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B. Foreign direct investment

As already discussed, FDI flows - as with capital market flows - which have been the fastest-growing component of long-term flows to developing countries as a whole and which, in the estimation of most analysts, are likely to remain the main source of foreign finance to developing countries over the long term, will, in the final analysis, depend on the growth and stability of the world economy. Moreover, it is important to note that the factors that have been shown in recent studies to be associated with the rapid growth in FDI in the 1990s, including the policy environment, high growth rates, low transaction costs and market size, are not particularly strong in the low-income countries, which have thus far been minor players in the world of FDI flows.

II. Evolving Trends in Official Development Finance

Official development finance, comprising grants and long-term concessional and non-concessional loans from bilateral and multilateral sources, is the other source of development finance to developing countries. It was indeed a major source of such finance throughout the 1970s and 1980s, when it constituted more than half the total resource flows to developing countries. Even at the start of the 1990s, official flows made up a larger proportion of these resource flows (table 2). However, from a peak in 1991, when they reached about $63 billion, net official long-term flows have declined both in absolute terms and as a percentage of total resource flows to developing countries, falling from about half at the beginning of the 1990s to just over a fifth of total resource flows in 1998. To be sure, some of this decline is attributable to currency values and classification factors (World Bank/IBRD, 1999: 70). But even after correcting for these factors, the decline in net flows of ODA in real terms has been significant, with only four countries - Denmark, the Netherlands, Norway and Sweden - exceeding the UN target for ODA of 0.7 per cent of GNP. The decline has been particularly marked in the G-7 countries.

Apart from the decline in the levels of ODA, there are other important trends that affect its role as a source of development finance. First, the share of ODA directed to emergency and relief work has risen, as has the share going to the administration of aid programmes in the donor countries themselves. Secondly, although the proportion of tied aid in total development assistance has reportedly fallen from a peak of about 50 per cent in 1979 to an estimated 20 per cent in 1996, it is still significant in terms of its impact on cost effectiveness. Some estimates suggest that aid tying increases the cost of supplies by between 10 to 30 per cent (World Bank/IBRD, 1999: 73)

Even so, the evidence of recent cross-country economic analysis confirms the rather self-evident view that aid not only promotes growth in countries where the policy environment is good, but also "crowds in" private investment and improves investor perceptions of risk. The World Bank cites the cross-country studies suggesting that an increase in aid of 1 per cent of GDP in the recipient country increases private investment by an additional 1.9 per cent of GDP in countries with good policies (World Bank, 1998). At the same time, the policy environment has improved markedly in the vast majority of countries in South Asia and sub-Saharan Africa. According to the World Bank's suggested criteria of growth, inflation and trade openness, policy performance in both sub-Saharan Africa and South Asia is better now than at any time in the previous quarter century.

It is therefore rather ironical that ODA should be experiencing a steady decline even as conditions are improving for its greater effectiveness. The prospects for a reversal of this trend are at best mixed. While a small number of countries increased their ODA budgets in 1998, it has been significantly reduced in Japan, which has been the largest donor in recent years. Fiscal constraints and the need to reduce deficits (in compliance with criteria set in the Maastricht Treaty for EU member States, for example) have been cited, and will probably continue to exercise a restraining influence on future aid flows, although recent experiences with international resource mobilization suggest that these constraints can be overcome with amazing speed when the stability of the international financial system is threatened! In the light of these experiences, it is probably true to say that the radical shift in strategic interests on the part of the leading industrialized countries following the end of the cold war is the most credible explanation for the downward trend in ODA, and may very well also determine future trends.

