Chapter 1
Development in private capital flows

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Flows from international capital markets to developing countries increased strongly during the first three quarters of 1997. In the last quarter, however, the eruption of the financial crisis in Southeast Asia (see chapter 2) had broad repercussions in emerging markets. The crisis triggered a period of extreme volatility in capital market flows, equity prices, currencies, and secondary market spreads, and many major borrowers experienced a deterioration in market access by year’s end. In examining developments over the course of the year, this chapter makes three main points:

• Emerging markets rode a rollercoaster during 1997. Against a favorable global economic environment, international capital markets remained liquid and several major borrowers continued their strong performance, which contributed to a rise in flows for the year as a whole. However, market access began to deteriorate with the Thai devaluation in July (affecting mainly Southeast Asia) and then worsened as the financial turmoil spread in late October and November (affecting Asia, Latin America, and Eastern Europe). In the last quarter of the year emerging markets experienced a sharp drop in flows from international capital markets, declines in portfolio equity flows on the heels of stock market declines, and in some countries, further pressures on exchange rates. The same forces that led to pronounced swings in flows induced sharp changes in secondary market spreads. After falling sharply from early 1995 to mid-1997, spreads shot up in late 1997 in response to the turmoil in financial and currency markets.

• Prior to the crisis, 1997 was also marked by increased depth and sophistication of developing countries’ participation in international capital markets. Most notably, the currency diversification of bond issues increased, new instruments were introduced to attract institutional investors, corporate and subsovereign borrowers increased their participation in the market, the number of mutual funds dedicated to emerging markets and the use of depository receipts continued to grow, and the availability of financial and equity derivative products continued to expand. This deepening of markets has the potential to increase capital flows to developing countries while enhancing the ability to hedge against risks. But the greater availability of derivatives and other financial innovations can also pose risks in countries that lack robust financial systems and appropriate regulatory policies. Balancing the potential and risks through the proper pacing and sequencing of financial reforms and financial innovations will continue to be a significant challenge for policymakers in emerging market economies.

• Flows of foreign direct investment (FDI) continued to represent the largest source of finance to developing countries in 1997. Net FDI flows to developing countries reached an estimated $120 billion in 1997, five times their level in 1990, although not much higher than in 1996. Of this amount, privatization revenues accounted for $15 billion. FDI declined in East Asia, with levels in China and Indonesia falling from their highs of 1996. The drop in East Asia was offset by a rise in Latin America as a result of privatization transactions (notably in Brazil), improved economic performance, and continued progress on liberalization.

FDI in the service sectors of developing economies has increased rapidly in the 1990s, reflecting the growth of domestic markets, advances in communications technology, privatization of infrastructure services, and expanded provision of investment insurance. The fast growth in FDI in services, as important sectors of the economy (particularly infrastructure) have been opened up to market forces, has contributed to greater efficiency of production and freed scarce public resources for pressing social needs.

The medium-term prospects for FDI are favorable, based on projections of continuing strong economic growth in developing countries (at almost twice the rate in high-income economies), buoyant world trade, and further liberalization of investment rules. Macroeconomic policies that enhance stability and an enabling environment for private sector development should also contribute.

Developments in capital markets in 1997

The international economic environment

Developing countries faced a broadly favorable international environment in 1997, marked by continued growth in demand from industrial countries, low inflation, and low to moderate interest rates. Growth rates in industrial countries remained solid, as the GDP of the Group of 7 (G-7) countries1 increased by an estimated 2.7 percent in 1997, approximately equal to the annual average growth rate during 1980–96 (table 1.1). The economic expansion in the United States entered its eighth year, while economic activity in Europe began to rebound in the second half of the year, reflecting in part accommodating monetary policies and depreciation of European exchange rate mechanism (ERM) currencies against the U.S. dollar. Growth slowed sharply in Japan, however, largely in response to strong fiscal consolidation measures. The acceleration of industrial country GDP was accompanied by faster growth of world trade volumes, from 5.3 percent in 1996 to an estimated 7.8 percent in 1997, less than the extraordinary 10 percent advance in 1994 and 1995 but well above the average since 1980. Non-oil commodity prices increased by an estimated 4.2 percent in real terms.

International nominal interest rates remained well below historical averages, a result of fiscal consolidation in the United States, weak growth in Japan, subdued inflationary pressures in the major industrial countries, and the convergence toward tighter fiscal policies in Europe in line with the requirements for the single currency. Average inflation in the G-7 countries is estimated at only 1.8 percent in 1997.

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Table 1.1 The international economic environment, 1981–97
(annual percentage change; annual rates for LIBOR)

a. Preliminary.
Source: World Bank data and staff estimates.

