate regimes in many low-income coun-tries have enhanced investor confidence, makinginvestors more willing to take on exchange rateand default risk. Dramatic increases in some com-modity prices over the past few years (metals andminerals in particular, see figure 1.19) have led tosizable exchange rate appreciations in commodity-exporting countries (notably Nigeria and Zambia),making some foreign investors more willing to takeon exchange rate risk with the expectation of up-side gains. In addition, debt relief provided underthe HIPC Initiative and the MDRI, along withadditional debt relief provided by the Paris Club ofcreditors, has significantly reduced the debt bur-dens of qualifying countries considerably (WorldBank 2006, p. 94). External debt declined below10 percent of GDP (in net present value terms) in10 of the 18 countries that qualified for debt reliefunder the HIPC Initiative and the MDRI.

Most low-income countries have graduallyliberalized capital controls since the mid-1990s,to the extent that neither capital controls nor taxpolicies, as they appear on the books, remainmajor constraints to foreign participation in mostlocal debt markets. In practice, however, varyinginterpretations of the regulations in some markets,particularly those regarding the remittance of in-terest proceeds, have impeded foreign investment.In some cases, capital controls or tax policies areemployed to channel investment into longer-termsecurities. Withholding tax rates on interest

60


earnings are lower than in many developed coun-tries and do not distinguish between resident andnonresident investors.

Nonregulatory barriers—particularly infor-mation constraints—prevent many low-incomecountries from attracting more foreign participa-tion. Most foreign investors lack the expertise andresources needed to monitor developments in fron-tier markets effectively. This is particularly true forthe smallest and poorest economies, about whichlittle reliable and timely information on economicand financial developments is available. For exam-ple, the lack of comprehensive data on the out-standing stock of domestic debt in most develop-ing countries makes it difficult for foreign anddomestic investors to assess debt sustainabilityand price the risk of debt default. Moreover, manylow-income countries do not have sovereign creditratings, which could help investors assess risks. In-formation constraints can explain why much ofthe existing foreign investment in domestic debtmarkets is channeled through hedge funds andinvestment funds that have developed specializedexpertise in frontier markets.

Despite improvement in domestic macroeco-nomic stabilization policies, low-income countriesare still believed to be subject to greater politicaland economic uncertainty than more developedeconomies. Many countries remain vulnerable tolarge terms-of-trade shocks, which have often ledto large exchange rate depreciations or devalua-tions, which have substantially reduced rates ofreturn. Local bond markets are not immune tosudden reversals in foreign investment at times ofheightened political or economic uncertainty, evenin relatively stable, well-performing economies.For example, in Botswana, an upper-middle-income economy with an investment-grade creditrating, nonresident holdings of local governmentbonds declined from 11 percent in early 2005 tovirtually nothing by the end of 2005, followinga sharp exchange rate devaluation. Maintaining asound monetary and fiscal policy framework, andallowing the exchange rate to adjust to alleviateexternal imbalances, will be critical for preservinginvestor confidence in the face of adverse shocks.

Lack of liquidity is a major problem, particu-larly in secondary markets. Foreign investors oftenrespond by opting for shorter maturities to reducethe risk of having to sell at a steep discount. Do-mestic bond markets in low-income countries are

also characterized by a rather small pool of securi-ties, particularly corporate issues from rated com-panies. If foreign investors came to dominate asegment of such a market, a sudden shift in senti-ment could lead to large movements in interestrates and the exchange rate. This risk is amplifiedwhere foreign investors with short-term horizons(particularly hedge funds) play a prominent role inthe market. The macroeconomic repercussions forthe country could be severe. These concerns pointto the need for developing countries to strive fora healthy balance between their local and foreigninvestor bases and to expand their base of localinstitutional investors as a means of deepening thedemand for longer maturities.

Despite some risks, foreign participation indomestic debt markets could benefit low-incomecountries in several ways. Broadening the investorbase to allow greater participation by foreign in-vestors has the potential to raise demand for bondissues considerably and to diversify issuance acrossa broader spectrum of investors with differing riskprofiles, potentially lowering financing costs andproviding greater liquidity. Foreign participationmay also play a catalytic role in stimulating finan-cial innovation, which can reduce financing costsand improve liquidity. More important, foreign par-ticipation can strengthen incentives for countriesto pursue policy reforms in key areas, includingenhancing transparency; building sound financialregulatory and supervisory institutions; adoptingmodern, internationally recognized accountingstandards; and strengthening the legal system toensure enforcement of creditor claims in the eventof arrears or default.

Because domestic debt is typically denomi-nated in the domestic currency, it reduces a country’svulnerability to the large exchange rate deprecia-tions and devaluations that have contributed to theseverity of most financial crises in emerging mar-kets over the past few decades. The development ofa domestic market for government securities couldhelp provide more flexibility in financing budgetdeficits, reducing incentives for governments tomonetize fiscal deficits.

International financial institutions play aprominent role in helping developing countriesdefine priorities and make progress on a reformagenda that aims to develop domestic debt mar-kets, one of many related elements required fora sound domestic financial system. The World

61


Bank and the IMF, together with developing coun-tries under the Financial Sector Assessment Pro-gram (FSAP), are working to identify vulnerabili-ties in financial systems and recommend reformsneeded to build stronger and more diversified fi-nancial sectors, which often entails developingdomestic debt markets. Moreover, initiatives areunderway to improve the quality to the data ondomestic debt so that borrowers and lenders canmonitor developments in a more comprehensiveand timely manner. The International FinanceCorporation (IFC) provides technical assistance tohelp develop corporate debt markets. The develop-ment of domestic bond markets in developingcountries plays a prominent role in the current G-8policy agenda.13

Prospects for capital flows

After four consecutive years of favorable exter-nal conditions supporting capital flows, there

is a danger that debtors, creditors, and policymakers may become complacent in assessing fu-ture risks. The episodes of financial-market turbu-lence that occurred over the past year, althoughshort-lived, were timely reminders of how suddenswings in investor sentiment can affect financialmarkets with little warning. The Mexican pesocrisis and the Asian crisis are two extreme illustra-tions of this phenomenon. Spreads on sovereignbonds issued by Mexico shot up from 266 basispoints in December 1993 to more than 1,800 injust 16 months. Spreads on Argentina’s sovereignbonds increased from 350 to 1,800 basis pointsover a similar period. In June 1997 bond spreadsin a number of emerging-market economies werebelow 200 basis points; by September 1998spreads in some of those countries (namely,Colombia and Malaysia) approached 1,000 basispoints (figure 2.28). Equity prices dropped sharplyin many of these countries, in several cases bymore than 50 percent (figure 2.29).

History has repeatedly shown that financialcrises are difficult to predict. It would therefore beimprudent not to weigh the risks ahead of a crisisand consider how they might be managed mosteffectively. Capital flows to developing countrieshave leveled off. Global growth is expected toslow modestly over the next few years, and thereis scope for long-term interest rates to rise. Undersuch conditions, capital flows as a share of GDP in

62

Figure 2.28 Emerging-market bond spreads inJune 1997, September 1998, and March 2007

0

400

800

1,200

1,400

Basis points

1,000

200

600

Mala

ysia

China

Korea

, Rep

. of

Poland

Thaila

nd

Colom

bia

Croat

ia

Turk

ey

Panam

aPer

u

Argen

tina

Brazil

Mex

ico


June 1997 Sept. 1998 March 2007

Figure 2.29 Change in emerging-market equityprices, June 1997–September 1998

Sources: Standard & Poor’s/International Finance Corporationcomposite indexes (S&P/IFCI).

�100

�80

�60

�40

�20

0

Indo

nesia

Russia

n Fed

.

Zimba

bwe

Mala

ysia

Thaila

nd

Philipp

ines

Venez

uela,

R. B

. de

Colom

bia

Brazil

Pakist

an

South

Africa

ChilePer

u

Sri La

nka

Nigeria

Turke

y

Mex

ico

Argen

tinaIn

dia

Egypt

, Ara

b Rep

. of

Hunga

ryChin

a

Czech

Rep

ublic

Poland

Percent

recipient countries are likely to decline moderately.Although it is always difficult to pinpoint theprecise timing and severity of a turning point incapital flows, it is nonetheless instructive to con-sider a range of possible outcomes.

Under the “soft-landing” scenario, globalgrowth declines from 4 percent in 2006 to 3.5 per-cent in 2009, consistent with the base-case projec-tion reported in chapter 1 (see table 1.1). In the“hard-landing” scenario, global growth falls moreabruptly, to 2.5 percent in 2009, as the result ofa recession in the United States (see table 1.3). By2009 capital flows are projected to decline from5 percent of GDP in 2006 to 4.75 percent in thefirst scenario and 3.3 percent in the second. Amore abrupt decline in global growth (under the


“hard-landing” scenario) is projected to have agreater impact on net debt flows, which tend to bemore volatile than net equity flows.

Between 2006 and 2009, net FDI inflowsare projected to decline by less than 0.1 percent-age point under the soft-landing scenario and by0.3 percentage point under the hard-landing sce-nario (figure 2.30). The modest impact on projectedFDI inflows of an abrupt decline in global growthreflects the fact that FDI flows do not have a strongcyclical element relative to GDP. (When globalgrowth fell by 2.5 percentage points in 2000–01,for example, there was virtually no change in theratio of FDI to GDP.) In nominal terms, FDI inflowsare projected to continue increasing under bothscenarios, rising from $325 billion in 2006 to$420 billion in 2009 in the first scenario and $377billion in the second.

Portfolio equity flows have been more volatilethan FDI inflows over the historical period con-sidered here. This feature is reflected in the pro-jections. The ratio of portfolio equity to GDP isprojected to decline by a little more than 0.1 per-centage point under the soft-landing scenario andby 0.5 percentage point under the hard-landingscenario. The impact is much greater in nominalterms than in the case of FDI inflows, with portfolioequity flows projected to increase from $90 billionin 2006 to $105 billion in 2009 in the first scenarioand fall to $50 billion in the second.

Net debt flows have been much more volatilethan net equity flows (figures 2.30 and 2.31). Net

debt flows collapsed in the wake of the series offinancial crises that rocked emerging markets in the1990s, toppling from a peak of 2.8 percent of GDPin 1995 to almost zero in 2000. As a percentageof GDP, they have still not recovered to previous lev-els. Volatility in emerging-market bond spreads waseven greater: the EMBI for Brady bonds rose from400 basis points in early 1994 to more than 1,600basis points in early 1995, returning to below 400basis points in mid-1997 before abruptly increasingto more than 1,300 basis points in mid-1998.

Given the volatile nature of net debt flows andemerging-market bond spreads, a high degree ofuncertainty surrounds any projections. Nonethe-less, a projection exercise can be informative inillustrating the extent to which debt flows have beeninfluenced by structural versus cyclical factors.

Under the soft-landing scenario, globalgrowth should moderate to sustainable levelswithout major swings in interest rates or exchangerates. Net debt flows are projected to recede onlyslightly under such conditions—by a little morethan 0.1 percentage point by 2009. In nominalterms they will rise from $152 billion in 2006 to$187 billion in 2009.

The impact of a more abrupt slowdown inglobal growth under the hard-landing scenario iseven more difficult to assess, because there is agreater risk that major swings in interest rates orexchange rates could lead to a sudden swing ininvestor confidence in those emerging-marketeconomies deemed to be most vulnerable. Such

63

Figure 2.30 World GDP growth and net equityflows as a percentage of GDP, 1990–2009


Note: p � projection.

0

1

2

3

4

5

Percent

Global growth

FDI

Portfolio equity

1990

1992

1991

1994

1993

1996

1995

1998

1997

2000

1999

2002

2001

2003

2004

2006

2005

2007

p

2008

p

2009

p

Soft landing Hard landing

Global growth

Net debt flows

Figure 2.31 World GDP growth and net debtflows as a percentage of GDP, 1990–2009


Note: p � projection.

0

1

2

3

4

Percent

5Soft landing Hard landing

1990

1992

1991

1994

1993

1996

1995

1998

1997

2000

1999

2002

2001

2003

2004

2006

2005

2007

p

2008

p

2009

p


swings have often had a major effect on bondspreads in vulnerable economies. But fundamentalshave improved significantly in many countries, andmany of today’s most active borrowers have lowlevels of external and public debt, ample foreignreserves, current account surpluses, flexible ex-change rate regimes, a low and stable inflation en-vironment, and a sound fiscal planning framework.Economies that have made the most progress alongthese lines are not immune to a sharp deteriorationin international financial and economic conditions,but they are less likely to experience a sudden swingin investor sentiment.

Given the improved fundamentals in mostemerging-market economies over the past fewyears, net debt flows are expected to be lessvolatile than in the past few decades. Even underthe hard-landing scenario, the ratio of net debtflow to GDP is projected to decline by 0.5 percent-age point by 2009, decreasing in nominal termsfrom $152 billion in 2006 to $130 billion in 2009.

Volatile periods in equity markets during thepast year have focused investors’ attention on thepossibility that equity prices may be overpriced incertain emerging-market economies. Althoughrecent declines have been relatively minor from ahistorical perspective, concerns persist that a moresubstantial correction could occur in somecountries. Over the past four years, equity priceshave risen by a factor of more than five inArgentina (525 percent), Brazil (520 percent),Colombia (517 percent), Egypt (760 percent),Peru (522 percent), and Russia (538 percent). Asharp correction in equity prices in theseeconomies would be likely to curtail portfolio eq-uity inflows considerably and possibly erode in-vestor confidence.

A downturn in the credit cycle could have amajor impact on low-income countries that arecurrently borrowing on nonconcessional terms.Countries that experience difficulties meeting theirfinancing needs with available concessional loansand grants may resort to financing on less favor-

able terms. Because low-income countries, particu-larly those whose export revenues are dominatedby just a few commodities, are the most vulnerableto external shocks, the danger of overborrowing isreal. A slowdown in global growth is likely to havesome impact on commodity prices elevated byseveral years of strong global demand. A markedslowdown in global demand could have a majorimpact on commodity prices, leading to severerepercussions for commodity exporters. Moreover,the institutional structures of financial markets inmost low-income countries are still relatively unde-veloped, particularly with respect to regulation andsupervision, and there is an acute lack of liquidityin most segments of the domestic debt market. Incountries where foreign investors play a prominentrole in certain segments of this market, a suddenswing in investor sentiment could lead to majorfluctuations in interest rates and exchange rates,possibly with severe macroeconomic repercussions.This is of particular concern for countries that havereceived significant debt relief. Imprudent borrow-ing could endanger debt sustainability over thelong term in the event of adverse shocks, erasingthe hard-won gains of debt relief.

Data limitations make it difficult to ascertainwhether current borrowing activity runs a highprobability of endangering debt sustainability overthe long term. Filling this gap requires increasingthe capacity of low-income countries to report theirborrowing activities accurately and on a timelybasis. A more modern monitoring framework isrequired to enable lenders, borrowers, and policymakers to assess underlying risks on an ongoingbasis, so that preventive measures may be consid-ered. Assessing the risks entailed by foreign partici-pation in domestic debt markets is complicated bythe lack of adequate monitoring systems for track-ing cross-border portfolio investment flows. Non-resident purchases of bonds issued in the domesticmarket should be reported as external debt (consis-tent with the balance of payments convention) andincluded in assessments of debt sustainability.

64


65

Developments between April 2006and March 2007

Developing countries continued to managetheir liabilities in a proactive way over the

past year. In 2006, Brazil, Nigeria, Panama, thePhilippines, and República Bolivariana deVenezuela retired about $12.8 billion in Bradybonds through buybacks and discounted swaps forunsecured bonds, almost completely extinguishingtheir remaining Brady debt. Peru also retired thebulk of its outstanding Brady debt in March 2007.Other parts of the bond market also saw major re-structuring activities as a continuation of strategiesto reduce debt service and improve yield curves.Some of these debt-management operations in-volved restructuring of stressed debt, such asBelize’s $497 million swap transaction.

Debt restructuring in low-income countriesNigeria. In November 2006, Nigeria bought backabout $1.5 billion of Brady par bonds due in 2020under the government’s plan to clear the last of itsLondon Club debt. Nigeria’s London Club debt is inthree parts: Brady par bonds, promissory notes, andoil warrants issued by the central bank in 1991 inconnection with the country’s Brady-style debt re-structuring. Having retired the par bonds last year,the Nigerian government in March 2007 discharged$512 million worth of promissory note payments. Italso retired about $0.37 million of oil warrants outof the total of $1.76 million outstanding, using amodified Dutch auction. The cost of the oil-warrantbuyback is estimated at $82 million. Complete pay-off of London Club creditors in 2007 would reduceNigeria’s external debt from 21 percent of GDP (in2005) to an estimated 3 percent of GDP.

Buybacks and swaps in middle-income countriesBelize. In February 2007, the government of Belizesuccessfully completed the restructuring of itsexternal debt, concluding a swap launched inDecember. Belize renegotiated more than 98 per-cent of its foreign commercial debt with bond-holders, affecting 50 percent of the country’s total

public debt. The government offered to exchange$497 million of foreign debt for new $546.8 mil-lion step-up bonds due in 2029. The new issue car-ries a coupon of 4.25 percent for the first threeyears, 6 percent for years four and five, and8.5 percent thereafter. The new bonds will amor-tize in equal, semi-annual installments beginningin 2019.

Brazil. Brazil’s government carried out threeliability-management operations in 2006. InApril, it exercised a call option at par value toretire all of its remaining $6.5 billion in Bradybonds, marking the end of a campaign to buyback $55 billion of original Brady debt. The op-eration was designed to improve Brazil’s externaldebt profile and interest rate structure. In June,the government bought back about $1.1 billion ofdollar- and euro-denominated global bonds duebetween 2007 and 2030. The deal fell far short ofthe target of $4 billion face value. The buybackinvolved 20 bonds of various types, includingboth short-maturity bonds and longer-dated off-the-run bonds. In August, Brazil reopened its2037 bond in the amount of $500 million in ex-change for five illiquid global bonds due between2020 and 2030. The swapped amount was muchlower than the expected $1.5 billion because in-vestors were less receptive than the governmenthad hoped.

Colombia. In September 2006, Colombiabought back $469.4 million of its global bonds duein 2020, 2027, and 2033, using part of the proceedsfrom the issuance of a new $1 billion global bonddue in 2037. The new issue was priced to yield 250basis points above the U.S. Treasury rate, with a7.125 percent coupon. The transaction reflects thecountry’s proactive liability-management and fund-ing strategy. In February 2007, the Colombiangovernment announced its plans to buy back bothexternal and domestic bonds using excess tax rev-enues and privatization windfalls.

Mexico. Between August 2006 and March 2007,Mexico carried out three liability-managementoperations to restructure about $8.9 billion of its

Annex 1: Commercial DebtRestructuring


66

outstanding external debt. In August 2006, Mex-ico carried out a surprise buyback of $3.4 billionin global bonds due between 2007 and 2033 afterraising more than expected in a domestic bond ex-change. The buyback was part of the government’sstrategy to reshape its debt profile by moving fromexternal to domestic debt. In January 2007, thegovernment reopened its global 2034 bonds foran amount of $2.3 billion and paid $400 millionin cash for $2.8 billion in shorter, higher-coupon,and less liquid bonds maturing between 2019 and2033 (mostly in 2033). In March 2007, itlaunched another round of exchange warrants toswap about $2.7 billion of hard-currency bondsfor local-currency debt later in the year.

Panama. In July 2006, Panama retired the lastof its outstanding Brady debt (originally $3.23 bil-lion) by exercising a call option for about $352 mil-lion in bonds. Eligible for the buyback were$9 million in par bonds, $13.2 million in discountbonds, $108.6 million in interest-rate-reductionbonds, and $220 million in past-due-interestbonds. Bonds were redeemed at par with accruedinterest. The operation was financed by the gov-ernment’s excess liquidity and a $320 million creditfacility from Barclays Capital. According to thegovernment, the deal cut its total external debtstock by $30 million and reduced its debt serviceby about $19 million per year for the next 10 years.

Peru. In February 2007, the Peruvian govern-ment concluded a liability management operationto swap and buy back about $2.5 billion in out-standing Brady bonds (FLIRB, PDI, pars, and dis-counts) and global 2012 bonds for new securitiesand cash. The government bought back about$1 billion of global 2012 bonds with cash and inexchange for bonds due in 2016 and 2033. It alsoissued $1.2 billion in new global 2037 bonds inexchange for approximately $1.5 billion in Bradybonds. The new bond, which carries a coupon of6.55 percent, will be the country’s longest-maturity external bond. The sovereign also soldabout $88 million of reopened local 2026 bondsto help finance the cash portion of the deal. This debt-management operation was part of the gov-ernment’s strategy to reduce its borrowing costsand extend the maturity of its debt.

The Philippines. In 2006, the Philippines un-dertook two buyback operations to retire about$575 million in Brady bonds. The sovereign alsocompleted a debt-exchange operation to swap

about $1.2 billion of expensive debt. In the firstbuyback, in June, the government exercised calloptions to redeem $410 million of interest-reduction bonds. The deal yielded a saving ofabout $32 million in interest payments and re-leased underlying collateral of about $256 million.In December, the government also redeemed itsoutstanding floating-rate bonds and interest-reduction bonds, worth about $165.3 million.This operation was financed entirely from officialgovernment reserves. In September, the Philippinesissued $764 million in new, amortizing bonds duein 2024 and reopened its 2031 bond in theamount of $435 million in exchange for $1.2 bil-lion of global bonds due between 2007 and 2017.Some holders of 2024 and 2025 bonds were alsoinvited to participate in the 2031 reopening. Thenew issue was priced to yield 7.38 percent at aspread of 200 basis points over the U.S. Treasuryrate. In March 2007, the Philippines announcedthat it would redeem $126 million in outstandingBrady bonds during the second quarter of 2007,marking the end of the country’s history withBrady bonds.

Turkey. In September 2006, Turkey carriedout its first international liability management op-eration by swapping seven short-dated bonds duebetween 2007 and 2010 and $330 million in cashfor new 10-year global bonds valued at $1.5 bil-lion. The new issue carries a 7 percent coupon andwas priced at 183 basis points over mid-swap, fora semi-annual yield of 7.12 percent. The exchangewas intended to smooth out the country’s redemp-tion profile, extend the average maturity, and es-tablish a more favorable yield curve. The countryhad previously made domestic bond exchanges.For example, in 2001 it swapped lira bonds valuedat $8.4 billion for U.S. dollar–indexed bonds.

Uruguay. In November 2006, Uruguay boughtback $1.14 billion in global bonds, including thoseit had restructured three years ago to avoid default.The government offered to swap up to $2.2 billionin global bonds maturing in 2019 or before, andone maturing in 2027. Investors were to be paid incash (up to $400 million) or in longer-dated securi-ties. In exchange for the old bonds, Uruguay willissue about $879 million of new bonds, including$602 million of 8 percent bonds due in 2022 and$277 million of 7.625 percent bonds due 2036.Earlier in the year the sovereign raised $800 mil-lion through peso- and dollar-denominated bonds,


financing the exchange through a $500 million re-opening of its 2036 bonds and the reopening of$300 million worth of existing inflation-linked2018 peso bonds.

República Bolivariana de Venezuela. In 2006,the Venezuelan government carried out twostraight buyback operations to retire an estimated$3.9 billion of outstanding Brady bonds, joiningBrazil, Colombia, and Mexico in paying off the

old obligations. In April, the sovereign boughtback about $2.9 billion in Brady bonds, includingSeries A fixed-rate par bonds maturing in 2020and Series A floating-rate discount bonds matur-ing in 2020. The buyback was mostly financed byreserves in various government funds. In May, thegovernment repurchased all of its outstanding parand discount Brady bonds maturing in 2020(Series B).

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Restructuring of intergovernmental loans and offi-cially guaranteed private export credits takes placeunder the aegis of the Paris Club. The agreementsare concluded between the debtor government andrepresentatives of creditor countries. The ParisClub treats each borrower individually, by consen-sus of all creditor countries. Most terms fall withinone of the following categories, listed below inorder of increasing concessionality:

• “Classic terms” signify the standard treatment(countries must have an appropriate programwith the IMF showing the need for Paris Clubdebt relief).

• “Houston terms” are reserved for highly in-debted lower-middle-income countries.

• “Naples terms” apply to highly indebted poorcountries.

• “Cologne terms” are for countries eligible forthe Heavily Indebted Poor Countries (HIPC)Initiative.

To make the terms effective, debtor countriesmust sign a bilateral implementing agreement witheach creditor.

Moldova. Following the IMF’s approval onMay 12, 2006, of Moldova’s arrangement underthe Poverty Reduction and Growth Facility(PRGF), Paris Club creditors agreed to consolidateroughly $150 million due on debt contracted be-fore December 2000, of which $68 million was inarrears and $82 million maturities falling due. Thematurities are being restructured on Houstonterms. The agreement is expected to reduce thecountry’s debt service from $149.9 million to$60.8 million and to satisfy Moldova’s financingrequirements for 2006–08.

Grenada. On May 12, 2006, Paris Club credi-tors agreed to a restructuring of Grenada’s exter-nal public debt, estimated at $17 million, follow-ing the IMF’s approval in April of the country’sarrangements under the PRGF. The agreementreschedules roughly $16 million in arrears and

maturities falling due and reduces by more than90 percent the debt service due to Paris Clubcreditors. The terms of the rescheduling were asfollows: medium- and long-term claims are to berepaid progressively over 12 years, including5 years of grace. Loans made as official develop-ment assistance will be rescheduled at a rate nothigher than the interest rate of the original loan.Other loans are to be rescheduled at a marketinterest rate.

Cameroon. In April 2006, Cameroon reachedthe completion point under the Enhanced HIPCInitiative. To help restore the country’s ability tosustain its debt, the Paris Club decided on June 17,2006, to cancel debt valued at $921 million innominal terms. Creditors also committed on abilateral basis to grant additional debt relief sothat the stock of debt owed to Paris Club creditorswould be reduced by a further $2,554 million. Asa result, the country’s debts will be reduced from$3,502 million to $27 million.

Afghanistan. Following the IMF’s approval ofa PRGF arrangement on July 19, 2006, Paris Clubcreditors agreed to a significant reduction ofAfghanistan’s external debt under Naples terms.The stock of debt owed to Paris Club creditorswas estimated at $411.3 billion. The agreementconsolidates $2.4 billion, cancels $1.6 billion,and reschedules $0.8 billion. On an exceptionalbasis, this agreement also defers 100 percent ofthe moratorium interest due over the consolida-tion period, with repayments to be made afterOctober 2011.

Malawi. In August 2006, Malawi reached thecompletion point under the Enhanced HIPC Initia-tive. As a means of restoring Malawi’s debt sus-tainability, the Paris Club, on October 19, 2006,canceled debt worth $137 million in nominalterms. Most creditors also committed on a bilat-eral basis to grant additional debt relief of$217 million in nominal terms. As a result,Malawi’s debt to Paris Club creditors will be re-duced from $464 million to $9 million. Malawi

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Annex 2: Debt Restructuringwith Official Creditors


agreed to allocate the resources freed up by debtrelief to priority areas identified in the country’spoverty reduction strategy.

Haiti. In November 2006, Haiti reached thedecision point under the Enhanced HIPC Initia-tive. A Paris Club agreement concluded underCologne terms on December 12, 2006, consoli-dated around $69 million in debt, of which$45 million consisted of arrears and late interest.An amount of $7.2 million was immediately can-celed. On an exceptional basis, the agreement de-fers 100 percent of the moratorium interest dueover the consolidation period, repayment of whichis to begin in November 2010. Haiti’s economicprogram is supported by a three-year arrangementunder the PRGF approved by the IMF. Haiti’s debtto Paris Club creditors was estimated to be$199 million in October 2006. Paris Club credi-tors have signaled their willingness to makefurther reductions in Haiti’s debt as soon asthe country reaches the completion point underthe Enhanced HIPC Initiative.

Notes1. Figure 2.3 shows foreign exchange reserves in

each of the countries as a percent of GDP in all developingcountries.

2. The London Club is an informal group of commer-cial banks that join together to negotiate their claims againstsovereign debtors.

3. See annex 1 of this chapter for more detailed infor-mation on commercial debt restructuring activities in 2006.

4. Gross “bank lending” (table 2.4) reported by theWorld Bank’s Debtor Reporting System (DRS) exceededcross-border loan commitments (table 2.5) reported inLoanware by almost $100 billion in 2006. The large dis-crepancy, concentrated in Europe and Central Asia, grewsubstantially over the past five years. Much of the increasereflects the fact that “bank lending” as defined in the DRSincludes interbank loans and trade credit, which are not in-cluded in the Loanware definition.

5. The figure for banks domiciled in high-incomecountries refers to syndicated loan transactions involvingsolely the participation of banks domiciled in thesecountries.

6. Data on bilateral loan commitments are not readilyavailable.

7. World Bank staff estimates.8. These figures are based on countries for which

reliable data are available. For many developing countries,data on public debt are either unavailable or of dubiousquality.

9. Cross-border merger and acquisition purchases bymultinational companies located in developing countries areexpected to reach about $100 billion in 2006.

10. World Bank and IMF (2006b). This calculationdoes not include Haiti, which reached the decision point inOctober 2006.

11. “Frequent basis” is defined as countries that issuedbonds in more than 22 of the 27 years in the sample.

12. From the perspective of the balance of payments,international capital flows are defined with reference to theresidency of the creditor, not the legal jurisdiction in whichthe bond is issued or the bank loan contracted. In contrast,the measure of external bonds examined here is definedwith reference to the legal jurisdiction and hence does nottake into account nonresident purchases of bonds issued inthe domestic market.

13. In February 2007 the G-7 finance ministers metwith their counterparts from Brazil, China, India, Mexico,Russia, and South Africa to discuss a proposal to promotethe development of local and regional bond markets in low-income countries, with a focus on countries in Sub-Saharan Africa. A high-level conference was held on May9–10, 2007, in Frankfurt to make recommendations.

References

Brainard, Lael. 2006. “Private Philanthropy HighlightsNeed for U.S. Foreign Aid Changes.” Brookings Insti-tution, Washington, DC. http://www.brookings.org/views/op-ed/brainard/20060906.htm.

Broadman, Harry. 2006. Africa’s Silk Road: China andIndia’s New Economic Frontier. Washington, DC:World Bank.

Desai, Mihir A., C. Fritz Foley, and James R. Hines, Jr.2004. “Dividend Policy inside the MultinationalFirm.” NBER Working Paper 8698, National Bureauof Economic Research, Cambridge, MA.

Foundation Center. 2006. “International Grant-MakingUpdate: A Snapshot on U.S. Foundation Trends.”October. New York.

Gelos, Gaston, Ratna Sahay, and Guido Sandleris. 2004.“Sovereign Borrowing by Developing Countries: WhatDetermines Market Access?” IMF Working PaperWP/04/221, International Monetary Fund, Washington,DC.

Government of China. 2006. “China’s African Policy”(January).

Grigorian, David. 2003. “On the Determinants of First-Time Sovereign Bond Issues.” IMF Working PaperWP/03/183, International Monetary Fund, Washington,DC.

International Energy Agency. 2006. World Energy Outlook2006. Washington, DC: International Energy Agency.

JPMorgan Chase. 2007. “Emerging Markets Debt andFiscal Indicators” (April 10).

Lehmann, Alexander, and Ashoka Mody. 2004. “Interna-tional Dividend Repatriations.” IMF Working Paper04–05, International Monetary Fund, Washington, DC.

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Mohapatra, Sanket, Dilip Ratha, K. M. Vijayalakshmi, andZhimei Xu. 2006. “Remittance Trends 2006.” Migra-tion and Development Brief 2. Development ProspectsGroup. World Bank, Washington, DC.

Moss, Todd, and Sarah Rose. 2006. “China’s Export-Import Bank and Africa: New Lending, New Chal-lenges” (November). Center for Global Development,Washington, DC.

World Bank. 2004. Global Development Finance 2004.Washington, DC: World Bank.

. 2005. Global Development Finance 2006.Washington, DC: World Bank.

. 2006. Global Development Finance 2006.Washington, DC: World Bank.

World Bank and IMF (International Monetary Fund). 2006.“Review of Low-Income Country Debt SustainabilityFramework and Implications of the MDRI.” March 27,Washington, DC.

. 2006b. “Heavily Indebted Poor Countries (HIPC)Initiative and Multilateral Debt Relief Initiative(MDRI)—Status of Implementation.” (August 21)Washington, DC.

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3The Globalization of Corporate Finance in Developing Countries

CORPORATIONS BASED IN DEVELOP-ing countries are raising vast sums of capi-tal on global markets on an unprecedented

scale. Indeed, the growing profile of such compa-nies, both public and private, in global investmentand finance is a defining feature of the current cycleof capital flows to developing countries. Firmsbased in developing countries raised $156 billionthrough international offerings of corporate debtand equity in 2006; syndicated bank loans to suchcompanies reached a record $245 billion; and cross-border mergers and acquisitions (M&A) involvingcompanies from developing countries bidding forforeign targets amounted to $100 billion. Theworld’s top Fortune 500 companies include 40 fromthe developing world, and the 394 developing-country firms traded on the world’s major stockexchanges account for one-third of all global over-seas cross-listings.

Developing countries stand to reap substantialbenefits from the access their corporations havegained to the world’s major financial centers, withtheir deep and liquid financial resources, broadinvestor bases, and modern trading platforms.The potential to redirect scarce domestic capital tohigh-priority purposes, such as rural developmentand small-scale business, without crowding outthe corporate sector is a valuable solution to atrade-off that has bedeviled development for half acentury.

Access to international capital markets is farfrom automatic. Companies qualify by complyingwith standards for financial accounting, disclo-sure, and corporate governance mandated by host-country exchanges and regulatory bodies. Most ofthe firms that have been able to access interna-tional capital markets are large, have high growth

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.

potential, and come from the banking, infrastruc-ture, and mining industries. Others have estab-lished a global presence through trade, investment,or strategic M&A.

This chapter highlights the growing global im-portance of corporations based in developingcountries and the implications of their ascent fordevelopment finance. It examines the factors thatinfluence corporations’ decisions to pursue exter-nal financing and how access to international cap-ital markets affects the cost of capital and thereturns on assets. The evidence and analysis pre-sented are based on information gathered fromfirms about their external financing practices. Thedata cover nearly every company in the developingworld that raised funds on global capital marketsbetween 1990 and 2006 or listed shares on one ofthe world’s major stock exchanges. The key mes-sages are highlighted below.

