35219 Public Disclosure Authorized Publication Summary › external › default › WDSContent... · SUMNIMARY .> 7~p# jj~I mo, --1' stoUC5g 'LiFtsion Librar The economic turbulence

35219

Publication Summary

Eighth in an Annual SeriesAvailable July 3, 1985

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An overview ofWORLD DEVELOPMENT REPORT 1985

(C) 1985 The International Bankfor Reconstruction and Development / The World Bank

Information about ordering is on pages 15-20.

CONTENTS OF THE REPORT

Foreword by A. W Clausen

Definitions and Data Notes

Part I Overview and Historical Perspective

1 Overview2 A Historical Perspective

Part II Role of Economic Policies

3 Macroeconomic and Trade Policy in Industrial Countries:A Developing-Country Perspective

4 Foreign Borrowing and Developing-Country Policies5 Managing Foreign Finance

Part III Mechanisms for International Financial Flows

6 The International Financial System and the Developing Countries7 Official Development Flows8 International Bank Lending and the Securities Markets9 Direct and Portfolio Investment

Part IV Perspectives and Policies for the Future

10 Perspectives and Policy Agenda

Statistical Appendix

Bibliographical Note

World Development Indicators

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The economic turbulence of the past few years has subsided. The recovery of Backgroundindustrial economies in 1983-84, policy adjustments by many developing coun- anrd focus oftries, and flexibility by commercial banks in dealing with debt-servicing difficul- the Reportties have all helped to calm the atmosphere of crisis. This does not mean,however, that the world economy has regained its momentum of the 1960s orthat development is again making rapid progress. Growth has slowed in mostdeveloping countries that experienced debt-servicing difficulties and in many ofthose that did not. Average per capita real incomes in most of Africa are nohigher than they were in 1970; in much of Latin America they are back to thelevels of the mid-1970s. Dozens of countries have lost a decade or more ofdevelopment.

The experience of the past few years has raised many questions about the roleof international capital in economic development; these are addressed in thisyear's World Development Report. Only a few years ago there was generalagreement that the more advanced developing countries could and should bor-row more commercial capital from abroad. That consensus has been broken.Some people believe that the case-by-case approach to addressing debt difficultiesis creating a sustainable balance of growth and debt servicing that will in timeencourage more lending, including bank lending, Others believe that newapproaches are needed if developing countries are to service their debt andresume economic growth. As with so many changes in conventional wisdom,both new and old arguments are often stylized and exaggerated. It is importantnot to lose sight of the fundamentals of international finance.

Capital has long flowed from richer to poorer countries. It has done so becauseit is relatively scarcer in economies that are at earlier stages of development, andthe expected rates of return tend to be correspondingly higher. What is at issue isthe nature of capital flows, their terms, and their uses. These questions wererelevant in the nineteenth century and remaini so today.

World Development Report 1985 offers a broad and long-term perspective onthe role of international capital in economic development. It emphasizes thatinternational flows of capital can promote global economic efficiency and canallow deficit countries to strike the right balance between reducing their deficitsand financing them. The availability of international capital also involves risks,however: first, that it may delay the policy reforms required for adjustment;and, second, that countries may borrow too much if they misjudge the woay inwhich external economic conditions are going to evolve.

Both benefits and costs can be illustrated by recent experience. On thebenefits side, most developing countries have made substantial eco-

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nomic progress over the past twenty years. Their GDP growth averaged6.0 percent a year in 1960-80. The life expectancy of their people rosefrom an average of forty-two years in 1960 to fifty-nine years in 1982,while infant mortality was halved and the primary school enrollmentrate rose from 50 to 94 percent. These advances reflected principally theefforts of developing countries themselves. But there is considerableevidence that capital flows, often accompanied by technical know-how,have played a part.

Foreign capital has also helped individual countries to cushionshocks-either internal ones such as harvest failures or external onessuch as big changes in commodity prices or recessions in industrialeconomies. External finance can act as a shock absorber, allowing coun-tries to adjust their spending gradually and reallocate their resources fora new environment. In the 1970s many developing countries were able,in the first instance, to pay for more expensive oil by borrowing more.Those countries that accompanied borrowing with policy reformsrestored rapid growth and avoided debt-servicing difficulties. Othercountries used borrowing to avoid the policy actions required for adjust-ment. Many of them ran into debt-servicing problems and needed tomake even more drastic and costly adjustments later.

