OVERVIEW

U n i t e d n at i o n s C o n f e r e n C e o n t r a d e a n d d e v e l o p m e n t

TRADE AND DEVELOPMENT REPORT, 2013

EMBARGOThe contents of this Report must not be

quoted or summarized in the print, broadcast or electronic media before

12 September 2013, 17:00 hours GMT

UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT

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TRADE AND DEVELOPMENTREPORT, 2013

OVERVIEW

UNITED NATIONSNew York and Geneva, 2013

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• TheOverviewcontainedherein is also issued aspartof theTrade and Development Report, 2013(UNCTAD/TDR/2013,salesnumberE.13.II.D.3).

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UNCTAD/TDR/2013 (Overview)

OVERVIEW

Five years after the onset of the global financial crisis the world economy remains in a state of disarray. Strong expansionary monetary policies in the major developed economies have not succeeded in fostering credit creation and strengthening aggregate demand. Fiscal austerity and wage compression in many developed countries are further darkening the outlook, not only for the short term, but also for the medium term. The burden of adjustment of the global imbalances that contributed to the outbreak of the financial crisis remains with the deficit countries, thus strengthening deflationary forces in the world economy.

The dominance of finance over real economic activities persists, and may even have increased further. Yet financial reforms at the national level have been timid at best, advancing very slowly, if at all. In 2008 and 2009, policymakers of several economically powerful countries had called for urgent reforms of the international monetary and financial system. However, since then, the momentum in pushing for reform has all but disappeared from the international agenda. Consequently, the outlook for the world economy and for the global environment for development continues to be highly uncertain.

Some developing and transition economies have been able to mitigate the impact of the financial and economic crises in the developed countries by means of expansionary macroeconomic policies. But with the effects of such a response petering out and the external economic environment showing few signs of improvement, these economies are struggling to regain their growth momentum.

Prior to the Great Recession, exports from developing and transition economies grew rapidly owing to buoyant consumer demand in the developed countries, mainly the United States.

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This seemed to justify the adoption of an export-oriented growth model. But the expansion of the world economy, though favourable for many developing countries, was built on unsustainable global demand and financing patterns. Thus, reverting to pre-crisis growth strategies cannot be an option. Rather, in order to adjust to what now appears to be a structural shift in the world economy, many developing and transition economies are obliged to review their development strategies that have been overly dependent on exports for growth.

It is not a new insight that growth strategies that rely primarily on exports must sooner or later reach their limits when many countries pursue them simultaneously: competition among economies based on low unit labour costs and taxes leads to a race to the bottom, with few development gains but potentially disastrous social consequences. At the present juncture, where growth of demand from developed countries is expected to remain weak for a protracted period of time, the limitations of such a growth strategy are becoming even more obvious. Therefore, a rebalancing of the drivers of growth, with greater weight given to domestic demand, is indispensable. This will be a formidable challenge for all developing countries, though more difficult for some than for others. In any case, it will require a new perspective on the role of wages and the public sector in the development process. Distinct from export-led growth, development strategies that give a greater role than in the past to domestic demand for growth can be pursued by all countries simultaneously without beggar-thy-neighbour effects, and without counterproductive wage and tax competition. Moreover, if many trade partners in the developing world manage to expand their domestic demand simultaneously, they can spur South-South trade.

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No sustained recovery of the world economy in sight

Theglobaleconomyisstillstrugglingtoreturntoastrongandsustainedgrowthpath.Therateofworldoutput,whichwas2.2percentin2012,isforecasttogrowatasimilarratein2013.Asinpreviousyears,developedcountriesareexpectedtoshowthepoorestperformance,witharound1percentincreaseingrossdomesticproduct(GDP).Developingandtransitioneconomiesarelikelytogrowbyalmost5percentand3percentrespectively.

Economic activity inmanydeveloped countries and a numberof emergingmarket economies is still suffering from the impactsof thefinancial and economic crisis that started in 2008, and fromtheunsustainablefinancialprocessesanddomesticandinternationalimbalancesthatledtoit.However,continuingweakgrowthinseveralcountriesmayalsobepartlyduetotheircurrentmacroeconomicpolicystance.

IntheEuropeanUnion(EU),GDPisexpectedtoshrinkforthesecondconsecutiveyear.Economiccontraction is likely tobemoresevere in theeuroarea than inotherEUcountries.Privatedemandremainssubdued,especiallyintheperipheryeconomies,duetohighunemployment,wage compression, low consumer confidence andthestillincompleteprocessofbalancesheetconsolidation.Giventheongoingprocessofdeleveraging,expansionarymonetarypolicieshavefailedtoinducebankstoprovidemuch-needednewcredittotheprivatesectorthatcouldreinvigoratedemand.Inthiscontext, theincreasedtendency towardsfiscal tighteningmakesaquickreturn toahighergrowthtrajectoryhighlyunlikely.Indeed,attemptstoresolvethecrisisintheeuroareathroughfiscalausteritymaybackfirebadly,asitaddsadeflationaryimpulsetoalreadyweakprivatedemand.Thecountries

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in the euro zone that have been suffering themost from the crisiscontinuetooperateunderextremelyadverseconditions,whilegrowthin the surplus countries has largely relied on strong exports. Sincegovernments in the lattercountrieshavebeen reluctant to stimulatedomesticdemandbyothermeansthanmonetarypolicy,disequilibriumwithinthezonepersists.

Atthegloballevel,itisnotablethatJapanisbuckingthecurrentausterity trend by providing strong fiscal stimulus andmonetaryexpansion that are aimedat reviving economicgrowth and curbingdeflationarytrends.ThesemeasurescouldhelpmaintainitsGDPgrowthatcloseto2percentin2013.TheUnitedStatesisexpectedtogrowatasimilarrate,butbasedonadifferentsetoffactors.Partlyowingtosignificantprogressmadeintheconsolidationofitsbankingsector,privatedomesticdemandhasbeguntorecover.Ontheotherhand,cutsinpublicspending,includingforneededinvestmentininfrastructure,arehavingacontractionaryeffect.Sincethenetoutcomeoftheseopposingtendencies is unclear, there is also considerable uncertainty aboutwhethertheexpansionarymonetarypolicystancewillbemaintained.

Growth in many developing countries driven by domestic demand

Developingcountriesareexpectedtogrowbybetween4.5and5percentin2013,similarto2012.Inmanyofthem,growthhasbeendrivenmorebydomesticdemandthanbyexports,asexternaldemandfromdevelopedeconomieshasremainedweak.Inaddition,short-termcapital inflows, attracted by higher interest rates than in themajordevelopedcountries,havebeenexertingappreciationpressureonthecurrencies of several emergingmarket economies, thusweakeningtheirexportsectors.

Asbefore,in2012outputgrowthwasstronginEast,SouthandSouth-EastAsia,at5.3percent,butrecentlytherehasbeenaslowdown,reflectingweakdemandfromsomeof themajorexportmarkets. In

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China,thecontributionofnetexportstoGDPgrowthdeclinedfurther,whilefixedinvestmentandprivateconsumption,asaresultoffasterwagegrowth,continuedtodriveoutputexpansion.Domesticdemand,encouragedbyvariousincomespolicymeasuresinanumberofothercountriesintheregion,suchasIndia,Indonesia,thePhilippinesandThailand, is also supporting output growth,whichmay thereforeacceleratemoderatelyintheregionasawholein2013.

EconomicgrowthinWestAsiasloweddowndramatically,from7.1percentin2011to3.2percentin2012,alevelthatisexpectedtobemaintainedin2013.Weakerexternaldemand,especiallyfromEurope,affectedtheentireregion,mostprominentlyTurkey,whosegrowthratedroppedsharplyfromaround9percentin2010and2011to2.2percentin2012.TheGulfCooperationCouncil(GCC)countriesmaintainedlargepublicspendingprogrammestosupportdomesticdemandandgrowth,despitescalingbacktheiroilproductionduringthelastquarterof2012tosupportoilprices.