• Global borrowing by developing-countryfirms has surged in recent years and its patternshifted, with borrowers originating in emerg-ing Europe and Central Asia now in the fore-front. With ample global liquidity and rapidgrowth in developing countries underpinninggrowing demand among international in-vestors for developing-country corporate as-sets, the markets have responded by offering anew generation of credit and equity productsdesigned to finance corporate activity inemerging markets. Since 2002, 422 emerging-market companies have tapped internationalbond markets at least once, 537 contractedbank loans on the international syndicatedmarket, and 360 raised capital on one of theglobal major overseas exchanges. Total foreign


capital raised through these instrumentsreached $1.04 trillion, up from $300 billion inthe previous three years.

The home bases of the major borrowershave changed as well. In the early 1990s, EastAsian corporations were the major borrowers;from 1997 to 2001, Latin American firms ledthe way. Since then, firms from emergingEurope and Central Asia, particularly banks,have come to the fore and now account for39 percent of total external borrowing by cor-porations in developing countries. Many areborrowing primarily to finance oil and gasand banking operations.

Transactions have also grown in size,with bond financing increasingly common.Large deals have brought greater liquidity tosecondary markets and stimulated the devel-opment of a market for credit default swapson emerging corporate debt.

• The pace of corporate globalization in the de-veloping world is likely to intensify in themedium term, subject to fluctuations in thebusiness cycle and cyclical changes in globalfinancial conditions. Improved domestic poli-cies and favorable international economicconditions have enhanced the ability of corpo-rations based in developing countries to accessinternational finance. Progressive trade and in-vestment liberalization, competitive pressures,and rapid change in technology are pushingmany to build a global presence throughM&A, trade, and investment. Cross-borderM&A by developing-country multinationalshas been on the rise in recent years, increas-ing from $400 million in 1987 (when thesecountries accounted for less than 1 percent ofglobal M&A transactions) to almost $100 bil-lion in 2006 (almost 9 percent of global M&Atransactions). Emerging-market corporatesecurities offer substantial opportunities for di-versification and growth-related gains to inter-national investors. Official and institutionalinvestors from emerging economies are awarethat they are among those who stand to gain;they have been adding corporate assets to theirinvestment portfolios as a way of enhancinglong-term financial returns. The state foreigninvestment corporation recently set up by theChinese authorities has a broad investmentmandate (encompassing energy and natural

resources) that could stimulate demand foremerging corporate assets and securities.

• Concerns are growing that corporate creditspreads may not fully reflect credit quality andthat corporations may be underestimatingglobal risk aversion. With global financialmarkets operating in recent years with un-precedented liquidity, heightened risk appetiteamong investors, and a spectrum of newplayers and actors, the possibility of corporatecredit spreads underestimating their long-termequilibrium levels is a real one. Favorableglobal financial conditions have reduced thecost of external financing to corporationsbased in developing countries not only directly,through lower international interest rates, butalso indirectly, by enhancing their creditwor-thiness as the value of their collateralizableassets increases. Such factors could encourageexcessive corporate borrowing, particularly inthe context of weak corporate governance andpoor supervision, engendering boom-and-bustcycles, with dire implications for growth andwelfare. Excessive corporate borrowing canalso limit the government’s capacity to issuesovereign debt on international markets.

• Managing these risks requires a comprehensiveresponse, from the level of the firm to themacroeconomic level. Credible commitment tocapital market development, greater financialtransparency, sound exchange rate systems(floating or under the European MonetarySystem [ERM II]), government regulation, andprudential oversight of banks’ foreign currencyborrowing can go a long way in mostcountries toward reducing the likelihood ofexcessive corporate borrowing and financialinstability. For banks, strong monitoring andsupervision, including prudential limits onforeign borrowing, are needed to ensure loanquality and the maintenance of adequate capi-tal reserves. Where supervision is less thanstringent, risks can be great—and they arerarely confined to the country in which therisky borrower is based. Several countries, par-ticularly in emerging Europe and Central Asia,are now experiencing a credit boom, spear-headed by banks of untested financial healthand stamina that have gained access to inter-national credit markets partly because globalliquidity is so great and competition in the

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international banking industry so intense.Concerns are growing that some of thesebanks—particularly in Estonia, Hungary,Kazakhstan, Latvia, Lithuania, Russia, andUkraine—are increasing their foreign ex-change exposure to levels that have the poten-tial to jeopardize financial stability.

For nonfinancial corporations, policymakers must create an enabling framework inwhich businesses can manage risks whilebuilding a balanced capital structure that willembrace both local and foreign financingsources. As most firms tapping internationaldebt markets tend to be large and relativelyhighly leveraged, they raise difficult publicpolicy concerns in the event of an adverseturn in the global financial climate. Whilecorporate decisions to raise capital on over-seas markets should be left primarily to mar-ket forces, pubic policy has an important roleto play in situations in which corporate finan-cial distress could spill over to the bankingsector, raising systemic risk. High levels ofcorporate debt also challenge policy makersand market participants to devise new toolsto measure and assess credit risk, market risk,and operational risk within the macroeco-nomic and regulatory context of developingcountries.

• Good policies reduce the cost of capital. Inter-national investors care about the macroeco-nomic, political, and institutional settings inwhich issuing companies operate. Such consid-erations define the entry and exit points forthe cross-country allocation and managementof investment portfolios. The econometricanalysis conducted for this report finds that a10 percent reduction in a country’s perceivedeconomic risk decreases corporate bond spreadsby 52 basis points, while a 10 percent declinein perceived financial risk reduces spreads by63 basis points—roughly equivalent to a credit-rating upgrade of two notches. The importanceof sound macroeconomic management is par-ticularly evident in the impact of higher growthand lower inflation on the spreads available tocorporate borrowers. Investments in financialinfrastructure to strengthen legal, regulatory,and supervisory institutions for local equity anddebt markets also reduce spreads for emergingcorporate borrowers.

• Greater coherence is needed in internationalstandards for cross-border listings and publicofferings of securities. In the years ahead,policy makers in both developed and develop-ing countries will be called upon to simplifythe complex international system for cross-border offering and listing of corporate securi-ties. A simpler system would greatly enhanceefficiency in the global allocation of capital.Currently, national accounting standards, dis-closure rules, corporate governance structures,and enforcement systems associated withequity financing vary widely across countries.Complying with several sets of rules can becostly for firms, raising their cost of capital ordeterring them from cross-listing. Market pres-sures and action by international regulatorshave brought some degree of convergence incertain areas, notably accounting standards(led by the International Accounting StandardsBoard). Mutual recognition of national regula-tions that meet a common minimum standardhas also been used, within the European Unionand, in certain areas, between the United Statesand Canada. But the need remains to strike abalance between regulations and market incen-tives in managing cross-border offerings andlistings on major exchanges. The wave ofconsolidations, mergers, and strategic alliancesthat have swept the world’s major stock ex-changes make this need even more acute.

The rapidly evolving corporate sectorin emerging economies The internationalization of corporate financehas followed several distinctive patterns

Mirroring broader global trends, corporatefinance in developing countries is taking on

an increasingly transnational character. The twinforces of internationalization of business activityand integration of financial markets are pushingcompanies to minimize their cost of capital bydiversifying their funding sources, building a long-term investor base, and increasing their interna-tional recognition.

Firms are funding their investment spending,cross-border acquisitions, and operating needsthrough a mix of local and foreign financing. Newcapital raised through corporate securities offer-ings and loans from international bank syndicates

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totaled $400 billion in 2006, a threefold increasefrom 2003 (figure 3.1). Since 2002, 422 companiesfrom developing countries have issued bonds oninternational markets, 348 of them for the firsttime. Relatively easy financing conditions in bank-ing markets have raised the number of internationalsyndicated loans to 2,497 since 2002, swelled theirvolume, and spread loan activity more broadlyacross countries and regions.

Growing numbers of firms are opting tocross-list their shares on major stock exchangesaround the world as a way of inducing foreign in-vestors to trade in their shares, establish an inter-national profile, and preserve their options formeeting future capital needs.1 Of the 1,574 foreigncompanies listed on major global stock exchangesin 1998, only 206 (13.1 percent) were based in de-veloping countries. By 2006 that percentage hadmore than doubled, with 394 (29.7 percent) of the1,328 foreign companies listed based in the devel-oping world. One-third of all companies nowcross-listed on their own and foreign marketscome from developing countries (figure 3.2).

Twenty middle-income countries account formost of the participation of developing-countryfirms in international capital markets, with Brazil,China, India, Mexico, and Russia most heavily rep-resented. With an average per capita income in2006 of $4,805, these countries accounted for95 percent of total bond issuance, 85 percent of

total bank borrowing, and 95 percent of totalequity offerings by developing-country companies(table 3.1). These 20 countries—home to 67 percentof the developing world’s population and the sourceof 78 percent of its GDP—are distinguished by theirlevel of development, growth potential, openness tocapital transactions, size and growth of their localequity markets, external financial position, andcountry risk status. Recent or potential membersof the European Union within the group are alsounder pressure to catch up with their peers. The20 countries have an aggregate stock market capi-talization of $5.3 trillion, 88 percent of the totalfor the developing world and 10 percent of the totalfor the entire world. Their 12,557 publicly tradedcompanies represent 95 percent of all those based indeveloping countries. Substantial foreign exchangereserves, rapid industrial growth, and relativelyflexible exchange-rate regimes are other importantcharacteristics that distinguish these countries fromthe rest of the developing world (table 3.2).

The macroeconomic stances and growthprospects of these 20 countries are largely positive.Nevertheless, several aspects of the participation oftheir corporations in global capital markets meritcareful attention. First, the rapid growth in exter-nal debt contracted by firms over the past fouryears may represent a trend whose potential impli-cations are not yet well understood. Second, as thepattern of corporate external borrowing has shifted

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01998 1999 2000 2001 2002 2003 2004 2005 2006

50

100

150

200

250

300

350

400

450

$ billions

Source: World Bank staff estimates based on data from New YorkStock Exchange (NYSE), NASDAQ, London Stock Exchange (LSE),Luxembourg Stock Exchange, and Dealogic.

Figure 3.1 Foreign capital raised by developing-country corporations, 1998–2006

Syndicated bank loans Bond issuesEquity offerings

0

100

1998 1999 2000 2001 2002 2003 2004 2005 2006

200

300

600

400

500

0

5

10

15

20

25

30

Number of companies Percent

Figure 3.2 Foreign companies listed on majorglobal stock exchanges, 1998–2006

Source: World Bank staff estimates based on data from NYSE,NASDAQ, LSE, Luxembourg Stock Exchange, and the WorldFederation of Exchanges.

Percentage of totalforeign companies

Number ofdeveloping-country

companies


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Table 3.1 Capital raised through equity issues, bond issues, and syndicated bank borrowing by firmsin selected middle-income countries, 1998–2006$ millions

Syndicated bankCountry Equity issues Bond issues borrowing Total

Argentina 1,321 6,911 33,719 41,951Brazil 8,798 56,051 100,226 165,076Chile 453 11,537 43,749 55,739China 71,997 14,168 80,304 166,469Colombia 0 516 9,229 9,744Egypt, Arab Rep. of 1,134 2,282 19,093 22,508Hungary 252 7,247 17,817 25,316India 13,398 8,140 49,441 70,978Indonesia 4 7,635 18,402 26,041Iran, Islamic Rep. of 0 0 18,775 18,775Kazakhstan 902 15,773 19,643 36,319Lebanon 896 1,645 344 2,885Malaysia 28 16,633 38,259 54,920Mexico 5,567 48,012 97,822 151,401Philippines 134 7,841 20,836 28,811Poland 1,655 5,684 30,186 37,524Russian Federation 14,052 63,222 98,522 175,797South Africa 1,663 14,248 32,396 48,307Thailand 1,207 3,725 26,711 31,643Turkey 1,589 9,049 72,432 83,069

Total 125,051 300,318 827,905 1,253,273As percentage of all developing countries 94.3 92.5 82.5 85.7

Source: World Bank staff estimates based on data from Dealogic Bondware, Loanware, and Equityware; NYSE; NASDAQ; LSE; andLuxembourg Stock Exchange.

in recent years from East Asia and Latin Americato Europe and Central Asia, with significant in-volvement by local commercial banks in borrowingand intermediation, the importance of regional fac-tors (notably integration within the EuropeanUnion) and bilateral lending have become promi-nent. Third, despite much recent improvement inthe credit fundamentals of many developing coun-tries, their access to the global corporate bond mar-ket remains vulnerable to sudden shifts in investorsentiment and to adverse turns in the global creditcycle. Each of these points is discussed below.

Substantial foreign capital has been raisedin the form of debt Private and state-owned corporations in develop-ing countries have borrowed in international debtmarkets on an unprecedented scale in the past fewyears. In 2006 they raised $333 billion throughsyndicated bank loans and international bondissuance, up sharply from $88 billion in 2002(table 3.3). Private sector companies accounted formore than 60 percent of total bank borrowing and75 percent of new bond issuance during 2002–06;they also propelled much of the increase in bor-

rowing. Regionally, firms from emerging Europeand Central Asia stand out, having contracted$135 billion in debt in 2006.

Financial corporations, particularly commercialbanks from India, Kazakhstan, Russia, and Turkey,have been at the forefront of what appears to be amajor foreign credit boom. Banks have tapped inter-national debt markets to fund their growing domes-tic loan portfolios and to meet increasing capitaladequacy requirements. Faced with competitivepressures and highly liquid markets, internationalbanks have been eager to lend at narrower marginsand on longer terms to a wider range of borrowers.

Foreign borrowing by companies in emergingmarkets has occurred in several distinct phases,mirroring the growth of industrial production inthe countries from which companies have bor-rowed (figure 3.3). Companies from East Asiawere the heaviest borrowers in the early 1990s.After the East Asian economic crisis, they weresucceeded by companies from Latin America. Be-tween 1997 and 2001, the share of Latin Americancompanies in emerging-market corporate banklending more than doubled, to an average of 46 per-cent, from an average of 22 percent between 1990

GL

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78 Table 3.2 Performance indicators of selected developing countries

Growth potential Local stock market growth Country risk rating, Foreign exchange reserves(annual %, 1990–2005)a (annual %, 2004–06)b 2000–06c (change in % of GDP, 1997–2005)d

China 9.7 Ukraine 87.7 Chile 78.6 Equatorial Guinea 64.1Lebanon 7.6 Egypt, Arab Rep. of 84.3 Malaysia 77.9 Algeria 38.1Vietnam 7.4 Colombia 65.0 Trinidad and Tobago 76.9 Malaysia 33.3Myanmar 7.3 Romania 58.3 China 76.1 Yemen, Rep. of 27.3Cambodia 7.1 Lebanon 51.7 Latvia 75.8 Bosnia and Herzegovina 24.8Malaysia 6.5 Russian Federation 50.8 Poland 75.3 Solomon Islands 24.0Maldives 6.5 Venezuela, R.B. de 48.5 Hungary 75.1 China 22.1Mozambique 6.4 Jordan 45.6 Estonia 75.0 Trinidad and Tobago 20.1Uganda 6.3 Argentina 43.5 Lithuania 74.7 Russian Federation 19.9Lao PDR 6.3 Mexico 42.5 Slovak Republic 74.5 Morocco 19.1Belize 6.0 Indonesia 40.6 Russian Federation 73.7 Ukraine 18.9India 6.0 Hungary 40.5 Mexico 73.5 São Tomé and Principe 18.3Chad 5.7 Bulgaria 40.4 Thailand 73.5 Slovak Republic 17.0Chile 5.6 Estonia 38.8 Croatia 73.4 Honduras 16.7Yemen, Rep. of 5.6 Peru 36.6 Morocco 73.4 Lebanon 15.2Bhutan 5.5 Botswana 36.3 Tunisia 73.0 Macedonia, FYR 14.4Botswana 5.3 Bangladesh 35.0 Costa Rica 73.0 Guinea-Bissau 13.8Cape Verde 5.2 Ecuador 34.9 Kazakhstan 72.6 Kyrgyz Republic 13.6Jordan 5.2 Jamaica 34.3 Panama 72.5 Jamaica 13.3Sudan 5.2 Mauritius 33.4 Jordan 72.3 Cape Verde 13.2Thailand 5.2 India 32.6 El Salvador 71.2 Congo, Rep. of 11.8Bangladesh 5.0 South Africa 32.4 Bulgaria 70.9 Croatia 11.6Panama 5.0 Morroco 31.2 South Africa 70.8 Thailand 11.6Iran, Islamic Rep. of 5.0 Sri Lanka 30.8 Vietnam 70.3 Uruguay 11.2Mauritius 4.9 Kenya 29.8 Peru 69.5 Rwanda 11.0Eritrea 4.9 Latvia 29.3 Guatemala 69.3 India 10.7Syrian Arab Republic 4.9 Pakistan 29.2 Syrian Arab Republic 69.3 Jordan 10.5Tunisia 4.9 Côte d’Ivoire 29.0 Jamaica 69.2 Bulgaria 10.2Sri Lanka 4.9 Brazil 28.6 Uruguay 69.1 Vietnam 9.9Indonesia 4.8 Poland 27.4 Gabon 69.1 Romania 9.7Costa Rica 4.7 China 26.8 Iran, Islamic Rep. of 69.0 Cambodia 9.3Trinidad and Tobago 4.5 Philippines 26.8 Philippines 68.9 Ghana 9.0Ghana 4.5 Turkey 26.5 Algeria 68.8 Tanzania 8.9Benin 4.5 Oman 23.7 Ukraine 68.6 Sierra Leone 8.3Tanzania 4.4 Tunisia 23.5 Azerbaijan 68.4 Barbados 7.9Mali 4.4 Croatia 23.4 Egypt, Arab Rep. of 68.4 Dominica 7.8Egypt, Arab Rep. of 4.4 Nigeria 22.9 India 68.1 Papua New Guinea 7.8Mauritania 4.4 Lithuania 21.8 Romania 67.9 Nepal 7.7Nepal 4.3 Bahamas 18.0 Dominican Republic 67.9 Nigeria 7.7Turkey 4.3 Chile 17.7 Gambia, The 67.5 Philippines 7.4Pakistan 4.3 Namibia 17.4 Bolivia 66.9 Pakistan 7.0Dominican Republic 4.2 Malaysia 11.6 Brazil 66.8 Grenada 6.7Burkina Faso 4.0 Trinidad and Tobago 9.3 Yemen, Rep. of 66.7 Paraguay 6.6Oman 4.0 Ghana 4.4 Mongolia 66.2 Mongolia 6.3Nigeria 3.9 Thailand �2.9 Albania 66.2 Angola 6.2El Salvador 3.9 Argentina 65.8 Sudan 6.0St. Kitts and Nevis 3.8 Papua New Guinea 64.6 St. Vincent and the Grenadines 5.8Angola 3.7 Senegal 64.6 Cameroon 5.6Guinea 3.7 Belarus 64.5 Senegal 5.5Senegal 3.6 Cameroon 64.3 Mongolia 6.3

Sources: World Bank (various years) and World Bank staff estimates.a. Average historical growth rate, 1990–2005, based on WDI.b. Based on data from Bloomberg.c. International Country Risk Guide (ICRG).d. IMF IFS.


79

and 1996 (figure 3.4). Most of the financing wasin the telecommunication and power sectors. Aseconomic and financial pressures grew in LatinAmerica during 2002 and 2003, corporate bor-rowing in East Asia picked up, both in absoluteterms and as a share of the developing-countrytotal. Since 2003 borrowing has been dominated

by companies from emerging Europe, which nowaccount for 39 percent of total foreign borrowingby developing-country firms, up from 19 percentduring 1996–2003. Oil and gas and banking werethe major destinations of financing.

The financing trends depicted in figures 3.3and 3.4 followed in part the waves of privatization

Table 3.3 Foreign debt contracted by developing-country corporations, 1999–2006$ billions

1999 2000 2001 2002 2003 2004 2005 2006

Total 91.86 110.29 86.83 87.54 117.58 147.96 237.59 332.92By instrument

Bond 19.20 14.78 19.03 21.67 35.95 41.38 65.93 87.70Bank lending 72.66 95.51 67.80 65.87 81.63 106.58 171.66 245.22

By regionLatin America and the Caribbean 46.17 54.23 46.87 25.89 36.58 43.45 54.16 86.07East Asia and Pacific 15.85 20.87 11.38 28.76 31.15 24.80 47.34 47.36Europe and Central Asia 14.31 22.25 16.10 20.83 28.71 50.55 92.43 134.92Sub-Saharan Africa 5.52 5.41 6.38 5.13 11.14 9.78 13.69 24.71Middle East and North Africa 3.42 3.51 2.68 1.92 3.91 7.70 14.54 10.71South Asia 6.58 3.91 3.37 5.00 6.11 11.58 15.37 29.15

By ownershipPublic 24.73 29.56 25.14 33.21 44.81 50.34 66.35 71.76Private 67.13 80.73 61.69 54.33 72.78 97.62 171.24 261.16

By sectorFinance 17.09 23.15 19.94 15.55 20.03 40.99 64.11 102.31Oil and gas 14.42 25.91 21.92 23.40 30.09 32.47 57.46 54.70Telecommunications 17.39 17.93 11.38 8.85 9.19 15.33 19.22 31.93Energy/utilities 16.57 16.66 9.66 11.05 19.52 11.37 14.89 15.92Construction/building/metal and steel 4.18 5.70 5.08 3.51 6.60 11.73 22.37 35.71Mining 2.58 2.70 2.88 1.78 2.38 7.04 7.11 7.67Others 19.62 18.24 15.97 23.41 29.78 29.03 52.43 84.68

Source: World Bank staff estimates based on Dealogic Loanware and Bondware.

�60

�40

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

�20

0

80

20

40

60

�3

�2

�1

0

1

2

3

4

5

6

7

% growth % growth

Figure 3.3 Trends in corporate debt and industrialproduction, 1994–2006

Source: World Bank staff estimates based on data from DealogicBondware and Loanware.

Industrial production(right scale)

Corporate debt(left scale)

0

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

10

20

30

40

50

60

Percent

Source: World Bank staff estimates based on data from Dealogic.

Figure 3.4 Foreign borrowing by companies fromemerging-market countries, by region, 1990–2006

EmergingEurope

Latin America

East Asia


and private participation in infrastructure in the1990s and the powerful impact of the EuropeanUnion on the growth prospects, financing needs,and internationalization of the corporate sector inemerging Europe and Central Asia. Borrowing bybanks in Russia and Turkey (which together ac-counted for just under half of external borrowingby developing-country banks in 2004–06) wasmore than five times greater than their externalborrowing during the 1995–97 surge. As a share ofGDP, external borrowing by Kazakhstan’s bankswas even greater, averaging more than 5 percent ofGDP in 2004–06. By contrast, the substantial ex-ternal borrowing by banks in Brazil and India didnot reach 0.5 percent of GDP (table 3.4).

One important feature distinguish firms rais-ing capital in overseas markets from their peersstaying at home is firm size. Whether measured byasset size or sales volume, the companies tappinginternational bond and syndicated loan marketsare local leaders. They tend to be larger than theirpeers by several orders of magnitude: ten timeslarger, on average, in assets, seven times larger insales. The difference is statistically significant evenafter the effect of country size on company size isfactored in (box 3.1).

Emerging-market corporations have becomesubstantial bond issuersThe opening of the global corporate bond market toa growing number of private and public companiesfrom Asia, emerging Europe, and Latin America

epitomizes the structural change under way inemerging-market finance. By any measure—thevolume of new issues, market size, liquidity, dis-tribution, or appeal to a broad range of globalinvestors—interest in bonds issued by firms fromemerging-market countries has increased in recentyears, embracing issuers with varied credit ratingsfrom the financial, industrial, and infrastructuresectors in many different countries.

Having risen from a modest $2.3 billion in1990 to $87.7 billion in 2006, corporate bondissuance from emerging economies now greatlyexceeds sovereign issuance, in both volume andnumber of offerings (figures 3.5 and 3.6). The av-erage size of issues rose from about $110 millionin the early 1990s to $222 million in 2006. Inrecent years several companies have floated issuesof a size once reserved for sovereign nationals,supranational agencies, and highly rated compa-nies from industrial countries. Larger issues tend tobe more liquid, which, in turn, facilitates tradingand risk management, further increasing demand.

Bond features have also evolved. Subordi-nated debt (issued particularly by banks for capitaladequacy reasons) is increasingly accepted. Thereis also less emphasis on negative-pledge clauses inbond covenants, more frequent inclusion of call orput provisions, and fewer third-party guaranteesof the issuing company (by a parent company orthe government, for example).

Narrower credit spreads are another signof bond market maturation. Emerging-market

80

Table 3.4 International borrowing by banks in 10 middle-income countries, 2004–06

Syndicated bank Total borrowing borrowing Bond issuance Total borrowing % of total as share of GDP Number of($ millions) ($ millions) ($ millions) borrowing (percent) banks

Russian Federation 17,029 13,932 30,961 26.3 0.9 51Turkey 24,014 637 24,651 21.0 2.5 19Kazakhstan 6,036 3,120 9,156 7.8 5.2 11India 6,637 1,580 8,217 7.0 0.3 20Brazil 4,106 3,718 7,824 6.7 0.4 27Hungary 1,944 4,871 6,815 5.8 1.6 6Malaysia 3,145 1,475 4,620 3.9 1.0 9South Africa 3,435 0 3,435 2.9 0.3 6Chile 2,396 200 2,596 2.2 1.0 8Romania 1,441 585 2,027 1.7 1.1 4

Total 70,184 30,119 100,301 85.3 0.9 161All middle-income countries 83,539 34,110 117,649 100.0 0.4 295

Source: World Bank staff calculations based on data from Dealogic Loanware and Bondware.Note: Ratio of total borrowing to GDP is based on 2004 and 2005 data. It is calculated by dividing the sum of total borrowing in 2004 and2005 by the sum of GDP in 2004 and 2005.


81

Among firms based in developing countries, whatdistinguishes those that borrow in international debt

markets? To assess the differences between the “accessgroup” and the “no access group,” several leading data-bases (Dealogic Bondware, Loanware, and Worldscope)

were mined for information on their capital structure andborrowing characteristics. One distinguishing characteristicstands out as statistically significant: firm size.

Firms that borrow abroad are significantly larger thanthose that do not. The differences in total assets and salesare statistically significant according to t-tests for theequality of firm size (measured in millions of U.S. dollarsfor all firms in the sample). Plotting the frequencydistributions of normalized logarithms of size, as shown inthe figure below, confirms the finding.

The table below shows the median asset size of firmsin 11 countries. The results confirm that firms that borrowabroad are significantly larger than those that raise all oftheir financing domestically.

Box 3.1 A profile of developing-country companies thataccess global financial markets

�5 0

464 firms 3,230 firms

5 �5 0 5

Source: World Bank staff estimates based on data from DealogicBondware, Loanware, and Worldscope.a. Given the potential for heteroskedasticity, two subsamples werefirst normalized by subtracting from the natural logarithm of a firm’stotal assets the logarithm of its home-country mean and dividingthe difference by the home country’s standard deviation.

0.6

0.4

0.2

0

Access

0.6

0.4

0.2

0

No access

Density Density

Distribution of size of emerging-market corpora-tions that have accessed international debtmarkets versus those that have nota

Asset size of emerging-market-based corporationsbased on access to international debt markets$ millions

Country No access Access

Argentina 78 915Brazil 466 2,407Chile 118 1,341China 180 1,712India 147 3,143Indonesia 86 467Malaysia 54 586Mexico 344 2,308Philippines 35 924Thailand 55 503Turkey 171 3,102

Number of firms 3,230 464

Source: World Bank staff estimates based on data from Dealogic Bondware,Loanware, and Worldscope.

corporate bonds carried spreads over comparableU.S. Treasury securities of about 452 basis pointsin 1999. The average spread narrowed to about349 basis points in 2006, despite a significantspike in 1997–98 during the East Asian and Russ-ian financial crises (figure 3.7). The narrowing ofspreads for investment-grade corporate borrowers(BBB and higher) has driven the overall drop. Thiseffect does not reflect an increase in average creditquality, because the average rating has been con-sistently in the BB range on the Standard & Poor’sscale (Ba2 on the Moody’s scale). Spreads for the

high-yield segment of the market remain relativelyhigh. Access to international capital markets ismore challenging for emerging-market corporateentities than for emerging-market sovereignsbecause of the higher information barriers andgreater market constraints facing corporations(box 3.2).

The segments of the global bond marketsthat best cater to the debt-financing needs ofdeveloping-country corporate issuers are theEurobond market and the foreign U.S. dollar bondmarket, known as the Yankee 144A market. The


yen-denominated Samurai market has been lessappealing to developing-country issuers, exceptHungarian and Polish companies, which havebeen regular issuers in recent years.

Many emerging-market firms have chosen toraise their capital in U.S. markets, where institu-tional investors (pension funds, insurance compa-nies, and mutual funds) had $24.17 trillion undermanagement at the end of 2004. Firms targetingthe U.S. market have opted overwhelmingly toissue under Rule 144A, a federal rule defining amarket in which securities are privately placedwith qualified institutional investors. Introduced

by the U.S. Securities and Exchange Commissionin 1990, Rule 144A exempts foreign issuers fromcertain U.S. disclosure and distribution regula-tions, including SEC registration and liabilityunder the 1993 Securities Act (Committee on Cap-ital Markets Regulation 2006).

The Eurobond market’s flexibility to accom-modate both the issuer’s choice of currency ofdenomination and of governing law (British orNew York) has been an attractive feature of thatmarket, as is the fact that Eurobonds are nottaxed. Their flexibility is of particular relevanceto emerging-market issuers domiciled in countries

82

0

50

100

150

200

250

300

350

400

450

Number of issues

0

10

20

30

40

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

50

60

100

70

80

90

$ billions

Figure 3.5 International bond issuance by sovereign governments and corporations, 1990–2006

Source: World Bank staff estimates based on data from Dealogic Bondware.

Sovereign(left scale)

Corporate(left scale)

Sovereign(right scale)

Corporate(right scale)

01990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

10

20

60

30

40

50

0

50

100

150

200

250

300

$ billions Number of issues

Figure 3.6 International bond issuance by public and private corporations, 1990–2006

Source: World Bank staff estimates based on data from Dealogic Bondware.

Public(left scale)

Private(left scale)

Public(right scale)

Private(right scale)


with different degrees of financial and trade link-ages with the major economic poles of Asia,Europe, and the United States. International cor-porate bonds from emerging economies that havearrived on the market in recent years have increas-ingly been in the form of combined Eurobondand 144A issues floated in London and New York.Issuing simultaneously in both markets maximizesboth investor demand and liquidity in secondarytrading, because both tranches become fungibleafter three months. The significant regulatory dif-ferences between Eurobond and 144A marketsimply different approaches to the primary distrib-ution of debt securities in registration, disclosure,and possible listing on a major stock exchange.

Euro-denominated international bond issuesby emerging-market firms took off in 1998, oncethe common European currency became a certaintyand investors began to switch from other Europeancurrencies into the euro. Total issuance grew from$720 million in 1998 to about $15.3 billion in2006. Euro-denominated issues tend to be some-what larger on average than similar dollar-denominated bonds (about $250 million versus$200 million in recent years), with similar creditquality at issuance. These issues had been in theBB range but have lately risen to investment grade.The increase in credit quality reflects the prepon-derance of Eastern European issuers in this seg-

ment, whose ratings have risen with those of theircountries of origin. As a result, spreads have beentypically tighter in the euro segment (84 basispoints in 2004 and 141 points in 2005) than inthe dollar segment. Average maturities have beencomparable.

Credit derivative instruments are findingnew applications in connection withemerging-market corporate debt The growth of emerging-market corporate debt hasspawned new applications for credit default swaps(CDSs). As investor demand for emerging-marketcorporate credit has increased in recent years, trad-ing in CDSs on selected emerging-market referenceobligations—primarily well-established companiesfrom Brazil, Mexico, Russia, and Turkey—has ex-panded, providing a mechanism for transferringrisk from banks to capital markets. This new ap-plication of credit derivatives to emerging-marketdebt complements their growing role in the sover-eign segment of the market, highlighted in GlobalDevelopment Finance 2006.

As in the case of the sovereign CDS market,emerging-market corporate CDSs are marketedto global investors, particularly hedge funds andinsurance companies, that wish to increase their ex-posure in emerging markets without having to in-vest directly in the underlying assets. Such investorsfunction, in essence, as sellers of credit protectionto other investors and to banks seeking to hedgetheir credit exposures against specific risks, such asdefault or a credit downgrade. The market operateson the basis of a contract between the seller and thebuyer of protection. The understanding is that theseller will compensate the buyer for specified creditrisks in return for periodic premium payments overthe term of the contract. The price of a CDS, typi-cally given as a basis point spread, is determinedby the demand for and supply of protection againstthe credit risk of the underlying reference obliga-tion. A widening of CDS spreads is a sign of themarket’s increasing concern about the referencecompany’s credit quality; a tightening implies mar-ket participants’ expectation that the company’scredit status is improving.

The fastest-growing segment of global deriva-tives, today’s market for CDSs on corporate debtcovers an estimated 3,000 firms worldwide. Themarket has expanded exponentially in recent years,

83

0

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

100

200

300

400

500

600

Basis points

Source: World Bank staff estimates based on data from DealogicBondware.

Figure 3.7 Average spread of emerging-marketcorporate bonds against U.S. Treasurybonds, by grade, 1993–2006

Noninvestment grade

Investment grade


84

Reflecting the influence of several factors, corporatebond spreads tend to be higher than sovereign spreads

(see figure below). First, corporate entities face higherinformation barriers and greater market constraints thando sovereigns. Governments derive advantages from mem-bership in multilateral financial institutions and from thestate-centric nature of the international economic order. Bycontrast, developing-country firms, particularly privateones, stand or fall on their own financial performance,track record, and growth potential.

Second, even locally creditworthy firms may beconstrained, for several reasons. Corporate ratings areoften subject to sovereign ceilings. Corporate assets are noteasily amenable to collateralization in international debtmarkets. Covenants written into corporate debt documentstend to be more confining than those that apply to sover-eign debt. And swap markets for credit derivatives arebetter developed and more liquid for emerging sovereignnames than for corporate names.

Box 3.2 The relationship between emerging-marketsovereign and corporate bond spreads

Source: World Bank staff calculations based on Bondware and JPMorgan EMBI Global. Note: Ratings shown above bars are those of Standard & Poor’s.

0

100

400

500

200

300

Corporate bond spreads vs. EMBI Global sovereign spreads for selected countries, 2006–07

Basis points

BB

B�

/BB

B

BB

B�

BB

B� B

B

BB

�/B

B

BB

B�

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A

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�

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B�

B�

Chile

Turk

ey

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a

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Mala

ysia

Russia

n Fe

d.

