LMOST TWO YEARS AFTER PROB-lemsin the U.S. mortgage market set inmotion the biggest financial crisis since theGreat Depression, global financial markets remainunsettled, and prospects for capital flows to thedeveloping world are dim. The intensification of the financial crisis in September 2008 dramaticallyaltered the world economic outlook. Global out-put is now expected to shrink by 2.9 percentin2009, the first contraction since World War II.International trade is likely to experience thesharpest drop since that time. Unemployment, al-ready soaring in industrial countries, will follow asimilar path in the export-dependent economies of East Asia, as high-income countries reel from anunprecedented asset-market bust, and global in-vestors retreat from emerging markets.The implications of these unfolding events forinvestment flows to developing countries havealready been dramatic: total private capital flows in2008 dropped to $707 billion (4.4 percent oftotaldeveloping-country GDP), reversing the strong up-ward surge that began in 2003 and reached a pinna-cle of $1.2 trillion in 2007 (8.6 percent of GDP). For2009 the most likely scenario is that as global equitymarkets regain momentum and credit markets heal,net private flows to developing countries will remainpositive—barely. But they will drop to $363 billion,approximately the level of 2004 and a decline of 5percentage points of GDP from 2007. The magni-tude of the decline is troubling for its macroeco-nomic consequences and for vulnerability to furthershocks, particularly in countries in which banks andfirms have high levels of external debt. Much of the$1.2 trillion external debt raised by emerging marketbanks and firms between 2003 and 2007 is now ma-turing, putting pressure on the borrowers’ financesat the time when the average cost of external bor-rowing has increased to 11.7 percent, comparedwith 6.4 percent in the pre-crisis years when the debtwas contracted.Although extraordinary policy responses bygovernments around the world have helped savethe global financial system from systemic collapse,they have not, thus far, closed the negative feed-back loop between financial instability and eco-nomic recession. Fragile consumer confidence anda much-diminished appetite for risk among in-vestors in developed countries have all contributedto a plunge in global aggregate demand. Simulta-neously, the deepening economic downturn hascaused major global banks to scale back domesticand international lending, thereby exacerbatingthe credit crunch. Actual bank lending in theUnited States and Europe, as well as surveys of bank intentions and credit terms, point to a slow-ing in the supply of bank credit to the corporateand household sectors. In recent months, thatslowdown has become a decline. Likewise, foreignclaims on developing-country residents held bymajor international banks reporting to the Bankfor International Settlements declined by $200 bil-lion between December 2007 and December 2008(from $4.3 to $4.1 trillion).To break the cycle and revive lending andgrowth, bold policy measures, along with substan-tial international coordination, are needed. In thisregard, the joint announcement by the Group of 20(G-20) leaders at their London summit in April2009 was encouraging. The leaders vowed tostrengthen the capacity of multilateral financialinstitutions to lend to emerging economies facingtraditional balance-of-payments shortfalls or ele-vated risks from debt rollover and refinancing.

Overview

GLOBAL DEVELOPMENT FINANCE 2009

Addressing the various regulatory failures,bank governance shortcomings, and macroeco-nomic imbalances that contributed to the crisis hasbeen another focus of the international policy re-sponse. Bad lending and poor investment decisionsstemmed from lax regulation as well as from over-confidence and euphoria associated with low realinterest rates and ample liquidity. Therefore, newmeasures that embrace all systemically importantfinancial institutions (including hedge funds), thatstrengthen international accounting standards toimprove transparency and asset valuation, andthat bolster the Financial Stability Board are desir-able and timely, even if their immediate successcannot be guaranteed.Inchartingthecourseahead,policymakersindevelopedanddevelopingcountriesshouldgivepri-oritytofourtasks:followingupontheG-20’spromisetorestoredomesticlendingandtheinterna-tionalflowofcapital,addressingtheexternalfinanc-ingneedsofemerging-marketsovereignandcorpo-rateborrowers,reaffirmingpreexistingcommitmentstotheaidagendaandtheMillenniumDevelopmentGoals (MDGs),and,eventually,unwindinggovern-ments’highownershipstakeinthebankingsystemandreestablishingfiscalsustainability.Rapid progress on these fronts will make iteasier for low-income countries to cope with thecrisis. Already under severe strain, low-incomecountries face increasingly grave economicprospects if the dramatic deterioration in theircapital inflows from exports, remittances, and for-eign direct investment (FDI) is not reversed in2010. As it stands, the amount of development as-sistance available to low-income countries will notfully cover their external financing needs in 2009,while the outlook for donor countries to increaseaid significantly is bleak, given the intense fiscalpressures they face because of the crisis.