Growth inAfrica is expected to slowdown in2013,owing toweakerperformanceinNorthAfrica,wherepoliticalinstabilityinsomecountrieshasbeenmirroredinrecentyearsbystrongfluctuationsingrowth.Insub-SaharanAfrica,bycontrast,GDPgrowthhasremainedstable, at above5per cent, owing to continuedhigh earnings fromexportsofprimarycommoditiesandrelativelystrongpublicandprivateinvestmentinsomecountries.However,thetwolargesteconomiesoftheregion,NigeriaandSouthAfrica,faceconsiderabledownsiderisksduetofalteringexternaldemandandsomeweaknessesonthesupplyside.Inaddition,severalleastdevelopedcountries(LDCs)oftheregionremainvulnerabletosuddenanddrasticswingsindemandforcertaincommodities.

GrowthisalsoexpectedtoremainrelativelystableinLatinAmericaandtheCaribbean,ataround3percent,onaverage,asaslowdowninsomecountries,includingMexico,islikelytobeoffsetbyfastergrowthinArgentinaandBrazil.Overall,growthintheregionisbeingdrivenbydomesticdemand,basedonpublicandprivateconsumption.

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Thetransitioneconomieshaveexperiencedadownwardtrendintheireconomicperformance.UndertheimpactofthecontinuingcrisisinmuchofWesternEurope,mostofthetransitioneconomiesofSouth-EasternEuropeenteredintorecessionin2012.Themembersof theCommonwealthofIndependentState(CIS)maintainedagrowthrateofover3percentin2012basedonsustaineddomesticdemand,butthisisexpectedtoslowdownslightlyin2013.TheeconomicoutlookfortheregionremainscloselylinkedtotheperformanceoftheeconomyoftheRussianFederationandtocommoditypricedevelopments.

Astherapidexpansionofdevelopingeconomiesasagrouphasfurtherincreasedtheirweightintheworldeconomy,anewpatternofglobalgrowthseemstobeemerging.Whiledevelopedcountriesremainthemainexportmarketsfordevelopingcountries,theshareofthelatter’scontributiontogrowthintheworldeconomyhasincreased,from28percentinthe1990stoabout40percentintheperiod2003–2007,andtocloseto75percentsince2008.However,morerecently,growthintheseeconomieshasdecelerated.Ifdevelopingcountriescan increase theroleofdomesticdemandandSouth-Southtradeintheirdevelopmentstrategies, theymaycontinue togrowata relativelyfastpace,withincreasingpotentialtorelyoneachotherfortheexpansionofaggregatedemand.However,theycannotbeexpectedtoliftdevelopedcountriesoutoftheirsluggishgrowthpatternthroughhigherimportsfromthem.

Global trade expansion has virtually ground to a halt

Internationaltradeingoodsandserviceshasnotreturnedtotherapidgrowthrateoftheyearsprecedingthecrisis.Afterasharpfallin2008–2009andaquickrecoveryin2010,thevolumeoftradeingoodsexpandedbyonly5percentin2011andbylessthan2percentin2012,anditaffecteddeveloped,developingandtransitioneconomiesalike.

Sluggisheconomicactivity indevelopedeconomiesaccountedformostof theslowdown in international trade. In2012,Europeanimportsofgoodsshrankbyalmost3percentinvolumeandby5per

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centinvalue.Extremelyweakintra-Europeantradewasresponsibleforalmost90percentofthedeclineinEuropeanexportsin2012.Japan’sexports have not yet recovered from their sharp fall caused by theearthquakeof2011,whilethevolumeofitsimportshascontinuedtogrowatamoderatepace.Amongthemajordevelopedeconomies,onlytheUnitedStatesmaintainedapositivegrowthrateinitsinternationaltrade,althoughthisappearstobeslowingdownin2013.

Tradealsodeceleratedconsiderablyindevelopingandtransitioneconomies.Bothexportsandimportsgrewsluggishlyin2012andthefirstmonthsof2013inmostdevelopingregions.ThesoleexceptionwasAfrica,whereexportsrecoveredincountriespreviouslyaffectedbycivilconflict.Exportgrowthdeclinedto4percentinthedevelopingcountriesasawhole.ThisslowdownincludedAsiancountriesthathadpreviouslyplayedamajorroleinboostinginternationaltrade.

TherateofgrowthofChina’sexports,byvolume,declinedfromanaverageannualrateof27percentduringtheperiod2002–2007to13percentin2011andto7percentin2012,alowerratethanitsGDPgrowth.Concomitantly,China’simports,byvolume,deceleratedto6percentin2012from19percent,onaverage,between2002and2007.Onlyregionsexportingalargeproportionofprimarycommodities(i.e.Africa,WestAsia and, to a lesser extent,LatinAmerica) sawa significantincreaseintheirexportstoChina.SeveralexportersofmanufacturesinAsiaregisteredasizeableslowdownofgrowthintheirexternaltrade.ThiswastheresultnotonlyoflowerimportsfromEurope,butalsoofslowergrowthinsomedevelopingregions,inparticularinEastAsia.

The crisis of 2008–2009 has altered trade patterns in bothdevelopedanddevelopingcountries.Importsbyalldevelopedregionsremain below their pre-crisis level, and only theUnitedStates hasmanagedtoincreaseitsexportstoahigherlevelthantheirpreviouspeakofAugust2008.Ontheotherhand,exportsfromthegroupofemergingmarketeconomieswere22percentabove theirpre-crisispeaks,while the correspondingfigure for their importswas 26percenthigher.However,thepaceofgrowthoftradeoftheseeconomies

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has sloweddown significantly: during thepre-crisis years, between2002and2007,theirexportvolumegrewatanaverageannualrateof11.3percent,butfelltoonly3.5percentbetweenJanuary2011andApril2013.Growthinthevolumeoftheirimportsalsosloweddownfrom12.4percentto5.5percentoverthesameperiod.

Overall, this general downward trend in international tradehighlightsthevulnerabilitiesdevelopingcountriescontinuetofaceatatimeoflacklustregrowthindevelopedcountries.Itisalsoindicativeofaprobablylessfavourableexternaltradeenvironmentoverthenextfewyears.

The particularities of a protracted downturn in developed countries

Thedifficultiesofthedevelopedcountriesasagrouptofindtheirwaytowardsapathofsustainedrecoveryfollowingtherecessionof2008–2009suggeststhatthelatestcrisisisofquiteadifferentnaturethanthecyclicalcrisesofthepast.From2008to2012,globaloutputgrowthaveragedjust1.7percent.Thisismuchslowerthanduringanyofthefive-yearperiodsthatfollowedrecessionsintheglobaleconomysincethe1970s.

Inthissituation,expansionarypolicieswouldbeneededtospurdomesticdemandandrestoretheconfidenceofhouseholdsandfirms.However,policymakershaveinsteadbeenfocusingtheirattentiononrestoringtheconfidenceoffinancialmarkets.Acentralelementofthisstrategyindevelopedcountrieshasbeenfiscalausterity,basedonthebelief that highpublic debt ratiosmay eventually trigger a generalaversiontosovereigndebt,whichcouldincreasetheriskpremiumandtherebyimposeaheavierdebtburdenonpublicfinances.Thisstrategyhasnotyieldedtheexpectedresults.Theoutcomeoffiscalcontractionhas negatively affected growth and job creation, as the expectedincrease in private demandhas notmaterialized to compensate, orovercompensate,forthecutsinpublicspending.Inaddition,thefact

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that several countries that had strong trade relations with each other have been following austerity regimes at the same time has amplified their deflationary impact in the same way as simultaneous fiscal stimulus in 2009 generated very positive results. Moreover, monetary policies have proved ineffective in the sense that strong monetary expansion has not translated into an increase in loans to the private sector. This shows that, without the prospect of a growth in demand, the increasing availability of credit is not enough to stimulate private investment and create jobs.