Mex

ico

Philipp

ines

Brazil

Indo

nesia

Thaila

ndChin

a

Ukrain

e

South

Afri

ca

Argen

tina

Corporate spread

EMBI Global spread

with the notional global value of traded CDSsincreasing from $2.2 trillion in 2002 to $26 trillionin 2006 (figure 3.8).

The expansion of trade in CDSs supports thefinancing efforts of large companies in emergingmarkets by enabling banks to expand their offeringof bilateral or syndicated loans while sharing theircredit risk exposure with the rest of the market.CDS spreads provide useful information about themarket’s assessment of the credit risk of the refer-ence obligations, often moving in tandem with cashbond spreads. And, like cash bond spreads, CDSspreads on blue chip emerging-market companieshave been range bound over the past year. After

spiking in May–June 2006, they have hoveredaround 40–60 basis points, closely parallelingspreads on highly rated U.S. companies (figures 3.9and 3.10).

Factors shaping corporate accessto international finance

Firms do not enter the international capital mar-kets by accident. They typically do so after a

deliberate process of corporate remaking and long-term corporate financial planning. Once the choiceis made, access to international capital marketshelps the company diversify its source of funds,


improve risk management through more sophis-ticated financing instruments, borrow at longermaturities, gain international visibility, and -possibly reduce the cost of capital. Accessingforeign capital markets helps firms reducedependence on small local capital markets whileexposing them to higher standards of accounting,reporting, disclosure, and corporate governance(Coffee 1999, 2002; Stulz 1999; Reese andWeisbach 2002).2

Among the developing-country firms thathave entered the international capital markets are

major global players that have amassed sufficientcapital and know-how to contemplate expandingtheir presence in global markets through invest-ment or M&A. Cemex, for example, is the leadingcement company in Mexico; CVRD is Brazil’sfourth-largest mining company. Tata Consultancy,Infosys Technologies, and Wipro are among thetop Indian providers of business services. In theutilities sector, UES of Russia is ranked 13th.Other nonfinancial corporations in developingcountries are major investors in certain countriesor regions. Thailand’s CP Group, for example, is

85

Source: International Swaps and Derivatives Association MarketSurvey, 1987–2006.a. As of end-June 2006.

0

10

15

25

30

20

5

2002 2003 2004 2005 2006a

Figure 3.8 Notional value of global credit defaultswaps, 2002–06

$ trillions

0

4 M

ar. 2

005

20

40

60

80

160

100

120

140

30

35

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70

Basis points Equity price index

Equity price (right scale)

0

20

40

60

80

180

160

100

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27 M

ay 2

005

8 Ju

l. 200

5

30Sep

. 200

5

11 N

ov. 2

005

6 Ja

n. 20

06

17 M

ar. 2

006

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ay 2

006

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l. 200

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1 Sep

. 200

6

24 N

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006

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n. 20

07

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eb. 2

007

3 M

ar. 2

006

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ar. 2

006

14Apr

. 200

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5 M

ay 2

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26 M

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006

16 Ju

n. 20

06

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l. 200

6

28Ju

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6

18 A

ug. 2

006

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. 200

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29Sep

. 200

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ct. 2

006

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ov. 2

006

1 Dec

. 200

6

22 D

ec. 2

006

12 Ja

n. 20

07

2 Fe

b. 20

07

Basis points

Figure 3.9 Five-year spreads on CDSs and ASWs

Source: World Bank (various years) and World Bank staff estimates.Note: ASW � asset swap.

Petroleos Mexicanos (Pemex) Brazil’s CVRD

CDS spreads

CDS spreads

ASW spreads

ASW spreads

20

Jan.

2005

Mar

. 200

5

May

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5

Jul. 2

005

Sep. 2

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Mar

. 200

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006

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006

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006

Jan.

2007

35

80

50

65

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300

350

400

450

500

550

Figure 3.10 Spreads on U.S. credit derivativeindex, 2005–07

Source: World Bank staff estimates based on JPMorgan Chase.

Investment-gradeindex spread (left scale)

High-yield indexspread (right scale)


national companies based in developing countriesmade more than 700 cross-border M&A purchasesin 2006, up from just 11 such deals in 1987. Thesedevelopments have put some of these companies onpar with large companies from developed countries(box 3.3).

86

The rise of developing countries’ multinational corpora-tions over the past decade reflects the impact of global-

ization, including the liberalization of trade and foreigninvestment flows, the falling cost of transportation andcommunication, and increased demand for product diver-sity. As many developing-country governments have easedtheir policies toward capital outflows, their companieshave expanded their operations abroad. Developing coun-tries now boast 15,000 multinational corporations. Theforeign assets of the top 50 nonfinancial multinationalcorporations reached $200 billion in 2006, representingnearly a third of the total assets of all developingcountry–based multinationals (see table below). Thesecompanies employ almost 500,000 people, 16 percent ofwhom are based abroad. Foreign sales account for some40 percent of total sales.

Globalization of production and sales may boostgrowth, as foreign markets provide additional sources of

demand, enable firms to capture economies of scale,increase access to finance, and introduce firms to more-efficient technologies and management practices. Mostcompanies in a survey of 200 outward investors fromemerging Europe and Central Asia increased exports andimproved their financial performance (Sevtlicic and Rojec2003). In India outward investment enhanced the exportperformance of small and medium-size manufacturingenterprises compared with those that did not invest abroad(Pradhan 2005). A survey of Chinese multinational corpo-rations indicates that their foreign operations tend to bemore profitable than their domestic operations (Yao andHe 2005). The 150 largest developing-country multina-tionals have achieved more rapid growth in assets andsales than domestic economies, although performancevaries across countries (see figures on next page).

Firms may invest abroad by acquiring, often throughM&A, technology, brands, and distribution networks—a

Box 3.3 Globalization and the growth of transnationalcompanies in the developing world

said to be the largest single foreign investor inChina, and América Movil is the largest telecom-munications company in Latin America.3

These firms increasingly invest in other coun-tries to leverage their advantages and to acquirestrategic assets, commonly through M&A. Multi-

Industry position of selected southern transnational corporations, 2006

Rank in the Sales Profits Assets Market valueCompany Country Industry industry ($ billions) ($ billions) ($ billions) ($ billions)

Embraer Brazil Aerospace and defense 14 3.85 0.47 5.23 7.26ICBC China Banking 2 — — — 251.10Tata Consultancy Services India Business services 5 2.23 0.45 1.21 18.34Infosys Technologies India Business services 6 1.63 0.43 1.54 17.50Wipro India Business services 9 1.87 0.37 1.64 16.66Cemex Mexico Construction 1 15.33 2.11 26.44 23.82Orascom Construction Egypt, Arab Construction 23 1.41 0.18 2.10 8.11

Rep. ofSiam Cement Thailand Construction 27 4.95 0.94 6.63 7.42CVRD Brazil Materials 4 10.37 2.43 15.97 53.22China Shenhua Energy China Materials 5 4.74 1.08 13.18 27.51Norilsk Nickel Russian Fed. Materials 17 7.29 1.90 13.63 17.81Novolipetsk Steel Russian Fed. Materials 27 4.70 1.84 5.17 12.05Gazprom Russian Fed. Oil and gas operations 4 36.47 7.24 104.56 184.37PetroChina China Oil and gas operations 5 46.95 12.43 73.68 172.23Petrobras-Petróleo Brasil Brazil Oil and gas operations 9 58.43 10.15 76.64 99.82China Telecom China Telecommunications 15 19.47 3.39 48.53 29.73América Telecom Mexico Telecommunications 22 17.17 1.11 22.85 20.13UES of Russia Russian Fed. Utilities 13 24.52 1.15 40.45 28.00�NTPC India Utilities 19 5.38 1.33 15.45 24.36

Source: Forbes Global 2000 list. Note: — � not available.


The global financial environment consists ofcompeting financial centers and jurisdictions thatoperate under different national regulatory regimes,accounting standards, and market practices. TheUnited States is by far the largest capital market,

accounting for about 40 percent of global equityand debt capital, followed by the euro area, theUnited Kingdom, and Japan (figure 3.11).

National (and regional) markets differ notonly in the rules governing issuance of securities

87

Box 3.3 (continued)

Source: UNCTAD data on cross-border M&As prepared for the World Bank.

0

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

300

400

700

800

500

600

200

100

Cross-border mergers and acquisitions by developing-country firms, 1987–2006

Number of deals

0

150

200

350

250

300

100

50

$ billions

Cumulative M&A purchases by sector

Primary

Manufacturing

Transport,storage, andcommunications

Other services

Finance

Services Manufacturing Primary

Source: World Bank staff calculations based on Worldscope and World Bank databases.

�10�10 �5 0 5 10 15

5

10

25

30

15

20

0

�5

Growth performance of southern MNCs vis-à-vis their home economies, 1995–2005

Growth of assets of MNCs

Industrial production growth in the home economies (percent)

�1020 4 6 8 10

5

10

25

30

35

40

15

20

0

�5

Growth of sales of MNCs

GDP growth in the home economies (percent)

strategy known as asset-augmentation. As rapid advancesin technology and globalization quickly erode comparativeadvantages, companies look to takeovers as a path togrowth. Recent mega-deals by Cemex and CVRD, as wellas the $1.75 billion purchase of IBM’s personal com-puter division by China’s Lenovo, are examples of asset-augmenting expansion. Cross-border M&A purchases by

developing-country multinationals increased from $400million in 1987 (when they made up less than 1 percent ofglobal M&A transactions) to almost $100 billion in 2006(almost 9 percent of global M&A transactions). The ser-vices sector accounted for almost half of the $350 billionin M&A purchases between 1987 and 2006 (see figuresbelow).


88

Figure 3.11 Distribution of global debt and equity capital, 2005

Otherdevelopedcountries,

18.3%

Developingcountries,

10.7%

Japan,10.9%

Euro Area,14.2%

UnitedKingdom,

7.0%

Stock market capitalization

Total world stock market capitalization: $38.98 trillion

UnitedStates, 41.0%

Japan,14.5%

Developingcountries,

6.2%

Other developedcountries,

10.5%

Euro Area, 23.2%

United Kingdom,

4.6%

Debt securities outstanding

Total debt securities outstanding: $54.87 trillion

Source: World Bank (various years) and World Bank staff estimates.

UnitedStates,38.9%

Source: World Bank staff calculations based on data fromDealogic Bondware.

0

100

150

250

300

200

50

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Figure 3.12 Spreads on investment-gradecorporate bonds from developing and developedcountries, 1996–2005

Basis points

Developing

United States

Developed exceptUnited States

but also in their “home bias,” which occurs wheninvestors give too much weight to home securitiesin their investment choices. Despite significantprogress in recent years in the transmission of in-formation across global capital markets (Eun andShim 1989; Kim 2003; Wongswan 2006), homebias remains an important phenomenon. Recentresearch suggests that Japan and Spain have thehighest home bias in equity markets (88 percent inJapan, 80 percent in Spain), while Canada andthe United States have the highest home bias infixed-income markets (93 percent in Canada,92 percent in the United States).

Emerging-market companies’ engagement ininternational capital markets has been driven bytwo structural forces: (a) growing demand frominvestors seeking higher yields and investmentdiversification and (b) companies’ increasingparticipation in international business transactions.But a variety of competitive disadvantages and in-stitutional, informational, and economic obstaclescontinue to hamper emerging-market companies intheir ability to access such markets. These includethe following:

• high information barriers, which prevent mar-ket participants and analysts from developingwell-informed views on a company’s creditquality and growth potential;

• undeveloped or poorly defined standards ofcorporate governance, accounting standards,and transparency, which raise the agency costsof raising capital abroad;

• partially closed capital accounts and managedexchange rates, which introduce uncertaintyabout the flow of funds;

• the vulnerability of corporate earnings andvaluations to the local business cycle and as-sociated policy risks; and

• country risk, which may cause investors to re-quire greater risk premiums from companiesoperating within the country’s jurisdiction.

The practical result of these obstacles anddisadvantages is an additional financing costfor emerging-market companies, one not borneby their competitors from developed countries (figure 3.12).


Business cycles in the industrial countrieshave converged in recent years, and volatilityhas declinedThe benefits investors obtain by diversifying acrossassets and markets in the major developed coun-tries have diminished in recent years, as businesscycles have tended to converge, financial volatilityhas decreased, and rapid transmission of informa-tion across markets has consolidated market link-ages and integration. The combined impact ofthese developments has been greater co-movementin national stock and bond markets (figure 3.13).

Along with a generalized moderation ofvolatility of economic activity, the secular trendtoward convergence of business cycles in the G-7countries has been a defining feature of the macro-economic landscape in recent years. The “greatmoderation” of the U.S. economy, in particular,has received a great deal of academic and policyattention (Summers 2005; Kahn, McConnell, andPerez-Quiros 2002; Kim and Nelson 1999). Sev-eral factors appear to be at play, including theadoption by major central banks of a uniform ap-proach to the conduct of monetary policy throughinflation targeting and enhanced transparency andcredibility; lower fiscal deficits in many countries;financial innovations, including risk-based loanpricing and securitization, which have made firmsand households less sensitive to income fluctua-tions; and, in the case of Europe, the increasedpolicy discipline associated with EU accession andthe broader forces prompting regional integration.

The effect of convergence and moderationon the investment opportunities open to global

investors is difficult to measure. It is possible toargue that the growth of the European Union hasshrunk the set of investment opportunities inworld equity markets, as intra–EU correlations ofasset returns have declined. Improvements in mon-etary policy in major industrial countries have alsoplayed a role in advancing convergence in maturebond markets, as the greater predictability of cen-tral banks’ policy intentions has stabilized infla-tion expectations and anchored national inflationrates around a narrow band of policy targets.

Financial volatility in mature markets has alsodeclined in recent years (figure 3.14). Two of thekey determinants of volatility—risk appetite amonginvestors and macroeconomic stability—have

89

U.S./Euro

U.S./Japan

MSCI index U.S./Europe, Asia, Australia

Jan.

1995

Jan.

1998

Jan.

2001

Jan.

2003

Jan.

2007

Source: World Bank staff calculations of 36-month rolling correlation based on Bloomberg and Morgan Stanley MSCI Barra.

�0.2

0.2

0.4

0.8

1.0

0.6

0.0

Dec. 1

996

Dec. 1

997

Dec. 1

998

Dec. 1

999

Dec. 2

000

Dec. 2

001

Dec. 2

002

Dec. 2

003

Dec. 2

004

Dec. 2

005

Dec. 2

006

Government bonds, 1996–2006 Equity index, 1995–2007

Figure 3.13 Correlation in mature debt and equity markets

0.0

0.2

0.4

0.8

1.0

0.6


5 5

20

15

10

25

35

45

40

30

25

20

15

10

35

30

45

55

50

40

Figure 3.14 Volatility measures in mature equitymarkets, 2002–07

Jan.

2002

May

200

2

Sep. 2

002

Jan.

2003

May

200

3

Sep. 2

003

Jan.

2004

May

200

4

Sep. 2

004

Jan.

2005

May

200

5

Sep. 2

005

Jan.

2006

May

200

6

Sep. 2

006

Jan.

2007

VIX index of implied volatilityof S&P 500 index options

VDAX index of impliedvolatility of DAX index options

VDAX

VIX


improved with the sustained expansion of theworld economy, growing global liquidity, betterrisk management techniques, and the expansion ofmarkets in risk transfer.4 Although correlation instock market returns across mature markets is sig-nificantly higher than across emerging markets(table 3.5), correlation of equity returns betweenemerging and mature markets has increased inrecent years (figure 3.15).

Significant recent advances in informa-tion and trading technology, the availability ofhigh-frequency financial data, and greater techni-cal capability for analyzing such data have in-creased the speed with which today’s financialmarkets react to macroeconomic and political

news. In the early 19th century, it took almost twomonths for changes in asset prices in New York,conveyed across the Atlantic in clipper ships, tohave an impact in London. Today U.S. macroeco-nomic announcements are incorporated in Germangovernment bond yields and prices in a matterof minutes (Goldberg and Leonard 2003; Sylla,Wilson, and Wright 2005).

Corporate assets in emerging markets offerdiversification and growth-potential gainsBusiness cycles in developing countries are weaklycorrelated with those of developed countries, andmonetary policies are less weakly aligned across de-veloping countries than across developed countries.There is thus considerable potential for gains frominternational diversification across developing-country corporate securities.

Despite a significant decline in inflation and awidespread acceleration of growth, developing-country macroeconomic conditions, businesscycle dynamics, and growth prospects respond toglobal conditions in an amplified cyclical fashion.Their capital markets remain segmented, not onlybecause of high informational barriers but alsobecause of the official capital controls that remainin place in many developing countries, which re-strict cross-border capital-account transactions(figure 3.16).

Economic, legal, and industrial structuresoften amplify diversification gains through thedifferential growth opportunities they offerlocal firms over the business cycle. As a result, andparadoxically, factors associated with market

90

Table 3.5 Correlation of mature and developing stock market indexesMonthly rate of return over 2000–06 period

United United Russian South States Kingdom Germany Chile Malaysia China India Hungary Fed. Mexico Thailand Brazil Africa

United States 1.00 0.85 0.75 0.37 0.22 0.02 0.39 0.39 0.33 0.55 0.41 0.58 0.52United Kingdom 1.00 0.77 0.36 0.17 �0.06 0.46 0.45 0.38 0.58 0.37 0.55 0.57Germany 1.00 0.35 0.37 0.17 0.42 0.43 0.29 0.56 0.22 0.54 0.50Chile 1.00 0.43 0.02 0.33 0.40 0.21 0.28 0.40 0.39 0.35Malaysia 1.00 0.13 0.32 0.36 0.23 0.34 0.22 0.27 0.22China 1.00 0.05 0.03 0.18 0.04 �0.08 0.13 0.09India 1.00 0.73 0.58 0.67 0.32 0.58 0.47Hungary 1.00 0.61 0.66 0.29 0.63 0.44Russian Fed. 1.00 0.67 0.33 0.60 0.41Mexico 1.00 0.37 0.72 0.60Thailand 1.00 0.49 0.62Brazil 1.00 0.62South Africa 1.00

Source: World Bank staff calculations based on data from Bloomberg.

Source: World Bank staff estimates of 36-month rollingcorrelation of returns based on Morgan Stanley MSCI Barra.

Figure 3.15 Correlation of equity returnsin emerging markets and world markets,February 1992–January 2007

0.2

0.5

0.4

0.3

0.6

0.8

0.9

0.7

Emergingmarkets/U.S.

Emerging markets/Europe, Australia, Asia

Emergingmarkets/world

Jan.

1995

Jan.

1998

Jan.

2001

Jan.

2004

Jan.

2007


segmentation may make emerging-market corpo-rate bonds and equities more attractive to global in-vestors. In recent years returns on emerging-marketbonds and equities have been superior to compara-ble returns in mature markets; risks have also beenhigher. A comparison of the simple correlations be-tween returns in selected developed and emergingequity markets over two periods confirms this ob-servation (figure 3.17 and table 3.6). Repeating thesame exercise for selected developed and emerging-market bond returns shows that market integrationprimarily affects developed-country bonds and that,in relative terms, emerging-market bonds still offermore opportunities for diversification.

Home-country growth prospects andinstitutional environment matter Local economic and institutional factors in a firm’shome country affect investors’ perceptions throughtwo channels. The first channel is corporate

91

Source: World Bank staff calculations using methodology in Dailami (2000) and using data from IMF (various years).

00.5 1.0

more open1.5 2.0

2

3

Density

1

Figure 3.16 Capital account openness in developed and developing countries

00.5 1.0

more open1.5 2.0

2

3

Density

1

Developing countriesHigh-income OECD countries

Figure 3.17 Systematic movement ofemerging-market equities with world markets

0.0

0.6

0.4

0.2

0.8

1.2

1.4

1.0

Beta correlation

Beta (EM, WD)

0.99

1.25

Beta (EM, EA)

0.57

1.19

Beta (EM, NY)

0.94

1.20

1992–97 2000–06

Source: World Bank staff estimates of beta based on returns fromthe Morgan Stanley MSCI Barra Index. Note: EM � emerging markets MSCI; WD � MSCI world;EA � MSCI Europe-Australia-Asia; NY � NYSE composite.

Table 3.6 Segmentation of emerging-market equities from world marketsCorrelation of selected market indexes, 1992–97 and 2000–06

MSCI emerging markets MSCI world MSCI Europe-Asia-Australia NYSE composite

1992–97 2000–06 1992–97 2000–06 1992–97 2000–06 1992–97 2000–06

MSCI emerging markets 1 1MSCI world 0.57 0.85 1 1MSCI Europe-Asia-Australia 0.43 0.84 0.92 0.96 1 1NYSE composite 0.48 0.75 0.76 0.94 0.46 0.86 1 1

Source: World Bank staff estimates based on data from Morgan Stanley MSCI Barra Index.


profitability and cash flow—and hence valuation.They are affected by local economic conditions,including both economywide and firm-specificfactors. Systemic factors include the business cycle,aggregate growth performance, the tax regime, andinterest rates. Important firm-specific factors in-clude the firm’s growth opportunities, the regula-tions to which it is subject, and the structure andquality of its management and governance. Thesecond channel is the host country’s legal, regula-tory, and economic infrastructure, which affectsthe quality and reliability of a firm’s disclosure andreporting policy, its transparency to local andforeign investors, and, more generally, the abilityof shareholders and bondholders to exercise effec-tive corporate oversight and contract enforcement.Foreign investors must incorporate all of thesefactors in their decisions.

Analysis of primary bond issuance by theemerging-market corporations that have tapped

international capital markets since 1990 confirmsthe importance of local macroeconomic and insti-tutional factors on corporate credit-risk premiums(box 3.4). Specific bond attributes and the juris-diction in which bonds are issued and traded arealso important factors.

The model results reported in the annex revealthat investors attach considerable importance tothe prospects for economic growth in the homecountry of companies whose securities they areconsidering: a 1-percentage-point increase in realGDP growth reduces corporate bond spreads byabout 7 basis points. But governments should notpursue growth policies at the price of inflation,which international investors clearly view in a neg-ative light: inflation in the home country, whichmakes the issuer’s domestic operations more risky,increases spreads by about five to six basis points.

Borrowers from countries with a well-developed stock market (one with high liquidity,

92

In pricing emerging-market corporate bonds, interna-tional investors take into account many factors, includ-

ing the terms, structure, liquidity, origin, and credit riskand marketability of the issues. To analyze market riskperceptions and the importance of issue characteristics,Bank staff specified various linear models of the offerings’at-issue credit spread as a function of offering terms, rat-ing, distribution, currency and jurisdiction, ownership, in-dustry, and various economic, financial, and institutionalcontrol variables for each issuer’s home country. Thechoice of specification follows the literature on reduced-form models of credit spreads (Elton and others 2001;Dailami and Hauswald 2003). The data consist of morethan 1,200 corporate bonds (denominated in U.S. dollarsor euros) issued by corporations from 34 emergingeconomies between 1990 and 2005. The importance of thevarious pricing factors and issue characteristics is gaugedby their statistical significance. (The underlying methodol-ogy, econometric specification, and results are reported inthe annex.)

This analysis yields several key findings:

• Because state-owned firms often carry an explicit orimplicit government guarantee, their bonds are pricedwith lower spreads (about 45 basis points on average)

than those of private companies from the same coun-try. A third-party guarantee also decreases credit risk,lowering the at-issue spread by about 40 basis points.

• Pure Eurobonds offered only in London and Luxem-bourg tend to be price about 18–20 basis pointshigher than fully fungible global bond issues offeredsimultaneously in the United States, Europe, and Asia.

• Bonds with a U.S. tranche or pure 144A/Regulation Sissues targeted at the U.S. institutional market tend tobe priced 20–26 basis points higher than globalbonds, making them about 2–6 basis points more ex-pensive than comparable pure Eurobonds.

• Unrated bonds come to market at a price that is about190 basis points higher than AAA–rated bonds. Eachdecrease in rating increases the at-issue spread of ratedbonds by about 19 basis points. Unrated bonds are thusissued at prices that are about 10 notches below AAA.

• The country rating has a greater effect on investorperceptions than the issue rating. A one-notch de-crease in the issuer’s home-country rating increases theat-issue spread by about 28 basis points. In contrast, asimilar decrease in the issue’s own rating raises thecost of the issue by just 18 basis points.

Source: World Bank staff.

Box 3.4 Determinants of emerging corporate bond spreads


93

as measured by the ratio of turnover to GDP) andbanking system (as indicated by a high ratio of pri-vate credit to GDP) pay significantly less for theirexternal debt. A 10-percentage-point increase instock market turnover decreases at-issue spreadsby 6–8 basis points, while a similar rise in privatecredit reduces spreads by 10–16 basis points.These results confirm anecdotal evidence and pre-vious findings that local financial developmentsignificantly facilitates access to global capitalmarkets for emerging-market firms (Caballero andKrishnamurthy 2003).

Using the indexes of the International CountryRisk Guide to analyze the effect of the home coun-try’s economic, financial, and political institutionson the cost of borrowing reveals that a 10-percent-age-point increase raises the home country’s eco-nomic risk index by 52 basis points and its finan-cial risk index by about 63 basis points. Thesefindings add to the extensive empirical evidencesuggesting that the quality of institutions is a cru-cial element underpinning economic and financialdevelopment.

Deal structure and security design can lowerthe cost of bond financingSpreads on corporate bonds issued by companiesbased in the same country may show considerablevariation. Such variations suggest ways to improvefirms’ terms of access to global capital markets.Larger offering sizes, for example, reduce the at-issue spread of emerging-market corporate bonds,because large deals offer greater liquidity in sec-ondary trading. The corresponding reduction inspreads can be viewed as the premium investorsare willing to pay for more-liquid issues.

Other attributes of issues also affect their cost(figure 3.18). By choosing variable-rate debt(float), issuers can reduce the spread by about 90basis points, reflecting both the greater risk borneby the issuer and built-in reset provisions for thecoupon triggered by covenant violations or ratingdowngrades. Such reset provisions partially com-pensate bondholders for increases in credit risk.Call provisions—that is, the ability of issuers torepay early, limiting their interest-rate exposure—increase credit spreads by about 35 basis points,the price of shifting interest-rate risk to bondhold-ers. Euro-denominated issues are priced 55 basispoints lower than comparable dollar-denominatedissues.

Covenant provisions also affect the price ofa bond. The explicit exclusion of a negativepledge—a commitment not to grant futurecreditors better terms—that does not safeguardbondholders’ standing in case of default increasesa bond’s riskiness, raising spreads by up to 25basis points. The explicit exclusion of cross-default, so that default on another debt obligationdoes not trigger default on the bond in question,limits bondholders’ credit exposure to one particu-lar issue, for which borrowers are rewarded with adecrease in spreads of up to 70 basis points.

Corporate issuers have a choice of marketson which to offer their securities The decision by emerging-market issuers to offerand sell securities in a particular jurisdiction in-volves balancing the associated transaction andagency costs with the benefits of liquidity, reputa-tion, investor base, and longer-term business ob-jectives. The main transaction costs are legal andinvestment banking fees, as well as the costs asso-ciated with complying with the jurisdiction’s regu-latory requirements and standards for disclosure,accounting, and reporting. Accounting standardsand practices differ widely across countries, evenacross industrial countries.5

Figure 3.18 Effect of selected characteristics of bond issues on at-issue spreads

�100

�20

�40

�60

�80

0

40

60

20

Basis points


No crossdefault

Floating rate

Euro-denominated

Guaranteed

CallableNo negative

pledge

Privatecorporate


With the exception of Chinese corporations,most emerging-market companies have chosen theUnited States (NYSE and NASDAQ), London(LSE and AIM), or Luxembourg as their preferreddestination for listing and offering their shares,raising $27.1 billion in equity capital on thesemarkets in 2006 (figure 3.19). On the contrary,Chinese companies mostly preferred listing theirissues on the Hong Kong (China) and Singaporestock exchanges. In 2006 they raised $38.4 billionon the Hong Kong exchange and $2.5 billion onthe Singapore exchange, largely through mega-sizeinitial pubic offerings (IPOs) placed by state-owned banks and companies. Proximity seems tohave been a key factor in influencing firms’ choiceof location for listing and offering equity shares,with firms from Latin America migrating largelyto the U.S. markets, Eastern European firms toLondon, and East Asian, particularly Chinese,firms to Hong Kong (China).

The choice of jurisdiction for a bond’s underly-ing debt contract closely corresponds to the issue’stype and location. Nearly all 144A offerings, andmost issues including a 144A tranche, apply NewYork law. Issuers often specify a second local juris-diction, either to satisfy domestic legal and regula-tory requirements or because local courts areneeded to enforce creditor rights over local assetspledged as security. Pure Eurobonds and somecombined Euro-144A issues generally elect U.K.law and London courts. Although some bonds

specify other jurisdictions, the preponderance ofNew York and U.K. law for international bondsstems as much from the substantive law offered bya given jurisdiction as the expertise of the courtsthat will interpret the debt contracts and the famil-iarity of lawyers with certain legal regimes.

More than 70 percent of bonds are listed,mainly on the Luxembourg stock exchange(77.1 percent of listed issues). Listing providesofficial prices for institutional investors, whoseinvestment guidelines often require such marked-to-market valuation. Although Luxembourg hasdominated all other markets as a listing location,the Swiss stock exchange has recently started tocourt international bond listings and cross-listings.However, almost all secondary trading in such is-sues takes place over the counter, because leadmanagers often provide liquidity services for up to18 months (on average about 6 months) by keep-ing inventory. They act as de facto market makersin the issue.

Prospects and risks

For much of the postwar era, borrowing by gov-ernments has been the quintessential feature of

financing for development. Having stood fordecades at the center of national and internationalpolicy concerns, emerging-market sovereignfinance has been the subject of a substantialstream of market practice, standards for credit-risk assessment, and international institutionalarrangements for debt restructuring and disputeresolution.

The growing importance of cross-border bor-rowing on capital markets by emerging-marketfirms since the early years of this century has raiseda new set of policy challenges for developing coun-tries and the international economic community,including concerns about corporate foreign debt.Since the East Asian crisis, the majority of emerging-market economies developed more open capitalaccounts, improved their local capital markets, andsignificantly reduced their public external debt.Some, such as Argentina, Mexico, Brazil, andRussia, have abandoned fixed or crawling pegs andmoved to flexible exchange rates, while new mem-bers of the European Union have pegged to the eurounder the European Monetary System (ERM II) aspart of their euro adoption plan. Such reforms havetended to shift the locus of currency and credit risk

94

0

4

6

8

10

12

14

16

2

0

40

60

80

100

120

140

160

20

$ billions raised

Figure 3.19 Number of listed companies andamount of equity raised on selected stockexchanges, 2006

Number of companies

Luxembourg StockExchange

LSE (AIM) NYSE � NASDAQ

Source: World Bank staff estimates based on NYSE, NASDAQ, and Luxembourg Stock Exchange data from the World Federation ofExchanges.

Number listed


associated with external borrowing from the sover-eign to the corporate sector, with important impli-cations for the conduct of public policy.

The pace of globalization of corporations inthe developing world is likely to intensify Improved policies and favorable international eco-nomic conditions have allowed corporations basedin developing countries to increase their engage-ment in global investment and finance, a processthat is likely to continue over the medium term.The World Bank (2006b) projects that developingcountries’ share in global output will rise fromabout one-fifth to almost one-third by 2030 andthat developing countries’ exports will increasefrom less than 25 percent of their output to almost35 percent. Rising incomes and higher exportrevenues will improve developing countries’ cred-itworthiness, facilitating corporate access to inter-national finance.

The growth of emerging-market multinationalswill also support increased borrowing from capitalmarkets. Greater participation by developing-country firms in overseas product markets isalso likely to increase their ability to access over-seas financial markets. Greater reliance on overseasmarkets for inputs and revenues will increasemultinationals’ incentives to diversify the currencycomposition of their balance sheets, which can be amore efficient approach to coping with exchangerate risk than purchasing derivatives.

Recent participation by emerging-market cor-porations in international capital markets mayalso help boost access by smaller corporate play-ers. First-time borrowers can face high costs, be-cause lenders must expend considerable resourcesin obtaining information. Once these initial ex-penses are absorbed, the marginal cost of makingsubsequent loans is lower, reducing financing costsfor all borrowers.6

Other forces may also reduce firms’ futureborrowing on international capital markets. Ris-ing incomes in developing countries are likely tobe associated with more efficient domestic bank-ing systems and capital markets, allowing firmsto rely more on domestic sources of financing. Inaddition, demographic forces are set to increasesavings rates in many developing countries whilelowering those in industrial countries, possiblyencouraging greater reliance on domestic finance(World Bank 2006b). The link between demo-

graphics and savings, and between savings andcurrent-account balances, is uncertain, however.The recent surge in borrowing by developingcountries, for example, has taken place in the con-text of a rising surplus in their current accounts.

The increasing access of developing-countryfirms to international capital markets over themedium term is likely to be interrupted from timeto time, because the growing role of corporationsin developing-country borrowing may increase thepotential for sporadic crises. Corporations may, forexample, borrow excessively, from the standpointof the economy as a whole, because they do nottake into consideration the overall indebtedness oftheir home country and its potential consequencesfor volatility in exchange rates and output. Mean-while, governments have considerable difficultymonitoring corporate exposure, judging the degreeof risk involved, and intervening effectively to re-solve minor problems of corporate indebtednessbefore they become major ones. Thus whileemerging-market corporations are likely to expandtheir reliance on international capital over the nextfew decades, the process could be subject to occa-sional sharp interruptions of a magnitude andduration that are impossible to predict.

Equally important in shaping the futurecourse of globalization of corporate finance inemerging markets will be how the internationalcommunity deals with and eventually accommo-dates internationally active firms. Policy and insti-tutional responses to the East Asian financialcrises of the late 1990s have highlighted the needfor better risk management and transparency atboth the corporate and national levels to avoidexcessive corporate foreign borrowing and indebt-edness. The market mechanisms, regulatory frame-works, institutional capabilities, and technicalexpertise needed to provide a safe and secureenvironment for overseas corporate securitiesofferings and listings are amply present in theworld’s major financial centers and jurisdictions.Untested is the ability of the international commu-nity to apply those mechanisms, frameworks, ca-pabilities, and expertise in a manner that is wellenough coordinated to provide stability to rapidlygrowing markets.

There is reason for optimism. The Yankeebond market (the foreign segment of the U.S. dol-lar bond market) came into existence in the early1900s. The yen-denominated Samurai market was

95


96

The number of foreign companies listed on the world’smajor exchanges has increased over time, particularly

since the 1980s. The trend reflects advances in tradingtechnology, competition among exchanges, and companies’desire to list on major exchanges to boost internationalrecognition and fund future M&A transactions.

