Global Policy Forum

Financing for Development: The Dynamics of the Changed Context


A Briefing Note for the Second Committee of the UN General Assembly

Irfan Ul Haque, South Center

June 1998

1. Changes in the Global Context

The main reason why there is a need for a fresh look at the policies and institutions that governs the financing for development is the changed economic environment in which developing countries are today striving to eradicate poverty and -raise: their standards of living. This context is very different from the state of affairs immediately after the Second World War, when the foundations of the current system were laid. The international financial system has undergone some profound changes in response to changing circumstances, but of Iate it has been showing some serious signs of strain.

In listing the significant changes that have taken place in the global economy, the increased differentiation in terms of per capita income among the developing countries must first be noted. A few developing economies grew very rapidly over the past several decades, and their living standards started to catch up with those of the industrialized economies. However, the large majority of countries were less successful; per capita incomes in many have remained unchanged or declined. The unfolding East Asian crisis has been a tragic setback for some of the most successful developing economies, but it has also underscored the vulnerability of developing economies despite their fundamental economic strengths.

Another development that his redefined the context for the developing countries is the phenomenon of globalization International trade today accounts for a much bigger share of the world output, more than 20 per cent. The great bulk of foreign trade is now in manufactured products; primary products account for less than one-fifth of world trade. As has been accompanied by a phenomenal increase in recent years in private international capital flows, along with a decline in official (bilateral and multilateral) resource transfers.

The increasing importance of international trade and private capital investments has several implications. First, it means that expanding exports has become a central element of developing country strategies to raise output and accelerate economic growth. The increased interest in foreign direct investment (FDI) is indicative of this. However, its corollary is that developing countries' room for maneuver in macroeconomic and financial policy has become much more limited. Finally, by becoming major producers of a few manufactures, developing countries have started to compete directly with production in industrial countries, which has given rise to fears --however exaggerated - that the high unemployment in the latter is the result of cheap imports and export of capital.

Globalization cannot be separated from the rise of a new economic orthodoxy -- consisting of conservative, anti-inflationary rnacroeconomic policy, market liberalization, deregulation, and privatization -- that took hold in an increasing number of countries. While this orthodoxy could be said to have been initially imposed by the Bretton Woods institutions, there is no denying that an increasing number of developing countries, with some variation, have now come to embrace it. This is despite the fact that there is little evidence that it has stimulated or accelerated economic growth, though it seems to have caused income distribution to worsen in both industrial and developing countries. A significant feature of this shift has been that new policies tend to favor capital over labor, a reversal to the post-war commitment to full employment the rise of the welfare state. Some of the strains that we observe in the global economy, therefore, have their origins in this policy shift.

Finally, the end of the Cold War has also had profound consequences for the South. It, of course, put an end to a major component of the ideological debate (viz., the relative merits of capitalism and socialism) that had dominated the discussion of economic policy, but it also spelled an end to a principal reason for bilateral assistance and weakened the bargaining power of the South vis-a-vis the North. At the same time, it has led to the emergence of numerous new nation states that have started to compete for the limited investment resources and markets. The end of the Cold War was also meant to yield a "peace dividend" that could have been used for promoting economic development, but it seems not to have materialized.

In brief, the increased differentiation among developing countries, globalization, the shift of economic policy towards the market and private sector, and the end of the Cold War have profound implications for the issue of financing for development. They point to two things: one, countries' requirements for development finance have come to differ more sharply (some countries can afford commercial finance, while many still need concessional capital flows) and, two, individual countries, whether developed or developing, have little control over the global economy, The latter point means that the rules that govern the world economy and the "architecture" -- as it has come to be called --of global finance have become crucially important issues.

2. Evolution of Development Financing

The need for concessional foreign finance, from official bilateral and multilateral sources, to support the low-income countries' development efforts has long been recognized. The availability of foreign finance makes it possible for the developing countries to invest more than what their meager savings can allow, while also helping meet their requirements for foreign exchange. Because of a general perception (born out of the 1930a depression) that rich countries would underconsume, capital flows to developing countries were also seen, in the early post-war period, to be helpful in sustaining overall higher levels of economic activity and growth.