This contrast emphasizes that foreign borrowing is not a painless orriskless alternative to adjustment. The accumulation of debt makes acountry more susceptible to international financial fluctuations, as theswing from negative real interest rates to unprecedentedly high positiverates has made all too plain. The need for rapid adjustment increased.Borrowers and lenders often fail to take full account of the institutional,social, and political rigidities that restrict a country's capacity to adjust.

The historical The ten years 1973-82 saw a big increase in the foreign finance goingcolltext to developing countries. As a result, both the gross and net debt of

developing countries increased sharply. Between 1970 and 1984 the out-

standing medium- and long-term debt of developing countries ex-

panded almost tenfold, to $686 billion (see Figure 1), despite the declinein capital flows since 1981. The most striking feature of this growth was

the surge in lending by commercial banks. Their share of total new flows

to developing countries increased from 15 percent in 1970 to 36 percent

in 1983.On every measure the debt-servicing abilities of developing countries

deteriorated, particularly after 1974, as their debt increased (see Figure2). The ratio of debt to GNP more than doubled, from 14 percent in 1970to almost 34 percent in 1984. The ratio of debt service to exports rose

from 14.7 percent in 1970 to a peak of 20.5 percent in 1982, declining to

19.7 percent in 1984. Interest payments on debt increased from 0.5 per-cent of GNP in 1970 to 2.8 percent of GNP in 1984 and accounted formore than half of all debt service payments in that year. These averages

conceal wide regional and country differences.Dramatic though the recent growth of foreign borrowing has been, it

is not unprecedented. Three things are clear.* The volume of international capital flows has often been larger in

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relative terms than in the 1970s. Between 1870 and 1913, Great Britaininvested an average of 5 percent of its GNP abroad; that figure rose toalmost 10 percent just before World War I. For France and Germany, thefigure was 2 to 3 percent of GNP. As a proportion of the recipientcountry's GNP, capital inflows were also often larger in earlier periods.Inflows to Canada, for example, averaged 7.5 percent of its GNPbetween 1870 and 1910 and accounted for 30-50 percent of its domesticinvestment. During the investment booms in Argentina and Australiaforeign capital was roughly half of all gross domestic investment. Bycontrast, net capital inflows to all developing countries averaged 2-3percent of their GNP between 1960 and 1973, while financing 10-12percent of their gross investment; since then, net capital inflows havebeen between 3 and 6 percent of their GNP and have financed 10-20percent of their gross investment.

* The structure of financial flows to developing countries haschanged several times. In the years before World War I private bondmarkets were the main source of capital. In the 1930s, following theGreat Depression and widespread defaults by borrowers in both indus-trial and developing countries, commercial lending to developing coun-tries virtually stopped. It was replaced after World War II by an expan-sion of official flows, mainly on concessional terms; the largest part was

Figure 1 Net capital flows and debt. 197G-84

Net flows to developiog coontnhe

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3

Figure 2 Trlds i selecled debt Indicators.197064

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bilateral aid, but some was channeled through the new multilateralagencies such as the World Bank and later the International Develop-ment Association. Along with private direct investment and suppliers'credits, official finance provided the bulk of external capital for develop-ing countries until the late 1960s, when commercial banks started toplay a prominent role.

Debt-servicingl * Debt-servicing difficulties have been common and usually haveOtt . if. . .been caused by a combination of poor domestic policies and a deterio-

rating world environment. The fifty years before World War I saw sev-eral debt repudiations, including the Peruvian and Turkish crises in the1870s and the Argentinian and Brazilian crises of the 1880s and 1890s.

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Defaults, however, were not confined to developing countries: someborrowers in the United States, for example, defaulted on their debts inthese years. In the 1930s defaults were widespread, starting with Ger-many in 1932. Argentina was the only country in Latin America toservice its debt on the terms contracted during these years. Except in the1930s countries were able to resume borrowing (albeit on more expen-sive terms) once they had reformed their policies.

By historical standards debt-servicing difficulties in the 1960s and ... anld1970s do not seem unduly serious. In 1955-70 seven developing coun- r'scheduidglstries (Argentina, Brazil, Chile, Ghana, Indonesia, Peru, and Turkey)were involved in seventeen debt reschedulings. There were also somedebt reschedulings for low-income countries, including India, but thesewere designed to provide additional finance when official lenders couldnot increase new lending. In the 1970s, despite the sharp fall in theirterms of trade in 1973-74, an average of three developing countries ayear rescheduled their debts.

