Foreign Investment, Remittances Outpace Debt As Sources of Finance For Developing Countries: World Bank - Europe and Central Asia

These changes are having profound consequences for developing countries. The boom and bust in private lending was a crucial element in a series of financial crises that started with the 1997-98 East Asia crisis and continued in a new round of Latin American debt problems in 2002. More positively, however, the lower volatility of foreign direct investment (FDI) and remittances is fostering a more stable environment for those developing countries that have learned to live with less external debt.

"The decline in private lending was especially steep in 2001 and 2002 as the global economy struggled through a recession caused by the bursting of the equity market bubble in the major economies," says Philip Suttle, lead author of the report. "Debt finance for developing countries has shrunk and won't come back quickly. Over reliance on debt has been a problem for many countries. Looking ahead there is room for cautious optimism that capital flows to developing countries will be less volatile in the future. This would be good for growth and for poor people."

According to the Global Development Finance 2003 report, net private debt flows to developing countries-bonds and bank loans-peaked at about $135 billion a year in 1995-96 and have since declined steadily, becoming net outflows in most years since 1998. Net debt flows from private sector creditors were negative again in 2002 - developing countries paid $9 billion more on old debt than they received in new loans.

Net FDI has slipped from a 1999 peak of $179 billion to $143 billion in 2002, but remains the dominant source of external financing for developing countries. Net portfolio flows were $9 billion, bringing total equity flows (FDI and portfolio) to more than $152 billion. Workers' remittances reached $80 billion in 2002, up from $60 billion in 1998.

In Europe and Central Asia (ECA), FDI flows have recently been reasonably stable, and the region is expected to receive an estimated $30 billion in FDI in 2003.  Notably, the Russian Federation is finally emerging as an attractive destination for foreign investment in the wake of its remarkable bounceback since the turmoil of 1998.   Overall corporate profitability in ECA has been relatively strong. That said, however, the average rate of return on FDI has been moderate at 4.2 percent, the lowest among other regions except Middle East and North Africa.

Developing countries overall ran a $48 billion current account surplus with the rest of the world, up from $28 billion in 2001, meaning that developing countries continued to be net exporters of capital. The increase was more than accounted for by developments in Latin America, where devaluations and falling imports yielded sharp increases in trade surpluses. East Asia continued to have about a $43 billion current account surplus, while higher oil prices had divergent effects across other regions.

The decline in debt is being driven in part by investors' preferences. Banks and bond holders have become more wary of holding debt claims on developing countries, whereas non-financial corporations, while cautious and increasingly sophisticated in their evaluation of individual countries, nonetheless recognize that a growing number of developing countries offer the potential for growth, according to the report.

The increased reliance on FDI is generally positive for developing countries, since FDI investors tend to be committed for the long haul and are better able than debt holders to tolerate near-term adversity. Many governments that previously borrowed abroad are instead borrowing domestically, on shorter maturities. While this reduces their foreign exchange risk, the shorter-term debt increases the risks from local interest rate fluctuations and the reluctance of local investors to roll over exposures at times of stress, the report said.

And while FDI tends to be less volatile then debt, its stability cannot be taken for granted, since both domestic and foreign investment depend on a positive investment climate.

"The shift from debt to equity highlights the importance of developing countries' efforts to foster a sound investment climate," says Nicholas Stern, World Bank Chief Economist and Senior Vice President for Development Economics. "Nine-tenths of investment in developing countries comes from domestic sources. But domestic investors' needs for a positive working environment are similar to those of foreign investors. Both seek stable macro conditions, access to global markets, reliable infrastructure, and sound governance, including restraints on bureaucratic harassment and corruption."

A positive investment climate is also important for effective utilization of workers' remittances. In countries with poor investment climates, remittances are more likely to be spent on just "getting by" while in countries with good investment climates recipients are more likely to invest in the farms and small and medium enterprises that are key to poverty reduction. "A positive investment climate is important for the effective utilization of all types of capital flows, including FDI, remittances, aid and debt," says Stern.

Like FDI, remittances are a more stable source of external finance than debt. Indeed, remittances tend to be counter-cyclical, buffering other shocks, since economic downturns encourage additional workers to migrate abroad and those already abroad increase the amount of money they send to families left behind. For most of the 1990s, remittances have exceeded official development assistance. Recent trends, including tighter restrictions on informal transfers and lower banking fees mean that remittances through the banking system are likely to continue to rise.

