C h a p t e r 3 Developing Countries and the Global Financial System

he 1990s saw a huge upsurge in flows of appeared—a huge pool of highly mobile private capital from industrial to devel- money channeled through mutual funds, oping countries. At the beginning of the pension funds, and wealthy individuals decade, private and official flows were that is ready to move across borders at a about the same, but only five years later moment’s notice in search of the highest private flows dwarfed official flows. Not short-term returns. T since the late 19th century have inter- Countries that open themselves up national capital flows assumed such to these short-term capital flows are dis- prominence.1 But there are marked dif- covering that such investments have ferences between the movement of cap- their costs. Rapid changes in investor ital at the end of the 20th century and sentiment can cause enormous insta- the movement of capital a century ear- bility, particularly in developing econ- lier. These differences have important omies. This realization has led to a policy implications for developing coun- reexamination of the international eco- tries as they integrate into the global fi- nomic architecture, raising some im- nancial system. portant questions: Are the benefits of At the end of the 19th century capi- liberalizing capital accounts worth the tal flows financed infrastructure projects costs? Can developing countries find such as railroads and direct investment ways to capture the gains from finan- in foreign companies. A hundred years cial globalization without running such later foreign direct investment is chan- enormous risks, which often jeopardize neled primarily through multinational the poorest individuals? The policy re- corporations that are establishing plants sponse is to calibrate a sequential ap- and service operations throughout the proach to financial reform that both en- world. These investments bring with sures stability in developing countries them more than money. They open ac- and captures the benefits of integration cess to markets, make new technolo- into world capital markets. gies available, and provide workers with This chapter emphasizes the four training. But another type of capital has key components of that approach:



(c) The International Bank for Reconstruction and Development / The World Bank      ⁄

Ⅲ Developing countries need to strengthen banking reg- developing and transition economies.3 Since 1980 the ulations and, where possible, build complementary amount of net foreign direct investment in developing and well-regulated securities markets, if the benefits countries has climbed more than twelvefold (figure of domestic financial liberalization are to materialize. 3.1).4 In contrast, net portfolio investment flows have Ⅲ While banking regulation is being strengthened, poli- been far more volatile throughout the 1990s, exceeding cies should be directed to reducing the demand for— $100 billion in 1993 and 1994 and falling considerably and volatility of—short-term foreign borrowing. since then. Ⅲ Further international cooperation in setting and im- Firms in developing and industrial countries alike plementing fiscal, monetary, and exchange rate poli- are raising more funds from international securities cies should be considered. markets. Multinational corporations are registering Ⅲ Long-term foreign investment should be attracted by their equity on more than one country’s stock exchange cultivating a healthy economic environment—in- and are raising funds from financial markets in differ- cluding investing in human capital, allowing domes- ent economies. Since 1993 the amount of outstanding tic markets to work without unnecessary distortions, international debt issued by all firms has risen by 75 and committing to a strong regime of investors’ percent, reaching $3.5 trillion in early 1998. Although rights and obligations—and not by offering subsidies financial and nonfinancial companies headquartered in or other inducements. industrial countries issue most of this debt, firms in countries such as Brazil, Mexico, and Thailand have The chapter examines the mixed record to date of also begun to tap the global market for capital—a path developing countries’ integration into the international others will surely follow (figure 3.2). financial system. It draws from a variety of experiences This rising number of international capital transac- to identify the principal benefits and risks of global fi- tions, together with the substantial growth in interna- nancial integration. Even more important, it proposes national and global responses that can further develop- ment goals without jeopardizing financial stability. Figure 3.1 Since 1980 net inflows of foreign direct The gathering pace of international and portfolio investment to developing financial integration economies have grown enormously

Rapid improvements in technologies for collecting, Net inflows processing, and disseminating information, along with (billions of U.S. dollars) 160 the opening of domestic financial markets, the liberal-

ization of capital account transactions, and increased 140 private saving for retirement, have stimulated financial Foreign direct investment

innovation and created a multitrillion-dollar pool of in- 120 ternationally mobile capital. At the same time, consoli- dation in the global banking industry and competition 100 from nonbank financial institutions (including hedge Foreign portfolio investment and mutual funds) have lured new players to the inter- 80 national financial arena. These trends accelerated in the 1990s, expanding investment opportunities for savers 60 and offering borrowers a wide array of sources of capi- tal.2 The same trends can be expected to continue well 40 into the 21st century. 20 The growing pool of international financial capital Over the last two decades, the financial markets of lead- 0 1970 1998199719961995199419931992199119901980 ing industrial countries have melded into a global finan- cial system, permitting ever-larger amounts of capital Source: IMF, Balance of Payments Statistics Yearbook, 1998. to be allocated not only to their economies, but also to

(c) The International Bank for Reconstruction and Development / The World Bank        

Figure 3.2 Figure 3.3 Firms from developing countries are issuing A growing pool of institutionally managed funds more international debt than before is invested abroad

Outstanding debt securities At home (billions of U.S. dollars) 1980 1995 Abroad 60 Brazil US$2 trillion US$20 trillion Hungary Mexico 5% 20% 50 South Africa Thailand

40

30 95%

80% 20

Source: IMF, International Capital Markets, 1998. 10

0 1993 1994 1995 1996 1997 1998 Liberalizing capital flows in developing Source: IMF, International Capital Markets, 1998. and transition economies The 1990s have seen a consistent trend toward more flexible exchange rate regimes and the liberalization of tional trade in goods and services, has increased turn- capital account transactions. The latter involves changes over on foreign exchange markets eightfold. In 1998 in policies toward different types of private capital the daily total stood at around $1.5 trillion, an amount flows, such as foreign direct investment, foreign bond equal to around one-sixth of the annual output of the and equity investment, and short-term borrowing from U.S. economy. Financial instruments with very similar abroad. Developing countries in Asia and the Western risks pay similar returns no matter where they are is- Hemisphere, and the transition economies, have moved sued, providing further evidence of the integration of toward having a single exchange rate, rather than try- national capital markets. The returns on these instru- ing to have one rate for those who are exchanging their ments varied widely across countries as recently as 10 currency because of foreign trade and an alternative rate or 20 years ago. for those who exchange currency in order to invest.5 Mutual funds, hedge funds, pension funds, insur- Old-style rules that used to require exporters to ex- ance companies, and other investment and asset man- change their earnings of foreign currency with the na- agers now compete with banks for national savings. Al- tion’s central bank have been relaxed by developing though thus far this phenomenon has been confined countries on every continent, particularly in the West- primarily to industrial economies, the consequences for ern Hemisphere and Eastern Europe. developing countries could be far-reaching. Institu- The speed and depth of capital account liberaliza- tional investors have taken advantage of the easing of tion have varied across countries, however. Most coun- restrictions in many industrial countries to diversify tries have moved toward capital account convertibility their portfolios internationally, enlarging the pool of as part of a wide-ranging, gradual economic reform financial capital potentially available to developing and program that includes measures to strengthen the fi- transition economies. In 1995 these investors con- nancial sector. But Argentina, the Baltic countries, trolled $20 trillion, 20 percent of it invested abroad. Costa Rica, El Salvador, Jamaica, the Kyrgyz Republic, This figure represents a tenfold increase in the funds Mauritius, Singapore, Trinidad and Tobago, and Vene- and a fortyfold increase in such investments since 1980 zuela have opened important parts of their capital ac- (figure 3.3). counts in one stroke.6

(c) The International Bank for Reconstruction and Development / The World Bank      ⁄