The economic rationale for foreign assistance was, however, in practice often subordinated, at least by some of the largest bilateral donors, to the pursuit of their foreign policy objectives in the context of the Cold War.1 But the other side of this coin was that the East-West rivalry gave a certain bargaining power to the developing countries, whose support, individually and as a group, was critical to carrying through resolutions in the United Nations and other international fora. It was at least partly due to this that the developing countries, in the early 1970s, were able to get the industrial countries to agree on a target for official development assistance (ODA) of 0.7 per cent of their GNP, a target that war, in fact missed by a wide margin by most developed countries.

There are several causes for the decline (in absolute teal terms as well as in relation to donors' GNP) in ODA that has been observed over the, past two decades. A major, factor has been the stringent budgetary situation that many industrialized countries began experiencing in the early 1980s. The way governments have chosen to tackle the problem -- reduction of both public expenditures and domestic taxes -- has left the funding of ODA with very low priority. In fact, national legislatures in a number of countries have become much more hard-nosed about foreign assistance because of the sharp cuts in domestic welfare programs. A general perception that foreign assistance has yielded poor results and buttressed corrupt regimes in the developing countries, while creating expensive aid bureaucracies in the donor countries, has tended to reinforce the declining political support for concessional flows.

The factors that have constrained the overall level of ODA have also created difficulties for the World Bank, especially in the United States, in mobilizing resources for IDA, the Bank's "soft-loan window." But the World Bank's own lending his also shown little increase in recent years, because of both demand and supply factors. Some of the best-performing developing countries started to opt for commercial borrowing, because it was available more readily and without the Bank's conditionality. The Bank's increased concern in recent years with the quality of its portfolio of investments in developing countries has probably been a contributing factor.

The shift in public policy from a pursuit of full-employment to fiscal conservatism, along with the doctrine of less government and free markets, led to a common belief in most industrial countries that developing countries did not suffer from some basic structural weaknesses that warranted concessions finance, but from market interventions, rigid labor markets, government regulations, and the state's encroachment of what were held to be the private sector domain. If developing countries were only to rid themselves of these ills, private international capital flows would fulfil their requirements for capital accumulation.

These developments occurred at a time when private financial institutions in industrial countries were being deregulated and new players (notably, the managers of pension and mutual funds) were stepping into the international financial market. Owing to structural adjustment programs, financial markets in an increasing number of developing countries also started to be liberalized and deregulated. As the mobility of capital increased globally, private capital flows to developing countries also rose in prominence, though remaining quite erratic. Private inflows started to exceed the official flows in the late 1970s, reaching a peak in 1981of nearly $70 billion, consisting mostly of commercial bank loans to developing country governments.

The Latin American debt crisis of the 1980s caused a sharp reduction in bank lending, and hence in overall private capital flows. This trend reversed itself dramatically in the 1990s, with almost a six-fold increase in private capital flows between 1990 and 1996, reaching a level close to $250 billion. This represented a sharp increase in both foreign direct investment (FDI) and portfolio investment in developing countries. These movements had a profound impact not only on the handful of middle-income countries that received the private inflows, but also on many others that sought them but did not -succeed.

3. Consequences of Private Capital Movements

There is little indication that the large private capital flows, which dominated the resource transfers to developing countries over the last decade, led to a general improvement in the pace of growth in economies that received the inflows, though the reverse his certainly been true. Rapidly growing economies have always been attractive to private investors, However, in a number of countries, capital flows appear to have contributed primarily to a rise in consumption rather than investment.

The general pattern has been that foreign capital, instead of responding to the developing country needs for investment or foreign exchange, itself became a major influence on the functioning of the real economy. To put it simply, inflows of foreign capital, which countries sought in the past to finance their trade deficits, has itself led to trade deficits. Thus, in such situations, the availability of finance had little to do with the country's investment needs.

