>~~~~ (ii i #@S m m 7' ;> >~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ mX F 'z r:-:,+::2 A World Bank Policy Research Report Private Capital Flows to Developing Countries TIhe Road to Financial Integration SUMMARY The World Bank Washington, D.C. A Note to the Reader This booklet contains the summary of Private CapitalFl/ows to De- veloping Countries: The Road to Financial Integration. It also in- cludes the foreword to the report and the table of contents for the text of the book. The full-length report has been published by Oxford University Press for the World Bank. To order copies, please use the form provided at the back of this booklet. (© 1997 The International Bank for Reconstruction and Development / THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433 All rights reserved Manufactured in the United States of America First printing April 1997 ISBN 0-8213-3926-5 Cover photographs (clockwise from top): Josef Polleross /The Stock Marker; Nadia Macken- zie ITony Stone Worldwidee;Jlian Calder ITony Stone Worldwide; Jane Evelyn Atwood /The Stock Market; D. Stoecklein /The Stock Market t lText printed on paper that conforms to the American National Standard fDr Permanence of Paper for Printed Librarv Materials, Z39.48-1984 o reword F INANCIAL MARKETS AROUND THE WORLD ARE RAPIDLY INTE- grating into a single global marketplace, and developing coun- tries are increasingly part of this process. The process is being driven by advances in communications and information technology, deregulation of financial markets, and the rising importance of insti- tutional investors that are able and willing to invest internationally. The good news is that developing countries are attracting private capi- tal flows by improving macroeconomic policy and by establishing institutions and regulatory regimes that have increased creditworthi- ness and promise a more stable environment. Moreover, investors are also becoming more sophisticated in differentiating among countries and their economic fundamentals. Finally, after the Mexican crisis of 1994-95, the international community has realized that more should be done to reduce volatility and risks in international financial mar- kets by improving market disclosure and strengthening coordination among national authorities. Nevertheless, there remain reasons for concern. First, for the twenty or so countries that have been the major recipients, the management of private capital flows has not proved to be easy. It is not just the volume of flows, but the speed at which such investment pours in-and can be withdrawn-that present particular challenges to these economies. Governments need to build the kind of macroeconomic, regulatory, and institutional environments that channel this private capital into broad-based and sustainable growth. Second, the overwhelming major- ity of developing countries, in particular the smaller low-income economies, still need to create the conditions to attract private capital and must depend on declining official flows. This report makes a serious and timely contribution to the analysis of these issues. It explores the nature of the changes that are leading to the integration of developing countries in world financial markets, and it analyzes the policy challenges these countries face in attracting and managing private capital flows. It concludes, for example, that coun- tries receiving large capital inflows should avoid using them to finance . . PRIVATE CAPITAL FLOV-S TO DEVELOPING COUNTRIES large fiscal deficits or consumption booms. The report also includes specific recommendations and warnings on regulatory design that may be useful to developing countries as they seek to maximize the positive contribution of capital inflows while minimizing their potentially dis- ruptive effects. This book, therefore, will be highly useful to policymakers in devel- oping countries and, more generally, to all development specialists. But it will also be essential reading for members of the global financial com- munity. Investors have seen in recent years how dynamic-and some- times volatile-emerging markets can be. Understanding these opportunities and challenges is critical for everyone. The report also comes at an important time for the World Bank. The challenge for the Bank and other development agencies is to create strategies to help developing countries leverage private capital flows so that all benefit. The research presented in this book is an important step in constructing such strategies. Like previous volumes in the Policy Research Report series, .NriNIrte Capital Flows to Developing Coitntries is designed for a wide audience. It is a product of the staff of the World Bank; the judgments made in the report do not necessarily reflect the views of the Board of Directors or the governments they represent. Joseph E. Stiglitz Senior Vice President and Chief Economist The World Bank April 1997 iv Summary HE WORLD'S FINANCIAL MARKETS ARE RAPIDLY integrating into a single global marketplace, and ready or not, developing countries, starting from different points and moving at various speeds, are being drawn into this process. If they have adequate institutions and sound policies, developing countries may proceed smoothly along the road to financial integration and gain the considerable benefits that integration can bring. Most of them, however, lack the prerequisites for a smooth journey, and some may be so ill prepared that they lose more than they gain from finan- cial integration. Developing countries have little choice about whether to follow this path, because advances in communications and new developments in finance have made the course inevitable. They can, however, decide how they wish to travel, choosing policies that benefit the economy and avert potential shocks. This volume describes the forces that have created and that sustain this