V Domestic and Foreign Saving in Developing Countries
Author: International Monetary Fund. Research Dept.
Language:
English
Keywords:
WEO; country; interest rate; exchange rate; developing country; labor market; debt-service obligation; investment rate; potential GDP; investment flow; saving rate; Exports; Domestic savings; Consumer prices; Total factor productivity; Africa; Sub-Saharan Africa; Western Hemisphere; Middle East; Asia and Pacific
Download PDF (1.5 MB)

Abstract

The policy reforms instituted by many developing countries in recent years have fostered macroeconomic stability, promoted higher domestic saving, and facilitated renewed access to international capital markets. These reforms have also raised the efficiency with which saving is utilized, which has contributed to improved international competitiveness and higher growth. Provided that the momentum of reforms is sustained, capital inflows are allocated productively, and the trade environment does not deteriorate, investment and growth prospects for many developing countries are more promising than they have been since the early 1970s. For some low-income countries, however, in addition to improved domestic policies, greater efforts will be needed on the part of the international community to ensure adequate flows of official and private external financing to complement domestic resources.

The policy reforms instituted by many developing countries in recent years have fostered macroeconomic stability, promoted higher domestic saving, and facilitated renewed access to international capital markets. These reforms have also raised the efficiency with which saving is utilized, which has contributed to improved international competitiveness and higher growth. Provided that the momentum of reforms is sustained, capital inflows are allocated productively, and the trade environment does not deteriorate, investment and growth prospects for many developing countries are more promising than they have been since the early 1970s. For some low-income countries, however, in addition to improved domestic policies, greater efforts will be needed on the part of the international community to ensure adequate flows of official and private external financing to complement domestic resources.

Growth, Investment, and Productivity

Developing country growth performance during the past five years has been encouraging. Despite weak activity in industrial countries, annual output growth averaged 4¾percent, and annual per capita growth exceeded 2¾ percent (Table 12 and Chart 26). Growth is projected to average 5¾ percent in 1993 and 1994, a rate of expansion that is expected to be sustained over the medium term. There have been marked differences across countries, with per capita income increasing at an annual average rate of over 5 percent in Asia but stagnating in many other countries. But there also have been successfully adjusting countries in all regions.31

Table 12.

Developing Countries: Economic Performance

(In percent of GDP or annual percent change)

article image
article image

Total factor productivity is calculated as the residual after taking into account the contributions of capital and labor to growth of potential GDP. Estimates reported as 1988-93 are for 1988-91.

Chart 26.
Chart 26.

Developing Countries: Real GDP Growth1

(Annual percent change)

1 Five-year centered moving average. Blue shaded area indicates staff projections.

Higher growth has been led by an increase both in the rate of investment and in the productivity of investment. Following the onset of the debt crisis, investment rates fell in all regions except Asia—with the sharpest declines in the Western Hemisphere and Africa—because of the effects of debt overhang, capital flight, and uncertainty about economic policies and longer-term prospects. Investment activity in many countries, especially in the successful adjusters, subsequently picked up markedly and has now stabilized in countries that experienced debt-servicing difficulties. Regionally, there has recently been an increase in investment in the Western Hemisphere countries, but capital formation remains weak in Africa.

The contribution of total factor productivity to overall output growth, which can be interpreted broadly as an indicator of the efficiency of resource use, generally declined in the first half of the 1980s, in part because of the dislocations caused by the sharp increase in oil prices in the 1970s and the misallocations associated with the subsequent abundance of foreign capital. During the past few years, efficiency of resource allocation has increased in all regions, especially among the successfully adjusting countries. Part of the improvement can be attributed to an increase in the share of private investment—which appears in many cases to have been more productive than public investment—in total investment.

The fall in world interest rates and the restructuring of external debt have played an important role in the recovery of investment and in restoring external creditworthiness, but the key to improved performance has been determined efforts to reduce unsustainable budget deficits and to control inflation (Box 5). Equally significant has been the recognition of the importance of market forces: most of the successful countries have implemented major fiscal reforms, curtailed subsidies, privatized state enterprises, and generally improved the environment for private sector activities. Outward-oriented trade policies—lowering of trade barriers, removal of disincentives to exports, and the implementation of currency convertibility—and financial market reforms have further promoted the efficient use of resources.

