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Changing the Face of Development Finance?

May 30, 2006—A new World Bank report says 2005 was a landmark year in global development finance.

The Global Development Finance 2006 report says net private capital flows to developing countries reached a record high of US$491 billion in 2005.

And significantly, the report shows capital flows between developing countries (the so-called south-south flows) are now growing more rapidly than those between developed and developing countries (north-south flows) particularly in foreign direct investment.

Mansoor Dailami, lead author of the 2006 Global Development Finance report says the flows between developing countries do have the potential to change the face of development finance – particularly if growth in developing countries continues to outpace that of developed countries.

Dailami says in terms of size, the amounts of the flows between developing countries are still small, but they do reflect those countries’ growing size and power.

“For instance, the foreign direct investment flows from developing countries to other developing countries we estimate is in the order of $47 billion,” he says. “The total amount of cross border bank lending is about $6 billion – which is relatively very small compared to the capital we see going from the rich countries to the developing countries.”

Growing Weight and Power

“However we do believe that this has important implications, reflecting the growing size and weight of developing countries in the global economy. Today for instance, developing countries account for 20 percent of the global GDP. They account for 26 percent of world trade, And even in financial markets, many developing countries are becoming much more important.”

The report says the $47 billion in FDI between developing countries in 2003 was up from $14 billion in 1995. In 2003, that investment accounted for 37 percent of the total foreign direct investment in developing countries.

Trade between developing countries rose to $562 billion in 2004, up from $222 billion in 1995. And as Dailami says, in 2004, that trade made up 26 percent of developing countries’ total trade.

Much of the FDI between developing countries originated with middle income country firms and is invested in the same region. For example, Russian and Hungarian firms invested in Eastern Europe and Central Asia, and South African companies invested elsewhere in southern Africa. About half of China’s foreign direct investment however went to natural resources projects in Latin America.

Resilient Global Growth

The report says global growth has remained “surprisingly resilient” to the rise in world oil prices over the past few years. Despite a doubling of oil prices from early 2003 to late 2005, world GDP expanded by a robust 3.6 percent in 2005.

Developing countries led the way with GDP growth of 6.4 percent, more than twice the rate of high income countries, at 2.8 percent.

The report says global economic and financial conditions remain favorable on the whole, despite several potential destabilizing developments, including high and volatile oil prices, growing global financial imbalances and rising short term policy interest rates in some of the major industrial countries.

It says the upward trend in private capital flows appears to have continued in the early months of this year and “the short run prospects are good.”

High Volatility and Risks

“The state of the global economy seems to be quite positive but we are entering a period of relatively high volatility and changed market assessment and risks,” Dailami says.

“I think there’s a combination of factors behind this,” he says referring to the growing global payment imbalances and changes in monetary policy on the part of the US and other industrialized countries.

“And the market has had three relatively good years and it’s kind of natural that after a boom, there would be a period of pause and profit-taking by various investors involved.”

The report says the sharp rise in private flows to developing countries came despite the uncertainties caused by high oil prices, rising global interest rates and growing global payments imbalances. It predicts growth will exceed five percent through 2008 in all developing regions, except Latin America and the Caribbean, where it’s expected to reach an average of 3.8 percent.

Hans Timmer, manager of the Bank’s Global Trends team, says high oil prices, rising interest rates and building inflationary pressures are expected to restrain growth in most developing regions over the next two years.

“But these regions are still expected to outperform high income economies, “ Timmer says. “While current account deficits in developing countries as a whole are close to balance, deficits in oil importing countries have increased substantially, reflecting both higher oil prices and in several cases, unsustainably rapid growth.”

The Director of the Bank’s Development Prospects Group, Uri Dadush, has also sounded a warning, saying while the favorable economic performance to date was backed by good policies, “it also reflects favorable external conditions that are expected to weaken.”

“Many developing countries have exhausted surpluses and other cushions that allows them to absorb higher oil prices, while growing quickly, “Dadush says.

“As a result they remain vulnerable to further shocks. These could include overheating in some economies, a disorderly unwinding of global imbalances, a sudden disruption in global oil supply, and the possibility of a decline in the prices of other commodities which have supported incomes in many developing countries.”




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