. Overview: Building Coalitions for Effective Development Finance Policy highlights nalize the evolving lessons--and to give them legiti- T HE STRING OF FINANCIAL CRISES IN DEVELOP- macy. Even then, these and other initiatives will re- ing countries in the second half of the 1990s quire a period of strong commitment to produce shook the confidence of many in global financial the desired results. markets. At the same time, aid, on the decline In this context the report attempts to identify through much of the decade, was increasingly crit- the conditions under which international financial icized as ineffective. Together these experiences transfers support the development process. And it called into question the long-held view that inter- considers what public policy--national and inter- national resource transfers--both private and offi- national--can do to foster productive transfers. cial--play a significant and positive role in eco- Among the key findings: nomic development. This report concludes that, to the contrary, in- · The cyclical slowdown of the global economy ternational financial flows to developing countries that began toward the end of 2000 has been are perhaps even more valuable than traditionally significant because U.S. equity markets, con- thought--and that the prospects for using them sumer confidence, and short-term economic effectively continue to improve. These flows work prospects have all dropped sharply and in tan- to transfer resources across national borders, from dem. A rebound in the course of this year rich countries to poor ones, and to create and real- seems possible due to the available policy in- ize investment opportunities. But they can have an struments for stabilization. even greater influence on development by stimulat- · After precipitous declines in 1998 and 1999, ing improvements in developing countries' policies capital flows to developing countries grew and institutions and keeping them sound. They can smartly in 2000, but their recovery has still thus reinforce those countries' initiatives to step up lagged behind growth of output and trade productivity and efficiency in the economy. since the late-1990s crises. The report also highlights ongoing interna- · For all countries with strong investment cli- tional initiatives to leverage the far-reaching poten- mates, private capital flows reinforce the pay- tial of international financial flows. Among these offs to good policies and good institutions initiatives are, at the global level, the reform of the through even faster growth. But the volatility international financial architecture and, at the coun- of those flows needs to be managed through try level, the World Bank's Comprehensive Devel- stronger domestic financial systems and, pos- opment Framework, which emphasizes the critical sibly, larger foreign exchange reserves and importance of a holistic approach to development. sources of contingent credit. The success of both will depend on effective coordi- · Aid flows increased in 2000, and the pace of nation among various parties, attention to diverse debt relief was stepped up--but it will take local conditions, and a track record of strong and vigilance to sustain these gains. The increases effective implementation. These, in turn, will re- in aid effectiveness in the 1990s support the quire international and national coalitions to inter- case for greater aid to achieve the Interna- 1 G L O B A L D E V E L O P M E N T F I N A N C E tional Development Goals set by the interna- tion of the global economy. The second is recent tional community. technological change, which requires increasingly · International resource transfers provide about sophisticated investment environments for effi- $5 billion a year to finance such international cient business operations. And the third is psycho- public goods as health, a clean environment, logical factors. Some of the chapter's findings: knowledge, and peace. To achieve the maxi- mum dividends from these activities, the inter- · Although the rise in capital inflows to devel- national financial institutions need to take a oping countries in the first half of the 1990s flexible and pragmatic approach to coalition received most of the attention, capital out- building. flows also increased. And at least a part of the decade's increase in capital inflows may reflect Challenges for developing countries during the transactions tied to capital outflows, perhaps cyclical slowdown to avoid taxes. Those outflows also reflect The cyclical slowdown of the global economy that greater economic integration with the rest of began in the second half of 2000, brought on by the world. higher interest rates and oil prices, suddenly inten- · The worldwide boom in cross-border capital sified toward the end of the year. Shifts in market flows has been directed to industrial econ- sentiment have become more important in deter- omies, especially the United States, reflecting, mining short-term output and trade trends. in part, optimism about technological trends. Chapter 1 of this report argues that a recovery Developing-country shares in capital flows in the course of this year from the current slow- have declined sharply since the crises. The down is more likely than prolonged slow growth, greater concentration of capital in a few coun- because economic cycles have become shorter and