Domestic Private and Public Saving

A critically important factor underpinning the increase in capital formation has been the strengthening in domestic saving performance (Chart 27) Although the recent increases in capital flows to developing countries have been helpful, domestic saving continues to be by far the most important source of funds, financing, on average, over 95 percent of investment in developing countries (Chart 28).32 The domestic saving rate of all developing countries, which had fallen from an average of 25 percent of GDP in 1976-81 to 22½ percent in 1982-86, rose to 24½ percent in 1991-93 (Table 13).33 Domestic saving rates had declined markedly in countries with debt-servicing difficulties as a result of sharply higher interest payments on external debt and a substantial widening of fiscal imbalances. In these countries, the implementation of effective stabilization policies and, to some extent, the reduction in the debt overhang have helped to reverse the earlier decline in saving rates since the mid-1980s. Countries without debt-servicing difficulties were able to maintain high saving rates throughout the 1980s and have recently increased them further.34 The successfully adjusting countries recorded a particularly sharp improvement.

Table 13.

Developing Countries: Saving1

(In percent of GDP)

article image

Domestic saving is defined in the Statistical Appendix, Table A43, and is based on individual countries' national accounts and balance of payments statistics. Foreign saving is equivalent to the current account balance.

Chart 27.
Chart 27.

Developing Countries: Domestic Saving and Investment1

(In percent of GDP)

1 Three-year centered moving average. Blue shaded area indicates staff projections.
Chart 28.
Chart 28.

Developing Countries: Domestic and Foreign Saving

(In percent of GDP)

1 Foreign saving excludes official transfers.2 For 1978-83, the Middle East exported net capital equivalent to 5 percent of GDP.

Private saving accounts for the bulk of domestic saving, although its share varies across regions. During 1985-93, private saving had the highest share in Africa, where it accounted for nearly 90 percent of total saving, followed by the Middle East, Asia, and Latin America (Chart 29). The private saving rate in all regions appears to be quite sensitive to fluctuations in income.35 Moreover, there is evidence that the private sector saving rate is negatively correlated with macroeconomic instability. Countries that managed to keep average inflation, and its variability, low have displayed markedly higher saving rates than those that did not (Table 14). This suggests that inflation, through its adverse impact on real interest rates and, more generally, by increasing uncertainty, tends to depress financial saving, in part by inducing a diversification into nonfinancial assets. Market-oriented exchange regimes also contribute to improved saving performance by reducing the risk of large changes in exchange rates and by reducing incentives for capital flight.

Chart 29.
Chart 29.

Developing Countries: Private and Public Saving1

(Average, 1985-93; in percent of GDP)

1 Based on a sample of 53 countries.
Table 14.

Developing Countries: Saving and Macroeconomic Stability

(Domestic saving in percent of GDP)

article image

The three groups are based on rankings by inflation or inflation variability during 1971-93, with the “low” group consisting of the bottom third, and so on. The results are essentially unchanged if transfers are excluded.

Financial sector reforms have played a key role in boosting private saving in many countries by increasing the menu of financial instruments available. Before the reforms, saving instruments in many countries had often been limited to cash, deposits in the domestic banking system, or accumulation of nonfinancial assets including real estate and precious metals. The abolition of interest rate controls in Malaysia and Thailand and continuing liberalization in Chile, Colombia, and Korea, combined with increased competition among financial intermediaries, have further expanded the options available to savers and increased returns on saving deposits. Moreover, many countries have expanded or established contractual saving institutions, including private and public provident and pension funds, that appear to have mobilized new private saving, rather than simply redistributing existing saving.

Other structural reforms have increased private saving directly and indirectly by spurring activity and growth. The liberalization of trade and exchange regimes has reduced price distortions of traded goods and has led to improved export performance and higher disposable incomes and saving. Liberalization has also reduced incentives for traders to underinvoice export earnings and has lowered the portion of these earnings that is diverted to the underground economy. Tax reforms in countries such as Ghana, Tanzania, and Thailand have reduced corporate tax rates or eliminated double taxation on profits, thereby raising corporate saving. The relaxation of excessive regulatory control over the private sector, while improving its performance and generating higher corporate incomes, has been conducive to the development of domestic capital markets, especially equity markets, thus further increasing the availability of saving instruments.36

There has also been a significant strengthening in the public sector's contribution to domestic saving as many developing countries have undertaken successful adjustment programs and major public sector reforms.37 The reduction in budget deficits resulting from these policies, especially in the Western Hemisphere (Argentina, Chile, and Mexico) has been essential to finance increased capital formation and to alleviate external imbalances.38 The reforms have led to an improvement in the efficiency of the tax system, higher revenues, and cuts in unproductive expenditures, including military expenditures, subsidies, and transfers.39 Budgetary positions have also improved through the privatization of public enterprises, many of them monopolies (Argentina, Guyana, Malaysia, Mexico, and Pakistan), both through the proceeds from asset sales and through reductions in subsidies that privatization subsequently made possible. Privatization is also likely to improve budgetary prospects over the medium term if significant efficiency gains are realized, which would enlarge the tax base. The introduction of hard budget constraints on public enterprises and the adjustment of tariffs in line with inflation have further improved fiscal balances.