It is only in the 1980s that debt problems have multiplied. The numberof reschedulings rose to thirteen in 1981 and to thirty-one (involvingtwenty-one countries) in 1983 and a similar number in 1984 (see Figure3). Countries have restructured their repayment schedules, sometimesfor several years at a time, in the context of agreed upon programs ofpolicy reform. Low-income countries, however, particularly in Africa,have yet to benefit from the kind of multiyear rescheduling that somemajor debtors have negotiated.

The similarities with the past should not obscure some differences aswell. Developing countries have become more vulnerable to debt-servic-

Figure 3 MrItilateral debt reschedulings, 1975-04

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ing difficulties for three related reasons. First, loans have far outstrippedequity finance. Second, the proportion of debt at floating interest rateshas risen dramatically, so borrowers are hit directly when interest ratesrise. Third, maturities have shortened considerably, in large partbecause of the declining share of official flows and debt-and by evenmore than Table 1 suggests if account is taken of the way in whichhigher inflation and interest rates have front-loaded repayments.

Table 1. Composition and terms of capital flows to developingcountries in selected periods

Component and term 1960-65 1975-80 1980-83

Direct foreign investment as a percentage ofnet capital flows 19.8 15.5 12.9

Floating interest rate loans as a percentage oftotal public medium- and long-term debt . . 26.5 37.9

Average years maturity on new public debtcommitments 18.0 15.0 14.0

Source: For investment: OECD Development Co-operation; for terms: World Bank data.

Another major and disturbing difference today is that many of thecountries with debt-servicing difficulties are in the low-income group.This is partly because their aid receipts have been erratic. The dollarvalue of receipts of net official development assistance (ODA) by alldeveloping countries in 1975 was two-and-a-half times the level in 1970,stagnated between 1975 and 1977, almost doubled between 1977 and1980, and has declined since then. In real terms the pattern is similar,but the fluctuations are less marked. This pattern is explained by varia-tions in bilateral ODA, particularly flows from OPEC countries, sincemultilateral ODA increased steadily between 1973 and 1980 and hasdeclined only slightly since then. Many low-income and lower middle-income countries borrowed commercially and accumulated largeamounts of debt. In earlier periods the poorest countries had obtainedvirtually all their foreign capital in the form of direct investment espe-cially for export-earning activities or official flows on concessional terms.

The historical perspective reveals certain broad characteristics of debt-servicing problems. The financial links between industrial and develop-ing countries depend on three variables: (a) the policies of industrialcountries, (b) the policies of developing countries, and (c) the financialmechanisms through which capital flows to developing countries. Noanalysis of international finance is complete unless it takes account of allof these variables. In doing so, it reveals a much wider range of countryexperience and why some countries have borrowed and encountereddebt-servicing difficulties, while others have not. It also highlights thefact that the economic difficulties of the early 1980s were the product ofindividual economic decisions that seemed rational when they weremade.

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The fiscal, monetary, and trade policies of industrial countries largely Policies ofdetermine the external climate for developing countries. The connection industrialis not simply that rapid growth in the industrial world pulls up the countriesgrowth of developing economies, though it helps to do so. Nor is it justthat prolonged recession and increased protectionism in the industrialcountries cause difficulties for developing countries. Increasingly, thelinks are financial, through changes in the availability of finance andmovements in interest rates and exchange rates.

This became clear in 1979-80, for example, when U.S. monetary pol-icy switched from targeting interest rates to targeting monetary aggre-gates. Interest rates became more volatile. Latin America, with a higherproportion of floating rate debt, was more affected by this change thaneither East Asia or Africa. The result was abrupt increases in debt-service payments. Developing countries find it difficult to make suddenand large changes in debt-service payments. The strains felt by manydeveloping countries were increased in the early 1980s by the recessionin the industrial countries, which reduced export volumes and weak-ened commodity prices at a time when real interest rates were rising. Itis hardly surprising that the combination made it difficult for manycountries to service their debts.

The recovery in the industrial countries has helped to ease some of theliquidity pressures on developing countries. World trade grew by about8.5 percent in 1984, and world output increased by 4.2 percent. In devel-oping countries GNP grew by 4.1 percent, and the volume of exportsincreased by an estimated 8.9 percent, compared with less than 4 per-cent a year in 1981 and 1982. Real interest rates have softened a little butremain at historically high levels. The world recovery in 1983-84 did notlead, however, to the normal cyclical rise in commodity prices in dollarterms. This was due in part to the U.S. dollar's further appreciation, aswell as to technological and other factors affecting the demand for com-modities. Thus, net primary commodity exporters (including Brazil)benefited less than countries that are net commodity importers (such asKorea). In addition, developing countries continue to be affected byprotectionist measures in the industrial economies.

