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FINANCING DEVELOPMENT

ISSUES FOR A SOUTH AGENDA

SOUTH CENTRE

THE SOUTH CENTRE

In August 1995, the South Centre became a permanent intergov-ernmental organization of developing countries. In pursuing itsobjectives of promoting South solidarity, South-South co-operation,and coordinated participation by developing countries ininternational forums, the South Centre has full intellectual in-dependence. It prepares, publishes and distributes information,strategic analyses and recommendations on international economic,social and political matters of concern to the South.

The South Centre enjoys support and co-operation from thegovernments of the countries of the South and is in regular workingcontact with the Non-Aligned Movement and the Group of 77. Itsstudies and position papers are prepared by drawing on the technicaland intellectual capacities existing within South governments andinstitutions and among individuals of the South. Through workinggroup sessions and wide consultations which involve experts fromdifferent parts of the South, and sometimes from the North,common problems of the South are studied and experience andknowledge are shared.

Financing Development. Issues for a South Agenda was first published inApril 1999 by the South Centre, Chemin du Champ-d'Anier 17, 1211Geneva 19, Switzerland.

Parts of the text may be reproduced without prior permission.However, clear acknowledgement of the South Centre's authorshipis requested. The Centre should be advised of any such reproductionand be provided with a copy of the reproduced text andacknowledgement.

© The South Centre 1999

Printed and bound by ATAR, Geneva

ISBN 92-9162-011-4 Paperback

CONTENTS

Foreword

Part I. Financing Development. Issues for a South Agenda....................... 1

A. Some key concerns of the South .............................................. 1B. The changing international policy framework ....................... 4C. Conclusion....................................................................................11

Part II. Financial Flows to Developing Countries. An Overview ...........15

A. Changing composition and overall trends..............................15B. Official capital flows ..................................................................18C. Private capital flows....................................................................30D. Other issues affecting the financing of development..........35E. Conclusion....................................................................................41

Part III. International Capital Flows and Development ..............................43A. International financial flows: the economic impact .............43B. Concessional flows......................................................................46C. Private capital flows....................................................................50D. Conclusion....................................................................................54

Part IV. Private Capital Flows and Financial Crises...................................57

A. Financial crises 1974-94.............................................................57B. The East Asian crisis ..................................................................62C. Crises and private capital flows................................................65D. Conclusion....................................................................................69

Part V. Towards a Development-Supportive International Financial System.....................................................................................................71

A. The quest for growth, stability and development..................71B. Strategic areas for action............................................................77C. Concluding remark .....................................................................99

FOREWORD

The decision of the United Nations General Assembly -- based on along standing proposal of the Group of 77 -- to set in motion “theconvening of a high-level international inter-governmental forum onfinancing for development” to be held before the end of 2001,presents a unique and much awaited opportunity for theinternational community to focus its attention on this issue of suchvital importance for the developing countries.1

In the process which is currently underway to determine theissues to be addressed and the level and nature of such a conference,developing countries will need to ensure that the agenda gives dueattention to their concerns, that a comprehensive approach is taken,and that the level of the deliberations is such that the conclusionsreached will carry weight and will be implemented.

In fact, if the development needs and objectives of the Southare to be given the attention they merit, there will need to be a majorchange both in the approach to and the institutional framework forfinancing development. Developing countries will need to formulatetheir detailed individual views and, importantly, the joint positionsthey wish to pursue, particularly if they wish to ensure that thesubsequent discussions and negotiations result in decisions andactions which address effectively the major problems they face andthe key objectives they hold in relation to financing development.

1 While the UN decision refers to a forum on “financing fordevelopment”, this publication usually refers to financing development.This choice of wording is deliberate. It corresponds to the view that, inorder to address developing countries’ problems regarding the financing oftheir development, there is a need to consider not only matters concerningfinancing intended for development, but also matters such as the debtburden, commodity prices and the terms of trade, as well as problemsassociated with international financial flows to developing countries whoseprime purpose is not necessarily their development. These all affect thecapacity of developing countries to finance their development.

viii International Capital Flows and the Developing Economies

This publication aims to contribute to the articulation of aSouth agenda on financing development, by briefly examining thechanging sources and nature of external capital flows to developingcountries, and addressing the question of their impact.

Section I pinpoints some of the key current concerns ofdeveloping countries with regard to financing development. Thissection also provides a brief overview of the changing contextregarding financing development.

This is followed, in section II, by an overview of the trends incapital flows, charting their changing composition over time. SectionIII outlines a number of the factors which need to be taken intoconsideration when assessing the impact of foreign finance ondeveloping countries. Section IV provides a brief overview of recentfinancial crises and the role played by private capital flows. Finally,section V draws policy conclusions from the previous sections andsuggests six strategic areas for action.

I. FINANCING DEVELOPMENT. ISSUES FOR A SOUTHAGENDA

A. Some key concerns of the South

Since developing countries first proposed, almost ten years ago,an international conference to consider the issue of financing fordevelopment, the range, complexity and urgency of the issues thatneed to be discussed have increased.2

A decade or so ago, one of the major concerns ofdeveloping countries with regard to financing development wasthe inadequate level of official capital flows, flows which at thetime in aggregate terms comprised a higher percentage of capitalinflows to developing countries than now, but which sufferedfrom important deficiencies regarding their level, composition anddistribution.

This matter continues to be a crucial issue. The largemajority of developing countries, particularly those with lowincomes and limited export earnings, continue to needconcessional flows to supplement their domestic capitalaccumulation and for sustaining their development efforts. Yetthese inflows have nowhere near matched the needs. The ever- 2 One of the most crucial issues in relation to financing developmentconcerns how to improve the mobilization of domestic resources fordevelopment or raise the level of domestic savings. Indeed most of theconsiderable development achievements in the South have been based ondomestic resources. The high domestic savings rates in East Asia, at leastuntil the financial and economic crisis, are considered to have been crucialto the extraordinary success of these countries. The mobilization ofdomestic resources is, however, a matter for domestic policy decisions and,as such, is not a matter discussed in this document whose aim is toconsider the external dimensions of financing development and to suggestthose matters which should be placed on the agenda of the proposedinternational forum.

2 Financing Development. Key Issues for the South

widening conditionalities attached to these bilateral andmultilateral official flows of development finance have givenadded cause for dissatisfaction.

The end of East-West rivalry has had profoundconsequences for the South. Among other things, economies intransition have begun to compete with the South for politicalattention, and hence for the limited official concessional flows offinance and for private investment resources, as well ascompeting in the markets of the industrial countries.

Furthermore, the continuing long term fall in realcommodity prices faced by developing countries has drasticallyreduced the resources available to these countries for theirdevelopment efforts and it has been partly responsible for thegrowing debt problems of many poor countries. The internationalinitiatives put in place earlier to deal with fluctuations incommodity prices and to assist developing countries to deal withthis financing shortfall have not provided a satisfactory solution.The prospects for a substantial change in this situation are notoptimistic, taking into account lower projections for world growthas a consequence of financial and economic crises, particularly inEast Asia.3

For more than a decade now, the need to service the debtowed by developing countries to bilateral aid agencies andmultilateral financial institutions has diminished in critical waysthe finance available for development. Debt servicing hasseriously eroded attempts to improve the well-being andproductive capacity of large segments of the population, as a 3 One of the factors contributing to falling commodity prices was thepolicies these countries were constrained to follow under structuraladjustment programmes set by the multilateral financial institutions.Among other things, they were required to put greater emphasis onproduction for export to facilitate greater openness in trade, with the resultthat the output of commodities increased at a time world demand for suchproducts was relatively slack.

Financing development. Issues for a South Agenda 3

result of the decline in output and cuts in public expenditures onhealth, nutrition, and education.

Of particular concern among developing countries havebeen the broad economic policy prescriptions they have beenrequired to pursue by the multilateral financial institutions inexchange for debt relief and financial assistance. These policies inmost cases have done little to enhance their growth anddevelopment or their capacity to repay their debt. This has givendeveloping countries added reason for dissatisfaction over theirlack of weight and influence in the governance and policy-makingof the multilateral financial institutions, including in decisionsconcerning the structural adjustment and similar policiesprescribed for them to follow.

It has been argued by some that these developmentfinancing problems would become less as private capital becameavailable to developing countries. While international flows ofprivate capital have increased very considerably in recent years,the bulk of such flows go to the advanced industrial countries,and of those going to the developing world most are concentratedin a very few countries which have particular attractions from theinvestors’ point of view.

The prevailing view until recently, including in developingcountries, has been that the greater the private capital inflows thebetter. Many developing countries have therefore taken a numberof measures to facilitate or attract such inflows. Experience,however, has demonstrated the potentially harmful macro-economic implications of unregulated private flows, particularlyshort term flows. Now, there are a greater number of advocatesof careful domestic policies regarding the content, level andsequencing of private capital inflows, as also of internationalpolicies regarding capital flows which aim both to minimize thelikelihood of financial crises occurring, and to provide appropriatemeans to deal with them if and when they nevertheless occur.


The adoption of policies of economic liberalization hasincreased the exposure of developing countries to externaleconomic forces over which they have little control, makingmacroeconomic management much more difficult, particularly inview of the fact that, as a result of IMF and WTO commitments,the room for policy manoeuvre is constrained. While theinternational economy is vulnerable to the vagaries ofinternational financial flows and world market developments,developing countries are particularly vulnerable. The East Asiancrisis has driven home the point that this vulnerability does notdisappear with the rise of robust export industries, impressivegains in living standards, and overall sound economicmanagement. The developing countries have witnessed theirvulnerabilities increase, and their political and economicindependence compromised, as they opened up their capitalaccounts and deregulated their capital markets.

As a result of the profound impact of the financial crisis onthe economies and societies of East Asia and its globalreverberations, there is now a greater awareness of the need toreconsider various aspects of international financial flows and theinternational financial system. These issues are as much politicalas economic and constitute an important dimension of North-South relations. Any new, comprehensive approach to financingdevelopment and a structuring of appropriate global institutionswill need to embrace measures which help to reduce the markedimbalance of power between the developed and developingcountries.

B. The changing international policy framework

The evolution of flows of finance to developing countries can beseen as part of, or in the context of, the evolution of theinternational financial system and of the global economy. It is


therefore pertinent to outline briefly some of the key aspects ofthe evolution of this system.4

The experience of the Great Depression of the 1930s wasthe single most powerful influence on the thinking of thearchitects of the post-war international financial system. Theystrove to put in place a system that would ensure fullemployment, prosperity, and economic growth. Towards thisend, co-operation and coordination among countries on financialand trade matters were held to be crucial in avoiding thedestructive protectionism and competitive devaluations of theinter-war period.

Central to the new financial architecture was theestablishment of the International Monetary Fund (IMF). It wasmade responsible for ensuring a smoothly functioning worldpayments system. The International Bank for Reconstruction andDevelopment (IBRD), namely the World Bank, was establishedto provide the second pillar of the emerging post-war economicorder. The intention was to provide public funds to help lead thereconstruction of the war-ravaged economies and assistdevelopment. Public funds were deemed necessary in view of thewidely shared belief that private capital alone could not be reliedupon for these tasks. The still-born International TradeOrganization (ITO) was intended to be the third pillar.

To perform the ambitious and difficult task of ensuring asmoothly functioning world payments system, a regime of fixedexchange rates was introduced, with the IMF keeping vigil over 4 It is worth pointing out that, although a clearly structured and purposefulsystem was originally set up to achieve orderly world payments, eventsover time and changes in ideology of the major powers have resulted in theintroduction of new practices and policies with little attention paid to theconsistency, or the impact or durability of the arrangements. Thesefactors, and the lack of any significant change in the structure and runningof the multilateral financial institutions involved, means that the resultingpractices, policies and institutions taken together hardly comprise anorderly arrangement meriting the term ‘system’.


these. The gold standard had of course been abandoned, butworld currencies under the fixed exchange regime were still tiedto gold. The US dollar, whose fixed parity of US$ 36 to oneounce of gold was crucial to the regime, became the principalmedium of international exchange and store of value.

This was the hub of what came to be called the BrettonWoods System. All IMF member countries -- whether industrialor developing -- were expected to tailor their macroeconomicpolicy to ensuring that the established exchange rate paritieswould be respected.

This effectively meant that countries had to keep theirbalance of payments current accounts (and hence their resort toexternal financing) at manageable levels. An exchange rateadjustment was held to be an exceptional, virtually last resortmeasure to correct a “fundamental disequilibrium” in the balanceof payments, and required the Fund’s prior approval.5

However, in 1971, an era of freely fluctuating exchangerates was ushered in when the dollar glut, resulting fromcontinuing United States balance of payments deficits, caused theUnited States to abandon the dollar’s established parity with gold.This in effect represented a breakdown of the Bretton Woodssystem.

This development had profound consequences for thefunctioning of both industrial and developing economies. Thegoal of maintaining stable exchange rates had constrained 5 Since capital movements at that time were rather restricted, the commoncause of balance of payments difficulties was the build-up of domesticinflationary pressures due to excessive demand growth and tighteninglabour markets. In this situation of “overheating” -- as it was then called --a rise in imports, and the concomitant worsening of the trade deficit,provided the relief valve. As will be discussed later, this notion of balanceof payments difficulties has unfortunately continued to condition theFund’s response in situations that are entirely different from the one justdescribed.


domestic macroeconomic management to keeping the balance ofpayments viable. Expansionary policies led sooner or later tounsustainable current account deficits through both price effects(because of the inflationary pressures) and income effects (bycreating increased demand for imports). In the absence ofexchange rate adjustment, the situation could only be set right bydeflation and economic contraction. As economic managementlost the tether of fixed exchange rates, the industrial countriesfound themselves able to pursue macroeconomic policy as thoughthere was no balance of payments constraint. The consequencewas a general acceleration of inflation in the 1970s.

Flexible exchange rates -- which directly or indirectly wererelated to higher inflation, the higher price of oil following theOPEC action in 1973-1974, increasing international liquidity, andgreater independence of countries in the exercise ofmacroeconomic policy -- paved the way for the liberalization ofcapital markets and the removal of controls over capitalmovements in the industrial countries.

Industrial country commercial banks were the directbeneficiaries of the rising fortunes of the oil producing countries,since there was disagreement over alternative schemes to “park”the mounting oil revenues. It was because of the increasedliquidity that commercial banks, initially rather tentatively butlater aggressively, became increasingly prominent as suppliers offoreign finance to developing countries. The IndonesianPertamina Crisis of 1974 marked the first casualty of excessive(and irresponsible) commercial bank lending, which in a few yearswas followed by the trauma of the Latin American debt crisis.

The above developments coincided with the period whenthe World Bank started to raise its own lending operationsdramatically, setting itself the goal of becoming the world’sleading source of development finance. The Bank’s originallending remit was extended beyond the traditional infrastructureprojects in power, transport, agriculture and heavy industry, to


cover social sectors, education, health, civil service reform andrural development.

As noted above, the World Bank had been established as asecond pillar of the emerging post-war financial architecture toprovide public funds, based on the widely shared belief thatprivate capital alone could not be relied upon to lead thereconstruction of the war-ravaged economies of Europe.Subsequently, it began to provide concessional funds to assist thedevelopment of the countries of the South. However, indeference to private capital, the World Bank was supposed tolend only when private financing on suitable terms could not bearranged. The fact that this stricture was interpreted ratherliberally in actual practice did much to enhance the World Banks’reach and role in developing countries. Its role was also enhancedas a result of the decision by OECD donor countries to channel aproportion of their official development assistance (ODA)through multilateral agencies.

As private external financing became more prominent,capital controls were gradually dismantled in the advancedcountries such that today there are virtually no controls on capitalmovements as far as the industrial countries are concerned andexchange rates are generally free to fluctuate. Many developingcountries have also liberalized their capital markets, often quiteprematurely, in order to attract foreign direct and portfolioinvestment. With exchange rates unstable and no effectivecontrols on capital flows, countries have found it difficult tomanage their economies and prevent financial crises fromoccurring.

It is important to appreciate that the above developmentswere partly the result of policy changes based on a deep beliefamong orthodox economists, initially in the North, that freelyfunctioning markets lead to greater efficiency, higher economicgrowth and the achievement of social and economic goals. Thisorthodoxy -- advocating conservative, anti-inflationarymacroeconomic policy, market liberalization, deregulation, and


privatization -- took hold first in major economies of the North.Subsequently, these orthodox policies have been imposed by theBretton Woods institutions on the countries that have soughttheir help (mainly the developing countries), the availability ofofficial finance being made contingent on their efforts toundertake such measures. These have been embraced, withvarying degrees of enthusiasm, by an increasing number ofdeveloping countries.

There have been other strong pressures on the countries ofthe South to open up their economies and integrate more fullyinto the world economy. These include parallel efforts vigorouslypursued in the World Trade Organization (WTO) to engagedeveloping countries in negotiations to establish global rules anddisciplines to extend and “lock in” liberalization in a wide range oftrade and trade-related matters.