Is the Debt Crisis Over?

It is now over a decade since the debt crisis erupted. The initial response to the crisis focused on safeguarding the integrity of the international financial system while providing debtor countries with financing support as they implemented stabilization programs. Banks provided cash-flow relief through the deferment of principal and, in some cases, through concerted new money loans; official creditors rescheduled debt-service obligations through Paris Club agreements and new lending, protected by the principle that loans committed after a certain fixed “cutoff” date would not be rescheduled. The international financial institutions helped to design adjustment programs, provided direct financial assistance, and played a catalytic role in mobilizing new financing from other sources.

This approach was broadly successful in maintaining financing to debtor countries and in providing banks with time to strengthen their balance sheets. At the same time, most developing countries that had adjusted and maintained solid records of debt servicing were able to sustain access to spontaneous financing. As the 1980s progressed, however, this approach proved increasingly difficult to implement. Banks were reluctant to lend; on the debtors' side, debt and debt-service ratios continued to rise, which undermined private sector confidence, discouraged investment, and clouded prospects for economic recovery and growth.

These developments led to new initiatives under the debt strategy that provided for the restructuring of both commercial and official bilateral debt. The 1989 Brady initiative included three key elements: adoption of medium-term adjustment and structural reform programs in debtor countries; market-related debt and debt-service reduction by commercial banks, partly financed with resources from the international financial institutions; and official support through bilateral debt rescheduling and new export credits.

Seven of the largest bank debtors have now completed market-related restructurings, covering $116 billion of claims, based on complex menus of debtand debt-service-reduction (DDSR) options. Three other countries, including Brazil, have also reached agreements with banks to restructure a further $50 billion of debt. In addition, five low-income countries have been able to virtually extinguish their commercial debt through buyback operations at very deep discounts. The international financial institutions have played a key role in this process, including financing for DDSR operations in the amount of some $6½ billion; the low-income countries have benefited from the debt-reduction facility of the International Development Association (IDA) and from other official concessional assistance.

All told, countries accounting for about 80 percent of the commercial banks' debt rescheduled in the 1980s have participated in debt restructurings. These operations have lowered the net present value of the stream of debt-service obligations payable by debtor countries by about $50 billion, or about one-third of the face value of the debt restructured. The total cost of the operations—in terms of resources for enhancements and cash payments—has amounted to some $18 billion.

Official bilateral creditors in the Paris Club have recognized the special need for concessional treatment for low-income countries. Beginning in 1988, Paris Club creditors have provided such concessions with up to one-third reduction, in net present value terms, of rescheduled debt service on debt unrelated to official development assistance; since December 1991, the concessional element has been increased to 50 percent. Moreover, many creditor countries have provided outright forgiveness of substantial amounts of claims related to official development assistance. For middle-income countries, concessions have been extended in the form of longer amortization schedules and graduated payments, and two countries with particularly difficult situations—Egypt and Polandobtained debt reduction on an exceptional basis.

Debt restructuring combined with improved policy implementation has allowed a number of countries to resolve their debt problems. Most of the middleincome countries with mainly bank debt have been able to graduate from the process of rescheduling their debts to banks and have also either exited from the Paris Club or are expected to do so in the near future. These countries' debt and debt-service ratios have been reduced substantially from the peak levels of the mid-1980s. At the same time, these countries have been able to achieve higher growth and lower inflation. This has been facilitated by the regaining of access to spontaneous private financing, particularly by Latin American countries, on a scale that had not been anticipated.

In light of these successes, is the debt crisis over? The answer is that the international financial system is no longer at risk but much remains to be done. Many low-income and lower-middle-income countries continue to experience serious debt-related problems, and continued attention will be needed to ensure early resolution of these difficulties. Some of the lowermiddle-income countries have faced particularly large initial imbalances or have taken longer to achieve sustained policy improvements. For most of these countries, successful economic reforms should make it possible to resolve debt problems with the instruments now in place. A number of these countries are now actively negotiating debt packages with banks, and others can be expected to follow. These negotiations are complicated by the substantial accumulation of arrears. Several of these countries will require a greater degree of debt reduction than that provided in the Argentina or Mexico packages, for example, and in some cases special treatment from official bilateral creditors may be called for.