road, analyzes the benefits and problems likely to be encountered on it, and examines the experiences of those who are farther along on the journey to see what can be learned from them. The Changing Financial Environment While the cyclical downturn in global interest rates provided an im- portant initial impetus for the resumption of private capital flows to developing countries in the 1990s, these flows have now entered a new phase, reflecting structural forces that are leading to progressive finan- cial integration of developing countries into world financial markets. The two primary forces that are driving investor interest in developing 1 PRIVATE CAP'ITAL FLO'WXS To DEEV1LOPING COUNTRIES countries are the search for higher returns and opportunities for risk di- versification. Although these forces have always motivated investors, the responsiveness of private capital to cross-border opportunities has gained momentum as a result of internal and external financial deregu- lation in both industrial and developing countries and major advances in technology and financial instruments. This process of financial integration is still unfolding. The pace of change will be especially rapid for developing countries, given their more insulated financial markets. Even in the more regulated economies, growing economic sophistication means that financiat inte- gration will increasingly not be a choice for governments to make. Mar- kets are making the choice for them. As a result, the financial integration of developing countries is expected to deepen and broaden ov,er the coming decade against a background of increasing global financial inte- gration. As part of this process, gross private capital flows may be ex- pected to rise substantially, with capital flowing not only from industrial to developing countries but also, increasingly, among developing coun- tries themselves and from developing to industrial countries. Given the continuing decline in investment risks, the higher ex- pected rates of return in developing countries, and the underweighting of emerging markets in institutional portfolios, net private capital flows to developing countries in aggregate are likely to be sustained. The rare of growth, though, will inevitably diminish. There will undoubtedly also be considerable variation among countries, depending on the pace and depth of improvements in macroeconomic performance and credit- worthiness. Such basic factors as domestic politics, the availability of re- sources, and the level of development that has been attained are bound to affect the flow of capital as well, so the process of financial integration can take many courses. In fact, in countries where economic and policy fundamentals are quite weak, the initial manifestation of growing finan- cial integration may take the form of net outfiows of private capital. With changes in the international financial environment, there are likely to be considerable year-to-year fluctuations in private capital flows to developing countries, even in aggregate. These nations are, and will continue to be, highly susceptible to both domestic shocks and changes in the international environment, such as in global interest rates. Never- theless, flows to developing countries in the aggregate are unlikely to suffer fromn major reversals as long as the probability of abrupt changes in the international environment remains low. The main risks of volatil- S U M M AR Y iry and large reversals lie at the individual country level and stem from the interaction of domestic conditions and policies with international factors. And as markets become more discerning, contagion effects of the kind seen after the Mexican crisis are not likely to be long-lasting. Winning and Losing in an Integrating Market The experience of nations that have successfully managed financial inte- gration suggests that the benefits of this process are likely to be especially large for developing countries. The direct advantages are twofold: these countries can tap the growing pool of global capital to raise investment, and they can diversify risks and smooth the growth of consumption and investment. The more important benefits of financial integration, how- ever, are likely to be indirect. These include knowledge spillover effects, improved resource allocation, and strengthening of domestic financial markets. In addition, the increasing safety of financial operations in de- veloping markets can support a shift to higher-return investments, with gains for both developing and industrial nations. As the Mexican peso crisis has so forcefully demonstrated, however, these benefits are by no means assured. In fact, there are large potential costs if integration is not carefully managed. There are two reasons for this. First, although international investors are becoming more discern- ing, market discipline tends to be much more stringent when investor confidence is lost-a fact that can lead to large outflows-than during the buildup to a potential problem. Second, and more important, many developing countries lack the preconditions needed to ensure the sound use of private capital and manage risks of large reversals. Finan- cial integration can magnify the effects of underlying distortions and institutional weaknesses in these countries and thereby multiply the costs of policy mistakes. The challenge, therefore, for developing countries is how to exploit the growing investor interest in their markets and so to enter a virtuous cycle of productive financial integration rather than a vicious cvcle of boom and bust. In a virtuous cycle, integration and access to external private capital lead to increased productive investment, momentum for policy and institutional reform, and greater resilience to potential in- stability. In contrast, when the necessary macroeconomic fundamentals are lacking, banking systems are