For the future, the effects that industrial countries have on developing Eff.. ofcountries will depend primarily on what happens in two areas of policy: interestreal interest rates and protectionism. In regard to interest rate develop- ratcs ...ments, large budget deficits in industrial countries remain an obstacle tolower interest rates. As a proportion of national income, combined bud-get deficits of all levels of government rose substantially between 1979and 1984 in nine of the principal industrial countries except Germanyand Japan. In 1984 the combined deficits of these industrial economies,adjusted for inflation, were 2.3 percent of their national income. TheU.S. deficit has grown the fastest over the past five years. Crediblemeasures are needed in these countries to reduce public sector relianceon domestic and foreign savings; this could lower interest rates andfoster growth. The United States has recently announced steps that,when implemented, would permit significant reduction in its fiscal defi-

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cits in the next few years. Avoiding a recessionary impact of such a

policy change will require careful coordination with monetary policy inthe United States and with monetary and fiscal policies in the otherlarge industrial countries.

... and of The second issue of vital concern to developing countries is protec-

protectioniismi tionism. To service their foreign debts, the biggest debtors will need to

run large trade surpluses in the next few years. Yet many import restric-

tions-on steel, sugar, and beef, for example-have affected primarily

such large-scale debtors as Argentina, Brazil, Korea, and Mexico. Otherrestrictions, such as the Multifibre Arrangement, affect a broader range

of countries. The more difficult the big debtors find it to service their

debt, the greater the strains on the world's banking system.When developing countries cannot earn the foreign exchange to

expand their imports, exporters in the industrial countries are also dam-

aged. To take one example, this was an important factor in explaining

why U.S. exports of manufactures to the largest debtors fell by 40 per-

cent between 1980-81 and 1983-84. Such harm is widespread, since

industrial economies run a surplus on trade in manufactured goods

with developing countries. And protectionism acts as a brake on the

adjustment and growth that the industrial countries themselves so

badly need.Over the longer term, protectionist barriers in the industrial world can

have a profound effect on development strategy. They suggest to gov-

ernments in developing countries that a strategy based on exportgrowth is highly risky, and thus encourage a return to the inward-

looking policies of earlier years. Evidence is abundant that such policies

are bad for growth and employment in the developing countries and

also reduce the scope for industrial countries to promote improvements

in productivity in their own economies.Policies of The past dozen years have underlined the crucial role of domesticdeveloping policies in determining the performance of developing countries-par-

countries ticularly in the use they make of foreign finance. Foreign finance canpromote growth through higher investment and technology transfers. It

can allow countries to adjust gradually to new circumstances in theworld economy. But it can also be misused, so that countries end upwith more debt but no corresponding increase in their ability to service

it.In the 1970s it was right for countries to borrow when real interest

rates were low or negative-but only if they followed appropriate poli-cies and invested in economically justified projects. Caution in definingborrowing limits was required. It was wrong to assume that low interest

rates would continue, and it is always expensive to reverse investmentdecisions. These mistakes are quickly exposed when world conditionsdeteriorate, as they did in the early 1980s.

Developing countries suffered in 1979-84 from a combination of more

expensive oil, historically high real interest rates, prolonged recession inindustrial economies, and more trade barriers. Despite this, as many as

100 countries have continued to service their foreign debt without inter-

8

ruption. Some have experienced only small shocks, including countriesthat are oil exporters or have benefited from workers' remittances (forexample, certain Asian and Middle Eastern countries). Some had bor-rowed only a little or mainly on concessional terms in the 1970s (forexample, China, Colombia, and India). And some who borrowedundertook economic policy reforms which facilitated debt servicing (forexample, Indonesia and Korea).

Countries that ran into debt-servicing difficulties, however, were not Causes ofnecessarily those which had suffered the biggest shocks. They were debt-sercicingcountries that had borrowed and failed to adjust or had not tackled the I r,. a..new problems with sufficient urgency. Among these were the low-income countries of Africa, whose development is a long-term processconstrained by weak institutional structures, a shortage of skills, andoften (as in the past ten years) natural disasters as well. These countrieshave traditionally used concessional capital from abroad to finance thebulk of their investment. In the 1970s they were faced with higherimport bills. Many African countries that had commodity booms wereable to borrow on commercial terms when interest rates were low. Theyused this foreign finance partly for consumption and also for investmentin large public projects, many of which contributed little to economicgrowth and to increased exports needed to service the debt. Capitalinflows enabled some countries to postpone policy reforms. Debt-serv-icing difficulties could have been expected and did occur. The net resulthas been a further setback to their economic development.