The macroeconomics works roughly along the following lines. In the first instance the autonomous inflow of foreign capital simply leads to excess supply of foreign exchange. Unless, the country is able to sterilize the inflows, the tendency is for the trade deficit to -rise. This can happen directly through the appreciation -of the exchange rate in the currency market because of the excess supply of foreign currency or through the build up of foreign exchange reserves that leads to an increase in money supply and subsequently to accelerated inflation. In the latter case, even if the normal exchange rate is not allowed to appreciate, the real rate does because of higher inflation. Once the trade deficits rise, it becomes difficult for the economy to adjust to lower levels when the supply of foreign capital declines or reverses its direction.

The impact of private flows gets magnified as private investors move into countries or regions as a herd, and leave, on the first signs of trouble, as a herd, shattering developing country economics in the process.2 The fact is that capital movements create problems for developing countries in either direction. The inflows put pressure on the local currency to appreciate, which erodes the profitability of the tradable sectors (mostly, agriculture and manufacturing), thus causing the trade balance to worsen and increasing dependency on foreign inflows. The outflows,, on the other hand, in anticipation of incipient trouble turn quickly into capital flight, bringing about sharp currency depreciations and interest rate increases. This simply makes a bad situation worse. It has to be acknowledged that the solution to this problem is far from simple, as his been evident from the controversy which the IMF's analysis and prescriptions have generated in connection with the Asian crisis. Some of the world-s well-known economists have suggested that the Fund's prescriptions may have aggravated the crisis.3

For all these reasons, private capital inflows proved to be quite difficult to manage, even by the East Asian economics that were until recently considered exemplary in economic management. While official foreign debt has posed, and continues to pose, serious servicing problems for a number of developing countries, the debt or financial crisis that have become a familiar occurrence over the past three decades have all been associated with private capital flows.4

A conspicuous feature of these crises has been that in each case the borrowing countries were made to bear the brunt of financial and economic adjustment, since there are at present no bankruptcy regulations governing foreign borrowers. There is not a single instance of an industrial country financial institution going bankrupt on account of its exposure in developing countries. On the other band, after more than a decade, Latin America still remains traumatized by the consequences of the debt crisis, with hardly a country where real wages or the general living standards have recovered to the pre-crisis level.

The frequency of financial crises points to some serious weaknesses in the functioning of the financial markets. Private foreign lenders have repeatedly shown themselves unable to take adequate account of the borrower's financial capacity even though debt service is quite predictable. Lessons have been learnt from each crisis, but somehow they -have not prevented the next one from happening. While the earlier crises could be blamed on borrowers' misguided policies and proclivity to waste resources explaining the East Asian crisis has proved to be a real challenge for economic and financial analysts for economic and financial analysts.

4. Towards an Agenda for South-North Dialogue

The existing international financial system, which governs and regulates international capital flows and world's payments arrangements, does not seem to be serving the developing economics well in their efforts to grow and develop. The large majority of the developing countries, especially those in Africa, cannot -- indeed, must not -- rely too heavily on private capital to finance development. There is a consensus among the development community that a satisfactory level of ODA is crucial especially for the least developed countries if they are to embark on a path of sustained, more rapid economic growth. They are just too poor and weak to afford the commercial terms of private finance or to cope with its swings.

Although the prospects of a significant increase in concessional finance do not appear to be bright; the South, as a collective group of countries, has nevertheless to continue to press for the fulfillment of donors' earlier continents on ODA. Humanitarian concerns in industrial countries remain strong and individual donors continue to have specific regional or sectoral interests. However, these factors have not provided sufficient inducement for raising adequate conccssional finance.

The fact that the Cold War eliminated a major reason for bilateral assistance can hardly be regretted, because, apart from other considerations, it meant that a good portion of foreign assistance did not go into supporting economic development of recipient countries. In fact, it often resulted in support for corrupt and dictatorial regimes in the developing world, the price of which some countries are still paying.

There is a need now for the South to convince the North that concessional assistance is not just "good politics, but also good economics". It is widely recognized that any help to the economies, of the South to grow helps the North through the expansion of markets for its products. However, it is also the case that countries do not share equally in the gains from international trade. Generally speaking, globalization and opening up of the markets -- which the industrial countries consider of great importance for them -- would tend to benefit the stronger, higher-income economies more than the weaker, low-income economies.5 A case can therefore be made for instituting, as part of the globalization process, a system of regular income transfers from richer countries to poorer countries on the basis of the benefits they derive from globalization and closer integration of economies. Such transfers are quite normal within federations, and remain pivotal to the enlargement of the European Union.