Experience has shown that an expansionary fiscal policy can have a much stronger impact in such a situation, because this is precisely when it has a particularly strong multiplier effect. The legitimate objective of improving fiscal balances is more likely to be achieved through an expansion of aggregate demand, and thus the tax base, than by fiscal contraction which reduces income and employment growth. In addition, central bank operations that focus on reducing the risk of sovereign debt and maintaining low interest rates would enable a reduction in public debt servicing, and thereby lower medium- to long-term public debt ratios that are considered too high.

Structural reforms are needed, but what kinds?

Despite marked differences in economic performance across regions, in general, policies pursued over the past three years have not succeeded in resolving the crisis. There can be little doubt that, in addition to demand-enhancing policies, structural reforms are needed in many countries to lead their national economies and the global economy back to a path of sustained growth. Several proposals for reform have been made, in particular relating to the financial sector, the labour market, public finances and central banking, but not all of them have adequately addressed the causes of the crisis.

A major reason for the crisis has been the dominance of the financial sector over the real sector. Financial liberalization has resulted in governments being increasingly influenced by the belief that they

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needtomaintainorregainthe“confidence”offinancialmarkets.Thereformsadoptedsince2008,whichaimatimprovingsupervisionandcapitalizationof thebankingsystem,arehelpfulbutareunlikely tobesufficienttopreventactivitiesofthefinancialmarketsfromposingathreattoeconomicstability.Governmentsneedtocontrolfinancialmarketsmoreresolutelythaninthepastandlimitthepowerofthosemarketsovernational,regionalandglobaleconomies.

Formany years preceding the financial and economic crisis,structuralreformwasvirtuallysynonymouswithintroducinggreaterflexibilityintothelabourmarket,especiallywageflexibility,andsuchreform isagainsuggestedasawayoutof thecrisis.Buta strategyaimedatstrengtheningthecompetitivenessofeconomiesbyreducinglabour costs completely neglects the fact thatwages are usually amajor sourceofdomesticdemand.Moreover,whensucha strategyispursuedbymanycountriesat thesametime, it leads toarace tothebottom,worsensincomedistributionandposesathreattosocialcohesion.Andgreaterinequalityofincomedistributionwasoneofthefactorsthatledtothecrisisinthefirstplace.Instead,anincomespolicyaimedatacceleratingconsumptiongrowthcouldcontributedecisivelytorestoringnationaleconomies,andtheglobaleconomy,toastrongerbutalsomorebalancedgrowthpath.

Reformsaimedatfiscalconsolidationmaybenecessaryinmanycountries,buttheyneedtoconsidertheoverallmacroeconomiccontext.Publicfinancescannotbemanagedlikethefinancesofahouseholdbecausetheyinevitablyhaveanimpactontheentireeconomyandthespendingbehaviourof theprivate sector.Attempts toachievefiscalconsolidation in the short run have been unsuccessful at best, andcounterproductive andprocyclical atworst. Such consolidation canonlybeachievedafterseveralyearsofsustainedeconomicgrowth,andshouldnotbeconsideredaprerequisiteforeconomicrecovery.

Centralbanksofmanydevelopedcountrieshave responded tothefinancialcrisis,and,intheeurozone,tothecrisisinsomememberStates’publicfinances,withanumberofunorthodoxmeasures.But

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theymayalsohave tofindnewwaysofmakingcredit available tonon-financialagentstouseinawaythatgeneratesdemand,incomeandemployment.

These various national reforms also requiremore determinedinternational cooperation, including long overdue reform of theinternationalmonetarysystem,inordertoachievegreatersymmetryofadjustmenteffortsamongdeficitandsurpluseconomies.Inthepresentsituation,severalcountrieswithlargecurrentaccountsurplusescouldprobablydomuchmoretohelprevivetheworldeconomy.

Developing and transition economies: better performance but continued vulnerability

Oneof themost significant changes in the shapeof theworldeconomyhasbeentheincreaseintheshareofdevelopingcountriesinglobalGDP.Theonsetoftheglobaleconomicandfinancialcrisisinitially reinforced this trend, as growth in developing countriesin 2008–2009decelerated less and recoveredmore rapidly than indevelopedcountries.Asaresult,theshareofdevelopedcountriesinglobalGDPdeclinedfrom79percentin1990toabout60percentin2012,whilethatofdevelopingcountriesmorethandoubled,from17percentto36percent,overthesameperiod.Mostofthischangeoccurredfrom2004onwards.

Nevertheless, economic developments in developed countriesremain crucial for growth in developing countries. Indeed, thegrowth acceleration in the latter set of countries during the 1990s,and especiallyduring theperiod2003–2007,was associatedwith alarger proportion of international trade in the composition of theiraggregatedemand.Combinedwiththegenerallyfavourableexternaleconomicenvironment,suchasgrowingimportsbydevelopedcountries(especiallytheUnitedStates)andhistoricallyhighcommodityprices,particularlyduringthefiveyearspriortotheonsetofthecurrentcrisis,

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thegreateroutwardorientationofdevelopingcountriescontributedtotheirgrowth.

However,anexport-orientedgrowthstrategyalsoimpliesgreatervulnerability to a deterioration of the external environment, as hasoccurred since 2008.The international price and demand shocksduring2008–2009hadasevereimpactonbothexportersofprimarycommoditiesandexportersofmanufactures.Thesubsequentreboundwasmorerapidanditsbeneficialimpactgreateroncountrieswhoseexportscomprisealargeproportionofprimarycommoditiesthanforcountriesthatexportmainlymanufactures.

WeakerdemandfromdevelopedcountriessuggeststhatSouth-Southtrademayneedtoplayagreaterroleindevelopingcountries’growthstrategy.Inthisrespect,itoffersgreaterpotentialthaninthepast,giventhattheshareofSouth-Southtradeintotalworldtradeincreasedfromslightlylessthan30percentin1995toslightlymorethan40percent in 2012.Moreover, the share ofmanufactures in a developingcountry’sexportstootherdevelopingcountriesandthevalueaddedinsuchtradeareusuallymuchhigherthantheyareinitsexportstodevelopedcountries,whichistestimonytothepotentialdevelopmentalroleofSouth-Southtrade.

Commodity price trends and outlook

UptothefinancialcrisisandtheGreatRecessionof2008–2009,rapid output growth inmany developing and transition economieswas the result of their strong increase in exports ofmanufacturesto developed countries.This in turn contributed to higher exportearningsofotherdevelopingcountriesthatreliedonexportsofprimarycommodities.Sincetheturnofthemillennium,theselattercountrieshavealsobenefited froma trendchange in the termsof trade.Thischangereflectednotonlyanupwardmovementinthemedium-termcommoditypricetrend,interruptedonlybrieflyin2008–2009,butalso

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adeclineinworldpricesofcertainmanufactures,especiallylabour-intensivemanufactures.

The increasing demand for commodities in rapidly growingdeveloping countries, notablyChina, and the resultinghigher pricelevels ofmanyprimary commodities, signifies a structural shift inphysicalmarketfundamentals.Theupwardtrendinpriceshasalsobeensupportedbyaslowsupplyresponse,ashistoricallylowpricelevels inthe1990shadledtoalongperiodofunderinvestmentinproductioncapacityforseveralkeycommodities,especially in themineralandminingsectors.Atthesametime,theincreasingpresenceoffinancialinvestorsincommoditymarketshasaccentuatedtheproblemofpricevolatility.Projectionsaboutthefurtherevolutionofcommoditypricesare particularly difficult in the current uncertain global economicenvironment, but there is little doubt that the growth outlook fordevelopingcountrieswillhaveasignificantimpactonfuturecommoditydemandtrends.