The second group of countries with debt difficulties includes manycountries in Latin America and some large debtors. The reasons for theirfinancing problems are more complex, but three common features are(a) fiscal and monetary policies that were too expansionary to achieve asustainable external balance, (b) overvalued exchange rates that pre-vented exports from competing on world markets and encouraged capi-tal flight, and (c) increased domestic savings efforts but investmentincreases that were even larger. Some countries, such as Chile andUruguay, attempted comprehensive economic reforms, but parts oftheir policy package were defective and the timing of measures takenwas inappropriate. Other countries borrowed heavily and undertooksome policy changes (for example, Brazil, Ivory Coast, and Philippines).But they underestimated the length and depth of the recession and thelarge rise in interest rates in the early 1980s. Many of these countries arenow in the process of reforming their policies, with results that are thusfar encouraging.

The diverse experiences of developing countries emphasize certain Lessoins jirbasic lessons for policy. One can be summarized as the need for flexibil- policyity. A characteristic of foreign finance is that it requires both borrowersand lenders to take account of uncertainty. The best way of doing so isto be able to respond flexibly to changes in the external environment.Countries as varied as India, Indonesia, Korea, and Turkey haveadapted their economic policies to changed circumstances. The mostcritical changes in the short term are the abilities to reduce fiscal deficits

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and to adjust real exchange rates and real interest rates. When for politi-cal or other reasons countries cannot adjust their policies quickly, theyshould be conservative in resorting to foreign borrowing.

A second lesson is that the policies required to make the best use ofexternal finance are essentially the same as those which make the bestuse of domestic resources. A country must earn a return on its invest-ments that is higher than the cost of the resources used. In the case offoreign finance, however, a country also has to generate enough foreignexchange to cover interest payments plus remittances of dividends andprofits. This depends on three groups of policies.

Economlic * Key economic prices must be aligned with opportunity costs. Theseprices and encourage activities in which the country has a comparative advantageopportunitY and increase the flexibility of productive structures. Subsidies, whencosts used, should be carefully targeted, for example, to the poorest segments

of society. When oil prices rose in 1973-74 many countries-includingboth oil importers and oil exporters-delayed raising their domesticenergy prices, thus increasing pressures on their balance of payments;many other countries avoided these pressures by raising energy pricesearlier. Furthermore, investment decisions are influenced by the appro-priateness of pricing structures, including interest rates. Governmentsneed to evaluate carefully their own investment programs and to createa framework of incentives to ensure that private investors allocateresources in the most efficient way. Countries such as Brazil, Ecuador,Ivory Coast, Nigeria, Peru, and Turkey combined negative real interestrates with overambitious or inefficient investment programs. By con-trast, Colombia and Malaysia had more appropriate interest rate levelsand investment incentives.

Exchange rates * Exchange rates and trade policies also play an important role. In theand trade policies 1970s and early 1980s many countries-notably Argentina, Chile, Mex-

ico, Nigeria, Philippines, Turkey, and Uruguay-allowed their exchangerates to become overvalued and their trade policies to become distorted.This biased production toward the domestic market, stimulatedimports, and provoked capital flight. Comprehensive trade and pricereforms by Turkey, following difficulties it experienced in the late 1970s,produced good results.

Domestic * Efforts to raise domestic savings should be strengthened despite thesavings availability of external capital. The correct role of foreign finance is to

supplement domestic savings; it must not substitute for it. The dangerof poor savings performance was well understood by many govern-ments. In fact, many developing countries managed a creditable perfor-mance on savings in the 1970s, with two-thirds of a sample of forty-fourdeveloping countries increasing their domestic savings ratios. Theyincluded such diverse economies as Cameroon, India, Korea, Malaysia,Malawi, and Tunisia. In other cases, including Morocco, Nigeria, andPortugal, inadequate domestic savings efforts contributed to overborro-wing. Improvements in savings performance require measures by bothpublic and private sectors. In the public sector tax measures, realisticpricing of public goods and services, and cuts in spending are required

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to reduce deficits and increase public saving. If higher public spendingis financed by borrowing more from abroad rather than by increasingfiscal revenues, cumulative strains are put on budgets (since govern-ments have to pay debt interest) and the balance of payments. Mexico'sexperience in 1981-82, when the budget deficit more than doubled as aproportion of GNP to meet increased public consumption and wasfinanced partly by external capital, sowed the seeds for its debt crisis in1982. As for private savings, domestic interest rates that are kept lowcurtail savings, contribute to capital flight, lead to credit rationing, andincrease the pressures for borrowing abroad. Government policies ofadjusting exchange rates by less than the rate of inflation and of subsi-dizing foreign borrowing artificially lower the domestic currency cost ofborrowing, thereby inducing capital inflows. This was the case inArgentina, Chile, and Uruguay.

