In the wake of financial turmoil in high income countries and amidst high food and energy prices, developing countries' growth is easing but is still robust. Private capital flows to emerging markets, which hit a record US$1 trillion in 2007, are expected to drop to around US$800 billion by 2009, which would still be the second highest level ever, says a new World Bank report.

Global Development Finance 2008 predicts a slowdown in world GDP growth from 3.7 percent in 2007 to 2.7 percent in 2008, while growth in developing countries is expected to slow from an extraordinary 7.8 percent in 2007 to 6.5 percent in 2008.

"Strong growth in the developing world is certainly helping to offset the sharp slowdown in the US," said Uri Dadush, Director of the World Bank's Development Prospects Group and International Trade Department. "But at the same time, rising global inflationary pressures - especially high food and energy prices - are hurting large segments of the poor around the world."

Developing country growth in recent years has been powered in part by expanding capital flows, including by foreign banks that have expanded their presence in developing countries through acquisitions and the establishment of local affiliates. As of end-June 2007, foreign claims on developing-country residents held by major international banks stood at US$3.1 trillion, up from US$1.1 trillion at the end of 2002.

"The presence of foreign banks in developing countries expands access to credit and as well as financial services, which can spur efficiency and innovation in domestic banks," said Mansoor Dailami, Manager of International Finance in the Development Prospects Group, and lead GDF author. "However, the ripple effect of shocks from the US and European markets to certain developing-country financial markets highlights the need for better and more coordinated financial regulation, liquidity provision, and macroeconomic management."

The report warns that countries with heavy external financing needs are potentially most vulnerable to a credit crunch, particularly in cases where private debt inflows into the banking sector have contributed to a rapid expansion of domestic credit, which stokes inflationary pressures. In 2007 and 2008, several countries in Europe and Central Asia, and a selected few in Latin America and the Caribbean and Sub Saharan Africa were most at risk.

While some low-income countries have recently accessed the international bond market, the bulk of private capital flows to developing countries go to just a few big economies, among them the so-called BRICs - Brazil, Russia, India and China. The poorest nations, meanwhile, remain reliant upon official aid, which further declined in 2007. Net official development assistance by members of the OECD's Development Assistance Committee totaled US$103.7 billion in 2007, down from a peak of US$107.1 billion in 2005, the report says.

Detailed findings

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

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

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

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

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

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

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

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

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

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

(China Development Gateway June 11, 2008)