Capital flowing ´uphill´ from poor to rich countries, challengings mainstream economic thinking, Report says

Many countries in South have become net capital exporters to North, but need remains for increased official aid, contends Trade and Development Report 2008

Geneva, 4 September 2008 - The capital-poor developing world is lately exporting more capital to developed countries than it receives, a "puzzle" that defies mainstream economic theory but, when analyzed, suggests a new and powerful approach for financing development, UNCTAD´s Trade and Development Report 2008(1) reveals. The puzzle is all the more intriguing because many of these capital-exporting countries have been achieving higher rates of investment and growth than those that rely on the standard economic model of net capital imports, the report says.

The report, known as the TDR, questions the traditional theoretical framework and suggests a new approach to the financing of development, focusing less on capital imports and on increasing household savings and more on the financing of investment from enterprise profits and from domestic bank credit. Using this approach, it says, developing countries in many cases can avoid dependence on foreign capital inflows by applying appropriate macroeconomic and exchange-rate policies. A strong increase in official development assistance (ODA) is nevertheless required to help poor, commodity-dependent countries meet the Millennium Development Goals set by the United Nations, the report notes.

Since 2002, many developing countries have seen strong improvements in their current- account balances. This is a result not only of the commodities boom, but of favourable real exchange rates and of rapid productivity growth that have boosted exports of manufactures from some countries.

Out of 113 developing countries and transition economies, 42 were net exporters of capital in 2002-2006. And 60 saw improvements in their current account balances in this period compared with 1992-1996. "Improvements in the current accounts, and swings from deficit to surplus, were initially driven by large exchange rate devaluations in emerging-market economies that are exporters of manufactures," the TDR says. "In most of these countries, their current-account improvements began in the aftermath of the Asian financial crisis and were sustained as governments and central banks subsequently sought to maintain a competitive real exchange rate." As this strategy often requires intervention in foreign-exchange markets, it contributes to a rapid accumulation of foreign-exchange reserves. For most countries whose trade performance is determined primarily by world demand for primary commodities, improvements in current accounts began in 2003, when the prices began to increase for oil and mining products.

"The macroeconomic and exchange-rate policies that have played a major role in the improvement of the current-account position of many developing countries mark a departure from past strategies", UNCTAD Secretary-General Supachai Panitchpakdi writes in the TDR´s overview. The report shows that overvaluation of exchange rates has been the most frequent and the most "reliable" predictor of financial crises in developing countries over the past 15 years, while depreciation of real exchange rates frequently has paved the way for current-account improvements and faster growth. However, to prevent governments from using exchange-rate manipulation to artificially improve the international competitiveness of domestic producers, UNCTAD continues to recommend the creation of a framework of international rules for exchange rate and financial policies similar to those governing trade through the World Trade Organization (WTO).

The fact that developing countries as a group are net capital exporters contrasts with mainstream economic expectations that -- with open capital markets -- capital will flow from rich to poor countries, attracted by higher rates of return. Increasing amounts of capital flowing "uphill" from poor to rich countries appears initially as a surprise. Even more surprising is the fact that, on average, productive investment and growth are higher in developing countries that are net exporters of capital than in those that receive net capital inflows. Thus, higher rates of investment for diversification and structural change do not always require current-account deficits or -- the same thing -- net capital inflows, as suggested by standard economic models. Indeed, many developing countries, particularly in Latin America, failed to achieve higher productive investment under the mainstream approach because the monetary and financial policies that attracted waves of capital inflows also led to high domestic financing costs and to currency appreciation. The TDR suggests that, instead, monetary policies and local financial systems must offer favourable environments for reliable and affordable domestic financing of private firms.

The approach of the TDR 2008 features another and even more fundamental departure from mainstream theory: An increase in household savings, which is difficult or even impossible because of low per capita incomes in developing countries, is not necessary to raise investment. UNCTAD proposes an alternative view on the savings-investment relationship where the financing of investment depends primarily on savings from corporate profits and on the potential of the banking system to create credit. In this view, the prerequisites for higher investment are no longer households "putting more money aside" or the availability of "foreign savings," but improved conditions for reinvestment of company profits and for an enhanced role for credit created by the banking sector as it seeks to provide long-term investment financing.

The report also notes that although more and more developing countries have significantly reduced dependence on foreign capital flows and have even become net exporters of capital, most poor, commodity-dependent nations with insufficiently diversified production structures continue to rely on foreign capital inflows to finance imports of essential capital goods. The TDR notes that for a realistic chance of meeting the Millennium Development Goals, which include halving extreme poverty by 2015, ODA would need to be increased by US $50-$60 billion a year above current levels.