Summary: The remarkable surge in private capital flow to developing countries since 1990 has greatly facilitated their rapid growth, at a time when OECD countries have been in, or passed through, recession. The importance of these flows to the current account of several large developing countries has caused concern about their sustainability, especially if international interest rates continue rising. The form of these flows, and their source - investors rather than commercial banks - causes concern about their short-term volatility. To address the issue of sustainability, the authors draw on analyses of international financial flows and economic prospects carried out by the Bank's International Economics Department. They conclude that private capital flows to developing countries are likely to be sustained at, or near, current total levels for the following reasons: (a) Much of the private flow comes from direct investment. Foreign direct investment has increased as international businesses pursue globalization strategies. Firms are taking advantage of liberalization drives and rising incomes in developing countries, as well as dramatic changes in transport and telecommunications - factors that are structural rather than cyclical, and that are likely to be reinforced by implementation of Uruguay Round agreements. (b) Sources of finance are more diversified. There is greater risk-sharing between creditor and debtor. Funds are predominantly going to the private sector (not sovereign governments). Also, developing countries still account for less than 1 percent of the investment portfolios of OECD investors. In the 1970s, commercial loans accounted for proportionately more flows. Now, increasingly large roles are played by bondholders, equity investors, and money market funds. (c) A prolonged major increase in international interest rates would jeopardize continuation of the flows at current levels, but the likelihood of such an increase in the next three to five years is slim. Any rise in interest rates in industrial countries will largely reflect rising demand for credit because of increased economic activity, which will benefit developing country exports. Commodity prices have surged in the past six months, but measures of core inflation, including unit labor cost, are at a historic low. This scenario is very different from the combination of high interest rates and economic recession the developing would faced in the early 1980s, as high and rising inflation induced sudden tightening of monetary policies. Still, significant areas of risk deserve attention from developing country governments, international financial institutions, and industrial country investors. Some major recipients of private capital flow are vulnerable to sudden changes in both domestic or external environments. And portfolio equity flows are likely to be more volatile than other forms of private capital flows. The policy response to large capital inflows should depend on whether the current account deficit is sustainable and the degree to which it is over - or underfinanced. While the external environment is favorable, vulnerable countries have a window of opportunity to undertake adjustment.
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