tries reemphasizes the importance of a hos- because the scope for policy adjustments (fiscal pitable business climate in attracting and sus- and monetary stimulus) is greater. However, the taining foreign direct investment (FDI) flows, possibility of a continued feedback from financial which, although resilient during the crises, ap- markets to the real economy may delay the recov- pear to have plateaued. ery. The slowdown is expected to differ in mag- · Capital market flows were bolstered last year nitude across developing countries, creating both by modest improvements in perceived credit- risks and opportunities. A harder-than-expected worthiness. But a lack of liquidity and indi- landing in the industrial world would have serious cations of investor nervousness suggest that consequences in many developing countries but the memory of the crises remains. For coun- could bring some partially offsetting benefits, such tries with marginal access but significant de- as lower interest rates. Even in the more likely pendence on international capital markets, the soft-landing scenario, some sectors and countries risk of being unable to roll over their borrow- will be hit hard. ings could be significant. Despite the strong rise in 2000, international capital flows are Trends in private capital flows likely to account for smaller shares of develop- As chapter 2 documents, resource transfers to de- ing countries' gross domestic product (GDP) in veloping countries increased in 2000 but remain the next few years. well below their 1997 levels, before the series of crises. In 2000, private capital flows increased International capital flows and economic smartly after the precipitous decline in 1998 and growth 1999, but the recovery of capital flows since the Private capital was implicated in the severe crises crises has not caught up with postcrisis growth of of the late 1990s, and some have questioned its ef- output and trade. This relative decline reflects some ficacy in stimulating long-term growth. Chapter 3 improvement in the "quality" of flows: volatile examines how private capital inflows are related short-term debt flows have fallen sharply. to, and perhaps contribute to, domestic investment Trends in capital flows to and from develop- and productivity, but also to volatility. The chapter ing countries reflect three forces. The first is the concludes that private capital flows bear a signifi- greater, although still imperfect, financial integra- cant relationship to long-term growth, although in 2 O V E R V I E W : B U I L D I N G C O A L I T I O N S F O R E F F E C T I V E D E V E L O P M E N T F I N A N C E general they tend to reinforce an existing positive countries improved, increasing their capacity to growth dynamic generated by domestic efforts and absorb aid, and in part because countries with initiatives. Among the chapter's findings: weak policies got less aid. But there exists signifi- cant potential to reduce poverty by directing flows · On average, private capital inflows raise do- from middle-income to low-income countries and mestic investment almost one for one. But the by increasing flows to countries with good perfor- effect is strongest for those countries least in- mance that thus far have received little or no in- tegrated with international financial markets, crease in aid. More resources can also be effec- where FDI augments domestic saving, identify- tively deployed for international public goods, as ing and financing new investment opportuni- discussed in chapter 5. ties. The association between greater foreign Recent moves toward donor specialization can inflows and domestic investment is thus strong also make aid more effective. So can increasing in Africa. For developing countries in general, the commitment to provide assistance through pre- however, the relationship has declined since the dictable and medium-term budgetary support to 1980s, because growing financial integration each country's chosen development programs, based means that countries' domestic investment de- on agreed-on policy frameworks and conditioned cisions depend less on the availability of exter- on results. The shift to programmatic approaches re- nal financing. flects the importance of country "ownership" of the · The potential for productivity growth through policy agenda and the long-standing difficulties in private capital flows has probably increased coordinating a host of separate projects, each with because of the growing importance of knowl- different donor reporting requirements. edge as a production input. But the benefits The Heavily Indebted Poor Countries (HIPC) are available mainly to countries that have a Initiative, which embodies some leading-edge ap- strong capacity to absorb these flows. proaches to aid effectiveness, marks an opportunity · Capital inflows, through their volatility, can for a new start. The recent enhancements to the ini- also impose significant costs. Although the tiative have quickened the pace and increased the management of this volatility has improved, resources for debt relief, although the extent to prudential safeguards (through greater liquid- which the initiative will increase total donor assis- ity and measures to limit domestic financial tance is unclear. Since weak policies and institutions instability) remain high on the policy agenda. are the key