The number of foreign companies listed on the LSEincreased from 387 in 1970 to 553 in December 1990 to636 in December 2006 (figure below). The exchange’s ap-peal and trading activity increased during the late 1980s,

The number of foreign firms listed on the New Yorkexchanges increased rapidly during the 1990s, before de-clining from 943 at the end of 2000 to 784 at the end of2006 (figure at right). The recent decline largely reflectsthe impact of more demanding and stringent regulatory re-quirements and associated costs, as well as delistings ofseveral Latin American firms and their return to home ex-changes. The annual tally of foreign companies delistingAmerican Depositary Receipts (ADRs) from the NYSE orthe NASDAQ peaked for the 1990–2006 period at 53 in2005, up from 38 in 2004. Nearly half (24) of the foreigncompanies delisting ADRs from these two exchanges in2005 were of British origin; the largest number of delist-ings in this peak year by developing country-domiciledfirms were of Mexican origin (7), followed by firms basedin Chile (3).

following the 1986 “Big Bang” deregulation, which abol-ished minimum commission charges for brokers and re-placed the trading floor with a screen-based electronictrading system. In recent years, foreign firms have beendrawn in particular to the LSE’s Alternative InvestmentMarket (AIM), a market for growing small-cap companies.Set up in 1995, AIM has less stringent regulatory and dis-closure requirements than the main list. Transfers from theLSE main list have boosted the tally of listings on AIM.

Box 3.5 Foreign company listings on major financialcenters continue to grow

Source: LSE.

300

400

450

550

600

650

500

350

Foreign companies listed on the LSE, 1966–2006

Number of non-U.K. companies at year-end

Main list AIM

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Source: NYSE.

0

200

300

400

500

600

700

800

900

1,000

100

Foreign companies listed on the NYSE andNASDAQ, 1984–2006

Number of non-U.S. companies at year-end

NYSE NASDAQ

198419

8519

8619

8719

8819

8919

9019

9119

9219

9319

9419

9519

9619

9719

9819

9920

0020

0120

0220

0320

0420

0520

06

and liquidity. More than 90 percent of the world’s500 largest corporations reportedly use deriva-tives, according to a survey conducted by theInternational Swaps and Derivatives Association(ISDA 2003). Over-the-counter derivatives aredominated by products designed to protect againstfluctuations in interest rates; individual stocksand equity indexes provide the basis for mostexchange-traded derivatives (figure 3.20).

Since the East Asian crisis of 1997–98,emerging-market corporations have taken advan-tage of favorable international financial conditionsto strengthen their ability to deal with unexpectedshocks. The decline in corporate credit spreads(from an average of 452 basis points in 1999 toless than 349 basis points in 2006), coupled withlow international interest rates, has enabled corpo-rations to build a substantial liquidity cushion. Asa result, corporate bond issuance has reachedrecord levels, while the widespread use of interest-rate swaps has substantially reduced interest-raterisk. The average cost of equity declined frommore than 18 percent during the East Asian crisisto about 9 percent in 2006 (figure 3.21), averagedebt-equity ratios in emerging-market corpora-tions declined from more than 60 percent in 1997to less than 40 percent in 2005 (figure 3.22), andaverage maturity of new corporate bond issues bynonfinancial companies increased from 6 years in2000 to 10.3 years in 2006 (figure 3.23).


created in the 1970s, as part of authorities’ effortsto manage the large current account surpluses ofthe time. The Eurobond market has served as theworld’s most important source of bond capital tosovereign and corporate issuers from both devel-oped and developing countries since 1963.7 U.S.corporate securities were traded in the 1790s inmarkets on both sides of the Atlantic. And histori-cally successive waves of privatization, liberaliza-tion, and growth spells in the world economy havekept a steady string of firms migrating to majorfinancial centers to list their shares and raise capi-tal (box 3.5).

With further domestic reform and the rightdegree of international cooperation, the outcomeof the rapid globalization of corporate financecould be a positive-sum game capable of consoli-dating trade and growth linkages between devel-oped and developing economies.

For international investors and their interme-diaries contemplating investing in emerging-marketcorporate debt and equity, success will depend onsound risk management based on a nuanced appre-ciation of the interplay of risks (at the level of thefirm, market, and country) in countries with par-tially open capital accounts, managed floating ex-change rate regimes, imperfect capital markets, andstandards and practices of corporate governancethat may well be unique and still in flux. Shiftingfrom sovereign to corporate debt demands greaterattention to the transparency and quality of ac-counting standards, the credibility of financial re-porting, the integrity of corporate governance, andthe characteristics of the jurisdiction in which cor-porate securities are listed and offered.

Corporations in many developingcountries need to improve their capacity for risk managementAs corporations in emerging markets have in-creased in size and expanded their internationaloperations, they have increased their exposure torisk. But they have also strengthened their riskmanagement abilities. Many of these corporationshave made efforts to hedge against the currencyrisk they face in financing and production. Liketheir counterparts in the industrial world, they areincreasingly relying on derivatives to manage risksrelated to foreign exchange, interest rates, credit,

97

Figure 3.20 Size of global derivative markets,June 2006

Source: Bank for International Settlements and World Federationof Exchanges.

Exchange-tradedderivatives

Over-the-counterderivative markets

Credit

Interest Government debt

Stocks Commodities

Equity indexFX

24.3%

9.2%2.0%

26.9%

37.6%

$84 trillion notional$10 trillion market value

+ 44%

78.5%

$370 trillion notional$10 trillion market value

+ 31%

11.4%

6.1%1.9%2.1%


Despite these improvements, two areas ofconcern remain that are reminiscent of the posi-tion of emerging-market corporations immediatelybefore the East Asian crisis. First, nonfinancialcorporations based in emerging markets may haveundertaken substantial liabilities denominated inJapanese yen, encouraged by very low interestrates on yen loans in recent years. Data from theBank for International Settlements indicate thatJapanese banks have cross-border claims totalingabout $218 billion on foreign nonbank privatesector companies (including those from industrial

countries), part of which may be carry-tradesand part of which may be corporate sector loansin Japanese yen (BIS 2006). Because even a modestappreciation of the yen could significantly weakencorporate balance sheets, debt-equity ratios andthe cost of debt financing may be significantly un-derestimated unless foreign exchange risks havebeen hedged.

Second, market participants have raisedconcerns over weak credit-risk management inemerging-market corporations. Credit risk is oftennot integrated into an enterprisewide risk manage-ment framework, making it difficult to measure,aggregate, and hedge. Liabilities from corporatepension plans may be underestimated, not least be-cause corporate pension managers appear to havetaken on high-risk assets in their quest for higheryields and may not fully understand the risk expo-sure involved in popular credit derivatives. More-over, credit risk may be substantially underestimatedduring the current peak of the credit cycle, andemerging-market corporations rarely analyze sce-narios in which credit spreads might widen.

The banking sector’s foreign exchangeexposure may affect financial stability The critical role played by banks in domestic mone-tary systems means that banks’ exposure to foreignborrowing warrants special attention from policymakers. Sharp increases in external borrowing bycommercial banks may be the result of a normalprocess of capital deepening in a rapidly growing

98

Source: MSCI, Worldscope, Morgan Stanley Research 2006.

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

0

20

40

60

80

100

120

Ratio

Figure 3.22 Net debt-to-equity ratios for nonfinancial corporations in emerging markets,1985–2005

MSCI EM except financial corporations

MSCI World except financialcorporations

Source: World Bank staff estimates based on data from DealogicBondware.

0

4

2

6

10

12

8

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Figure 3.23 Average maturity of issues by financial and nonfinancial corporations,1990–2006

Years

Financial

Nonfinancial

Source: MSCI, Worldscope, Morgan Stanley Research 2006.

Jan.

1992

Jan.

1993

Jan.

1994

Jan.

1995

Jan.

1996

Jan.

1997

Jan.

1998

Jan.

1999

Jan.

2000

Jan.

2001

Jan.

2002

Jan.

2003

Jan.

2004

Jan.

2005

Jan.

2006

Figure 3.21 Implied cost of equity in emerging markets, 1992–2006

Percent

5

7

9

11

13

15

17

19

21


developing country or transition economy. More-over, these increases may be justified by the avail-ability of profitable investments. If the underlyingpolicy and regulatory frameworks promote healthybanking practices, sound credit allocation, andproper risk management, these developments poselittle risk. By contrast, external borrowing canpose serious macroeconomic and financial stabilityrisks if banks hold large currency mismatches intheir portfolios, maturities are short, or large exter-nal inflows fuel a rapid expansion of bank credit tothe private sector, particularly for consumer loanand housing finance, without sufficient prudentialcontrols.

Several countries that have combined largeinflows of external capital with a boom in banklending to the private sector may be vulnerableto such risks.8 Between 2001 and 2005, Estonia,Hungary, Kazakhstan, Latvia, Lithuania, Nicaragua,Romania, Russia, and Ukraine experienced stronggrowth in private credit accompanied by substan-tial external borrowing by banks. Both metrics roseby more than 50 percent, and banks’ foreign liabil-ities now exceed their foreign assets (figure 3.24).Moreover, since 2005 the average maturity of theforeign loans contracted in these countries hasbeen significantly shorter than the average across

99

Source: IMF IFS and World Bank, World Development Indicators.Note: The sample includes all developing countries except offshore banking centers and countries with fewer than five commercialbanks. Net foreign assets equal foreign assets minus foreign liabilities of the banking sector as a whole.

�1,000

�1,500�100 �50 0 50 100 150

500

1,000

2,500

3,000

1,500

2,000

0

�500

200 250

Figure 3.24 Foreign borrowing by the bankingsector and domestic private credit growth indeveloping countries, 2001–05

Percentage difference between 2001 and 2005

Change in ratio of private credit to GDP

Change in net foreign assets to GDP

Kazakhstan

EstoniaUkraine

Latvia

Lithuania

Nicaragua

Hungary

Russia

Romania

Source: World Bank staff calculations based on Dealogic Loanware.Note: Sample countries are Estonia, Hungary, Kazakhstan, Latvia, Lithuania, Romania, Russia, and Ukraine. Loans for trade financingare excluded.

15

25

30

35

40

20

2000 2001 2002 2003 2004 2005 2006

Figure 3.25 Average foreign loan maturitycontracted by commercial banks in selectdeveloping countries, 2000–06

Months

All countries

Sample countries

developing countries, signaling potential liquidityproblems when the credit cycle turns (figure 3.25).Evidence also indicates that in several countries,including Hungary, Russia, and Ukraine, bankloans to households, for consumer and mortgageloans, have increased considerably.

The extent of the risks to domestic financialstability posed by banks that borrow heavilyabroad may be best assessed by focusing on thebehavior of individual banks in relation to otherbanks in the same country and in relation to thehome countries’ overall macroeconomic andgrowth conditions With some exceptions, the topborrowers in most countries do not appear to betaking on excessive risks.

• Except in Kazakhstan and Russia, the assetsof most of the top foreign borrowers did notgrow much more rapidly than those of otherbanks in the country (figure 3.26).

• The asset quality of top foreign borrowers in allof these countries, as measured by the ratio ofloan-loss reserves to gross loans, has improvedin recent years, and indicators of efficiency andoperational performance are in many cases bet-ter than those of other banks. However, in allcountries except Hungary, the asset quality ofthe top borrowers is significantly worse thanthat of other banks (table 3.7).

• Loan growth of the top external borrowers ismatched by increased deposits to a larger


extent than is the case for other banks in thesame country, possibly indicating that the topexternal borrowers are more established banksthat inspire greater confidence in depositors.

• In almost all cases, the ratio of equity to totalassets is lower for the top borrowers (seetable 3.7), placing them in a relatively poorposition to cope with a decline in global liq-uidity. In particular, major external borrowersin Russia score worse than other Russian

banks on all vulnerability indicators, althoughmost of the banks that perform poorly in thisrespect have a relatively low market share.

An agenda for strengthening thetransparency of corporate governance

Devising rules to strengthen governance inemerging-market corporations is primarily

the responsibility of developing-country govern-ments. But the international community also has arole to play in ensuring the stability of the rapidlyevolving international financial system. Interna-tional financial institutions, international policybodies, and standard setters in securities, account-ing, and other fields are all well placed to promotebetter corporate governance in emerging marketsthrough their work on the rules governing theissuance of corporate securities in major capitalmarkets, on standards for accounting and report-ing, and on regulatory and legal frameworks per-taining to corporate governance.

Globalization may help improve corporategovernance, but more coherent capital marketrules are needed as wellDeveloping-country corporations may well im-prove their governance to some degree simply bycompeting with corporations that are subject to in-dustrial-country transparency requirements andcomplying with industrial-country standards toraise capital through overseas listings and IPOs.However, the degree to which industrial-countryrules can be extended to improve corporate

100

Table 3.7 Performance and vulnerability of top foreign borrowers compared with other banks, selectedaggregates, 2000–05

Asset quality Efficiency and operational Vulnerability indicators

Loan loss Liquidprovision/ Return Net assets/customer

Loan loss net Net on Cost-to- income/ and short- Other operatingreserves/ interest interest average income total Equity/total Interbank term income/average

gross loans revenue margin assets ratio assets assets ratio funding assets

Hungary � �

Kazakhstan � � � � �

Latvia � � � � �

Romania � � � � � �

Russian Fed. � � � � � � � �

Ukraine � � � �

Source: World Bank staff calculations based on Bankscope.Note: � � top borrowers perform significantly better at 10% level; � � top borrowers perform significantly worse. Each indicator is calculated for each bank in each country (2000–05 averages) and then averaged for the banks included in the list of largestforeign borrowers and other banks in the respective country.

Figure 3.26 Asset growth of largest foreignborrowers versus country asset growth, 2005

�10

60

50

40

30

70

90

100

80

20

10

0

Percent

Top foreign borrowers All banks

Source: World Bank staff calculations based on data fromBankscope.Note: Country asset growth is the average of the growth ratesof all commercial banks, savings banks, cooperative banks andmedium and long-term credit banks located in the country and reported in Bankscope.

Hunga

ry

Kazak

hsta

n

Latvi

a

Roman

ia

Russia

n

Fede

ratio

nUkr

aine


governance elsewhere is limited by the multiplicityof global financial “jurisdictions,” each of whichpresents issuers and investors with a different arrayof trading rules, investor protections, disclosureand reporting requirements, and methods of com-plying with international accounting standards.

The U.S. and European capital-market regimeshave been subject to separate waves of rule changesin recent years. Designed to strengthen governance,these changes have in some ways pushed the twosystems farther apart. In the United States, theSarbanes-Oxley Act of 2002 imposed a series ofrequirements aimed at ensuring the independenceof boards of directors and assigning clear responsi-bility for the accuracy of financial statements.9 Inthe European Union, national rules have had to betightened recently to meet EU directives governingprospectuses for securities issuance, disclosure re-quirements for main-board listings on members’stock exchanges, and the detection and preventionof insider dealing and market manipulation.

A major difference between the two ap-proaches is the wide extraterritorial reach of theU.S. regime. U.S. regulation of investor protectionapplies not only in the United States but alsoabroad. In contrast, the European approach setsminimum common standards while recognizing,where possible, the authority of home-market reg-ulators (Coffee 1999).10

The European Union has adopted a “complyor explain” principle, under which companiesdeviating from any provision of the code must ex-plain why they are not embracing best practice incorporate governance (see EU 2006; Arcot, Bruno,and Faure-Grimaud 2007). At the same time, it hassought to encourage convergence and coordinationof the national codes of corporate governance ofmember states. Recognizing the advantages of theEuropean approach, in 2006 the U.S. Committeeon Capital Markets Regulation recommended amore principles-based approach to regulation toenhance shareholder rights while reducing overlyburdensome regulations and litigation. This maysignal progress toward the harmonization ofcapital-market regulation.11

The growth of international norms andstandards has helped developing-countrygovernments improve governanceA set of international financial standards andcodes was developed in 1999, in response to the

101

widespread weaknesses in financial supervisionand corporate governance revealed by the EastAsian financial crisis. A joint World Bank–IMFprogram assesses the observance of standards andcodes by member countries; Corporate Gover-nance Country Assessment reports for more than40 countries are available to the public on theWorld Bank’s Web site. A few countries, such asPakistan, have adopted mandatory corporate gov-ernance guidelines. At least 35 countries have de-veloped voluntary national corporate governancestandards (“codes of best practice”). These codeshave had a “major impact” on reform in manycountries, according to one study (Berg 2007).

Many countries have improved their protec-tion of shareholder rights (notably in proceduresfor shareholder meetings and recordkeeping) andmade significant progress in strengthening the pro-fessionalism, independence, and accountability ofcorporate boards of directors. For example, morethan 35 countries have established institutes totrain directors or developed detailed guidelines forboard members. Many countries are also adoptingregulations to increase the transparency of changesin corporate control during takeovers and to pro-vide fair treatment for existing shareholders.12

Many concerns nevertheless remain regardingthe effectiveness of corporate governance rulesin transition economies, developing countries, andmany developed countries. When the generalenforcement environment is weak, few of thetraditional corporate governance mechanisms areeffective (Berglof and Claessens 2004). Moreover,although many countries have adopted interna-tional financial reporting standards, very few havemade progress toward meeting nonfinancial disclo-sure standards, particularly with regard to owner-ship, control, and related-party transactions. Muchmore needs to be done to instill commitment tosound corporate governance at the national andfirm levels in many developing countries.

Challenging macroeconomic policymanagement tasks remain Protecting the benefits of financial globalizationfor developing countries will require carefullycrafted policies, both macroeconomic andregulatory, by governments in the developingworld. Recognizing that the process of corporateglobalization in developing countries is driven bylong-term structural as well as short-term cyclical


factors, governments must focus on managingshort-term fluctuations and risks while continuingto play a steady, supportive, and catalytic role.

The key long-term requirement is to sustain,and in some cases extend, the structural changesand institution-building efforts that have madepossible the growing involvement of developing-country corporations in global investment andfinance. Under way in many countries since theearly 1990s, those changes include progresstoward a floating exchange rate regime (free ormanaged) or a peg arrangement (especially in thecase of new European Union members), carefullyphased easing of capital controls in combinationwith better governance and stronger domesticregulation, and privatization of public enterprises(World Bank 2006a). Far greater efforts areneeded to spur the development of well-regulatedand liquid local capital markets and to ensureprudential regulation of foreign borrowing by do-mestic banks and other regulated entities. Suchstructural improvements would greatly reduce thelikelihood of corporate financial distress and vul-nerability while promoting the growth of newmarket mechanisms and the regulatory capacityneeded for effective macroeconomic managementof the increasingly open economies of the devel-oping world.

With almost half of developing countries nowoperating under a floating exchange rate regime,a key task facing policy makers is to find ways toreduce wide swings in local currency. Doing so re-quires a judicious mix of monetary policy and inter-vention in foreign exchange markets, tempered byrecognition that the level and type of corporate in-debtedness carry important monetary and exchangerate implications.13 Success in stabilizing local-cur-rency fluctuations has been the hallmark of macro-economic management in several emerging-market

102

Source: Bloomberg and World Bank staff calculations.Note: Short-term volatility is defined as one-month impliedvolatility for options on the currency versus the U.S. dollar.

Figure 3.27 Short-term volatility in emergingmarket currencies, January 2006–April 2007

0

15

10

5

20

30

35

25

Percent

Brazilian real

Turkish lira

Mexican peso

Jan.

2006

Feb.

2006

Mar

. 200

6

Apr. 2

006

May

200

6

Jun.

2006

Jul. 2

006

Aug. 2

006

Sep. 2

006

Oct. 2

006

Nov. 2

006

Dec. 2

006

Feb.

2007

Jan.

2007

Mar

. 200

7

Apr. 2

007

countries, including Brazil, Mexico, and Turkey(figure 3.27). In these countries, currency volatilityagainst the U.S. dollar—as measured by one-monthimplied options on such currencies—declined sig-nificantly over the course of 2006 and now com-pares well with the volatility of the British poundand Swiss franc. Lower currency volatility wouldhelp stimulate demand among foreign investors forcorporate assets and give companies the confidencethey need to commit capital to long-term invest-ment and growth. Policy makers can reinforce thatconfidence-building effect by steering monetarypolicy toward price stability, a necessary conditionfor the smooth operation of market-determined in-terest rates aligned with international trends, andthe adoption of inflation-targeting policies beingpursued by a growing number of emerging-marketeconomies.


Annex: Econometric Methodology andEstimation of Corporate Bond Spreads

segment (Eurobond, 144A issue, global bond); thecurrency of denomination (U.S. dollars or euros);the applicable law and jurisdiction (New York,U.K., or other governing law); and the listingchoice. The term xi

b represents a set of controlvariables pertaining to the terms of the issue—namely, the coupon, log(amount), log(maturity),rating, seniority, call or put, common covenantprovisions, and guarantees. The term xi

f representsfirm-specific variables, such as private versuspublic ownership and industry dummies. Themodel controls for the economic environment ofthe issuer’s home country by including economicindicators (zi

econ: [the log of] per-capita GDP, infla-tion, real growth); the home country’s level offinancial development (zi

fin: stock-market capital-ization or turnover as a percentage of GDP, privatecredit as percentage of GDP); and the quality of itslegal, political, financial, and economic institu-tions (zi

ins: the ICRG indexes of economic, finan-cial, and political stability and its subindexes).

Various linear models of the offerings’ creditspread at issue over comparable U.S. Treasury orGerman government debt securities are providedas a function of offering terms, rating, distribu-tion, currency and jurisdiction, industry and own-ership variables, and various economic, financial,and institutional control variables for each issuer’shome country. All specifications are estimatedusing ordinary least squares (OLS) with countryfixed-effects and clustered standard errors thatare adjusted for heteroskedasticity across coun-tries and correlation within countries. In the inter-est of parsimonious specifications, statistically in-significant control variables have been eliminated(table 3A.1).

103

To analyze the determinants of at-issue yieldspreads of international bonds offered by corpo-rations located in emerging markets, Bank staffcollected data from Bondware on 1,599 U.S. dollar-or euro-denominated offerings in 44 countriesbetween 1990 and 2005. The sample represents awide cross-section of issues in terms of maturity,amount, seniority, coupon, offering terms and legalprovisions, listing, applicable law and jurisdiction,rating, industry, and market segment.

These data were matched against data from avariety of sources on the institutional, legal, finan-cial, and economic development of each issuer’shome country by month, quarter, or year. Variablesfrom the World Bank’s Financial Structure and De-velopment database and the monthly InternationalConsulting Resources Group (ICRG) country-riskindexes were used to gauge the degree of financial,legal, and institutional development of each issue’shome country. Fifteen industry dummies wereconstructed on the basis of each issuer’s two-digitStandard Industrial Classification (SIC) code tocontrol for industry effects. Matching the variousdata sources leaves 1,206 observations for whichfull data were available.

The following linear model of emerging-market corporate bond spreads was then specified:

Si � xim �m � xi

b �b � xif �f � zi

econ �econ

� zifin � fin � zi

ins � ins � ui,

where Si is the bond’s at-issue credit spread overthe yield of a maturity-matched U.S. Treasury se-curity or, in the case of a euro issue, a comparableGerman Bundesobligation. The term xi

m representsa set of variables relating to the issue’s marketingchoice, such as dummy variables for the market


104

Table 3A.1 Regression results of analysis of at-issue corporate bond spreads

Dependent variable (1) (2) (3) (4)

Bond attributeFloating rate note �87.532 �90.065 �96.123 �90.255

(0.000)*** (0.000)*** (0.000)*** (0.000)***Euro-denominated �55.465 �24.481 �23.689 �65.350

(0.007)*** (0.250) (0.176) (0.000)***Log (maturity) �1.287 �6.397 �3.699 �2.354

(0.800) (0.328) (0.586) (0.710)Log (amount) �25.444 �23.564 �26.683 �29.634

(0.002)*** (0.003)*** (0.000)*** (0.000)***Nonrated issue 191.125 168.340 178.244 197.207

(0.000)*** (0.000)*** (0.000)*** (0.000)***Issue credit-rating index 19.361 16.852 17.531 18.324

(0.000)*** (0.000)*** (0.000)*** (0.000)***Private ownership 47.615 45.307 44.583 47.877

(0.000)*** (0.000)*** (0.000)*** (0.000)***Third-party guarantee �22.748 �26.307 �24.630 �23.441

(0.015)** (0.014)** (0.012)** (0.009)***No negative-pledge clause 24.785 21.779 24.566 6.935

(0.001)*** (0.106) (0.045)** (0.784)No cross-default clause �69.673 �65.921 �63.247 �66.153

(0.002)*** (0.003)*** (0.009)*** (0.062)*U.S. (N.Y.) law �15.861 �30.100 �27.652 �6.812

(0.450) (0.185) (0.207) (0.728)U.K. law �22.982 �33.162 �27.077 �15.299

(0.352) (0.192) (0.257) (0.469)Eurobond 20.235 20.514 18.723 17.964

(0.060)* (0.077)* (0.079)* (0.025)**144A only �0.496 �4.049 �16.492 9.544

(0.976) (0.843) (0.384) (0.581)Macroeconomic variableLog (GDP per capita) 212.774 75.806 �153.672 �56.602

(0.054)* (0.477) (0.129) (0.370)GDP growth rate �3.843 �7.256 �5.525 �3.904

(0.015)** (0.000)*** (0.002)*** (0.035)**Log (1 � inflation) 96.637 103.637 104.160 104.100

(0.000)*** (0.000)*** (0.000)*** (0.000)***Home stock-market turnover/GDP �79.722 �109.443 �98.186

(0.005)*** (0.004)*** (0.003)***Private credit/GDP �97.267 �58.030 �182.505

(0.206) (0.278) (0.002)***Capital/trade flow restrictions 5.253

(0.001)***External debt as percentage of GDP 1.909

(0.090)*Institutional indicatorCountry credit-rating index 21.626

(0.005)***ICRG Composite Risk Index 9.262

(0.000)***ICRG Economic Risk Index 5.248

(0.000)***ICRG Financial Risk Index 6.316

(0.000)***ICRG Political Risk Index 1.314

(0.524)SectorBanking (SIC 60) �28.001 �28.793 �33.740 �25.406

(0.000)*** (0.001)*** (0.000)*** (0.002)***Telecommunications (SIC 48) 13.483 20.642 28.958 8.123

(0.217) (0.077)* (0.012)** (0.569)Chemicals (SIC 28) 60.832 78.341 75.118 65.070

(0.006)*** (0.006)*** (0.009)*** (0.004)***Railways (SIC 40) 198.479 186.036 179.946 176.296

(0.000)*** (0.000)*** (0.000)*** (0.000)***


Notes1. The universe of publicly traded companies is esti-

mated at 41,246 firms in the world’s major 50 stock ex-changes (members of the World Federation of Exchanges),of which 2,789 are foreign-listed companies.

2. Recent theories have extended Merton’s (1987) intu-ition by arguing that firms can attract investor interest in atleast three ways: by improving disclosure practice, by mak-ing themselves more familiar, and by committing to goodcorporate governance.

3. América Movil took advantage of the liquidation ofthe emerging-market assets of U.S. operators such as AT&T,Bell South, and MCI, gaining more than 100 million sub-scribers by March 2006. Its Spanish-owned competitor,Telefónica Móviles, has 74 million subscribers.

4. A recent study by the Bank of Italy (2006) providesevidence of a significant reduction in the level of volatilitybetween July 2004 and March 2006 relative to the historicalaverage in both the stock and bond markets of France,Germany, Italy, Japan, Switzerland, the United Kingdom,and the United States.

5. From the perspective of international investors, themost important difference in accounting standards relates tothe U.S. Generally Accepted Accounting Principles (GAAP)and the International Financial Reporting Standards (IFRS)adopted by the European Union for application to publiclytraded companies as of January 2005. National adoption ofIFRSs has been widespread across regions in recent years andthe momentum continues. See, for example, Tweedie andSeidenstein (2005). In addition to moves toward an overall

trend of convergence of national financial reporting stan-dards, the International Accounting Standards Board (IASB)and the U.S. Financial Accounting Standards Board (FASB)have also launched an effort to harmonize differences be-tween IFRSs and the U.S. GAAP. At their political summitmeeting on April 30, 2007, European and U.S. leadersagreed to promote conditions for recognition of U.S. GAAPand IFRSs in both jurisdictions without need for reconcilia-tion by 2009 (see the IASB Web site at http://www.iasb.org).

6. Empirical work confirms that developing countries’borrowing costs fall with greater participation in interna-tional capital markets. Spreads on sovereign loans fell withcontinued borrowing (Ozler 1992), and spreads on loans toboth public and private borrowers fell with repeated loancommitments (Eichengreen and Mody 2000). However, re-peat borrowing has little impact on bond markets, whichrely largely on publicly available information (Eichengreen,Kletzer, and Mody 2005).

7. The first Eurobond issue is reported to have beenthe $15 million bond issuance by Italy’s Autostrade in 1963.

8. Several papers examine the potential risks of rapidcredit growth in Central and Eastern Europe. See, for exam-ple, Enoch and Otker-Robe (2007) and World Bank (2007).

9. These included requirements that the boards ofcompanies listed on a U.S. exchange have a majority of in-dependent directors; have wholly independent committeesoverseeing auditing, compensation, and nominations of di-rectors; and require the company’s chief executive and chieffinancial officer to sign a statement affirming the accuracy

105

Table 3A.1 (Continued)

Dependent variable (1) (2) (3) (4)

Year dummy1998 65.847

(0.000)***1999 130.428

(0.000)***2000 61.385

(0.033)**2001 103.125

(0.000)***2002 165.231

(0.000)***2003 162.757

(0.000)***2004 94.013

(0.003)***2005 48.148

(0.077)*Constant �1,776.928 �481.740 1,287.628 412.311

(0.042)** (0.592) (0.122) (0.402)Number of observations 1,211 1,206 1,206 1,310R-squared 0.629 0.591 0.596 0.662

Source: World Bank staff estimates.Note: Fixed country effects are not reported; clustered P-values (standard errors adjusted for heteroskedasticity across countries and correla-tion within countries) are shown in parentheses.* Significant at the 10 percent level.** Significant at the 5 percent level.*** Significant at the 1 percent level.


of financial statements and the effectiveness of internal con-trols over financial reporting.

10. The EU Prospectus and Market Abuse Directivesplace greater emphasis on harmonization, however (Scott2005).

11. The IASB, made up of accountancy bodies in morethan 100 countries, publishes international financial report-ing standards (IFRS, known until 2001 as “international ac-counting standards”) that have been adopted by more than90 countries. EU members, Switzerland, and Hong Kong(China), among others, use these standards. The 2005 EUdecision to make IFRS binding for all publicly listedEuropean firms is considered the first major standard-ization. China, India, Japan, and many other countrieshave begun to make strides toward adopting IFRSs, whilethe IASB and the U.S. FASB have launched an effort to har-monize differences between IFRS and the U.S. GAAP.

12. Studies have also shown the importance of corpo-rate governance for developing countries’ corporations.Higher corporate governance standards are associated withhigher company valuation (Black, Jang, and Kim 2006) andgrowth (La Porta and others 2000; Djankov and others2006). Moreover, better legal protection at the country levelcan be a substitute for poor governance at the companylevel (Klapper and Love 2004; Durnev and Kim 2005).

13. Foreign and local debt are often imperfectly substi-tutable on the corporate balance sheet, either because ade-quate currency hedging instruments are not available (or arenot used) or because of differences in the degree of flexibil-ity of the two types of financing (foreign debt is harder forfirms to restructure than local debt). For these reasons, cor-porate foreign debt plays a role in the transmission of mon-etary policy (Bolton and Freixas 2000, 2006).

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Dailami, Mansoor. 2000. “Managing Risks of Global Finan-cial Market Integration.” In Managing Financial andCorporate Distress: Lessons from Asia, ed. CharlesAdams, Robert E. Litan, and Michael Pomerleano,447–80. Washington, DC: Brookings Institution Press.

Dailami, Mansoor, and Robert Hauswald. 2003. “TheEmerging Project-Bond Market: Covenant Provisionsand Credit Spreads.” World Bank Policy ResearchWorking Paper 3095, Washington, DC.

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East Asia and the Pacific1

Recent developments

The developing economies of the East Asia andPacific region grew 9.5 percent in 2006, led

by 10.7 percent growth in China (table A.1). Forthe region, this was the fastest growth in the lastten years, and the fourth year in a row that GDPin China expanded by more than 10 percent.

Industrial production slowed in the second halfof the year in China (figure A.1) following thestagnation of U.S. import demand, a rise in domes-tic interest rates, and the imposition of administra-tive restrictions in some sectors. The latter causedinvestment volume growth to slow from a pace ofmore than 25 percent year-over-year in the first half

109

.

Appendix: Regional Outlooks

of 2006 to 19 percent in the fourth quarter. Thiscontributed to weaker real import growth andslowed the growth of exports among othereconomies in the region. High-frequency datasuggest that industrial production recovered into2007 and that Chinese export growth and mone-tary aggregates accelerated in early 2007 comparedwith the last quarter of 2006 (although seasonalfactors linked to the Chinese New Year may also beat play).

Growth in the rest of the region was alsorobust, expanding by 5.7 percent. Notwithstand-ing a pronounced slump in high-tech demandin the second half of 2006 and a weakening inChinese import demand, growth in most countries

Table A.1 East Asia and Pacific forecast summaryannual percent change unless indicated otherwise

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

GDP at market prices (2000 $)b 8.4 9.0 9.0 9.5 8.7 8.0 7.9GDP per capita (units in $) 7.1 8.1 8.1 8.6 7.8 7.2 7.1PPP GDPc — 9.2 9.2 9.6 8.8 8.2 8.0

Private consumption 7.3 6.8 6.4 7.5 7.5 6.9 6.5Public consumption 9.0 6.7 8.8 8.4 7.6 7.2 6.8Fixed investment 10.3 11.5 8.0 7.9 8.1 6.3 6.0Exports, GNFSd 11.7 22.6 18.4 18.4 15.5 15.8 13.2Imports, GNFSd 11.3 20.6 11.2 14.8 14.8 13.1 11.1

Net exports, contribution to growth 1.2 6.5 9.9 12.2 13.2 15.3 17.0Current account balance/GDP (%) 0.1 3.5 6.1 8.1 7.8 7.6 6.5GDP deflator (median, LCU) 6.5 6.1 4.0 4.2 5.4 3.9 3.9Fiscal balance/GDP (%) �0.7 �1.5 �1.6 �0.7 �0.9 �1.0 �1.1

Memo items: GDPEast Asia excluding China 4.8 6.1 5.4 5.7 5.7 5.9 6.0China 10.4 10.1 10.2 10.7 9.6 8.7 8.5Indonesia 4.2 5.1 5.7 5.5 6.3 6.5 6.4Thailand 4.5 6.2 4.5 5.3 4.5 4.5 5.0

Source: World Bank.Note: e � estimate; f � forecast; LCU � local currency units; — � not available.a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.b. GDP measured in constant 2000 $. c. GDP measured at PPP exchange rates.d. GNFS denotes goods and nonfactor services.