This substantial policy shift has had several consequencesfor the developing countries. Expanding exports has become acentral goal of developing country strategies for raising outputand accelerating economic growth. Countries have viewed theinflow of foreign direct investment (FDI) and portfolioinvestment as a reward for their pro-market and pro-privatesector policies.

A major preoccupation of policymakers now is to retaininternational competitiveness, whether by means of exchange rateadjustments or productivity increases. The competition amongthe newly industrialized countries, which export broadly similarmanufactured products, to capture a share of the world markethas become intense. This has meant a fall in the prices of theirexports and a decline in their terms of trade, especially as thisstrategy was being pursued during a period of relatively low worlddemand.

In industrial countries, on the other hand, a strong body ofopinion has emerged that maintains that developing countries’success in selling goods in their markets reflects the unfair


advantage that developing countries enjoy on account of their lowenvironmental and labour standards. These views -- howevergroundless or exaggerated -- feed the protectionist sentiments andlobbies in the North and the pressures exerted by the industrialcountries on developing countries to further open up andliberalize their markets.

The corollary to these developments is that, with theincreasing exposure to the outside world, developing countries’room for manoeuvre in macroeconomic and financial policy hasbecome severely constrained. A deceleration in the growth oftheir export earnings is immediately viewed by foreign investorsas a sign of economic weakness, as happened in the case of theEast Asian economies now trapped in a financial crisis.

A slight deviation of the exchange rate or interest rate frommarket expectations can cause “a run” on the currency andfinancial instability. Moreover, governments as a matter of coursefeel constrained to take into consideration the judgement of thefinancial markets as to what these consider to be “responsible”fiscal and social policies. With regard to fiscal policy, this usuallymeans a market preference for low revenue/low expenditurebudgets, which may make it extremely difficult for countries toachieve their socio-economic objectives.

Policies to liberalize trade and finance and achieve greaterintegration into the world economy continue to prevail despite thefact that in many countries such policies have failed to stimulateor accelerate economic growth, while they have caused incomedistribution to worsen in both industrial and developing countries.A significant feature of this shift has been that the new policiestend to favour capital over labour, a reversal from the post-warcommitment to full employment and the rise of the welfare state.Some of the strains that one observes in the global economy,therefore, have their origins in this policy shift.

As a result, in the management of their economies, thedeveloping countries have faced increasing external pressures and


impulses over which individually they have little or no control.While the increased differentiation among them may suggestdifferent capacities to cope with the gyrations of the globaleconomy, they have all in different ways been harmed -- some forlack of adequate international finance, others for too much of it,particularly of the more destabilizing type.

As regards world finances, the role of the IMF, which for awhile seemed to have considerably diminished with the collapseof the Bretton Woods’ system in 1971, has now become pivotalas countries in crisis, in most cases developing ones, turn to it forfinancial support and guidance. How well the institution isdischarging its role is thus not only of critical importance tocountries in crisis, but is the key to the health and functioning ofthe international financial system.

C. Conclusion

The context in which the current debate on the internationalfinancial system and financing of economic development is takingplace is, in significant ways, different from the conditions thatprevailed in the earlier period, which began immediately after theSecond World War with the setting up of the Bretton Woodsinstitutions. One significant difference not mentioned earlier isthat many more countries, including developing ones, are nowinvolved in the increasingly complex world financial andeconomic system. But while the developing countries have thesame interests in global growth and financial and economicstability as do the advanced industrial countries, they are alsoconcerned that the policies that govern world financial mattersand the nature of the institutions governing world finance shouldassist rather than hinder their development and impinge on theirnational sovereignty.

For the system to serve developing countries’ needs, aconcerted attempt to devise a comprehensive approach to


financing development is required, ensuring that adequate andappropriate external finance is available to supplement domesticsavings. The planned international conference on financing fordevelopment, therefore, is of major political significance.Developing countries must, however, be clear on their goals andstrategy with respect to the conference. Otherwise, there is a riskthat the conference will focus only on a limited number of issuesand preoccupations, often narrow in scope, while giving scantattention to important policy and structural questions andinterrelationships which suggest the need to undertake afundamental rethink and reform of the system itself.

From the point of view of the developing countries, thereare at least six interrelated areas where action by the worldcommunity is required to create a more just and efficient financialsystem which is supportive of development and improvesprospects for global co-operation and security. These are:

• The continuing need of developing countries toreceive international transfers of concessionalfinance to promote development;

• • The need for a renewed and vigorous approach toresolve the external debt problem of developingcountries;

• • The need to devise international measures to helpraise commodity prices from persistently depressedlevels and to introduce a better medium termbalance in commodity markets;

• • The need to agree on measures that reduce the riskof financial crises;

• The need to establish a normative and legalframework for the conduct of foreign investors;


• The need for reform of the international financialarchitecture, inter alia to end the exclusion ofdeveloping countries from key areas ofinternational decision-making.

For these matters to be considered properly, it is importantthat the proposed conference take place at the highest policy leveland within the framework of the United Nations, the world bodyentrusted with the mandate to tackle global problems, includingeconomic, political and social ones, in an integrated manner.Unlike in the Bretton Woods Institutions, in the UN thedeveloping countries participate on an equal footing with thedeveloped countries, and are able to speak more freely and to actjointly, and can wield greater political influence.

II. FINANCIAL FLOWS TO DEVELOPING COUNTRIES.AN OVERVIEW

A. Changing composition and overall trends

During the last decade a major change has occurred in thecomposition and volume of financial flows to developingcountries. (See Table 1.) Official development assistance (ODA),traditionally of special interest to developing countries, whileincreasing slowly until 1994, thereafter began to decline and in1997 had fallen below the 1990 level.6 At the same time, however,the total net resource flows from DAC member countries andmultilateral agencies to “aid recipients” (which also includeseconomies in transition, offshore centres, and territories of donorcountries), increased two and a half times, from US$ 130 billionin 1990 to US$ 325 billion in 1997.7

This increase in total net inflows has been due entirely toprivate capital flows, which rose from US$ 43.6 billion in 1990 toUS$ 252 billion in 1997. This represented an increase from 33.6per cent of total net resource flows to 77.7 per cent, while ODAdeclined from 39 per cent to 15.3 per cent. Over the period1995-97, private flows amounted to almost three times themagnitude of official development finance flows, or over fourtimes the magnitude of ODA.

6 The data on ODA are provided by donor countries to the OECD whichprocesses the information and publishes the Development Co-operationReport. OECD’s data can not be reconciled with the information from thebalance of payments of the recipients, because much of the ODA neverleaves the North, involving, as it does, transactions within the donorcountries.7Net resource flows comprise gross capital flows, minus principalrepayments and minus interest payments.


TABLE 1

Financial Flows to Developing Countries. An Overview 17

The rise in private capital flows, and in particular of foreigndirect investment, was celebrated by many as evidence of thesuccess of market liberalization and was seen as an indication ofthe potential for private flows to replace official concessionalflows.

Quite apart from the dubious nature of this claim regardingliberalization, the East Asian crisis and the subsequent crisis inBrazil have changed the situation and have introduced uncertaintyas concerns the outlook for private financing flows to developingcountries. Just as commercial banks withdrew from lending todeveloping countries after the Latin American crisis of the 1980s,private investors are, at least for the time being, more circumspectregarding investing in developing countries.

The flow of private capital to developing countries has notbeen evenly distributed. Most of the increase in private capitalflows went to only a handful of middle income countries in EastAsia and Latin America. Altogether twelve countries account forover 80 per cent of private flows to the developing countries. Sixcountries -- Argentina, Brazil, China, Indonesia, Malaysia, andMexico -- remained consistently among the top recipients of FDIduring the 1990s. China was the single largest recipient of netprivate flows, accounting for more than 60 per cent of theregion’s total and 25 per cent of the private flows to alldeveloping countries.8

Generally speaking, developing countries with little or noaccess to international private capital markets are those whereboth incomes are low and local markets are small, and whereeconomic growth has been modest, or altogether absent. For themajority of developing countries which are bypassed by privatecapital, official flows are therefore their principal and, in somecases, the only source of external capital. 8 The bulk of FDI which goes to China is from the rest of Asia,particularly from the Chinese in Hong Kong and Taiwan. Some of this iscapital “re-routed” from China to take advantage of certain tax benefitsextended to foreign investors. Some of this investment by overseasChinese may also have come from outside the region.


Yet, in line with the overall decline in net receipts of ODA,OECD data indicates that there has been a decline in net receiptsof ODA by Sub-Saharan Africa, the poorest continent, from US$18.9 billion in 1994 to US$ 15.1 billion in 1997. Similarly, the leastdeveloped countries experienced a decline from US$ 16.7 billionin 1995 to US$ 13.5 billion in 1997. (Table 2.)

It is also important to appreciate that most bilateral aidgoes to the fifteen or twenty countries or particular interest toeach donor country, leaving many developing countries with verysmall inflows of even official external capital. Most of thesechosen few have topped the list for more than a decade.

B. Official capital flows

Official concessional flows, as indicated earlier, originated as partof the efforts to rebuild Europe in the wake of World War II andwere subsequently extended to developing countries. Therationale for concessional finance for the purposes of economicdevelopment was fairly straightforward. It was recognized thatpoor countries had only a limited debt-servicing capacity, whichmeant that borrowing from commercial sources could play only arelatively minor role in financing development, at least in the earlystages. Private lending, because of its generally short-termhorizon, was also held to be unsuitable for financing projects withlong gestation periods, such as infrastructure projects, which werethe focus of reconstruction and development efforts at the time.

But there were also macroeconomic considerations thatjustified concessional finance. Foreign financing was needed to makeit possible for developing countries to invest more than what theirdomestic savings could allow. This would also help to supplement thecountries’ foreign exchange resources, which were generallyseverely constrained. Because of a general perception (born out ofthe 1930s Great Depression) that rich countries would under-consume, capital flows to developing countries were also seen tohave the incidental benefit of helping to sustain overall higher


levels of economic activity and growth in industrial countries.


Table 2


During the earlier years, when central economic planningwas favoured by many of the countries of the South, domesticpolicymakers as well as their counterparts in bilateral andmultilateral development financing agencies relied on economicmodels to determine foreign financing requirements which weredirectly linked to a targeted economic growth rate. The basicapproach consisted of projections of export earnings and importsrelated to a stipulated rate of economic growth, on the one hand,and projections of required domestic investment (usually derivedby multiplying the incremental capital-output ratio, or ICOR, bythe growth rate) and of domestic savings.

This approach came to be called the “two-gap” model, andserved as the basis for discussions and donor pledges of foreignassistance in the World Bank-led aid consortium meetings. Theeconomic rationale for foreign assistance was, however, inpractice often subordinated, at least by some of the largestbilateral donors, to the pursuit of their foreign policy goals in thecontext of the East-West conflict. The other side of this coin,however, was that the East-West rivalry gave some influence tothe developing countries, whose views and position, individuallyand as a group, mattered to the big powers. It was at least partlydue to this that the developing countries, in the early 1970s, wereable to secure the industrial countries’ agreement on a target forofficial development assistance (ODA) of 0.7 per cent of theirGNP.

Over the years, political considerations, far fromdisappearing with the end of the East-West conflict, continue toplay a major role in determining the allocation of official flows.The difference is that, instead of support being given to countrieson account of their position in this conflict, foreign assistance isnow directed to countries on the basis of their adherence to theprinciples and policies of free markets, trade liberalization, andprivatization. During the 1980s and 1990s, a large component ofthe lending from the World Bank and other multilateralinstitutions, for example, was made in support of structuraladjustment programmes, which aimed at market-oriented policiesand institutional reforms in developing countries. This was also


an important factor in the rapid expansion of official flows to theeconomies in transition over the past decade.

Thus, there is now a common tendency, on the part ofbilateral and multilateral donors, to equate “aid-effectiveness” notwith actual results with respect to output growth, general livingstandards, employment level, etc., but with their success inbringing about the stipulated policy and institutional change in therecipient country. It is also the case that donors have becomeincreasingly and openly explicit in linking the provision of foreignassistance with their commercial and financial interests.

Official Development Assistance

As noted above, total DAC net disbursements of officialdevelopment assistance have experienced a declining trend since1994, the decline being greater for bilateral than for multilateralflows. (Table 1) Both bilateral concessional and non-concessionalflows have experienced a considerable decline.

Official Development Assistance (ODA), a component ofofficial flows, merits detailed attention because of its particularrelevance for developing countries. Comprising grants, or loanswith low interest, long grace periods, and long periods forrepayment -- it was one of the principal means of helping meetdeveloping countries' needs for external financial resources. Itembodied an explicit commitment of the industrial countries tosupport financially the development of the South.

In order to quantify the commitment and obligation, thenotion of having a target for donors of development assistancewas first suggested as long ago as 1958 by an NGO, whichproposed that 1 per cent of the North's GNP be transferred tothe developing countries in the form of grants and concessionalloans. Ever since, the measurement, content and implementationof the target have been major issues in the development dialogueand negotiations. Years passed in discussion and debate beforethe 0.7 per cent target was incorporated into the Strategy for theSecond Development Decade adopted in 1970. It stated that each


developed country should attempt to transfer to developingcountries by the middle of the 1970s a minimum net amount of0.70 per cent of its GNP at market prices. As defined, officialdevelopment assistance was to be understood as bilateral grantsand loans on concessional terms, and official contributions tomultilateral agencies.9

It was expected that setting the 0.7 per cent aid targetwould help to reverse the decline experienced in the level ofODA since 1960, when it amounted to 0.52 per cent of GNP ofDAC member states. But, the long term trend has continuedsteadily downwards. Although in the 1970s and 1980s, thevolume of ODA increased by 2 to 3 per cent a year in real terms,the target was far from being met collectively by DAC memberstates, with the ODA/GNP ratio hovering around 0.35 per cent.

The end of the East-West conflict marked the beginning ofa steady decline in DAC net ODA. Thus, the hopes for a “peacedividend”, namely that industrial countries, when reducing theirdefence expenditures, would make available some of the savedresources for official assistance to developing countries, did notmaterialize. To the contrary, the developing countries findthemselves now competing with a number of countries intransition for scarce official assistance..

Between 1990 and 1997, total net ODA flows declined byUS$ 5 billion, from US$ 53 billion in 1990 to US$ 48.3 billion in1997. (See the penultimate row of Table 1.) Over this periodthe ratio of official development assistance to GDP of DACmembers has steadily declined from an average of 0.33 per centfor 1986-87, 0.30 per cent in 1993 to 0.22 per cent in 1997.(Table 3.) This is the smallest share of DAC countries’ GNPgiven in aid since such statistics first began to be collected in the1950s. Moreover, it is significant that all of the real fall in ODAin recent 9 Note that "other official flows", that is, export credits extended byindependent governmental institutions, the purchase of bonds ofmultilateral agencies, in combination with ODA, constitute "officialdevelopment finance".


TABLE 3


years reflects the decline in contributions by the world’s largesteconomies. Non-G7 countries now provide 28 per cent of DACODA, that is, double their share in total DAC GNP.

The decline in ODA over the years has been due to severalcauses. An important factor was the tight budgetary situation thatmany industrialized countries began experiencing in the early1980s. The way governments chose to tackle this problem --reduction of both public expenditures and domestic taxes -- leftthe funding of ODA with very low priority. In fact, nationallegislatures in a number of countries became more stringentabout foreign assistance, partly in view of cuts in domestic welfareprogrammes. Declining political support for bilateral assistancewas also fuelled by a widespread perception that foreignassistance had yielded poor results and, in some instances,buttressed disreputable regimes in the developing countries whilecreating expensive aid bureaucracies in the donor countries.

More importantly, however, support for providing foreignassistance declined because of the rise of the new ideology in theleading donor countries which caused a shift in public policy.This shift involved a change in emphasis from the pursuit of full-employment to fiscal conservatism, along with policies inspired bythe doctrine of less government and free markets. This led to acommon belief in most industrial countries that developingcountries did not suffer from some basic structural weaknesses orfrom the impact of an unfavourable external economicenvironment that warranted concessional finance, but frommarket interventions, rigid labour markets, governmentregulations, and the state’s encroachment of what was held to bethe private sector domain. It was held that, if developingcountries were only to rid themselves of these ills, privateinternational capital flows would meet their requirements forexternal resources to aid their capital accumulation.

The global figures provided on ODA do not quite conveythe true picture of the decline in assistance flows from theviewpoint of developing countries. For one thing, as alreadynoted, there are today more countries competing for DAC fundswith the developing countries in Asia, Africa and Latin America,


which were the original intended recipients of flows under the 0.7per cent target. The ODA flows to the 10 CEECs/NIS countriesin the Part I list have risen from US$ 0.6 billion in 1993 to US$1.4 billion in 1997. 10 (Table 4.) The total of ODA flows to theCEECs/NIS countries, to the territories of the donors and tohigh income developing countries in the Part I list rose from US$1.7 billion in 1993 to US$ 2.3 billion in 1997. If these arededucted, the volume of ODA flows to developing countries ofAsia, Africa and Latin America falls from 0.30 to 0.29 per cent ofthe donors’ GNP in 1993 and from 0.22 to 0.21 per cent in 1997.