Policies determining the level of domestic savings and investment also Managingdetermine the need for foreign borrowing, so the management of capital foreignflows should be an integral part of macroeconomic management. Cer- borrouingtain aspects of debt management deserve special attention. and debt

The first issue is whether and how governments should regulate for-eign borrowing and lending by the private and public enterprise sectors.The answer depends fundamentally on a government's macroeconomicand incentive policies; in general, less government intervention isneeded the more prices, interest rates, and exchange rates reflect oppor-tunity costs. Although some governments have constructed elaboratecontrols over capital inflows and outflows, experience strongly suggeststhat these are no substitute for sound macroeconomic policies. None-theless, some procedures for regulating capital movements-priorapproval for borrowing, minimum maturity or deposit requirements, orwithholding taxes-have sometimes proved a helpful complement tofiscal, monetary, and trade policies.

The second broad area of concern is the composition of capital flowsand debt. This involves decisions about (a) the terms of foreign borrow-ing (interest, maturity, and cash flow profiles), (b) the currencies inwhich liabilities are denominated, (c) the balance between fixed rate andfloating rate instruments, (d) ways of sharing risk between lenders andborrowers, including the balance between debt and equity, and (e) thelevel and composition of a country's reserves. It is not possible to for-mulate precise rules for external debt management that will apply to allcountries. The experience of the past few years, however, argues forprudence by developing countries in deciding on both the volume offoreign borrowing and its composition and in maintaining enoughreserves to give a country time to adjust to domestic or internationalpressures without unduly jeopardizing its economic growth. If thecapacity to borrow abroad is not stretched to its limits, it will provide acushion in times of particular need.

Many countries fail to manage capital flows effectively because ofinadequate data, a lack of technical expertise about financing options,and an absence of institutional arrangements to integrate debt manage-

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ment with macroeconomic decisionmaking. In all these areas, institu-tional development is an important priority.

Financial Developing countries account for only a small proportion of interna-mechanismrls tional flows of capital, so their influence on the international financial

system is limited. The system itself changes in response to three mainfactors. The first is the external environment. For example, changes inregulations, financial innovation, and high and volatile inflation in the1970s led investors to lend on floating rate rather than fixed rate terms.The second factor is the demand for the services of financial markets andinstitutions, which is heavily affected by imbalances in global payments.For example, OPEC countries in the 1970s and early 1980s preferredinitially to keep their surpluses in highly liquid form, so commercialbank deposits and lending increased. More recently the large currentaccount deficits run by the United States, which have their counterpartin surpluses in Japan and other industrial countries, have led to a muchlarger role for international asset markets. The third factor is the prefer-ences of financial institutions. For example, in the 1970s commercialbanks chose to lend abroad to satisfy their own portfolio and profitabil-ity objectives.

Long-term In the short term, developing countries have to make the most of thequestions. .. opportunities presented by the international financial system. From a

longer-term point of view the critical policy questions are: how can thestability of external capital flows be increased and lending by banks berestored? What arrangements can be made for future capital flows,including enough concessional assistance to meet the needs of low-income countries?

The answers lie in five areas.... and * Longer maturities. Developing countries can borrow long term,answers though seldom directly from the market; they rely almost exclusively on

the intermediation of the World Bank and regional development banks.These institutions will remain the primary sources of longer-maturitycapital for developing countries in the next few years. They need tohave the capability to provide more financing to developing countries,since the prospects for expansion of private financing are not good.Financial innovation to expand the range of maturities available todeveloping countries would help them to manage their debt and reducerefinancing risks.

* Hedging. The nature of the financing instruments used in the 1970smeant that developing countries assumed the risks of adverse develop-ments in the world economy. One of the central functions of a financialsystem-effective risk sharing-was not efficiently served. Instrumentsfor hedging risks already exist in many financial markets: it would bedesirable to make greater use of them in lending to developing coun-tries.

