Hat-trick of highs in private capital flows

NEW DELHI: Flows of private capital to developing countries touched a record $491 billion in 2005, soaring for the third consecutive year, even as official flows of grants and loans fell for the fourth consecutive year.

Calling 2005 a landmark year in development finance, the World Bank’s World Development Finance 2006 report notes that the increase in private capital flows were broad-based across debt and equity instruments. 

Long-term bonds, bank lending and portfolio equity showed particularly robust growth. At the same time, the report warned that developing countries must learn to manage capital flows effectively if macro economic stability is to be maintained.

Sudden changes in exchange rates and global interest rates could cause volatility in these flows, the report notes.

It particularly points to the surge in portfolio inflows associated with a dramatic increase in stock market prices, especially in Asia.

This could raise the risk of asset price bubbles, it cautioned. The report suggests that international efforts are needed to maintain a financial environment conducive to a balanced expansion and deployment of capital flows.

Interestingly, capital flows - especially FDI - between developing countries are growing more rapidly than flows from developed to developing countries.

Along with that, official flows of grants and loans fell for the fourth consecutive year.

What’s driving this surge in private capital flows?

Robust global economic growth, for one, especially in developing countries who’ve been growing faster than developed countries.

The other driver is financial innovations, especially local-currency financing, and structured financial instruments like credit default swaps.

This has helped investors manage their exposure to risks associated with emerging market assets, the report notes.

The report identifies the policy agenda for managing the volatility of capital flows.

The gradual opening of capital accounts, it says, must be accompanied by a further strengthening of macroeconomic policies, the development of local capital markets and regulatory institutions and risk management systems. It, however, rejects the idea of a return to capital controls.

Noting the huge accumulation of foreign exchange reserves - far in excess of liquidity and intervention requirements - the report suggests that countries would be well placed to allow local institutional investors to diversify their investment portfolio globally.

This, it says, could transfer currency risks from central banks to investors with a longer investment horizon. Besides, retail investors, it suggests, could also be allowed to invest in approved international assets.

It also recommends that developing countries strengthen corporate governance norms, as this will boost investor confidence and help the stability of capital markets.