The situation of many low-income countries remains particularly difficult (see Box 6). For such countries, debt and debt-service ratios remain high, notwithstanding that in recent years the bulk of bilateral assistance has been on a grant basis and that new loans from the international financial institutions have been mainly on concessional terms. Recognizing these difficulties, Paris Club creditors have agreed to consider a stock-of-debt operation three to four years after a rescheduling on enhanced concessional terms has been completed, provided that certain conditions are met. For such debt-stock operations to provide decisive solutions to debt problems, debt reduction may have to go well beyond 50 percent in some cases. Comparable terms will also be needed from creditors outside the Paris Club (in some cases debt to such creditors accounts for a substantial part of total debt). It should be recognized that even after debt reduction, these countries will continue to depend heavily on new official financing on concessional terms, and the international financial institutions will have a substantial part to play in the process.

Capital Flows

Since the late 1980s, many developing countries have experienced a major improvement in their access to foreign capital markets (Table 15). This follows an extended period when little private capital flowed to developing countries because of the poor economic performance and uncertain prospects associated with the debt crisis. The resumption of capital flows reflects largely the same factors that have reinvigorated domestic saving. However, for many low-income countries with large official debt burdens, especially in Africa, market access has not improved, and this consequently has required sustained growth of official concessional flows (Box 6).

Table 15.

Developing Countries: Capital Flows1

(In percent of total unless otherwise noted)

article image
Source: IMF staff estimates; and World Bank.

Gross flows (excluding short-term loans). These data should be regarded as illustrative of the broad trends of flows to developing countries.

Deflated using 1985 = 100 unit value of total imports.

The new pattern of private external flows is radically different from that of the 1970s and early 1980s. Commercial bank loans, which dominated the earlier period, have been replaced by bond and equity portfolio flows and by foreign direct investment (Chart 30). The main significance of this change is less in terms of cost—the average return required by foreign investors is likely to be at least as high as the interest rate on commercial debt—than in terms of the benefits associated with the new flows. These include the bearing of both commercial and exchange rate risks by the foreign investor; a diversified investor base; and, in the case of foreign direct investment, availability of state-of-theart technology, increased scope for human resource development, stronger domestic competition, and easier access to foreign markets.

Chart 30.
Chart 30.

Developing Countries: Capital Flows

(In percent of total)

Foreign direct investment flows have increased sharply since the mid-1980s and now account for nearly a fifth of all flows. The share of global foreign investment going to developing countries increased from less than 12 percent in 1987 to 22 percent in 1992. Although the flows—over twothirds of them originating from the United States and Japan—are highly concentrated in a few middle-income developing countries, the concentration appears less marked when seen in relation to income. For instance, during 1989-92, the top ten countries, ranked by inflow of direct investment, received 78 percent of total investment flows to developing countries and accounted for 48 percent of total developing country output. The United States has been the main source of foreign investment in Latin America, which has been directed mainly toward the purchase of existing companies, often through debt-equity swaps. Japan and the newly industrializing economies have been the main source in Asia, where foreign investment has mainly supplemented new fixed capital formation. In both Latin America and Asia, investment flows have shifted from the extractive and manufacturing sectors to capital-intensive service industries such as telecommunications, transport, and banking.

The main factors behind the surge in investment flows, especially in Latin America and Asia, have been sound monetary and fiscal policies and structural reforms (including large-scale privatization), which have contributed to the development of an efficient private sector. In addition, debt reduction and restructuring have improved creditworthiness and removed the perceptions of a debt overhang (for instance, in Argentina, Chile, and Mexico; see Box 5). Convertibility and policy changes that have improved access to foreign exchange for imported inputs and have increased the freedom to remit dividends and profits—reflected in the relaxation of exchange controls in China, India, Pakistan, and the Philippines—have also been important. Further impetus was provided in Argentina, Indonesia, and Thailand by the adoption of a transparent regulatory and legal regime with equal treatment of foreign and domestic investors.

There has also been a sharp increase in both shortand long-term portfolio flows, consisting in part of international bond issues and equity investmentcomprising external stock offerings, country funds, and direct purchases of equity in developing country enterprises by foreign investors—from under $8 billion in 1989 to over $34 billion in 1992. As with foreign investment, these flows are highly concentrated in a small number of middle-income countries—Argentina, Brazil, Mexico, Korea, and Turkey accounted for over three-quarters of the cumulative flows between 1989 and 1992, with Mexico being the recipient of the largest share. Initially, much of these flows represented repatriated flight capital, but more recently flows by institutional investors in industrial countries seeking to diversify their portfolios have also become important.