The low-income countries are a particularly capital scarce group among the developing countries. They must import capital from the developed countries (and use it efficiently) even as they improve the environment for domestic resource mobilization through increased savings, which have tended to closely match investment rates. Indeed, their need to reduce reliance on 3 foreign savings is widely recognized. Such an effort is being made in sub-Saharan Africa, for instance, with some impressive results (see Table 3). At the same time, it is also recognized that in the near term, these efforts will continue to be constrained by low levels of income. In these countries, therefore, and especially in sub-Saharan Africa, capital scarcity has been filled largely by ODA, the outlook for which is not promising, as discussed in the preceding section. Given the limited prospects for a significant and sustained upturn in the level of ODA flows, the future of the low-income countries depends on their ability to attract larger flows of FDI, the dynamics of which have also been examined above. Increased reliance on FDI will not only enable them to avoid a worsening of their debt burden, it will also, hopefully, improve their access to technology and management expertise. We now turn to the issue of debt relief for the low-income countries, both as a way of improving their ability to attract FDI and also as a way of providing them with additional and predictable financing for development.

Ever since the HIPC Initiative was launched in 1996, it has become the framework and the operational instrument for negotiations and for the provision of debt relief to debt-burdened developing countries. A reduction in the debt stock through this initiative would promote growth by attracting more investment, especially FDI. At the same time, resources freed through relief from debt servicing would help finance larger investment spending by government, provided the cost of the scheme is not financed by a diversion of current or existing ODA resources.

Under the original HIPC Initiative, eligible countries qualified for debt relief once they went through two stages of three years each. In the first three years, a country seeking relief would establish a track record of good performance in its implementation of a structural adjustment programme prescribed by the Enhanced Structural Adjustment Facility (ESAF) of the International Monetary Fund. In return, its Paris Club creditors would commit themselves to rescheduling debt service payments so as to achieve a roughly 67 per cent reduction in the net present value (NPV) of eligible debt (this essentially meant a Naples-terms rescheduling), while non-Paris Club members would provide comparable relief.

At the end of the first three-year period, the country would reach a "decision point" when it would be decided whether it would be given HIPC debt relief if the Naples-terms reduction it had obtained failed to reduce its debt burden to a sustainable level. The country would then begin a second three-year period, also requiring an ESAF-supported programme, during which time the Paris Club creditors would provide additional debt service relief up to 80 per cent in NPV terms (Lyon terms), with the non-Paris Club members also providing relief. A so-called "completion point" would be reached at the end of the second three-year stage, when the creditors would reduce the country's debt burden to a sustainable level (a debt-to-exports ratio of 200-250 per cent in NPV terms), implying up to 80 per cent stock relief in NPV terms.

The changes in the HIPC arrangements agreed at the recent meeting of the G-7 in Cologne (hereafter referred to as the Cologne Initiative) made important modifications to the original proposals, which would improve them in at least four ways: first, by accelerating the pace of debt relief through the provision of interim relief before the "completion point"; secondly, by allowing countries to advance the "completion point" by accelerating the pace of policy reforms; thirdly, by broadening country eligibility through changes in the sustainability thresholds. Finally, the Cologne Initiative also sought to link debt relief to poverty alleviation.

However, even with these improvements, the Cologne Initiative still suffers from three major pitfalls that erode the potential of the HIPC Initiative to become an important stimulus for development finance: (i) it applies an inappropriate criterion for determining the ability of the HIPCs to pay their debts; (ii) it misses the fact that these countries need large transfers from the rest of the world and that, for the most part, they pay their debts at the cost of investments in physical infrastructure and human capital; and (iii) the current mechanisms for easing the debt burdens of these countries leave them with marginally positive net resource flows that are grossly inadequate to meet urgent social expenditures; moreover, they are unstable and unpredictable, making long-term strategic planning impossible.(4)

A. The capacity to service debt

The original HIPC Initiative determined a country's ability to pay based on its ratio of debt to exports, when in fact its capacity to service debt depends more on its fiscal position. Although "fiscal sustainability" is by no means a trouble-free concept, it nevertheless provides a better 5 measure of debt-servicing capacity, since not all export receipts accrue to the country's budget from which debt service payments must be made.