A P P E N D I X : R E G I O N A L O U T L O O K S

exceeded 5 percent. The expansion was particu-larly strong in Vietnam and Cambodia (GDP wasup an estimated 8.2 and 10.5 percent, respectively),backed by across-the-board strength in exports,domestic consumption, and investment. InIndonesia, growth slowed in the first half of 2006,reflecting an earlier tightening of monetary policyand the withdrawal of fuel subsidies. Growthpicked up subsequently, coming in at 5.5 percentfor the year as a whole, spurred by a rebound in do-mestic consumption and investment. Growth alsopicked up in Malaysia, with GDP rising 5.9 per-cent, supported by strengthening exports and do-mestic demand. In the Philippines, output experi-enced a modest increase, with growth coming in at5.4 percent for the year. Economic activity in Thai-land expanded by 5.3 percent in 2006, an improve-ment over the 4.5 percent outturn in 2005, mainlyon the back of strong export growth. Growth in2005–06 was, however, more than 1 percentagepoint less than in the previous three years, mainlybecause of depressed business and consumer confi-dence due in part to high oil prices, increasedpolitical uncertainty, and recent policy changesaffecting foreign investment.

Trade continues to fuel the growth dynamic inthe East Asia and Pacific region. The accession ofVietnam to the World Trade Organization (WTO)in January 2007 will provide another boost totrade flows. Apart from an average 4 percentagepoint reduction in import tariffs, the accession will

110

strengthen regulations and financial managementin Vietnam. Elsewhere in the region, the move-ment toward free trade persists. Since becominga WTO member in 2001, China has launched aflurry of bilateral trade negotiations with morethan 30 economies around the world. And inNovember 2006 the Asia Pacific Economic Coop-eration forum (APEC) agreed to “seriously con-sider” negotiating a Free Trade Area of the AsiaPacific.

A generalized tightening of monetary policy inthe region, following a pickup in consumer pricesinduced partly by high oil prices in 2005, has suc-ceeded in lowering inflation in many economies(figure A.2). In Indonesia, the removal of energysubsidies has only temporarily raised inflation (fig-ure A.3). The moderation of inflation has allowedIndonesia and Thailand to begin easing interestrates. Elsewhere, despite the downward trend inregional inflation, nominal interest rates have beenstable or have declined less rapidly, leading, for ex-ample, to a tightening of monetary conditions inthe Philippines. Given the continued robustness ofgrowth, China increased interest rates and reserverequirements in the first quarter of 2007, the latestof several increases over the past year. Inflationthere has been rising but was still fairly low at3.3 percent in March 2007 (year over year).

Regional equity markets remain generallybuoyant, although concern over valuations led toheightened volatility in February/March 2007,

0

Jan.

2003

Jul. 2

003

Jan.

2004

Jul. 2

004

Jan.

2005

Jul. 2

005

Jan.

2006

Jul. 2

006

1

2

3

4

5

6

7

8

9

10

Jan.

2007

Monthly % change in consumer prices, year-over-year

Source: World Bank.

Figure A.2 Inflation in Malaysia, the Philippines,and Thailand

Philippines

Thailand

Malaysia

0

Jan.

2001

Oct. 2

001

Jul. 2

002

Apr. 2

003

Jan.

2004

Oct. 2

004

Jul. 2

005

Apr. 2

006

Jan.

2007

5

10

15

20

25

30

% change in industrial production


Figure A.1 Chinese industrial production

Year-over-year

3-month�3-month at anannualized rate

Third quarter 2006


111

reminiscent of the more widespread correctionobserved in May/June 2006. More generally, thisvolatility serves to remind investors and policymakers of the riskiness of emerging markets,which are relatively thinly traded and thereforemore sensitive to changes in market sentiment.

Notwithstanding acceleration in the ren-minbi’s appreciation with respect to the dollar,economic pressures for the appreciation of curren-cies in developing Asia are likely to remain strong.Overall, the region’s balance of payments is insignificant surplus (8.1 percent of GDP, or 4.8 per-cent of GDP excluding China). In addition toreducing global imbalances, greater currency flexi-bility and exchange rate appreciation would helpcontain inflationary pressures, improve domesticmacroeconomic management capabilities, steadyasset markets, and, over time, improve living stan-dards for local populations.

The strong current account position of EastAsia and Pacific countries reflects large financialinflows, particularly in the form of FDI (table A.2).

0

2

4

6

8

10

12

14

16

18

20


Figure A.3 No permanent impact on inflation ofa removal of energy subsidies in Indonesia

Jan.

2003

Jul. 2

003

Jan.

2004

Jul. 2

004

Jan.

2005

Jul. 2

005

Jan.

2006

Jul. 2

006

Jan.

2007

Source: World Bank.

Table A.2 Net capital flows to East Asia and Pacific$ billions

1998 1999 2000 2001 2002 2003 2004 2005 2006e

Current account balance 59.4 50.0 45.4 36.7 56.1 73.4 92.2 179.1 272.2as % of GDP 4.2 3.3 2.7 2.0 2.8 3.3 3.5 6.1 8.1

Financial flowsNet private and official flows 21.2 40.0 35.4 41.4 47.3 67.9 120.4 167.2 167.6Net private flows (debt � equity) 6.5 27.5 28.8 38.2 55.2 75.1 125.7 169.7 179.9Net equity flows 54.7 51.7 51.7 49.5 60.8 66.0 85.1 123.0 136.7Net FDI inflows 57.8 50.4 45.1 47.7 57.0 53.5 66.1 96.9 88.3Net portfolio equity inflows �3.1 1.3 6.6 1.8 3.8 12.5 19.0 26.1 48.4

Net debt flows �33.5 �11.7 �16.3 �8.1 �13.5 1.9 35.3 44.2 30.9Official creditors 14.7 12.5 6.6 3.2 �7.9 �7.2 �5.3 �2.4 �12.3

World Bank 2.8 2.4 1.8 0.9 �1.7 �1.5 �1.9 �0.6 �1.0IMF 7.0 1.9 1.2 �2.5 �2.7 �0.5 �1.6 �1.6 �8.4Other official 4.8 8.2 3.5 4.8 �3.5 �5.2 �1.7 �0.2 �2.8

Private creditors �48.2 �24.2 �22.9 �11.3 �5.6 9.1 40.6 46.7 43.2Net medium- and long-term debt flows �3.5 �10.9 �13.1 �13.0 �12.4 �9.4 8.0 7.2 11.4

Bonds 1.0 0.9 �0.7 0.4 0.1 2.1 9.7 9.9 7.1Banks �4.8 �12.0 �11.3 �11.8 �10.2 �8.4 0.2 �0.6 7.2Other private 0.3 0.2 �1.0 �1.6 �2.3 �3.1 �1.9 �2.2 �2.9

Net short-term debt flows �44.7 �13.3 �9.9 1.7 6.8 18.5 32.6 39.5 31.8Balancing itema �58.7 �62.0 �72.4 �29.7 �14.2 �4.0 24.0 �130.4 �150.1Change in reserves (� � increase) �21.9 �28.0 �8.4 �48.4 �89.2 �137.2 �236.6 �215.8 �289.6

Memo itemsBilateral aid grants 5.2 5.2 5.3 4.9 5.0 5.9 6.4 7.9 5.6of which Technical cooperation grants 2.7 2.7 2.8 2.7 2.8 3.4 3.6 3.9 3.5Other 2.5 2.5 2.5 2.2 2.2 2.5 2.8 4.0 2.1

Net official flows (aid � debt) 19.9 17.7 11.9 8.1 �2.9 �1.3 1.1 5.5 �6.7Workers’ remittances 12.9 15.7 16.7 20.1 29.5 35.3 38.8 45.1 47.2Repatriated FDI Income 7.1 5.9 6.4 13.0 11.6 13.0 23.0 29.5 —

Sources: World Bank Debtor Reporting System and staff estimates.Note: e � estimate; LCU � local currency units; — � not available.a. Combination of errors and omissions and net acquisition of foreign assets (including FDI) by developing countries.


FDI has been increasing during the course of theexpansion but eased to some $88 billion in 2006,with $67 billion going to China. The region hasalso attracted significant levels of bank lending andmore volatile equity investments.

Net capital inflows to East Asia and Pacific to-taled $167 billion in 2006, unchanged from 2005,marking a decrease in share of total flows to devel-oping countries to 30 percent from 35 percent in2005. The broad composition shifted from debtand FDI to portfolio equity. Higher equity inflows(up $22 billion to $48 billion) were offset by lowernet (private and official) debt flows (down $13.3billion to $30.9 billion) and lower net FDI inflows(down $8.5 billion to $88 billion). At $7 billion in2006, net bank lending finally showed some activ-ity after being negligible in 2004–05 and averagingnet outflows of $10 billion in the six years follow-ing the Asian crisis in 1997. Repayments to officialcreditors outstripped lending by $10 billion in2006, mostly due to an $8 billion prepayment byIndonesia to the IMF.

Net portfolio inflows to the region accountedfor 53.5 percent of the total for all developingcountries, up from an average of 47 percent overthe previous five years. The increase reflectedhigher inflows to China (up $11 billion to $31 bil-lion in 2006), mainly due to IPOs by the Industrialand Commercial Bank of China ($12.8 billion)and the Bank of China ($8.9 billion). Both trans-actions, launched on the Hong Kong exchange,were oversubscribed by a wide margin, defying thelong-held belief that transactions of this magni-tude needed to be listed in New York or Londonto gain access to a global pool of capital.

The estimated $8.5 billion decline in FDI in-flows to the region in 2006 was concentrated inChina and Indonesia. FDI to Indonesia declined by$3 billion following exceptional privatization andmerger and acquisition activity in 2005 (totaling$5 billion). FDI inflows to China also declined by$3 billion, reducing its share from 28 to 23 per-cent of the total to all developing countries. FDIinflows to China have shifted from the manufac-turing sector to the financial and real estate sec-tors, partly reflecting greater access by foreignersto investment in the banking and insurance sectorsin compliance with WTO accession requirements.

Partly as a reaction to these strong inflowsover the last 4–5 years, policy makers in the regionhave adopted increasingly flexible exchange rate

112

regimes. Both China and Malaysia announcedtheir intentions to replace the dollar as the refer-ence for their exchange rate management schemeswith a basket of currencies in 2005.

Medium-term outlookGrowth is projected to slow in 2007, although to astill-robust 8.7 percent, and continue moderatingtoward 7.9 percent by 2009. Somewhat weaker in-vestment in China should be partially offset bystronger consumer demand, so that China’s overallGDP is projected to expand about 9.6 percent in2007 before slowing to 8.5 percent in 2009(table A.3). Notwithstanding currency apprecia-tion, China’s current account surplus is projectedto remain high at 7.8 percent of GDP in 2009. Incontrast, growth in the remainder of the regionis expected to pick up over the period, reaching6 percent in 2009, up from 5.7 percent in 2006.Output in Indonesia is expected to accelerate to6.3 percent in 2007 and remain strong at around6.5 percent over the next couple of years due tocontinued buoyant domestic demand, and despiteweaker Chinese imports. Growth in Thailand isprojected to weaken further in 2007, to 4.5 per-cent, as policy changes and political turmoil con-tinue to impact output, before picking up to 5 per-cent in 2009. Growth in Malaysia and thePhilippines is also expected to remain robust onthe back of continued gains in domestic demand,with a recovery of export growth toward the endof the forecast period.

Risks and uncertaintiesThis relatively rosy outlook is subject to a numberof uncertainties. In particular, the projected slow-down in China is predicated on trend moderationin export growth, as the period of very rapidgrowth following the relaxation of trade barriersthat accompanied its accession to the WTO givesway to increases more reflective of underlying dif-ferentials in productivity growth. Output in othercountries in the region will be sensitive to this out-turn, as China has become the major initial desti-nation for most of their exports. Should China’sexport growth not slow as quickly as predicted,the expansion throughout the region could bestronger than projected, potentially placing addi-tional pressures on prices and requiring a furthertightening of macroeconomic policies.


Prospects in the region are also vulnerable tothe possibility of a sharper-than-expected slow-down in the United States, a potential deteriora-tion in global financial conditions, and an oil sup-ply shock. While a substantial reduction in U.S.imports would certainly affect East Asian andPacific exports, most of the region’s export growthhas reflected increased market share rather thanvery rapid import growth by the United States andother high-income countries. Moreover, directtrade links to the United States among the ASEANcountries, newly industrial economies, and Japan

113

Table A.3 East Asia and Pacific country forecastsannual percent change unless indicated otherwise

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

CambodiaGDP at market prices (2000 $)b — 10.0 13.4 10.5 9.0 6.8 6.5Current account balance/GDP (%) — �3.7 �6.4 �7.9 �6.0 �5.8 �5.6

ChinaGDP at market prices (2000 $)b 10.4 10.1 10.2 10.7 9.6 8.7 8.5Current account balance/GDP (%) 1.5 3.6 7.4 9.3 9.2 9.1 7.8

FijiGDP at market prices (2000 $)b 2.1 5.3 0.7 3.4 �2.5 2.0 2.5Current account balance/GDP (%) �3.1 �16.8 �16.3 �13.2 �9.0 �7.9 �8.4

IndonesiaGDP at market prices (2000 $)b 4.2 5.1 5.7 5.5 6.3 6.5 6.4Current account balance/GDP (%) �0.4 0.6 0.3 2.8 2.3 1.3 0.7

Lao PDRGDP at market prices (2000 $)b — 6.4 7.0 7.5 7.1 9.0 8.5Current account balance/GDP (%) — �6.3 �24.6 �17.0 �26.6 �22.5 �18.8

MalaysiaGDP at market prices (2000 $)b 7.1 7.2 5.2 5.9 5.6 5.8 5.7Current account balance/GDP (%) �0.4 12.6 15.2 14.6 12.9 13.9 13.1

Papua New GuineaGDP at market prices (2000 $)b 4.8 2.7 3.0 3.8 4.0 4.0 4.0Current account balance/GDP (%) 2.2 �1.5 5.9 4.4 �2.0 �3.3 �3.5

PhilippinesGDP at market prices (2000 $)b 3.0 6.2 5.0 5.4 5.6 6.0 6.0Current account balance/GDP (%) �3.1 1.9 2.4 3.5 3.2 2.5 2.1

ThailandGDP at market prices (2000 $)b 4.5 6.2 4.5 5.3 4.5 4.5 5.0Current account balance/GDP (%) �1.2 4.2 �2.2 3.5 2.3 1.0 1.0

VanuatuGDP at market prices (2000 $)b 4.1 4.0 2.8 3.0 2.4 2.4 2.5Current account balance/GDP (%) �8.2 �19.7 �4.3 �4.4 �4.7 �4.4 �4.4

VietnamGDP at market prices (2000 $)b 7.6 7.7 8.5 8.2 8.0 8.0 7.8Current account balance/GDP (%) �5.1 �1.0 0.4 1.5 �0.5 �1.0 �1.0

Source: World Bank.Note: Growth and current account figures presented here are World Bank projections and may differ from targets contained in other Bank

documents. American Samoa, the Federated States of Micronesia, Kiribati, the Marshall Islands, Myanmar, Mongolia, Northern MarianaIslands, Palau, the Democratic People’s Republic of Korea, the Solomon Islands, Timor-Leste, and Tonga are not forecast owing to datalimitations. e � estimate; f � forecast; — � not available.

a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.b. GDP measured in constant 2000 $.

have diminished as a share of GDP. As a result, theprojected impact of the slowdown in the UnitedStates is expected to be relatively minor (see IMF2006).

The strong growth, large capital inflows intothe private sector, and rising asset prices mightseem strikingly similar to the situation 10 yearsago, just before the 1997–98 crisis, when a rever-sal in investor sentiment resulted in a liquiditysqueeze and a severe recession. However, it isunlikely that history will repeat. Contrary to the1990s, most countries in the region now have


large current account surpluses and have accumu-lated reserves well beyond what is needed to ab-sorb sudden reversals in capital flows.

Reduced vulnerability to external financialshocks and the expansion of domestic debt andequity markets has shifted the balance of risks todomestic financial markets. Despite improvementsin capitalization, governance, risk management,and operational efficiency in the banking sectors,there is still significant risk linked to limited avail-ability of good information to price securitiesaccurately. Therefore, improving corporate gover-nance and the degree and quality of corporatefinancial disclosure remains a priority.

Europe and Central Asia Recent developments

GDP in the Europe and Central Asia region isestimated to have increased 6.8 percent in

2006, up from 6.0 percent growth the year before(table A.4). An acceleration of growth in high-income Europe, still-low real interest rates, andfurther increases in incomes of regional oil ex-porters2 helped to generate an acceleration in out-put among many countries in the region (notably

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Table A.4 Europe and Central Asia forecast summaryannual percent change unless indicated otherwise

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

GDP at market prices (2000 $)b �0.9 7.2 6.0 6.8 6.0 5.7 5.8GDP per capita (units in $) �1.1 7.2 6.0 6.7 6.0 5.7 5.7PPP GDPc �0.8 7.4 6.0 6.9 6.1 5.8 5.9

Private consumption 0.5 8.3 7.4 8.2 6.9 6.4 6.3Public consumption 0 2.0 2.9 3.6 3.6 3.5 3.3Fixed investment �6.1 13.1 11.5 13.8 10.2 10.4 9.6Exports, GNFSd 1.4 13.4 7.9 9.5 9.0 9.0 9.4Imports, GNFSd �0.9 17.6 9.9 13.6 10.8 10.8 10.5

Net exports, contribution to growth 0.5 0.4 �0.5 �2.6 �3.6 �4.7 �5.6Current account balance/GDP (%) — 0.3 1.0 0.6 �0.8 �1.6 �1.8GDP deflator (median, LCU) 104.7 6.1 6.1 3.9 6.0 5.5 5.3Fiscal balance/GDP (%) �5.8 �0.9 1.0 1.7 0.7 0.3 0.3

Memo items: GDPTransition countries 1.8 6.7 5.6 6.2 5.4 5.4 5.1Central and Eastern Europe 1.0 5.6 4.6 6.2 5.9 5.3 5.0Commonwealth of Independent States �4.2 8.0 6.8 7.7 6.9 6.3 6.6

Russian Federation �3.9 7.1 6.4 6.7 6.3 5.6 5.8Turkey 3.6 8.9 7.4 6.0 4.5 5.5 5.4Poland 3.8 5.3 3.5 6.1 6.5 5.7 5.0

Source: World Bank.Note: e � estimate; f � forecast; LCU � local currency units; — � not available.a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.b. GDP measured in constant 2000 $. c. GDP measured at PPP exchange rates.d. GNFS denotes goods and nonfactor services.

in Bulgaria, Estonia, Latvia, Poland, Romania,Russia, and other oil exporters, the Slovak Repub-lic, and Ukraine). Growth in Bulgaria and Roma-nia was also bolstered by improved confidenceand capital inflows tied to EU accession in January2007. Strong capital inflows, including significantlevels of FDI, into countries that recently joinedor expect to join the EU,3 coupled with extremelyrapid domestic credit expansion and in somecases loose fiscal policy (such as Hungary and theSlovak Republic), are at the root of excess demandin several countries (including the Baltic countries,Bulgaria, Hungary, Romania, the Slovak Republic,and Turkey).

Among the region’s larger economies, GDP inRussia increased 6.7 percent, boosted by risingoil revenues (oil prices were up 20 percent for theyear as a whole) that fed into increased govern-ment spending, private consumption, andinvestment. In Poland, a welcome expansion inconsumption, thanks to rising wages and employ-ment and double-digit increases in investment vol-umes, helped to propel growth to 6.1 percent aftera relatively modest and mainly export-led 3.5 per-cent expansion in 2005. In contrast, growth inTurkey declined from 7.4 to 6.0 percent between


2005 and 2006, as private investment and con-sumption growth slowed markedly in response tothe tightening of monetary policy in the wake ofthe May 2006 currency crisis.

The European recovery, coupled with rapidlygrowing demand from large regional oil exporters,notably Russia, bolstered exports among oil im-porters, whose economies grew 6.3 percent.Moldova represented a notable exception to thisstrong regional performance. Growth there declinedsharply from 7.1 to 4.0 percent between 2005 and2006 due to higher gas import prices and Russia’simposition of trade restrictions on Moldovan ex-ports (especially on wine, which generates 30 per-cent of Moldova’s GDP). High oil prices and thecoming on stream of oil projects and export capac-ity lifted the 2006 GDP growth among smaller oilexporters to 13.7 percent (notably Azerbaijan,where GDP rose by 34.5 percent, and Kazakhstan,where GDP rose by 10.6 percent).

Macroeconomic policy varies considerablyacross Europe and Central Asia. All but sevencountries in the region have general governmentdeficits of less than 3 percent of their GDP, withAlbania, Croatia, the Czech Republic, Hungary,the Kyrgyz Republic, the Slovak Republic, andTajikistan being the exceptions. Despite strong re-gional growth, fiscal positions deteriorated bynearly 1 percentage point or more of GDP in Azer-baijan (2.5 percentage point deterioration), FYRMacedonia (0.9), Hungary (3.0), Moldova (1.0),and Romania (0.9), which contributed to strongdemand but also added to risks. Among oil im-porters, several have used strong revenue growth to

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reduce deficits. Government spending has in-creased rapidly among hydrocarbon exporters, al-though elevated energy sector revenues have keptbalances in the black, and fiscal surpluses haveactually risen as a share of GDP in Kazakhstan,Russia, Turkmenistan, and Uzbekistan.

Several years of fast growth, a rapid expansionof credit (often fueled by capital inflows), and therise in fuel prices have exacerbated inflationarypressures in a number of countries. Median con-sumer price inflation in the region accelerated to6.6 percent in 2006, up from 5.8 percent in 2005—the highest rate since 2001. Inflation rose by 1 ormore percentage points in several countries:Armenia, Bosnia and Herzegovina, Bulgaria, Kaza-khstan, the Kyrgyz Republic, FYR Macedonia, theSlovak Republic, and Turkey (figure A.4). Manyother countries had inflation rates in excess of 5 per-cent: Bosnia and Herzegovina, Bulgaria, Latvia,Romania, Turkey, and all countries in the Com-monwealth of Independent States except Armenia.

Tighter monetary policy helped Belarus,Romania, Russia, Serbia and Montenegro, andUkraine to lower inflation by 2 percentage pointsor more. Ukraine brought its inflation rate downsignificantly in 2006, to 9.1 percent, from 13.5 in2005. For some EU member countries, achievinginflation rates in line with the Maastricht criteria(2.8 percent in 2006) remains a challenge, espe-cially for those seeking to adopt the euro at anearly date.

The very strong domestic demand and capitalflows that underlie the rise in regional inflationhave also generated a substantial increase in


�2

2

4

8

10

12

6

0

Figure A.4 Building inflationary pressure in Europe and Central Asia

Quarterly inflation rate, year-over-year

�4Kyrgyz Republic TurkeyArmenia Lithuania Hungary Estonia Bulgaria Kazakhstan

Q1 2005 Q3 2005Q2 2005 Q4 2005

Q1 2006 Q3 2006Q2 2006 Q4 2006


external imbalances among regional oil importers,whose current account deficits deterioratedsharply from 4.7 percent of GDP in 2005 to6.3 percent of GDP in 2006. Current accountpositions deteriorated precipitously, by 4 percentof GDP or more, in a number of oil-importingcountries: Belarus, Bulgaria, Estonia, Georgia, theKyrgyz Republic, Lithuania, and Ukraine. In theKyrgyz Republic, an exceptionally sharp deterio-ration of over 15 percent of GDP reflected a surgein imports and a fall-off in gold production, whichrepresents roughly one-third of total exports. Cur-rent account deficits in excess of 10 percentof GDP were posted in Bosnia and Herzegovina,Bulgaria, the Baltic countries, Kyrgyz Republic,Montenegro, Romania, and Serbia.

Net capital inflows to the region surged by$71 billion in 2006, reaching a record $241 billionand accounting for 42.6 percent of total flowsto all developing countries, up from 35.5 percentin 2005 (table A.5). Private capital flows have

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expanded tremendously over the past five years,rising from a low of $27 billion (2.8 percent ofregional GDP) in 2001 to $271 billion in 2006(11 percent of regional GDP). In contrast, repay-ments to official creditors continued to outstriplending by a wide margin ($30 billion in 2006), asplentiful oil revenues enabled Russia to finish pay-ing off its Soviet-era debt with a $22 billion pre-payment to Paris Club creditors, following a$15 billion prepayment in 2005. Multinationalcompanies with headquarters located in the regioncontracted $135 billion in foreign debt in 2006,accounting for 40 percent of cross-border borrow-ing by companies in developing countries, withmost of the funds financing the oil and gas sectors.

FDI inflows increased from $62.8 billion(3.6 percent of GDP) in 2004 to $116 billion(4.6 percent of GDP) in 2006, accounting for overone-third of the total to all developing countries,with most of the flows concentrated in Russia($28 billion), Turkey ($19 billion), Poland

Table A.5 Net capital flows to Europe and Central Asia$ billions

1998 1999 2000 2001 2002 2003 2004 2005 2006e

Current account balance �24.7 �1.1 16.7 17.7 6.0 �0.1 4.8 22.6 13.8as % of GDP �2.1 �0.1 1.8 1.8 0.5 0 0.3 1.0 0.6

Financial flowsNet private and official flows 68.3 44.2 47.9 29.3 52.9 88.7 148.6 170.7 241.4Net private flows (debt � equity) 59.8 44.6 47.8 27.2 50.3 95.7 158.7 206.9 271.4Net equity flows 26.6 25.2 26.0 26.8 26.5 33.6 68.1 80.0 126.9Net FDI inflows 23.7 23.4 25.4 27.2 26.4 34.2 62.8 73.7 116.4Net portfolio equity inflows 2.9 1.8 0.6 �0.4 0.1 �0.6 5.3 6.3 10.5

Net debt flows 41.7 19.0 21.9 2.5 26.4 55.1 80.5 90.7 114.5Official creditors 8.5 �0.4 0.1 2.1 2.6 �7.0 �10.1 �36.2 �30.0

World Bank 1.5 1.9 2.1 2.1 1.0 �0.6 0.4 �0.7 0.3IMF 5.3 �3.1 �0.7 6.1 4.6 �2.0 �5.9 �9.8 �5.6Other official 1.6 0.8 �1.3 �6.1 �3.0 �4.4 �4.6 �25.6 �24.6

Private creditors 33.2 19.4 21.8 0.4 23.8 62.1 90.6 126.9 144.5Net medium- and long-term debt flows 27.1 18.9 13.4 6.3 19.1 31.1 70.7 103.9 114.4

Bonds 14.4 7.8 5.6 1.2 3.7 9.5 23.3 28.4 48.3Banks 13.7 11.9 9.3 7.2 17.0 21.7 48.7 76.7 66.9Other private �1.0 �0.7 �1.5 �2.2 �1.6 �0.2 �1.3 �1.2 �0.8

Net short-term debt flows 6.1 0.5 8.4 �5.9 4.7 31.0 19.9 23.0 30.1Balancing itema �38.8 �36.9 �46.0 �36.4 �14.9 �27.7 �74.9 �99.9 �80.2Change in reserves (� � increase) �4.8 �6.2 �18.6 �10.5 �43.9 �60.9 �78.6 �93.4 �175.0

Memo itemsBilateral aid grants 9.5 12.5 11.4 10.5 13.1 12.7 14.4 6.6 13.0of which

Technical cooperation grants 4.2 4.4 2.9 3.5 4.7 4.3 4.3 2.6 1.9Other 5.3 8.1 8.5 7.0 8.4 8.4 10.1 4.0 11.1

Net official flows (aid � debt) 18.0 12.1 11.5 12.6 15.7 5.7 4.3 �29.6 �17.0Workers’ remittances 14.4 12.2 13.4 13.0 14.4 17.3 22.7 31.4 31.7Repatriated FDI Income 2.5 2.4 2.9 4.2 7.1 12.2 16.4 27.8 —

Sources: World Bank Debtor Reporting System and staff estimates.Note: e � estimate; — � not available.a. Combination of errors and omissions and net acquisition of foreign assets (including FDI) by developing countries.


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Table A.6 Europe and Central Asia country forecastsannual percent change unless indicated otherwise

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

AlbaniaGDP at market prices (2000 $)b 1.4 5.9 5.5 5.0 6.0 6.0 6.2Current account balance/GDP (%) �5.6 �4.8 �7.8 �7.2 �7.5 �7.3 �7.2

ArmeniaGDP at market prices (2000 $)b �3.8 10.5 14.0 13.4 9.0 7.0 6.7Current account balance/GDP (%) �12.0 �4.5 �3.9 �4.0 �4.5 �4.8 �4.8

AzerbaijanGDP at market prices (2000 $)b �5.2 10.2 26.2 34.5 27.0 21.0 25.0Current account balance/GDP (%) �15.8 �29.8 1.3 17.7 22.0 24.0 26.8

BelarusGDP at market prices (2000 $)b �1.2 11.4 9.2 9.3 6.3 5.2 4.8Current account balance/GDP (%) — �5.2 1.5 �3.1 �5.5 �5.3 �4.1

BulgariaGDP at market prices (2000 $)b �1.7 5.7 5.5 6.3 6.0 5.2 5.4Current account balance/GDP (%) �2.3 �6.0 �11.2 �15.8 �13.0 �11.6 �10.6

CroatiaGDP at market prices (2000 $)b �1.5 3.8 4.3 4.8 4.5 4.2 4.3Current account balance/GDP (%) 1.1 �5.2 �6.6 �7.4 �7.0 �6.0 �5.8

(Continues)

($12 billion), and Hungary ($9 billion). Major pri-vatizations and mergers and acquisitions in severalcountries, notably Turkey, Kazakhstan, Hungary,and Ukraine, contributed to the strong gains inFDI inflows to the region. In Turkey, despite therecent deterioration in external balance, quality offinancing has improved as the share of short-termflows dropped to 18 percent in 2006 from 41 per-cent in 2005. FDI inflows reached a historichigh of $19.2 billion (4.8 percent of GNP) in2006, up from $8.7 billion (2.4 percent of GNP)in 2005.

Private debt flows to the region increasedfrom $0.4 billion in 2001 to $144 billion in 2006,accounting for almost two-thirds of the total to alldeveloping countries. Substantial external borrow-ing by banks in several countries in the region(notably Estonia, Hungary, Kazakhstan, Latvia,Lithuania, Russia, and Ukraine) has financed asurge in credit growth, accompanied by mountinginflationary pressures (in Estonia, Latvia, Kaza-khstan, and Ukraine). There are also growing con-cerns about exchange rate exposures in the bank-ing sector in countries such as Hungary, Romania,Ukraine, and the Baltics, where half of the totalvalue of loans is denominated in foreign currency,as well as concerns about interest rate risk inthe banking sector in the Baltics, Ukraine,Kazakhstan, and Russia, where short-term banklending is prevalent.

Foreign exchange reserves increased strongly,by $175 billion, during 2006, nearly double the$93 billion level of reserve accumulation recordedin 2005. This primarily reflects increases posted inthe region’s oil-exporting countries, with foreignreserves rising $120 billion in Russia and $12 bil-lion in Kazakhstan. Worker remittances are pro-jected to have been sustained at the 2005 level ofover $31 billion, falling somewhat as a share ofGDP to 1.3 percent in 2006 from 1.5 percent in2005, although still above the average of 1.2 per-cent recorded during 2000–04.

Medium-term outlookOutput in the region is expected to decelerate to6.0 percent in 2007 and to remain close to thatmore sustainable level until 2009 (table A.6).Among oil exporters, lower oil prices and a moder-ation in the pace at which new productive capacitycomes online is projected to lower the pace ofgrowth from 7.7 percent in 2006 to about 6.8 per-cent in 2009. For oil importers, growth should alsoease from 6.3 percent in 2006 to 5.2 percent in2009 due to tighter policy conditions and lessrobust demand from regional oil exporters. An ex-pected tightening of monetary policy in high-income Europe will likely contribute to theslowdown by raising the opportunity cost of invest-ment in emerging markets, resulting in an expectedslowdown in FDI and other financial inflows.


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Table A.6 (Continued)

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

Czech RepublicGDP at market prices (2000 $)b 0.3 4.2 6.1 5.9 4.9 4.6 4.3Current account balance/GDP (%) �2.5 �6.0 �2.0 �4.4 �4.1 �3.3 �3.2

EstoniaGDP at market prices (2000 $)b �0.8 7.8 9.8 11.4 9.2 7.9 7.0Current account balance/GDP (%) �4.5 �13.0 �10.5 �14.8 �14.8 �13.9 �12.4

GeorgiaGDP at market prices (2000 $)b �9.3 5.9 9.3 9.0 7.5 7.0 6.7Current account balance/GDP (%) — �8.3 �5.4 �9.5 �13.0 �8.6 �7.9

HungaryGDP at market prices (2000 $)b 0.8 5.2 4.1 3.9 2.4 2.8 4.0Current account balance/GDP (%) �5.4 �8.5 �7.3 �6.8 �5.5 �4.9 �3.5

KazakhstanGDP at market prices (2000 $)b �3.6 9.6 9.7 10.6 9.0 8.8 9.4Current account balance/GDP (%) �1.8 0.8 �1.8 �2.3 �7.0 �6.5 �6.0

Kyrgyz RepublicGDP at market prices (2000 $)b �4.0 7.0 �0.2 2.7 5.5 5.0 4.8Current account balance/GDP (%) �10.6 �3.4 �8.3 �23.6 �11.0 �10.9 �10.8

LatviaGDP at market prices (2000 $)b �2.8 8.6 10.2 11.9 10.0 7.5 6.5Current account balance/GDP (%) �1.6 �12.9 �12.7 �16.5 �17.8 �16.7 �15.6

LithuaniaGDP at market prices (2000 $)b �3.3 7.0 7.6 7.4 6.5 6.3 6.1Current account balance/GDP (%) �5.9 �7.7 �7.2 �11.5 �10.5 �10.4 �10.2

Macedonia, FYRGDP at market prices (2000 $)b �0.9 4.1 3.8 3.1 4.5 4.0 4.3Current account balance/GDP (%) — �8.0 �1.4 �0.4 �3.2 �3.8 �4.3

MoldovaGDP at market prices (2000 $)b �9.8 7.4 7.1 4.0 5.0 5.0 5.2Current account balance/GDP (%) — �2.0 �9.1 �9.4 �6.7 �5.7 �4.5

PolandGDP at market prices (2000 $)b 3.8 5.3 3.5 6.1 6.5 5.7 5.0Current account balance/GDP (%) �3.5 �4.2 �1.7 �2.3 �2.9 �3.0 �3.1

RomaniaGDP at market prices (2000 $)b �1.7 8.4 4.1 7.5 6.2 6.0 5.8Current account balance/GDP (%) �4.8 �8.5 �8.7 �10.5 �10.8 �10.0 �9.3

Russian FederationGDP at market prices (2000 $)b �3.9 7.1 6.4 6.7 6.3 5.6 5.8Current account balance/GDP (%) — 10.0 10.9 10.2 6.4 3.6 2.1

Slovak RepublicGDP at market prices (2000 $)b 0.3 5.5 6.0 8.3 8.5 6.2 5.7Current account balance/GDP (%) — �3.1 �8.6 �7.8 �4.8 �3.8 �3.5

TurkeyGDP at market prices (2000 $)b 3.6 8.9 7.4 6.0 4.5 5.5 5.4Current account balance/GDP (%) �1.1 �5.2 �6.5 �8.2 �6.9 �6.4 �5.7

UkraineGDP at market prices (2000 $)b �8.0 12.1 2.6 6.8 5.3 5.8 5.7Current account balance/GDP (%) — 10.7 3.2 �1.7 �5.1 �5.2 �5.1

UzbekistanGDP at market prices (2000 $)b �0.2 7.7 7.0 7.3 5.0 5.0 5.0Current account balance/GDP (%) — 10.1 13.6 18.4 15.3 15.1 13.8


documents. Bosnia and Herzegovina, Tajikistan, Turkmenistan, and the former Yugoslavia (Serbia and Montenegro) are not forecast owingto data limitations. e � estimate; f � forecast; — � not available.