In addition to domestic policies and the development of domestic capital markets, countries such as Argentina, Chile, India, Korea, and Mexico have encouraged portfolio flows by reducing restrictions on foreign holdings, improving settlement and clearance procedures, and reducing taxes and fees on transactions. In some cases, especially in countries in Latin America, external factors have also played a key role. The unusually low interest rates prevailing in the United States during the past three years have attracted investors to the high yields available in both fixed-return and equity investments in developing economies. Low international interest rates have also improved indicators of creditworthiness by reducing countries' debt-service obligations. In the case of equity flows, growth has been facilitated by changes in regulations in the United States that served to make private placements in general more attractive to investors.

Although there has been little new commercial bank lending to the developing countries, bank loans in total are still relatively large compared to bond or equity flows. These loans continue, however, to be highly concentrated, and the debtrestructuring countries, in particular, have had little access to new loans. For the most part, the weakness in lending reflects capital constraints on commercial banks arising as much from problems with domestic loans within the industrial countries as from concerns about the debt situation in developing countries.40

Official flows, including grants and loans, still account for over 40 percent of all flows to developing countries and for nearly twice that share to the low-income countries. Such flows have increased considerably in real terms over the past decade, and there has been an increase in the degree of concessionality for the poorest countries, with grants often replacing loans. The geographical allocation of aid has shown a strong rise in the proportion going to sub-Saharan Africa, reflecting perceptions of a growing need for concessional finance for that region, and a decline in the share going to South Asia, due in part to a decline in donor aid by the oil exporting countries in the Middle East.

Trends in the international financial systemincluding the globalization of markets and the diversification of investor portfolios—are likely to continue to facilitate equity flows to developing countries, even though the prospects for continued access to private flows vary across countries. Provided that sound policies are maintained, countries that already have access to a broad investor base, particularly many of the East Asian countries, are likely to remain attractive for foreign investors. For the countries that have only recently restored their creditworthiness, the investor base is still relatively narrow. Expanding this base will require further progress toward economic and political stability, reforms to deepen local capital markets, and enhanced financial supervision. Such policies would also help to improve credit ratings further, which would facilitate access to institutional investors.

Countries with currently limited market access appear to have the potential to attract significant private resources by sustaining progress toward creditworthiness and the development of corporate and financial sectors with appropriate regulatory frameworks. In countries with heavy external indebtedness and significant arrears, debt-restructuring operations and the normalization of creditor relations can be expected to improve access to international capital markets. International financial institutions have an important role to play in this process, mainly through the provision of financial support (including enhancements for debt restructuring) and policy advice. For many other developing countries, especially the low-income countries of sub-Saharan Africa that have limited resource endowments and large debt burdens, the scope for private capital inflows may remain constrained. These countries will need to continue to build up their physical and social infrastructure, supported by domestic saving and concessional external finance to increase the prospects of gaining access to private capital flows on a significant scale.

Economic Performance and Financing Needs in Africa

Since the mid 1980s, several sub-Saharan African countries have had arrangements with the IMF under the structural adjustment facility (SAF) or enhanced structural adjustment facility (ESAF), have implemented major structural reforms, and have undertaken substantial adjustment. Growth in these countries has improved considerably. These policy efforts and improvements in performance, especially in recent years, have often been achieved in the face of weak initial conditions and significant terms of trade deteriorations.

Despite these efforts, growth in most of sub-Saharan Africa has stagnated since the mid-1980s, with real per capita incomes falling by nearly 1 percent a year. In many countries, saving and investment rates fell to under 15 percent of GDP—well below those for other developing countries—reflecting inappropriate policies, political instability, and adverse circumstances such as harvest failures. The financial returns on the limited investments that did take place also plummeted, often because of misallocations associated with public sector projects.

Export growth in the region was weak throughout the 1980s, with few exceptions, reflecting in part import substitution policies and persistently overvalued real exchange rates, but also because of weak demand for primary commodities in industrial countries. An undiversified export base, combined with an almost continuous deterioration in the terms of trade since 1984, also depressed export earnings (see chart). Low export earnings in turn led to tighter foreign exchange constraints, thus reducing the availability of imported inputs and further weakening growth.

uch05fig01

Developing Countries: Export Volume and TERMs of Trade1

(Logarithmic scale; 1971 = 100)

1 Blue shaded area indicates staff projections.
uch05fig02

Developing Countries: External Debt and Debt Service1

(In percent of exports of goods and services)

1 Debt service refers to actual payments of interest on total debt plus actual amortization payments on long-term debt. The projections (blue shaded areas) incorporate the impact of exceptional financing items.