But this is not all. For some time now the donors have puta broad interpretation on what constitutes developmentassistance, and include categories which bear little relationship tothe need of the developing countries for long term developmentcapital. Thus, the range of purposes for which ODA funds areused has been expanded to include debt relief; subsidies onexports to developing countries; food aid which disposes of

10 There are 22 countries in Central and Eastern Europe and the formerUSSR (population 395 million) whose receipts of ODA and Official Aid(OA) combined were US$ 6.6 billion in 1993 and US$ 5.5 in 1997, that is,12.5 per cent of combined ODA and OA in 1993, and 10 per cent in 1997.These countries fall into two separate OECD lists of countries eligible toreceive official flows. The Part I list comprises developing countries andterritories eligible to receive Official Development Assistance (ODA).The Part II list contains a small number of more advanced developingcountries, some territories of donor countries and 12 Central and EasternEurope Countries and Newly Independent States of the former SovietUnion (CEECs/NIS), which are eligible to receive Official Aid (OA). (Thehigh income developing countries were Republic of Korea and NorthernMarianes. In recent years, the flows to these countries were oftennegative.) The more advanced developing countries in the 1997 Part II listare Bahamas, Brunei, Taiwan (China), Cyprus, Israel, Kuwait, Qatar,Singapore, United Arab Emirates. However, there is an occasional shiftingof countries from the Part I list to the Part II list. In 1997, the Part I listincluded 10 CEECs/NIS countries, and the Part II list included 12 suchcountries. In theory, the volume of aid flows to the economies intransition is determined separately from ODA but in practice both comeout of the same declining aid budgets.


agricultural surpluses resulting from government subsidies;


Table 4


provision of surplus commodities which would otherwise havelittle economic value; administrative costs; payments for the careand education of refugees in the donor countries; grants toNGOs and to domestic agencies to support emergency reliefoperations; and technical co-operation grants which pay for theservices of nationals of the donor countries. Some of these itemsare discussed in greater detail below.

Debt service support. Many developing countries are experiencingserious difficulties in servicing their official bilateral andmultilateral debts. Donors have started to provide debt relief incertain extreme cases, which amounted to US$ 2.7 billion in 1993,US$ 3.7 billion in 1995, and US$ 3.1 billion in 1997. (Table 5.)The cancelled debt service payments are counted as ODA. Thiscan cover the cancellation of military debt, the provision of debtrelief on non-ODA debt, and payments to the internationalfinancial institutions to service the multilateral debt of some poorcountries. The value of debt relief to the recipients is not inquestion, but the fact is that, in cases where debt is not actuallybeing serviced, this entails no net addition to the resourcesavailable to the country for economic development.11

Export promotion. Donor countries are under increasing pressurefrom businesses to strengthen the trade/aid link, but suchexpenditures are more in the nature of domestic exportpromotion rather than development assistance. ODA, forexample, is sometimes used to subsidize export credits to financepurchases in the donor countries. Food aid is also now includedin ODA. OECD countries spend over US$ 300 billion a year onagricultural subsidies that result in the over-production of a widerange of commodities. The surplus stocks of milk powder, butterfat, meat, cheese, wheat, corn and other commodities areprovided to the developing countries, valued at world marketrates, and then shown as ODA when reporting to OECD. Often 11 This point can be explained by the following example. If a countryowes x amount in debt service but gets it written off, it receives no actualresource transfer, though the donor does forgo its claims and can shownotionally x amount as resource transfer, offset by an equal amount in debtrepayment, for domestic budgetary reasons.


Table 5


these surplus stocks have little value to the donor countries, andtheir disposal in developing countries requires no additionalbudgetary appropriations and tends to overstate the performanceof and burden on donor countries. From the perspective of thedeveloping countries, however, while meeting the immediateneeds, the disposal of food aid can harm long term developmentand food security, as it depresses the prices of locally producedgoods and discourages their production, undermines livelihoodsof important population groups giving rise to social unrest,political tensions and migration to cities, and can cause a fall inexports from recipient countries.

Humanitarian assistance. Compared with the 1980s, there was anincrease in official flows for humanitarian assistance in the early1990s. In 1997, bilateral emergency and distress relief totalledUS$ 2.2 billion. Several donors charge to the aid budget the costof domestic programmes to support refugees and grants tooverseas students. Many of these programmes were previouslyfinanced from other budget sources and not charged to theforeign aid budget.

Other items included in ODA. Technical co-operation grantscurrently account for around 27 per cent of ODA, reflectingpayments for the services of donor country nationals andconsultants, some of whom never leave their own countries. Thecosts of administration of development assistance programmesand contributions to NGOs which help to administer theemergency assistance and development programmes are alsoincluded as ODA.

In short, the composition of ODA has drifted considerablyaway from the original intent of providing long term capital fordevelopment on favourable terms. It is true that many items ofexpenditure charged to ODA, notably humanitarian assistance, dobenefit the recipients in important ways, but some are purelydomestic expenditures that benefit the donors and some arefictional from the point of view of their economic cost, such asthe provision of surplus commodities.


Expenditures which do not directly promote higher levelsof investment, namely, debt relief, technical co-operation, foodaid, emergency relief and administrative costs, amounted to US$21.9 billion in 1997. The revision of the OECD data to excludethese items results in a decline in bilateral ODA flows from US$32.4 billion to just over US$ 10 billion in 1997. The revised totalof bilateral and multilateral ODA for that year amounts to US$ 26billion rather than US$ 48 billion, or only 0.12 per cent of GNP(Table 5).12

The situation outlined above indicates a significant erosionin ODA in comparison with its original intent and content, and inrelation to the 0.7 per cent target. It will no longer suffice tomerely repeat that ODA targets should be fulfilled. What isrequired, in view of the policy trends in the North and themounting need for and importance of concessional flows to alarge number of countries in the South, is a fundamental andcomprehensive review of the approaches by the internationalcommunity to the question of concessional financial flows fordevelopment, covering the estimated needs, the composition andsources of concessional flows, the quantity and terms on whichthey are available, and the destination and uses.

C. Private capital flows

The rise in private capital flows to developing countries is in partboth a reflection and consequence of the shift away from stateeconomic activity towards the market and the growth of theprivate sector that has taken place since the late 1970s. Privatecapital flows to developing countries have also reflected investorgoals, attitudes and strategies, both in the case of multinational

12 The revised estimate of net ODA flows is closer to the actual financialtransfers to the developing countries as reflected in their balance ofpayments accounts. The data provided by the OECD greatly exceed thedata in the balance of payments of the recipients, simply because a goodportion of ODA never leaves donor countries.


companies and investment funds. The forces behind the varioustypes of private capital flows are somewhat different, and nosingle explanation can explain the behaviour of the aggregate.

Foreign Direct Investment

An important feature of private flows (comprising commerciallending, FDI and portfolio investment) in the 1990s has been theshift from commercial bank to non-bank sources of externalfinance. The rise of FDI to developing countries is one indicatorof the pace of globalization, as multinational corporations(MNCs) expanded or took over production facilities abroad. Thiswas motivated by a complex of factors. While the traditionalreasons of wage costs and closeness to markets or sources of rawmaterials continued to be important, strategic decisionsconcerning specialization and corporate mergers and acquisitionswere also prominent factors. Particularly in the so-called emergingmarkets, FDI has also been attracted by the pace of privatizationand increased private sector financing of infrastructure projects,especially in countries with large and growing markets andmacroeconomic stability.

Industrial country multinationals, particularly those of theUnited States, United Kingdom, and Japan, account for the majorpart of the flows to and stock of foreign direct investment in theSouth. In recent years there has also been a noticeable increase inFDI from developing countries, such as Korea, Taiwan (China),Thailand, Brazil and Chile, to other developing countries.

The concentration of FDI flows in a handful of developingcountries has been noted earlier. The group of developingcountries receiving the bulk of FDI is rather diverse, and theredoes not appear to be a strong relationship between the degree oftrade and financial sector liberalization and the amount of FDI acountry receives. Controls and regulations governing capital flowsremain strong in China, but it receives more FDI than any othercountry, thanks to its large and rapidly growing market and cheaplabour. Malaysia and Thailand also received much more FDIthan the more liberalized Latin American countries, and African


countries received little FDI despite their moves to liberalize andopen up their economies. Tax and other incentives offered byhost countries also seem not to be important considerations inattracting FDI. In short, the principal pull factors appear to be theavailability of some high value natural resources, the size andgrowth of the domestic market, the proximity of other largemarkets, the possibility of high profits and the assurance of beingable to repatriate such profits, and the availability of skilledlabour.

It is, however, important to note that the data on flows ofFDI are more approximate than accurate, for there are significantproblems of definition and interpretation of the data. Accordingto the World Trade Organization (WTO), for example, FDI“occurs when an investor based in one country (the homecountry) acquires an asset in another country (the host country)with the intent to manage that asset. The management dimension iswhat distinguishes FDI from portfolio investment in foreignstocks, bonds and other financial instruments.” Theinterpretation of ‘acquires an asset’ or ‘intent to manage’ is farfrom precise.

The common sense understanding of FDI as flows tofinance investment projects is no longer sufficient. Investorsattach a value to the intangibles (technical and managerialexpertise and marketing networks) and this is included in theestimate of their equity contribution together with developmentcosts incurred in the home countries. These components do notcorrespond to any actual inflows of capital into the recipientcountry, and they are hard to give value to in normalcircumstances, but for developing countries their accuracy isparticularly difficult to assess. These ambiguities have been acause of much corruption in deals relating to foreign privateinvestment. It is clearly advantageous to the investor to inflatethe value of the investment since it can affect the value of benefitsfrom tax holidays, repatriation of profits, and the allowance fordepreciation.

What constitutes foreign management is equally unclear.Some countries may consider foreign ownership of 20 per cent of


the assets of a company as constituting control while others mayconsider 50 per cent or more. The World Bank considers 10 percent of the voting stock as a basis for determining managementcontrol, and defines FDI as “the sum of equity capital, reinvestedearnings, other long term capital and other short term capital asshown in the balance of payments”.

FDI can also take the form of intra-firm loans, portfolioflows, and reinvested earnings, which are all poorly recorded anddo not necessarily correspond to any act of physical investment.Moreover, account needs to be taken of the fact that, to theextent that FDI involves purchasing ownership in the case ofprivatizations or mergers and acquisitions, this does not lead toan immediate increase in capital accumulation.

Portfolio Flows

Developed country institutional investors (pension funds,insurance companies, and mutual funds) have over the yearsbecome key actors in the world’s capital markets. The combinedassets of all the pension funds, insurance companies and mutualfunds of the seven major industrial countries were estimated atclose to US$ 17 trillion in 1994, having risen from US$ 5 trillionin 1985. These assets exceed the capitalization of equity marketsin developing countries by a factor of 17:1, and they exceed the1995 GNP of the low and middle income developing countries bya factor of 3.5:1.

The assets of mutual funds, which have become the mostpopular means for portfolio investment by relatively smallinvestors, have risen at the expense of commercial bank depositsfor almost two decades. The share of household savingschannelled to mutual funds in Japan, the UK and the US, doubledbetween 1975 and 1994, and this trend has accelerated in recentyears. In 1993 alone, US mutual funds had inflows of US$ 250billion, the largest annual increase ever, raising the share ofinstitutional investors in all financial assets to 52 per cent,compared to 32 per cent in 1978. Similar trends could beobserved in other leading industrial countries.


In 1995, some 10 per cent of their portfolios consisted ofoverseas investments, mostly high grade bonds and foreigncurrencies. During the 1990s large institutional investors becameprominent purchasers of bonds and equities in a few developingcountries, which came to be referred to as the emerging markets,in search of higher and quick returns and to diversify theirportfolios.

Factors on both the demand and supply side contributed tothe rise in inflows of portfolio investment into developingcountries. An important factor that increased the supply of fundsfor overseas portfolio investment was the liberalization of capitalmarkets in industrial countries. All industrial countries hadremoved exchange controls by the end of the 1980s and movedtowards complete capital account convertibility only in the 1970sand 1980s. France and Italy introduced capital accountconvertibility only in 1990. Of particular significance was therelaxation of regulations governing the holding of foreign assetsby U.S. pension funds. Changes in government regulations and inthe provision of tax benefits encouraged increases in pension fundcontributions by both individuals and companies.

The decline in interest rates in the industrial countries wasanother major factor contributing to the rise in the supply offunds for portfolio investment. Interest rates in the United Stateshave been at a thirty-year low, in Germany, they have been lowestsince the war, while in Japan, such low rates have not beenwitnessed over the past century.

On the demand or “pull” side, domestic capital markets ina number of developing countries opened up to foreigninvestment as part of the process of deregulation and capitalaccount liberalization, making it easier for capital to move in andout of countries. Capital markets of countries with strongeconomic growth and rapidly rising export earnings were, ofcourse, particularly attractive to foreign investors. The fact thatmany developing countries maintained interest rates on bankdeposits in foreign currencies at significantly higher levels thanthose offered in industrial countries was, despite the obviousrisks, another attraction for foreign capital.


Portfolio diversification through investment in developingcountries appeared particularly attractive because the availableevidence suggested that while stock markets of the industrialcountries tended to rise or fall together, no such relationshipseemed to exist with respect to the movements in developingcountry markets, a reflection of the fact that there were fewportfolio investments by outside investors.

Nevertheless, portfolio investment in developing countrieswas still considered marginal and relatively risky and it accountedfor only a modest share (perhaps, 1 or 2 per cent) of the assets ofinstitutional investors. The recent financial and economic crisisaffecting East Asian countries and the contagion effect showedthe high potential of portfolio investment and currencyspeculation to wreak havoc upon the economies of recipientdeveloping countries. Emerging markets as a whole are currentlyconsidered overly risky by overseas portfolio investors.

D. Other issues affecting the financing of development

As mentioned earlier, in order to address developing countries’problems regarding the financing of their development, there is aneed to consider a broader range of matters than the externalflows intended for development, in particular the issue of externaldebt and that of commodity prices and the terms of trade.

External debt

A considerable number of developing countries have a largeexternal debt which they are finding difficult or impossible toservice. Many of these heavily indebted countries are leastdeveloped countries, with very low levels of income per capita.13

13 During the early 1990s, between 55 and 60 developing countries facedserious debt servicing difficulties, with arrears in excess of 20 per cent ofscheduled debt service. Being in arrears on debt servicing obligations is a


The rising debt reflects a large accumulation of debtarrears, involving an accumulation of principal in arrears and ofcapitalized interest. The greater part of the long term debt of thevery many developing countries with arrears in debt servicing isowed to official bilateral and multilateral creditors, andparticularly to multilateral creditors.14 The high ratios of nominaldebt stock to actual and likely annual export earnings means thatin effect the debt of most countries will be impossible ever to repay.

External debt indicators exhibit wide differences acrossregions. Thus, while in 1997 the ratio of external debt to exportswas just over 100 per cent in the East Asia and Pacific region, itwas roughly twice as much in Africa and Latin America. (Table

key indicator of the intensity of a developing country’s debt burden: it is aclear sign that its debt service is beyond its capacity to pay. In 1992,among 58 countries with arrears exceeding 20 per cent of scheduled debtservice, more than three quarters had arrears exceeding 50 per cent, halfhad arrears larger than 75 per cent, and more than a quarter had arrears inexcess of 90 per cent. (See Non-Aligned Movement, The Continuing DebtCrisis of Developing Countries, Report of the Non-Aligned Movement Ad HocAdvisory Group of Experts on Debt, 1994.)14 The arrears on debt servicing is higher with respect to bilateral ascompared with multilateral debt, due to the fact that debtors giveprecedence to servicing the debt of the multilateral creditors -- the so-called “preferred creditors” -- who have until recently shown themselvesto be unwilling to countenance the rescheduling, reduction or forgivenessof developing countries’ multilateral debt. Private external debt, owed tocommercial banks, accounts for a relatively small proportion of the totalbecause the banks earlier wrote off considerable amounts of debt assumingthat they would never be paid. This was done with the help of funds fromthe IMF and World Bank and by converting the remaining debt into bondswhich could be sold on the secondary market. The problem of privateexternal debt has now resurfaced, this time in the East Asian economies incrisis, where the private sector received considerable foreign loansdenominated in foreign currency which they had difficulty in repayingfollowing depreciation of the local currency. Moreover, the IMF policiesprescribed to deal with the economic crisis in these countries turned whatwas a liquidity crisis into a problem of solvency for large parts of thecorporate sector.


6.) Although there was a large increase in the ratio of the externaldebt to export earnings (in some cases more than doubling)between 1980 and 1990, there has generally occurred someimprovement during the 1990s.

The decrease in the ratio between 1990 and 1997 for LatinAmerica was much larger than the decrease for Africa, implying thatdebt burden continues to be a particularly serious problem forAfrica. In Asia, however, the current financial and economic crisiswill have increased external indebtedness in the most recent years.