In Russia, the region’s largest economy, GDPgrowth rate is projected to decline from 6.7 per-cent in 2006 to 5.8 percent by 2009, reflectingweaker oil revenues, capacity constraints in the oiland other sectors, and a deceleration in investmentas implementation of much needed structural re-forms is slow. The still-robust domestic demand,exacerbated by an expected appreciation in theruble, is projected to yield a marked reduction inthe current account surplus from about 10 percentof GDP in 2006 to about 2 percent in 2009.

In Turkey, growth is expected to deceleratefurther to 4.5 percent in 2007 due to sustainedhigher interest rates, which have already led toa dampening of growth. Inflation at just below10 percent remains well above the central bank’starget and therefore policy is expected to remaintight in an effort to break inflationary expecta-tions. These efforts and sustained fiscal restraint(Turkey has a primary government surplus of7.0 percent of GDP in 2006) are expected to helpgradually restore internal and external balance, al-lowing policy to relax somewhat toward the endof 2007 or in 2008. As a result, growth is pro-jected to pick up to around 5.5 percent in 2008and 2009.

In Poland, growth is projected to acceleratefurther to 6.5 percent in 2007 from 6.1 percentin 2006 due to strong private consumption—supported by accelerated lending and improve-ments in the labor market—and by double-digitinvestment growth, which will be bolstered byhigh corporate profits, rising FDI, and improvingabsorption of EU structural funds. Assuming thatmore restrictive fiscal policy is instituted, growthis projected to decelerate in 2008 and 2009, com-ing in at a sustainable 5.0 percent in 2009.Growth in Hungary is expected to weaken further,to around 2.4 percent in 2007, under the weight ofsubstantial fiscal and monetary policy tightening(interest rates were increased 425 basis points in2006). However, growth should begin to pick uptoward the end of the forecast period as the initialimpact of these measures wears off. In the CzechRepublic, an anticipated tightening of monetarypolicy, a deterioration in business and consumerconfidence tied to political wrangling within thecoalition government, and delays in structural re-forms are expected to cause growth to slow tobelow 5.0 percent in 2007 and toward a more sus-tainable 4.3 percent pace by 2009.

119

Growth among the region’s small hydrocar-bon exporters is projected to slow as the expansionin production and export capacity that have under-pinned recent strong growth wind down and en-ergy prices fall. Azerbaijan and Kazakhstan areexpected to receive a boost to growth in 2009 asnew oil capacity comes on stream. The projecteddeceleration of growth in Russia and other oil ex-porters, along with a general deceleration in thepace of world trade volumes, should contribute toslower growth in many countries in the Common-wealth of Independent States. Growth in CentralEurope is also projected to ease. In addition toweaker demand for the region’s exports, growthamong the first round of accession countries is ex-pected to slow due to tighter monetary conditionsand a reduced growth impetus from EU integration.

Risks and uncertaintiesThe combination of rising inflation and elevatedcurrent account deficits poses a persistent chal-lenge for policy makers in the region. To the extentthat the contractionary influence of higher interestrates continues to be offset by capital inflows, fur-ther fiscal tightening may be unavoidable—even ifit means pushing government balances into sur-plus in some countries.

While the baseline forecast assumes policymakers are able to manage soft landings, the risksinvolved with a bumpier adjustment process re-main significant for countries that have becomedependent on large capital inflows, even if inflowswere in the form of less volatile FDI. Capital in-flows are expected to remain strong, motivated byinvestment opportunities associated with EUintegration. However, the real-side disequilibriumthey have provoked (domestic demand in excess ofsupply and unsustainably large current accountdeficits) makes these countries sensitive to achange in investor sentiment, as was the case forTurkey in May 2006. If private capital inflowsdrop sharply, adjustment in countries with rela-tively inflexible exchange rate regimes, such asBulgaria, Croatia, Estonia, and Lithuania, couldbe particularly challenging. Absorbing the impactof a sudden drop in capital inflows would alsopose difficulties to countries with large currentaccount deficits, such as Turkey, given the largefinancing requirement. Countries with strong re-liance on short-term capital inflows are especiallyvulnerable (figure A.5).


An upside risk derives from the timing ofRussia’s accession to the WTO. While the boostto Russian exports is expected to be modest, this isnevertheless an important step binding the countrymore firmly into the system of world trade rulesand could provide a significant boost to investor

120

confidence and have a positive effect on medium-term growth.

On the other hand, declining populations,evident in Russia and many other European andCentral Asian economies, will pose a significantchallenge that may dampen medium-term growthprospects. The declines stem from both dynamicsof more deaths than births (high mortality andlow fertility) and emigration in countries includingBulgaria, Latvia, Lithuania, Moldova, Poland,Romania, and Ukraine. For other countries, in-cluding Belarus, Russia, and the Central Europeancountries that are new EU members, decliningpopulations are the result of natural populationdeclines not being fully offset by immigration.

Latin America and the Caribbean Recent developments

Economic growth in Latin America and theCaribbean strengthened to 5.6 percent in

2006, up from 4.7 percent in 2005 (table A.7).This marks the third year of solid growth for theregion. Over the past three years, regional GDPhas increased more than twice as quickly as during

Table A.7 Latin America and the Caribbean forecast summaryannual percent change unless indicated otherwise

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

GDP at market prices (2000 $)b 3.4 6.2 4.7 5.6 4.8 4.3 3.9GDP per capita (units in $) 1.6 4.7 3.2 4.2 3.5 3.0 2.6PPP GDPc 4.3 5.9 4.5 5.5 4.8 4.3 3.9


Net exports, contribution to growth �0.3 1.0 0 �1.4 �2.2 �2.6 �2.9Current account balance/GDP (%) �2.8 1.0 1.6 1.8 0.7 0.1 �0.2GDP deflator (median, LCU) 10.8 7.4 6.2 7.2 5.3 4.6 4.2Fiscal balance/GDP (%) — 0 0.4 0.8 0.3 0.2 0.1

Memo items: GDPLAC excluding Argentina 3.2 5.8 4.0 5.1 4.4 4.0 3.9Central America 3.6 4.1 3.0 4.9 3.6 3.7 3.7Caribbean 3.6 2.6 6.5 8.7 5.3 4.9 4.6

Brazil 2.7 5.7 2.9 3.7 4.2 4.1 3.9Mexico 3.5 4.1 2.8 4.8 3.5 3.7 3.6Argentina 4.5 9.0 9.2 8.5 7.5 5.6 3.8

Source: World Bank.Note: e � estimate; f � forecast; LCU � local currency units; — � not available. a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.b. GDP measured in constant 2000 $. c. GDP measured at PPP exchange rates.d. GNFS denotes goods and nonfactor services.

Source: World Bank.

0

10

20

30

40

50

60

70

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Percent Ratio

Figure A.5 Short-term debt in selected countries ofEurope and Central Asia, Q3 2006

Czech

Rep

ublic

Turke

y

Slovak

Repub

lic

Mold

ova

Estonia

Lithu

ania

Ukrain

e

Bulgar

ia

Latvi

a

Belaru

s

Share of short-termdebt in total debt (left scale)

Ratio of short-term debt to foreignreserves (right scale)


the preceding six years. Growth slowed in onlysix countries and accelerated in the rest. In 2006,output expanded by 3.5 percent or more in 22 ofthe 27 economies of the region. Many countrieshave benefited from increasing commodity prices,which boosted export revenues and contributed tohigher incomes and domestic and import spend-ing. Fixed investment, which grew at double-digitrates, and rapid growth of private consumptionwere the dominant factors in the acceleration ofoutput (figure A.6).

Following a slow start in 2006, GDP in Brazilaccelerated in the second half of the year in re-

121

�2

�4

0

2

10

4

6

8

% contribution to GDP growth

Sources: World Bank; Datastream.Note: e � estimate; f � forecast.

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

e20

07f

2008

f

2009

f

Figure A.6 Contribution of consumption,investment, and exports to GDP growthin Latin America and the Caribbean

GDP growth

Consumption Gross investment Net exports

sponse to an easing of monetary policy and in-creased fiscal stimulus. Using the National Statisti-cal Office’s revised methodology (see box A.1),GDP increased by 3.7 percent, faster than the 2.9percent growth recorded in 2005, with the acceler-ation concentrated in industrial and mining activi-ties. Real interest rates are declining and are cur-rently below 9 percent. This still-elevated levelprovoked an appreciation of the real and con-tributed to a decline in inflation from 5.7 percent in2005 to 3.1 percent in 2006, the lowest rate sincethe adoption of the inflation targeting regime in1999. Monthly inflation picked up toward the endof the year and into the first quarter of 2007, partlyreflecting an increase in regulated prices, althoughmost analysts concur that inflation will continue itsrecent downward trend in the near future.

GDP in Mexico accelerated sharply to 4.8 per-cent in 2006 from 2.8 percent in 2005 as lowerinterest rates boosted domestic demand and con-struction activity. Stronger sales of cars to theUnited States and oil exports also contributed to thepickup in growth. While growth in Argentina easedsomewhat, domestic demand remains very strong,and GDP expanded by 8.5 percent—significantlyabove potential. Inflation in Argentina, which hadreached 12.3 percent toward the end of 2005,dropped to 9.1 percent in March 2007 with thehelp of administrative price measures.

Growth elsewhere in Latin America continuesto be supported by very strong commodity prices.GDP in República Bolivariana de Venezuela ex-panded by an unsustainable 10.3 percent in 2006,fueled by rising government transfers. Despite pricecontrols, inflation accelerated further to 18.5 per-cent in March 2007. Falling oil production and

On March 21, 2007, the Brazilian Institute of Geogra-phy and Statistics published a revision of the nominal

and real values of Brazil’s GDP between 1995 and 2005.The headline news is that the country’s economy in 2005was 10.9 percent larger than previously thought and itsgrowth rate since 2000 has increased from an annualaverage rate of 2.6 percent to 3.0 percent.

The revisions rely more than previously on annualsurveys which sample economic activities of firms andhouseholds. As a result of these better measurements, two

major changes emerged: a) in the new 2000 base year, ser-vices’ value added as a share of total value added increasedby 10 percentage points (from 56 percent to 66 percent);b) on the demand side, household private consumption in-creased from 60.9 percent to 63 percent of total GDP. Thecontribution of investment to GDP declined from 19.3 to16.8 percent due to a change in structure, as machineryand equipment were previously undervalued and construc-tion was overvalued.

Box A.1 New GDP estimates for Brazil


weak investment growth, which has been discour-aged by high taxes and royalties and antibusinesspolicies, meant that despite strong demand, indus-trial production declined 4.9 percent in the 12months ending February 2007. Domestic demandin Colombia is also growing fast and inflationpicked up to 5.8 percent in March 2007. As a result,the central bank has increased interest rates twice inthe first few months of the year, bringing its bench-mark rate to 8 percent. In Chile, mining stoppages,a waning investment boom, and higher importscontributed more than 2 percentage points to theslowing of the economy despite booming copperprices. The authorities have responded to the weak-ening of growth by lowering interest rates for thefirst time in three years and there are some signs ofa strengthening in domestic demand and activity.

Growth accelerated in most Central Americanand Caribbean countries in 2006, boosted by ro-bust private consumption and investment. Theconstruction sector has been an important driverof activity as the region continues to recover fromthe damage caused by Tropical Storm Stan. In con-trast to most of the region, growth in Nicaraguahas been weak due to poor rainfalls that have heldback the agricultural sector and reduced externalreceipts. Despite the expectation of acceleratinggrowth following the implementation of the Do-minican Republic-Central America Free TradeAgreement (DR-CAFTA), big gains are unlikely inthe near future. Members who have ratified theagreement (congressional debate on the agreementcontinues in Costa Rica) are still losing marketshare of their maquila exports to China, whileGuatemala and El Salvador are experiencing in-creased competition from low-wage regional ex-porters such as Honduras and Nicaragua. Despitehealthy revenues from tourism and mining, exportvolume growth in the Dominican Republic andJamaica have been disappointing. Elsewhere, ro-bust remittances have offset the deterioration inthe trade balance. While some countries, mostnotably Guatemala, have adopted a more relaxedfiscal and monetary stance, others, such as CostaRica, have taken advantage of strong private sec-tor growth to increase tax receipts and signifi-cantly reduce the size of the fiscal deficit.

Although the currencies of a number of coun-tries were affected by the financial turbulence inMay 2006, the adjustments were either welcomecorrections or short-lived. Stock markets also

122

underwent a major correction. The resilience ofcountries in the region to this shock, and to thesmaller one of February 2007, reflects improvedfiscal and monetary policies and reduced indebted-ness. Indeed, with a few notable exceptions, infla-tion is on a downward trend in the region despitethe cyclical upturn and fiscal policy has been lessexpansionary during the upswing and recent elec-tions than in the past.

Net capital inflows to the region increasedslightly to $68 billion in 2006, up from $65 billionin 2005, but were well below the $110 billion levelattained in 1998. As a percentage of GDP, net cap-ital inflows declined from 2.8 to 2.5 percent andrepresented less than half the 5.5 percent of GDPlevel observed during the late 1990s (table A.8).Net private (debt and equity) inflows declined by$3.4 billion in 2006, with net equity inflows of$80.5 billion were substantially higher than netprivate debt inflows of $12.3 billion. The pace atwhich countries in the region repaid existing debtto official creditors declined and, as a result, netcapital outflows from the region fell from $31.2billion in 2005 to $24.6 billion in 2006. In 2006,the outflows were mainly due to large voluntaryprepayments by Argentina ($9.6 billion) andUruguay ($2.5 billion) to the IMF, and by Mexico($2.5 billion) to the Inter-American DevelopmentBank and the World Bank.

Net FDI inflows were unchanged at $70 billionin 2006, declining from 3.0 to 2.5 percent of GDP.Net bank lending surged from zero in 2005 to$17.4 billion in 2006, due entirely to a record $17.6billion bridge loan contracted by the Brazilian min-ing company Compania Vale do Rio Doce (CVRD),to acquire the Canadian mining company Inco.

The large buybacks of sovereign debt byBrazil ($15 billion), Mexico ($5.4 billion),República Bolivariana de Venezuela ($4.6 billion),and Colombia ($4.3 billion) in 2006 reduced theaverage cost of capital of these countries and sig-nificantly improved their debt-servicing profiles.With less than $6 billion outstanding, Bradybonds, once the mainstay of the emerging-marketasset class, have been almost completely retired.Despite these improvements in the external debtstatistics, dependence on foreign capital has likelydeclined to a lesser extent because sales of bondsissued on domestic debt markets purchased by for-eigners are not recorded in these statistics. Twoother developments are worth mentioning: the


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Table A.8 Net capital flows to Latin America and the Caribbean$ billions

1998 1999 2000 2001 2002 2003 2004 2005 2006e

Current account balance �89.6 �55.8 �47.4 �52.8 �15.6 8.5 21.1 37.1 51.1as % of GDP �4.5 �3.2 �2.4 �2.8 �0.9 0.5 1.0 1.6 1.8

Financial flowsNet private and official flows 109.8 101.2 75.4 95.2 50.4 63.8 58.0 65.0 68.2Net private flows (debt � equity) 98.7 99.6 86.5 74.9 37.7 59.1 68.3 96.2 92.8Net equity flows 71.9 85.0 79.4 73.1 53.2 47.4 61.9 82.4 80.5Net FDI inflows 74.1 88.6 80.0 70.6 51.8 44.0 62.5 70.0 69.4Net portfolio equity inflows �2.2 �3.6 �0.6 2.5 1.4 3.4 �0.6 12.4 11.1

Net debt flows 37.9 16.2 �4.0 22.1 �2.8 16.4 �3.9 �17.4 �12.3Official creditors 11.1 1.6 �11.1 20.4 12.7 4.7 �10.3 �31.2 �24.6

World Bank 2.4 2.1 2.0 1.3 �0.3 �0.4 �1.0 �0.8 �4.4IMF 2.5 �0.9 �10.7 15.6 11.9 5.6 �6.3 �27.6 �10.9Other official 6.2 0.4 �2.4 3.5 1.1 �0.4 �3.0 �2.9 �9.3

Private creditors 26.8 14.6 7.1 1.8 �15.5 11.7 6.4 13.8 12.3Net medium- and long-term debt flows 55.1 19.5 8.0 16.4 �5.0 9.0 �0.9 16.6 10.2

Bonds 17.7 20.1 8.4 2.9 �0.4 11.0 �1.8 16.6 �7.1Banks 39.1 �1.4 0.4 15.2 �2.6 �1.0 0.9 0.1 17.4Other private �1.7 0.8 �0.8 �1.6 �1.9 �0.9 0 �0.1 0

Net short-term debt flows �28.3 �4.9 �0.9 �14.6 �10.5 2.6 7.3 �2.8 2.1Balancing itema �29.2 �52.7 �25.3 �40.5 �32.9 �37.7 �54.1 �67.3 �64.0Change in reserves (� � increase) 9.0 7.3 �2.7 �1.9 �1.9 �34.6 �25.0 �34.8 �55.3

Memo itemsBilateral aid grants 5.5 5.2 5.2 6.1 5.7 6.6 8.7 8.0 6.6of which

Technical cooperation grants 2.3 2.3 2.7 2.9 2.9 3.6 3.8 3.2 2.9Other 3.2 2.9 2.5 3.2 2.8 3.0 4.9 4.8 3.7

Net official flows (aid � debt) 16.6 6.8 �5.9 26.5 18.4 11.3 �1.6 �23.2 �18.0Workers’ remittances 15.9 17.7 20.1 24.4 28.1 35.0 41.4 48.2 52.5Repatriated FDI Income 13.8 12.6 14.0 14.6 12.7 14.7 18.8 29.7 —


accumulation of reserves and the rapid expansionof remittance inflows. The latter supported importspending, especially in Central American andCaribbean countries.

Medium-term outlookRegional GDP growth is expected to moderatefrom 5.6 percent in 2006 to 4.8 percent in 2007and ease further to 3.9 percent in 2009 (table A.9).However, this slowdown in regional growthmainly reflects a return toward more sustainablegrowth rates in Argentina and República Bolivari-ana de Venezuela, following a postcrisis rebound ingrowth. Excluding these two countries, expansionin the rest of the region is projected to remain rela-tively steady at 4.1 percent during the forecast pe-riod, down only 0.6 percentage points from 2006.

Prospects for individual countries reflect anumber of offsetting influences. The projectedslowdown in global activity should moderate

demand for commodities, resulting in a modestdecline in their prices and slower volume growth.As a result, growth among commodity exporterswill moderate, although their export revenues willremain elevated in historical perspective. GDPgrowth for exporters of agricultural commoditiesis expected to decelerate from 7.7 percent in 2006to 5.2 percent in 2008. Despite softening metalprices, growth among exporters of these commodi-ties should pick up due mainly to expansionarymonetary policies in Chile and Brazil. Notwith-standing lower projected oil prices, growth ofsmall oil importers (excluding Brazil and Chile) isprojected to slow from 7.1 percent in 2006 to4.5 percent in 2009 due to weaker demand in theUnited States and slower investment growth inCentral American and Caribbean countries.

The positive trends recently observed inBrazil—decreasing unemployment, creation offormal jobs, recovery of real earnings, and


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Table A.9 Latin America and the Caribbean country forecastsannual percent change unless indicated otherwise

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

ArgentinaGDP at market prices (2000 $)b 4.5 9.0 9.2 8.5 7.5 5.6 3.8Current account balance/GDP (%) �3.1 2.1 2.8 3.1 2.3 1.6 1.2

Antigua and BarbudaGDP at market prices (2000 $)b 3.3 4.3 5.2 5.6 5.8 5.7 5.6Current account balance/GDP (%) �6.0 �11.9 �11.4 �12.0 �12.3 �12.3 �11.7

BelizeGDP at market prices (2000 $)b 5.9 4.6 3.1 4.0 2.8 3.3 3.4Current account balance/GDP (%) �7.3 �14.4 �12.0 �8.7 �6.3 �6.1 �6.0

BoliviaGDP at market prices (2000 $)b 3.8 3.9 4.1 4.5 4.6 4.1 3.5Current account balance/GDP (%) �6.1 3.9 5.2 8.1 8.3 7.9 7.6

BrazilGDP at market prices (2000 $)b 2.7 5.7 2.9 3.7 4.2 4.1 3.9Current account balance/GDP (%) �2.1 1.9 1.9 1.5 1.0 0.3 0.6

ChileGDP at market prices (2000 $)b 6.4 6.2 6.3 4.2 5.1 5.0 4.9Current account balance/GDP (%) �2.7 1.7 0.6 3.8 1.7 0 �0.7

ColombiaGDP at market prices (2000 $)b 2.5 4.8 5.3 6.8 5.5 4.8 4.5Current account balance/GDP (%) �1.9 �0.9 �1.7 �1.9 �2.4 �2.7 �2.9

Costa RicaGDP at market prices (2000 $)b 5.2 4.1 5.9 7.6 5.7 4.6 4.3Current account balance/GDP (%) �3.6 �4.3 �4.8 �4.7 �4.6 �4.2 �4.2

DominicaGDP at market prices (2000 $)b 1.8 3.2 3.6 2.5 2.6 2.5 2.4Current account balance/GDP (%) �16.6 �6.4 �6.1 �6.3 �6.5 �6.7 �6.9

Dominican RepublicGDP at market prices (2000 $)b 6.0 2.0 9.3 10.7 6.8 5.2 4.8Current account balance/GDP (%) �3.2 4.3 �1.9 �2.5 �2.6 �2.5 �1.8

EcuadorGDP at market prices (2000 $)b 1.8 7.9 4.7 4.6 3.4 3.2 3.1Current account balance/GDP (%) �2.3 �1.7 0.8 3.0 1.8 0.4 0.2

El SalvadorGDP at market prices (2000 $)b 4.6 1.8 2.8 4.2 3.4 3.4 3.3Current account balance/GDP (%) �2.0 �4.0 �4.6 �5.6 �4.4 �4.1 �4.0

GuatemalaGDP at market prices (2000 $)b 4.1 2.7 3.2 4.6 3.9 4.1 4.0Current account balance/GDP (%) �4.6 �4.4 �4.3 �5.5 �4.4 �3.4 �3.0

GuyanaGDP at market prices (2000 $)b 4.9 3.3 �3.0 4.5 3.8 3.0 3.0Current account balance/GDP (%) �15.1 �2.5 �18.6 �15.1 �14.0 �14.3 �14.5

HaitiGDP at market prices (2000 $)b �1.3 �2.2 2.3 2.8 3.0 3.3 3.5Current account balance/GDP (%) �1.8 �1.7 1.4 �0.4 �2.0 �3.5 �3.6

HondurasGDP at market prices (2000 $)b 3.3 5.0 4.3 5.2 3.9 4.0 4.0Current account balance/GDP (%) �7.7 �5.7 �0.5 �1.6 �2.3 �1.9 �2.0

JamaicaGDP at market prices (2000 $)b 1.9 1.1 1.4 2.7 3.1 3.0 2.9Current account balance/GDP (%) �2.7 �5.7 �11.1 �8.1 �7.7 �8.0 �7.8

MexicoGDP at market prices (2000 $)b 3.5 4.1 2.8 4.8 3.5 3.7 3.6Current account balance/GDP (%) �3.7 �1.0 �0.6 �0.2 �1.2 �1.5 �1.8

NicaraguaGDP at market prices (2000 $)b 3.4 5.1 4.0 3.5 3.0 3.2 3.1Current account balance/GDP (%) �28.7 �15.5 �16.3 �12.8 �14.2 �15.1 �14.1

(Continues)


improvements in productive capacity—will mostlikely continue to bolster economic activity in thecoming months. There remains scope for furtherloosening of monetary policy, although the centralbank has reduced the pace of monetary easing(during the most recent meetings, the Selic targetrate was cut by 25 basis points as compared with50 basis points earlier during the current easingcycle). Additionally, the recently reelected adminis-tration has launched a growth acceleration plan(PAC) whose centerpiece is an investment programof $240 billion, equivalent to 27 percent of 2006GDP, to be carried out over 2007–10. These fac-tors will support a strong GDP growth of around4.1 percent in the forecast period.

Lower oil prices and the declining contribu-tion of government spending are expected to slowthe growth rate of domestic demand in RepúblicaBolivariana de Venezuela, resulting in a significantslowdown in GDP growth from 10.3 percent in2006 to 6.5 percent in 2007 and around 3 percentin the following two years. While this should

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1991–2000a 2004 2005 2006e 2007f 2008f 2009f

PanamaGDP at market prices (2000 $)b 5.1 7.6 6.4 7.5 6.1 5.0 4.8Current account balance/GDP (%) �4.8 �7.5 �8.5 �3.7 �3.4 �4.3 �4.6

ParaguayGDP at market prices (2000 $)b 1.8 4.1 2.7 3.8 3.8 3.4 3.1Current account balance/GDP (%) �2.2 2.0 �0.3 �3.4 �2.0 �1.6 �1.2

PeruGDP at market prices (2000 $)b 4.0 5.2 6.4 8.0 6.6 5.7 5.2Current account balance/GDP (%) �5.5 0 1.5 2.8 1.8 1.2 �0.4

St. LuciaGDP at market prices (2000 $)b 3.1 3.9 6.5 6.1 5.7 5.2 4.9Current account balance/GDP (%) �11.4 �6.4 �7.1 �6.5 �6.2 �5.8 �5.3

St. Vincent and the GrenadinesGDP at market prices (2000 $)b 2.1 5.4 2.8 3.2 3.4 3.1 3.0Current account balance/GDP (%) �19.8 �10.5 �12.5 �12.4 �12.1 �11.3 �10.6

Trinidad and TobagoGDP at market prices (2000 $)b 3.2 6.5 7.0 12.0 4.7 6.3 5.8Current account balance/GDP (%) 0.2 11.9 27.0 33.4 27.2 20.7 20.2

UruguayGDP at market prices (2000 $)b 3.0 11.8 6.8 6.9 5.1 4.1 3.8Current account balance/GDP (%) �1.5 0.3 0 �1.6 �0.9 �0.8 �1.1

Venezuela, R. B. deGDP at market prices (2000 $)b 2.1 17.9 10.3 10.3 6.5 3.3 3.0Current account balance/GDP (%) 2.6 14.1 18.5 14.4 8.2 5.6 3.1

Source: World Bank.Note: Growth and current account figures presented here are World Bank projections and may differ from targets contained in Bank

documents. Barbados, Cuba, Grenada, and Suriname are not forecast owing to data limitations. e � estimate; f � forecast.a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.b. GDP measured in constant 2000 $.

prevent further deterioration in the current ac-count balance and reduce inflationary pressures,inflation is expected to remain high until domesticsupply catches up with demand levels. GDPgrowth in other energy exporters is projected toslow from 6.2 percent in 2006 to about 4.4 per-cent by 2008. In the case of Mexico, the antici-pated cycle in the United States will reduce exportgrowth and is projected to slow GDP by 1.3 per-centage points to 3.5 percent in 2007, followed bysomewhat stronger growth in 2008–09.

In Argentina, the slowdown is expected to bemore gradual. Growth in industrial production hasbeen strong recently, which has attracted additionalcapital inflows that have supported strong domesticdemand. As a result, growth is projected to remainstrong in 2007 (7.5 percent). Macroeconomic pol-icy restraint will be needed to align growth with po-tential output over the medium term, as sustainedexpansionary policy raises the risk that growth willhave to slow more abruptly to reestablish equilib-rium between demand and supply.


Risks and uncertaintiesA major uncertainty for the region concerns thefuture path of commodity prices and export de-mand, both of which are likely to be sensitive togrowth developments in the United States. A moreforcible spreading of the housing recession toother sectors in the U.S. economy could have im-portant consequences for Latin American andCaribbean countries with close trade links withthe United States, notably Mexico. Indirect chan-nels may also be important. In particular, a sharpslowdown in U.S. demand could cause commodityprices to weaken much more rapidly thananticipated in the baseline. The combination ofweaker demand and lower prices for the exportsof countries in the region could generate signifi-cant difficulties for some countries, where underly-ing problems may have been hidden by thecommodity boom of the past few years.

In general, the region has become more re-silient to external shocks in the past few years andmost countries have taken steps to restructure andreduce debt burdens as well as to establish ampleinternational reserves. For many countries, re-serves accumulation was supported not only byrecent favorable international financial marketconditions but also by improved competitivenessand stronger current account positions. Thesedevelopments, combined with a higher share ofFDI in capital inflows, have reduced the vulnerabil-ity of the region to sudden capital flow reversals.The end-February 2007 declines in equity marketsthat started in China and quickly reverberated inother markets (Brazil’s market fell 6.6 percent,Russia’s fell 3.3 percent, Turkey’s fell 4.5 percent,and the Dow Jones Industrial Average fell byaround 3 percent) did not produce lasting negativeeffects on sovereign bond spreads (the EMBIGlobal rose to about 195 basis points but hassince leveled off at 190 basis points, a historicallylow level for this index).

Several Latin American and Caribbean coun-tries have adopted a number of policies that couldsignificantly reduce their long-term growth poten-tial, increasing the likelihood of a sharp growthdisruption should today’s virtuous cycle of strongexternal growth, robust export prices, and low in-terest rates turn into a vicious circle characterizedby falling commodity prices, rising interest rates,and slower demand. With the external environ-ment toughening and some internal tensions

126

remaining, markets may become more volatilegoing forward, as was illustrated by the recentincrease in the VIX index, a measure of investors’forecasts regarding risk and an indication of riskaversion.

Middle East and North Africa4

Recent developments

The low- and middle-income countries of theMiddle East and North Africa5 region contin-

ued on a robust growth path during 2006, withreal GDP increasing by 5 percent (3.2 percent inper capita terms), a significant improvement fromthe 4.3 percent gain posted the year before(table A.10). Notwithstanding a further 20 percenthike in oil prices during 2006, GDP growth for theresource-poor economies6 of the region acceler-ated from 3.8 percent in 2005 to 5.6 percent,partly reflecting a rebound in growth amongMaghreb countries following a severe drought in2005. Growth among the oil-exporting economiesdipped to 4.5 percent in 2006 from 4.7 percentin 2005, principally as hydrocarbon production inAlgeria languished, restricting overall growth inthat country to 1.4 percent.

Rising oil prices during the first eight monthsof 2006 served to bolster revenues and domesticdemand among the major oil-exporting countriesin the region. Many governments have usedrevenues to boost spending. Measures includedsubstantial investments to augment oil-sectorcapacity, infrastructure projects, and other nonoil-sector investments in human and social capital, allof which should help boost future supply. How-ever, a significant share of the additional spending,such as substantial civil service wage increases inseveral countries, and increased spending on fuelsubsidies, merely stoked demand and may provedifficult to sustain should oil prices decline further.

Though their oil import bill has soared, oil im-porters such as Morocco and Tunisia have also ben-efited from the region’s boom in oil revenues as FDIflows from the Gulf Cooperation Council (GCC),comprised of Bahrain, Kuwait, Oman, Qatar,Saudi Arabia, the United Arab Emirates, and theRepublic of Yemen have picked up considerably,while recovery in the Euro Area has served to boosttourism revenues and remittance inflows. StrongSuez Canal revenues in Egypt and better cropsfollowing a drought in the Maghreb are additional


factors that explain the acceleration of growth inthese countries from 3.8 to 5.6 percent between2005 and 2006. An exception to the strong growthperformance was Lebanon, where the conflict be-tween Israel and Hezbollah and political uncer-tainty caused GDP to contract by about 5.5 percentin 2006.