Given the politics of budgets in industrial countries, there still remains the question of finding new sources of concessions financing. There seems to be some promise in developing mechanisms that help the whole world community while generating revenue. These mechanisms include the proposal for a carbon tax to regulate the emission of greenhouse gases, an agreement on the exploitation of the global commons, and the idea of introducing some version of the so-called Tobin tax on short-term, speculative capital movements. (The latter has the advantage of discouraging destabilizing short-term capital movements.) Negotiating an agreement in these areas will obviously not be easy, but an attempt to create a new architecture that allows the entire world community to benefit will be a positive step, and may stand a better chance of success than raising budget allocations to concessional assistance in the North.

Quick resolution of the problem of the official debt, which many developing countries face, is intimately tied up with the issue of ODA. The debt service burden in some of the world's weakest and poorest economies has become so onerous that it has, by squeezing public expenditures, led to a sharp deterioration in health and nutrition standards, of their populations. The G-8, at their recent meeting in the United Kingdom, did note the urgency of the problem, but chose to postpone action to the year 2000. This cannot be acceptable to the world community, and it must apply all its moral pressure behind a speedy resolution of what amounts to a crisis of survival in many countries. And this must be done without insistence on unrealistic conditionality.

A careful weighing of the terms, conditions, and magnitude of foreign capital inflows is in fact as important for the more advanced as the lagging developing countries. However, the current system of global finance leaves countries that can better afford borrowing on commercial terms also with serious concerns about private capital flows with regard to their development effectiveness, predictability, and swings. These flows are driven by expected, short-term, financial returns, which are generally poor indicators of the real economic return. A substantial portion of private capital in recent years his gone into the purchase of existing assets (real estate, stock markets) rather than augmenting the host country's productive capacity. In short, a system of incentives and penalties needs to be devised to ensure that private capital actually serves the development needs of the developing countries. In the light of the grave situation in East Asia, this could be an opportune time for the world community to work on developing in international "code of conduct" for private foreign investors that makes them more development oriented, which could benefit both industrial and developing countries.

The large swings in capital movements can be directly-related to the deregulation of the capital markets in the developing countries. The East Asian economies, which were thought to be adept at channeling foreign capital into development activities, also fell victim to the fickleness of private capital flows, as they deregulated their financial markets too far and too fast. The proponents of deregulation and liberalization of capital markets base their case essentially on the desirability of allowing capital to move to areas or activities where the real returns are higbest.6 Theoretically, this could be of general benefit since the movement of capital would tend to move the returns towards equality across countries.7 However, given that financial returns are a poor indicator of real returns, there is little likelihood that this would happen in reality. The case for unfettered capital movements is therefore far from robust.

A number of leading economists argue that steps need to be taken to better monitor and regulate private capital flows and that great caution needs to be exercised in the opening -up of the capital account in developing countries.8 In this regard, the use of controls and penalties on short-term capital movements, as undertaken in Chile, deserves a consideration by other developing countries. The most pressing matter before the world community, however, is to devise mechanisms to predict and avoid future financial crises, and to minimize their ill-effects once they have broken. A crucial element of this would have to be a system of international bankruptcy resolution that ensures equitable sharing of burden between lenders and debtors, as some economists have argued.

In the current debate on improving the international financial system the attention is focused on better monitoring of capital movements (i.e., the IMF, must have better, more complete, and timely information on all forms of capital movements) and their better regulation in developing countries. However, better regulation alone may not suffice so long as currency markets remain highly unstable.9 Speculative capital movements cannot be separated from perverse exchange rate movements, and the resolution of one problem is not possible without dealing with the other.

Finally, the question of conditionality associated with the debt workouts needs to be considered. The stabilization packages must be such that they strengthen, rather than weaken, the countries in crisis. This would not be possible without establishing guidelines and institutional mechanisms that govern the conduct of tile governors of the system.10 It is significant that the IMF to date has no independent audit of its approaches and performance.11 It faces no penalty for poor analysis, misprediction, or faulty advice, even though mistakes in these areas have created literally life-and-death situations in many developing countries. Although the internal audit mechanism of the World Bank also leaves much to be desired, it his provided useful insights on the institution's performance and on the borrowers' needs and priorities.