constraint on growth in most heavily in- · There has been no environmental "race to the debted countries, the tie to policy reform is the key bottom": FDI to developing countries is not at- factor for success. At the same time, greater access tracted primarily by lower environmental stan- to industrial-country markets will help these coun- dards. Countries experiencing rapid growth of tries integrate with global markets and grow. FDI have also steadily improved their environ- ments, because communities in those countries Financing international public goods place a growing value on protecting their en- Chapter 5 attempts a first-ever comprehensive in- vironment, and because foreign investors have ventory of the use of international resource trans- reputations to maintain. fers to fund the creation of international public goods in developing countries. It finds that, for Making aid and debt relief more effective all developing countries worldwide, transfers of The achievement of the International Develop- about $5 billion a year go to finance international ment Goals will require a significant rise in aid public goods, and an additional $11 billion fi- flows--and in their effective use. As chapter 4 re- nances the complementary domestic infrastructure ports, aid flows did increase in 2000, and the pace that allows the absorption of these goods. These of debt relief was stepped up, but continued com- resources mainly support activities in health, envi- mitment is required to ensure that these increases ronmental protection, knowledge creation and dif- are not temporary. fusion, and safeguarding peace. With active sup- The effectiveness with which aid was allo- port from private charitable foundations, donors cated across countries also increased in the 1990s. have been channeling more resources to interna- This happened in part because policies in recipient tional public goods, even as aid budgets have de- 3 G L O B A L D E V E L O P M E N T F I N A N C E clined. Some key global public goods, such as re- 2.2 percent in 2001. Industrial country growth ducing global warming and maintaining financial should slow from 3.6 percent to 1.6 percent, stability, require more than funding--they also and growth in the developing and transition demand greater incentives for collective action. economies from 5.4 percent to 4.2 percent. The returns from greater coordination can be ex- · The period of slower output growth is ex- tremely high. pected to be relatively short-lived. Rapid re- The effective provision of international public covery in high-tech sectors (currently hit hard goods requires a three-pronged approach: by a downturn in the global semiconductor cycle), lower interest rates, tax reduction, and · Integrating global and country-based finance some softening in the oil price should under- · Leveraging public resources with additional pin a rebound in industrial country growth to- private money ward 3 percent over 2002­03. Developing · Improving frameworks that enhance incen- and transition countries' output is anticipated tives for responsible action. to rise toward 5 percent in these years, sup- porting world GDP growth at rates around The lessons of aid effectiveness also apply to inter- 3.3 percent. However, the risk of a sharper national public goods: good-quality projects in and more prolonged slowdown has increased which attention is paid to the details of implemen- over the last months. tation are required as much as they are for country- · World trade growth is likely to be more than based projects. halved from its record 13 percent advance in International financial institutions seeking to 2000 to 5.5 percent in 2001, and to stabilize support the provision of international public goods thereafter at still-robust rates of more than will need to adapt to a world of many actors and 7 percent. Diminished demand will require the decision points--sometimes convening the actors, Organization of Petroleum Exporting Coun- and other times deferring to those with more ex- tries to reduce oil production in order to main- pertise and legitimacy. In short, they need to take tain prices within their target range of $22 to a pragmatic and flexible approach to coalition $28 per barrel. Oil prices are expected to aver- building. age $25 per barrel in 2001, easing to $21 and The overriding message of this report is that $20 per barrel in 2002­03 respectively. Recov- the domestic environment of the recipient econ- ery in non-energy commodity prices will be omy is the key to the effective absorption of inter- postponed until 2002, with prices falling by national resource flows--whether official or pri- 0.3 percent in 2001 before advancing at a 5.5 vate. To paraphrase Albert Hirschman, resource percent annual rate during the years following. transfers are "environment takers," not "environ- ment shapers." And because many imperfections Trends in external finance remain in how official and private flows move · External resources to developing countries in- across borders, their quality can be enhanced by creased from around $246 billion in 1999 to cooperative action and by coalitions that involve $299 billion in 2000. various actors within countries and across national · Short-term external resources, which had boundaries. The global community is now engaged reached a peak of $43.2 billion in 1996, in exciting