Despite strong demand growth, industrialproduction declined by 0.2 percent in 2006, re-flecting capacity constraints among both oil im-porters and oil exporters, real effective exchangerate appreciation related to Dutch disease in sev-eral countries, and OPEC-dictated cuts in hydro-carbon production. The combination of rapidlyexpanding demand and declining or relativelystagnant industrial production led to a 2 percent-age point increase in regional inflation, a notion ofconcern, although the increase was moderate in re-lation to the scope of the region’s oil price boom,suggesting that countries are coping better withthese pressures than they have in the past. Risingimported agricultural and other raw-material

127

Table A.10 Middle East and North Africa forecast summaryannual percent change unless indicated otherwise

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

GDP at market prices (2000 $)b 3.8 4.8 4.3 5.0 4.5 4.6 4.8GDP per capita (units in $) 1.6 3.0 2.6 3.2 2.7 2.8 3.1PPP GDP c 4.7 4.8 4.3 5.3 4.5 4.6 4.8


Net exports, contribution to growth �0.8 �1.7 �2.0 �4.4 �6.6 �8.9 �10.9Current account balance/GDP (%) �0.3 2.6 6.6 6.3 4.0 2.9 1.9GDP deflator (median, LCU) 7.4 9.1 13.5 8.5 3.5 4.4 4.0Fiscal balance/GDP (%) �2.7 �2.7 0.8 0.6 0.5 0.9 0.6

Memo items: GDPMENA geographic regione 3.4 5.0 5.3 5.4 5.0 4.9 4.9

Resource poor, labor abundantf 4.2 4.8 3.8 5.6 4.9 5.1 5.5Resource rich, labor abundant g 3.3 4.9 4.6 4.3 4.0 4.2 4.1Resource rich, labor importing h 3.0 5.2 6.8 6.0 5.7 5.2 4.9

Egypt, Arab Rep. of 4.3 4.2 4.6 6.9 5.3 5.4 6.0Iran, Islamic Rep. of 3.7 5.1 4.4 5.8 5.0 4.7 4.5Algeria 1.7 5.2 5.3 1.4 2.5 3.5 4.0

Source: World Bank.Note: e � estimate; f � forecast; LCU � local currency units.a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.b. GDP measured in constant 2000 $.c. GDP measured at PPP exchange rates.d. GNFS denotes goods and nonfactor services.e. Geographic region includes high-income countries: Bahrain, Kuwait, and Saudi Arabia.f. Egypt, Jordan, Lebanon, Morocco, and Tunisia.g. Algeria, the Islamic Republic of Iran, Syria, and the Republic of Yemen.h. Bahrain, Kuwait, Oman, and Saudi Arabia.

prices, coupled with increased domestic energycosts (several countries lifted subsidies on gasolineand other fuels), also contributed to the pickup inconsumer inflation from 3.2 percent at the end of2005 to 5.6 percent in the final months of 2006.Inflation in the Islamic Republic of Iran remains inthe double digits, while the consumer price indexpicked up in Algeria, Egypt, and Oman over thecourse of 2006. Tighter policy in Tunisia and Mo-rocco has helped reestablish a downward trajec-tory for inflation in those countries. Inflation inJordan has declined somewhat in recent months,though it is still higher than it was a year earlier(figure A.7).

Tourism revenues, which rose by 11 percent to$17.8 billion in 2006, account for 7 percent of theregion’s external receipts, and an even larger sharefor resource-poor countries. Gross remittance in-flows to countries in the region were up 8.8 per-cent in 2006, double the pace of 2005, standing at$25.1 billion. Together, remittances and tourismrepresent some 28 percent of recipients’ foreign


currency revenues. While Morocco is the most im-portant destination for remittances ($5.2 billion),Jordan received a larger share of its income (17.5percent of GDP in 2006) from this source, mainlyreflecting transfers from citizens working in re-gional high-income oil-exporting countries. Partlybecause of these revenues, the current account po-sition of resource-poor and oil-importing countriesremained in balance, despite deterioration in mer-chandise trade balances.

The divergence between higher oil prices (onaverage, oil prices were up 20 percent in 2006)and reduced oil export volumes meant that petro-leum and related receipts of the region’s low- andmiddle-income oil exporters increased by only $10billion (compared with a $30 billion increase in2005). This, combined with a rapid increase in do-mestic demand, meant that the aggregate currentaccount surplus of these countries edged lowerfrom 11.2 to 10.9 percent of GDP. Moreover, de-spite strong oil revenues, aggregate fiscal surplusslipped from 5.5 to 4.4 percent of GDP. In con-trast, the same reduction in energy subsidies thatserved to increase domestic inflation rates amongthe region’s oil importers also helped them to re-duce their fiscal deficits from an average of 6.8percent of GDP in 2005 to a still-high 6.2 percentin 2006.

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For the region, 2006 was a year of ample fi-nancial liquidity, strong revival of privatization,and robust cross-border mergers and acquisitions,particularly in the banking industry. Regional in-vestment demand, fueled in part by intraregionalFDI flows, increased by more than 12 percent forthe second year in a row. Total FDI flows reacheda new high of more than $19 billion in 2006, or3 percent of regional GDP (table A.11), concen-trated in Egypt, Jordan, Lebanon, and Tunisia. Incontrast with equity markets elsewhere in the de-veloping world, markets in the region consideredas a whole have yet to recover from the turbulenceintroduced in May/June 2006. Prices in dollarterms remain below levels of early June, althoughthis mainly reflects weakness in Iranian and Iraqimarkets. Prices elsewhere continue to rise rapidly,outpacing the rest of the developing world (figure A.8).

The combination of high trade surpluses andlarge capital inflows has boosted the region’s fi-nancial resources, adding to central banks’ foreignexchange reserve holdings and increased foreigninvestment, not only in the energy sector but alsoin infrastructure, real estate, and tourism. As inother regions, sovereigns in the Middle East andNorth Africa continued to reduce their externaldebt through debt repayment.

Traditionally strong local and regional bankshave benefited from the favorable combination ofgrowing local economies, ample oil-generated for-eign currency liquidity, closer regional financialintegration, and a new wave of privatization andbanking sector reform implemented in severalcountries, including Egypt, Algeria, and Lebanon.Shares of several state-owned banks (for example,Bank of Alexandria in Egypt) have been offered toboth local and foreign investors. Rising real estateprices have created a growing market opportunityfor banks to expand lending. However, the combi-nation of increased bank borrowing from overseasmarkets to help finance this sharp rise in activity,efforts to strengthen capital adequacy through for-eign equity injections, and a surge in other capitalinflows may make the region vulnerable to over-pricing of assets and sudden corrections similar tothose of May/June 2006.

Aid grants provided by bilateral donors to theMiddle East and North Africa region increasedsubstantially over the last few years, although

�2

3

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13

18

23

Figure A.7 Rising inflation in selected countriesof the Middle East and North Africa



Jan.

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Algeria Egypt, Arab Rep. of Iran, Islamic Rep. ofJordan Morocco Oman Tunisia


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Table A.11 Net capital flows to the Middle East and North Africa$ billions

1998 1999 2000 2001 2002 2003 2004 2005 2006e

Current account balance �14.6 3.1 22.5 13.2 8.4 12.8 12.9 38.1 42.1as % of GDP �4.1 0.9 5.9 3.3 2.1 2.9 2.6 6.6 6.3

Financial flowsNet private and official flows 7.6 0.5 1.2 4.8 6.0 9.3 10.4 20.7 13.9Net private flows (debt � equity) 9.2 3.0 3.9 6.0 8.5 11.8 14.3 24.3 23.4Net equity flows 4.0 3.5 5.0 4.0 4.6 8.4 7.5 16.1 20.8Net FDI inflows 3.8 2.8 4.8 4.1 4.9 8.1 6.8 13.8 19.2Net portfolio equity inflows 0.2 0.7 0.2 �0.1 �0.3 0.3 0.7 2.3 1.6

Net debt flows 3.6 �3.0 �3.8 0.8 1.4 0.9 2.9 4.6 �6.9Official creditors �1.6 �2.5 �2.7 �1.2 �2.5 �2.4 �4.0 �3.6 �9.5

World Bank �0.2 0.2 �0.3 �0.1 �0.3 �0.3 �0.6 0 �0.9IMF 0 0 �0.2 �0.1 �0.3 �0.6 �0.5 �0.7 �0.1Other official �1.4 �2.8 �2.2 �1.0 �2.0 �1.6 �2.8 �2.8 �8.5

Private creditors 5.2 �0.5 �1.1 2.0 3.9 3.4 6.8 8.2 2.6Net medium- and long-term debt flows 1.8 �1.4 0.8 3.8 4.5 0.2 2.4 4.9 0.6

Bonds 1.3 1.4 1.2 4.4 5.0 0.7 3.3 2.6 �2.3Banks 2.0 �1.6 0.5 �0.1 �0.2 �1.0 �0.8 3.4 4.4Other private �1.5 �1.2 �0.9 �0.5 �0.2 0.5 �0.2 �1.0 �1.5

Net short-term debt flows 3.3 1.0 �1.9 �1.8 �0.6 3.1 4.5 3.2 1.9Balancing itema 5.4 �4.5 �19.0 �8.8 �2.3 0 �9.1 �37.7 �19.0Change in reserves (� � increase) 1.6 0.9 �4.7 �9.2 �12.1 �22.1 �14.3 �21.1 �37.0

Memo itemsBilateral aid grantsb 4.9 4.7 4.1 4.6 7.8 10.7 27.2 11.9 15.4

of which Technical cooperation grants 1.6 2.1 1.5 1.8 2.1 2.1 1.8 2.2 2.9Other 3.3 2.6 2.6 2.8 5.7 8.6 25.4 9.7 12.6

Net official flows (aid � debt) 3.3 2.2 1.4 3.4 5.3 8.3 23.2 8.3 5.9Workers’ remittances 13.1 12.8 12.9 14.7 15.8 20.3 23.0 24.0 25.1Repatriated FDI Income 1.7 2.0 2.6 3.3 3.3 4.4 6.0 6.7 —

Sources: World Bank Debtor Reporting System and staff estimates.Note: e � estimate; — � not available.a. Combination of errors and omissions and net acquisition of foreign assets (including FDI) by developing countries.b. Including aid grants provided to Iraq, which are not included in the financial flows because they do not report to the Debtor Reporting

System.

much of the increase in flows was in the formof debt relief to Iraq by Paris Club creditors($13.9 billion during 2005 and $3.4 billion in2006). Assistance provided to Iraq accounted formore than 40 percent of total ODA flows to theregion in the last two years. In January 2007, agathering of donors (Paris III) pledged some $7.5billion to facilitate the rebuilding process inLebanon, grounded in a renewed program of fiscaland economic reforms.

Medium-term outlookProspects for the region through 2009 are broadlyfavorable. A gradual easing of growth among theresource-rich economies, in tandem with softeningoil prices, implies that oil revenues are likely to de-cline. Weaker output growth among oil exportersis projected to be compensated for by a pickupamong the resource-poor economies. On balance,

0

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100

50

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Developing countries

Diversified

Entire region

ExcludingIraq and Iran

Figure A.8 Stock market valuations in the MiddleEast and North Africa

Stock market valuations in $, index � 100

Sources: World Bank; Datastream.Note: Diversified economies are countries whose exports comprise amix of goods and services and include Jordan, Lebanon, Morocco,and Tunisia.


volumes and prices ease. As a result, the currentaccount balances of developing oil exporters areprojected to decline from a 10.9 percent of GDPsurplus in 2006 to about 4.4 percent of GDP in2009, while fiscal surpluses are expected to nar-row from 4.4 percent of GDP to about 2.9 percentof GDP in 2009.

For resource-poor and oil-importing eco-nomies, growth is expected to ease to about4.9 percent in 2007, as one-off factors thatboosted growth in 2006 fade. Output should pickup once again beginning in 2008 and reach 5.5 per-cent in 2009 as the supply effects of the recent FDIboom begin to be felt. Stronger growth in high-income Europe should bolster exports of NorthAfrican countries, for which Europe is the destina-tion of 40–80 percent of merchandise exports7 and

regional GDP growth is projected to ease onlymodestly from 5 percent growth in 2006 to 4.8 in2009 (table A.12).

For oil exporters, a projected decline in oilprices and the resurgence of non-OPEC supply un-derpin an expected slowdown in growth from 4.5percent in 2006 to 4.2 percent by 2009. Already,OPEC has cut production by some 0.55 millionbarrels per day (mbpd) in contrast to the averageincrease of 1.7 mbpd during 2004 and 2005.Falling oil prices and production levels are ex-pected to restrain government spending in the re-gion. While oil revenues remain very high andshould continue feeding domestic demand in oil-producing countries, capacity constraints are ex-pected to limit domestic production growth, caus-ing imports to continue to rise rapidly as export

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Table A.12 Middle East and North Africa country forecasts annual percent change unless indicated otherwise

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

AlgeriaGDP at market prices (2000 $)b 1.7 5.2 5.3 1.4 2.5 3.5 4.0Current account balance/GDP (%) 3.2 13.2 20.4 23.2 17.9 16.2 12.8

Egypt, Arab Rep. ofGDP at market prices (2000 $)b 4.3 4.2 4.6 6.9 5.3 5.4 6.0Current account balance/GDP (%) 0.9 5.0 3.0 1.5 1.3 �0.7 �0.5

Iran, Islamic Rep. ofGDP at market prices (2000 $)b 3.7 5.1 4.4 5.8 5.0 4.7 4.5Current account balance/GDP (%) 1.6 0.9 7.4 5.3 2.4 2.2 1.0

JordanGDP at market prices (2000 $)b 5.1 8.4 7.3 6.3 5.0 5.0 5.5Current account balance/GDP (%) �4.3 �0.2 �19.6 �23.0 �22.2 �17.3 �9.8

LebanonGDP at market prices (2000 $)b 7.2 6.3 1.0 �5.5 4.5 2.9 3.5Current account balance/GDP (%) .. �16.5 �18.8 �22.9 �20.9 �19.3 �17.1

MoroccoGDP at market prices (2000 $)b 2.2 4.2 1.7 7.3 3.5 4.5 4.6Current account balance/GDP (%) �1.4 1.8 2.1 4.1 2.9 2.0 0.8

OmanGDP at market prices (2000 $)b 4.6 3.1 5.6 6.4 5.7 4.8 4.8Current account balance/GDP (%) �3.7 2.3 15.7 21.2 23.1 18.7 15.3

Syrian Arab Rep.GDP at market prices (2000 $)b 5.1 3.9 4.5 5.1 3.2 3.5 3.2Current account balance/GDP (%) 1.0 �2.5 1.2 1.2 �2.1 �2.3 �2.7

TunisiaGDP at market prices (2000 $)b 4.7 6.0 4.2 5.3 5.6 6.0 6.2Current account balance/GDP (%) �4.3 �2.0 �1.1 �1.2 �1.5 �1.2 �1.1

Yemen, Republic ofGDP at market prices (2000 $)b 5.5 2.5 3.8 3.9 2.5 3.0 2.5Current account balance/GDP (%) �4.3 1.7 4.6 �4.5 �8.4 �11.4 �11.0

Source: World Bank.Note: Growth and current account figures presented here are World Bank projections and may differ from targets contained in Bank

documents. Djibouti, Iraq, Libya, and the West Bank and Gaza are not forecast owing to data limitations. e � estimate; f � forecast.a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.b. GDP measured in constant 2000 $.


is a dominant source of tourism and remittancerevenues. Oil importers’ current account positionsare expected to remain broadly stable as thebeneficial effects of lower oil prices are offset byincreased leakages from strengthening domesticdemand. Government revenues should benefitfrom reduced expenditures on energy subsidiesboth because of lower prices and measures to re-duce these subsidies. As a result, the fiscal deficit ofoil importers is projected to improve from 6.2 per-cent of GDP in 2006 to 2.9 percent of GDP in2009.

For resource-poor economies in the MiddleEast and North Africa, inflationary pressures areexpected to recede over 2007–09, in part as theworkout of oil-price-related pressures from earlierlifting of fuels subsidies comes into play. From a5.8 percent pace in 2006,8 CPI should ease to 4percent in 2007. Thereafter, inflation is expectedto diminish to 3.4 percent by 2009, on the back offurther terms-of-trade improvement and nascentgains in productivity. For oil exporters in the cur-rent regional sample, price pressures are antici-pated to remain elevated, due to continued fiscaland monetary stimulus in the Islamic Republic ofIran. From a GDP-weighted 8.7 percent advancein 2006, inflation is predicted to range between10.5 and 11 percent through 2009, as Iranian in-flation accelerates to 17 percent by the end of theforecast period.

Risks and uncertaintiesThe past few years represent the region’s bestgrowth performance in a decade. A major uncer-tainty facing the region concerns its ability to sus-tain such growth in the face of a less supportive in-ternational environment characterized by slowergrowth, lower oil prices, and increased competi-tion. Downside risks can be clearly envisionedunder a more substantial deterioration of condi-tions in the external environment than posited inthe baseline assumptions. Additionally, the eco-nomic and political challenges of the next fewyears are magnified by rapidly growing popula-tions and large cohorts of youth, who are lookingfor—or will be looking for—work.

For the oil exporters of the region, the futurepath of oil prices, global oil demand, and non-OPEC supply are critical sources of uncertainty.OPEC faces the very difficult challenge of main-taining prices at levels that are high enough to

131

maximize revenues for the group, but which arenot so high as to induce substantial additional sup-ply. The group’s past success in achieving this bal-ancing act is not encouraging, although long-termtrends suggest that the organization’s marketpower is likely to grow and therefore its capacityto manage global demand and supply conditionsare likely to strengthen.

Managing the windfall oil revenues of the lastyears is a continuing challenge for oil exporters.The risk of overheating domestic demand and itspotential inflationary consequences loom as anoverarching threat. It appears, however, that incontrast with earlier episodes of oil booms, judi-cious use of oil stabilization funds and other finan-cial management approaches have served tocounter overheating and to augment the nonoilsupply potential of the economy. Continued pur-suit of these approaches should remain a priority.Importantly, domestic reform efforts may stand atsome risk against the background of abundant liq-uidity and rapid growth. Should oil prices take asudden and sustained downturn, economies mayfind adjustment difficult.

The emergence of large-scale capital flowswithin the broader region, largely among the GCCand from GCC to the resource-poor economies inthe region, offers new opportunities as well asrisks. The 2005/06 crash of GCC equity marketsserves as a reminder of the potential of overshoot-ing in a new financial environment. At the sametime, FDI-based flows from the GCC to theMaghreb and Mashreq appear to be more deeplyintegrated with the structures of the hosteconomies, and hence less subject to the risks asso-ciated with capital flight.

South Asia Recent developments

GDP in South Asia expanded a robust 8.6 per-cent in 2006, reflecting generally expansion-

ary policy conditions, although down slightly from2005 due primarily to a deceleration of growth inPakistan (table A.13). Inflation remains high andhas shown limited signs of declining, despite loweroil prices in the second half of the year and a mod-est tightening of fiscal and monetary policies. Pricepressures are partly being kept in check byproduct-specific tax cuts and direct and indirectsubsidization of consumer energy prices, but by


supporting real incomes these measures are con-tributing to strong domestic demand. Higher oilprices in the first half of 2006 and strong domesticdemand contributed to deterioration in the re-gion’s current account balance despite strong ex-ports and remittances inflows.

With the exception of Nepal, which is onlynow emerging from political strife, growththroughout the region was strong in 2006. InIndia, GDP increased by 9.2 percent, althoughsigns of slowing appeared toward the end of theyear. In the fourth quarter, GDP growth slowed to8.6 percent, due mainly to weak (1.5 percent)agriculture growth (down from 8.7 percent in thefourth quarter of 2005), despite a firming inmanufacturing output to 10.7 percent (relative to8.2 percent in the fourth quarter of 2005). InPakistan, GDP increased by 6.6 percent in 2006,significantly down from the 7.8 percent growthrate recorded the previous year. In part, the slow-down reflects a weakening of industrial produc-tion in the third quarter, itself likely a reflection ofthe waning effect of the boost to production pro-vided by the reintroduction of quotas on Chineseclothing and textile exports the year before. In-deed, growth in the value of merchandise exportsin the region declined from 30 percent in mid-yearto 16 percent by the end of the year.

132

Output among the smaller countries in the re-gion increased a strong 6.4 percent, the notableexception being Nepal, where economic activityexpanded a disappointing 1.9 percent on accountof political turmoil. Output in the Maldiveswas supported by a rebound in tourism and post-tsunami reconstruction efforts, while a new hydro-electric plant helped boost output in Bhutan.

Notwithstanding robust export growth, ro-bust domestic demand and a 20 percent increase inoil prices for the year as a whole caused theregional current-account deficit to deterioratefrom 1.9 percent of GDP to 2.4 percent in 2006,with Sri Lanka exhibiting the largest deterioration.Strong remittance inflows have helped finance for-eign purchases in the region for some time now(figure A.9), with such remittances having helpedto propel the current account of Bangladesh to a0.6 percent of GDP surplus in 2006.

Rapid growth and the relatively expansionarystance of fiscal and monetary policies in the regionhave provoked a rise in inflation. Successive hikesin policy rates in India have led to higher interestrates across the spectrum, but higher inflationmeans that real rates remain low (figure A.10). InPakistan, tighter monetary policy brought infla-tion down to 6.6 percent in January 2007 and to7.9 percent during 2006 from 9.3 percent in 2005,

Table A.13 South Asia forecast summaryannual percent change unless indicated otherwise

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

GDP at market prices (2000 $)b 5.2 7.8 8.7 8.6 7.9 7.5 7.2GDP per capita (units in $) 3.2 6.1 7.0 7.0 6.4 6.0 5.8PPP GDPc 6.4 7.9 8.8 8.7 8.0 7.5 7.3

Private consumption 4.0 5.7 7.3 8.5 7.1 6.5 6.2Public consumption 3.9 5.3 8.9 5.6 5.3 4.8 4.6Fixed investment 5.5 10.2 14.0 12.3 11.2 10.5 10.2Exports, GNFS d 9.0 14.5 19.1 21.8 13.5 13.0 12.7Imports, GNFS d 7.9 32.9 21.7 24.2 12.9 12.0 11.7

Net exports, contribution to growth �3.6 �2.6 �3.4 �4.4 �4.4 �4.4 �4.3Current account balance/GDP (%) �1.6 �1.3 �1.9 �2.4 �2.3 �2.1 �2.1GDP deflator (median, LCU) 8.0 4.9 4.6 7.6 8.6 6.7 6.1Fiscal balance/GDP (%) �7.8 �6.7 �6.7 �6.2 �5.9 �5.6 �5.3

Memo items: GDPSouth Asia excluding India 4.4 6.1 6.8 6.4 6.1 6.2 6.2India 5.5 8.3 9.2 9.2 8.4 7.8 7.5Pakistan 3.9 6.4 7.8 6.6 6.4 6.3 6.1Bangladesh 4.8 6.3 6.0 6.2 6.0 6.1 6.4

Source: World Bank.Note: e � estimate; f � forecast; LCU � local currency units. a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.b. GDP measured in constant 2000 $. c. GDP measured at PPP exchange rates.d. GNFS denotes goods and nonfactor services.


133

0

1

2

3

4

5

2000 2001 2002 2003 2004 2005 2006e

Figure A.9 Strong workers’ remittancesin South Asia

% regional GDP

Source: World Bank.Note: e � estimate.

Net FDI inflows Portfolio equity inflows

Workers’ remittances

Net capital inflows to South Asia increased to$40.1 billion (3.6 percent of GDP) in 2006, upfrom $28.3 billion (2.8 percent of GDP) in 2005,with most of the increase in going to India(table A.14). Strong capital inflows were largelydue to a $12 billion expansion in net private debtflows, while net equity inflows to the region in-creased only slightly, as a $3 billion increase inFDI was partly offset by a decline in portfolio eq-uity flows. At $22.9 billion in 2006, net equity in-flows nonetheless account for the bulk (60 per-cent) of net private inflows to the region.

Much of the FDI inflows into India were con-centrated in the service sector (telecommunica-tions in particular) in response to liberalizationpolicies designed to attract FDI, such as easingownership restrictions. FDI outflows from Indiaare also on the rise due to increasing cross-borderM&A purchases by Indian companies, mainly inhigh-income economies. Since 2004, FDI flowsfrom India to the United Kingdom exceeded flowsfrom the United Kingdom to India. The Indianmultinational Tata acquired the Dutch steel com-pany Corus for more than $10 billion in early2007. FDI inflows to Pakistan increased from $2.2billion in 2005 to $3.5 billion in 2006 with muchof investment in the oil and gas and financial sec-tors, along with installments made on a major tele-com privatization deal in 2005.

Reserve accumulation in India picked up sig-nificantly in 2006, by $39 billion, to reach $171billion, 6 percent of the total stock of reserves heldby all developing countries. Given the strong risein imports, foreign reserves in terms of months ofimport cover (for merchandise trade) declined to11.2 months on average for 2006 from 13 in2005.

Medium-term outlookRegional GDP growth should moderate to about7.5 percent and 7.2 percent in 2008 and 2009, re-spectively, due to a combination of tighter policyconditions and weakening of external demand(table A.15). Despite these factors, sustained highgovernment deficits—currently running about 6.5percent as a share of GDP in India, over 8.0 per-cent in Sri Lanka, and about 3.5 percent inBangladesh and Pakistan—and strong interna-tional capital inflows are expected to keepdomestic demand expanding rapidly, albeit not asstrongly as in recent years. Robust domestic

Figure A.10 Real interest rates in South Asia

�10

�8

�6

�4

�2

0

2

4

6

8

Bangladesha

Sri Lanka

Nepal

India

Pakistan

Source: World Bank.a. Deposit rates deflated by consumer price inflation.

Policy rate deflated by price inflation

Jan.

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Jan.

2007

Oct. 2

006

Jul. 2

006

Apr. 2

006

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005

although it showed signs of accelerating more re-cently, rising again to 7.7 percent year-over-year inMarch 2007. Prices have been rising particularlyrapidly in Sri Lanka, reflecting pressures on do-mestic demand resulting from loose monetary pol-icy. Strong capital inflows have also played a role,boosting domestic liquidity and stock marketvaluations. As of early March, the Standard &Poor’s/IFC Global (S&P/IFCG) index9 was up92 percent compared to January 2006, despite theglobal decline in market valuations the previousmonth.


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Table A.15 South Asia country forecastsannual percent change unless indicated otherwise

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

BangladeshGDP at market prices (2000 $)b 4.8 6.3 6.0 6.2 6.0 6.1 6.4Current account balance/GDP (%) �0.4 �0.5 �0.2 0.6 0.2 �0.5 �0.8

IndiaGDP at market prices (2000 $)b 5.5 8.3 9.2 9.2 8.4 7.8 7.5Current account balance/GDP (%) �1.2 �1.4 �1.9 �2.2 �2.1 �2.0 �2.0

NepalGDP at market prices (2000 $)b 5.0 3.7 2.7 1.9 3.0 4.5 4.7Current account balance/GDP (%) �6.4 �0.7 0 0.6 �0.6 �1.6 �2.4

PakistanGDP at market prices (2000 $)b 3.9 6.4 7.8 6.6 6.4 6.3 6.1Current account balance/GDP (%) �3.7 �0.8 �3.3 �4.9 �4.3 �3.6 �3.0

Sri LankaGDP at market prices (2000 $)b 5.2 5.4 6.0 7.4 6.0 6.2 6.3Current account balance/GDP (%) �4.6 �3.4 �3.2 �4.9 �4.0 �3.9 �3.3

Source: World Bank.Note: Growth and current account figures presented here are World Bank projections and may differ from targets contained in other

Bank documents. Afghanistan, Bhutan, and the Maldives are not forecast owing to data limitations. e � estimate; f � forecast.a. Growth rates over intervals are compound average; growth contributions, ratios and the GDP deflator are averages.b. GDP measured in constant 2000 $.

Table A.14 Net capital flows to South Asia$ billions

1998 1999 2000 2001 2002 2003 2004 2005 2006e

Current account balance �9.5 �5.3 �6.3 2.2 11.4 10.6 �11.5 �19.6 �26.7as % of GDP �1.8 �0.9 �1.1 0.4 1.8 1.4 �1.3 �2.0 �2.4

Financial flowsNet private and official flows 7.6 6.0 10.3 8.1 7.3 14.0 24.7 28.3 40.1Net private flows (debt � equity) 5.3 3.5 9.8 6.0 9.7 15.6 23.7 24.9 37.7Net equity flows 2.9 5.5 6.8 8.8 7.7 13.6 16.1 22.1 22.9Net FDI inflows 3.5 3.1 4.4 6.1 6.7 5.6 7.3 9.9 12.9Net portfolio equity inflows �0.6 2.4 2.4 2.7 1.0 8.0 8.8 12.2 10.0

Net debt flows 4.7 0.5 3.5 �0.7 �0.4 0.4 8.6 6.2 17.2Official creditors 2.3 2.5 0.5 2.2 �2.4 �1.7 1.0 3.4 2.5

World Bank 0.8 1.0 0.7 1.5 �1.0 �0.2 2.0 2.2 1.8IMF �0.4 �0.1 �0.3 0.3 0.1 �0.1 �0.3 0 �0.1Other official 2.0 1.6 0 0.4 �1.5 �1.5 �0.7 1.2 0.8

Private creditors 2.4 �2.0 3.0 �2.8 2.0 2.0 7.6 2.8 14.8Net medium- and long-term debt flows 3.7 �2.1 3.9 �1.9 0.2 1.3 4.9 1.2 12.0

Bonds 4.2 �1.2 5.4 �0.4 �0.7 �3.1 4.1 �2.9 2.0Banks 0.7 �0.5 �2.0 �1.1 1.0 4.4 1.1 4.2 9.9Other private �1.1 �0.4 0.5 �0.3 �0.1 0 �0.3 �0.1 0.1

Net short-term debt flows �1.3 0.1 �0.9 �0.9 1.8 0.7 2.6 1.6 2.8Balancing itema 4.8 4.6 0.7 �0.1 8.2 11.3 14.0 �3.0 28.3Change in reserves (� � increase) �2.9 �5.3 �4.6 �10.2 �27.0 �35.9 �27.2 �5.7 �41.7

Memo itemsBilateral aid grants 3.2 3.4 3.1 4.2 3.7 5.4 5.0 6.6 3.9

of whichTechnical cooperation grants 1.1 1.1 1.0 1.0 1.2 1.5 1.5 1.6 1.8Other 2.1 2.3 2.1 3.2 2.5 3.9 3.5 5.0 2.2




demand, combined with the delayed pass-throughof higher oil prices, is expected to maintain infla-tionary pressures in the region and to sustain im-port growth in the double digits. As a result, theexternal sector is expected to make a significantnegative contribution to growth, with the regionalcurrent account deficit projected to exceed 2.0 per-cent of GDP over the forecast horizon.

In India, more restrictive policy conditions areexpected to lead to deceleration in investmentgrowth and weaker private consumption andgovernment spending, contributing to a slowdownin GDP growth to 7.8 percent and 7.5 in 2008 and2009, respectively. In Pakistan, growth is alsoforecast to ease, although more gradually, as pol-icy conditions are expected to remain broadly ac-commodative in the lead-up to the 2007 presiden-tial elections, which are scheduled to take placeduring September and October. Recent heightenedpolitical tensions are expected to hamper businessand consumer confidence and to partly contain theimpact of stimulative policy conditions. Tighten-ing of fiscal and monetary policies is expectedin 2008, leading to further restraint of domesticdemand and further deceleration of growth to6.1 percent in 2009.

Among the smaller economies in the region,growth in Sri Lanka is projected to hover close to6.0 percent during 2007–09, down from 7.4 per-cent in 2006, due to disruptive effects of civil war,which are partially mitigating the positive growthimpacts of the ongoing recovery from the tsunami(including the reconstruction of roads and build-ings). Growth is projected to strengthen in Nepaldue to improved political conditions and cessationof fighting. In Bhutan, growth is expected to re-main robust, rising by a projected 17 percent in2007—a sharp acceleration from the estimated5.5 percent in 2006—driven primarily by the stim-ulative effects of the Tala hydropower project (theplant is expected to begin operating at full capac-ity in mid-2007), and to a lesser extent by the ex-panding tourism industry. Growth in Bhutan is ex-pected to decelerate to 10 percent in 2008 and5 percent in 2009 as the stimulative impacts of thehydropower project unwind. In Afghanistan, GDPgrowth is expected to accelerate over the forecasthorizon, initially due to an anticipated recoveryfrom drought in the agricultural sector, and overthe forecast horizon due to the stimulative impact

135

of donor-led construction projects. In the Mal-dives, an expansion of GDP growth is expectedto be supported by the ongoing reconstructioneffort following the devastating December 2004tsunami.

Risk and uncertaintiesThe high growth rates posted in recent years havehelped South Asia make significant progress to-ward achieving the Millennium DevelopmentGoals. Most notably, the percentage of peopleliving on less than a dollar a day declined to justover 30 percent in 2003 from 40 percent in 1990,and is now projected to reach about 13 percent in2015—below the initial goal of 20 percent. Theseheadline numbers, while heartening, mask persis-tent social inequalities, as well as considerablesubregional and subnational variation. Sustainedgrowth will be necessary for continued povertyreduction, and achieving further improvements ininstitutional service delivery will be critical tomaking progress in all other dimensions of theMDGs.10

Sustaining high growth will require continuedeconomic reform, expansion of infrastructurecapacity, and further reduction of security threats.These efforts will also contribute to higher capitalinflows, which have been spurred by progress inthese areas in recent years. Revamping tax collec-tion systems to reduce evasion and improve taxcollection to help finance the extensive govern-ment agendas is also important. In Pakistan, forexample, tax evasion is reportedly very high: it isestimated that less than 1 percent of the popula-tion pays income tax.

Given vibrant domestic demand and high oilprices, a significant portion of the cushion thatwas built up in terms of foreign currency reservesand a regional current account surplus (lastrecorded in 2003) has been absorbed. Since 2003,the period for which imports could be covered byforeign reserves has declined by about fourmonths in both India and Pakistan. While reservesin India remain significantly above the level ofthree months worth of imports, they are muchcloser to that level now in Pakistan and below it inboth Bangladesh and Sri Lanka, suggesting thateach country would be vulnerable to a significantterms-of-trade shock, such as another hike in oilprices. In Pakistan, relatively modest (5.5 percent


Sub-Saharan Africa Recent developments

Strong global growth, improved macroeconomicperformance, significant aid flows, rising FDI,

and a continued spell of relative political stabilityhelped GDP in Sub-Saharan Africa expand by5.6 percent in 2006, the third consecutive yearthat growth exceeded 5 percent (table A.16). De-spite high oil prices, oil-importing countries in theregion (even when excluding South Africa) contin-ued to grow rapidly, with output increasing byclose to 5.0 percent. Output growth among oil ex-porters was also strong, but the expansion slowedfrom 7.4 percent in 2005 to 6.9 percent in 2006as some countries pushed against production con-straints and unrest in the Niger Delta underminedgrowth in Nigeria’s oil sector.