In the 1980s, low growth, stagnating exports, and political instability also fueled capital flight and led to a decline in private financing, both in absolute terms and as a share of total medium- and long-term capital flows to the region. Indeed, only four countries—the Congo, Cote d'Ivoire, Gabon, and Nigeria—have been market borrowers, and even these countries have largely lost their access to private financing (except in the form of highly secured loans to the oil sector). Moreover, sub-Saharan Africa has attracted little foreign direct investment, in part because of an unfavorable policy environment, including restrictions on the operations of foreign-owned firms and difficulties in repatriating profits. The small size of domestic markets, combined with impediments to trade, has prevented full exploitation of economies of scale, thus further depressing foreign investment.

Persistent current account deficits, high international interest rates, and public borrowing for investment in large development projects have led to a significant buildup in sub-Saharan Africa's external debt (see chart). At end-1992, the debt-GDP ratio for the region exceeded 70 percent, and the debt-export ratio exceeded 400 percent—by far the highest of any region in the world. The debt-service ratio more than doubled, from 2 percent of GDP in 1980-81 to about 4½ percent in 1990-91. This deterioration occurred even though in recent years most bilateral assistance has been on a grant basis and new loans from international financial institutions have been mainly on concessional terms.

Most of the heavily indebted low-income countries are in sub-Saharan Africa. These countries are indebted primarily to bilateral official creditors.1 As discussed in Box 5 on the debt crisis, a decisive solution to Africa's debt problem may require substantial debt-reduction operations. Moreover, even after debt reduction, official financing on concessional terms will be necessary, but not sufficient, to improve growth prospects. A sustained improvement in sub-Saharan Africa's prospects would require an early implementation of these measures, which—combined with strong adjustment programs, political stability, and increased human capital formation—could help to break the cycle of low saving, low investment, and low growth.

1For a detailed analysis of Africa's debt problem, see Jack Boorman and Ajai Chopra, “Issues and Options,” in Policies for African Development: From the 1980s to the 1990s, edited by I.G. Patel (IMF, 1992).

Policy Response to Capital Inflows

The recent increases in private capital flows have been highly welcome, but the size of these inflows has raised concerns about the consequences for domestic macroeconomic stability and external competitiveness. The experience of the past three years suggests that a surge in financial inflows can lead to inflationary pressures, loss of competitiveness, and a deterioration in the current account. Countries have responded in varying degrees to minimize these dangers, and to contain the risks of a reversal of the inflows (which are larger when inflows are monetary rather than related to fixed investment).41 In general, the most appropriate response appears to be fiscal restraint, which can limit the pressure on interest rates, and the risk of inflation. However, the form that fiscal consolidation takes can be important, with expenditure restraint, particularly on nontraded goods and services, being the most effective. Governments should, to the extent possible, avoid measures that would impede capital formation because doing so would adversely affect future growth prospects.

If there is uncertainty about the sustainability of inflows, or if fiscal consolidation is not feasible (for instance, because of an existing surplus), sterilization—the exchange of bonds for foreign exchange—can help to insulate the economy from some of the effects of capital inflows. Other measures to reduce the monetary impact of capital inflows include increasing bank reserve requirements, shifting government deposits from commercial banks to the central bank, and curtailing access to rediscount facilities. In many countries, these measures appear to have temporarily prevented a widening of the current account deficit while locking in large increases in official reserves. In this way, the impact of the capital inflows can be smoothed over time, and countries' vulnerability to subsequent outflows can be reduced. These measures can act to raise domestic interest rates, however, leading to further capital inflows. Moreover, sterilization can, by increasing public debt, entail quasi-fiscal costs when the interest rate on domestic bonds is higher than the return on foreign exchange reserves.

Many countries have also adopted structural measures to reduce, or to limit, the adverse effect of inflows. The former have included the reduction of quotas and duties on imports, the easing of exchange controls and restrictions on capital outflows (including external investment by domestic residents), and financial reforms. In this way countries have used inflows as an opportunity to reduce or eliminate existing market imperfections, further expanding growth opportunities. A number of countries, however, have tried the latter course—to limit inflows by imposing taxes or physical controls. These measures, although temporarily slowing the inflows, tend to hinder economic efficiency. Moreover, in some cases they have had to be broadened in response to tax evasion, and ultimately they have proved to be ineffective.