* Commercial risk sharing. Whereas conventional bank loans do notinvolve sharing of commercial risks, foreign direct and portfolio invest-ment does. The introduction of equity-based instruments in lending todeveloping countries is another area in which progress could be made.

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* Secondary markets. Since most commercial lending to developingcountries in the 1970s was done by banks, it tended to increase risks byconcentrating assets in a single group of creditors. The expansion ofsecondary markets for some kinds of liabilities of developing countries'could widen the range of lenders and so increase the stability of lending.Such a development, although desirable, must be a phased process. Inthe long run, secondary markets could also provide an extra indicator ofcountry creditworthiness, making it easier for lenders to diversify theirrisks.

* Aid volume and (ffCtli; . Il- Low-income countries need a consider-able quantity of aid, more than is available at present. They also need touse aid efficiently. Donors can improve their own efficiency by focusingtheir aid primarily on development objectives and by coordinating theirefforts within programs agreed upon with the recipient.

How much and what kind of foreign finance will developing countries Prospects andneed in the years ahead? That question can be answered only by analyz- optionsing the global outlook for growth, trade, interest rates, and so onthrough presentation of alternative scenarios for the future. Such sce-narios, it must be emphasized, are not predictions; their outcomesdepend on the policies adopted in industrial and developing countries.Nor do they allow for exogenous shocks to the world economy.

The next five years are a period of transition. During that time about The niext fivetwo-thirds of the debt of the developing countries will have to be rolled ilearsover or amortized. The constructive and collaborative actions taken bydebtors, creditors, and international agencies in recent years need to becontinued. Their objective is to accelerate the return to creditworthinessof countries that are pursuing sound economic policies, but have sizableshort- to medium-term debt-servicing requirements. They need in par-ticular to be extended to countries-several middle-income exporters ofprimary commodities and many low-income African countries-inwhich debt-servicing difficulties and development problems are inter-twined. Consideration needs to be given to the extent to which multiy-ear debt restructurings for official credits and other arrangements mightbe considered on a case-by-case basis as part of the overall financingpackage supporting stabilization and adjustment, particularly in low-income sub-Saharan African countries committed to strong adjustmentefforts. Beyond that, much will depend on whether industrial anddeveloping countries successfully pursue policies for structural adjust-ment.

Over the past few years many developing countries have madeprogress in dealing with their financial difficulties. The economic situa-tion, however, continues to remain fragile in many countries. Growth ofGDP in 1980-85 is currently estimated at slightly more than one-halfthat of 1973-80. Exports have grown at close to 6 percent a year, but thepressure of continued high interest payments has meant that importscould grow at only a little more than 1 percent a year. Substantial tradesurpluses run by many developing countries have been used to meetgreatly increased interest payments. The high level of real interest rates

13

is thus one of the critical variables whose course will influence outcomes

in the next five years. Developing countries need to keep the rate of

growth of export earnings above the rate of interest-even if the current

account, net of interest payments, remains in balance-if the principaldebt ratios are to return to more sustainable levels. This will depend not

only on their own policies, but also on the rate of growth of industrialeconomies and whether protectionist measures are rolled back.

Assumptionis: Two simulations-a Low and a High-prepared for the period 1985-90

High and Lou) assume that developing countries will continue with their present

scenarios course of policies, which in many cases (as in some low-income Asian

economies) imply substantial policy reform and adjustment effort. Pol-

icy improvements are in three principal areas-key economic prices,

exchange rates and trade policies, and domestic savings. These contrib-

ute to efficiency in the use of resources and to export competitiveness.As for industrial economies, the difference between the simulations is

that the Low one assumes a set of policies that fail to address current

problems and as a result lead to further problems, whereas the High one

embodies policy changes that result in greater progress in adjustment.The Low simulation makes three basic assumptions: no progress in

reducing budgetary deficits and in improving the monetary-fiscal bal-

ance so that real interest rates remain high; a failure to tackle labor

market rigidities so that unemployment stays high and real labor costs

continue to increase; and a substantial increase in protection. By con-

trast, the High simulation assumes reduced fiscal deficits comparedwith the Low simulation, thus permitting improvements in the mone-

tary-fiscal balance and a resultant lowering of real interest rates; reduc-

tions in labor market rigidities such that unemployment declines and

the increase in real labor costs slows down; and an increasing success in

adjustment that results in a steady decline in protection.For developing countries, the implications of these assumptions are