weak, and domestic distortions are pervasive, countries may experience capital flight rather than capital in- 3 PRIVATE CAPITAL FLOWVS TO DEVELOPING COUNTRIES flows, or they may be unable to use inflows efficiently-with very high costs in terms of growth and instability. The Lessons from Evolving Experience This report provides perspectives on how developing countries can re- spond to these challenges, drawing on the evolving experience of the more rapidly integrating countries. Although the agenda confronting policymakers is necessarily broad and complex, ranging from m.acro- economic issues to the so-called plumbing of markets, a number of strategic themes emerge from this study. * Given thegrozving trend towardfinancial integration, developing coun- tries need to vigorously pursute policies that wili enable them to benefit from global capitalflows and avoid the associated dangers. There is broad consensus-based on lessons from country experience and the considerable literature on the sequencing of reforms-that the most important prerequisites for successful financial integration are a sound macroeconomic policy framework, in particular a strong fiscal position, the absence of large domestic price distortions (for example, those arising from import protection), a sound domestic banking sys- tem with an adequate supervisory and regulatory framework, and a well- functioning market infrastructure and regulatory framework for capital markets. All these are key elements of the broader policy agenda that de- veloping countries need to adopt in any case, and financial integration only makes their pursuit more urgent, for several reasons. First, progress on these prerequisites will help improve a country's creditworthiness and attractiveness to foreign investors. Second., these preconditions will encourage capital flows (such as foreign direct in- vestment) based on long-term fundamentals rather than short-term re- turns. Third, attainment of these preconditions will ensure that capital inflows are well used, ultimately determining whether countries can reap the benefits from financial integration and avoid its risks. Fourth, the more robust a country is with regard to these preconditions, the greater will be its latitude in responding to surges and volatile flows. * How countries respond to the initial surge of capital inflows, which is often associated with the openingphase of integration, will largelv deter- 4 S U M MARY mine their success in dealing not only with overheating pressures but also with potential vulnerability. Countries have typically used a combination of policies to respond to large surges of capital inflows. Capital controls, when combined with other policies, appear to have been at least partially successful in reducing the magnitude of inflows and altering their composition. Sterilized intervention has been the most widely used instrument and has been generally successful as an initial response in curbing the growth of base money and building up reserves. Most important, coun- tries that have resisted real exchange rate appreciation by placing greater emphasis on fiscal tightening have tended on average to have lower current account deficits, a mix of absorption oriented toward in- vestment, and faster economic growth. The main lesson for macroeconomic policy from recent country ex- perience is that a heavy reliance on fiscal policy, supported by steriliza- tion and some nominal exchange rate flexibility-and in the more extreme cases by temporary taxes or controls on inflows-can be an ef- fective response to overheating and can reduce the likelihood of vul- nerability to large reversals of private capital flows. More generally, countries are likely to suffer a loss of investor confidence when the real exchange rate is perceived to be out of line, the government's debt obligations are large in relation to its earning capacity and external re- serve position, fiscal adjustment is perceived to be politically or admin- istratively infeasible, or the country's growth prospects are bleak. * There is much merit in curbing lending booms associated with capital in- flows while addressing the underlying weaknesses in the banking system. The banking system plays a dominant role in the allocation of capi- tal in a developing country, and the health of this system largely deter- mines whether a country wvill be able to exploit the benefits of financial integration and avoid its pitfalls. In many developing countries, bank- ing systems have only recently been deregulated, incentives for banks are distorted toward excessive risk taking, banks are poorly capitalized, and adequate prudential regulation and supervision capabilities have not yet been established. Addressing the underlying weaknesses of the banking svstem be- comes more urgent in a globally integrated environment because banks 5 PRIVATE CAPITAL FLOWS TO DEVELOPING COUNTRIES can increase lending more easily and incur greater risks. The standard tools for bank monitoring and supervision are rendered less effictive. Institution building, removing incentive distortions (for instance, in the form of excessive insurance), and strengthening bank supervision capabilities are therefore crucial. Since reforms of the banking system will take time to implement, it will probably be necessary to curb the lending booms associated with capital inflows by using macroeconomic policies, as well as more tar- geted restrictions, such as raising reserve requirements or adopting risk- weighted capital adequacy requirements. This will help alleviate overheating pressures resulting from surges in capital inflows and will reduce the vulnerability of the banking system. * Developmenzt of well-f inctioning capital markets will reduce risks of potential instability as wvell as attract the growing pool of portfolio investment. Investors are concerned with the unreliability