Short-term debt as a proportion of the total debt (Table 6),which is another indicator of debtor countries’ vulnerability,shows relative stability over time, except in the case of the EastAsia and Pacific region.

It is debt service ratios, however, which give someindication of the debt burden of developing countries. A heavyexternal debt burden undermines the efforts of particularly thepoorest countries to increase the level of capital accumulation,prevents the improvement of infrastructure and reduces the levelof expenditure on health and education, all of which prejudicefuture growth and development. Nominal debt service burdensmay be many times the level of a debtor’s export earnings buteven actual debt service payments indicate the major drain onnational resources.(Table 7.) Regional aggregates, however, maska wide variation in particular country situations. In the case ofAfrica, the actual debt service payments of many countries rangebetween 20 and 60 per cent of all official foreign exchangereceipts.

Commodity prices

Developing countries’ ability to finance their development hasbeen seriously affected by the huge loss of foreign exchangeearnings they have incurred due to the sharp and continuing fall inthe real prices of primary commodities since the early 1980s.Table 6


Table 7


Right through the 1980s, commodity prices fell on averageby 5 per cent annually in real terms. By 1990 they were 45 percent below their 1980 level. In fact they had fallen by then to 10per cent below the 1932 level -- the lowest reached in the GreatDepression of the 1930s. Between 1980 and 1991, thedeveloping countries suffered an estimated cumulative loss intotal export earnings in real terms of US$ 290 billion, an annualaverage loss of US$ 25 billion.

Nominal commodity prices continued to decline untilmid-1993; as from then until mid-1994 there was an unexpectedrise of some 20 per cent and by late 1994 nominal commodityprices had recovered to almost 75 per cent of the 1980 level, butin real terms commodity prices were little higher than 50 per centof the 1980 level. This recent upswing was relatively modest whenviewed against the magnitude of the collapse of the early 1980s.The situation has worsened dramatically in the last couple ofyears following the Asia financial crisis and sharp economicdownturn. The commodity situation threatens to remain criticalfor developing countries, not only for low income countries butalso for middle income countries, particularly as world growthlevels have been revised downwards in the wake of widespreadfinancial crises.

Developed countries, in the meantime, have reapedconsiderable benefits from the continuing decline in the price oftheir primary commodity imports from developing producingcountries.15

15 This data on commodity prices is from South Centre, InternationalCommodity Problems and Policies. The Key Issues for Developing Countries, SouthCentre, Geneva, 1996.


E. Conclusion

This brief overview depicts significant changes in thecomposition, quantity, quality and distribution of financial flowsto the South.

Public flows have not kept up with the needs for this typeof external financing. They have in fact diminished in quantityand quality. The private flows which have emerged haveconsiderably different motivations from those underpinning theprovision of ODA, and do not necessarily serve the extensivedevelopment needs in the South. Moreover, they are moreunpredictable than public flows and highly volatile. Oftenassociated with increased integration into the world economy andwith increasingly open financial markets, they have become thesource of instability and crisis in many countries

Both public and private flows in their different waysimpinge considerably on developing countries’ decision-makingand sovereignty. The conditionalities of the multilateral financialinstitutions and bilateral donors, and the preferences andstrictures of investors and the market, exert a powerful influenceon social and economic policy choices and on the politicalframework. The pervasiveness of Northern influence is such thatmany developing countries sense a loss of control over their owndestinies.

The serious problems faced by many developing countrieswith respect to their debt servicing burden and the declining trendof commodity prices increase their need for financial inflows tofacilitate servicing the debt and closing the trade gap.

Some of the development implications of these finance-related factors are discussed briefly in the next section.

III. INTERNATIONAL CAPITAL FLOWS AND DEVELOPMENT

A. International financial flows: the economic impact

At an early stage of development, domestic savings are often notsufficient to finance the investment needed to achieve capitalaccumulation and faster economic growth. Foreign financing mayusually be expected to be associated with higher rates ofinvestment, to the extent that machinery and technology whichcontributes to productivity growth needs to be imported fromabroad.

Moreover, as incomes rise, the demand for importedconsumer goods and raw materials tends to rise, leading to ahigher trade deficit, which needs to be financed from abroad.Thus, for example, the East Asian economies, despite theirreliance on export-led growth, and the fact that they have had ahigh level of domestic savings, found themselves with largeforeign financing requirements during the 1970s, 1980s and1990s.

Foreign financing is, however, only one of a host of factorsthat influence the rate of economic growth. It is not surprisingtherefore that there does not seem to be a one-to-one relationshipbetween the growth of developing economies and foreign capitalinflows, though the two are closely linked.

If developing countries are to seek external financial flowsto augment and complement what can be mobilized through theirdomestic savings, it is essential that there be a clear understandingof the impact that different types of capital inflows can have ontheir economies, both at the macro- and the microeconomiclevel.16 Such an assessment is itself a complex and often

16 This is particularly important for those countries which are said by someto be “marginalized” from the global economy, due to the low level andshare of private capital inflows and low level of international trade. Anunderlying assumption in this view is that a higher level of capital inflows


controversial matter, and in this document it can only bebroached in a very summary fashion.

It is important to note that financial flows do not properlymeasure resource transfers to developing countries. Thesubstantial decline in real commodity prices and the deteriorationin the terms of trade has been a major factor in worsening thetrade balance of many developing countries, and not just ofprimary producers. This implies hidden resource transfers fromthe South to the North which are in the nature of a grant, onwhich no repayment or interest is due.

A trade deficit will require a higher level of foreignfinancing just to fill the enlarged trade gap. The developmentimpact is likely to be lower than if external flows went tofinancing investment.17

The perverse transfer has been particularly severe andonerous for developing country primary producers. The lossessustained by most commodity exporting developing countries,particularly the poorest and weakest, have accounted for much ofthe growth of their foreign debt, the collapse of their growth rates of whatever nature would be an unquestionable advantage. This issue isdiscussed later in this section.17 A deterioration in the terms of trade implies a real income transfer fromthe country concerned to the outside world. Conversely, improved termsof trade can serve roughly the same role as income transfers from abroad.It was in recognition of this that UNCTAD in the 1960s considered aSupplementary Financing Scheme, which was supposed to offset thedifficulties arising in developing countries from unexpected shortfalls intheir export proceeds which, due to their nature and duration, could not bedealt with by short-term balance of payments support. However, in the endthis scheme, which amounted to development finance, was not accepted bythe leading industrial countries. Instead, the IMF’s CompensatoryFinancing Facility, which was liberalized and enlarged in 1966, allowedcountries facing temporary balance of payments problems due to terms oftrade shocks resulting, for example, from low commodity prices, to drawon the Fund’s resources for short term balance of payments support.

International Capital Flows and Development 45

and the decline in social indicators, subjecting them to enormousstresses and strains.

It is also an undisputed fact that a large number ofdeveloping countries, especially in Africa, are suffering a majorsetback in their economic development due to the heavy burdenof debt, particularly official debt. The external factors referred toabove have contributed to the difficulty of speeding up the paceof economic growth and hence also of improving their debtservice capacity. With a significant portion of public revenues pre-empted for the servicing of official debt, investment programmesoften have to be curtailed or suspended, while resources for suchsocially and economically important sectors as education, health,and nutrition are choked off. Indeed, the debt service burden insome of the world’s weakest and poorest economies has becomeso onerous that it has led to a sharp deterioration in the health,nutrition and educational standards of their populations, amongother things.

Difficulty in meeting debt service obligations fully and ontime has resulted in the persistent accumulation of debt servicingarrears, which inhibits further inflows of development finance,whether development loans, private investment or tradefinancing.

It is not only the heavily indebted poor countries (HIPC)whose development is thwarted by the heavy debt burden theybear. There are a number of other countries whose high debtand debt servicing levels are likely to impose a substantial burdenfor very many years to come.

There is, of course, also the question as to whether foreigncapital inflows do actually augment domestic investment orsimply replace domestic savings. A related concern has been that,even where foreign funds are employed for specific investmentprojects, they set free public resources for other (less productive)purposes. There is no firm finding on this. In some instances,foreign finance has been found to be associated with a reduced


level of domestic savings, leaving investment levels more or lessunchanged.

It is important to appreciate that the micro and macroimpact of foreign financing is likely to depend not only on theaggregate level of inflows but also crucially on the frequency andintensity of fluctuations. The composition of inflows is thereforeimportant because different types of inflows generally behave verydifferently.

Capital inflows can also have important micro and macroimplications due to their influence over key domestic policies.This is as true for official flows as it is for private flows, as isindicated in the brief discussion below of some aspectsconcerning the impact of inflows of official and private capital.

B. Concessional flows

The raison d’être of official flows remains the support of economicand social development in the South. There is, however, no singleway in which to examine the extent to which the objective isactually achieved, partly because the type and manner of supportis very varied. Thus, what is often termed “aid-effectiveness” canbe viewed from different angles or perspectives with differentconclusions.

First, there is the potential macroeconomic impact, whichdepends on the absolute level of inflows of concessional finance,the extent to which they are a net addition to savings, and theirrelative level as a proportion of GDP and of gross domesticinvestment. But an equally important issue is the stability orotherwise of these inflows and the extent to which these arecyclical or countercyclical. These characteristics will vary fromcountry to country and possibly over time.

Many would argue that it is not only difficult to measureaccurately the macro-level impact of concessional assistance butalso that it is not necessarily the most crucial thing to measure.


Rather, the focus should be on the distributional impact and onthe extent to which such inflows reduce poverty. Others,however, insist that the emphasis should be on assessing theextent to which concessional funds for specific developmentprojects or programmes such as for clean water, health oreducation achieve their aims.

A recent World Bank study on aid effectiveness argues thatnew empirical evidence shows that financial aid works best in a“good policy environment”.18 If a country has “sound economicmanagement” financial assistance leads to faster growth, povertyreduction, and gains in social indicators. But efforts to “buy”policy improvements through aid have failed where there is noexisting support for policy reform. The World Bank thereforeargues that if aid was targeted to countries with sound economicmanagement (good policy) the effectiveness of each US$ 1 billionof global aid would be greater. To achieve maximumeffectiveness, it suggests that resources should therefore betargeted on low income countries with sound economicmanagement and that policy-based aid should be provided tonurture policy reform in “credible reformers”. While thedocument suggests that there have been considerableimprovements in governance and policies in the past decade, iturges “further reform of the same magnitude”.

During the 1980s and 1990s a large component of thelending from the World Bank and other multilateral institutionswas made in support of structural adjustment programmes, whichaimed at policy and institutional reforms in developing countries.How well these programmes performed could also be an indicatorof the effectiveness of official foreign financing. The WorldBank’s own evaluations of the structural adjustment programmes,at least until recently, have tended to be self-congratulatory,concluding that, barring a few cases, the policy reforms hadrestored conditions for long term economic expansion.

18 World Bank, Assessing Aid: What Works, What Doesn’t and Why, OxfordUniversity Press, New York, 1998.


However, there have been strong misgivings among someoutside the Bank. For one thing, there is little evidence thateconomic liberalism in developing countries, with some notableexceptions, yielded the promised acceleration of economic growthor led to poverty reduction and improved income distribution.19

Linking “good policies” with aid-effectiveness clearlysuffers from the problem of defining those policies in contextsthat differ very widely. Budget deficits, subsidized interest ratesand exchange rate over-valuation can certainly do harm in manysituations, but are highly effective tools of economic managementin others. The recent experience of East Asia has, in fact,demonstrated that erstwhile good policies can quickly turnineffective, even dysfunctional. But apart from the problem ofdefining good policies, there is also evidence suggesting thatpolicies as such may not have much impact on economic growth.Some studies have reported that in certain instances (notably inAfrica), “good luck” in the form of good weather or favourableworld market conditions, rather than “good policy”, explainedbetter a country’s growth experience.

Finally, the ability of countries to continue servicing theirexternal debts could be considered as a useful indicator of theeffectiveness of foreign financing. Keeping the debt serviceburden manageable requires that borrowed funds are used inproductive activities. Thus, when countries get into debtservicing problems, one could conclude that they must have usedthe financing for unproductive purposes. The fact that currentlya number of developing countries, especially some of the poorestin Africa, face a serious problem of servicing their debts owed to

19 The general experience of “adjusting” countries in Latin America andAfrica has been one of slower economic growth, with increasedvulnerability to external influences, compared to the situation in the 1960sor 1970s. At the same time, the rise in income inequalities and povertyseems to have been a widely observed consequence of market liberalism,including in some industrial countries. See UNCTAD, Trade andDevelopment Report, UNCTAD, Geneva, 1997.


bilateral and multilateral donors has been attributed to thesecountries’ failure to use their resources effectively. Thisattribution is not, however, always valid.

There are complex reasons for debt servicing problemswhich cannot be gone into here. Three points can, however, bemade. First, if foreign financing was poorly used, it was at leastpartly because aid was given for considerations other thanpromoting economic development, as reported by some studies.So, the donors cannot completely absolve themselves of thedifficulties developing countries have got into. Second, a numberof countries were made to adopt rapid trade liberalization andother market-based solutions to overcome their problems whichgenerally failed to turn the situation around. Thus, policyprescriptions given by the donors must also be considered to haveplayed a role in the countries’ failure. And, finally, a number ofdeveloping countries in distress have experienced sharplydeteriorating terms of trade and generally unfavourable worldmarket conditions for their exports, which have not only severelyhandicapped their efforts at development, but causedconsiderable domestic political and social unrest.

Conditionality

One important point to emerge from the above discussion is thequestion of conditionality associated with foreign assistance.Foreign assistance is being increasingly used by bilateral andmultilateral donors to push their reform agendas on thedeveloping countries. The proposed reforms have generally lessto do with the problems faced by the recipient than with thedonors’ ideology, pet notions, commercial and strategic interestsand domestic politics. It is, of course, only realistic to expect thatforeign financing will be made available only on condition thatcertain project performance, accounting and reportingrequirements are agreed to. But the nature of the political andeconomic conditions currently attached to foreign financing raisesserious questions concerning both the political morality of usingso-called development assistance to promote highly intrusive


policies reflecting particular Northern views of the “goodsociety”, and concerning the issue of aid-effectiveness.

Here two points need to be made. First, the policy reformsthat donors propose need to be based on the actualcircumstances, capacity, and capabilities of the recipient, ratherthan following some standard prescription. This, however, is notpossible -- and this is the second point -- without the recipient’sactive involvement in the design of the reforms. Time and again,World Bank studies have found that the effectiveness of Banklending depended crucially on the “ownership” of reforms by thecountry concerned, and yet progress in remedying this problem ishard to discern.

C. Private capital flows

The recent rise of private capital flows has fundamentally changedthe conventional notion of foreign finance filling a given resourcegap. A large part of these recent inflows has been motivated bythe actual, perceived, or expected relative macroeconomicconditions of countries, namely, differences in interest rates andexpectations concerning future inflation and movements ofexchange rates across different countries. Such flows are notexpressly in response to developing countries’ needs.

While, as part of foreign capital inflows into developingcountries, they would in principle seem to contribute to capitalaccumulation, they may easily cause major changes inmacroeconomic balances which frustrate domestic policy andtargets for economic growth, inflation, and employment. Not toorarely, they create serious financial difficulties for the countryconcerned. To discern the development impact of foreign privateflows, it is necessary to consider the different components of suchflows separately.

Foreign direct investment


Recent years have witnessed a growing enthusiasm in developingcountries for FDI as a means of raising the level of capitalaccumulation and achieving development objectives including, forexample, speeding up the rate of technological change.

However, in their concern to derive the important benefitsto be gained from FDI, there has been a tendency amongdeveloping countries to underestimate or overlook the potentiallysignificant costs associated with an inappropriate level and kind ofFDI.

Thus, while FDI, either through purchase or theestablishment of new production facilities (“green field”investment), may contribute to capital formation and to exportearnings, its wider contribution to technological change andgrowth of the economy may be limited if, for example, the FDI isvirtually an enclave activity and not well integrated into the rest ofthe economy.

In particular, insufficient attention has been paid to thepotentially serious implications which FDI may have for thebalance of payments, currency markets and macro-economicpolicy, and even the longer run financial viability of the economy.

For FDI to make a positive long term contribution to theeconomy of developing countries, care needs to be taken toensure that the economy generates a sufficient export surplus tobe able to cope with both the additional import demandsgenerated by FDI and the repatriation of FDI profits. In theabsence of such, there is likely to be a foreign exchange crisis.

Flows of FDI can also be quite volatile, and their balanceof payments and macroeconomic effect therefore need to betaken into account. Previously FDI was largely characterized bythe fact that it involved a purchase of fixed assets and was long-term in intent, whereas portfolio investment flows were alwaysknown for their volatility. Now, with the introduction of financialliberalization and foreign exchange markets, those involved inFDI are able to liquidate their investments rapidly by borrowingfunds on the local market, to buy foreign exchange and take


capital out of the country as they choose. Other financial activitiesassociated with FDI, such as currency hedging operations, alsoadd to the volatility of financial flows. Volatility aside, FDI flowsmay act in a pro-cyclical manner. Either of these patterns ofbehaviour can cause serious problems for macroeconomicmanagement.