In addition to moves toward capital account con- A proliferation of bilateral investment treaties rein- vertibility, other policies have made many developing forced these domestic reforms. Between 1990 and 1997 countries a more attractive destination for foreign in- developing countries were parties to 1,035 bilateral in- vestment: macroeconomic stabilization and structural vestment treaties, which protect the rights of foreign in- reforms, privatization policies, relaxed rules on foreign vestors and engender a regulatory environment that pro- direct investment, and lower interest rates in industrial motes investment. Other treaties also reduce investor countries. Rising confidence in the economic prospects exposure to double taxation by authorities in the home of developing countries in the 1990s was reflected in country of the investor and in the destination of the the fact that foreign direct investment accounted for a investment.11 Argentina, China, the Arab Republic of greater proportion of capital inflows, which signals a Egypt, the Republic of Korea, and Malaysia have signed commitment to invest over a longer time horizon than the most treaties, followed by Central and East European portfolio investments like equity holdings.7 countries. More recently, Latin American countries By 1997 approximately half of all capital flows to have also begun signing such treaties, starting, as is tra- developing countries was foreign direct investment.8 ditional, with their regional neighbors. By reinforcing These investments fell slightly in 1998 in response to commitments to stable national investment regimes, the East Asian crisis, a change that may prompt many these treaties are encouraging greater international in- countries to reevaluate their policies toward such in- vestment flows. In addition, these bilateral treaties are vestments—and the recommendations developed later being reinforced by a growing set of regional and sectoral in this chapter provide a framework for action. Devel- investment accords.12 oping countries are also becoming foreign investors A small group of developing countries has consis- themselves. In 1996 they invested $51 billion abroad, tently attracted most foreign investment (figure 3.4).13 raising their share of global foreign direct investment Brazil, Indonesia, Malaysia, Mexico, and Thailand have outflows to 15 percent. Like industrial countries, they been among the top 12 recipients in each of the past invest predominantly in economies in the same region three decades. China (including Hong Kong) joined this or continent. group in 1990 and by 1998 had received $265.7 billion Foreign direct investment in service industries ac- in foreign direct investment, making it the most sought- counts for close to two-thirds of such capital flows, after destination among developing countries. A few while the share of such investment in manufacturing African and Middle Eastern countries have been very has been falling. Although these aggregate figures con- successful in attracting foreign investment as well, but as ceal differences across countries, the shift toward ser- a group Africa and the Middle East have received less vices is significant. Traditionally, service industries have than 10 percent of foreign direct investment flows. In been less exposed to international trade and so lacked 1997 the stock of such investment in Africa was less than this stimulus to control costs, develop products, and in- 2 percent of the world total. For this reason many Sub- novate. Foreign direct investment offsets this deficiency Saharan countries will continue to rely on multilateral by enhancing the degree of competition in domestic and bilateral aid to finance investment projects (box 3.1). service markets and by transferring best practices from Although multinational corporations typically in- abroad (see chapter 2). In addition, firms in develop- vest in foreign countries in order to sell in domestic ing countries have become more involved in cross- markets or to create new bases for exporting, interna- border partnerships with foreign firms—joint ventures tional firms have long shown an interest in exploiting with or without equity stakes, franchises, licensing, and developing countries’ natural resources, including oil, subcontracting or marketing agreements. Since 1990 minerals, and lumber. Investment in natural resources more than 4,000 such agreements have been signed, is often enclave investment. It brings needed capital complementing the flows of foreign investment.9 into a country but offers few of the other benefits— The continuing liberalization of national regulatory new technologies, new markets, and increased human frameworks for foreign investment has fostered these capital—that are usually associated with manufactur- capital inflows and interfirm agreements. In 1997 at ing investment. In many cases, the economic activities least 143 nations had frameworks for foreign direct in- such investments entail are located in relatively remote vestment in place. Some 94 percent of the regulatory areas, far from other areas of economic activity. changes since 1990 have actually helped create more fa- The benefits to developing countries of foreign in- vorable environments for foreign direct investment.10 vestment in natural resource exploitation have been

(c) The International Bank for Reconstruction and Development / The World Bank        

Figure 3.4 Box 3.1 A few developing countries received A continuing role for aid the lion’s share of FDI invested outside industrial countries in 1997 Among least-developed countries, the smallest and most resource poor are the least likely to receive substantial pri- Worldwide stock of FDI in 1997 ($3,456 million) vate capital flows. These countries still need official aid flows to finance investments in health, education, the en- Other developing countries 10% vironment, and basic infrastructure. In 1998 net official flows worldwide totaled approximately $51.5 billion. China 6% Aid can be highly effective in promoting growth and re- ducing poverty. But aid is also a scarce resource that needs Brazil 4% to be used well, and using it well requires good decisions by governments and donors alike. Whether aid increases eco- 20% Mexico nomic growth, for instance, depends on a country’s policy 3% and institutional environment. Good macroeconomic man- Singapore agement, sound structural policies and public sector admin- 2% istration, and measures that increase equity are all impor- Indonesia 2% tant. They promote growth themselves, and they support Industrial the growth-enhancing effects of development assistance. countries Malaysia 70% 1% Development assistance, like so many other economic Saudi inputs, is subject to diminishing returns. Even countries Arabia with excellent policies are limited in their capacity to ab- 1% sorb such aid. Once official assistance reaches around 12 Argentina percent of GDP, its potential contribution to growth is usu- 1% ally exhausted. But few countries receive such high levels Source: UNCTAD, World Investment Report, 1998. of aid, so that only a country’s policy environment limits its capacity to absorb development assistance. While the governments of developing countries deter- mine the effectiveness of aid in the growth process, ambiguous, for several reasons. First, the benefits to a donors determine how effective aid is in global poverty re- duction. For it is donors, not recipient governments, that developing country may be smaller than GDP indica- decide which countries receive assistance. In making this tors initially suggest, as these indicators do not take into decision, donors need to keep in mind two factors: account the wealth the country loses when resources are extracted. Second, the resulting economic growth may Ⅲ The extent to which assistance will raise the growth rate, not be sustainable. In some cases the legacy may be a factor that depends on the policy and institutional envi- ronment and thus differs considerably across countries more negative than in others. If gold extraction tech- Ⅲ The existing level and distribution of income in the recip- nologies lace the surrounding environment with cya- ient country, since income growth in a country like Chile, nide, the costs of restoration can be enormous. In con- where poverty is low, tends to reduce poverty less than trast, companies can replant hardwood forests that have it would in a country with mass poverty, like India. been logged. Three-quarters of the world’s poor (those living on less The kinds of foreign direct investment that are most than $2 per day) now live in countries where the policy en- likely to provide useful benefits and sustainable, long- vironments are such that additional aid would raise the term growth are associated with manufacturing pro- growth rate. The challenge is to allocate the assistance ducer services. Unfortunately even those African coun- available in order to take advantage of the favorable cli- tries with a five-year record of good economic policies mate for growth. have found it difficult to attract this kind of investment, Source: Collier and Dollar 1998; World Bank 1998a, 1999i. in spite of evidence showing that the overall returns in these economies may be just as good as elsewhere.

