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Private investment needs in developing countries.

The breathtaking pace of recent global events -- German reunification, the liberation of Eastern Europe, the Gulf War -- continues to unfold. Although these events have significantly reduced political tensions between the major powers, they have also raised new questions and new uncertainties. What steps need to be taken to link the nations of Eastern Europe effectively into the international economy? Can the successful conclusion of the Gulf War be used as a vehicle to bring a more permanent settlement and renewed economic growth to the Middle East? How can stability and a modicum of economic well-being in the Soviet republics be assured? How will these events affect other continuing problems in the world economy as, for example, the developing needs of poorer nations?

One common element in all of these questions, however, is that solutions demand financial resources. The magnitude of need for these resources over the next decade will be unprecedented and will inevitably add stress to international financial market operations. The case of Germany even now provides a ready example. Financial demands of reunification pushed up German longterm interest rates by almost two points between September 1989, and March 1990, and rates have fluctuated at high real levels since that time. Add to German reunification the continuing needs of various Eastern European countries, the financial costs of reconstruction in Kuwait (and, later, Iraq) and the enormous, but as yet indeterminate capital requirements of what was once the Soviet Union, and the stage appears set for global capital shortages and high interest rates for years to come.

Capital shortages, however, should not be equated with a cessation of financial flows; international transfers will continue and, in all probability, expand. The real question is how world savings, which have been declining during the 1970s and most of the 1980s, are to be allocated among the rapidly growing investment demands partially enumerated above and the domestic demands of the industrial countries, where most savings arise. In a world of higher interest rates and scarce funds, it is difficult to say which investment ultimately will be financed and which will be deferred. More particularly, will the postwar international effort to raise living standards in Third World countries, an effort without precedent in history, be blunted by the need to satisfy competing capital demands from other parts of the world, particularly from Eastern Europe and the former Soviet Union? And, more specifically, will diminished growth prospects in developing nations serve to dampen business interest in such areas?

To address these questions, some background on the source of developmental funding is useful. In the last 15 years, the major providers of finance for developing countries have been official governmental agencies and such multilateral institutions as the World Bank and the International Monetary Fund (see Figure). Since the early part of the 1980s, financial flows from official sources have accounted for about two-thirds of the total. Private financial flows, which had made up nearly half of the total in the years prior to this decade, have more recently remained quite constant as a proportion of the total. Within the private category, however, substantial changes have taken place. Bank lending rose sharply in the 1970s, but it has fallen recently as servicing transfers and repayments have faltered. Much of this lending went to governments, not to private companies, within the developing countries. Foreign direct investment (FDI), the other major part of private capital flows, has increase as bank lending has fallen, but thus far not sufficiently to bring private financing back to the levels prior to the debt crisis of the early 1980s.

Insofar as developing countries concerned, the critical financing question concerns the likely amount and sources of future capital flows from the industrial nations. Since there appears to be little likelihood of a resurgence of commercial bank lending soon, the financing requirements of developing countries, if they are to be met, clearly will involve the other two major potential sources of capital: official agencies and FDI.

Concerning the first of these, continued fiscal conservatism in the major industrial countries is likely to curb any substantial growth of official assistance; in fact, with one or two exceptions, governmental dissaving already is exacerbating the global problem of capital shortages. Given the continuing demands in these countries for infrastructural improvements, environmental investments, improved educational facilities, etc., fiscal budgets are likely to remain tight. In addition, the external financing made possible in the past by German and Japanese balance of payments surpluses will decline, as Germany concentrates on problems in its east and Japan responds to pressures from importers to reduce trade imbalances while investing in its own infrastructure.

Future growth in financial flows to the Third World will, therefore, have to come from private sources. Unfortunately, as the figures indicate, investment other than bank lending and FDI has never been a significant source of funds for developing countries. These countries rarely have had access to international financial markets in issuing securities, and their own capital markets have not been a significant investment vehicle for industrial country investors. Although this situation is changing, as local capital markets continue to be developed, the fact remains that most private investment in developing countries by outsiders has been made by companies establishing or expanding businesses in the same location. Loans and equity investments by direct investors have more than tripled since their low point in 1965, rising from 10 percent of gross domestic product to 12 percent. This trend will need to continue and even accelerate if financial flows to developing countries are to be increased or, indeed, maintained in the near-term future.

Fortunately, there are some encouraging signs that the climate for private risk capital in developing countries is improving, and recent increases in direct investment might be considered a response. More and more governments are removing impediments to investment, many privatizing state-controlled enterprises in the process. At the same time, such increased international competition has been forcing company managements in industrial countries to monitor costs carefully.