From the point of view of macro-economic stability anddevelopment, therefore, the level and type of FDI are ofconsiderable importance and FDI has to be managed in the sameway as other debt creating flows.

Other problems associated with FDI can be seen byconsidering, for example, such investment in the context of theprivatization of public facilities and enterprises in developingcountries. The change in the ownership of assets may provide ashort term inflow of foreign exchange revenues to the immediatebenefit of the public finances. But the transaction does notnecessarily generate any short term improvements in technologyand management to raise productivity or lead to an expansion ofcapacity. Nor, in most cases, will it generate new export earnings.It will, however, give rise to a permanent stream of profitremittances abroad, assuming that profits are actually made.Often, too, the developing country government providesguarantees to the enterprise so that, in the event of failure, thegovernment is responsible for servicing the debt or compensatingthe investors. For the maximum benefits to be derived, there isneed for careful negotiations and an appropriate regulatoryframework.

There are, in addition, other potentially problematicalaspects of FDI, including the impact on the competitiveenvironment resulting from investment by large multinationalcorporations which may exercise considerable market power.Moreover, in an increasingly open and more competitive worldeconomy, there is the possibility that a local company’s assets areacquired by a foreign investor with a view to downsizing or evenclosing down the enterprise, as part of the new owner’s globalcorporate strategy. In addition to economic interests, less tangiblebut no less important political issues may be at stake, as, for


example, when foreign investment comprises a large proportionof total investment and involves a loss of national control overstrategic sectors of the economy, vital infrastructure or naturalresources.

Considerations such as the foregoing have given rise towidespread concern among developing countries at the prospectof a multilateral investment agreement being pressed for by theNorth to provide for almost unfettered flows of FDI. What, ineffect, would become a global regime extending the right forforeign investors to invest as and how they wished anywhere inthe world, and with no attendant responsibilities on their part,cannot be acceptable to developing countries. Such a regimewould prevent developing countries from deciding what eachconsiders to be an appropriate level of FDI and what types offoreign investment they wish to encourage, thereby underminingthe management of FDI flows which is essential to goodmacroeconomic management.

Portfolio capital flows

Considerable pressures have been exerted by the multilateralfinancial institutions on developing countries both to developlocal capital markets, including establishing stock markets, and toengage in international financial liberalization. In recent years theso-called emerging markets began to attract considerable flows ofportfolio investments, which are mostly in response to the chanceof making a rapid gain.

Inflows of such capital may help finance a current accountdeficit, but there is no assurance that they will contribute tophysical capital accumulation. The highly volatile nature of theseshort term investments presents serious problems for maintainingeconomic stability in developing economies, creating particularproblems for the balance of payments and exchange rate stability.

The volatility is largely rooted in the herd-like behaviour ofinvestors, which became more pronounced as northern pensionand investment funds began to invest abroad, including in some


developing countries. Moreover, the “contagion effect”, wherebywhat investors do in one market often affects what investors doin another, means that there may be serious widespreadinternational ramifications of events in one single country.

Policies of financial liberalization which permit orencourage inflows of short term capital also create conditions inwhich hedging operations and other speculative currencytransactions give rise to exchange rate instability and currencydepreciation with disastrous economic consequences. Even inmore normal times, financial markets are able to exercise a sort ofconditionality or veto over government policy and choices, withpotentially serious social, economic and political consequences.

A series of financial crises over the last two decades,emanating from problems associated with private flows, haveseriously hampered the process of economic development.Indeed, especially of late, it almost seems that the developingworld has just been moving from one crisis to the next.

D. Conclusion

As the above section has made clear, two different dimensionsconcerning financing development need to be kept in mind: firstthat of the inflows of public and private finance to developingcountries, and second what are in effect reverse flowsrepresenting the drain on potential development finance causedby falling commodity prices and adverse terms of trade and theburden of servicing the external debt.

From the above brief discussion of public and privatecapital flows to developing countries, it can be seen that externalfinance can have a profound impact on developing countrieswhich is out of all proportion to the actual size of the flows. Inthe past such critical aspects have been overlooked in policy


dialogues on the subject of external finance, the focus havingbeen mainly on the issue of quantity.

Leaving the issue of external financing for developingcountries to market forces is to renounce any responsibility on thepart of international community, and specifically the Northgovernments, to work towards a more equal partnership.Moreover, wholly unfettered capital markets in developingcountries can only subject these countries to volatility andspeculators’ whims, presenting the risk of financial crisis,economic collapse and social dislocation.

In view of the far-ranging and potentially highly damagingconsequences for developing countries of free flows of short-termcapital, the next section of this document takes a brief look atrecent financial crises and the issue of unregulated private capitalflows.

IV. PRIVATE CAPITAL FLOWS AND FINANCIAL CRISES

The dramatic rise in private capital flows during the 1990s was acause for much celebration among those urging free markets andeconomic liberalism. It was held to be evidence of the privatesector’s ability to promote world trade and economic growththrough freely functioning world capital markets. However, thecelebration came to an abrupt halt when Thailand devalued itscurrency in July 1997 which set off a chain reaction that hasengulfed the East Asian economies in what is perhaps the mostserious financial and economic crisis since the Second World War.Furthermore, the financial crisis now affecting Brazil also hassevere domestic economic implications and may have importantramifications throughout Latin America, if not further afield.

The so-called financial meltdown has turned capitalmarkets everywhere jittery, alarmed the world’s financialinstitutions, and given cause for reflection and debate on the roleand impact of private foreign financing and on the functioning ofthe international financial system.

A brief review of past financial crises provides insights intothe pathology of the current crisis and what needs to be done toimprove the functioning of the international financial system.The cost of the crises is immense in terms of lost output andemployment, and the associated social strains and politicaldisruption. The search for means to reduce the risk of futurecrises and minimize their cost once they occur is a challenge tothe entire world community.

A. Financial Crises 1974-94

Over the last 25 years, the countries of the South have witnesseda number of major debt or financial crises, starting with thePertamina crisis of 1974, which broke when it was discoveredthat Pertamina, Indonesia’s state-run oil company, could not

58 International Capital Flows and the Developing Countries

service its accumulated external debt, virtually all owed to foreigncommercial banks. This crisis, however, could be relatively easilycontained since it was limited to Indonesia and it occurred at thetime when the oil price had risen four-fold within a matter ofmonths, brightening Indonesia’s prospects of future foreignexchange earnings.

Pertamina had been able to borrow abroad despite theexistence of tight restrictions on commercial borrowing, imposedby the IMF as part of the arrangements to reschedule Indonesia’slarge external debt a few years earlier. The circumvention of theIMF’s conditions occurred through borrowing short-term (lessthan 360 days), which was technically not subject to theborrowing limits, and with the lenders in the knowledge of whatthey were doing. Under the aegis of the IMF, arrangements wereworked out whereby the Pertamina debt was restructured and thecommercial banks were assured of debt repayment. But the costto the Indonesian nation of this settlement was heavy, for a largeportion of the oil revenue was pre-empted by Pertamina’s debtliabilities. The approach to resolving this crisis set the pattern forthe management of future crises.

The Latin American debt crisis of the early 1980s, whichwas set off by Mexico’s default on its external debt in August1982, had its roots also in the oil boom of the 1970s. Theaccumulation of the so-called petro-dollars had made the world’sleading commercial banks highly liquid. As a result of recyclingthe petro-dollars from countries with large balance of paymentssurpluses (the oil exporters) to those in need of external finance,commercial lending to developing countries, mostly in LatinAmerica, rose rapidly in the late 1970s, reaching a level of US$ 20billion (in terms of net flows) in 1980. Reports of commercialbanks pushing loans, with scant attention to the borrowers’ debt-carrying capacity, were submerged under the euphoria that hadtaken hold of the world financial community. The IMF andWorld Bank, among others, commended the commercial banksfor ably recycling the oil money.

Mexico’s inability to meet its large short-term liabilities andthe ensuing crisis was viewed as one of the Mexican government’s

Private Capital Flows and Financial Crises 59

own making since it had tried to defend the peso when it wasindefensible. The country’s foreign exchange reserves werelimited and the government had resorted to heavy short-termforeign borrowing to offset the massive capital flight (estimatesplace it at US$ 20-30 billion during 1981-82), which occurred inanticipation of the peso devaluation.20 Bad timing of themanagement of the exchange rate adjustment was given a centralplace in the explanation of the Mexican crisis by the internationalfinancial institutions and other observers, as has been frequentlyasserted in relation to crises elsewhere. Once the internationalbanks, who were the main lenders to Mexico, became nervous,they not only stopped extending credit to Mexico but alsowithheld credit from other Latin American countries, regardlessof their macroeconomic situation (the “contagion” effect).

The Latin American crisis was more difficult to resolvethan the Pertamina episode because of both the sums and thenumber of lenders and borrowers involved. Nevertheless, afteryears of negotiations between the banks and the debtors, theultimate outcome basically was that the Northern commercialbanks, in exchange for debt restructuring, succeeded in obtainingassurances on having their loans repaid. While these negotiationswere going on, the countries had to undertake severe belt-tightening in order to meet their debt service obligations. Theremedies imposed by the IMF and World Bank did nothing tostop the sharp declines in output in most of the countriesconcerned; in fact, by insisting on steep cuts in publicexpenditures, they almost certainly contributed to the decline.This could only aggravate the debt burden. It took almost adecade before economic growth in the region could resume, thentoo at a pace significantly slower than that achieved during the1960s and 1970s, when at least some Latin American countrieshad started to catch up with the industrial world.

20 Capital account convertibility enabled wealthy Mexican citizens toconvert their pesos into foreign currency in order to acquire foreign --mainly dollar-based -- assets. This capital flight abroad could only befinanced to the extent that the Mexican government was able to continueto engage in short-term foreign borrowing.


The support of the IMF and the World Bank (and othermultilateral financial institutions) came with “conditionality”,which sought a major overhaul of economic policy andinstitutions in the indebted countries. The focus of policyreforms to turn the bankrupt economies of Latin America (andother regions) into commercially viable ones was a universaldiminution of the state’s role, trade liberalization, deregulation,privatization, and stringent fiscal and monetary policy. Thejustification given for the new policy orientation was the allegedfailure of the old strategy of import-substitution and stateintervention, but the diagnosis seemed more to reflect theprevailing orthodoxy during the Thatcher-Reagan era of the1980s. However, the policy shift in favour of the market,whatever its merits, sowed the seeds for the next major financialcrisis -- that of December 1994 -- that again broke in Mexico.

Mexico had come to be considered by some observers asexemplary in economic management, for it had, in response to the1980s crisis, gone further than any other Latin American countryin embracing the new ideology. It had balanced its budget,brought inflation down, drastically liberalized its commercialpolicy, joined the GATT, privatized many state enterprises, andopened up its capital market to foreign investors. Despite all this,private fixed investment and overall economic growth hadremained weak. The economic collapse of the 1980s resulted in asharp decline in the market value of Mexico’s physical productiveassets, which was reflected in the share prices quoted on the stockexchange. With the removal of foreign exchange controls oncapital movements and the deregulation of the capital market,foreign investors and Mexicans with overseas accounts seized theopportunity to profit from the greatly undervalued capital stock.

Private capital inflows (FDI and portfolio investment) intothe country averaging US$ 15 billion during the period 1992-94were said to be the reward for Mexico’s good policies. But itbecame soon clear that the level of inflows could not realisticallybe maintained for long. Rapid trade liberalization along with thelarge capital inflows resulted in a steep rise in imports, causing thetrade deficit to rise to about 7 per cent of GDP during the early1990s. Private investment in new physical capacity, however,


remained hesitant, and the trade deficit reflected largely anincrease in consumer goods imports. In other words, foreigninflows, largely in the form of portfolio investment, did nothing toraise fixed investment. Instead, they caused a stock market boomand a rise in private consumption. Once it became apparent, inlate December 1994, that the macroeconomic situation was notviable, there was a massive run on the peso, which triggered acrisis.

The overvalued peso was again blamed by the financialcommunity and many professional economists. But the realitywas far more complex. It was evident, several years earlier, thatsooner or later the stock market would cease to attract foreigninvestors and Mexico’s trade deficits would have to be reduced tomore manageable levels. What the government should do to bringthis about was a subject of much discussion and speculation inpolicy-making circles within Mexico and outside. The governmentfaced a hard choice on how it could bring the macroeconomicsituation under control without creating a panic.

The Mexican government could have taken basically one ormore of the following actions: devalued the peso, deflated theeconomy, or re-imposed trade barriers. There was yet anotheroption that might have been considered -- the imposition ofcontrols on capital movements. But it was both too late (becausethe issue was one of adjusting to lower capital inflows) and totallyagainst the prevailing belief in free capital mobility and unfetteredcapital markets.

The Mexican government could not go back on tradeliberalization because of its commitments to GATT and pursuitof NAFTA negotiations. Deflation was a poor remedy becauseinflation was relatively low and output growth had been modest.In the light of the impending presidential elections, this avenuewas also politically very unattractive. The government chose notto devalue the peso mainly because it was worried about re-igniting inflation, without having any certainty of reducing thetrade deficit. An early devaluation could conceivably have inducedan even higher volume of capital inflow. In the event, the


government chose to do nothing, probably in the hope that theproblem would somehow disappear on its own.

Once again the IMF, along with the financial backing of theUnited States, came to the rescue by providing large-scalefinancing (some US$ 50 billion, or roughly the amount Mexicoowed to private foreign bond-holders and other investors) to stopthe currency’s collapse. The crisis was brought under controlrelatively quickly and its impact on the other Latin Americaneconomies, though considerable, was more or less contained. Thecountry again paid a heavy price in lost output, falling wages, anda rise in unemployment. Questions, however, started to be raisedon the IMF’s role in the crisis, not so much from the viewpoint ofits prescribed remedies, but on grounds of the “moral hazard”created by the bailing out of foreign lenders. It was feared that,by not making the foreign investors bear the cost of theirmisadventure, the IMF support encouraged their continuingirresponsibility.

B. The East Asian crisis

The East Asian miracle economies became a major attraction forforeign investors during the 1990s. These economies were wellmanaged, had been growing rapidly, their exports wereinternationally competitive, governments were well disposed toforeign investment, and labour was hardworking, well-trained,and motivated. With stock markets expanding, and privatizationof several public enterprises underway, these were ideal emergingmarkets, promising high returns with relatively low perceived risk.The East Asia region as a whole received almost US$ 500 billion(or a little under 40 per cent of the world total) in net capitalinflows during the five-year period 1993-97. About 60 per centof the inflows consisted of FDI and portfolio investment.

The macroeconomic fundamentals of the East Asianeconomies remained on the whole strong right up to the outbreakof the crisis with the devaluation of the Thai baht. For instance,Indonesia, Korea, Malaysia and Thailand had all enjoyed strong


economic growth for many years and their inflation rates were insingle figures. Their domestic savings rates were among thehighest in the world and their levels of investment were very high.Government fiscal balances were either in surplus or showed onlysmall sustainable deficits. All had the ability to service their debtsin the long term.

GDP growth for Indonesia, Malaysia, and Thailand duringthe 1990s averaged at rates higher than those prevailing in theprevious two decades, though in Korea’s case it was a little lower,but still an impressive 7.5 per cent a year. But the other side ofthe large foreign capital inflows was that each of these countriesstarted to run high current account deficits, though at least in thecase of Korea and Indonesia not quite as large as those witnessedin the earlier Latin American crises. With government accountsmore or less in balance, it was the private sector in each of thesecountries that was rapidly accumulating foreign liabilities.

A number of observers have explained the East Asian crisisin terms of misguided investments in real estate, “cronycapitalism” in which governments and private enterprise engagein reciprocal favours, lack of prudential regulation of domesticfinancial institutions, and various other failures.

While each of these explanations had some factual basis,and cannot be dismissed offhand, they give rise to awkwardquestions. Why were these weaknesses not evident to foreigninvestors before it was too late? Or, if they were evident, whywere they not taken into account in their investment decisions?

The close government/business relationship in East Asia,though widely denoted in the press as corruption, had beenapplauded as an example of successful partnership in economicmanagement, which other countries needed to follow. The softprudential regulation and other weaknesses of the financial sectorwere also well-known, and noted by the World Bank in itscountry reports. But granting that these weaknesses alreadyexisted points only to one conclusion: that the opening up of thecapital account and financial deregulation in the East Asianeconomies was premature and should have been undertaken only


after the correction of the weaknesses that are now held toexplain the crisis. It was the rapid opening up of the capitalaccounts and deregulation of the financial sectors that attractedthe massive capital inflow (especially short-term loans) into theregion’s economies, and should be considered as the major causeof the crisis.