In general, inflows tend to generate an appreciation of the real exchange rate, which limits their adverse macroeconomic effects by reducing aggregate demand. The real exchange rate may appreciate through an appreciation of the nominal exchange rate or through higher inflation. Many countries have resisted a nominal appreciation in this context—despite its advantages in reducing inflationary pressures—because of concerns about a deterioration of the current account. This policy has, however, not been successful in eliminating the needed real appreciation (which occurred instead through higher domestic prices) and, therefore, has had little longer-term benefit in terms of the external position. A real exchange rate appreciation may not be appropriate for countries that already have an unsustainably large current account deficit or for which the widening deficit reflects a fall in domestic saving instead of a rise in investment. In this case, there is no alternative to fiscal consolidation.

Efficient Allocation of Capital Inflows

Apart from concerns about stabilization, access to external capital raises some fundamental issues regarding the benefits and risks of relying on foreign saving as a form of financing. Capital inflows can, by relaxing foreign exchange constraints, help to finance imports needed for domestic investment. External flows can thereby help countries that may be caught in a low-growth, low-saving trap to invest more and to move onto a higher growth path. They can also help countries to adjust to shocks—either internal, such as harvest failures, or external, such as changes in world commodity prices. Inflows may also improve access to world goods markets and thereby support a reorientation of trade policies from import substitution to export promotion, as has occurred in Israel, Korea, and Taiwan Province of China.

But reliance on foreign saving also entails risks. Foreign capital can substitute for domestic saving (that is, finance consumption rather than capital formation); be wasted on inefficient investments; or generate inadequate export earnings to service debt, profit, and dividend remittances.42 Moreover, if capital imports grow faster than a country's absorptive capacity, which depends in part on workers' skills and infrastructure, productivity can decline sharply. Inflows may also delay essential reforms as governments seek to delay incurring the transitional social and political costs associated with adjustment.

Cross-sectional analysis provides a mixed picture of the effects of capital flows on investment and growth in developing countries. In the decade ending in 1978, there was a significantly positive relationship between changes in the debt-GDP ratio and changes in the investment rate, indicating that external borrowing tended to raise investment rates. During 1979-83, however, this relationship vanished, suggesting that borrowing may have served primarily to postpone adjustment. During 1983-89, when net inflows slowed considerably and were channeled mainly to countries that maintained the highest standards of creditworthiness, a weak positive relationship re-emerged.43 Moreover, the productivity of investments does not appear to have been high, with the result that the cross-country relationship between economic growth and changes in the debt-GDP ratio was weakly positive in the period up to 1978, negative in the following five years, and became positive again in the following decade.

Over the past two decades, countries that relied most on foreign saving—defined as the top third of countries ranked by the ratio of all capital flows to GDP—tended to have higher fiscal deficits, higher inflation, lower investment, and lower growth compared with the countries that had low reliance on foreign saving (Table 16). These results do not imply that reliance on foreign saving led to worse performance, but they do indicate that foreign saving may not have been used efficiently or may have substituted for domestic saving.

Table 16.

Developing Countries: Foreign Saving and Economic Performance

(Anual percent change unless otherwise noted)

article image

End of period.

The three groups are based on rankings of the ratio of foreign saving to GDP during 1971-92, with the “high” group consisting of the top third, and so on.

The extent to which foreign saving promotes growth and development depends critically on government policies. This is illustrated by the very different longer-term consequences of commercial borrowing by several Latin American countries and the Philippines, on the one hand, and by Korea, Indonesia, and Malaysia, on the other (Table 17). In Korea, for instance, foreign capital flows, mainly in the form of commercial credits, were a very important source of funds during the 1960s and 1970s—as illustrated by the extremely large current account deficits, averaging 9 percent and6¾ percent a year during the two decades, respectively—and resulted in a sharp increase in external indebtedness. These inflows, accompanied by strong fiscal discipline, added their full value to investable resources without any marked deterioration in the efficiency of investment. The incremental capitaloutput ratio averaged around 2, one of the lowest in the developing world. At the same time, the domestic saving rate—both public and private—rose sharply, and investment was increasingly financed domestically rather than externally. An outwardoriented strategy, supported by a competitive exchange rate, led to a surge in exports. Although severe macroeconomic difficulties in 1979-82, owing to a disastrous harvest and to terms of trade shocks, led to an increase in external indebtedness, by 1986-87 the current account was in surplus, and the debt burden had been substantially reduced.44

Table 17.

Selected Developing Countries: Debt, Investment, and Growth

(Annual percent change unless otherwise noted)

article image

Data are weighted averages using 1990-93 purchasing power parity (PPP) weights.

Total factor productivity is calculated as the residual after taking into account the contributions of capital and labor to growth of potential GDP. Estimates are for the period up to 1991.

End of period.

