THE WORLD ECONOMY HAS endured a period of financial turmoil and slowing growth since mid-2007. As these events have unfolded, financing conditions facing developing countries have shifted from the benign environment of 2002–06 to the current state of heightened market volatility and tight credit conditions. With these tensions setting the stage, 2008 is shaping up to be a challenging year for development finance.

Strong fundamentals underpinned most developing countries’ initial resilience to deteriorating economic and financial conditions. As of mid- 2007, total developing-country foreign exchange reserves amounted to $3.2 trillion (23.6 percent of their combined GDP, with the top five countries accounting for 68 percent of the total figure), many countries were posting strong economic growth, emerging equity markets were rallying (outperforming mature markets by a wide margin for the fourth consecutive year), and spreads on emerging-market sovereign bonds had reached record low levels.

The balance of risks, however, has now plainly tilted to the downside. Various indicators signal that economic growth in the United States and Europe is slowing more than previously expected. Across the developing world, inflationary pressures, stemming from dramatic increases in energy and food prices in many cases, complicate the role that monetary and fiscal policy can play in maintaining macroeconomic stability over the medium term. Meanwhile, as financial services have become increasingly globalized, the reconciliation of national autonomy with the demands of international banking has become more difficult.

The international financial community has a complex burden to shoulder in ensuring that the turmoil does not undermine long-term global growth and stability. In mature markets, governments have responded with a series of unprecedented policy measures aimed at preserving orderly conditions in certain financial market segments and instilling confidence in the financial system as a whole. Yet developing and highincome countries alike face the challenge of balancing short-term and long-term policy goals.

Striking the appropriate balance will vary from country to country, but in general policy makers need to recognize the limitations of activist measures.

Countries that undertake prudent fiscal planning and use monetary policy instruments to effectively maintain price stability will be better placed to sustain growth over the long term.

• Global growth is slowing
• Tighter financing conditions are curbing private capital flows
• Developing countries have become more vulnerable to external shocks
• Soaring food and energy prices pose daunting challenges
• Internationalization of banking offers distinct economic benefits
• Current challenges require an enlightened international policy response

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DETAILED FINDINGS

    * A year ago, total developing-country foreign exchange reserves amounted to $3.2 trillion, many countries were posting strong economic growth, emerging equity markets were rallying, and spreads on emerging-market bonds had reached record low levels. With the onset of the sub-prime crisis in the U.S., credit conditions deteriorated markedly. Even though emerging markets have shown considerable resilience so far, the balance of risks has plainly tilted to the downside.

    * Nevertheless, despite a downward adjustment, the projected developing-country growth rate of 6.4% in 2009-10 is above the average over the first half of this decade (5.6%) and well above the average of the 1980s and 1990s (3.4 %). This illustrates the sharp rise in the underlying growth potential of developing countries as both structural and macroeconomic polices have improved in recent years.

    * High commodity prices are a major worry. Prices of both energy and internationally-traded food increased 25% in nominal terms over the second half of 2007. For oil, the increase was mostly due to years of underinvestment and tight supply. For food and agricultural commodities, the big drivers are demand for biofuels in the U.S. and Europe, high prices for fertilizer and energy inputs, and export bans on key staple crops. Such bans exacerbate shortages in global markets in the short term and can curtail supply responses to higher prices in the long term. Additionally, poor weather reduced output in some countries, and commodity-market speculation also pushed up prices. Grain prices rose the most?during the first months of 2008, they were twice as costly as a year earlier.

    * High food and energy prices are now the dominant force behind increased inflation across developing countries-and worryingly, they are hitting the poorest people the hardest.

    * Net FDI inflows to developing and high-income countries continued to surge in 2007, with global inflows reaching an estimated $1.7 trillion, just over a quarter of which went to developing countries.

    * Net FDI inflows to developing countries as a whole increased to an estimated $471 billion. This was led by strong gains in Brazil ($16 billion) and Russia ($22 billion).

    * China remained the top destination among developing countries for FDI in 2007, although its share continued to decline relative to other countries. Although the overall environment for foreign investment in China remains positive, recent developments have mad it more difficult for foreign firms to invest. In particular, the Chinese government is becoming more selective in approving investment projects with foreign involvement.

    * The presence of foreign banks has increased in developing regions for different reasons: in Sub-Saharan Africa because of the limited reach of local banking infrastructure; in Europe and Central Asia along with regional integration into the European Union; and in Latin America as a way for governments to open up to foreign competition. In many countries, however, foreign bank presence was permitted only after a financial crisis with local banks suffering from massive non-performing loans and was spurred by the need to jumpstart the banking system.

    * Today, foreign banks have over 2,000 local offices in 127 developing countries, giving the international banking industry the operating infrastructure and technology platforms to book overseas transactions, not only their headquarters in major financial centers, but also from a big local network of branches and subsidiaries in developing countries.

    * Countries particularly active in international interbank markets - Brazil, China, Hungary, India, Kazakhstan, Russia, South Africa, Turkey, and Ukraine - need to be concerned about the possibility that their domestic banks will face funding difficulties in international markets, should liquidity pressures in interbank markets remain at elevated levels.