Growth was broadly based, with output inhalf of the countries in the subcontinent advancingby 5.0 percent or more. Only 7 of 34 oil-importingeconomies grew by less than 2.0 percent: theComoros, Eritrea, Guinea-Bissau, Swaziland, theSeychelles, Togo, and Zimbabwe. While exportgrowth has been strong, domestic demand hasprovided the largest contribution to growth. In-vestment is estimated to have contributed more

136

Table A.16 Sub-Saharan Africa forecast summaryannual percent change unless indicated otherwise

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

GDP at market prices (2000 $)b 2.3 5.3 5.8 5.6 5.8 5.8 5.4GDP per capita (units in $) �0.4 2.9 3.4 3.5 3.7 3.8 3.4PPP GDPc 3.4 5.5 6.0 5.9 6.2 6.0 5.7


Net exports, contribution to growth 0.5 �1.4 �2.4 �4.8 �5.5 �6.5 �7.2Current account balance/GDP (%) �2.1 �1.1 �0.1 �0.5 �1.4 �2.3 �2.7GDP deflator (median, LCU) 10.1 7.0 6.7 7.2 5.0 4.5 4.5Fiscal balance/GDP (%) �4.0 �0.7 1.1 3.3 0.9 �1.4 �3.0

Memo items: GDPSub-Saharan Africa excluding South Africa 2.6 5.5 6.2 5.9 6.6 6.2 5.7

Oil exporters 2.7 6.0 7.4 6.9 8.3 7.4 6.6CFA countries 2.6 4.1 3.8 3.2 3.4 4.2 3.5

South Africa 1.8 4.8 5.1 5.0 4.4 5.2 4.9Nigeria 2.8 6.0 6.9 5.6 6.4 6.6 5.9Kenya 1.9 4.9 5.8 5.9 5.1 5.2 4.9

Source: World Bank.Note: e � estimate; f � forecast; LCU � local currency units. a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.b. GDP measured in constant 2000 $.c. GDP measured at PPP exchange rates.d. GNFS denotes goods and nonfactor services.

as of end-2006) increases in reserve holdings since2003 in conjunction with a more than doublingof imports (GNFS) resulted in a sharp fall in theimport-cover ratio, an unsustainable trend.

Downside risks to growth are also tied to theinexorable lifting of restrictions on Chinese textileand clothing exports at end-2007 and to astronger than projected slowdown of demandfrom the United States in 2007, an important tradepartner for most countries in the region.

The recent surge in cross-border bank lendingto multinational corporations in India has raisedconcerns that borrowing abroad by the corporatesector could contribute to inflationary pressures,which would require a more aggressive monetarypolicy response and possibly have negativerepercussions for growth prospects over themedium term.

Increased political instability represents an-other main risk. Heightened security concernscould hurt investor sentiment and undermine for-eign capital inflows, which have contributed to theregion’s record four-year expansion. The contin-ued easing of political tensions between thegovernments of India and Pakistan bodes well forcontinued progress toward improved relations.


than 2 percentage points to the growth of oil-importing economies in 2006 and investment hasrisen to represent some 20 percent of GDP amongoil-importing countries from an average of 17 per-cent in the 1990s (figure A.11). Resource-poorand landlocked countries, typically expected toperform poorly in an environment characterizedby high oil prices, have also recorded stronger eco-nomic growth from a historical perspective (3.8and 5.9 percent, respectively).

The performance of South Africa, the region’slargest economy, continued to surprise on the up-side, with GDP expanding by 5.0 percent for thethird consecutive year. Robust domestic demandunderpinned this growth, with consumer demandand investment responding to low interest rates,rising real incomes, and public-sector investmentin transportation and sports infrastructure in therunup to the FIFA World Cup in 2010. GDP grewat a 5.6 percent annualized clip in the fourth quar-ter, despite an 8.4 percent contraction in the agri-cultural sector, due to particularly rapid growth inmining and manufacturing. Overall, the externalsector’s contribution to growth has been negative,reflecting strong import growth fueled by robusthousehold consumption. As a result (notwith-standing high prices for metals), South Africa’scurrent account deficit ballooned to 6.4 percent ofGDP in 2006, which contributed to the sharp de-preciation of the rand during May and June. Over-all, the rand has depreciated 17.4 percent as of

137

March 2007 on a trade-weighted basis sinceMarch 2006, which has contributed to boost in-flation to 6.1 percent in March 2007, up from3.4 percent a year earlier. Nevertheless, consumerconfidence remains at historically high levels, al-though recent retail sales data point to some soft-ening in consumer demand.

In Nigeria, the region’s second-largest econ-omy, a vibrant private sector and strong invest-ment spending kept overall growth at 5.6 percentin 2006, despite an estimated 1.6 percent contrac-tion in the oil sector caused by unrest in the NigerDelta. Non-oil GDP expanded in excess of 8.0 per-cent, boosted by government infrastructure spend-ing. Despite the strength of domestic demand,inflation declined during the course of the year asa stronger currency reduced import costs and theinflationary effects of the removal of subsidies in2004 and 2005 played out on the year-on-yearcomparison. There were, however, some signs of aresurgence in inflationary pressures in the thirdand fourth quarters. Among other oil exporters,growth has been particularly robust in Angola(16.9 percent), Sudan (11.8 percent), and Maurita-nia (14.2 percent), which began oil production inFebruary 2006.

Elsewhere, high international metal and min-eral prices are generating buoyant domestic de-mand and prompting additional investments, whichhave contributed to strong growth in Burundi, theDemocratic Republic of Congo, Ghana, Mali,Mozambique, Tanzania, and Zambia. Economicperformance was also strong in reform-orientedeconomies such as Burkina Faso, Ghana, Mali,Mozambique, Senegal, and Tanzania, as well asin countries emerging from conflict—Burundi,Sierra Leone, Liberia, and the Democratic Repub-lic of Congo.

Growth throughout the continent, however, isstill hampered by multiple and diverse obstacles.Drought-related crop failure, high fuel costs, andenergy rationing have contributed to weakenedresults for East African oil-importing countries. Inaddition, while the number and the intensity ofconflicts in Sub-Saharan Africa have subsided,the risks associated with political turmoil remainhigh and are undermining growth in Chad, Côted’Ivoire, the Democratic Republic of Congo,Eritrea, Lesotho, Nigeria, the Seychelles, Somalia,Sudan, Swaziland, and Zimbabwe. Limitedprogress on reforms and stagnant oil production

15

1990

1991

1993

1992

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

f

16

17

18

19

20

21

Figure A.11 Ratio of nominal investment to nominal GDP among Sub-Saharan oil importers

Source: World Bank.Note: f � forecast.

Percent


in Cameroon and Gabon, in conjunction with theongoing sociopolitical crisis in Côte d’Ivoire anda moderate real-effective appreciation of the cur-rency have undermined economic performance inthe CFA zone countries, where growth is signifi-cantly weaker than elsewhere on the subcontinent.

High fuel costs and energy scarcity, whichcombined have led to rationing and widespreadblackouts, have kept economic growth belowpotential in a number of countries, most notablyin East Africa. Power outages have become morefrequent in recent years, as rapidly increasing de-mand is outpacing the increase in generating ca-pacity, which has suffered from years of underin-vestment and neglect, in part due to pricingpolicies that have forced electricity providers toproduce at a loss. The problem is especially acutein rapidly growing economies such as Ghana,Kenya, Senegal, and Tanzania. Even oil-producingcountries like Nigeria are facing power shortagesdue to lack of generating capacity. With mostelectricity grids operating at or near capacity anddemand expected to increase by more than 5 per-cent per year over the medium term, the energyproblem is likely to constrain growth over themedium term, especially in the mining and manu-facturing sectors.

Oil-exporting countries have been the princi-pal beneficiaries of the estimated 43.5 percent in-crease in FDI into the Sub-Saharan Africa regionoutside South Africa. As in the past, FDI hasflowed mostly into resource-rich countries and pre-dominantly into extraction and related services, forwhich cross-border mergers and acquisitionstripled in the first half of 2006. Because linkagesbetween mining industries and the local economiesare limited, a distinct two-speed growth patternhas emerged, with the resource sectors growingfaster than the rest of the economy.

Current accounts have come under pressure inseveral oil-importing economies in the region (no-tably, as discussed, in South Africa), althoughhigher commodity prices and increased officialand private transfers have helped contain the dete-rioration. Net ODA, excluding debt relief, to Sub-Saharan Africa climbed to $13.2 billion in 2005up from $7.7 billion in 2002, but it declined in2006. In almost half of the oil-importing coun-tries, aid (excluding debt relief) accounted formore than 5.0 percent of GDP on average over2003–05. In countries including Burundi, Eritrea,

138

Malawi, Sierra Leone, Mozambique, Rwanda,Guinea-Bissau, and Ethiopia, ODA exceed 10 per-cent of GDP on average (figure A.12).

The pace of foreign exchange reserve accumu-lation is picking up in the region, with reserves ris-ing by $33 billion in 2006, following increasesof just over $20 billion in 2004–05, with abouthalf of the accumulation in just three countries:Nigeria ($5.9 billion), Angola ($5.4 billion), andSouth Africa ($4.5 billion). Reserves providedcover for at least three months of imports in80 percent of the countries in the region in 2006,up from two-thirds in 2005.

Net private capital inflows to Sub-SaharanAfrica recorded another year of significant gainsin 2006, as foreign investors continued to searchfor higher yields and as robust growth and im-provements in macroeconomic stability, credit-worthiness, and the investment climate madesome countries more attractive to investors. Totalnet capital inflows increased from $28.9 billion or4.6 percent of GDP in 2005, to $39.8 billion, or5.6 percent of GDP in 2006 (table A.17). The re-gion’s share of net capital flows to developingcountries remains small at 7.0 percent, relativelyunchanged from the 6.4 percent share received onaverage over the previous three years. Net privatecapital flows exceeded bilateral aid grants in2006, the first time since 1999. Net equity flowsincreased $7 billion to $31 billion, and net privatelending almost doubled to $10.6 billion, while netofficial lending declined by $1 billion. The in-crease in net private lending was mainly in the

Burundi

0 5 10 15 20

ODA (net of debt relief) as a % of GDP

25 30

Eritrea

Malawi

Sierra Leone

Mozambique

Rwanda

Cape Verde

Guinea-Bissau

Ethiopia

Figure A.12 ODA (net of debt relief) in selectedSub-Saharan African countries, 2003–05

Sources: OECD; World Bank.


form of cross-border bank loans, up $5 billion to$7.4 billion, most of which were medium- andlong-term loans. Net FDI flows to the region roseby $2 billion to $18.5 billion, and continued to belargely resource-seeking, with Nigeria, SouthAfrica, Sudan, Equatorial Guinea, and Angola ac-counting together for more than two-thirds oftotal regional net FDI inflows. Net portfolio eq-uity inflows have increased from less than $1 bil-lion in 2003 to $12.5 billion in 2006, and now ac-count for 30 percent of all private capital flows tothe region, significantly higher than the 12 percentshare for all developing countries.

Despite improvements in creditworthiness andfavorable financing conditions, few countries inthe region managed to gain access to the interna-tional bond market over the past few years. In2006, the Seychelles became the first country inthe region aside from South Africa to issue asovereign or corporate bond in the international

139

Table A.17 Net capital flows to Sub-Saharan Africa$ billions

1998 1999 2000 2001 2002 2003 2004 2005 2006e

Current account balance �17.7 �9.9 3.5 �4.9 �5.9 �3.2 �6.0 �0.9 �3.8as % of GDP �5.4 �3.1 1.0 �1.5 �1.7 �0.7 �1.1 �0.1 �0.5

Financial flowsNet private and official flows 14.4 17.8 10.9 12.2 10.0 18.3 23.9 28.9 39.8Net private flows (debt � equity) 13.9 17.4 10.2 12.2 7.4 16.9 22.0 29.6 41.6Net equity flows 15.7 18.7 11 14.3 9.9 15.3 19.1 24.0 31.0Net FDI inflows 7.1 9.7 6.8 15.2 10.3 14.6 12.4 16.6 18.5Net portfolio equity inflows 8.6 9.0 4.2 �0.9 �0.4 0.7 6.7 7.4 12.5

Net debt flows �1.3 �0.9 �0.1 �2.1 0.1 3.0 4.8 4.9 8.8Official creditors 0.5 0.4 0.7 �0.1 2.6 1.4 1.9 �0.7 �1.8

World Bank 1.3 1.1 1.5 1.8 2.2 2.2 2.5 2.4 1.8IMF �0.3 0 0.1 0.1 0.5 �0.1 �0.1 �0.4 0.1Other official �0.5 �0.7 �0.8 �2.0 0 �0.7 �0.4 �2.7 �3.7

Private creditors �1.8 �1.3 �0.8 �2.1 �2.5 1.6 2.9 5.6 10.6Net medium- and long-term debt flows �1.3 �0.7 0.3 0 �0.7 2.5 1.3 2.5 7.4

Bonds 0.3 1.2 1.0 1.9 2.7 4.6 1.2 0.4 1.3Banks �1.3 �1.7 �0.7 �1.6 �2.7 �1.3 0.4 2.2 6.4Other private �0.2 �0.2 0 �0.3 �0.7 �0.7 �0.3 �0.2 �0.4

Net short-term debt flows �0.5 �0.6 �1.1 �2.1 �1.8 �1.0 1.6 3.2 3.3Balancing itema 2.0 �6.6 �8.4 �6.8 �3.8 �11.0 4.4 �7.1 �3.2Change in reserves (� � increase) 1.2 �1.3 �6.0 �0.5 �0.3 �4.0 �22.3 �20.9 �32.8

Memo itemsBilateral aid grants 14.0 13.2 13.6 13.9 18.4 27.2 29.6 36.5 36.9

of whichTechnical cooperation grants 3.9 3.3 3.6 3.8 4.4 5.1 5.4 5.8 7.0Other 10.1 9.9 10.0 10.1 14.0 22.1 24.2 30.7 29.9



market in the past two decades. Four additionalcountries—Ghana, Kenya, Nigeria, and Zambia—are expected to launch debut sovereign bond is-sues in international markets this year. There hasbeen, however, growing interest on the part offoreign investors in local currency bond markets,most notably in Botswana, Nigeria, Kenya, andZambia. High commodity prices in conjunctionwith currency appreciations have boosted returnson local currency bonds in commodity-exportingcountries such as Nigeria and Zambia. In thelatter, the share of outstanding public debt held bynonresidents increased from a negligible amountin 2004 to 13 percent by the end of 2006. A lackof timely, comprehensive data makes it difficult toassess the prominence of foreign participation indomestic debt markets, however.

It is worth noting that cross-border lendingfrom banks located in other developing countriesplays a prominent role in the region. Over the


140

Table A.18 Sub-Saharan Africa country forecastsannual percent change unless indicated otherwise

1991–2000a 2004 2005 2006e 2007f 2008f 2009f

AngolaGDP at market prices (2000 $)b 0.8 11.2 20.6 16.9 25.1 14.2 13.4Current account balance/GDP (%) �6.1 3.5 16.1 18.6 15.4 7.1 5.4

BeninGDP at market prices (2000 $)b 4.8 3.1 3.9 4.3 4.4 4.2 4.1Current account balance/GDP (%) �6.8 �7.8 �6.9 �7.3 �6.1 �6.4 �6.6

BotswanaGDP at market prices (2000 $)b 6.2 5.9 6.2 4.8 4.3 4.2 4.1Current account balance/GDP (%) 8.1 2.9 14.3 14.8 12.3 11.7 12.9

Burkina FasoGDP at market prices (2000 $)b 4.0 3.9 4.8 5.7 5.5 5.7 5.4Current account balance/GDP (%) �5.6 �10.7 �11.7 �9.7 �9.8 �9.1 �8.3

BurundiGDP at market prices (2000 $)b �2.0 4.8 0.9 5.4 5.1 5.3 5.1Current account balance/GDP (%) �3.4 �8.1 �12.7 �16.1 �15.3 �14.8 �14.8

CameroonGDP at market prices (2000 $)b 1.4 3.7 2.0 3.9 4.1 3.9 3.5Current account balance/GDP (%) �3.0 �2.6 �1.8 0.5 �1.7 �3.1 �3.3

Cape VerdeGDP at market prices (2000 $)b 5.8 4.5 5.9 5.8 6.1 6.3 6.2Current account balance/GDP (%) �8.3 �7.3 �4.5 �6.7 �8.8 �10.9 �13.2

Central African RepublicGDP at market prices (2000 $)b 1.6 1.3 2.2 3.3 3.6 3.4 3.1Current account balance/GDP (%) �4.3 �4.6 �3.3 �3.9 �3.6 �4.1 �4.4

ChadGDP at market prices (2000 $)b 2.3 29.5 5.6 1.7 �1.4 5.1 2.1Current account balance/GDP (%) �5.5 �18.7 0.7 0.1 2.0 �0.9 �3.7

ComorosGDP at market prices (2000 $)b 1.1 �0.2 4.2 1.3 2.6 2.7 2.4Current account balance/GDP (%) �6.8 �3.4 �5.0 �6.8 �6.0 �4.8 �3.5

Congo, Democratic Rep. ofGDP at market prices (2000 $)b �5.6 6.6 6.5 5.3 7.2 6.8 6.4Current account balance/GDP (%) 2.0 �8.8 �4.4 �4.1 �4.6 �4.6 �4.8

Congo, Rep. ofGDP at market prices (2000 $)b 1.5 3.6 7.7 6.3 0.9 6.1 6.2Current account balance/GDP (%) �16.5 15.5 12.0 19.4 5.1 6.7 3.6

Côte d’IvoireGDP at market prices (2000 $)b 2.3 1.8 1.8 1.3 1.9 2.5 2.6Current account balance/GDP (%) �4.0 1.6 0.7 2.1 2.1 1.1 �0.5

Equatorial GuineaGDP at market prices (2000 $)b 18.4 10.0 6.5 1.2 6.9 9.0 �1.4Current account balance/GDP (%) �42.4 8.8 4.7 2.7 5.7 10.5 11.0

EritreaGDP at market prices (2000 $)b — 1.9 4.8 1.7 1.9 2.0 1.8Current account balance/GDP (%) — �13.6 �6.3 �2.9 �3.0 �2.9 �2.8

EthiopiaGDP at market prices (2000 $)b 2.3 12.3 8.7 7.3 6.1 5.5 5.4Current account balance/GDP (%) �0.8 �6.9 �9.3 �11.0 �10.0 �8.8 �7.6

GabonGDP at market prices (2000 $)b 2.4 1.4 2.8 1.2 3.5 2.1 2.3Current account balance/GDP (%) 5.7 12.8 17.5 20.5 13.1 8.8 4.1

Gambia, TheGDP at market prices (2000 $)b 3.3 5.1 5.0 6.4 3.8 4.1 3.9Current account balance/GDP (%) �1.6 �11.1 �16.1 �14.5 �11.5 �11.2 �7.6

GhanaGDP at market prices (2000 $)b 4.3 5.6 5.9 6.1 5.9 6.0 6.1Current account balance/GDP (%) �6.4 �3.6 �8.2 �8.1 �7.5 �8.1 �7.8

(Continues)


141


1991–2000a 2004 2005 2006e 2007f 2008f 2009f

GuineaGDP at market prices (2000 $)b 3.9 2.7 3.3 3.1 2.9 3.2 3.0Current account balance/GDP (%) �5.7 �4.3 �3.7 �4.2 �4.7 �5.7 �6.5

Guinea-BissauGDP at market prices (2000 $)b 1.5 2.2 3.5 1.9 3.4 3.7 3.4Current account balance/GDP (%) �24.0 �4.9 �3.4 �4.8 �15.4 �15.5 �16.3

KenyaGDP at market prices (2000 $)b 1.9 4.9 5.8 5.9 5.1 5.2 4.9Current account balance/GDP (%) �1.6 �2.2 �2.6 �4.3 �4.6 �4.2 �3.4

LesothoGDP at market prices (2000 $)b 3.4 3.1 1.2 2.8 1.6 1.2 2.2Current account balance/GDP (%) �13.3 �5.6 �2.7 �1.9 �0.8 �0.4 �1.9

MadagascarGDP at market prices (2000 $)b 1.7 5.3 4.6 4.8 5.0 5.3 5.1Current account balance/GDP (%) �7.8 �12.4 �11.2 �9.4 �8.1 �8.4 �8.8

MalawiGDP at market prices (2000 $)b 3.4 7.1 2.6 8.3 5.4 5.6 5.4Current account balance/GDP (%) �8.5 �4.7 �12.9 �8.3 �2.9 �1.4 �0.7

MaliGDP at market prices (2000 $)b 4.0 2.2 6.1 4.9 5.3 5.2 5.1Current account balance/GDP (%) �8.9 �8.4 �9.0 �8.8 �6.1 �5.9 �5.4

MauritaniaGDP at market prices (2000 $)b 2.9 5.2 5.4 14.2 7.4 8.4 6.7Current account balance/GDP (%) �0.3 �20.1 �43.9 �3.1 �4.0 �8.0 �8.0

MauritiusGDP at market prices (2000 $)b 5.3 4.7 2.5 4.6 2.9 2.7 2.5Current account balance/GDP (%) �1.6 �1.9 �3.7 �7.0 �6.9 �5.6 �4.2

MozambiqueGDP at market prices (2000 $)b 5.2 7.5 7.7 7.4 7.1 6.8 6.7Current account balance/GDP (%) �18.2 �5.6 �9.8 �12.7 �11.4 �11.6 �13.8

NamibiaGDP at market prices (2000 $)b 4.2 6.0 4.2 4.4 4.6 4.3 3.8Current account balance/GDP (%) 4.1 10.0 7.3 12.8 12.5 9.5 6.6

NigerGDP at market prices (2000 $)b 1.8 0 6.8 3.4 4.1 4.3 4.5Current account balance/GDP (%) �6.9 �7.6 �7.9 �7.3 �10.0 �9.8 �10.0

NigeriaGDP at market prices (2000 $)b 2.8 6.0 6.9 5.6 6.4 6.6 5.9Current account balance/GDP (%) �0.8 6.8 11.9 11.3 7.4 6.5 5.2

RwandaGDP at market prices (2000 $)b 0.2 4.0 6.0 4.4 5.0 4.9 4.6Current account balance/GDP (%) �3.5 �3.9 �4.4 �7.7 �8.3 �6.9 �6.5

SenegalGDP at market prices (2000 $)b 2.9 5.6 5.5 3.3 4.7 5.1 4.6Current account balance/GDP (%) �6.0 �7.0 �8.0 �10.3 �9.4 �8.6 �8.2

SeychellesGDP at market prices (2000 $)b 4.6 �2.0 �2.3 �1.1 �0.8 �0.5 1.1Current account balance/GDP (%) �7.4 �9.1 �25.8 �15.6 �18.8 �20.6 �23.3

Sierra LeoneGDP at market prices (2000 $)b �4.7 7.4 7.3 7.1 6.1 6.2 6.0Current account balance/GDP (%) �9.0 �5.4 �8.1 �6.2 �5.4 �5.5 �5.5

South AfricaGDP at market prices (2000 $)b 1.8 4.8 5.1 5.0 4.4 5.2 4.9Current account balance/GDP (%) �0.2 �3.2 �3.8 �6.4 �6.0 �6.4 �6.7

SudanGDP at market prices (2000 $)b 5.7 5.2 8.0 11.8 10.1 9.2 8.1Current account balance/GDP (%) �6.7 �4.1 �10.9 �7.6 �7.3 �8.4 �8.9

(Continues)


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1991–2000a 2004 2005 2006e 2007f 2008f 2009f

SwazilandGDP at market prices (2000 $)b 3.1 2.1 1.8 1.5 1.4 1.1 1.2Current account balance/GDP (%) �2.6 4.6 1.7 1.5 �0.3 �2.4 �4.3

TanzaniaGDP at market prices (2000 $)b 2.9 6.7 6.8 5.7 7.1 6.6 6.2Current account balance/GDP (%) �12.5 �2.2 �6.0 �11.3 �12.5 �11.1 �11.2

TogoGDP at market prices (2000 $)b 2.2 3.0 1.2 1.9 1.6 1.8 2.1Current account balance/GDP (%) �8.5 �10.0 �12.0 �11.8 �9.6 �10.0 �10.2

UgandaGDP at market prices (2000 $)b 6.8 5.5 6.6 5.1 5.7 5.8 5.7Current account balance/GDP (%) �7.0 �2.8 �2.9 �4.8 �5.3 �6.2 �6.2

ZambiaGDP at market prices (2000 $)b 0.7 5.4 5.1 5.7 5.8 5.7 5.5Current account balance/GDP (%) �10.5 �10.3 �7.8 �8.3 �9.1 �8.9 �8.5

ZimbabweGDP at market prices (2000 $)b 0.9 �3.8 �6.5 �3.9 �3.7 �2.5 �2.1Current account balance/GDP (%) �7.5 20.7 8.5 �1.8 �1.2 �1.1 �1.2


documents. Liberia, Mayotte, Somalia, and São Tomé and Principe are not forecast owing to data limitations. e � estimate; f � forecast;— � not available.


2004–06 period 20 percent of cross-border South-South syndicated loan commitments went to bor-rowers in low- and lower-middle-income countriesin Sub-Saharan Africa, of which three-quarterswere provided by Chinese banks, compared to amuch smaller 6 percent share of the North-Southsyndicated loan commitments.

Workers’ remittances remained unchanged at$8.7 billion in 2005–06, an amount equal to lessthan one-quarter of net private capital flows($41.6 billion) and bilateral aid grants ($37 bil-lion), but are almost certainly underestimated by awide margin.

Medium-term outlookGDP growth for the region as a whole is projectedto remain broadly stable, coming in at about5.4 percent in 2009. In South Africa, higher interestrates are projected to dampen growth this year,despite strength in the mining and manufacturingsectors, before the latter forces and preparation forthe FIFA World Cup in 2010 generate a recovery in2008. For the region as a whole, South Africa’scontinued solid growth is expected to be partlyoffset by weaker growth among oil exporters andother commodity-rich countries as prices ease andcapacity constraints impose themselves.

Growth is projected to remain strong inreform-oriented economies such as Burkina Faso,Mali, Mozambique, and Tanzania, while robustgovernment spending ahead of elections shouldboost output in countries like Senegal and Ghana.The pace of the expansion is expected to slowmarginally but remain robust in Ethiopia andKenya, while limited progress on reforms inCameroon and Gabon, in conjunction with theongoing sociopolitical crisis in Côte d’Ivoire andcurrency appreciation, will keep growth in theCFA zone countries below 5 percent.

In the baseline projection, emerging electricalshortages due to insufficient generating capacityare expected to constrain output in Burundi,Kenya, Malawi, Rwanda, Tanzania, Uganda, andZambia, but improved rainfall in East and WestAfrica should help replenish hydroelectric dams,thereby improving electrical supply, and easing thestress on manufacturing production. An end todrought should also boost agricultural growth anddomestic incomes, although weaker agriculturalprices and high fertilizer prices may negatively af-fect crops and could represent a drag on growth.

Lower commodity prices, and in particularlower oil prices, and appreciating currenciesshould help reduce inflation in Sub-Saharan Africa,


143

notwithstanding robust economic growth. Foodsupply remains the wild card, as drought-inducedfood scarcity could result in an overshooting ininflation rates, notwithstanding lower fuel prices.

Aid continues to play a prominent role in theregion, accounting for more than 10 percent ofGDP for one-quarter of countries. Preliminarydata show that the amount of aid allocated to theregion by bilateral donors increased by only about2 percent in 2006, excluding the nearly $11 billionin debt relief provided to Nigeria by its Paris Clubcreditors. Donors will have to scale up the amountof aid provided to the region significantly over thenext four years in order to achieve their objectiveof doubling aid to the region by 2010 ($50 billion)from the 2004 level ($25 billion).

To ensure that the scaling up in aid is most ef-fective, it is necessary that the right mix of policiesare implemented to avoid a buildup in inflationarypressures and currency appreciation in the recipi-ent countries, and the subsequent Dutch diseasesymptoms. It is necessary to ensure that thelarge aid inflows will not result in undesirablestructural changes and that the public sector,which in many cases is the largest recipient of aid,will not crowd out the private sector as publicspending surges.

Risks and uncertaintiesSub-Saharan Africa’s economic growth is subjectto a series of global risks, including a sharper-than-expected slowdown in the global economy,which would cause commodity demand and pricesto drop sharply. This would reverberate through-out the region, cutting incomes and underminingprivate consumption. In the baseline, we projectinvestment growth rates of about 9 percent in oil-importing economies, and of around 13 percentfor oil-exporting countries. A sharp drop in com-modity prices may prompt investors to postponetheir investments. A second significant risk is thatof sharp increases in food prices on the globalmarkets, which would disproportionately affectlow-income countries, where food accounts for alarge share of private expenditure.

At a regional level, political and social insta-bility continue to remain a palpable risk, notwith-standing notable improvements on these fronts inthe recent past. Political turmoil remains severeand is undermining growth in Chad, Côte d’Ivoire,the Democratic Republic of Congo, Eritrea,

Lesotho, the Seychelles, Somalia, Sudan, Swazi-land, and Zimbabwe. The move toward more de-mocratic institutions is illustrated by the fact thatthis year, 17 countries are scheduled to hold presi-dential or legislative elections (or both). Notable isthe possibility that elections will be finally held inCôte d’Ivoire toward the end of the year. If theelections are successfully conducted, they wouldrestore a sense of stability in a country marred byfive years of political and social tensions. In con-troversial election races, however, there is scopefor political violence that would derail growth.

The possibility of drought is also a concern,especially in East Africa, which tends to be morefrequently and more severely affected by the prob-lem. A severe drought would cause food pricesto surge and would further reduce the supply ofenergy, which is already at critically low levels.

Notes1. In addition to the Prospects for the Global Econ-

omy Web site (http://www.worldbank.org/outlook) theWorld Bank’s East Asia Update provides more detailed in-formation on recent developments and prospects for theEast Asia and Pacific region. (http://www.worldbank.org/eapupdate/). This appendix partly summarizes thatmore extended publication.

2. Regional oil exporters (oil and natural gas) in-cluded in the forecast are Azerbaijan, Kazakhstan, Russia,and Uzbekistan; regional oil importers are Albania, Arme-nia, Bulgaria, Belarus, Croatia, the Czech Republic, Estonia,Georgia, Hungary, the Kyrgyz Republic, Latvia, Lithuania,Moldova, FYR Macedonia, Poland, Romania, the SlovakRepublic, Turkey, and Ukraine. Slovenia is grouped with thehigh-income countries and is not included in the regionalaggregates here.

3. The Czech Republic, Estonia, Hungary, Latvia,Lithuania, Poland, the Slovak Republic, and Slovenia becameEU members in 2004, and Bulgaria and Romania joined in2007.

4. The World Bank’s Middle East and North AfricaWeb site, Economic Developments and Prospects-2007(http://www.worldbank.org/mena) provides a morecomprehensive discussion of recent economic developments,projections, and policy priorities for the region. It shouldbe noted that the country composition of the region—andhence references to economic growth and other concepts—differs between the Middle East and North Africa region’sEDP report and this appendix. In particular, high-incomeGulf Cooperation Council countries are considered an inte-gral part of the Middle East and North Africa in the region’sanalysis and forecasting exercises.

5. For the purposes of this appendix the developingcountries of the region are Algeria, Egypt, Jordan, theIslamic Republic of Iran, Lebanon, Morocco, Oman, Syria,Tunisia, and the Republic of Yemen. Among middle-income


economies, Djibouti, Iraq, and Libya were excluded fromthe projections due to a lack of data. Important regionaleconomies such as Bahrain, Kuwait, and Saudi Arabiaare included in the high-income aggregate. Among the high-income group, data limitations excluded Qatar and theUnited Arab Emirates from the analysis.

6. The resource-poor economies are Egypt, Jordan,Lebanon, Morocco, and Tunisia; all except Egypt are oilimporters.

7. For Egypt, Europe is the destination of 40 percentof exports. Ratios are similar for other economies: 50 per-cent for Algeria, 60 percent for Syria, 70 percent forMorocco, and 80 percent for Tunisia.

8. Consumer price changes are aggregated using realGDP weights.

144

9. The S&P/IFCG index tracks the performance of themost actively traded stocks in various emerging markets,including India.

10. See http://ddp-ext.worldbank.org/ext/GMIS/gdmis.do?siteId=2&menuId=LNAV01REGSUB5.

Reference

IMF (International Monetary Fund). 2006. World Eco-nomic Outlook: Financial Systems and EconomicCycles. Washington, DC: IMF.

Eco-AuditEnvironmental Benefits Statement

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International private capital flows to developing countries reached a record net level of $647 billion in 2006 as a

wave of cross-border mergers and acquisitions boosted foreign direct investment (FDI) flows and much-improved domestic policies and favorable international economic conditions enhanced the ability of corporations based in developing countries to raise unprecedented sums of capital on global debt markets.

In a year characterized by heightened uncertainty over the course of global economic growth and shifting views on global inflationary trends and monetary policy responses, the continued expansion of private capital flows to developing countries speaks well for the resiliency of emerging economies and for the broader investment opportunities that globalization of the corporate sector offers to international fund managers and investors. The manner in which investors retreated from emerging markets during the broad equity sell-off in mid-2006, however, is also a telling reminder of underlying vulnerabilities and lingering weaknesses. As the tide of easy credit ebbs, it is important that emerging market governments renew their commitment to the sound policies of the recent past and recognize the implications of changes in the financial climate.

Supporting low-income countries in establishing access to private sources of capital remains an integral part of financing for development. For poor countries, which have limited access to market-based external financing, the development community should step up efforts to enhance aid flows to meet the development goals articulated under the Monterrey Consensus in 2002 and endorsed by the G-8 in July 2005.

Global Development Finance 2007, I: Review, Analysis, and Outlook is the World Bank’s annual review of recent trends in and prospects for financial flows to developing countries. This year’s special topics—low-income countries’ access to commercial debt markets and financial globalization of the

corporate sector in developing countries—highlight two areas of increasing importance to the future growth and financial stability of emerging market economies.

“Prospects for the Global Economy” is an online companion to Global Development Finance. It provides information on the global economic outlook, detailed regional forecasts, and additional features such as interactive graphs, analytical tools, and access to underlying data. This online publication is available in English, French, and Spanish at www.worldbank.org/globaloutlook.

Global Development Finance 2007, II: Summary and Country Tables includes a comprehensive set of tables with statistical data for 136 countries that report debt under the World Bank Debtor Reporting System, as well as summary data for regions and income groups. It contains data on total external debt stocks and flows, aggregates, and key debt ratios, and provides a detailed, country-by-country picture of debt. Global Development Finance 2007 debt data are also available in electronic format: GDF Online (an electronic subscription database) and the GDF CD-ROM. Each of these electronic databases provides access to 217 time series indicators from 1970 to 2005, and country group estimates for 2006.

The Little Book on External Debt is a new publication that provides a quick reference to key debt data in aggregate and for individual countries.

With analysis and data extending from short-term bank lending to long-term bond issuance in local and foreign currency, Global Development Finance 2007 is unique in its breadth of coverage of the trends and issues of fundamental importance to the financing of the developing world, including coverage of capital raised by corporations in developing countries. The report is an indispensable resource for governments, economists, investors, financial consultants, academics, bankers, and the entire development community.

For more information on the analysis, please seewww.worldbank.org/prospects; further detail aboutthe Summary and Country Tables can be found atwww.worldbank.org/data. For general and orderinginformation, please visit the World Bank’s publications Website at www.worldbank.org/publications, or call 1-703-661-1580; within the United States, please call 1-800-645-7274.

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