5. Summing Up

The selection of agenda for the proposed conference on financing for development is a challenging task given the diversity of interests between industrial and developing countries. I should like to conclude with some ideas on issues that might be considered in the development of the agenda.

First, care must be taken to select only those issues where international action and collaboration are required. Thus, while no one can deny the crucial importance of domestic resource mobilization in promoting economic development (as has been noted in the earlier deliberations of this Committee) this is basically it matter that requires national action, learning from other countries' experience notwithstanding. In other words, this issue does not demand any international action.

Second, financing for development should not be viewed purely as a technical, economic issue. As Ambassador de Rojas has noted: "International cooperation cannot be based only on the concepts of 'mutual benefit and common interest' of countries. There must also be an element of the call for justice, for the duty of those who have more means towards those who have less." I would just add that greed and selfishness, which have been the unfortunate side-effects of the ruling orthodoxy, would need to be tempered if there is to be a truly international collaborative effort at redesigning the financial architecture.

A United Nations conference on development finance will be a particularly effective forum to raise and discuss basic questions of principle, rather than technical minutiae. My presentation has focused on five areas, where arrival at a global consensus can be expected to make a lasting contribution to world peace and prosperity. These are:

  • An agreement on the right of developing countries to receive concessions transfers from richer, industrial countries.
  • An agreement on the rights of debtor countries
  • An agreement on regulations that reduce the risk of financial crises.
  • A consensus on a code of conduct for foreign investors, including the multinationals. And,
  • A mechanism for "governing the governors", i.e., devising means for auditing the performance of multilateral financial institutions.


1. This influenced not only the bilateral foreign assistance but also the operations of the multilateral financial institutions, where voting is weighted on the basis of capital contribution.

2. There are several reasons for the herd-like behavior of private lenders. A principal reason is that as agents handling other people's money, private lenders feel more assured moving together. When mistakes are made, they are made at least in good company.

3. There has been a spate of articles in newspapers and professional journals by leading economists on the Asian crisis. The critics of Fund prescriptions include Jeffrey Sachs, Paul Krugman, Joseph Stiglitz, and Martin Feldman.

4. There have been to date four major debt/financial crises that have afflicted the developing world: the Peramina crisis of 1974 in Indonesia, the Latin American debt crisis of the early 1980s, the Mexican crisis of December 1994, and the most devastating of all, the ongoing East Asian crisis.

5. One evidence of this is the behavior of the terms of trade between the developing and industrial countries.

6. It is also often argued that a country will not attract foreign capital in the presence of capital account controls. This is obviously a weak argument, considering that China is currently the largest recipient of FDI.

7. The proponents, however, fail to make a similar case for the movement of labor across countries, on grounds that if capital moves, there is no need for labor to move.

8. See, e.g., Joseph Stiglitz, 1998, "More Instruments and Broader Goals: Moving Toward the Post-Washington Consensus." WIDER Annual Lectures 2.

9. The goal of allowing capital to move to where the real return is higher is difficult to realize in an environment, where exchange rates are unpredictable.

10. Over the years it number of proposals, originating from the world's leading economists and financial experts, have been made on the reform of the international financial system. The South needs to critically view all these ideas as it develops its own position on what needs to be done.

11. Helleiner has discussed this issue at length. See Gerald K. Helleiner, 1998, "A Conference on Finance and Development" in Barry Herman and Krishnan Sharma (ed.), International Finance and Developing Countries in a Year of Crisis. United Nations University, United Nations.

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FAIR USE NOTICE: This page contains copyrighted material the use of which has not been specifically authorized by the copyright owner. Global Policy Forum distributes this material without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. We believe this constitutes a fair use of any such copyrighted material as provided for in 17 U.S.C § 107. If you wish to use copyrighted material from this site for purposes of your own that go beyond fair use, you must obtain permission from the copyright owner.