The global recession has deepened

he tight links between global trade in durable,capital, and high-tech goods, and the closely en-twined investment spending that supports economicactivity in both high-income and developing coun-tries, can be detected in the vicious circle that nowoperates between the financial and real sectors of theglobal economy. The difficulty of obtaining capital,togetherwithuncertaintyaboutfuturedemand,hasdelayedinvestmentsandcausedacollapseindemandfordurablegoods,resultinginasharpcontractionintheproductionofandglobaltradeinmanufacturedgoods.Worldindustrialproductiondeclinedbyanunprecedented5percentinthefourthquarterof 2008(or21percentatanannualizedrate).Outputcontinuedtodeclineinthefirstquarterof2009,reducingthelevelofindustrialproductioninhigh-incomecountriesby17.3percentinMarch2009,relativetoitslevelayearbefore,andindevelopingcountriesby2.3percentrelativetoMarch2008.Thecollapseinindustrialproductionistrulyglobal,withmajorproducersofadvancedcapitalgoodsparticularlyhard-hit—Japan(34percent,year-on-year)asofMarch2009,Germany(22percent),andtheRepublicofKorea(12percent).GDP growth in developing countries is pro-jected to slow sharply but remain positive in 2009,moving from 5.9 percent in 2008 to 1.2 percent.Nevertheless, developing countries as a whole willoutperform by a sizeable margin high-incomecountries, whose aggregate GDP is projected tofall 4.5 percent in 2009. Two developing regions,Europe and Central Asia and Latin America andthe Caribbean, are likely to end 2009 with nega-tive growth. Moreover, when China and India areexcluded, GDP in the remaining developing coun-tries is projected to fall 1.6 percent or 0.6 percentin per capita terms, a real setback for poverty re-duction. The simultaneous collapse in growthacross high-income and developing countries can-not be explained solely by trade links, for the do-mestic economies of a large number of developingcountries have been directly affected by the finan-cial crisis. The reversal of capital flows, the col-lapse in stock markets, and the general deteriora-tion in financing conditions have broughtinvestment growth in the developing countries to ahalt. In many developing countries, investment isfalling sharply.For developing countries that are significantcommodity importers, one of the few silver liningsof the financial crisis is that commodity prices aredown some 35 percent from their record levels of mid-2008, limiting current-account deficits andhelping to quell the inflation produced by highfood and fuel prices during the years leading up tothe financial crisis. Lower commodity prices havealso had the salutary effect of mitigating the impact

OVERVIEW

of the current crisis on the poor. Commodity mar-kets seem to have found a bottom, one that is stillnearly 60 percent above the price levels of the late1990s. In several markets, commodity productionis being reduced because the marginal costs of exploiting the least resource-rich or most difficult-to-reach sites now exceed current prices.While the global economy is projected tobegin expanding once again in the second half of 2009, the recovery is expected to be much moresubdued than might normally be the case. GlobalGDP is forecast to increase a modest 2.0 percent in2010 and 3.2 percent by 2011, as banking sectorconsolidation, negative wealth effects, and riskaversion continue to weigh on demand throughoutthe forecast period. Among developing countries,expected growth rates should be higher (givenstronger underlying productivity and populationgrowth) but remain similarly subdued at 4.4 per-cent and 5.7 percent, respectively, in 2010 and2011. Given the output losses already absorbedand because GDP only reaches its potentialgrowth rate by 2011, the output gap (the differ-ence between actual GDP and its potential) andunemployment are expected to remain high andrecession-like conditions will continue to prevail.

Private capital flows are shrinkingatan unprecedented rate

hile the global economic cycle has alwayscolored the emerging-market asset class, thecurrent downturn has been especially noteworthy inits impact on asset valuation in equity markets andliquidity conditions in primary bond markets. Rela-tive to their peers in mature markets, corporate andsovereign bond issuers in emerging markets havebeen particularly affected by liquidity concerns andrisk aversion among investors. There was virtuallyno issuance between mid-September and mid-December 2008, in the wake of the collapse of Lehman Brothers. Local stock markets, meanwhile,experiencedtheworstyearlydeclineinrecenthistory,astheMSCIEmergingMarketIndexsank55per-centduringtheyear,erasingsome$17trillioninmarketvaluation.Investors’flightfromperceiveddangercontributedtothesharpdropincapitalflowstothedevelopingcountries,atrendthatisverylikelytopersistthroughtheendof2009.Although interest-rate spreads in developingcountries have not widened by as much as inpast crises, the decline in private capital flows todeveloping countries is expected to set a record.Net private debt and equity flows are projectedto decline from a record high of 8.6 percent of GDP in 2007 to just over 2 percent in 2009, ex-ceeding the peak-to-trough drop during theLatin American debt crisis in the early 1980s(3.3 percentage points) and the combined EastAsian and Russian crises of the late 1990s (2.4 per-centage points). Unlike in these past crises,however, the decline in inflows has hit everydeveloping region. The most affected region isemerging Europe and Central Asia, which alsoexperienced the largest expansion of inflowsbetween 2002 and 2007. Net private inflows tothe region were an estimated 6.4 percent of GDPin 2008, down from 15.1 percent in 2007.Unlike portfolio equity and bond investments,FDI decisions are made with long-term horizons inview. They express the intention to build productivemanufacturing facilities, exploit natural resources,or diversify export bases. Thus, FDI flows are lesslikely to be liquidated or reversed in times of crisis.Driven by the strong momentum of the first half of the year, FDI inflows to developing countries posteda slight increase in 2008, reaching $583 billion,equivalent to 3.5 percent of the aggregate GDP of developing countries. Almost all the increase oc-curred in middle-income countries, notably theRussian Federation, India, Brazil, and China. Incontrast, FDI inflows to high-income countries fellsharply—from $1.3 trillion in 2007 to $827 billionin 2008. Most of the decline was concentrated inEurope; flows to the United States were up slightlycompared with previous years.

Financing conditions havedeteriorated rapidly

eveloping countries will most likely face adismal external financing climate in 2009.With private capital flows expected to post adramatic decline, many countries will have diffi-culty meeting their external financing needs, esti-mated at $1 trillion, $600 billion higher than in2003 at constant 2009 prices. Private debt andequity flows will likely fall short of meeting