In any case, the purveyors of foreign capital once againdemonstrated their inability, or unwillingness, to see the financialstrains and avoid another financial collapse. Perhaps the problemof “moral hazard”, which had been noted in the context of theMexico crisis, is real: private lenders from the North shared theexpectation -- born out of past experience -- that they would be“bailed out” by governments or international public agencies intime of trouble.

The IMF responded with policy prescriptions that it hadapplied in other countries with altogether different conditions andcircumstances. It also insisted on a broad range of socio-politicalinstitutional measures, to deal with labour market reforms,corporate governance, government/business relations andcorruption, among other things, and to further open up to foreigninvestors. In prescribing a regime of sharp demand compression,accompanied by steep increases in interest rates, the IMF mayhave deepened instead of alleviating the East Asian crisis. In theevent, the steep rise in interest rates failed to prevent the currencycollapse, but the two together raised the burden of external andinternal debt to unsustainable levels, resulting in the technicalbankruptcy of major segments of the domestic private sector.Industrial disruption has been widespread, with decliningdomestic output and sharply rising unemployment.

The resolution of a serious financial crisis is bound toinflict the pain of adjustment on an economy. But a situationwhere adjustment reduces, rather than enhances, the economy’sability to cope with the crisis can hardly be regarded as a remedy.The IMF has therefore come under considerable criticism, andnot only from the quarters generally hostile to the institution.Recently, certain well-known mainstream economists, includingsome in the World Bank, have questioned the soundness of the


IMF’s diagnosis and the standard remedies prescribed for thecountries in deep trouble. These comments are a welcomeaddition to the more longstanding critiques of the “Washingtonconsensus”, which so far has been unshakeable.21

C. Crises and private capital flows

The frequency of financial crises over the last three decadespoints to some serious weaknesses in the functioning of theinternational financial system that governs international capitalmovements. While official foreign debt has posed, and continuesto pose, serious servicing problems for a number of developingcountries, it has always been the private flows that have ended ina financial crisis, giving rise to an acute economic crisis. Eachcrisis has been extensively analysed, and lessons have been drawn,but this has not prevented the next crisis from happening. Privateforeign lenders have repeatedly shown themselves unable orunwilling to take adequate account of the borrower’s financialcapability and foresee the consequences of their actions. Yet, theinformation on external debt is readily available and the debtservice liability is fairly accurately known in advance.

There are several factors explaining why private lenders orportfolio investors fail to anticipate the difficulties that theiractions create, especially with respect to developing countries.One is the herd-like behaviour of private investors. Investors

21 The “Washington consensus” holds that good economic performancerequires the deregulation and liberalization of trade and finance,macroeconomic stability (based on tight monetary and fiscal policy toachieve low inflation), and getting prices right, all of which entail less“government” and greater reliance on the market, and hence privatizationtoo. Proponents of Washington consensus policies consider that aligningdomestic prices with world prices is the best way for developing countriesto achieve an efficient allocation of resources and fast overall economicgrowth. Hence the emphasis on appropriate exchange rates, the removalof restrictions on exports and imports, and unrestricted capital flows.


converge on countries on the basis of some favourabledevelopment, such as improved growth prospects, a shift ingovernment policy, the opening up of new capital markets, etc.The herd-like behaviour on the part of lenders and portfolioinvestors is particularly common with regard to their investmentsin developing countries, where higher returns are associated withhigher risk. Investors feel a greater sense of security whenmoving and bearing the risk of their investments together. Asagents handling other people’s money, they face an asymmetricsituation. If they do not join the herd, they risk missing agenuinely attractive investment opportunity. But if they join andthe investment turns sour, the mistake would have been made ingood company, and no one would individually be heldresponsible.

The second factor is closely linked to the first. Wheninvestors converge on a specific area, expectations of a highreturn can become self-fulfilling. Investing in an asset whosesupply is relatively fixed in the short run (land, urban property,stocks, works of art, etc.) merely pushes up its price. This cancause a spiral of rising investment and rising asset prices, withexpectations of higher returns being continuously realized. Stockmarket bubbles are quite common.

Finally, over-investment can be caused by informationfailure. Investors know that sooner or later the boom in assetprices will burst, but they cannot know exactly when, as itdepends on others’ actions. In other words, an investor needs toanticipate competitors’ expectations about the market. Given thisdual uncertainty, it becomes difficult for an individual investor tobe the first one to pull out of a booming market. It is usually anoutside event (a political crisis, for example) that pierces thebubble, and causes the withdrawal of investors and fall in assetprices.

An important feature distinguishing the Mexican (1994)and East Asian crises from previous episodes of crisis is themacroeconomic impact of private capital flows. As already notedabove, in the earlier period, the developing countries resorted toforeign borrowing in order to fill the resource gap created either


through inadequate domestic savings or export earnings. Therecent capital inflows, on the other hand, were driven largely bythe prospect of high returns in markets that were being opened upto foreign investors and they exerted a powerful influence on themacroeconomy.

In the first instance, the autonomous inflow of foreigncapital simply leads to an increasing supply of foreign exchange.Unless the country is able to “sterilize” the inflow (not an easything to do), the trade deficit must ultimately rise, because foreignexchange can only be spent on foreign goods and services.Sterilization can happen directly through the appreciation of theexchange rate in the currency market, because of the excesssupply of the foreign currency, or through the build up of foreignexchange reserves that leads to an increase in the money supplyand domestic demand and, ultimately, to accelerated inflation. Inthe latter case, because domestic prices rise faster than foreignprices, there occurs a real appreciation of the exchange rate evenif the nominal rate is not allowed to appreciate. Once theeconomy gets used to the higher trade deficit, which essentiallyimplies a higher level of expenditure, it becomes difficult to adjustto lower levels when the supply of foreign finance declines orreverses its direction.

In short, capital movements create problems for developingcountries in either direction. The inflows put pressure on the localcurrency to appreciate, which erodes the profitability of thetradable sectors (mostly, agriculture and manufacturing), bymaking exports more expensive and thus causing the tradebalance to worsen, which in turn increases the dependency onforeign inflows. The outflows, on the other hand, necessitatedomestic demand cuts, which result in a fall of domestic output.In a highly open economy, the situation can quickly turn into afinancial crisis brought on by the flight of capital, currencydepreciations, and interest rate increases.

In the aftermath of the crisis, there is always a search forpolicy mistakes that caused the crisis. These were relatively easilyfound when the public sectors in developing countries wererunning large deficits and experiencing other problems, a situationthat prevailed in the Latin American countries at the time of the


1980s crisis. The 1994 Mexican crisis was a little moreproblematic since, until the crisis, the government had been givenhigh marks for its economic management by the internationalfinancial community. The poor handling of the peso devaluationwas widely held to be the proximate cause of the crisis, but giventhat the Mexican economy had become highly open, a crisis ofsome magnitude was probably unavoidable.

Explaining the East Asian crisis in terms of governmentfailure has proved to be even more difficult: how does oneexplain that policies that brought about the Asian miracle couldsuddenly turn wrong? Although, with hindsight, it is possible topinpoint policy failures or wrong decisions, policy choices ex anteare not always clear cut.

A conspicuous feature of all previous crises has been thatthe borrowers have been made to bear the brunt of financial andeconomic adjustment. There has not been a single instance ofbankruptcy of private lending institutions in industrial countrieson account of lending to developing countries. The debt-workouts (such as the so-called Brady plan22 for the resolution ofthe Latin American debt problem) have so far focused on financialmechanisms that make “orderly” debt repayment possible, ratherthan on means to return the indebted countries tocreditworthiness through income and export growth. The result isthat, after more than a decade, Latin America remainstraumatized by the consequences of the debt crisis.

There are at present no international bankruptcy resolutionmechanisms, analogous to the ones found in industrial countriesfor domestic debtors, that protect the interests of developingcountry debtors. This further fuels the pessimism regarding the

22 This was a plan that was introduced in the late 1980s which allowed theconsolidation and conversion of the Latin American debt into long-termbonds, backed by the U.S. Treasury and tradable in the capital market.The plan was named after the then U.S. Treasury Secretary. In addition toachieving a reduction in debt levels, the Brady plan may also have achieveda reduction in the interest burden.


time it will take for the East Asian economies to recover from thefinancial and economic crisis.

The IMF and World Bank programmes’ stated goal is to laythe foundations for long-term growth, but the means used mostfrequently to restore economic stability -- demand compression,devaluation, rise in interest rates, and general credit contraction --invariably cause the financial and economic situation to worsenwithout providing any assurance for a recovery in the near future.

There are few countries in Latin America or East andCentral Europe where conditions for satisfactory economicgrowth have been restored. In fact, a situation of decliningoutput and incomes makes the restoration of economic stabilitymuch more difficult. That is why a number of countries in Africaand many economies in transition find themselves entrapped in adownward spiral of economic decline and instability. This pointsto a fundamental problem with the IMF’s standard package ofreforms: recommending expenditure cuts in a deflationarysituation to achieve economic stability is likely to be self-defeating.

D. Conclusion

Three basic policy points emerge from the foregoing discussion ofrecent financial crises in developing countries, namely:

• • The overly rapid opening up by developing countriesof their capital accounts and the deregulation offinancial markets, and the failure to put in placeadequate prudential regulations and monitoringmechanisms, have made developing countries inparticular vulnerable to financial crises.

• • The manner in which recent financial crises have beenmanaged imposes a highly unequal distribution of thecosts and benefits. Financial crisis resolution policiesgenerally work to safeguard the interests of the privateforeign investor and the cost is borne mainly by


developing country taxpayers and the citizenry ingeneral.

• • Furthermore, the economic policies imposed by the

multilateral financial institutions and other Northerncontributors, as a condition for the bail-out fundsextended to crisis countries, frequently add to therecipient’s external debt but have done little toenhance the latter’s capacity to service the debt.

These are crucial issues that need to be raised by the countries ofthe South, as a collectivity, as matters needing urgent attention inthe global policy arena. Developing countries themselves,however, have it within their power to reduce their vulnerabilityto financial crises by individually or collectively adoptingappropriate policies to regulate short term capital flows, drawingon the policy experience of a number of them in this respect.

The concluding section of this document considers theseand other finance issues as they relate to development and drawsconclusions regarding the set of interrelated strategic issues thatshould form the core of a South agenda as developing countriesembark on preparations for the UN conference on financing fordevelopment.

V. TOWARDS A DEVELOPMENT-SUPPORTIVE INTER-NATIONAL FINANCIAL SYSTEM

A. The quest for growth, stability and development

International financial and monetary issues have emerged as thepivotal economic factor in contemporary North-South relations,and a determining element in the national efforts of developingcountries to foster economic and social development. Developingcountry policies and macroeconomic outcomes are very muchinfluenced by the actions and policies of the centres of decision-making and economic power in the North, whether of themultilateral financial institutions, major international banks orinvestment companies, or of the governments of the rich andpowerful nations. The time has long passed when these externalfinancial forces seemed remote or abstract, or only beneficent, asrecent successive financial crises have demonstrated so forcefully.

The foregoing sections which have briefly reviewed anumber of key issues relating to the financing of developmentsuggest the need for urgent action in a number of areas ifdeveloping countries’ development efforts are to be sustained.

The existing international financial system, such as it is,seems far from serving to promote the adequate or appropriatefinancing of development of countries at widely differing levels ofdevelopment. A curious mixture of laissez-faire and interventionistapproaches has been adopted, leaving individual developingcountries to navigate increasingly complex waters as best they canin search of external financing.

While additional types of external financing have becomeavailable, these flows are not available to most developingcountries; nor have they reduced or supplanted the need fortraditional development finance. But for those developing


countries which have received such inflows, they have oftenbrought new problems in their train. Moreover, the continuingfailure to deal with developing country debt and low andfluctuating commodity prices and the associated poor terms oftrade means that the need of many developing countries forexternal financing is that much greater.

The result is that many countries, including the poorest, arelargely deprived of external financing to supplement domesticsavings, while considerably more advanced developing countrieswhich received substantial private flows have been catapulted intofinancial crisis with enormous economic, social and politicalconsequences.

Meanwhile, the “preferred” approaches of the multilateralfinancial institutions to exchange rate policy and internationalcapital flows have created problems for developing and developedcountries alike.

Serious questions are raised, moreover, concerning theconsistency, economic appropriateness and political morality ofthe policies attaching to financial assistance provided by themultilateral financial institutions to developing countries in timesof financial crisis.23

23 Martin Feldstein, chairman of the US Council of Economic Advisorsunder the Reagan administration, has argued that the IMF “should not usethe opportunity to impose other economic changes that, however, helpfulthey may be, are not necessary to deal with the balance of paymentsproblem and are the proper responsibility of the country’s own politicalsystem.” “In deciding whether to insist on any particular reform, the IMFshould ask three questions: Is this reform really needed to restore thecountry’s access to international capital markets? Is this a technical matterthat does not interfere unnecessarily with the proper jurisdiction of asovereign government? If the policies to be changed are also practiced inthe major industrial countries of Europe, would the IMF think itappropriate to force similar changes in those countries if they were subjectto a Fund program? The IMF is justified in requiring a change in a client

Towards a Development-Supportive International Financial System 73

Developing countries are clearly concerned about a systemin which the decisions and policy preferences of the centralfinancial institutions and the powers which control them canimpinge so forcefully on their sovereignty.

It is clear to developing countries that the existinginternational financial system, which governs and regulatesinternational capital flows and world payments arrangements,does not seem to be serving them well in their efforts to grow anddevelop. Moreover, it is doubtful that it is, on the whole, helpfulto the interests of the international community.

The severity of the economic set-back, the massive andprecipitate increase in poverty, and the political and socialdislocation resulting from financial crisis in some of the Asiancountries has caused even some erstwhile adherents to the“Washington consensus” to seriously question both theappropriateness of key tenets of current orthodoxy concerningfree capital flows, as well as key elements of the IMF/developedcountry policy prescriptions.

Thus, systemic issues are now being raised in addition toquestions concerning the inequities inherent in the presentinternational financial system. In fact, there is now a widelyshared belief that the system is seriously malfunctioning, asevident from the failure of existing institutional mechanisms andmacroeconomic remedies in containing the ongoing financialcrisis.

There are many reasons, therefore, for arguing that it isnow time for efforts to be made at the international level toconsider financing development in an integrated manner. Whileaction is required to improve external financing for developingcountries and measures are needed which could lessen the need

country’s national policy only if the answer to all three questions is yes.”Martin Feldstein, “Refocusing the IMF”, Foreign Affairs, March/April 1998.


for such flows, action is also required to alter the internationalpolicy and institutional framework within which internationalflows for financing development take place.

From the developing country perspective, the issues thatmost warrant immediate attention are the following:

• Concessional official flows to developing countries havedeclined over the years, while the list of recipients ofassistance has expanded to include economies-in-transition.ODA has been channeled to many and varied purposes otherthan capital transfers for long term development, with a largepart of what is counted as ODA flows never leaving thedonor countries. If these additional uses are subtracted fromthe total ODA flows, the South is in fact receiving today onlyaround 0.12 per cent rather than 0.7 per cent of the North’sGNP -- the stipulated ODA target.

• A number of economies, especially the poorest, face a seriousburden of bilateral and multilateral official debt, which isbeing allowed by the donors to fester like an old wound,sapping debtor countries of capital vital for development, andsubjecting them to continuing conditionalities andinterference in their national policy making and priorities.Financial crisis has recently aggravated the economic situationof a number of major debtor countries, such that anothermajor debt crisis looms on the horizon.

• Many developing countries have suffered what is in effect acontinuing and substantial reverse transfer of resources dueto the decline in commodity prices and adverse terms oftrade. This has set back their development and added to theirproblems of indebtedness.

• As far as private flows are concerned, the great majority ofdeveloping countries have been bypassed by the recent surgeof such capital flows. But it is debatable whether they are


necessarily worse off than some of those that have beenrecipients of private flows but have ended up with financialcollapse and economic disruption, from which recovery islikely to be slow.

• The current system is strongly biased in favour of the

suppliers of capital in the North, who have managed to reapthe profits but, thanks to the structures and arrangements inforce, have avoided sharing the losses from their rashventures in the South.

• The principal guardian of the international financial system --

the International Monetary Fund -- is an international publicorganization, as also are the international developmentfinance institutions (the World Bank, IDA and the regionaldevelopment banks). But their accountability, for all practicalpurposes, is confined to their biggest shareholders. Thedeveloping world has little voice and influence in theirdecision-making procedures, operations, conduct or policies,including in the crucial area of loan conditionality.

The system can be changed, however. It is the product of humanthought and action, and has been shaped largely by thosecountries and interests with greatest power and influence.Notwithstanding the path-dependency of the evolutionaryprocess, there is nothing immutable about the system. The matteris one of political choice and the South now needs to press for itsviews and interests to be taken fully into account.

The planned UN international conference on financing fordevelopment, to be held not later than the year 2001, offers anopportunity when the world community can come together andcontribute to the design of new international policies andinstitutions -- the so-called new financial “architecture”.