Financial interruptions to development: banking cies (or lack thereof) toward foreign portfolio invest- and currency crises ment and short-term foreign borrowing.14 These kinds Even though it is widely accepted that developing coun- of flows have been closely linked with the financial and tries have substantially benefited from large inflows of currency market volatility of the late 1990s. Countries foreign direct investment, the far more controversial as- with high levels of short-term debt are vulnerable to sud- pect of capital account liberalization has concerned poli- den changes in investor sentiment. The resulting mas-

(c) The International Bank for Reconstruction and Development / The World Bank      ⁄

sive shifts in the direction of flows are often too much ing countries must raise their rates. The higher costs are for even strong financial systems and are certain to have passed on to domestic borrowers, increasing the likeli- disastrous consequences for weaker ones. The economic hood of defaults. Second, many firms in developing crises resulting from such vacillations have imposed countries borrow from overseas banks. When such enormous costs on the countries involved—costs that borrowing is widespread, increases in interest rates in have affected not only borrowers but also huge numbers industrial countries create a common macroeconomic of innocent bystanders. In some cases workers have seen shock, leaving firms unable to repay their loans to unemployment soar and wages fall by one-fourth or domestic as well as to foreign banks.20 Balance sheets more.15 Small businesses with prudent levels of debt deteriorate even further when a jump in industrial have found themselves either cut off from access to countries’ interest rates leads to a depreciation in a de- credit or facing astronomical interest rates few can af- veloping country’s exchange rate, so that domestic bor- ford. Bankruptcies have soared, contributing to the eco- rowers need more domestic currency to repay their for- nomic havoc and destroying information and organiza- eign currency debts. tional capital that will not be recovered for years. Third, speculative attacks can seriously jeopardize In considering the risks inherent in the ebbs and the stability of a developing economy’s banking sys- flows of international capital, governments will want to tem.21 A speculative attack on a currency occurs when differentiate between liberalizing domestic financial in- foreign and domestic depositors suddenly shift their stitutions and liberalizing the capital account. Although funds out of domestic banks into foreign currency, they involve different policy instruments and pose dif- often leaving the domestic banking system facing a ferent risks, both types of liberalization can result in fi- bank run. These attacks take place because investors re- nancial instability if they are poorly managed. The past ceive new information that affects the attractiveness of two decades should leave no doubt about the heavy costs keeping money in a country. And financial contagion of global banking crises. Between 1977 and 1995, 69 tends to occur when a country’s economic characteris- countries faced banking crises so severe that most of tics resemble those of another country that is known to their bank capital was exhausted.16 Recapitalizing these be in severe macroeconomic difficulties (box 3.2).22 banks was extremely expensive, with budgetary costs Fears of a banking or currency run may be self- reaching approximately 10 percent of GDP in Malay- fulfilling, creating a macroeconomic crisis that would sia (1985–88) and 20 percent of GDP in Venezuela not otherwise have occurred.23 During the banking cri- (1994–99). These crises can retard the progress of eco- sis in Argentina in 1995, deposits fell by one-sixth in nomic growth for years. As the Mexican crisis of 1994 the first quarter of the year, and the central bank lost and the East Asian crisis of 1997–98 made clear, bank- $5 billion in reserves. The crisis was attributed in part ing and currency crises often come as a pair.17 to the collapse in confidence in Latin American finan- Liberalizing the capital account also influences do- cial markets that followed the Mexican crisis in Decem- mestic financial stability because portfolio investment ber 1994.24 The two recent financial crises in East Asia can be volatile.18 Latin America has seen its foreign cap- and Latin America suggest that geographic proximity ital flows rise and fall sharply. Net inflows were $60 bil- is an important determinant of financial contagion. lion in 1993, but in the wake of the Mexican crisis in “Institutional proximity,” or similarities in legal and 1995, net outflows reached $7.5 billion. Access to a regulatory systems, and exposure to the same shocks growing pool of global capital can mean more volatil- may also be factors. Countries thus have an interest in ity in emerging financial markets and greater exposure ensuring that the financial systems and macroeconomic to changes in sentiment by institutional investors in in- policies of neighboring countries do not increase the dustrial countries, too. Many empirical studies have likelihood of a financial crisis and induce contagion. demonstrated the sensitivity of portfolio flows of for- Potential spillovers across countries provide a com- eign capital to interest rates in industrial economies. pelling rationale for regional cooperation and coordi- Increases in interest rates in industrial countries raise nation in macroeconomic policy, banking standards, the probability of a banking crisis in developing and and the enforcement of bank regulations—a proposal transition countries, for three reasons.19 First, to retain explored later in this chapter.25 investments from industrial country investors who can Recent cross-country studies find that imposing cap- now realize higher returns at home, banks in develop- ital controls has little effect on economic growth.26 One

(c) The International Bank for Reconstruction and Development / The World Bank        

Box 3.2 What causes financial contagion?

During a financial crisis elsewhere, contagion is said to have oc- through the attitudes of investors worldwide, is the response curred when a country succumbs to a financial crisis for rea- of mutual fund managers to country crises. Fund managers can sons other than a change in its fundamentals. The crises that spread financial volatility in several ways: began in Mexico during 1994 and Thailand in 1997 spread rapidly around the world. These crises had a major effect on fi- Ⅲ Emerging market fund managers often allocate their portfo- nancial markets, labor markets, and output in a range of other lios across different countries according to percentages countries in different regions—even half a world away. specified beforehand. When the value of investments in one What causes financial contagion?27 The series of events country drops, one manager’s response might be to sell could begin with a country that experiences a currency deval- stocks in other emerging markets to rebalance the portfo- uation, perhaps as the result of a combined bank and currency lio, depressing stock prices and putting pressure on curren- run by foreign investors. That country’s export goods become cies in all the countries in which the manager invests. cheaper for foreign consumers to buy, and other countries that Ⅲ Fund managers facing losses from investments in one coun- export the same goods find themselves at a competitive dis- try may have liquidity problems, forcing the sale of invest- advantage. The latter countries then come under pressure to ments in other markets. devalue their exchange rates. In 1997 and early 1998 many Ⅲ Investors, especially in emerging markets, find information feared that East Asian countries, in an attempt to shore up ex- on the prospects of a company or a country costly to collect. port sectors against regional competition, would engage in This difficulty encourages herd behavior: the disposal of rounds of “competitive devaluations” that would damage the stock by one investor is assumed to be based on news that economic prospects of every country involved. is not yet widely known, so other investors interpret this ac- These sorts of trade and exchange rate effects emanated tion as a signal to sell their own holdings. The lack of infor- from the Thai devaluation in 1997 and helped spread the East mation also encourages investors to take news of poor per- Asian crisis. But they cannot explain the depth or breadth of fi- formance in one emerging market as a signal that bad news nancial contagion. An alternative cause, which is disseminated is imminent in similar markets.

plausible interpretation of this finding is that the bene- tal accumulation, productivity, and economic growth.30 fits of having access to a global pool of capital—like the This evidence and the frequent banking crises develop- opportunity for adding to investment capital or diversi- ing countries experience suggest that a robust banking fying risks—have been offset by the costs of the crises fi- regulatory framework offers substantial payoffs. Such a nancial liberalization causes. While cross-country regres- framework would ensure that bank managers and own- sions are always open to scrutiny, they do underscore the ers balance the costs and benefits of risk-taking behavior. difference between the evidence on the effects on eco- Striking the appropriate balance in designing bank nomic growth of trade liberalization and capital account regulations is difficult, however. Lax regulation raises liberalization. A wealth of studies exists on trade liberal- the risk that lending will move from the realm of mea- ization, all of them suggesting that it has many benefits, sured risk-taking to foolhardiness. But excessive bank but the evidence on capital account liberalization is regulation is likely to send funds flowing to the more much more mixed. The challenge is to devise policy and lightly regulated nonbank financial sector.31 This sec- institutional responses attractive enough to lure invest- tor is less likely to be associated with systemic failures ments that will have a significant positive impact on than banks, since severe bank failures lead to difficul- growth and, at the same time, to reduce the potential for ties with the payment mechanism. Yet this sector can costly financial crises. The rest of this chapter presents also breed financial instability, suggesting that at least an integrated program to do just that.28 some regulations may need to extend beyond the bank- ing system to other financial entities. Toward a more robust and diversified The growing complexity and diversity of banking banking system activities are straining bank regulatory resources every- Banking systems are especially important for raising and where, but especially in developing countries where allocating capital in developing countries, where the these resources are scarce. Private monitoring of banks banking sector typically accounts for a larger share of can complement formal regulations, and only a judi- total financial intermediation than it does in industrial cious combination of public and private oversight will economies (figure 3.5).29 Cross-country studies point to allow developing economies to reap all the possible the beneficial effects of a healthy banking sector on capi- benefits of financial liberalization.