experiments to do precisely this. recorded net outflows in 1998 and 1999, and a small net inflow of about $3.5 billion in 2000. · Long-term inflows fell from their peak of $342 billion in 1997 to $265 billion in 1999 Numerical highlights but rebounded to $296 billion in 2000. · Developing countries' share in global private The global economy flows fell from 14.4 percent in 1997 to 7.6 per- · A sharp slowdown in economic activity, pri- cent in 2000; their share of FDI fell from 36.5 marily in the United States and East Asia, is an- percent to about 16 percent over that period. ticipated to lower world GDP growth from its · Developing countries' aggregate current ac- decade-high advance of 4 percent in 2000 to count was in a significant surplus of $60 bil- 4 O V E R V I E W : B U I L D I N G C O A L I T I O N S F O R E F F E C T I V E D E V E L O P M E N T F I N A N C E lion, and their international reserves increased $41.6 billion, although even after the rise, aid by $53 billion. Hence much of the capital in- levels were lower than in the early 1990s. flow is balanced by capital outflows or inade- quately accounted for. International private capital and growth · Just as in the last major episode of large inter- Private finance national capital flows a century ago, capital · FDI to developing countries declined modestly flows in recent decades have for the most part (by 4 percent) for the first time in a decade, re- been reactive rather than proactive--in where flecting a slowing of merger and acquisition ac- they go and the impact they have. tivity and the completion of some large-scale · Bank lending and FDI are strongly related to privatization projects. increases in domestic investment: a dollar of · World FDI flows continued to grow rapidly such flows is associated with an increase in and even accelerated somewhat in the second domestic investment of about a dollar. half of the 1990s. Mergers and acquisitions · Cross-country growth regressions suggest that grew particularly rapidly, reaching $720 billion private capital flows are associated with faster in 1999. Industrial countries accounted for productivity growth: an increase in capital in- much of this upsurge, with their share in world flows equal to 1 percent of GDP is associated FDI flows rising from a low of 65 percent in with an increase of about 0.25 percent in GDP 1994 to an estimated 84 percent in 2000. growth. This influence may have become more · Capital market flows to developing countries, pronounced over time. Case studies show that after falling in 1998 and 1999, rose in 2000 the assimilation of productivity benefits re- but remained at about three-fourths of their quires a strong investment climate. 1997 level. Developing countries' share of · The regressions also reveal a negative relation- worldwide capital market flows has also fallen. ship between capital flow volatility and growth · Flows to three middle-income countries rates--more volatility means slower growth. (Brazil, China, and Turkey) increased by $43 · Despite the high visibility of recent crises, the billion in 2000, or just $7 billion less than the volatility of capital flows does not appear total rise in capital market flows to developing to have increased substantially for developing countries as a group. The Republic of Korea countries as a group. Countries are also, in and South Africa together received an addi- general, managing volatility better. tional $11 billion. Capital market flows to the · Although exposing domestic financial markets rest of the developing world fell by $4 billion. to foreign capital tends to increase instability in the first year, in the medium term (starting Official finance from about the third year) foreign inflows are associated with greater stability, not less. · Official development finance--concessional Larger international capital market flows are, and nonconcessional--to developing coun- on average, associated with greater develop- tries fell to $38.6 billion in 2000, from $45.3 ment of the financial sector. billion in 1999. · There is no sign of a race to the bottom in · Nonconcessional flows from official sources pollution levels in the urban centers of Brazil, fell from their peak of $16.2 billion in 1998 to China, and Mexico during the past two $5 billion in 1999 and were ­$3.0 billion in decades: particulate pollution is down in all 2000 as new lending fell and some countries three countries, even though foreign invest- prepaid funds received to contain financial ment is up. crises. · Concessional official flows rose slightly, con- tinuing the trend that started in 1998 after the Trends in official flows sustained fall from 1992 to 1997. Concessional · Official development assistance, measured aid flows--official development assistance, from the donor side (and including technical consisting of grants and loans with a grant cooperation grants), rose 5 percent in 1999, component of at least 25 percent--increased to to $56 billion. 