Global Development Finance 2006 The Development Potential of Surging Capital Flows By Mansoor Dailami TDLC, Tokyo, Japan May 31, 2006

2005 – A Landmark Year in Development Finance Private capital flows have reached record levels South-South flows are important aspect of development finance For the poorest countries, donors have enhanced their aid effort Risks and vulnerabilities remain

Private capital flows to developing countries grew at record pace in 2005 Total net private capital flows to developing countries $ billions Percent Percent of GDP (right axis) $491 billion in 2005 The statistics on net flows are compiled only once a year, which is based on the cycle when the member countries of the Bank report their external liability positions through the Debtor Reporting System. Thus, we rely on GROSS capital market financing figures to formulate a sense of the trends and issues in development finance. This chart shows the trend in GROSS flows. As can be seen, the robust volume in gross flows supports the rise in NET flows in 2003 and 2004, as was shown in the chart earlier. 2005

… with all types of private flows recording gains in 2005 $137 billion $62 billion $61 billion $238 billion $ billions The statistics on net flows are compiled only once a year, which is based on the cycle when the member countries of the Bank report their external liability positions through the Debtor Reporting System. Thus, we rely on GROSS capital market financing figures to formulate a sense of the trends and issues in development finance. This chart shows the trend in GROSS flows. As can be seen, the robust volume in gross flows supports the rise in NET flows in 2003 and 2004, as was shown in the chart earlier.

Both global and domestic factors have contributed On the global side Booming international trade Relatively low international interest rates On the domestic side Improved domestic monetary and exchange rate policy Large official reserve holdings Better external debt management Development of local debt markets Progress toward meeting international standards for transparency and corporate governance

Developing-country credit quality improved markedly in 2005 Number of credit upgrades/downgrades by Fitch, Moody’s and S&P According to S&P, investment-grade countries accounted for 38% of total rated developing countries in 2005, up sharply from 22% in 1996. In 2005, Much of credit upgrades occurred in LAC and ECA countries. For LAC, 10 countries received rating upgrades including Dominican Republic, Grenada, Mexico, Trinidad and Tobago, Argentina, Brazil, Chile, and Ecuador. For ECA, 10 countries experienced upgrades including Kazakhstan, Bulgaria, Lithuania, Romania, Russia, Serbia, Slovakia, Turkey, Ukraine, and Macedonia.

Net private debt flows have fluctuated substantially… Net private debt flows to developing countries $ billion Percent Percent of GDP (right axis) $192 billion in 2005 (left axis) Although the top 10 countries (China, Russian Federation, Brazil, Mexico, Czech Republic, Poland, Chile, South Africa, India, and Malaysia) still accounted for almost 65 percent of FDI to developing counties in 2005, the concentration is considerably less than the 75 percent level of the late 1990s.

…portfolio equity flows have also been volatile Net portfolio equity inflows to developing countries,1990-2005 $ billion Percent $61 billion in 2005 (left axis) Percent of GDP (right axis) …which has fueled the surge in portfolio equity flows. A sudden reversal in emerging market equity prices could lead to abrupt decline in portfolio equity flows

…while more stable FDI accounted for half of net private flows Net FDI inflows to developing countries $ billion $237 billion in 2005 (left axis) Percent Percent of GDP (right axis) Although the top 10 countries (China, Russian Federation, Brazil, Mexico, Czech Republic, Poland, Chile, South Africa, India, and Malaysia) still accounted for almost 65 percent of FDI to developing counties in 2005, the concentration is considerably less than the 75 percent level of the late 1990s.