(c) The International Bank for Reconstruction and Development / The World Bank      ⁄

Figure 3.5 cerned about the security of their money must try to Bank intermediation typically accounts for a gauge the quality of their bank’s lending practices, larger share of the financial sector in developing which determine whether the bank is solvent enough to countries return deposits on demand. If many depositors—for

a Bank intermediation ratio, 1994 good reasons or bad, based on good information or (percentage of total) poor—demand their deposits back at the same time, 100 Latin banks face a liquidity problem. When banks lend large Asia America G-3 90 sums to each other, the resulting financial commitments can put pressure on a number of entities. If depositors 80 cannot differentiate between them, a run on one bank 70 may lead to runs on others, threatening the stability of 60 the entire financial system. To limit this possibility, gov-

50 ernments often insure deposits, guaranteeing depositors that they will get their money back and thereby reduc- 40 ing the incentive to start a bank run in the first place. 30 Central banks may also act as lenders of last resort to 20 help banks deal with short-term liquidity problems.

10 Deposit insurance has been criticized as contribut- ing to the fragility of the banking system, and without 0 b the appropriate regulatory structure this can well be the

India Chile Brazil Japan case. With deposit insurance, depositors simply put Mexico MalaysiaThailand enezuela Indonesia Colombia V Argentina Germany their money in the bank offering the highest return. A

Rep. of Korea aiwan (China) United States T variant of Gresham’s law—with bad banks driving out

a. Ratio of the banking sector’s assets to the assets of all financial good banks—can occur; a bank that is willing to take institutions. greater risks with higher expected returns can offer b. The Universal banking system in Germany accounts for its very higher depositor rates; as funds flow to that bank, the high bank intermediation ratio. Source: World Bank 1997c. profitability of more conservative banks that invest in low-risk, low-return activities declines.34 Actually, the problem is not formal deposit insurance, as govern- In industrial countries an extensive legal and regula- ments will bail out any large bank because the risks of tory structure underpins banking operations. Laws systemic crisis are simply too great. Financial crises have protecting the rights of creditors permit banks to lend afflicted countries with and without formal deposit in- confidently and to collect deposits. Laws regulate bank- surance, as Sweden’s recent crisis bears testimony. In ruptcy and the recovery of assets and collateral, and ju- short, the moral hazard problem arises whenever there dicial proceedings implement such laws quickly and are large banks, and in most developing and transition impartially.32 Accounting and auditing standards help economies the concentration of banking activity is suf- in comparing investment projects and are prerequisites ficiently high that it is implausible that government for building efficient bond and stock markets. The rise would not intervene. of international bank lending increases the importance Not all deposit insurance schemes are alike, how- of global accounting standards.33 And because these le- ever.35 Some are more efficient than others, incorporat- gal and professional institutions take years to build, it ing practices that could usefully be emulated elsewhere. is important to begin constructing them now. In the Some governments limit deposit insurance coverage, meantime governments can develop regulatory frame- setting a ceiling on the size of deposits or the number works that address some of the special problems of of accounts that can be insured. Some collect premi- banking activities in developing countries. ums from all banks on a regular basis, rather than im- posing levies on surviving banks after a crisis. This last Why are deposits insured? practice is particularly pervasive, since leaving the sur- Banks borrow money on a short-term basis from depos- vivors to pick up the tab gives banks no incentive to itors and lend it out for longer periods. Depositors con- avoid collapse in the first place. Theoretically, deposit

(c) The International Bank for Reconstruction and Development / The World Bank         insurance premiums can be linked to the risk level of a lending only to certain industries or regions. To the ex- bank’s portfolio or to the proportion of nonperforming tent that they prevent a bank from maintaining a well- loans. But to date, no government has tried this idea. diversified loan portfolio that balances risks in one industry or region against risks in others, such restric- Regulatory incentives to reduce risk-taking tions should be avoided. This concern is particularly A banking regulatory structure deals with many aspects important for banks that lend in only one geographic of bank operations: the requirements for setting up a region and where most borrowers are in the same bank, the services banks can provide, the levels of capi- industry. In such situations a collapse in prices that tal they must hold, the reserves they need to protect threatens the industry’s solvency will also affect the sol- themselves against nonperforming loans, and the liquid- vency of the banks. ity levels they must have to handle withdrawals. The reg- Two other challenges faced in designing appropriate ulatory structure defines the terms for disclosing a non- bank regulation are worth noting: competing jurisdic- performing loan, governs the portfolio composition of tions over banks, and close links between provincial banks, and specifies remedial measures in the event of banks and subnational governments.41 To avoid dupli- deteriorating loan portfolios or bank runs. As the num- cation of subnational and national regulatory resources, ber and variety of services banks offer increase, regula- subnational pressure for regulatory forbearance, and tors need to respond to the possibility that problems can the offer of implicit guarantees by subnational govern- occur simultaneously in many areas. ments, there is a strong case for executing bank regula- The reluctance of ever-hopeful regulators to control tion at the national level. risk-taking or to preemptively close banks with deterio- rating loan portfolios has made many banking crises Establishing private incentives to reduce risk-taking worse.36 For this reason, creating mechanisms that limit Private incentives that complement the framework of such “regulatory forbearance”—the term for putting off government regulation can help align the costs and tough actions in the hope that the bank will recover on benefits of the risks banks take. Banks can, for instance, its own—is another important step governments must periodically issue a special category of subordinated take to make bank regulations more effective.37 Some debt that is not guaranteed by the government. Since governments have already begun to remedy this prob- those holding subordinated debt lose their capital if a lem by insisting on independent audits of banks’ bal- bank defaults, they have a powerful incentive to moni- ance sheets, punishing failures to disclose nonperform- tor the riskiness of bank lending practices.42 But unlike ing debt in a timely fashion, and fining (or closing) holders of bank equity, holders of subordinated debt do banks that do not meet their capital adequacy require- not see higher returns if a bank increases its revenues ments. After its banking crisis in 1982, Chile intro- by making high-risk loans, since the market sets the ini- duced reforms specifically intended to reduce regulatory tial rate of return on subordinated debt.43 forbearance by increasing regulators’ autonomy and Banks wanting to reduce high interest payments to mandating public disclosure of the activities of both reg- those holding subordinated debt (especially because ulators and banks. Chilean law also proscribes links be- high interest rates send a signal to depositors and gov- tween insured banks and business conglomerates.38 ernment regulators) have an incentive to establish mon- The growing number of banking crises calls into itoring and disclosure practices that regularly report on question the merits of certain other government policies. the quality of the bank’s lending portfolio. Chile and For example, governments have tried to encourage lend- Argentina have adopted some of these practices.44 ing to targeted industries either by guaranteeing loans or by simply directing banks to make loans.39 Some Credible banking reform commentators on the East Asian crisis argue that these A new bank regulatory system may well face credibility initiatives have created implicit or explicit government problems, especially in countries with histories of di- guarantees.40 In these situations banks have little incen- rected government lending, regulatory corruption, and tive to carefully screen loan applications for favored proj- recurrent banking crises. Arm’s-length relationships be- ects, a lapse that often results in widespread default. tween regulators and regulated may well be a novel Banks are also sometimes restricted in the types of idea, along with the notion that strong interventions loans they can make. Often these restrictions permit occur automatically and without regulatory discretion