The financing of development and the question of theinternational financial architecture cannot, however, simply be


viewed as narrow technical matters. The present system must beredesigned so that it is better equipped and geared to achieve thegoals of raising general living standards, sustaining economicstability, and promoting full employment in both developing andindustrial countries. It must respond to the developmentobjectives and needs of developing countries, many of which havebeen adopted by the international community and incorporatedinto the work of the United Nations system.

This means that the international community must riseabove the mere accommodation of immediate national interests(usually only those of the most powerful states), if it is to dealadequately with major overarching matters affecting the future ofthe whole of humanity. Greed and selfishness -- the unfortunateside-effects, if not the driving force -- of the ruling economicorthodoxy will need to be tempered.

The deeply entrenched interests and the habit of the“haves” to ignore the “have-nots” are likely to be strong andprogress is likely to be slow and difficult. This should notdiscourage the countries of the South from making a determinedeffort and being well prepared to engage in what may beprotracted discussions and negotiations.

The architects of the original Bretton Woods system weredriven by the logic of constructing an international economicsystem more capable than the preceding one of achievinginternational economic stability and welfare and was focusedprimarily, and perhaps inevitably, on the then developedcountries. Such vision is needed as much as ever to reshape theworld economy, which is currently characterized by adysfunctional economic system which generates gross injusticeand inequity both nationally and internationally, such that its mainfocus would now be on helping less developed areas.

A high-level United Nations conference on financing fordevelopment will be a particularly opportune forum in which toraise and discuss basic questions of principle and strategic options, as the


basis for designing an international financial system adequate tomeeting the major global economic and development challengesof the 21st century.

B. Strategic areas for action

Six key matters emerge from the analysis in this document asstrategic areas where action is needed to contribute to the creationof a system which is efficient, fair and responsive to developmentneeds in the South and which makes a major contribution toimproved international co-operation, and thus to world peace andprosperity. The six areas are as follows.

• • Development assistance and concessional finance. Developmentassistance and concessional finance continue to be of criticalimportance for buttressing the development of large areas ofthe South, and in supporting development-related objectivesor activities which are not attractive to private capital or themarket. Indeed, massive transfers of resources to thedeveloping world are needed to promote sustainabledevelopment, eliminate the causes of poverty, and in generalequip the four-fifths of humankind living in the South toparticipate in and benefit from the global economy -- in otherwords overcome the development gap. Developmentassistance and concessional finance must therefore be placedonce again on the global agenda as a top priority issue. Butthe approach must be recast to reflect lessons learned, currentrealities and new global challenges. Development assistanceand concessional finance for development should become anentitlement to help developing countries attain a set ofinternationally agreed development goals and standards. Itsprovision should become an obligation of the internationalcommunity, and in particular of the rich industrial countriesof the North.


• • External debt. Servicing external debt continues to drainmassive resources from developing countries, depriving themof resources which otherwise could be used for developmentpurposes. The external debt issue is one of the mostdisturbing and inequitable features of contemporary North-South relations. Resolving the external debt overhang calls fora global political response based on the need to promotedevelopment. Moreover, an agreement establishing the rightsof debtor developing countries is needed as an integral part ofa comprehensive solution to resolve developing countryindebtedness. Greater attention also needs to be paid topromoting a more favourable external environment fordeveloping countries, such that debt and debt servicing donot assume critical proportions.

• • Commodity prices and financing development. The problem of

commodity prices continues to thwart the developmentefforts of many developing countries, in particular the poorestand weakest. Past international policy responses have beenwholly inadequate. It is now time for the internationalcommunity to give serious attention once again to devisingmechanisms which would raise commodity prices from theirpersistently depressed levels and introduce better medium-term balance into commodity markets, while encouragingdiversification away from the production of commodities inpersistent surplus.

• Governing capital flows, reducing the risk of crisis, and crisis

management. Financial crises have become a frequent andchronic occurrence in the international financial system,ravaging countries and regions and affecting the worldeconomy. To try to reduce the likelihood of crises occurring,it is now time to work towards internationally agreed rules toregulate international financial markets and to permit nationalpolicies to control short term capital flows. Similarly, thereneeds to be a reassessment of the policies to be adopted tomanage financial crises should they nevertheless occur. While


this is clearly a highly complex matter, such an effort seemsindispensable.

• A normative and legal framework for foreign investors. Foreign

investors have become key actors in the global economy.Considerable effort has been devoted both in the North andin the South to facilitating their activities and acquiescing totheir policy demands. The extensive influence of foreigninvestors, particularly of large multinationals, in developingcountries and in global development suggest that it is nowtime to introduce a degree of balance and to spell outinvestors’ duties and obligations. Thus, attention needs to bedevoted at the international level to developing a normativeand legal framework to regulate the behaviour of foreigninvestors.

• Democratizing the governance of the international financial system.

Measures are urgently required to end the marginalization ofdeveloping countries from decision-taking and policy-makingin the multilateral financial institutions and to make the latteraccountable and responsive to the entire community ofnations. Democratization is a maxim very much in vogue.The international financial institutions have not, however,espoused such a belief when it comes to their owngovernance and continue to be governed by a powerful few.Hence, the rules and functioning of the international financialsystem reflect the interests and preferences of those whodominate the institutions. It is therefore crucially necessary todevise means to make the multilateral financial institutionsgenuinely open to participation by, and fully accountable to,the entire global constituency.

These six strategic areas for action are outlined in somewhatgreater detail below.


Development assistance and concessional finance

The large majority of developing countries, especially those inAfrica, cannot -- indeed, must not -- rely too heavily on privatecapital to finance development. Currently, they are just too poorand weak to afford the commercial terms of private finance or tocope with its moods and swings. There is a consensus among thedevelopment community that a satisfactory level of ODA iscrucial especially for the least developed countries if they are toembark on a path of sustained, more rapid economic growth.Without a considerable development of their productive structureand concomitant increase in their capacity to achieve sustainablehuman development, it will be difficult for poor African countriesto achieve the much-desired end to “aid dependency”.

Concessional finance is also of vital importance to a widerrange of developing countries, since many of their developmentobjectives are unlikely to be served by private capital and themarket.

Although the prospects of a significant increase inconcessional finance do not appear to be bright, the South,collectively, has nevertheless to continue to press for thefulfilment of donors’ earlier commitments on ODA, which, asimportantly, will require some considerable redefinition andupgrading. Solidarity and humanitarian concerns remain strong ina few countries and among some groups in the North, but thesefactors have not provided sufficient inducement for raisingadequate concessional finance.

There is a need now for the South to convince the Norththat concessional assistance is “not just good politics, but alsogood economics”. It is widely recognized that any help to theeconomies of the South to grow helps the North through theexpansion of markets for its products. However, it is also thecase that countries do not share equally in the gains frominternational trade and the process of globalization. Generallyspeaking, globalization and opening up of developing country


markets -- which the industrial countries consider of vitalimportance to them -- tend to benefit the stronger, higher-income economies more than the weaker, low-income economies.One indication of this is the behaviour of the terms of tradebetween the developing and industrial countries.

• • Regular income transfers from the North to the South. A case cantherefore be made for instituting, as part of the globalizationprocess, a system of regular income transfers from richercountries to poorer countries on the basis of the benefits theformer derive from globalization and closer integration ofeconomies. Such transfers are quite normal within federationsor customs unions. There are, for example, within theEuropean Union, inter-country income transfers to benefitnational regions whose income falls below a specifiedpercentage of the EU average gross domestic product. Othersuch transfers relate among other things to the level ofunemployment in different national regions.

• A global balance sheet of resource flows. In order to make progressin establishing such global resource transfers, a seriousattempt will have to be made to obtain a fuller andcomprehensive picture of resource flows between the Northand the South. The published data fail to record the flightcapital, foreign bank deposits of developing country residents(often consisting of payments for illegitimate practices) and,of course, the implicit income transfers on account of changesin the terms of trade. Systematic collation and presentation ofdata is also required on profit remittances on foreign directand portfolio investment in the South. There is also a needfor a more comprehensive assessment of the distribution ofthe benefits from measures to liberalize trade and capitalmovements. This and other information needs to be broughttogether to bring greater clarity to the issues and alsopresented in a form easily understood by the ordinary person.The exercise, both economic and political in intent, is longoverdue. It will prove useful in informing public opinion inthe North, which tends to accept the frequently repeated


assertion, however misguided, that developing countries liveat the expense of the taxpayers in the industrial countries. Itwould also help the South argue its case.

• Quantifying the needs for development assistance and concessional flows.It should be recalled that, in the early stages of the UN debateon multilateral development assistance, the trade and savingsgaps were estimated in order to provide a benchmarkregarding the broad needs for development assistance. Morerecently, at the UNCED conference in Rio, an attempt wasmade to estimate the additional expenditures the South wouldincur were developing countries to put into practice thevarious measures recommended in Agenda 21. Calculatingthe broad magnitude of capital needed for achieving growthtargets in developing countries and for specific developmentobjectives (for example, for meeting given education andhealth goals in Africa), would help to provide an indication ofhow concessional financial transfers (bilateral andmultilateral) from the international community measure up toa broad estimate of the need for such flows. Such figures,even if rough and ready, provide a benchmark for one way ofperceiving or measuring "needs”, against which to assess thelevels of ODA provided.

• • Democratizing the process. The case needs to be made fortransforming the process governing concessional anddevelopment assistance flows into a genuinely multilateral,democratic and participatory partnership. For too long now,there has been a lopsided donor-recipient relationship, withdonors exercising choices and imposing conditionalities whichgenerally reflect their own political and other objectives, andoften taking little account of the needs and situation of therecipients. Development assistance and concessional financehas been generally perceived by donors as a voluntary andmagnanimous gesture on their part and a matter to be dealtwith only among donors, namely in the DevelopmentAssistance Committee (DAC) of the OECD. The beneficiary


countries have been passive recipients. A sense of collectivepurpose will only be built through measures and institutionalmechanisms to involve the beneficiaries and to achievegreater transparency. This will require, among other things,revitalizing the United Nations in this area, giving it thecapacity to pursue more vigorously its mandate regardingdevelopment finance, a field in which in the past it exercized avery important policy role, including that of influencing thebroad direction of some of the work of the specializedBretton Woods institutions.

• • New mechanisms to generate revenues. There still remains thequestion of finding adequate sources of concessional finance.Given the often parochial politics of the national budgetprocess in industrial countries, there is likely to be continuedresistance to agreeing increases in development assistancetransfers from countries of the North to the South. Attentiontherefore needs to be devoted to devising additional revenue-raising measures to fund concessional financing and involvingnew relationships based on new foundations. Flows andtransfers derived from the globalizing world economy, andbelonging to the international community as a whole,therefore also merit special attention. These should not,however, be considered as a substitute for nationalcontributions of concessional financing from the developedcountries of the North.

There seems to be some promise in developing mechanismsthat would help the whole world community in certainimportant global policy areas while at the same timegenerating revenue on an automatic basis for financingdevelopment. These mechanisms include the proposal for acarbon tax to regulate the emission of greenhouse gases, anagreement on the exploitation of the global commons, andthe idea of introducing some version of the so-called Tobintax on short-term, speculative capital movements which, inaddition to generating income, has the advantage of


discouraging destabilizing short-term capital movements.There have been several other ideas on obligatory,international levies to generate revenue, which need also to beconsidered.

All members of the international community are to a greateror lesser extent incorporated in a globalizing world economy.New financial mechanisms involving them all in a relationshipof rights and obligations, geared to overcoming the mostpressing development objectives, would be a key positivefeature of a new international financial system.

A just and development-oriented system of external debtresolution

The programme of relief for the Heavily Indebted Poor Countries(HIPC), which was agreed at the September 1996 annual meetingof the IMF and the World Bank following widespread pressuresfor measures to reduce the crippling debt burdens of 40 or moreof the poorest developing countries, has not lived up toexpectations. For the first time, the Bretton Woods institutionsand other multilateral financial institutions agreed to provide reliefon the debts owed to them. In parallel, the Paris Club of bilateralcreditors agreed to increase the rate of debt reduction on debtsowed to them. Thus, the HIPC initiative brings together allofficial creditors to deal with the matter of debt in a “coordinatedand concerted way”.

The aim of this initiative is to reduce the qualifying poorcountries’ debt to a level considered to be within their capacity torepay on a continuing basis. This “sustainable” level of debtservice is defined as one where the debt stock to exports ratio isin the range of 200-250 per cent. A fiscal ceiling has also been setto limit the pressures caused by debt on the budget.


However, to qualify for debt relief, the country must notonly be poor and highly indebted, but must fulfil stringent policyperformance conditions by implementing two successive IMFpolicy programmes so that debt relief in not given without priorevidence of “true adjustment”. Tackling the wide range of factorsdeemed by the multilateral financial institutions to limit thegrowth performance of the HIPC countries may take up to sixyears. These impediments include poor infrastructure, a lack ofeffective policy-making institutions, and problems of governance.Only when these have been satisfactorily dealt with, and privatesector led growth has been stimulated, are HIPC countriesdeemed to be in a position to use effectively the additionalresources made available through debt relief. Yet, as they alreadystruggle under the heavy weight of the debt, it is difficult if notimpossible for poor indebted countries to demonstratesatisfactory policy performance over a lengthy period of time.

Progress in implementing this initiative could hardly havebeen slower. The G7 creditor countries have been reluctant tocontribute to the Trust Fund established by the World Bank tofacilitate multilateral debt reduction under this initiative, and theIMF itself has been reluctant to contribute to the initiative.Moreover, the Paris Club creditors have different goals andexpectations, and disagree on the respective shares each shouldpay for debt relief. In addition, the proposed minimum debt reliefof 80 per cent only applies to bilateral (Paris Club) debt up to adefined cut-off date, which reduces significantly the value of thepotential debt relief and some creditor countries are refusing tocountenance relief on some classes of debt. The multilateralbodies’ own contribution to debt reduction is contingent onaction by the bilateral creditors.

Given the extremely onerous conditions countries mustsatisfy to qualify and the dilatory approach adopted by creditors,few indebted countries have reached the point where debt reliefhas been agreed. Indeed, of the 21 highly indebted countriesconsidered by the creditors themselves as requiring urgentattention, only five countries -- Burkina Faso, Mozambique,


Uganda, Bolivia, Guyana -- qualify to receive debt relief by theyear 2000, and possibly also Mali.24

Donor delay in providing debt relief to the poorest ofcountries contrasts starkly with the relative speed with which largefinancial rescue packages have been made available recently formajor developing countries in financial and economic crisis, andcompares very poorly with the substantial debt write-offs in thecase of Poland and Egypt earlier in the decade.

The performance of the HIPC initiative to date suggeststhat it is little more than a device to ensure that developing debtorcountries pay at least some of their debt arrears. No account istaken in the calculations of what resources the countries need toraise the rate of growth and living standards. Countries granteddebt relief on a basis which considers a debt burden of, say, 250per cent of exports as sustainable, will find it extremely difficult toembark on a path of sustained economic growth. For it could stillmean that around 20 per cent (depending on the repayment termsagreed upon) of a country’s export earnings will be dedicated toservicing the debt. The case of Mozambique, which wasapparently given all the debt reduction possible under the scheme,indicates that the actual reduction in annual debt servicepayments (from US$ 113 to 100 million) falls far short of the levelnecessary to make a real difference in economic prospects, andindeed can be considered a mere token.

Recently, under mounting international pressure the WorldBank itself expressed the need for a “fundamental review ofHIPC” which should be taken as an opportunity to press, amongother things, for a reassessment of the structure and content ofthe current framework for debt relief, for improvements in thedebt sustainability analysis and criteria and in the fiscal indicators,and for greater flexibility in the HIPC initiative. However, ifgrowth and development are the objective, there is a strong case 24 The development agencies and other NGO and community groupswhich constitute a worldwide debt coalition suggest that at least 50 poorand indebted countries ought to receive debt relief under this initiative bythe year 2000.


for arguing that for a good number of poor developing countriesthe goal must be total debt forgiveness. And this must be donewithout insistence on unrealistic conditionality. The cost ofmeeting this goal is not prohibitive.

Apart from the heavily indebted poor countries, there are anumber of developing countries with high levels of debt and highdebt servicing ratios.25 In many cases the prospects of their beingable to pay off their debt within a reasonable period seem remote.The debt thus threatens to exact a heavy toll on the population interms of development foregone. In the case of the Asian crisiscountries, the policy approaches attached to the emergencyfinancing provided to these economies to help cope with thefinancial crisis has generally tended to aggravate the situation bydiminishing the prospects for growth and reducing their futuredebt servicing capacity.26 There is a risk that their debt burdenwill reach unsustainable levels. Prompt action by the internationalcommunity is needed to achieve a reduction in the debt of thesemajor debtor countries, before the situation develops into a newdebt crisis.

The resolution of financial and debt crises in which privatedebt is a substantial component raises important economic andpolitical issues. Markets left to themselves are unlikely to achievea means of dealing with the debt in a way that limits the economicand social damage or restores economic confidence such thateconomic activity is quickly resumed.