Estimates of resource flows

Private flows continued to dominate developing countries’ long-term finance in 1997. Net long-term private flows rose from $247 billion in 1996 to an estimated $256 billion in 1997, reaching 85 percent of total net flows (table 1.2). The largest form of net private flows was foreign direct investment, estimated at $120 billion in 1997, followed by bonds ($54 billion), commercial bank lending ($41 billion), and portfolio equity ($32 billion).

Table 1.2 Net long-term resource flows to developing countries, 1990–97

a. Preliminary.
Source: World Bank Debtor Reporting System.

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Two aspects of these data on resource flows are worth emphasizing. First, the data include only long-term liability transactions—that is, gross disbursements minus repayments on loans. Asset transactions (such as changes in foreign bank deposits held by developing country residents) and short-term flows are not included. Their exclusion explains why estimates for net long-term resource flows to developing countries are so much greater than net financing as recorded in the balance of payments. As explained in box 1.1, this difference has increased as the more advanced developing economies have become more integrated with the rest of the world. The discrepancy was particularly large in 1997, as the financial turmoil in emerging markets no doubt resulted in significant capital outflows in the form of asset transactions and reductions in short-term debt stocks.

Second, the availability of reliable estimates for the most recent year (1997) varies considerably by type of flow. Data on gross commercial bank lending and on bond issues (taken from market sources) are fairly reliable, and repayments are calculated based on reports from debtor countries. Estimates of net FDI inflows also rely on country reports. Data on portfolio equity flows are the most difficult to estimate. Information on international equity issues is available from market sources, but data on direct investments by foreigners in developing country stock markets are collected only sporadically.

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Debt flows with an original maturity of one year or less (not included in table 1.2) also have played an important role in developing countries’ external finance over the past few years. Developing countries’ total short-term debt stocks rose from $286 billion at the end of 1994 to $361 billion in mid-1997 (the latest available data from the Bank for International Settlements at the time of writing; table 1.3). The $75 billion increase in short-term debt was equivalent to about 30 percent of total net long-term private debt flows during 1995–97 and to about 70 percent of net commercial bank lending. More than half of the rise was accounted for by East Asia and the Pacific. Contributing to the increase were rising world trade (developing countries’ imports rose from $1,221 billion in 1994 to $1,714 billion in 1997) and high interest rates in several countries (for example, Brazil, Indonesia, Malaysia, South Africa, Thailand) that created incentives for external borrowing. Even with the increase, however, short-term external debt amounts to only 17 percent of developing countries’ total stock of external debt.

Table 1.3 Developing countries’ short-term debt stocks, 1994–97 (billions of U.S. dollars)

Note: Excludes interest arrears on short-term debt. a. As of June 1997.
Source: World Bank and Bank for International Settlements.

Global and regional trends in long-term debt flows

Low to moderate international interest rates, which encouraged lenders and investors to turn to emerging markets, coupled with strong growth in major borrowers supported an increase in debt flows to developing countries through much of 1997 (figure 1.1). Net bond transactions and commercial bank lending reached $95 billion in 1997, a 19 percent rise from the $80 billion in 1996 (see table 1.2).

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However, annual estimates of net flows conceal extraordinary differences among regions and over the course of the year. These differences are revealed by data on debt commitments (commercial bank loans and bond issues), for which monthly data are available. Total debt commitments to developing countries reached $125 billion in the first half of 1997, or more than 70 percent of the record total for all of 1996. However, commitments to East Asia fell with the onset of the financial crisis in July and declined to most major borrowers in late October (table 1.4), when stock markets plunged in Hong Kong, China, touching off widespread drops in bond, stock, and currency markets.

Table 1.4 Bond issues and loan commitments to developing countries, 1996 and 1997
(billions of U.S. dollars and percentage change)

a. Countries immediately affected by the currency crisis (Indonesia, Malaysia, the Philippines, and Thailand).
Source: Euromoney Bondware and Loanware and World Bank staff estimates.

East Asia and the Pacific was the only region among emerging markets to experience a decline in gross flows during the year. Borrowing by Southeast Asia slowed in the first half of the year— partly reflecting the decline in flows to Thailand as the market grew increasingly concerned about economic performance—and then plummeted with the onset of the financial crisis. By the fourth quarter debt commitments to the ASEAN-4 countries (Indonesia, Malaysia, the Philippines, and Thailand) had dropped to $5 billion, 67 percent below the level of the year before. In China commitments totaled almost $15 billion in the first three quarters (nearly matching the $14 billion for all of 1996), although the pace fell off in the fourth quarter. Net disbursements of debt flows to East Asia and the Pacific for the year as a whole totaled $34 billion, up 22 percent from 1996 as amortization payments declined.