(c) The International Bank for Reconstruction and Development / The World Bank      ⁄

when a bank fails to meet its legal obligations. Devel- in the form of additional pressure for appropriate risk- oping countries can improve the credibility of new taking by domestic banks. Admitting foreign banks is bank reforms by adopting and enforcing international no panacea, but if it is carefully timed and the economy banking standards. The various accords of the Banking can withstand the short-term disruptions, the benefits Regulations and Supervisory Practices Committee of can be considerable. the Bank for International Settlements, more widely Governments can foster the transfer of skills and best known as the “Basle Accords” or “Basle Standards,” can practices to their countries by allowing high-quality in- provide such standards. ternational banks with impeccable reputations to sup- Many argue that the current Basle Accords do not go ply domestic markets with financial services.47 This step far enough and in fact are now being revised.45 Critics requires governments to give foreign banks the right to say they do not do enough to discourage directed lend- establish themselves and to permit the immigration of ing, promote transparency (through the publication of skilled banking personnel. These international banks regulatory standards), or minimize the risks of regula- inevitably recognize that local bankers have a better tory discretion. The standards have also been criticized knowledge of the domestic economy, business practices, for recommending relatively low capital standards for and customs—and so offer them employment. Over developing countries that may face significant external time, local bankers will learn from the practices of the shocks.46 But developing countries can draw up a mem- international banks and acquire skills that they retain orandum of understanding with international finan- when they move back to domestic banks. cial bodies like the World Bank and the International The benefits of admitting foreign banks are not lim- Monetary Fund (IMF) adopting standards stronger ited to the transfer of skills and technology. Foreign than those in the Basle Accords. Or, given the risks of banks can stimulate competition, encouraging all banks regional contagion, neighboring countries can create to lower margins and overhead costs. A recent study of stronger voluntary banking standards for the region. the effects of foreign banks on the banking systems of Adopting internationally recognized banking stan- 80 countries found that in economies with relatively dards does more than just stabilize the banking system. large numbers of foreign banks, domestic banks have There are other payoffs, such as reduced borrowing lower expenses. However, domestic banks also have costs for domestic banks, which will be considered safe lower profitability.48 The findings suggest that the tim- risks. Realizing the payoffs is likely to require some ex- ing of foreign bank entry should be considered care- ternal monitoring of the country’s compliance with the fully. It would be highly undesirable if a rise in foreign new standards. For example, if a group of neighboring competition caused domestic banks to expand their countries agrees to a set of voluntary standards, the portfolio of high-risk loans in a desperate attempt to agreement can include a mechanism for periodically in- stave off default.49 vestigating compliance. This mechanism may be simi- Foreign banks are generally more diversified than lar to the Trade Policy Review Mechanism of the World domestic banks and can better withstand the effects of Trade Organization (WTO). An impartial body con- internal shocks. A severe macroeconomic downturn can ducts an investigation and, after a nonconfrontational push a domestic bank into default. But if a foreign bank discussion among the countries involved, publishes a has assets in healthy economies, a macroeconomic report on its findings. The country under investigation shock in the host country is likely to be less damaging. can produce a rejoinder that includes commitments for Of course, this benefit works only if the business cycles further reforms. These reports are available to investors, of the various countries differ. Economic shocks can be enabling them to better differentiate among countries. region-specific, continent-specific, or industry-specific. Ultimately, such a system reduces the likelihood of In such cases developing economies can expect little banking crises and financial contagion by inducing benefit from diversification if their foreign banks are countries to conform to higher banking standards. from the same region or continent or from countries with similar production structures. Another warning A role for foreign banks concerning the admission of foreign banks: events Allowing foreign banks to enter a country can disrupt abroad will affect the banks’ willingness to lend in the the domestic banking sector in the short term. But the new host country. For example, lower real estate and presence of foreign banks also offers long-term benefits stock prices in Japan in the 1990s led to reduced lend-

(c) The International Bank for Reconstruction and Development / The World Bank        

ing by Japanese banking subsidiaries in the United restraint in short-term foreign borrowing is a matter of States.50 In general, however, the risks posed by an un- government will. In the Mexican crisis, for example, diversified banking system overshadow this possibility. state entities were heavy foreign borrowers.54 Private A final benefit of admitting foreign banks is that the demand for short-term foreign debt should not be en- presence of these banks conserves on scarce administra- couraged with preferential tax treatment, as happened tive and bank regulatory resources in developing coun- in Thailand with borrowing through the Bangkok In- tries. Foreign banks are traditionally regulated by au- ternational Banking Facility. thorities in their home country. If foreign banks are A more aggressive way to limit short-term foreign allowed to take over domestic banks—or to buy domes- borrowing is to directly influence capital inflows.55 tic banks in privatization sales—regulatory responsibil- This discussion focuses on controls on inflows because ities are transferred abroad, and domestic regulators can controls on outflows are typically ineffective.56 One concentrate their resources on the remaining domestic method of circumventing outflow controls has multi- banks. This scenario highlights the need for a clear al- national firms selling goods to overseas parent compa- location of regulatory responsibilities across interna- nies at very low bookkeeping prices, transferring value tional borders. out of the country. Foreign investors wanting to cir- cumvent the controls also sometimes swap their funds The orderly sequencing of capital for the overseas assets of a domestic resident. account liberalization A scheme that provides disincentives for short-term Improving bank regulation would be an important pol- capital inflows has been in place in Chile since 1991.57 icy step even if world financial markets were not becom- This scheme imposes a one-year unremunerated reserve ing increasingly interconnected. However, the safety and requirement on all foreign inflows that do not increase security of a developing country’s banking system mat- the stock of physical capital, such as foreign loans, fixed ters even more in light of the volatility of international income securities, and equity investments. A portion of capital flows. The question then becomes one of find- any such inflows must be held in a non-interest-bearing ing a way to fit bank regulation into national strategies account for one year. The amount was initially set at 30 to liberalize the capital account. The macroeconomic percent, but it was lowered to 10 percent in June 1998 crises in Mexico and East Asia following the liquidation and subsequently to zero. The requirement remains on of short-term capital holdings by foreign investors has the statute book and can be reinstated, however. This rekindled interest in proposals for a measured, sequen- experience demonstrates that such a requirement can be tial approach to capital account liberalization.51 varied in order to stabilize the level of capital inflows. This discussion identifies a number of pitfalls devel- Rather than targeting specific types of capital inflows— oping countries face as they consider liberalizing their a measure investors can easily circumvent by rela- capital accounts. Each of these pitfalls must be side- beling—this scheme provides a sharp disincentive to stepped in order to minimize the risk of a financial cri- investing for less than one year.58 Empirical studies sis. Of course, developing countries differ substantially suggest that the effect of this tax has been to alter the in the nature of their legal institutions, corporate gover- composition of capital inflows toward less “footloose” nance practices, banking regulations, capital market de- foreign direct investment, although evidence on the velopment, and macroeconomic conditions.52 A unique overall impact on the level of capital inflows is mixed.59 recipe for sequencing capital account liberalization is Countries may be able to reduce their exposure to therefore unlikely to exist. Instead, the formula will vary changes in the sentiments of foreign portfolio investors across countries, dictated in part by how quickly coun- without banning such investment outright. Then, as tries can correct macroeconomic imbalances and enforce governments strengthen their bank regulation systems, credible financial regulations. they can gradually lower the nonremunerated deposit A key element of the sequential approach involves requirement. This approach reduces an economy’s vul- devising policies that control the demand for short- nerability to capital outflows by limiting certain of the term foreign debt.53 This type of foreign capital is the original inflows. most likely to flee, destabilizing the banking sector and In addition to modulating short-term foreign bor- the entire economy. Policies affecting short-term debt rowing, governments must decide how to treat foreign are best implemented before the inflows occur. In part, currency deposits in their domestic financial systems.