Continuingfastpopulationgrowthandrisingincomeindevelopingcountries should lead to greater demand for several food items.Moreover,asproductionisunlikelytoincreaseinlinewiththegrowingdemand,includingforbiofuels,agriculturalcommoditypricescouldremainhighoverthenextdecade.

Demandconditionsinthemarketsofmanyprimarycommoditiesthat are used as inputs for the production ofmanufactures and forconstruction are determined by a number of factors.One factor iswhetherChinasucceedsinrebalancingitsgrowththroughanincreaseindomesticconsumption.Anotheriswhetherotherhighlypopulatedandrapidlygrowingdevelopingcountrieswillmovetoamorecommodity-intensive phase of economic growth and industrialization. Even ifChina’sGDPgrowthslowsdown, resulting ina loweruseof somecommodities,itsongoingindustrializationandpercapitaincomegrowthcouldcontinuetohaveaconsiderableimpactonglobalmarkets,giventhesizeofitseconomy.If,inaddition,otherlargeandhighlypopulateddevelopingcountriesalsopursueapathofrapidindustrialization,the

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demand prospects for industrial commodities, particularlymetals,could remain robust. Infrastructure development associatedwithrapidurbanizationalsooffersstrongpotentialtoincreasedemandforcommodities.

Inaddition,risinglivingstandardsinmanydevelopingcountriesmayboostdemandforenergycommoditiesinthemediumterm,despiteimprovementsinenergyefficiencythatcouldcontributetoadeclineinenergyuseperunitofGDP.Oilpricescouldremainhistoricallyhigh,even if they fall slightly comparedwith their 2011–2012 levels, asdemandfromsomeoftherapidlygrowingdevelopingcountrieswillcontinuetoriseandbecausetheexploitationcostsofnewsuppliesarehigherthanthosefromconventionalsources.

Overall,commoditypricesmaynotriseasfastastheyhaveoverthepastdecade,but,followingsomedownwardadjustmentsintheshortterm,theyshouldstabilizeatarelativelyhighlevelincomparisonwiththeearly2000s.However,thisshouldnotleadtocomplacencyinthedesignof development strategies in natural-resource-rich countries.Theirmainchallengeremainsthatofappropriatingafairshareoftheresource rents and channelling revenues towards investment in thereal economy in order to spur the diversification andupgrading ofproductionandexports.

Export-led growth strategies are reaching their limits

Akeyproblemforpolicymakersinthedevelopingandtransitioneconomiesthathavealargeshareofmanufacturesintheirexportsisthatgrowthofexportsandincomesintheircountriesislikelytobeadverselyaffectedbycontinuedslowgrowthindevelopedcountries’final expenditure for several years to come. In a number of thesecountries,productionofmanufacturedgoodsfortheworldmarkethasdriventheexpansionoftheirformalmodernsectors,butinmostofthemdomesticdemandhasnotincreasedapace.Thishasbeenpartlyduetoweaklinkagesbetweentheexportsectorandtherestoftheeconomy,

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andpartlytothestrategyoftheirfirmsandgovernmentstostrengthentheinternationalcompetitivenessoftheirdomesticproducersbykeepingwageslow.Suchastrategywilleventuallyreachitslimit,aslowwagesdampendomesticdemandgrowth,especiallywhenmanyothercountriespursuethesamestrategysimultaneously.Sincethegrowthofdemandindevelopedcountriesislikelytoremainweakforanextendedperiodof time, the limitationsofsuchastrategybecomeevenmoreacute.Inthesecircumstances,continuingwithexport-ledgrowthstrategiesthroughwageandtaxcompetitionwouldexacerbatetheharmcausedbyslowergrowthinexportmarketsandreduceanyoverallbenefits.

The adoption of countercyclicalmacroeconomic policies cancompensate for resulting growth shortfalls for some time. Indeed,mostdevelopingcountriesreactedtothedeclineintheirnetexportsbyincreasingtheshareofgovernmentexpenditureinGDP.Therewasalsoan increaseofprivateconsumptionasashareofGDPinsomeofthesecountries,andofgrossfixedcapitalformationasashareofGDP in someothers.However, beyond such short-term responses,developing countriesmayneed to take amore comprehensive andlongertermperspective,involvingashiftindevelopmentstrategiesthatgivesgreaterweighttodomesticdemandasanengineofgrowth.Suchamovetowardsamorebalancedgrowthpathcouldcompensatefortheadverseimpactofslowergrowingexportstodevelopedcountries.Moreover,thismorebalancedgrowthstrategycouldbepursuedbyalldeveloping countries simultaneouslywithout beggar-thy-neighboureffects.However,therearemanychallengesinvolvedinmovingtowardsamore balanced growth strategy.These include boostingdomesticpurchasingpower,managingdomestic demand expansion in awaythat avoids an excessive increase in import demand, and nurturingtheinterrelationshipbetweenhouseholdandgovernmentexpenditure,ontheonehand,andinvestmentontheother,toenablethesectoralcompositionofdomesticproductiontoadjusttonewdemandpatterns,includingthroughincreasedregionalandSouth-Southtrade.

Hence,shiftingthefocusofdevelopmentstrategiestodomesticmarketsdoesnotmeanminimizingtheimportanceoftheroleofexports.

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Indeed,exportscouldexpandfurtherifseveraltradepartnersweretoachievehighereconomicgrowthatthesametime.

Rebalancing domestic and external forces of growth

Inseekinggreaterintegrationintoarapidlyglobalizingeconomy,the critical importanceof domestic demand as amajor impetus forindustrialization is often overlooked.Growth of domestic demandaccountsforaboutthreequartersoftheincreaseindomesticindustrialoutput in large economies, and slightlymore than half in smalleconomies.Acceleratingdomesticdemandgrowthcouldthereforebehighlybeneficialforoutputgrowthandindustrialization,particularlyinacontextofweakeningexternaldemandgrowth.Thepossibilityofchangingrapidly towardsamoredomestic-demand-orientedgrowthstrategywill depend largely on how closely the sectoral structureofdomesticproductionislinkedtothepatternofdomesticdemand.This linkagewill be particularlyweak in countries that export alargeproportionof primary commodities. It therefore remainsveryimportantforthesecountriestousetheirresource-relatedrevenuestodiversifytheirsectoralstructureofproductionbyincreasingthesharesofmanufactures andmodern services, both public and private.Bydevelopingthelinkagesbetweentheexportingsectorsandtherestoftheeconomy,thisdiversificationwouldgeneratenewemploymentandincomeopportunities,andstrengthenthedomesticmarket.

Astrategythatplacesgreateremphasisondomesticdemandwillneedtoaimatanappropriatebalancebetweenincreasesinhouseholdconsumption,private investmentandpublicexpenditure.There is astronginterrelationshipbetweenthesethreecomponentsofdomesticdemand. Increased consumption of goods and services that can beproduceddomesticallymakesproducersofthosegoodsandservicesmorewillingtoinvestintheirproductivecapacity.Higherinvestmentisnotonlyitselfasourceofdomesticdemand(evenifalargeshareofthecapitalgoodsmayhavetobeimported),butitisalsoaprecondition

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forthecreationofemploymentandforproductivitygainsthatallowwagestogrowalongwiththepurchasingpowerofdomesticconsumers.Moreover,higherincomesofhouseholdsandfirmsraisetaxrevenues,whichcanthenbespentbythegovernmentforenhancingpublicservicesandinfrastructuredevelopment,evenatunchangedtaxrates.Higherpublicspending,inturn,cancreateadditionalincomeforhouseholdsandfirms, and improve the conditions forprivate investment.Suchinvestmentisindispensableforincreasingdomesticsupplycapacity,andthusforreducingleakagesofdomesticdemandgrowththroughimports.