 Forward:

THE WORLD ECONOMY HAS ENTERED a period of financial market turmoil, slowing growth, and heightened inflationary pressures, a reality that poses complex policy challenges for the international community. Although developing countries have weathered the storm well thus far, they cannot afford to be complacent, particularly with unusually high uncertainty in the global macroeconomic outlook and with their growing trade and investment linkages with highincome countries. It is imperative that policy makers in both developing and high-income countries take firm actions to alleviate the impact of soaring food and energy prices on the poor while they address the longer-term challenges of financial globalization and economic interdependence.

An important consequence of this growing interdependence is that developing countries are now a locomotive of world economic growth, serving to cushion the impact of the slowdown in the United States. Global growth is projected to drop to 2.7 percent in 2008, from 3.7 percent in 2007, with much of the weakness originating in high-income countries. Developing-country growth is projected to decline—from 7.8 percent in 2007 to 6.5 percent in 2008—but remain well above the average of the 1980s, 1990s, and even the recent period of 2000–05, indicating that improved underlying structural factors are influencing overall economic performance.

The emerging-market asset class has moved into the mainstream in the wake of deepening financial integration across high-income and developing countries and much improved macroeconomic management in many developing countries.

Private capital inflows to developing countries surged to an all-time high of $1 trillion in 2007, the fifth consecutive year of strong gains. It is important to keep in mind, however, that the bulk of private capital flows go to relatively few of the largest economies. Although some developing countries have recently gained access to the international bond market, many will continue to depend heavily on concessionary loans and grants from official sources to meet their financing needs.

Thus, in the lead-up to the implementation review conference on the Monterrey Consensus of 2002 in Doha late this year, it is essential that donor countries reaffirm their commitment to fulfill the goals laid out in that consensus and make concrete progress to honor their commitments over the balance of the decade.

Concurrent with the ongoing globalization of financial markets, the world is confronting dramatic increases in commodity prices. Indeed, no other issue captures the complexity of the current policy agenda facing the international community than rapid inflation in food prices, particularly for such basic items as wheat and rice. For both food and agricultural commodities, the dominant drivers of higher prices are increased demand for biofuels in the United States and Europe, the weak dollar, and increased prices of fertilizer and energy inputs. Low inventories of grains and export restrictions by a number of countries have exacerbated the problem and contributed to the price increases.

Additionally, weather patterns have reduced agricultural output in some countries, and speculation by commodity market investors has also pushed up prices. The increases have been largest for grains, which during the first months of 2008, were twice as expensive as a year earlier. High food prices are now the major force behind increased inflation across developing countries—and worryingly, they are hitting the poorest people the hardest.

Demand for international banking services in developing countries has evolved over time in response to their changing position on the global economic and financial stage. Attracted by the prospects of asset growth and risk diversification, foreign banks have expanded their business in developing countries through both cross-border and local market activity. The benefits of a growing international bank presence—enhanced sources of credit to firms and households, greater provision of sophisticated financial services, knock-on efficiency improvements in domestic banks, and in the long run, contributions to economic growth—are significant. Efforts to reap these benefits, though, require greater attention to bank soundness at entry through closer coordination with homecountry regulators, and improved safeguards against the risk of financial contagion in the international
banking system.

A high premium should also be placed on parent banks’ compliance with international standards and regulations regarding capital adequacy, corporate governance, and transparency. There is no room for complacency, as today’s increasingly globalized financial system has the potential to speed the transmission of negative financial shocks throughout the world; in recent months, this potential has played out primarily through troubles in the banking industry.

Tackling these challenges requires collective resolve and clear thinking. That the magnitude of the credit turmoil was not on financial regulators’ radar screens, however, reveals a critical shortcoming in the current framework of financial market supervision and regulation. In developing countries, it is vital that policy makers maintain their commitment to the sound macroeconomic and financial policies of the recent past while recognizing changes in the international financial climate and differences in their monetary framework, exchange-rate regime, regulatory and supervisory capability, level of financial sector development, and nature of exposure to foreign capital.

In highincome countries, recent collaboration between major central banks on the provision of liquidity has been a positive step in calming market volatility. And reworking financial market supervision and regulation in several major financial centers could help avert another credit crisis, as could enforcing more transparency in complex financial instruments and institutions’ exposure to them. In general, greater coordination between high-income and developing countries will contribute to greater international financial stability in the long run.

Global Development Finance is the World Bank’s annual review of global financial conditions facing developing countries. The current volume provides analysis of key trends and prospects, including coverage of the role of international banking in developing countries. A separate volume contains detailed standardized external debt statistics for 134 countries, as well as summary data for regions and income groups. Additional material and sources, background papers, and a platform for interactive dialogue on the key issues can be found at www.worldbank.org/prospects. A companion online publication, “Prospects for the Global Economy,” is available in English, French, and Spanish at www.worldbank.org/globaloutlook.

Justin Yifu Lin
Chief Economist and Senior Vice President
The World Bank

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