(c) The International Bank for Reconstruction and Development / The World Bank      ⁄

Such deposits often account for a substantial percent- change rate regimes do provide different incentives to age of the broad money supply in developing countries potential borrowers of foreign short-term capital. In and in fact exceeded 30 percent in 18 countries in particular, a fixed exchange rate regime offers what 1995.60 While so-called dollarization undoubtedly has some interpret as an implicit guarantee to borrowers many implications for macroeconomic management, that they can ignore the risk of changes in the exchange the focus here is on its effects on financial stability and rate. Coupling fixed exchange rate regimes with deposit the implications for capital account liberalization.61 insurance is tantamount to relieving foreign depositors In a fractional reserve banking system, a rapid expan- of much of their credit risk.65 Such guarantees encour- sion of foreign currency deposits increases the liabilities age capital inflows, potentially exacerbating an econ- of domestic banks’ loan portfolios. The risk involved omy’s dependence on short-term foreign debt. More stems from the fact that the amount of net foreign cur- troublesome still, when investors call these guarantees rency in the economy is much lower than the total vol- into question, substantial capital outflows are likely. ume of foreign currency–denominated assets and lia- The exchange rate regime is then in jeopardy unless the bilities. Faced with a run on foreign currency deposits country has enough foreign reserves to cover the out- in the domestic banking system, the central bank may flows. Apparently, the preconditions for successfully come under pressure to act as lender of last resort and maintaining a fixed exchange rate are more stringent provide substantial loans in foreign currency to domes- than was previously thought. tic banks. 62 But these loans require the central bank to In contrast, flexible exchange rate regimes provide hold a relatively high level of costly foreign currency re- incentives for investors to take exchange rate risk into serves. In addition, the liquidation of foreign currency account and offer no protection against a fall in the ex- deposits may affect the exchange rate and the solvency change rate. As the experiences of Mexico in 1995, of domestic firms that have borrowed in foreign cur- Thailand in 1997, and Indonesia in 1998 show, the vi- rency. These factors argue for discouraging holdings of ability of a national banking system can be threatened foreign currency deposits in banking systems with rudi- when corporate borrowers face insolvency because a de- mentary regulatory oversight, by means of taxation or valuation of the national currency substantially in- higher bank capital-adequacy requirements. creases their foreign currency exposure. Financial crises Developing countries can also reduce the risk of fi- are certainly possible in flexible exchange rate regimes, nancial and economic crises from capital outflows by but these regimes create more incentives for investors maintaining high levels of foreign currency reserves.63 to take account of exchange rate movements than fixed The necessary level of reserves will depend on the coun- exchange rate regimes. Exchange rate regimes also dif- try’s level of international trade and on the amount of fer in the options available to policymakers when fac- footloose capital invested in the economy. Countries ing a surge of capital inflows—an issue discussed in the with enough reserves send a signal to investors, who World Bank’s Global Economic Prospects 1998/99. know they can convert their assets into foreign curren- The extent of macroeconomic instability and im- cies at the prevailing exchange rates. This knowledge balances suggests that other considerations are impor- reduces the risk that investors will all stampede for the tant in determining the appropriate pace of capital ac- exits at the same time because they fear a currency count liberalization. Although the consequences of crash.64 But accumulating reserves comes at a price. liberalization may depend on the exchange rate regime, Usually, domestic consumption and investment must removing barriers to capital flows at a time when a be limited so that exports exceed imports and the net massive inflow or outflow of funds seems likely is im- receipts are retained. Alternatively, reserves can be bor- prudent. For example, an outflow can be precipitated rowed by issuing long-term bonds, in which case the if capital account liberalization occurs during a period cost equals the difference between short-term and long- of high inflation, when domestic investors prefer sta- term interest rates. ble returns overseas. The choice of exchange rate regime is another im- The objective of a measured policy of sequential portant element affecting the sequencing of liberaliza- capital account liberalization is to gradually increase a tion. Of course, which exchange rate regime best serves national financial system’s tolerance for external disrup- a country’s interests depends on many considerations tions. While governments are building domestic capi- other than the regime’s compatibility with capital ac- tal market institutions (like bank regulation), they can count liberalization. However, different types of ex- also focus on ways of reducing exposure to changes in

(c) The International Bank for Reconstruction and Development / The World Bank        

the sentiments of holders of foreign debt instruments— vestment and technology, workers must be sufficiently so long as the methods chosen do not scare off too well educated—often with industry-specific skills— much long-term foreign investment. and able to continue to learn.69 And as foreign investors increasingly discriminate between regions and cities Attracting foreign investment within countries, the payoff to subnational govern- Long-term foreign investment will continue to provide ments of improving local systems of education and developing countries with important benefits. Public training increases still further. sector infrastructure projects will be in ever-greater de- mand in expanding cities, and governments and do- Liberalizing the trade policy regime mestic savers need not be the sole sources of financing. Foreign direct investment has a more profound impact In the private sphere the benefits of long-term for- on growth in countries that pursue policies promoting eign investment begin with the expansion of the host exports than it does in countries that follow import- country’s capital stock. However, since multinational substitution policies.70 The reason may be that foreign- corporations are responsible for most foreign direct in- owned companies aiming for global competitiveness vestment, there are other benefits as well. This invest- and international markets have a greater incentive to ment enhances competition in domestic markets, so re- bring in technology and training—with the accompa- sources are allocated more efficiently and domestic nying spillover benefits. In East Asian countries, foreign firms invest more. Foreign direct investment that in- direct investment has played an important role in bol- volves joint ventures or licensing arrangements between stering advanced manufacturing exports and output. In local and foreign firms often transfers technology66 and Korea, for example, foreign affiliates accounted for be- best practices to the host nation, stimulating produc- tween 65 and 73 percent of output in the electrical and tivity growth.67 (The importance of foreign direct in- electronics sector.71 vestment to Egypt and Tanzania is taken up in two case An open trade policy is also important for attracting studies in chapter 8.) foreign direct investment. Surveys of Japanese firms How can countries attract foreign investment? This which had decided to invest abroad found that a positive discussion presents several of the most effective meth- perception of policies governing such investments was a ods: adopting complementary human capital policies, strong determinant of plans to invest in a country and liberalizing the trade policy regime, avoiding induce- that low trade barriers made it more likely that multina- ments for foreign investors, creating a stable set of tional companies would enter a country.72 When first- rights and responsibilities for those investors, and de- rate information technology systems reinforce liberal veloping stock markets as alternative funding sources. market access, a country is further integrated into the world economy and becomes still more attractive as a Adopting complementary human capital policies destination for investment. A survey of international One recent study found that countries with low levels firms in Hong Kong (China), Singapore, and Taiwan of education and low rates of foreign direct investment (China) found that the presence of advanced infrastruc- grow much more slowly than countries with high edu- ture was the most important consideration in choosing cation rates and levels of inflow.68 Countries whose to locate regional headquarters and service and sourcing working populations have less than an average of five operations in a country, and the second most important months of secondary schooling and whose levels of for- factor in siting production. Foreign direct investment is eign investment are less than 0.1 percent of GDP have increasingly connected more with trading opportunities annual growth rates of less than 1 percent. But coun- than with local market exploitation.73 For example, the tries whose workers have an average of more than one huge increase in foreign direct investment in Mexico after year of secondary schooling and inflows worth more the North American Free Trade Agreement (NAFTA) than 0.2 percent of GDP enjoy, on average, annual came into force is evidence that the country is seen as a growth rates of 4.3 percent. Countries with high edu- desirable base for supplying the U.S. market. cational levels but low foreign direct investment, or Export-oriented development means that invest- with low educational levels but high foreign invest- ment decisions depend less on the scale of home mar- ment, do little better than countries that score low on kets, since firms are looking to sell in the global mar- both measures. These results may in part reflect the fact ketplace. Because multinational corporations are no that if labor is to facilitate continuous transfers of in- longer tied to domestic markets, they have more flexi-