of emerging markets in three main areas: market infrastructure (where the consequences in- clude high transaction costs, frequent delays in settlement, and out- right failed trades); protection of property rights, in particular those of minority shareholders; and disclosure of market and company infor- mation and control of abusive market practices. Unfortunately, there are no simple solutions to preparing capital markets for financial inte- gration, which requires concerted action across a broad array of areas to improve market infrastructure and the regulatory framework. International standards for market infrastructure provide excellent medium-term benchmarks for emerging markets, although they need to be tailored to fit individual country circumstances. The experience of the more advanced emerging markets, especially those in Asia, indi- cates that it is possible to improve market infrastructure in a relatively short period by leapfrogging to state-of-the-art systems. This experi- ence, however, together wvith the not infrequent weaknesses in emerg- ing market financial intermediaries, also suggests two cautionarv notes. First, improving the speed of settlement and custodv functions should not be achieved at the expense of reliability. Second, despite the impor- tance of promoting competition among Financial intermediaries, mem- bership standards in key capital market institutions should be set high to bolster market safety and improve investor confidence. 6 S UMM AR Y A regulatory model based on disclosure and self-regulation is gain- ing wide acceptance in emerging markets because it has strong advan- tages over direct government regulation. But government regulation and oversight are still essential, and the state can play a crucial role in capital market development in partnership with the private sector, pro- viding the basic legal structures, for example, and fostering vital market institutions. Given the weaknesses in the regulatory systems of many emerging markets and their susceptibility to "reputational risk," the tradeoff between market development and effective regulation required to develop and maintain market confidence is less pronounced than is sometimes thought. Emerging markets should also promote the development of domes- tic institutional investors. By mobilizing significant amounts of re- sources, these investors can serve as a counterweight to foreign investors and thereby assuage fears of excessive foreign presence; they also reduce the vulnerability of domestic capital markets to foreign in- vestor herding, and their presence may reassure foreign investors about the nation's respect for corporate governance and property rights. All these policy and institutional initiatives to attract foreign in- vestors and contain the potential negative impact of financial integra- tion on capital market volatility will significantly help the development of domestic capital markets. In turn, there is increasing evidence that well-functioning capital markets make an important contribution to the overall growth process. * Developing countries need to build better shock absorbers and develop mechanisms to respond to instability because they will remain highly vulnerable to economic disturbancesfor some time. Growing financial integration may require three types of shock ab- sorbers. First, the level of international reserves needs to be established in relation to the variation in the capital account, rather than in terms of months of imports, since the level of gross flows is higher following in- tegration. For countries where investor confidence is less firm, there is a case for an even larger cushion of reserves. International reserves can also be buttressed with contingent lines of credit, as Argentina has done re- cently. Second, financial integration heightens the need for fiscal flexi- bility, which in turn will depend on the level of public debt, among other things. Third, there is strong merit in building up cushions in the 7 PRIVATE CAPITAL FLOWS TO DEVELOPING COUNTRIES banking system. Authorities should use periods of credit boom to in- crease bank capitalization and provisioning requirements as a way to promote sound banking practices and increase the resilience of banks. Even with these shock absorbers, countries need to have well-delin- eated mechanisms that enable policymakers to deal with crises promptly and effectively. This is particularly important for the banking system, where delaying actions intended to contain a crisis will only in- crease its cost. * International cooperation between regulators and adequate disclosure of information at all levels are increasingly important to ensuring safe and efficient markets. The globalization of financial markets, along with new forms of in- vestment and the growing prevalence of financial conglomerates, in- creases the number of channels that transmit systemic shocks across borders and sectors and the speed at which these shocks travel. At the same time it reduces the transparency of the marketplace. Despite the worldwide integration of financial markets, the author- ity of regulators has remained mainly national in scope. In a global marketplace, it is difficult to assess the risk exposure of financial inter- mediaries, and such complex operations as derivatives trading make risk evaluation even more uncertain. To address these problems, regu- latory authorities from industrial countries are increasingly cooperating and coordinating with one another. In addition, to reinforce market discipline, these regulators are emphasizing the supervision of the qual- ity of risk management by financial firms (rather than the position of a firm at a particular moment in time) and improved disclosure practices. In this new environment, reducing information asymmetries across borders will have a significant payoff for emerging markets. At the macroeconomic level, more accurate and timely disclosure of country information would decrease the likelihood of cross-country contagion of financial shocks. Adequate disclosure of the risk profile and financial status of financial intermediaries would increase the effectiveness of market discipline and facilitate supervision by regulators. And for reg- ulators, there will be a large payoff in coordination and information- sharing agreements, with both industrial and other emerging markets, in particular with those likely to share financial institutions and, sources of financial shocks. 