Increasing domestic consumption

Labour income is themost important source of householdconsumption,which generally accounts for betweenhalf and threequartersofaggregatedemand,eveninrelativelypoorcountriesandcountrieswith a relatively large export sector.Thus fostering thepurchasingpowerofthepopulationingeneral,andofwageearnersinparticular,shouldbethemainingredientofadomestic-demand-drivengrowthstrategy.

While export-led strategies focuson the cost aspect ofwages,a domestic-demand-oriented strategywould focus primarily on theincomeaspectofwages,asitisbasedonhouseholdspendingasthelargestcomponentofeffectivedemand.Ifwagegrowthfollowsthepathofproductivitygrowth,itwillcreateasufficientamountofdomesticdemand to fully employ the growing productive capacities of theeconomywithouthavingtorelyoncontinuedexportgrowth.

Ineconomieswithfairlylargeformalsectors,thefunctioningofsuchanincomespolicycouldbeenhancedbybuildinginstitutionsforcollectivebargainingandtheintroductionof legalminimumwages.In countrieswhere informal employment and self-employment arewidespread, targeted social transfers andpublic sector employmentschemes can play an important complementary role. In countries

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with a large rural sectorwithmany small producers, introducingmechanisms that ensure fair prices for agricultural producers – forinstancebylinkingthosepricestotheoverallproductivitygrowthoftheeconomy–wouldbeanotherelementofastrategytoincreasedomesticconsumption,strengthensocialcohesionandatthesametimeinducemoreproductivity-enhancinginvestments.Moreover,thelayersofthepopulation thatwill primarily benefit from such an incomespolicywouldbe likely to spendmostof their incomeon locallyproducedgoodsandservices.Inaddition,governmentscantakediscretionaryfiscalactions,suchasprovidingtaxrebatesoncertainconsumergoodsthatare,orcanbe,produceddomestically.

Spurring domestic demandby facilitating access to consumercreditfortheacquisitionofdurableconsumergoodstendstoberisky,asamplydemonstratedbyrecentexperiencesinanumberofdevelopedcountries.Thedebtservicingburdenofhouseholdsmayrapidlybecomeexcessiveifinterestratesrise,growthofhouseholdincomesstallsorthepricesofassetsusedascollateralfall.

Increasing domestic investment

Domesticinvestment,bothprivateandpublic,playsacrucialroleinanygrowth strategy, regardlessofwhether it isoriented towardsexportsordomesticdemand.Theexpectationthatfuturedemandwillbehighenough to fullyutilizeadditionalproductivecapacity is themainincentiveforentrepreneurstoinvestinexpandingthatcapacity.Sinceexportsareunlikelytogrowatthesamepaceasinthepast,giventhecurrentstateoftheworldeconomy,domesticdemandgrowthwillbecomemoreimportantinformingthedemandexpectationsofpotentialinvestors.Akeydeterminantoftheirabilitytostrengthenproductivecapacityistheavailabilityoflong-termfinanceatanaffordablecostandacompetitiveexchangerate.Thisinturndepends,toalargeextent,oncentralbankpolicyandthestructureandfunctioningofthedomesticfinancialsystem.

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Direct and indirect demand effects of public expenditure

Thepossibilityofstrengtheningdomesticdemandbyincreasingpublicsectorspendingdependsontheinitialconditionsofthepublicfinances ineachcountry,butalsoon theeffectsof increasedpublicexpenditure on public revenue. Public spending and taxation arepotentiallykeyinstrumentsforshapingthedistributionofpurchasingpowerinaneconomy.Beyonditsdirecteffectsonaggregatedemand,publicinvestmentininfrastructureand/orpublicservicestospecificindustrialclustersareoftenapreconditionfortheviabilityofprivateinvestment,forenhancingtheproductivityofprivatecapital,andforcomplementingthemarketmechanismbyfacilitatingthecreationoflinkages between export industries and the rest of the economy. Inaddition,publicexpenditureoneducationandtrainingcaninfluencethepotentialoflabourtocontributetoproductivitygrowth.Moreover,countercyclical fiscal policy can stabilize domestic demandduringperiodsofslowgrowthorrecession,andthuspreventaloweringofthedemandexpectationsofdomesticinvestors.Thisstabilizationpotentialwillbegreater,thelargertheshareofthepublicsectorinGDP.

Incomeredistributionthroughthetaxationstructureandtransferstohouseholdscanstrengthenthepurchasingpowerofthoseincomegroups thatspenda largershareof their incomeonconsumption ingeneral,andondomesticallyproducedgoodsandservices,inparticular,thanhigherincomegroups.

Raising public revenues

The“fiscalspace”forstrengtheningdomesticdemand,directlyorindirectly,throughincreasedpublicspendingindevelopingcountries,especially in low-incomeand leastdevelopedcountries, tends tobemorelimitedthanindevelopedcountries.Thisisnotonlybecausetheirtaxbaseissmaller,butalsotheircapacitytoadministerandenforcetaxlegislationisoftenweak.Moreover,inmanyofthesecountriespublicfinancesarestronglyinfluencedbyfactorsthatarebeyondthecontrol

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oftheirgovernments,suchasfluctuationsincommoditypricesandininterestratesontheirexternaldebt.Buttoalargeextentfiscalspaceisalsodeterminedendogenously,sincespendingofpublicrevenuecreatesincome, and thus additional spending in the private sector, therebyenlargingthetaxbase.Theseincomeeffectsvary,dependingonhowthetaxburdenisdistributedandpublicrevenueisspent.Takingaccountofsuchcompositionaleffectsofboththerevenueandtheexpendituresideimpliesthatthescopeforusingtaxationandgovernmentspendingfor strengtheningdomestic forcesofgrowthmaybegreater than isoftenassumed.

Inmanydevelopingandtransitioneconomies,thereappearstobescopeformoreprogressivetaxationandfortaxingwealthandinheritance,aswellasforraisingadditionalrevenuebyimposinghighertaxesonmultinational corporations.The latterwould require that developingcountries, in their efforts to attract foreign direct investment (FDI),avoidengagingintaxcompetitionwitheachother.Suchcompetition,likeinternationalwagecompetition,isattheexpenseofallthecountriesconcerned.Theseconsiderationsareofparticularrelevanceforcountriesthatarerichinmineralresources,whereoftenonlyaverysmallshareoftheresourcerentsremainsintherespectivecountriesintheformofprivateincomeorpublicrevenue.

Inseverallow-incomeandleastdevelopedcountriesmultilateralfinancial institutions and bilateral donorswould need to help byprovidingadditionalresourcesforsocialspending,aswellassupportforimprovingtheadministrativecapacitiesneededtostrengthentheroleofpublicfinancesindevelopmentstrategies.

The rationale for debt-financed public spending

Rebalancingdomestic and external forces of growthmay alsorequireadifferentapproachtodebtfinancingofpublicexpenditure.Itcanbeastrategicinstrumentnotonlyinthecontextofacountercyclicalfiscalpolicy,butalsoforstretchingthefiscalburdenoflargepublic

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infrastructure projects. Such projects typically help to increase theproductivityoftheeconomyatlargeandgeneratebenefitsforhouseholdsandfirmsinthefuture,bywhichtimeeconomicgrowthwouldhelpservicetheinitiallyincurreddebt.

While itmaybe preferable for governments to pay all publicexpenditureoutofcurrentrevenue,arationalapproachinafast-growingdevelopingeconomycouldalsobebasedontheprinciplethatcurrentexpenditure, including social expenditure, should be financed bytaxationandothercurrentrevenues,whereaspublicinvestmentmaybefinancedbyborrowing,sincesuchinvestmenthasapay-offintheformofadditionaltaxreceiptsfromanenlargedtaxbaseinthefuture.Governmentsshouldconsiderborrowinginforeigncurrencyonlytotheextent thatpublic investmentsorgovernment support toprivateinvestmentsrequireimportingcapitalgoods,materialsandknow-how.Wherethereisasufficientpossibilityforpublicsectorborrowingforthesepurposes,anincreaseincredit-financedpublicexpendituremaybeconsideredawaytoboostnotonlydomesticdemandbutalsodomesticsupplycapacities.