(c) The International Bank for Reconstruction and Development / The World Bank      ⁄

bility in choosing locations. Both points suggest that icy, which can be designed to induce foreign invest- stable and attractive economic policies have become ment. Chapter 8 describes Hungary’s successful efforts much more important. In fact, foreign direct invest- to attract foreign buyers for its formerly state-owned ment seems to be responding faster to economic factors banks. The second involves a country’s obligations than it has in the past.74 under the WTO’s General Agreement on Trade in Ser- vices. These obligations may include commitments to Avoiding inducements for foreign investors allow foreign firms access to certain domestic service Not all measures to attract foreign direct investment markets, as chapter 2 notes. have enhanced national welfare. In an assessment of Even if a nation implements sound macroeconomic 183 foreign direct investment projects in 30 countries policy, market liberalization measures, and clear legal over the past 15 years, one recent study found that be- rules, it is not always possible to ensure that successor tween 25 and 45 percent of projects had a negative net governments, including subnational governments and impact on national welfare. 75 This unwelcome and un- their agencies, will honor the commitments of their expected finding reflects the fact that foreign direct in- predecessors over the long term. This risk can limit the vestment is often accompanied by distortive policies. attractiveness of investments with high set-up costs and Such policies include requirements that producers use long payback periods, such as urban infrastructure proj- a specified number of domestic inputs; trade protection ects. The growing activities of subnational governments against imports that compete with the goods produced may exacerbate this problem (box 3.3). by foreign investors; financial inducements, subsidies, A dispute settlement mechanism can help resolve or tax holidays; and mandated joint ventures and tech- the issue of commitment. International arbitration is nology licensing arrangements. At least some of these often the preferred option. Arbitration clauses can be policies may encourage investment, but for society as a included in investment agreements with subnational whole the losses all too often outweigh the gains. Yet entities. In certain situations arbitration under the aus- another problem arises when urban centers and other pices of the International Centre for Settlement of In- subnational entities compete for investment, often en- vestment Disputes (ICSID) can be made available to gaging in inefficient beggar-thy-neighbor competition subnational governments that contract with foreign in- to provide public subsidies and incentives. National vestors. Almost 1,000 bilateral investment treaties and governments can play a role here in restricting the types 4 multilateral investment treaties contain clauses pro- of inducements that subnational governments can offer viding for binding arbitration under the ICSID. Some foreign investors. of the bilateral treaties explicitly state that their provi- sions cover acts and omissions of local governments in Creating a stable set of rights and responsibilities states signing the agreements. for foreign investors In the end, long-term investment agreements that National policies and regulatory institutions help fos- are balanced and mutually beneficial may be the most ter a climate conducive to foreign direct investment by lasting safeguards. Providing specialized training to in- multinational corporations. Taking steps to clearly de- crease local governments’ capacity to negotiate fair agree- fine the rights and obligations of multinational in- ments in the first place can advance this objective. The vestors is a start. Many developing countries are taking International Development Law Institute in Rome steps to create such legal frameworks and to simplify trains developing country lawyers to deal effectively bureaucratic procedures. This sort of institutional re- with foreign investors and lenders, and a number of form is especially attractive to investors considering in- World Bank initiatives also work to ameliorate this vesting in countries plagued by political risk and cor- commitment problem (box 3.4). ruption, since these practices are negatively associated The collapse of negotiations on a multilateral invest- with foreign direct investment.76 Countries that reduce ment agreement in 1998 suggests that a global treaty on red tape and bureaucratic delays not only make them- investment rules is still some way off. However, the num- selves more attractive to investment but help their own ber of bilateral and regional investment agreements and producers as well.77 treaties has increased. Signatories to these agreements re- Two other types of domestic regulations and com- alize that extending protections to foreign investors pro- mitments have particularly important ramifications for vides an incentive to cosignatories not to renege on long- foreign direct investment. The first is privatization pol- term deals with their own foreign investors. Since most

(c) The International Bank for Reconstruction and Development / The World Bank        

Box 3.3 Box 3.4 Subnational governments face commitment Mitigating the commitment problem: the role problems, too of the World Bank

A U.S. company agreed to build the Dabhol Power Project, The World Bank has provided loans to host governments which would supply the Indian state of Maharashtra with to fund their obligations under political risk guarantees that 2,000 megawatts of power over a 20-year period.78 After are in turn issued to foreign investors. The Bank also of- the agreement was signed in 1993, the foreign investor fers lenders a guarantee that covers the risks of debt ser- began to incur heavy expenses for the construction of the vice defaults resulting from the failure of host govern- power station. The state government officials who signed ments to perform specified obligations in respect of the this contract lost the 1995 election, in which the invest- project. When issuing this guarantee, the Bank requires ment project had become a contentious political issue. that host governments sign a counterguarantee to reim- The new state government canceled the project, and only burse the Bank for any compensation the Bank pays the after 10 months of negotiations and several concessions foreign investor(s). Unless the host government plans to by the foreign investor was a new agreement signed. default on its obligations to the Bank (jeopardizing its en- Many argued that the original agreement was too gener- tire relationship with the World Bank Group), this counter- ous to the investor, and the fact that the company did not guarantee diminishes the government’s incentive to break abandon the project but instead chose to renegotiate its contractual obligations. offers some evidence for this view. With renegotiation, The Multilateral Investment Guarantee Agency (MIGA) the formal cost of construction fell from $1.3 million per provides foreign investors with insurance against losses megawatt to $0.9 million per megawatt.79 Canceling a proj- from war and civil disturbances, expropriations, and cur- ect the previous administration had agreed to was clearly rency inconvertibility. When a foreign investor cannot en- not the best way of attracting further foreign investment force a contract with a host government in that country’s to the sector. The investor reported that the delay cost ap- courts, MIGA can insure it against losses caused by the proximately $250,000 a day, and the international financial breach of contract. Between 1991 and March 1996, MIGA press gave the crisis extensive coverage. issued 30 contracts involving approximately $3.5 billion in This case shows how the proliferation of assertive sub- infrastructure projects. These contracts are in addition to national entities, which this report identifies as one of the those supplied by private insurers, which now offer con- chief political reactions to localization, can complicate the tracts for “breach of undertaking.” efforts of national governments to make binding commit- In 1992, at the request of the Development Commit- ments. If foreign investors cannot discriminate among tee, the World Bank Group issued a set of guidelines em- subnational entities in a given nation, the actions of one bodying commendable approaches to the legal framework entity may be seen as reflecting the behavior of all others. for the treatment of foreign investment. The guidelines This kind of spillover is a serious concern for national gov- cover the main areas dealt with in investment protection ernments keen on attracting foreign direct investment. treaties: the admission, treatment, and expropriation of foreign investments and the settlement of disputes be- tween governments and foreign investors. By their terms foreign direct investment is intraregional—with devel- the guidelines are not binding and are intended to comple- ment applicable international agreements. Moreover, by oping countries now investing substantial amounts their terms they are intended to apply to both states and abroad and so recognizing the need to protect their in- any of their constituent subdivisions. vestments—an even greater role for regional investment agreements is likely to emerge. When these investment accords include commit- tify them, and negotiate common guidelines for their ments to maintain domestic reforms, the reforms are use. Signatories can then negotiate additional con- more credible. Reversing the reforms once the accords straints later on, in much the same way as signatories to are signed would do more than wreak domestic havoc; international trade agreements have renegotiated tariff it would also invite retaliation by foreign governments. levels. These agreements also reduce incentives to en- NAFTA’s investment provisions in effect “locked in” gage in beggar-thy-neighbor policies to attract capital. Mexico’s domestic regulatory and institutional reforms. They allay fears that countries may be tempted to re- Similarly, the Mercado Común del Sur (MERCOSUR) duce environmental and other important protections in preferential trade agreement reinforced reforms in Brazil return for the promise of an investment project (the so- and Argentina and stimulated foreign direct investment called “race to the bottom” syndrome). from other countries, principally the United States.80 Regional foreign investment agreements can also Developing stock markets as alternative include constraints on the use of subsidies, tax induce- funding sources ments, and regulatory competition. The initial agree- Although foreign portfolio investment does not offer ment can identify accepted forms of favoritism, quan- the same opportunities for technology transfer and in-