The ECA region received $10 billion in workers' remittances in 2002, somewhat low relative to other regions. Turkey has been among the top 10 recipients since the 1980s; however, its inward remittances declined significantly to $2.8 billion in the crisis year of 2001 from $4.6 billion in 2000, underlining the growing sensitivity of these flows to economic factors.  The EU accession of several countries (scheduled for mid-2004) is likely to increase inward workers' remittances to the region.
 
Despite the relative strength of equity flows and remittances, adapting to weak private debt flows poses a challenge for many developing countries that have come to rely on foreign loans. The net $9 billion that developing countries repaid private-sector creditors in 2002 came on top of a 2001 figure of almost $25 billion.

While it is likely that the third quarter of 2002 marked the bottom of the current credit cycle, any rebound is likely to be hesitant. Net debt flows to developing countries are likely to be broadly flat in 2003. More broadly, the short-term growth prospects for developing countries will continue to depend heavily on the outlook for high-income countries, which in turn will be influenced by geopolitical factors.

"In the near term-the next six to eight months-much will depend on factors that are beyond the control of policymakers in developing countries," says Uri Dadush, Director of the Development Prospects Group. "Over the medium term, however, the improvements that developing countries make in their policy framework and investment climate can be a powerful force for higher growth and more rapid poverty reduction." 

Some disruptions from military actions in Iraq, including a temporary rise in the oil price, are built into the forecasts, but no severe, lasting dislocations are assumed. Based on these assumptions, growth in rich country GDP is expected to accelerate from 1.4 percent in 2002 to 1.9 percent in 2003, reaching near-term peak rates of 2.9 percent by 2004 before easing to 2.6 percent in 2005.

Growth in developing countries was 3.1 percent in 2002, up by a small 0.3 percentage points from weak 2001 results. Growth was restrained by the lackluster recovery in the rich countries and by financial and political uncertainties in several large emerging markets. World trade grew by a meager 3 percent, while prices for non-oil commodities rose by 5.1 percent. 

GDP growth in ECA was 4.1 percent in 2002, up from 2.5 percent in 2001. This impressive increase in the growth rate was mainly due to the sharp recovery of economic activity in Turkey following its 2001 crisis. However, growth in transition countries in the region actually slowed down by a full percentage to 3.6 percent due to slowing growth in Euro Area. This occurred despite strong growth induced by high and rising oil prices in Russia and other CIS exporters.

GDP growth is expected to hold near present rates of 3.5 to 4 percent in the near term. Growth is expected to moderate in Turkey as political problems remain and the conflict in Iraq takes its toll. The problems in the Middle East can benefit Russia and CIS countries, however, as they may receive more oil-related investments. The build up to EU accession should help boost growth in the 10 accession countries.

Net debt flows were very weak especially to Latin America, and foreign direct investment, while more resilient than debt, was nonetheless $29 billion lower in 2002 than in 2001. The price of oil jumped from $19 to $28 per barrel over the course of 2002. For oil importers, this rise more than offset gains in agricultural and metals prices. The baseline forecast projects growth in developing countries to accelerate to 4 percent in 2003 and to 4.7 percent in 2004.

Growth performance over the past 18 months has differed substantially across the major regions of the developing world, largely due to differences in domestic conditions.  The report explains that the variability in performance across regions masks underlying similarities in the developing world. A truly global business cycle has emerged with the advancing integration of developing countries into global production, trade, and financial flows. Economic conditions in rich countries now tend to be mirrored rapidly in developing countries through enhanced trade links, just-in-time logistics, and stronger financial tie-ups with affiliates and suppliers in middle-income countries.

Financial conditions facing developing countries are expected to be a little less austere in 2003 than in 2001-02. Flows of FDI are projected to rebound slightly, while net flows from private sources should be modestly positive, albeit still quite anemic. As noted, this outlook is based on the assumption of a quick resolution to the situation in Iraq and a significant decline in the oil price as 2003 progresses.

The report and related materials are available at:
http://www.worldbank.org/prospects/gdf2003