25 These major debtors include Argentina, Brazil, India, Indonesia, Mexicoand Thailand. In some cases a considerable proportion of the debt isprivate short term debt.26 In East Asia, the currency depreciation has made it impossible for banksand firms to meet payments due on loans taken out in foreign currency.The remedies imposed by the IMF in exchange for rescue package loans tothe governments of the countries in crisis have added to the pressures,pushing companies and banks to virtual bankruptcy. What was initially aliquidity crisis soon became a solvency crisis, with highly adverse economicramifications for the economy as a whole.


Nevertheless, there are a number of drawbacks to the sortof intervention in which the government, in what is tantamount toa bailout of private lenders, takes over the private sector’s debtservicing obligations, possibly with financial backing from themultilateral financial institutions. The debt burden is therebytransferred onto the public sector and the general public, whileprivate foreign lenders who engaged in rash lending bear little ornone of the cost. Furthermore, this approach does nothing todiscourage future irresponsible lending.

Thus, the issue of bankruptcy resolution is central to thereform of the international financial system and there is need for afundamental rethinking on “debt workouts” and “debtor rights”,whether the crisis is one of official or private debt.

Other aspects of the matter also require attention. Debtcrises are hard to resolve if the debtors’ ability to meet theirobligations is compromised. The countries in the South, whetherin Latin America and Africa or more recently in East Asia, havehad to deal with their debt crises from a grossly weakenedeconomic and financial position resulting from declining nationaloutput, steeply rising interest rates, and collapsing nationalcurrencies. Within individual industrial countries, there areelaborate laws governing bankruptcy resolution, which ensure thatthe debtors’ earning capacity, to the extent possible, is notcompromised in working out a debt settlement. Thus, apartfrom creating an institutional mechanism of internationalbankruptcy resolution, the policy conditionalities imposed by theinternational financial institutions need to be properly assessed toensure that they enhance rather than reduce developing countries’development capacity, including that of meeting their debtobligations.

International commodity policy

The future trend in commodity prices will depend heavily, on thedemand side, on the rate of economic growth in the mainindustrial countries, as modified by changes in the “intensity of


use” of primary commodities, and demand expansion forimported commodities in industrializing developing economies.On the supply side the most important factor affecting futurecommodity prices will be the extent to which the recent expansionrate of commodity exports from developing countries will bemaintained.

The situation does not augur well for commodity pricesand commodity exporters. The already low forecasts for the trendrate of growth over the 1990s and early into the next century(significantly below 3 per cent) have had to be adjusteddownwards as a result of the pervasive impact of the Asianfinancial and economic crisis. Moreover, it seems probable thatthe decline in the intensity of use of primary commodities willcontinue, partly as a result of the adoption of new technologiesnow being developed.

The import of non-fuel commodities by the NICs of EastAsia had been growing rapidly prior to the East Asian crisis,accounting for 15 per cent of the increment in the value of worldnon-fuel imports. However, the precipitate decline in growthrates in East Asian countries is having a negative impact on theprices of certain primary commodities and the problem willpersist until their growth rates undergo recovery.

On the supply side, the extent of future expansion is likelyto depend among other things on the degree of pressure exertedon commodity-exporting countries to expand their exports inorder to restructure their economies and to meet their debtservice obligations. An international agreement to achieve aconsiderable reduction in debt levels and debt cancellation for thepoorest countries would significantly reduce the pressure ondeveloping countries to expand their commodity exports for solong as real commodity prices remain at historically depressedlevels.


Under present circumstances, therefore, the probability isthat the underlying trend of depressed levels of commodity priceswill continue at least well into the first decade of the 21st century.Thus, it must be assumed that, in the absence of remedial action,commodity prices will continue to have an adverse impact on theeconomies of commodity-dependent countries. There are manysuch countries and many of them are among the poorest.

This situation is inefficient and inequitable. The debtburden of most developing countries is high in relation to theirexport incomes, resulting in continuing pressure to expandexports for the purpose of fulfilling their foreign debt serviceobligations. Commodity export supply therefore tends to react tochanges in the debt situation rather than to changes in worldcommodity prices, which means that a “low-income trap” iscreated for many developing countries: depressed export pricesare a major element in the rise in debt, while the higher debtrequires an increased supply of commodities to be exported toraise foreign currency needed to service the debt, a process whichfurther intensifies the depressive forces on world commoditymarkets.

At the same time, there is a huge misallocation of resourcesinvolved in subsidizing high-cost agricultural production in theOECD countries, rather than importing competitive agriculturalproducts from low-cost producers, whether developed ordeveloping.

Developing country commodity producers therefore bear adisproportionately high share of the real costs of adjustment tochanges in world supply and demand of commodities.

Leaving international commodity markets to free marketforces cannot be expected to deal with the underlying problem ofthe downward trend in real prices of commodities exported bydeveloping countries. Moreover, the free play of market forces islikely to exaggerate the scarcity/glut cycle characteristic of many


commodity markets, which underlies the swings in commodityprices.

Past efforts to deal with these problems throughinternational action have not been effective and by the 1990sthere was no effective market stabilizing mechanism in place.The UNCTAD Integrated Programme for Commodities (IPC),approved in 1976, which differed from the earlier commodity-by-commodity agreements, was beset by a number of difficulties,including the lack of enthusiasm for such mechanisms.Furthermore, both the IMF and the European Communityschemes have failed to provide more than very marginalcompensation. It is therefore urgent to search for an effectiveinternational strategy for strengthening the commodity sector ofdeveloping countries.

An alternative approach advocated in recent years by theWorld Bank and supported by the governments of a number ofdeveloped countries involves the management of commodityprice risks through commodity-linked financial instruments. Theuse of forward contracts and other commodity-linked financialinstruments can substantially reduce the commercial risk ofcertain individual commodity exporters, particularly those whoare large and have expert knowledge and finance available. Butthere are clearly limitations to the widespread use of suchinstruments in developing countries for many years to come.Moreover, although the use of financial instruments may reduceindividual commercial risks, it will not by itself reduce priceinstability in the commodity markets.

The usefulness of hedging on the financial markets doesnot, therefore, obviate the need for renewed efforts to establishprice-stabilizing mechanisms of the sort envisaged by theIntegrated Programme for Commodities combined with acompensatory finance scheme. These would need to beaccompanied by measures to resolve the longer term causes ofdepressed levels of prices, namely chronic excess supply,


involving concerted efforts to help diversify the economies ofproducing countries away from commodities.

Regulating international financial markets and controllingcapital flows

It is tragic that the massive private resource flows to developingeconomies which, under certain conditions, have contributed totheir growth and prosperity, also contributed eventually tofinancial turmoil and an associated economic crisis from whichrecovery has always been painful and slow. Not infrequently suchcrises also give rise to widespread social and political turmoil,which tears apart the social fabric. The issue before thedevelopment community is whether the waste and disruptionassociated with private flows can be avoided and the benefits fordevelopment and for host countries maximized.

In thinking about ways to improve the financing ofdevelopment, several points need to be considered. First, a carefulweighing of the terms, conditions, and magnitude of foreigncapital inflows is as important for the more advanced as for theless advanced developing countries. Countries that can betterafford borrowing on commercial terms, or are otherwise attractiveto foreign private investors, still have to confront the problems ofunpredictability and swings in private capital flows, particularlyshort term flows, as well as their often dubious developmentimpact. Private short term flows are driven by expected short-term financial returns, which are not necessarily good indicatorsof the real economic return. A substantial portion of privatecapital in recent years has gone into portfolio investment, that is,the purchase of existing assets (real estate, stocks, etc.). This doesnot necessarily generate an increase in the host country’s


productive capacity, and it can lead to real losses, as well as realgains, to the host country.27

It is always difficult to repay and service foreign loans whenthese are not invested in ways which generate foreign exchangeincome or are used simply for consumption. Experience hasshown that freely functioning markets alone cannot always ensurethat foreign private capital will create productive assets and yieldincome. There is a role here for the government to regulate theinflow of foreign capital and to channel it into areas of nationalpriority.

Experience has also shown that developing countries havebeen too hasty, and international financial institutions tooinsistent, in opening up their capital accounts and deregulatingtheir financial sectors. This increases their vulnerability to theswings in the world’s capital markets and handicaps them in theirpursuit of national development. Thus, for example, managementof the exchange rate is particularly difficult with an open capitalaccount; currency depreciation may be required to keep thetradable sectors competitive and appreciation may be necessary toabsorb the capital inflows.

In the current debate on improving the internationalfinancial system, much attention is focused on the bettermonitoring of capital movements, that is, the IMF must havebetter, more complete, and timely information on all forms ofcapital movements in developing countries. However, bettermonitoring alone, or even weak regulation, may not suffice solong as currency markets remain highly unstable. Speculativecapital movements are intimately tied with perverse exchange rate

27 When stock markets are closed to foreign investors, gains and losses onexisting assets are cancelled out within the country. However, whenforeign investors invest in the stock market, the repatriation of their gainson assets that they did not necessarily help to create can imply a net lossfor the country. It can, of course, work in the opposite direction also --foreign investors’ losses will be a net gain to the country.


movements, and the resolution of one problem is not possiblewithout dealing with the other. Experience has shown that short-term capital movements tend to feed on currency movements: themore a currency appreciates the more it is sought by short-terminvestors, and vice-versa.

The large swings in capital movements can be directlyrelated to the deregulation of capital markets in developingcountries. The East Asian economies, which were thought to beadept at channelling foreign capital into development activities,fell victim to the fickleness of private foreign flows, as theyopened up their financial markets too far and too fast. However,the case for unfettered international capital movements is farfrom robust. A number of leading economists argue that there isneed for better international regulation of capital markets and forindividual developing countries themselves to operate controlsover short term capital flows, as undertaken already by somedeveloping countries. Great caution therefore needs to beexercised in the opening up of the capital account in developingcountries and they should resist proposals for prompt andcomplete liberalization of their capital accounts.

The regulation of short-term capital movements will,however, have a bearing also on the pace of liberalization of trade,since in many cases balance of payments difficulties, and theconsequent need for external financing, arose out of rapid growthin imports following too rapid an opening up of the economy toforeign trade. In the absence of trade policy interventions, theentire burden of adjustment to reduce the trade deficit falls onexchange rate changes or domestic demand contraction.

While the greater regulation of international capital marketscan be expected to reduce the incidence of financial crises, as willboth domestic measures to regulate capital flows and prudentialregulation of the financial sector, other measures will be requiredto minimize their ill-effects once crises do occur. One importantshortcoming of the current international arrangements is the


absence in the South of credibly constructed regional interventionfacilities and other measures to inhibit contagion.

A normative and legal framework for foreign investors

There is no question that foreign investment can have animportant role in the development of the South. Foreign directinvestment can contribute a great deal by providing not onlyphysical capital, but also the transfer of technology and moreefficient business practices. In particular, it has been observedthat where foreign direct investment has been carefully andpurpose fully managed by the host country, as in some East Asiancountries, it can make a considerable and strategic contribution tonational development.

The industrial countries had been pursuing in OECD theobjective of concluding an international agreement on foreigninvestment, known as the Multilateral Agreement on Investment(MAI). This was intended to ensure rights and guarantees forinvestors, even though it is not evident that the currentarrangements are inadequate. It seems doubtful that foreigninvestors, 90 per cent of which are multinationals of the North,are in need of protection. However, no consideration was givento the responsibilities and obligations of foreign investors andhome countries. The negotiations in OECD, which have beensuspended, represent an example of pursuing “corporate welfare”and have proven to be controversial not only in the developingcountries, but also in the industrial countries.

However, efforts by the North to achieve an internationalagreement on foreign investment are not likely to be abandoned,and may be pursued within the WTO where the developedcountries continue to press the issue.

There is a general assumption that, while external debtneeds to be managed carefully, foreign direct investment does notneed any regulation: investors seek profits and they themselveswill pay for the their mistakes. Even if this were true, there are


often economic and social costs of these mistakes to be borne bythe host country. For example, the recent experience of countrieswhich aggressively sought FDI for infrastructure projects shows ahigh incidence of irregularities and corruption. Furthermore,certain of the financial factors that have contributed to the recentfinancial crises in East Asia -- and indeed aggravation of theexternal indebtedness of the countries involved -- are intimatelylinked with foreign direct investment. Owners of foreign directinvestments, for example, often engage in other financialtransactions such as local borrowing and hedging which can behighly volatile and contribute to financial instability and crisis.

Thus there is a case for instituting a normative and legalframework, and a system of incentives and disincentives, toensure that foreign capital actually serves the development needsof the recipient countries.

There was, some time ago, extensive discussion within theUnited Nations on the development of a “code of conduct” formultinational corporations. This was an attempt to define therights and obligations of foreign investors. However, noagreement could be reached despite various revisions in the draftproposals, and the matter was shelved in 1988. In the light of theserious economic disruption in East Asia, and the prospect offoreign investors taking unfair advantage of the current,temporarily collapsed values of productive assets, the time seemsopportune for the world community to make another attempt atdeveloping an international framework intended to ensure thatforeign investors are more socially responsible and developmentoriented. This would benefit both industrial and developingcountries.

The international financial architecture, governance andaccountability

It has been suggested earlier in this document that far higherlevels of concessional finance are required by developingcountries. Whether these are to be channeled through the


Bretton Woods institutions or whether a new institutionalapparatus is to be created is a matter that must be an integral partof any international discussions on financing development.Attention must in any case be given to long-standing issuesconcerning the governance and policies of the existinginstitutions, particularly with a view to ending the marginalizationof developing countries in the decision-making and policyprocess.

Over the past two decades, developing countries facingeconomic and financial collapse have had little alternative but toturn to the Bretton Woods institutions. Both institutions,however, have used these occasions to push the currentorthodoxy of market liberalism on the client countries, in thename of structural reforms. The most recent instance of this hasbeen the IMF imposed policy packages intended to stabilize theEast Asian economies in financial crisis.

The fact that the policies and reforms dictated by theBretton Woods institutions have generally failed to restoreeconomic growth (and in some instances made matters worse), isnow acknowledged by at least some in the World Bank, who viewthe matter as an experiment which failed. The loss in output andthe decline in the indicators of human development (health,nutrition, and education) that the developing countries sustainedis seen by the multilateral financial institutions as regrettable. Inthe meantime, those countries remain burdened with private andofficial external debt, much of the latter contracted precisely toget out of their economic problems, and have little room formanoeuvre to make a fresh start.

This raises fundamental issues concerning theaccountability of the multilateral financial institutions and the roleof members countries in policy making. Over the past few years,issues of governance within developing countries have featuredprominently in the lending and policy deliberations of the BrettonWoods institutions. It is, therefore, not too soon to raise thequestion of governance of the multilateral financial institutions


themselves and also their accountability on questions of policiesand performance.

The Bretton Woods institutions are, of course, governed byand answerable to their member countries but, because of theweighted voting in their respective boards, the United Statestogether with a few other industrial countries virtually control theinstitutions. This state of affairs is far from satisfactory and thesematters concerning governance and control of these institutions,and their policies and practices, need to be addressed in anyproposed conference on financing for development. It is crucialthat they be taken into account when considering institutionalarrangements for raising and disbursing a higher volume ofdevelopment financing.

With regard to evaluating the performance of themultilateral financial institutions, NGOs, including some fromdeveloping countries, have in recent years been effective ininfluencing some policies and decisions of the World Bank atleast. These avenues will continue to be important in the future.But more formal means are needed which make clear that theseinstitutions are accountable to their entire membership.

One step would be to institute a formal external audit ofthe institutions’ performance in relation to their declaredobjectives. It is significant that the IMF to date has noindependent audit (internal or external) of its approaches,practices, or performance. The institution and its staff are notheld responsible for poor analysis, mistaken projections andpredictions, or faulty advice and conditionality prescriptions, eventhough mistakes in these areas have created extremely seriousproblems and situations in many developing countries. Althoughthe internal audit mechanism of the World Bank leaves much tobe desired, it has provided useful insights regarding theinstitution’s performance and borrowers’ needs and priorities.The independent audit of the international financial institutionswill need to ensure full representation of developing countries inthe evaluation.


Another step would be to devise a mechanism whereby thepolicies and performance of IMF and the World Bank could becritically reviewed in one of the United Nations fora. Suchproposals in the past have been successfully resisted by the majorindustrial countries, but, given the debacle of IMF prescriptionsin Africa, East Asia and Latin America, it might be possible tomobilize the necessary support. The proposed UN conference onfinancing for development could act to establish such amechanism.

C. Concluding remark

In conclusion, it needs to be repeated that the above-mentionedsix areas of action raise complex issues of institutional andpolitical change. No set solutions are prescribed here, for thesewould be found only through debate, discussion and negotiationswithin the world community. The proposed UN conference onfinancing for development provides an opportunity for that. TheSouth must, however, thoroughly prepare itself for the challengeof entering a new phase of dialogue with the North on financingdevelopment and new international institutional arrangements,with an agenda based on clearly defined goals and concreteproposals. It is hoped that this background document contributesto this process.

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