Indeed, it would seem that the world already recognizes that these countries simply cannot service their debts. Under current arrangements, a proportion of debt service due is rescheduled either formally through negotiation, or informally through a build-up in arrears. The substantial portion that is paid is, in fact, financed from new loans and grants from bilateral sources. In general, the HIPCs receive net resource transfers that are just marginally positive. In 1997, these net resource transfers amounted to less than $10 per head in the HIPCs. As figure 1 shows, for the years 1996 and 1997, net resource transfers were negative for all loans for the HIPCs as a group; that is, they paid more in interest and amortization than they received in new loans. New grants, however, exceeded the negative net transfers from loans, thereby making the overall net resource transfer positive; in effect, grants and loans together exceeded interest plus amortization. Net resource transfers from the rest of the world to the HIPCs - that is grants plus new loans minus debt servicing - have been positive throughout the 1990s. But, as figure 1 shows, they have been on the decline as new loans have declined in relation to debt servicing, while grants have remained more or less unchanged in nominal terms. Net transfers have fallen from a peak of about $10 billion in the mid-1990s to about $6 billion in 1998.

Moreover, the process by which these burdensome debt service payments are financed through new loans and grants is rather unstable, and the net resource transfers are highly volatile and unpredictable (Annex Tables1, 2 and 3). Malawi, for instance, saw its net resource transfers fall dramatically in a two-year period, from 129 per cent of revenues in 1995 to 48 per cent of revenues in 1997. In contrast, a write-off of debt servicing on public and publicly guaranteed debt, with bilateral loans and grants remaining unchanged at current levels, would result in positive net resource flows of some $5 billion a year to the HIPCs,6 compared to net flows of long-term debt of $4.8 billion and net FDI of $4.0 billion to these countries in 1998. Thus, the case that is being made by some academics and NGOs, notably Jubilee 2000, for more generous relief than is envisaged under the Cologne Initiative is particularly strong.

However, in a development that is very much a sign of the times, it is worth noting that even the original HIPC Initiative was never fully financed, and it is therefore reasonable to expect that there would be difficulties with financing the Cologne Initiative, let alone proposals for a complete write-off of outstanding debt for all or the poorest of the HIPCs.

Total costs of the original HIPC Initiative were estimated at $12.5 billion in 1998 NPV terms (7), and of the Cologne Initiative at about $27.4 billion (8). Costs are based on a proportional basis, or burden-sharing principle. Under the Cologne Initiative, the costs for bilateral and multilateral creditors are estimated to be about equal, with multilateral costs being roughly doubled. Estimated costs by creditor group are broken down in table 4.

Judging from these orders of magnitude, and also from the recent record of international resource mobilization for bail-out operations and for humanitarian relief in the wake of the Kosovo crisis, it is clear that the question of HIPC financing is largely a matter of political will. The total cost of some $40 billion is, after all, about a fifth of the resources that were mobilized in the space of a few months for bail-out operations for a handful of countries as a result of the Asian crisis. Indeed, the speed with which the G-7 has mobilized a consensus to revise the terms of the original HIPC Initiative proves the point. However, for the Initiative to be truly effective in providing HIPCs with fresh budgetary resources - estimated by the IMF to be about 2 per cent of GDP - the financing will have to come from genuinely additional sources, along with a commitment by the bilateral donors to continue to provide ODA. But funding difficulties still remain, among them the unevenness of creditor country exposure, with a disproportionate burden falling on Japan and France. It is also worth noting that Japan's decision to make countries, notably Ghana, choose between HIPC relief and continued Japanese concessional assistance is a most unfortunate development.(9)

B. Africa's special circumstances

Of all the regions of the world, sub-Saharan Africa faces the most daunting development challenge in the new millennium. According to the World Bank's latest estimates, output per head - without South Africa, which accounts for about 40 per cent of the region's output - was lower than South Asia's. Sub-Saharan Africa also has the largest "poverty gap" and, arguably, the highest levels of income inequality. Although Africa shares these grim indicators with South Asia, there is a growing belief that development prospects for South Asia are more hopeful than for sub-Saharan Africa (see, for instance, Qureshi, 1997).