Similarly, Indonesia's external borrowing in the 1970s was used mainly to finance domestic investment. Prudent exchange rate management from 1979 onward, facilitated by sustainable budget deficits and cautious monetary policy, discouraged capital flight and nurtured a strong non-oil tradables sector. This sector was able to earn enough foreign exchange to service the debt when high world interest rates in the early 1980s increased the cost of foreign borrowing and the price of oil began to fall from 1984 onward. In Malaysia, external financing of public enterprises helped to reduce the crowding out of private investment, which was financed largely by domestic resources. The incremental capital-output ratio fell over time, and a sharp increase in investment and exports led to impressive growth and declining debt-service ratios. Moreover, prudent management of the maturity structure—maintaining a very small share of shortterm debt—also helped to minimize debt-servicing difficulties.

In several Latin American countries (including Argentina, Chile, and Mexico) capital inflows during 1976-81, mostly in the form of external borrowing, to a large extent substituted for domestic public saving, effectively financing public expenditures in the absence of politically costly expenditure cuts and higher taxes. Rapid monetary expansion, low interest rates, and real exchange rate appreciations also fueled excessive private consumption and stimulated massive capital flight.45 Lenders did not pay sufficient attention to the reasons for borrowing and hence allowed the accumulation of debt to continue. World nominal interest rates nearly doubled in 1980-82, which—combined with a marked deterioration in the unit value of nonfuel exports—sharply increased the real cost of borrowing, thus setting the scene for the debt crisis (Table 18).46 In recent years, these countries have reoriented their policies; along with the decline in world interest rates, this has resulted in greatly improved economic performance.

Table 18.

Developing Countries: Illustrative Indicators of the Real Cost of Borrowing

(Annual average; in percent)

article image

Six-month London interbank offered rate.

Nominal LIBOR deflated by changes in the export unit value index of each region or group. The estimates do not take into account margins over LIBOR, which reflect risk characteristics of individual countries.

Four newly industrializing Asian economies.

In the Philippines, which has rescheduled its debts with commercial banks and the Paris Club several times in the past few years, foreign borrowing in the late 1970s and early 1980s was used in large part to fund capital-intensive investment projects with long gestation lags or for infrastructure development. These projects, which used up a large proportion of foreign funding, did not directly earn foreign exchange. Moreover, the country's industrial strategy favored import-substituting industries over export-oriented activities. Thus, the gap between foreign exchange requirements and foreign exchange earnings grew. These difficulties were reenforced by budgetary problems and associated financing issues.

In summary, the experience of the past two decades suggests that capital inflows can provide significant benefits, but that they also entail risks—especially when the inflows are large relative to the economic and financial potential of the country. The policies required to make best use of these flows are essentially the same as those that best use domestic resources: a return on investments that is higher than the cost of resources used. In the case of external financing, however, a country also has to generate enough foreign exchange to cover interest payments or remittances of dividends and profits. Policies that promote high domestic saving and adequate rates of return on domestic investment include a strong commitment to market forces, prudent financial policies, an outward-oriented trade strategy, and competitive exchange rates. Such policies are now being implemented in a large number of developing countries, including, in particular, many of the Latin American countries.

Within Same Series

Other IMF Content

Other Publishers Content

Cover World Economic Outlook, October 1993
World Economic Outlook, October 1993
Author: International Monetary Fund. Research Dept.
ISBN:
9781557753403
ISSN:
0256-6877
Publication Date:
30 Oct 1993
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557753403.081
Pages:
210
  • View in gallery

    Developing Countries: Real GDP Growth1

    (Annual percent change)

  • View in gallery

    Developing Countries: Domestic Saving and Investment1

    (In percent of GDP)

  • View in gallery

    Developing Countries: Domestic and Foreign Saving

    (In percent of GDP)

  • View in gallery

    Developing Countries: Private and Public Saving1

    (Average, 1985-93; in percent of GDP)

  • View in gallery

    Developing Countries: Capital Flows

    (In percent of total)

  • View in gallery

    Developing Countries: Export Volume and TERMs of Trade1

    (Logarithmic scale; 1971 = 100)

  • View in gallery

    Developing Countries: External Debt and Debt Service1

    (In percent of exports of goods and services)

Developing Countries: Real GDP Growth1

(Annual percent change)

Developing Countries: Domestic Saving and Investment1

(In percent of GDP)

Developing Countries: Domestic and Foreign Saving

(In percent of GDP)

Developing Countries: Private and Public Saving1

(Average, 1985-93; in percent of GDP)

Developing Countries: Capital Flows

(In percent of total)

Developing Countries: Export Volume and TERMs of Trade1

(Logarithmic scale; 1971 = 100)

Developing Countries: External Debt and Debt Service1

(In percent of exports of goods and services)