8 Contents of the Report Foreword The Report Team Acknowledgments Definitions and Abbreviations Summary 1 The Main Findings A New Age of Global Capital Benefits and Risks of Financial Integration Policy Challenges and Emerging Lessons Notes 2 The New International Environment The Structural Character of New Private Capital Flows The Structural Forces Driving Private Capital Flows to Developing Countries The Outcome of Structural Changes: Growing Investment in Emerging Markets The Prospects for Private Capital Flows Volatility Arising from the International Environment Conclusion Annex 2.1. Key Deregulations, Financial Innovations, and Technological Advances Notes 3 The Benefits of Financial Integration Integration and Growth Diversification Benefits Conclusion Notes 9 PRIVATE CAPITAL FLOW'S TO DEVELOPING COUNTRIES 4 Challenges of Macroeconomic Management Capital Inflows and Overheating: The Country Experience Policy Regimes and Vulnerability Macroeconomic Management with Growing Financial Integration Lessons for Macroeconomic Management Annex 4.1. Monetary and Fiscal Policies during Capital Inflow Episodes Annex 4.2. Can Sterilization Be Effective? Notes 5 The Effects of Integration on Domestic Financial Systems Bank Lending and Macroeconomic Vulnerability Bank Lending and Financial Sector Vulnerability Financial Sector Reforms in the Context of Integrationu: Policy Lessons Annex 5.1. Capital Inflows, Lending Booms, and Banking Crises: Country Episodes Annex 5.2. Government Guarantees, High Real Interest Rates, and Banking Sector Fragility Annex 5.3. Risk-Adjusted Capital-Asset Ratios: The BIS Classification of Risky Assets Annex 5.4. Crisis Management in a Constrained Setting: The Case of Currency Boards Notes 6 Preparing Capital Markets for Financial Integration The Main Issues Capital Markets and Financial Integration Improving Market Infrastructure Summary and Conclusions Annex 6.1. G-30 Recommendations and Suggested ISSA Revisions Annex 6.2. Market Microstructure Annex 6.3. Construction of the Emerging Markets Index No tes Bibliography 10 World Bank Publications Order Coupon I CUSTOMERS IN THE UNITED STATES CUSTOMERS OUTSIDE THE UNITED STATES Complete this coupon and return to: Contact your local Bank publications distributor The World Bank for information on prices in local currency and P.O. Box 7247-8619 payment terms. (See next page for a complete list of Philadelphia, PA 19170-8619 distributors.) If no distributor is listed for your country, USA. use this order form and return it to the U.S. address. 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Box 32379 Fax: (92 42) 636 2328 M dPrnaBceoaLusaka PERU Mundl-Prensa Barcelona Tel: (260 1) 252 576 Editorial Desarrollo SA 08009 Barcelona Fax: (260 1) 2S3 952 Apartado 3824 Tel: (34 3) 488-3492 ZIMBABWE Tel 51 14) 2853I 0 Fax: (34 3) 487-7659 Longman Zimbabwve )Pte.)Ltd. Fax: (51 14) 296628 SRI LANKA, THE MALDIVES PO. Box ST125 Lake House Bookshop Southerton 100, Sir Chittampalam Gardiner Maivatha Harare Colombo 2 Tel: (263 4) 6216617 Tel: (94 1) 32105 Fax: (263 4) 621670 Fax: (94 1) 432104 T HE W OR L D BANK PRIVATE CAPITAL IS FLOWING TO DEVELOPING COUNTRIES in record amounts, reflectng their progressive integration with the world's financial markets. Already five times larger than official flows to these nations, this stream of international investment has become a powerful force in emerging markets, and its effects are bound to increase. Developmg countries stand to reap substantial gains, both direct and indirect, from these private capital flows. But if countries are unprepared for financial integration, they can lose rather than gain from the process. Successful participation in the global marketplace requires sound economic policies and robust financial institutions, and developing countries vary greatly in their readiness Ready or not, however, they all face the challenge of attracting international mvestment while establishing con- ditions that will ensure the sound use of this capital and safeguard the domestic economy from shocks and financial crises. The book analyzes the process of international financial integration and the structural forces driv- ing private capital to developing countries Against this background, it details the potential benefits of integration and the implications of fast-moving global capital flows for emerging economies. Examining the experience of countries that have attracted substantial private capital flows, the book provides invaluable guidance as to what works and what doesn't during the transition to financial inte- gration It will be of compelling interest to policymakers and also to international investors and bankers, financial analysts, and researchers. Private Capital Flows to Developing Countties is the fifth volume in a senes that brings to a broad audience the results of research on development policy issues carried out by the staff of the World Bank These reports take stock of what is known about these issues and contribute to the debate on appropriate public policies for developing economies The previous volumes in the series are The East Asian Miracle, Adjustment in Africa, Averting the Old Age Crisis, and Bureaucrats in Busizness. 9 780821 339268 ISBN 0-8213-3926-5 COVER DESIGN BY SYLVIA GASHI/THE MAGAZINE GROUP