Understandably, therefore, much attention has been focused on the region's development prospects in recent discussions on development cooperation, and also in academic literature. Attempts have been made over the years to estimate the development finance needs of the region, some of them under the auspices of the United Nations, and others by international financial 10 institutions (ECA, 1993; ADB, 1995). Most recently, fresh attempts have been made to estimate the level of development financing that would be required to achieve the development targets set by the international community, including that of reducing poverty by half by the year 2015. However, none of these exercises is free from methodological and other technical problems. One recent critique has focused, for instance, on the use of the incremental capital output ratio (ICOR) for these estimates (Easterly, 1997). Nevertheless, these calculations offer broad indications of Africa's resource needs, and, provided their limitations are understood, they can be useful points of departure in measuring the depth of the crisis in development finance.

One such recent study by Amoako and Ali (1998), based on ICORs and domestic savings and investment rates that the authors consider reasonable, estimates external financing requirements that far exceed what would be considered within the realm of possibility, given current trends. For 1998, for instance, they estimate development financing requirements for sub-Saharan Africa alone of $82.4 billion.(11)

While in recent years international capital markets have surged and become by far the most significant source of development finance to developing countries, even in the wake of the Asian crisis, market access has been highly concentrated in a narrow group of middle-income countries. Flows to low-income countries have been rising in recent years, but these too are concentrated in a narrow range of countries, with India alone accounting for the bulk of these flows. Overall, capital market financing has been less important than FDI, but it too has been characterized by a high degree of concentration among oil and mineral exporting low-income countries.

Many low-income countries in both South Asia and sub-Saharan Africa have undertaken important policy reforms and have begun to achieve high levels of growth, in some cases backed by a rising share of investment in total output. But even for these fast growing countries with a good policy environment, the recent levels of growth are unlikely to be sustained without significant flows of external finance, especially private finance.

The mobilization of additional resources to help sustain high levels of growth where they have already been attained, and to accelerate growth in other cases, will require action both in the domestic policy arena and at the international level. Important domestic policy issues include export expansion, diversification and competitiveness. Much has been written about the need for further policy reform to improve the macroeconomic and governance environment. This is important not only for attracting foreign investment but also for reducing the extent of capital flight, which, by all indications, is higher than in other regions of the world (see table 5). In addition, a lot can be done at the regional level to bolster the macroeconomic environment and improve investor perceptions of risk. Promoting the image of the sub-Saharan region as an emerging market, for instance, would be a good way of improving prospects for attracting investments in equity portfolios. There are over 13 functioning stock markets in the SSA region, with a total capitalization of over $309 billion and a turnover of $21 billion as at end-December 1995. The markets have great potential but are fragmented, and have, on average, low levels of capitalization. The World Bank estimates that between 1970 and 1993 Africa's loss of market share in current prices amounted to an annual loss of some $68 billion (equivalent to 21 per cent of GDP). For non-oil producing African countries (excluding South Africa), for instance, the World Bank estimates that the cumulative terms-of-trade losses since the early 1970s represent about 120 per cent of GDP.

In the domain of international action, the crucial issue of debt relief (which we have discussed in the preceding sections) and the important issue of trade access, especially for textiles and clothing, need to be addressed. The successful resolution of developing country trade issues within the framework of the WTO is, like debt relief, an important aspect of the development finance debate.

There has been phenomenal growth in prosperity since the end of the Second World War. A number of developing countries, mainly in Asia, have made unprecedented strides in eradicating poverty. Some of these gains have suffered significant erosion in the wake of the recent crisis, and even with the faster than anticipated recovery that is taking place in the crisis-hit countries, a return to pre-crisis peaks of growth will take time. At the same time, the recent improvements in the policy environment in many low-income countries, and their efforts at achieving faster growth through integration in the world economy, are in danger of being throttled by the limited availability and undue concentration of development finance. The low-income countries themselves have the primary responsibility for pursuing domestic policies aimed at boosting domestic competitiveness. These include policies in the areas of exchange rate management, trade and technology. But conscious efforts are required at the international level, not just to boost the outlook for and effectiveness of aid, but also to create new instruments for the mobilization and channelling of long-term development finance to the low-income countries.