(c) The International Bank for Reconstruction and Development / The World Bank      ⁄

creased competition as foreign direct investment, it can on individual countries. The contributions of regional also be very useful to developing countries. Opening and global agreements to foreign direct investment and stock markets to foreign participation increases liquid- financial supervision have already been discussed. But a ity by deepening the pool of buyers and sellers. Price- corollary to the growing trend toward a globalized econ- earnings ratios rise as liquidity increases, making the omy exists. As economies become increasingly interde- market a far more attractive source of equity financ- pendent, the effects of national policy decisions spread, ing.81 As the stock market develops and strengthens, it with ramifications—including potentially disruptive benefits other parts of the financial sector as well as the ones—for other countries.85 Although the interdepen- wider economy—foreign direct investment accompa- dencies are typically strongest among neighboring coun- nies stock market purchases, for instance. Stock market tries, macroeconomic conditions in industrial economies development and banking development have a strong have distinct consequences for the rest of the world. positive relationship, as do stock market liquidity and Fluctuations in interest rate differentials between in- economic growth.82 dustrial countries alter the flow of capital to and from The potential volatility of a stock market is an on- developing countries, potentially destabilizing their fi- going concern. Many policies for reducing volatility in nancial systems. A variety of vehicles for international the banking sector can help reduce the volatility of cooperation could be considered that would enable in- bourses, however, and approaches to sequencing capi- dustrial countries to meet their own goals without buf- tal account liberalization can be applied to portfolio feting the outside world. equity flows as well. But as with other parts of the fi- The growing links among countries in the same nancial sector, the cause of stock market volatility is region also suggest a motivation for regional networks often a lack of reliable, up-to-date information. Accu- to prevent and fight financial crises.86 Because of the rate information from independent sources makes an growing trade and financial links among regional econ- emerging market attractive to foreign equity investors omies, one economy’s poor performance can profoundly and increases the stability of capital flows. Rules man- effect its neighbors. This fact argues for close monitor- dating the regular public reporting of financial posi- ing and mutual support among countries in the same tions in key areas such as investment, property and region. However, the growing strength of regional link- equipment, foreign currency operations, and long-term ages will cause national economic cycles within a region contracts reduce uncertainty.83 Financial markets de- to move more closely in phase. In this case the IMF’s velop best in the presence of legal codes that stress the function as an extraregional crisis management body rights of shareholders (especially minority holders) and will take on added importance, as countries in the same regulatory systems that encourage the disclosure of cor- region are likely to enter downturns together, reducing porate information.84 the resources they have available to help their regional During the next 25 years the flow of foreign invest- partners. ment to and from developing economies will increase One promising approach builds on the steps some substantially. Developing countries will have a growing countries are already taking toward regional economic interest in establishing secure and stable regimes that monitoring. The Association of Southeast Asian Nations protect their overseas investors—and that clearly delin- (ASEAN) agreed to implement an economic moni- eate their responsibilities. As the supply of capital grows, toring mechanism in November 1997. The mechanism subnational and central government entities will increase aims to monitor policies in “vulnerable” sectors, to im- their demands for capital to fund urban infrastructure prove economic policy coordination among members, projects. Developing economies can take action to attract and to assist members during a crisis.87 But doubts have and maximize the benefits of long-term foreign invest- been raised about this mechanism, with skeptics ques- ment by participating in regional agreements that en- tioning not only whether enough resources have been hance investor security and by maintaining stable macro- devoted to it, but whether governments will actually be economic, trade, and regulatory policies. willing to release timely information or to criticize each other’s domestic policies.88 This points to the difficulty Revitalizing international macroeconomic of sustaining cooperation in regional initiatives such as cooperation this and the Manila Framework. This sketch of international financial integration has de- When a regional grouping does establish a credible liberately avoided placing the entire burden of reform monitoring scheme to certify that members have im-

(c) The International Bank for Reconstruction and Development / The World Bank        

plemented commendable regulatory and macroeco- world. Since 1997, when the East Asian crisis began, the nomic practices, members can extend cooperation to world has learned that poorly managed financial liber- include pooling funds to deter speculative currency at- alization can lead to a protracted economic downturn tacks. This “seal of approval” helps investors differenti- and a renewed cycle of poverty. But the potential upside ate among member states. This pool of regional funds of international capital flows is enormous, as the posi- can be used to augment the national reserves of what tive contribution of foreign direct investment to boost- might otherwise become the “trigger economy” for a re- ing productivity in recipient countries demonstrates. gional crisis. If these additional reserves reduce the like- The discussion in this chapter has highlighted four lihood of a future devaluation of a country’s currency, essential and related measures for developing economies foreign and domestic investors will be less inclined to wishing to integrate into global financial markets. First, liquidate their portfolio investment in that country, even if an economy is completely isolated from foreign possibly preventing a currency run altogether. financial flows, the benefits of domestic financial liber- Countries can also explore opportunities for cooper- alization cannot be assured without strong banking reg- ation with regional partners during a financial crisis. ulation. Second, strengthening those regulations takes Crisis management accords can be signed in advance, years, and in the interim governments must develop providing investors with the expectation of a coordi- policies that reduce the volatility of short-term foreign nated response to shocks and helping allay the most inflows. Third, developing countries will want to in- pessimistic expectations. These accords can then serve crease their attractiveness to long-term foreign invest- as a framework for a coordinated fiscal policy of tax cuts ment. The rise of global production networks (dis- and spending increases that provides a safety net for cussed in chapter 2) shows that multinational firms are those most affected by shocks and stimulates the re- slicing up production processes, distributing them gional economy.89 The accords can also lay the ground- across economies. Large domestic markets are likely to work for commitments not to engage in competitive become less important to multinationals looking for devaluations or impair market access by raising existing new locations, creating opportunities for smaller devel- tariff and nontariff barriers. oping countries with suitable infrastructure and educa- tion. Finally, efforts to coordinate aspects of financial ••• and regulatory policies can be advantageous to devel- Internationally mobile capital is here to stay. Growing oping economies. Financial crises in developing coun- trade links, new communications technologies, and in- tries are not always homegrown. Fluctuating interest creasingly sophisticated financial products are making rate differentials between industrial countries have in- national borders more porous to financial flows. The creased the volatility of global capital flows, which can challenge facing policymakers in developing countries be ameliorated by policy coordination among industrial is how to navigate through this financially integrating countries.

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