FDI flows dominate private capital inflows to East Asia $ billion FDI flows …which has fueled the surge in portfolio equity flows. A sudden reversal in emerging market equity prices could lead to abrupt decline in portfolio equity flows Portfolio equity flows Debt flows

China continues to dominate FDI inflows to East Asia FDI flows into East Asia and the Pacific $ billion China …which has fueled the surge in portfolio equity flows. A sudden reversal in emerging market equity prices could lead to abrupt decline in portfolio equity flows Other countries

Non-FDI flows to China increased markedly in recent years Non-FDI flows into East Asia and the Pacific $ billion China …which has fueled the surge in portfolio equity flows. A sudden reversal in emerging market equity prices could lead to abrupt decline in portfolio equity flows Other countries

Developing economies are highly integrated with each other Share of flows to developing countries and originating from developing countries Percent Developing countries’ GDP as a share of global GDP

South-South FDI is significant in banking sector, particularly in low income countries Share of South-South in total number of foreign banks Share of South-South in total foreign bank assets Percent Percent Low Income Middle Income All Developing Low Income Middle Income All Developing

Donors continue to scale-up aid… Net ODA disbursements from DAC donors $106.5 billion in 2005 $79.6 billion in 2004 Debt relief Other special purpose grants ODA increased from 58.3 billion in 2002 to $69.0 billion in 2003, a 18 percent increase in nominal terms, but only 5 percent in real terms ($58 billion in 2002 to $61 billion in 2003). Other components of ODA

…and enhance commitments for future aid Net ODA as a percent of GNI in DAC donor countries, 1990-2005 Projection: 2006-10 Percent 0.36% in 2010 0.33% in 2005 ---partly due to large debt relief grants to Iraq and Nigeria ODA rose from $79.5 in 2004 to $106.5 in 2005 a $27 billion increase, by far the largest on record debt relief totaled $20 billion in 2005, with $14 billion provided to Iraq and $5 billion to Nigeria Underlying aid effort remains on upward trend ODA excluding debt relief increased by 8.7% in 2005 in real terms, up from 5.6 percent average annual increase over the previous three years 2002-04 OECD DAC Secretariat is projecting ODA to increase to 0.36% of GNI in 2010, just above levels attained in the early 1990s, but well below most estimates of levels of aid required to accelerate progress on the MDGs The share of ODA allocated to Africa has increased over the past few years, and is expected to continue increasing over the balance of the decade based on commitments made at the G-8 Leaders Summit in July Donors plan on allocating at least half of the increase in total ODA to Africa by 2010, which would raise Africa’s share of ODA to 50%, up from a low of 25% in 1999 Total ODA excluding debt relief to Iraq and Nigeria 0.27% in 2005

This time around, what has changed? More flexible exchange rate regimes: 62 percent of countries versus 33 percent during the previous episode Oil exporters and emerging Asia now have sizable current account surpluses and reserves External debt positions have improved More countries have developed local debt markets Less reliance on short-term bank debt Equity flows dominate: FDI accounts for 57 percent of private capital flows versus 47 percent last time

Considerable improvements in external liability positions of East Asia Percent Percent Reserves/short-term debt (right) Total debt/GDP (left) a. Including Brazil, India, Mexico, Thailand, and Turkey

East Asia’s current account surplus continued to rise led by China $ billion a. Including Brazil, India, Mexico, Thailand, and Turkey

But, risks and vulnerabilities remain Heightened market anxiety associated with global payments imbalances Possibility of higher global interest rates and economic slow-down Uncertainties associated with geopolitical risks Higher inflation expectations and possibility of more aggressive monetary policy responses Recent pace of sterilized intervention and reserve accumulation in emerging market economies is not sustainable

With U.S. monetary tightening, emerging market bond spreads have widened recently Basis points Percent US Federal Funds rate (right) EMBIG spreads (left)

Boom in local equity market prices has raised the risk of sharp market correction Jan. 2004 = 100 Emerging Market equity price index (MSCI ) FTSE 100 S&P The strong gains in emerging market equity prices over the past few years have significantly outpaced gains in developed countries

Policy implications For developing countries… Consistent management of monetary and exchange rate policy Sound fiscal policy to promote price stability Integrated approach to internal and external debt management Own responsibility to improve business environment and governance Prudence approach to commercial borrowing, while maintaining debt sustainability

continued …. Policy Implications For the international policy community… Multilateral cooperation to prevent disorderly market reaction to global imbalances Shared responsibility between deficit and surplus countries Recognizing structural asymmetry between international reserve currency countries and others Donor commitments: Follow through on pledges to enhance aid , and ensure aid allocations in line with development priorities