Changing composition of consumption with rising personal incomes

Consumptionpatternsarechangingwithrisingincomelevels.Oncetheincomeofindividualconsumerscrossesacertainthreshold,theywilluseasmallershareofthatincomeforsatisfyingtheirbasicorsubsistenceneeds.Thethresholdswhichtriggeranaccelerationofdemandforotherconsumptionitemstypicallyclusteratalevelofpercapitaincomeatwhichanindividualisconsideredtoenterthe“middleclass”(i.e.thosesegmentsofthepopulationinanysocietythathaveacertainamountofdiscretionaryincomeattheirdisposal,whichallowsthemtoengageinconsumptionpatternsbeyondjustthesatisfactionoftheirbasicneeds).Thefutureevolutionofconsumptionpatternsthereforedependsonthenumberofpeoplethatareataroundtheentrylevelofthemiddleclass,wherethenewspendingpatternsstartemerging.

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Based on a number of projections, it has been estimated thattheproportionofthemiddleclassinthetotalworldpopulationwillincreasefrom26percentin2009to41percentin2020and58percentin2030,andthatthisproportionwillgrowmorethanfourfoldindevelopingcountries.Asiawillaccountforthebulkofthisincrease,withthenumberofpeoplebelongingtothemiddleclassinthisregionestimatedtogrowsixfold;inCentralandSouthAmericathenumberisexpectedtogrowbyafactorof2.5,andinsub-SaharanAfricaitshouldtriple.Astrategythatgivesgreateremphasistodomestic-demand-drivengrowth,ifsuccessful,mightwellacceleratethesetrends,asitwouldbe associatedwith fasterwage increases and amore equal incomedistributionthaninthepast.Therefore,manydevelopingandtransitioneconomiescouldachievearapidaccelerationofconsumptionofdurableconsumergoodsinthemediumterm.

Anenlargedmiddleclassmaybethemostimportantsourceofbuyingpowerfordomesticmanufacturers,becauseitwilleventuallydetermine the extent of horizontal complementarities across allindustriesoftheeconomy.Andtotheextentthatthepurchasingpowerofincomegroupsbelowthelevelofthemiddleclassalsogrows,theremaybeadditionalproductivitygainsinsectorsandfirmsthatproduceprimarilyforthedomesticmarket,asthelowerincomegroupstendtospendtheirincomesonagreatershareoflocallyproducedorproduciblegoodsandservices.

Domestic demand growth and its implications for the development of productive capacities

Theimportintensityofthethreecomponentsofdomesticdemand(i.e.householdconsumption,governmentexpenditureandinvestment)varieswidely. Imports tend to be strongly correlated, on average,withinvestmentandproductionforexport,butlesswithconsumption(especiallyconsumptionbyhouseholdsinthelowerincomebrackets)andpublicexpenditure.Still, ifdomesticproductivecapacity isnotupgraded in accordancewith the changing pattern of demand in a

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growingeconomy,theincreaseindomesticconsumptionexpenditurewilltendtoinducehigherimports.Inordertopreventadeteriorationinthetradebalanceasaresultofbothfastergrowthandthechangingcompositionofdomesticdemandgrowth,coupledwithlowerexportgrowth, itwill be essential to strengthen domestic investment andinnovationdynamicstobringaboutappropriatechangesinthesectoralcompositionofdomesticproduction.

Efforts toorientdomesticproduction torespond to thechanginglevel and compositionof domestic demandwill tend to be easier forthosecountrieswhichinthepasthavereliedsignificantlyonexportsofmanufactures todevelopedcountries, because they canbuildon theirconsiderableexistingproductivecapacityandexperienceinmanufacturingactivities.However,itwillbemoredifficultiftheseactivitieshavebeengearedmainly to the production of sophisticated goods for affluentconsumersindevelopedcountries,whichfewdomesticconsumerscanafford.Arapidshiftfromanexport-drivengrowthstrategytoonethatgivesgreateremphasistoanexpansionofdomesticdemandtodrivegrowthwillbeevenmoredifficultincountriesthathavebeenrelyingontheproductionandexportofprimarycommodities.

Ontheotherhand,whiledevelopingcountriesshouldstillseektodeveloporadaptnewtechnologiesaccordingtotheirspecificneeds,anadvantageforproducersindevelopingandtransitioneconomiesthatfocusmoreondomesticthanonglobalmarketsisthattechnologicallaggingtendstobelessofaconstrainingfactor.

Advantages of proximity to markets and regional integration

Anotheradvantageforproducersindevelopingcountriesistheirproximitytotheirdomesticmarketand,whereapplicable,theirregionalmarket.Changesinmarketconditionsarisingfromtheexpansionandchangingcompositionofdomesticdemandnecessitatetheidentificationof“latentdemand”andthe“steering”offirmstomeetrequirements

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specific to those newmarkets. In this regard, the local knowledgeofdomesticfirmsforthedevelopmentofappropriatenewproducts,distributionnetworksandmarketingstrategiesmaybecomeavaluableassetincompetingwithforeignsuppliersofsimilargoods.Inaddition,totheextentthatdevelopingandtransitioneconomiesassumeagreaterweight in global consumption growth, the resulting changes in thepatternofglobaldemandarelikelytoinfluencemarketopportunitiesforalltheseeconomiesinareasofproductionthataremorealignedthan in thepast to thepatternsofdemandprevailing indevelopingcountries.Thisinturnwillleadtochangesinthesectoralallocationofinvestmentsinawaythatbettercorrespondstothepatternofdomesticdemandinthosecountries.

Moreover,ifmanytradepartnersinthedevelopingworldweretoexpandtheirdomesticdemandsimultaneously,theycouldbecomemarketsforeachother’sgoodsandservices.Theresultingincreaseinexportswouldhelp reduce thebalance-of-payments constraints thatarisefromaslowdownofexportstodevelopedcountries.Consequently,strengthenedregionalintegrationand,moregenerally,intensifiedeffortsto strengthenSouth-South trade,maybe important complements todomestic-demand-ledgrowthstrategies.

Industrial policies in support of investment and structural change

Experience in developed anddeveloping countries has shownthatgovernments,inadditiontomarketforces,canplayanimportantroleinsupportofindustrialization.Inthepast,industrialpolicieshaveoftenfocusedonstrengtheningexportcapacitiesandestablishinganexport-investmentnexus.However,achangeintherespectiveweightsofforeignanddomesticdemandmayrequireanadaptationofindustrialpolicy,withagreateremphasisonstrengtheningthecompetitivenessof domestic producers in domesticmarkets andgearingproductionstructures to the changing compositionof domestic demand as percapita incomegrows.Suchadaptationmayneed to fullyutilize the

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policyspacestillavailabletothesecountriesfollowingtheUruguayRoundtradeagreementsandvariousregionalandbilateraltradeandinvestmentagreements.Furthermore,someoftheseagreementsmayneedtoberevisedtotakebetteraccountoftheinterestsofdevelopingcountries,forexamplebyallowingthemagreaterdegreeoftemporaryprotectionofcertainindustriesthatareatanearlystageofdevelopment.

Capitalformationthatrespondstochangingdemandpatternsmaybesupportedbyhelpingprivatefirmstoidentifytheproductgroupsthatshowthegreatestdynamismasanincreasingshareofthepopulationenters themiddleclass.Publicsupportmeasuresmayalsofacilitatecoordinationofproductionalongthevalue-addedchain,includingfiscalandfinancialsupportfornewproductionactivitiesthatareconsideredstrategicallyimportantfordomesticproductionnetworks.Aproactiveindustrialpolicymaybeespeciallyimportant−andhavethegreatestimpact−ineconomiesthatarestilldependentonnaturalresourcesandwherethereisanurgentneedfordiversificationofproduction.