In Latin America and the Caribbean commitments rose to $87 billion in the first three quarters of 1997 (23 percent higher than for all of 1996), driven by liquid international markets and positive market sentiment as evidenced by credit upgrades in Argentina, Brazil, and Uruguay; improving terms (in Argentina, Brazil, and Mexico secondary market spreads on sovereign eurobonds fell by about 100 basis points from December 1996 to September 1997); and global bond issues by Argentina, Panama, and Venezuela to retire collateralized Brady bonds. (See appendix 3 for a more detailed discussion of Brady bonds and these transactions.) In the fourth quarter, however, bond issues and loan commitments shrank to an estimated $10 billion. Despite the strong rise in debt commitments for the year as a whole, net disbursements fell to $37 billion (from $44 billion in 1996), owing to the large increase in repayments, particularly the prepayment of Brady bonds.

Improved performance on economic stabilization and liberalization in the transition economies contributed to a surge in debt commitments to Europe and Central Asia through October 1997. Russian bond issues and loan commitments amounted to $13 billion in the first three quarters, almost three times the 1996 level. After October, spreads widened and debt commitments declined sharply as many large issues were postponed. The region’s near doubling of commitments in 1997 resulted in an increase in net disbursements on debt from $11 billion in 1996 to an estimated $17 billion in 1997.

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Portfolio equity flows

Prices in several developing country stock markets rose strongly during much of 1997, accompanied by large inflows of portfolio equity (in the form of both international issues and foreign direct investments in local stock markets). However, with the turbulence in the Hong Kong stock market in late October, stock prices fell in industrial countries and most emerging markets suffered sharp falls, wiping out a significant share of the gains achieved since the beginning of the year (table 1.5). While industrial country markets recovered quickly, several emerging markets continued to decline over the rest of the year. In addition, many currencies depreciated sharply, further eroding the profits of foreign investors. Data from U.S. mutual funds show that the price declines since late October have been accompanied by net outflows from some markets. Net portfolio equity flows are estimated at $32 billion for the year as a whole, down from the $46 billion in 1996.

Table 1.5 Changes in stock market and exchange rate indexes, 1997
(percentage change)

a. Percentage change in an exchange rate index defined as the local currency divided by the dollar, where a negative sign indicates an increase in the index.
Source: Bloomberg.

As with debt flows, the pattern of equity flows showed marked changes over time and regions. Price-earnings ratios in major Latin American markets (except Argentina) began the year at low levels relative to their own recent history and to ratios in East Asia. For example, the price-earnings ratio in Mexico was 13.5 in December 1996, down from 20.6 in December 1995 and well below Malaysia’s 29 and the Philippines’s 26. These relatively low price-earnings ratios may have encouraged the substantial portfolio equity flows and the boom in Latin American stock markets for much of 1997 (the IFC’s index of Latin American stock markets rose 44 percent in the 12 months through September 1997). The major Latin American markets experienced sizable declines in late October, with many of them, particularly in Brazil and Mexico, recovering toward the end of the year, unlike East Asian markets. Most Latin American markets recorded price increases for the year as a whole, and portfolio equity flows are estimated at $16 billion for 1997, up 11 percent from 1996.

Stock markets in Eastern Europe showed a similar pattern, with low price-earnings ratios at the end of 1996 (4.2 for the Russian market in December 1996), substantial increases in stock market indexes and portfolio equity flows for the first three quarters (the Russian market index increased 150 percent from January to mid-October), and some decline since late October. The estimated $9 billion in portfolio equity flows in 1997 was about the same as in 1996.

Markets in East Asia followed a different pattern. Price-earnings ratios started the year relatively high, with China’s at 37.3 in December 1996 and Indonesia’s at 19.6. Stock market indexes fell steadily in Southeast Asia, following the decline that had begun in Thailand’s market in early 1996. The Malaysian and Philippine markets began dropping in early 1997 and by December were 45 percent and 34 percent below their levels on July 1. Indonesia’s market started to fall in July and by December had plummeted 45 percent (with a net outflow from the domestic stock market of $300 million in July and August alone). The market suffered further sharp declines in the first half of January 1998. Only China’s market escaped relatively unscathed in 1997. For the region as a whole domestic stock markets are estimated to have registered a $7 billion outflow in 1997 following a $10 billion inflow in 1996. However, international equity issues rose from $5 billion in 1996 to $9 billion in 1997, lifted by the $5.5 billion increase in issues from China. Total net portfolio equity flows for the region are estimated to have fallen from $14 billion in 1996 to $2 billion in 1997.

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