It is important that these efforts also include action to improve developing country access to the markets of the developed countries, and to their products of science and technology. Above all, the reform of the international financial architecture should include contingency financing arrangements for compensating the low-income countries with limited access to capital market financing for income losses arising from the global effects of international crises. They have a decidedly better claim to compensation than the large international banks and hedge funds that benefit from bail-out operations. There should be a special focus on sub-Saharan Africa in future discussions on development finance for reasons of its exceptional capital scarcity and relatively weak prospects for rapid integration in the growing world of foreign private capital flows.

1. In the economics profession itself, the business of estimating financing gaps according to the Harrod-Domar growth model has long gone out of fashion. Only its ghost still lurks. See table 2 for investment rates in Fisher et al. (1998).

2. Within the space of a few months, August-December 1998, the international community pledged this sum in support of Brazil, Indonesia, the Republic of Korea, the Russian Federation and Thailand. The amount does not include the $30 billion pledged by Japan in support of the East Asian countries (see World Bank/IBRD, 1999: 91-92).

3. For investment rates see Fisher et al. (1998, table 2).

4.This critique is based on a study by Sachs et al. (1999).

5. It is difficult to apply where, for instance, a country's fiscal position depends, to a significant extent, on foreign grants.

6. This would be half the gross bilateral ODA disbursements to sub-Saharan Africa in 1996, for instance.

7. Excluding Liberia, Somalia and Sudan. With these countries included, total costs were estimated at about $19 billion.

8. Without Liberia, Somalia and Sudan. With these countries included, total costs would increase to $36 billion.

9. Ghana has in fact opted out of the HIPC Initiative for this reason, although it is by no means clear that this is in its best long-term interest.

10. For example, the United Nations Programme of Action for African Economic Recovery and Development (UNPAAERD) in 1986 and the United Nations New Agenda for the Development of Africa in the 1990s (UN-NADAF).

11. This compares to net official development finance of about $48 billion for that year to all developing countries.

ADB (1995). African Development Report, Abidjan, African Development Bank.

Amoako KY and Ali AAG (1998). Financing development in Africa: Some exploratory results. African Economic Resaearch Consortium (AERC),Collaborative Research Project on the Transition from Aid Dependancy (mimeo).

Collier P and Gunning W (1997). Explaining economic performance. Oxford, University of Oxford, Centre for the Study of African Economies.

Easterly W (1997). The ghost of financing gap: How the Harrod-Domar growth model still haunts development economists. Policy research paper No 1807, Washington DC, World Bank.

ECA (1993). Strategies for Financial Resource Mobilization for Africa's Development in the 1990s, E/ECA/CM.19/5. Addis Ababa, Economic Commission for Africa.

Elbadawi I, Ndulu B and Ndungu N (1996). Debt overhang and economic growth in sub-Saharan Africa. In: Igbal Z and Kanbur R, eds. External Finance for Low Income Countries. Washington DC, IMF.

Fisher S et al. (1998). Africa: Is this the turning point? IMF Paper on Policy Analysis and Assessment. Washington DC, International Monetary Fund.

Qureshi M (1997). Persistent poverty in developing countries. Opening address at the Conference on International Peace and Security, The Aspen Institute, Broadway, United Kingdom, 2 December.

Sachs J et al. (1999). Implementing debt relief for the HIPCs. Policy paper 2 (mimeo). Cambridge MA, Center for International Development, Harvard University, August.

World Bank (1998). Bank Policy Research Report, Assessing Aid: What Works and What Doesn't, and Why. New York, Oxford University Press.

World Bank/IBRD (1999). Global Development Finance: Analysis and Summary Tables. Washington DC, World Bank/International Bank for Reconstruction and Development.

World Bank et al. (forthcoming, 2000). Can Africa Claim the 21st Century? Washington DC.

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