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International financial system and development


International financial system and development

International financial system and development
Photo credit: Anne Wangalachi | CIMMYT

The present report summarises information on trends in international public and private capital flows to developing countries, options to address financial stress in developing countries, and on-going efforts to strengthen the international financial system for the implementation of the 2030 Agenda for Sustainable Development.

It highlights progress on commitments and actions in the Addis Ababa Action Agenda of the Third International Conference on Financing for Development related to development finance institutions, financial regulation, the global financial safety net, policy coordination and economic governance reform.


The General Assembly, in its resolution 71/215, requested the Secretary-General to submit to the General Assembly at its seventy-second session a report on implementation of the present resolution and to consider including in the report “an analysis of options for an enhanced approach to financial stress in developing countries.” The resolution recognized the need to continue to enhance the coherence and consistency of the international monetary, financial and trading systems, and to ensure their openness, fairness and inclusiveness. It also encouraged international financial institutions to align their programmes and policies with the 2030 Agenda for Sustainable Development.

The mid-year update of the World Economic Situation and Prospects 2017 forecasts that world gross product will expand by just 2.7 per cent in 2017. While this marks an acceleration compared to 2016, growth in many regions remains below the levels needed for achieving the Sustainable Development Goals (SDGs), and a high degree of uncertainty in the international policy environment continues to cloud the outlook.

The Addis Ababa Action Agenda recognises that the international financial system is critical to enabling sustainable and inclusive growth and development aligned with the SDGs. The financing needs for SDG implementation indicate that the international financial system has not adequately allocated resources towards long-term sustainable development, with insufficient investment in critical areas. In addition, systemic risks threaten financial stability, including in developing countries.

To achieve the SDGs, the global financial system will need to allocate long-term public and private resources toward sustainable development in an effective and stable manner. Ultimately, stability and sustainability are mutually reinforcing. Without a stable financial system, achievement of the SDGs will be derailed by future financial crises; and without sustainable investment, we will sow the seeds for future environmental catastrophes and economic crises.

Trends in international financial flows to developing countries

Theoretically, finance should flow to countries and sectors where capital is scarce and returns are high, thus providing the resources necessary for development. However, capital has not always flowed to areas where needs are greatest, while volatile boom-bust patterns have led to instability in the real economy and made macroeconomic policy management more challenging.

In 2016, net international financial flows to developing countries were negative for the third year in a row. Net capital outflows from developing and transition countries were recorded at $498 billion. Net outflows are expected to continue in 2017 ($267 billion) and 2018 ($79 billion), though at a slower pace reflecting the somewhat improved economic situation. These trends are primarily driven by flows to and from China, which moved from a position of large net outflows in 2015 and 2016 to net inflows of $36.8 billion in the first quarter of 2017, in part reflecting policy changes enacted to stabilise flows.

Capital flows have three main components: foreign direct investment (FDI), portfolio flows, and other investment. FDI remains the most stable component, and, as noted in the Addis Agenda, can make an important contribution to sustainable development, particularly when projects are aligned with national and regional sustainable development strategies. Global FDI remained steady in 2016, at an estimated $1.75 trillion, with projections for 2017 of continued high levels. However, these levels were driven by inflows to developed economies. FDI to developing economies shrunk by 14.1 per cent in 2016 to $646 billion, primarily due to falls in FDI to East Asia and South-East Asia. FDI to the least developed countries (LDCs) declined by 13 per cent to $38 billion, reflecting weak interest in primary sectors given persistently low commodity prices.4 In net terms, the IMF data projects FDI inflows in all developing regions in 2017 except for South and East Asia.

The largest capital outflows from developing countries have been in the ‘other investment’ category, which is primarily composed of cross-border bank loans.

Other investment recorded outflows of $395 billion in 2016 with an expected decline to $283 billion in 2017, with South and East Asia and Latin America and the Caribbean experiencing large outflows. Following broader trends, other investment is expected to remain negative in 2017, though at a lower level than in 2016. Data from the Bank for International Settlements specifically on cross-border bank exposures to emerging markets, show quarterly declines throughout 2016 and a $151 billion increase in the first quarter of 2017.

Net portfolio flows to developing countries also remained negative in 2016, at $165 billion in outflows, and are expected to remain so in 2017 ($143 billion) and 2018 ($157 billion). Portfolio investment exhibits strong regional differences, with East, South and West Asia witnessing large net outflows, and Latin America and the Caribbean and Sub-Saharan Africa experiencing net inflows.

The boom bust cycle of inflows and outflows is indicative of the high volatility associated with these flows. Analysis of high frequency data on capital flows in select developing countries over the past 12 years has shown that international capital inflows, particularly portfolio flows and cross-border bank loans, remain subject to periodic episodes of high volatility, often triggered by global systemic risks.

While large global banks are the main providers of other investment (i.e. cross-border bank loans), institutional investors are generally the main drivers behind portfolio flows.

There is increasing interest in the role that these investors, particularly those with long-term liabilities such as pension funds, life insurance companies and sovereign wealth funds, can play in financing long-term sustainable development. These three types of investors were estimated to have assets under management of approximately $79 trillion at end-2014.

Nonetheless, the high volatility of portfolio flows in many ways reflects a short-term bias of institutional investors. This bias is also reflected in asset allocation. Most funds, even funds with long-duration liabilities, are generally invested in short-term and/or liquid assets. For example, in 2016, pension funds in the seven largest pension markets invested 76 per cent of their assets in liquid assets, overwhelmingly in developed countries, rather than long-term illiquid assets such as infrastructure.

Reallocation of even a small portion of these resources to long-term investments to achieve the SDGs, particularly in developing countries, will remain a challenge, without stronger measures to change incentives.


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