5 G L O B A L D E V E L O P M E N T F I N A N C E · This represents 0.24 percent of the combined terms. The eventual cost of the HIPC Initiative gross national product of the principal in NPV terms is estimated at $28.6 billion. donors: the 22 members of the Development · With debt relief, debt service due for the 22 Assistance Committee of the Organisation for countries that had reached decision points by Economic Co-operation and Development. the end of December 2000 will decline to $2.1 · This increase continues the upward trend that billion a year (in current dollars) in 2000­05, began in 1998, when aid flows rose $3.2 bil- or 25 percent less than the average in 1998­99. lion, and suggests an end to the decline in aid Debt service as a share of fiscal revenue is pro- from 1992 to 1997. jected to decline by about 10 percent in 2001­ · Japan registered the most significant increase 05 (by an average of 14 percentage points from in aid among major donors, thanks to its spe- 1998). Debt service as a share of exports is ex- cial assistance program for countries affected pected to decline over the same period, from by the East Asian financial crisis. At $15.3 bil- about 17 percent to about 8 percent. lion in 1999, Japanese aid was $4.6 billion higher than in 1998. Financing international public goods · The other major factor influencing the 1999 · About $5 billion in international resource rise in aid flows, particularly those from the transfers (about 10 percent of official develop- United States, was the international effort to ment assistance) is spent each year on the pro- assist refugees from Kosovo. duction of international public goods. · Among developing regions, East Asia and Pa- · This expenditure, referred to as core spending cific, and Eastern Europe and Central Asia, on international public goods, is supplied by saw a marked increase in aid in 1999­2000, private foundations ($1 billion), official trust accounting for nearly 45 percent of total flows. funds ($2 billion), and official development as- · But their larger shares meant smaller shares sistance ($2 billion), to provide different pub- for Sub-Saharan Africa and, to a lesser extent, lic goods with varying reach. South Asia. · In addition, an estimated $11 billion of offi- · East Asia's increase was driven by the surge cial development finance is devoted each year in aid from Japan. The main beneficiary was to complementary spending on international Indonesia, where the net inflow of aid dou- public goods: country measures and infra- bled between 1997 and 1998 and doubled structure for the effective absorption of these again in 1999­2000, to an annual average of goods. $1.9 billion. · Annual foundation spending for international programs is now about $1 billion, having The Heavily Indebted Poor Countries grown at roughly 8 percent a year in the 1990s. Initiative · A decade ago, international grants of private · In the three years from September 1996 to foundations, at about $400 million, were less September 1999, seven countries were ap- than 1 percent of official development assis- proved under the original HIPC Initiative: tance. Today they are about 2 percent of offi- Bolivia, Burkina Faso, Côte d'Ivoire, Guyana, cial development assistance (which has been Mali, Mozambique, and Uganda. From Sep- declining) and about 20 percent of resource tember 1999, when the enhanced HIPC Ini- transfers for international public goods. tiative was endorsed, to the end of 2000, debt · Official trust funds contribute about $2 bil- relief was granted to 15 more countries: Be- lion a year to regional and global activities, or nin, Cameroon, The Gambia, Guinea, Guinea- about 4 percent of official development assis- Bissau, Honduras, Madagascar, Malawi, tance, up from modest amounts in the early Nicaragua, Niger, Rwanda, São Tomé and 1990s. Principe, Senegal, Tanzania, and Zambia. · Official donors contribute to many trust funds · By the end of 2000, total committed debt relief administered by various agencies. The World stood at $20.3 billion in net present value Bank has the largest portfolio of these trust (NPV) terms, and $33.6 billion in nominal funds, with $1.3 billion in cash contributions 6 O V E R V I E W : B U I L D I N G C O A L I T I O N S F O R E F F E C T I V E D E V E L O P M E N T F I N A N C E in 2000, about $700 million of which is tar- rose from about 7 percent of all official devel- geted to regional and global programs. Other opment assistance in the 1970s to more than international organizations manage another 15 percent in the late 1990s. $200 million. An important resource and cat- · Core and complementary aid allocated to alyst for funding directed to regional and health has grown the fastest, boosting overall global programs is the World Bank's Develop- expenditure on international public goods. ment Grant Facility, which mobilizes about · Nonconcessional lending from the multilat- $1.1 billion a year for international public eral lending organizations has largely been goods. An additional $900 million from multi- for complementary activities. At about $3 bil- partner trust funds brings the total channeled lion a year in recent years, such financing con- through official trust funds each year to about stitutes about 8 percent of lending by such $2 billion. organizations. · A significant part of development assistance-- · The official financial community has pledged estimated at about $8 billion a year in the late more than $280 billion in rescue packages to 1990s, or about 15 percent of the total--is prevent financial distress in crisis countries, channeled to complementary expenditure for thus contributing to the international public international public goods. Such expenditure good of global financial stability. 7