far-reaching. In the High simulation their output grows at a healthy 5.5

percent a year (or 3.7 percent a year per capita), and there is a major

improvement in all the major debt indicators. The Low simulation pro-

duces a different and more problematic outcome: growth slows to 4.1

percent a year (or 2.3 percent a year per capita). If there is a sizablereduction in economic growth, however, the effect on debt servicing is

even more striking. A combination of high real interest rates and protec-

tion makes debt servicing considerably more difficult. The main debt

indicators deteriorate; for a large number of countries debt-service ratios

reach high levels. The volume of concessional aid declines as a result of

slower growth in industrial economies, and "involuntary" lending, in

the face of deteriorating creditworthiness, continues to be required.The two simulations outline a continuing bleak outlook for many low-

income African countries. In the High simulation, their average per

capita income stagnates at present reduced levels; in the Low simula-

tion, there is yet another period of falling per capita incomes. Specialefforts are therefore needed to deal with these prospects. Additional

external assistance is not, by itself, the solution to Africa's problems. It

14

must be based on major changes in African programs and policies.Nonetheless, such reforms are unlikely to be sustained without addi-tional external assistance, over and above that projected in the Highsimulation.

The challenge for the next five years is to ensure that the worldreaches the High case. How it could do so is made explicit in the Report.It is quite clear that foreign capital will play a significant part in meetingthe challenge of faster growth; it is also possible that its legacy from thepast ten years will act to slow growth unless creditors, debtors, and theinternational community continue to ease the pressure of debt.

In contributing to the resumption of growth and the restoration ofcreditworthiness of the developing countries, the World Bank isaddressing investment and institutional development issues crucial tosustaining longer-term progress. Against the background of growingstrength in domestic institutions in borrowing countries and muchgreater resource scarcity than in the 1960s and 1970s, Bank assistance ishelping governments to strike an appropriate balance between addi-tional investments and the maintenance of existing capacities, toachieve greater selectivity and efficiency in public sector investments,and to develop a framework of policy and institutional arrangementsconducive to the growth of activities in the private sector.

The financial resources provided directly by the Bank make importantcontributions to restored growth and momentum in development, butthey can never be more than a rather small proportion of total resourcesas required. The Bank is, therefore, strengthening its catalytic functions,particularly with respect to aid coordination in sub-Saharan Africa,cofinancing with commercial banks and export credit agencies, and thepromotion of private investment. In addition to its direct lending, thetasks of complementing and-to the extent possible-exercising a con-structive influence on capital flows from other sources are also impor-tant factors in shaping the future role of the Bank.

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International Debt andthe Developing Countriesedited by Gordon W Smithand John T Cuddington

This book presents a well-balanced blend of theory, country experience, andeconometric analysis to address the problem of international debt. Applies newmicroeconomic theories of international borrowing and lending to recent experi-ence. Suggests ways to reduce future debt crises.

Focuses on the domestic and external roots of the current problem, thedynamics of debt crises, and proposals to improve the international system fortransferring resources to developing countries.

Includes case studies of Argentina, Brazil, Chile, the Republic of Korea, andMexico.

Subject Headings: International Debt-Developing CountriesDescriptors: International debt, developing country debt, international financial markets, debtrepayment, Argentina, Brazil, Chile, the Republic of Korea, Mexico, debt crisesOrder: Stock No. BK 0457 $20 320 pages8'12 x 11

What Others Say about theWorld Development Report

''One of the finest summaries of economttic conditions in the less developed

countries. Style is clear and readable, information is careflully presenited and

explained, issues covered are topical. All in all, a consistenttly 1 valuable resource

for undergraduate teachintg. "-JEFF FRIEDEN, University of California,Los Angeles

"Essential reading for any individuial or organization interested in or

involved woith developinig counitries. "-THE SUDAN PROGRESS

"An excellent source for readily accessible data on the world economy-I

rely on the tables in every interniational economtics-related course I

teach! "-GAUTAM CHATTERJEE, Simmons College

"Its concern with developing countries' economies and their relationships

to the industrialized world . . . is a welcome addition . . . to the internia-

tional scene. "-DAWN (Pakistan)

"The best single-volume summary/ of the level of economtiic progress

among countries. "-ERIC MONKE, University of Arizona

". . . an important document from many viewpoints . . . a consistent

framework for exploring the links between countries and between economic

variables, so as to illustrate the effects of different policies and events on the

developing countries, to abstract from cyclical fluctuations and concenitrate

on underlying trends. "-LE MONDE (Paris)