For a continued expansion of private investment to occur, however, two problems need to be overcome. First, direct investment in developing regions by industrial country firms will have to be expanded to include more companies than are currently involved in this activity. The fact is that foreign direct investment involves additional risks for companies, particularly in a developing country environment. As a consequence, most FDI has been done by large multinational companies, where managements have vast experience in assessing risk and dealing with it. Many smaller companies, however, lack this experience and are reluctant to venture unaided into what their managements perceive to be the highly uncertain circumstances of operating abroad, again


particularly in developing countries. This appears to be true even in situations where managements see potential cost or strategic advantages in locating facilities in these countries. The point is this: In order to encourage such companies to invest in developing areas, some way needs to be created to reduce investment uncertainties. Among the companies needing such assistance are those from newly industrializing countries, where interest in establishing operations in second-tier developing countries -- Indonesia, Thailand, etc. -- has been increasing.

The second problem that needs to be solved concerns companies already domiciled in developing countries. Frequently, these companies have growth opportunities they cannot address, because sources of financing in these countries are difficult to find. Where it is available, it is often shortterm financing or, at best, longer-term loans. Local equity financing, aside from that coming from retained earnings, is scarce. Potential investors from abroad typically view developing country equity as too risky, incorporating unknown business uncertainties with risks of erratic foreign exchange rate movements. A critical need for developing countries, therefore, is to develop their own capital markets and to find ways to attract equity investors from both the local economy and abroad.

Both of these requirements for increased flows of private investment of developing countries have to do with enticing more risk capital to what are seen by investors to be demonstrably risky business environments. This task has been the explicit role of the International Finance Corp. (IFC), and affiliate of the World Bank, since its founding 35 years ago, and its efforts to improve the functioning of private sectors in developing countries has recently been supplemented by initiatives of such regional institutions as the European Bank for Reconstruction and Development (EBRD). As a general proposition, each of these institutions seeks to improve the overall climate for investment in developing countries and to find mechanisms that assist companies in dealing with risk. And yet, business executives frequently are unaware of how the institutions function and, particularly, how they can contribute to lowering uncertainty in specific investment situations in developing countries.

IFC's activities are illustrative. What distinguishes IFC from traditional international institutions, such as the World Bank, is the requirement that its loans and equity investments must be carried out with no governmental guarantees. Thus, IFC's own participation in developing country projects is as risk-bearing as any of its business partners. It raises most of its own funds through borrowing in the international financial market and, like any private financial institution, it must charge market rates in its lending activities and earn profitable returns.

In IFC's efforts to increase the flow of private funds to developing country investments, it directly attacks the two basic problems noted above. For example, it actively seeks to identify and technically evaluate potential investment projects in developing countries throughout the world. These projects can come from a variety of sources -- multinational companies, smaller firms from industrial nations, local companies -- and invlove a variety of industries, including manufacturing, agribusiness and mining, among others. Because of its long experience in supporting private enterprise in developing countries and its willingness to share project risks as a lender or quity investor, IFC serves to reduce the perception of excessive risk that may have inhibited other investors, both local and international. Therefore, it plays an important catalytic role in mobilizing other private funding, either through co-financing, syndications or underwritings, always taking minority positions in the enterprises supported.

IFC has been increasingly active in fostering local capital market growth in developing countries as well. These efforts have a two-fold purpose. First, local financial markets are broadened as new financial services are introduced or services are extended to a new market. IFC has introduced mutual funds, housing finance companies, leasing firms and variety of financial services agencies. Second, IFC works to improve the quality of financial sector performance in developing countries, often advising governments on how to alter policies that serve to distort financial market operation and on methods that can be employed to privatize state-owned companies.

A side benefit occurs when new developing country securities become available to industrial country investors, allowing them to diversify their holdings in new and profitable ways.

Assisted by IFC and other institutions, developing country governments throughout the world are taking steps to improve the climate for business investment. Although adjustments have been difficult for some countries, there are increasing signs that the new policies are beginning to show success -- Mexico, Chile, Indonesia and Thailand are examples. In each of these countries, private investment, including both domestic and FDI, has increased markedly in recent years.

Although the demands of Eastern Europe and elsewhere will surely raise capital costs, developing countries will still be able to attract private investment funding, if governmental policies are correct. Solid investment opportunities occur when a business environment of distortion-free growth is apparent, and developing regions should be able to hold their own.

Sir William Ryrie is executive vice president of International Finance Corp., Washington, D.C.
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Author:Ryrie, William
Publication:Industrial Management
Date:Mar 1, 1992
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