Challenges for financial policies in developing countries

Theadjustmentofproductivecapacitiestochangesinthecompositionofaggregatedemand indevelopingand transitioneconomies requiresreliableandlow-costaccessoftheirproducerstofinancialresourcesforproductiveinvestment.Inthecurrentglobalcontext,althoughthereisampleliquidityinthebankingsystemsofthemajordevelopedcountries,uncertaintyinfinancialmarketsisparticularlyhigh.Thisincreasestheriskof emergingmarkets being affectedbydisturbances emanatingfrom thebehaviourof internationalcapitalmarkets, sinceavolatileinternationalfinancialenvironment,fragilenationalbankingsystemsandweakdomesticfinancialinstitutionshaveoftenhinderedinvestmentinmanycountries.

This presents a number of challenges for financial policy indevelopingandtransitioneconomies:first,theyneedtoprotecttheir

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nationalfinancialsystemsagainstthevagariesofinternationalfinance;second,policymakersshoulddrawtherightlessonsfrompastfinancialcrises,inparticular,thatanunregulatedfinancialsectortendstogenerateeconomicinstabilityandresourcemisallocation;andthird,theyshouldaimtomaketheirdomesticfinancialsystems,especiallytheirbankingsystems,moresupportiveofinvestmentinrealproductivecapacity.

Atypical behaviour of international capital flows since 2008

Overthepastthreedecadesemergingmarketeconomiesexperiencedfrequentwavesofinternationalcapitalflows.Suchwavestypicallystartedwhengrowthwasslow,liquiditywasabundantandinterestrateswerelow in the developed countries.Thismade emergingmarkets seemattractivedestinationsforprivateinternationalcapitalflows.However,thosewavesebbedwheninterestratesroseinthedevelopedcountriesorwhenfinancialmarketparticipantsdeemedexternaldeficitsortheforeign indebtedness of the destination countries to have becomeunsustainable.

Atpresent,monetaryandfinancialconditionsinmajordevelopedcountries resemble those that in thepastproved tobeconducive tosurgesofcapitalflowstoemergingmarketeconomies.Indevelopedcountries,interestrateshavefallentoalmostzeroinanefforttotackleboththeprotractedcrisisandthedifficultiesintheirfinancialsectors.Theircentralbankshavealsoinjectedlargeamountsofliquidityintothefinancialsystem.However,thesemeasureshavenotsucceededininducingbankstoincreasetheirlendingtotheprivatesector.Moreover,therearefairlylargeinterestratedifferentialsinfavourofemergingmarkets. So far, these conditions have not resulted in strong andsustained capital outflows fromdeveloped to developing countries;rather,wheresuchoutflowshaveoccurred,theyhavebeenveryvolatile.

Prior to the eruption of the financial crisis, therewere largecapitalflowsfromdevelopedcountriestoemergingmarketeconomies,

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whichendedabruptlyin2008.But,distinctfrompastepisodes,this“suddenstop”wasnottriggeredeitherbyanincreaseininterestratesinthedevelopedcountries,orbyexcessivecurrentaccountdeficitsordebtservicingproblems in theemergingmarketeconomies.Rather,theyappeartohavebeenmotivatedbyuncertaintyaboutthepossiblerepercussionsofthefinancialcrisisonthelattereconomies,andattemptsbyinternationalinvestorstominimizetheiroverallriskexposure.Whenprivatecapitalflowstoemergingmarketeconomiessurgedagainin2010and2011,thistoowasatypical,becausesuddenstopsareusuallyfollowedbyaprolongedperiodofstagnationofinflowsorevenoutflowsfromthesecountries.Facedwithlowprofit-makingopportunitiesinthemajorfinancialcentres,itmayhavebeenexpectedthatinvestorswouldbeencouragedbytherapidresumptionofGDPgrowthintheemergingmarket economies and the perception that their financialsystemsweremorestablethanthoseofdevelopedcountries.However,newlyworseningprospectsindevelopedcountriesinthesecondhalfof2011,includinghigherperceivedrisksrelatedtothesovereigndebtofsomeofthem,againcurtailedcapitalflowstowardstheemergingmarketeconomiesasinvestorssoughttoreducetheiroverallportfoliorisks.

The vagaries of international finance remain a threat

Emergingmarketeconomieshavebeenrelativelyresilientinthefaceof thedestabilizingeffectsof the latestwavesof capitalflowsontheirnationalfinancialsystems.Thisobservationdoesnotmean,however,thattheyhavebecomestructurallylessvulnerable.Rather,itshowsthemeritsoftheirpolicyreorientationwithrespecttoexternalfinance since the turn of themillennium.An increasing number ofdeveloping-countrygovernmentshaveadoptedamorecautiousattitudetowardslargecapitalinflows.Someofthemwereabletopreventorat leastmitigate currency appreciation through intervention in theforeignexchangemarket,alongwithassociatedreserveaccumulation.Othersalsoresortedtocapitalcontrols.Anotherfactorexplaininghowseveralofthemwereabletocopewiththeadversefinancialeventswas

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their lowerlevelsofexternaldebtanditsmorefavourablecurrencycompositioncomparedwithearlierepisodes.

However,sinceglobalfinancialassetsamounttomorethanthreetimes the value of global output, evenminor portfolio adjustmentsorientedtowardsdevelopingcountriescanleadtoanincreaseinsuchflowsataratethathasthepotential todestabilizetheeconomiesofthesecountriesinthefuture.Inthecurrentsituationofhighuncertainty,investorsentiment,ratherthanmacroeconomicfundamentals,istendingtodrivecapitalmovements,ashasfrequentlybeenthecaseinthepast.Butthereisalsouncertaintywithregardtothefundamentals.Ontheonehand,anextendedperiodoflowinterestratesinthedevelopedcountries,combinedwithstrongergrowthandatendencytowardshigherinterestratesinemergingmarketeconomiescouldleadtoanewsurgeofcapitalflowstothelatter.Ontheotherhand,atighteningofmonetarypolicyinthemajorreservecurrencycountriescouldcauseadrasticreductionorreversalofnetprivatecapitalflowsfromthem.

Reducing exposure to international financial markets

Aslongastheinternationalcommunityfailstoagreeonfundamentalreformsoftheinternationalfinancialandmonetarysystem,developingandtransitioneconomiesneedtodesignnationalstrategiesand,wherepossible,regionalstrategies,aimedatreducingtheirvulnerabilitytoglobalfinancialshocks.Inthecurrentsituation,thismeansthattheseeconomiesneedtoexerciseextremecautiontowardscross-bordercapitalflows,bearinginmindthattheseedsofafuturecrisisaresowninthephaseofeuphoria,whenawaveoffinancialinflowsisinthemaking.

Formanyyears,theprevalentviewconsideredalmostanykindofforeigncapitalflowstodevelopingcountriesasbeneficial.Thisviewwasbasedontheassumptionthat“foreignsavings”wouldcomplementthe national savings of the recipient countries and lead to higherrates of investment there.However, both theoretical considerationsandempirical evidence show that evenhugecapital inflowscanbe

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accompaniedbystagnatinginvestmentrates,becausethelinkbetweencapitalinflowsandthefinancingofnewfixedinvestmenttendstobeveryweak.Forthesamereason,substantialincreasesinfixedinvestmentcanbeaccompaniedbystrongcapitaloutflows.

Externalfinancingofdevelopingand transitioneconomieshasrepeatedly proved to be a double-edged sword.On the one hand,it can be away of alleviating balance-of-payments constraints ongrowth and investment.On the other hand, a large proportion offoreign capital inflowshas oftenbeendirected to private banks forfinancingconsumptionorspeculativefinancialinvestmentsthathavegenerated asset price bubbles.Moreover,when capital inflows arenotusedforfinancingimportsofgoodsandservices,theyoftenleadtoastrongcurrencyappreciationthatmakesdomesticindustrieslessprice competitive in internationalmarkets. Financial inflows andoutflows,and their instability,haveoften led to lendingboomsandbusts, inflationary pressures and the build-up of foreign liabilitieswithout contributing to an economy’s capacity to growand servicesuchobligations.Adryinguporreversalofinflowsexertspressureonthebalanceofpaymentsandonthefinancingofboththeprivateandpublicsectors.Arelianceonprivatecapitalinflowshasthereforetendedtoincreasemacroeconomicandfinancialinstabilityandhamper,ratherthansupport,long-termgrowth.Moreover,privatecapitalflowshavebeenmostlyprocyclical.Forboththesereasons,theyhaveplayedamajorroleinbalance-of-paymentsandfinancialcrisesinthedevelopingworldoverthelastthreedecades.

Greaterrelianceondomesticcapitalmarketsforthefinancingofgovernmentexpenditurehelpsreducevulnerabilitytocreditcrunchesandexchange-rateinstability.Debtdenominatedinlocalcurrencyalsoallowsmonetary authorities to counter external shocks or growingtradedeficitswithadevaluationofthenominalexchangeratewithoutincreasing the domestic currency value of that debt. Finally, debtdenominated in local currency allows the government a last-resortoptionofusingdebtmonetizationinatimeofcrisis,therebyreducingtheinsolvencyriskandloweringtheriskpremiumonthedebt.Onthe

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otherhand,theamountanddirectionofforeigncapitalflowsarelargelydeterminedbyfactorsthatareoftenunrelatedtotheinvestmentandtrade-financingneedsof the receivingcountriesandarebeyond thecontroloftheirauthorities.

Protective measures against external disturbances

Pragmatic exchange-ratemanagement aimed at preventingcurrencyovervaluationcanlimitthedestabilizingeffectsofspeculativecapitalflows.Inaddition,interestratedifferentials,whichoftenattractcarry-trade speculation, canbe limitedwhen inflation iskeptundercontrol.This can be done not primarily bymeans of a restrictivemonetarypolicyandhighpolicyinterestrates,butwiththehelpofotherinstruments,suchasanincomespolicythataimsatkeepingaveragewageincreasesinlinewith,andnotexceeding,productivitygrowthandtheinflationtargetofthecentralbank.

Destabilizingeffectsofcapitalflowscanalsobeprevented,oratleastmitigated,byresortingtocapitalcontrols,whicharepermittedundertheInternationalMonetaryFund’s(IMF)ArticlesofAgreement,and forwhich there is extensive experience in both developed anddevelopingcountries.WhiletheIMFhasrecentlyrecognizedthatcapitalcontrolsarelegitimateinstruments,itrecommendsresortingtothemonlyinsituationswhenabalance-of-paymentscrisisisalreadyevident,andafterallothermeasures(e.g.monetaryandfiscaladjustment)havefailed.Theproblemwithsuchanapproachisthatitdoesnotrecognizethemacroprudential role that control of capital inflows canplay inpreventingsuchacrisisfromoccurringinthefirstplace.

Reconsidering regulation of the financial system

Thehypothesis that deregulatedfinancialmarkets are efficientbecauseactorsinthesemarketspossessalltheinformationnecessarytoanticipatefutureoutcomes,andwillusethisinformationrationally

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so that thefinancial systemcan regulate itself, hasbeen refutedbythe present crisis.This should prompt policymakers in developingandtransitioneconomiestodrawtheirownlessonsforshapingtheircountries’financialsystems.

Certainregulatorymeasuresthatarenowenvisagedindevelopedcountriesmayalsoberelevantandimportanttodevelopingcountries.Suchmeasures include, in particular, those aimed at improving thegovernanceofbanks,reducingincentivesforhighlyriskybehaviourofmarketparticipants,andresolutionmechanismsallowingauthoritiestowinddownbadbanksandrecapitalizeinstitutionsthroughpublicownership.The separation of commercial retail banking (receivingdeposits, delivering loans andmanaging payments) from riskyinvestmentbankingactivitiesisaprinciplethatshouldalsoguidebankregulationsindevelopingcountries.Thiswouldhelppreventindividualfinancialinstitutionsfromgrowingexcessivelylargeandassumingsuchadiversityofactivitiesthattheirperformancebecomessystemicallyimportant. Suchmeasuresmaybe easier to implement in countrieswherefinancialsystemsarestill in theprocessof takingshape,andwherethefinancialsectorisstillrelativelysmallbutboundtoexpandastheireconomiesgrow.

InternationalstandardsandrulesrelatingtocapitalrequirementsandliquidityundertheBaselaccords,whichaimatreducingtheriskofbankfailureandtheneedforpublicbailoutsbycontainingexcessiveleveraging,maynot always be suited to the specific circumstancesand requirements of developing countries.Relatively small banksin developing countriesmay require different rules than large,internationally operating banks in developed countries.But it alsoneedstoberecognizedthatinmanyofthedevelopingcountrieswhichhaveexperiencedseriousbankingcrisessincethe1980s,capitalandliquidityrequirementsweremuchhigherthanthoseprescribedbytheBaselrules,andthattheapplicationofthoserulesledtoarestrictionofbanklending,especiallytosmallandmedium-sizedenterprises(SMEs).Thesecountriesshouldthereforebeallowedtoadaptprudentialrulestotheirspecificsituationandneeds.

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Inanycase,financialregulationshouldbeconceivedinsuchawaythatitisnotinimicaltogrowth.Inparticular,itshouldencouragelong-termbanklendingtofinanceproductiveinvestmentanddiscouragelendingforunproductiveandspeculativepurposes.Thisisimportantbecauseoftheinterdependencebetweenfinancialstabilityandgrowth:financialstabilitysupportsgrowthbecauseitreducestheuncertaintythat is inevitably involved in anyfinancing operation,while stablegrowthsupportsfinancialstabilitybecauseitreducestheriskofloansbecomingnon-performing.

Monetary versus financial stability

Thecurrentexperienceinmajordevelopedcountriesshowsthatmassivemoneycreationbycentralbankshashadlittle,ifany,effectontheexpansionofcredittotheprivatesector.Thissuggeststhat,contraryto themonetaristapproach,policymakersshould focusmoreon thevolumeofbankcreditthanonmoneycreationforpromotingfinancialstability.Moreover,thepurposesforwhichbankcreditisusedhaveanimpactonthelevelandcompositionofaggregatedemand.Inprovidingcredit,bankscanplayakeyroleinensuringfinancialstability.Theyhavetodiscriminatebetweengoodandbadprojects,andreliableandunreliableborrowers,insteadofbehavinglikepassiveintermediaries,orlosinginterestintheeconomicperformanceoftheirborrowersaftersecuritizingtheirdebtandtransferringtherisktoanotherentity.

Theexperienceofthedevelopedcountriesinthepastfewyearshasshownthatmonetarystability,inthesenseofconsumerpricestability,cancoexistwithconsiderablefinancial instability. In theeurozone,theeliminationofexchangerateriskandlowinflationevenservedtogeneratefinancialinstability:itfavouredlargecapitalflowsfrombanksinthecorecountriesofthezonetocountriesintheperipheryandthevirtualeliminationofinterestratedifferentialsbetweenthesetwosetsofcountries.However,thosecapitalflowswerenotusedforspurringcompetitiveness and production capacities, but rather for feedingbubblesandthefinancingofcurrentaccountdeficits.Thisamplified

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intraregionaldisparities,insteadofreducingthem,andgeneratedthecrisisinthedeficitcountrieswithinthecommoncurrencyarea.Thisoutcomeissimilartothatofmanydevelopingandtransitioneconomiesinpreviousdecades,particularlyinLatinAmericaandSouth-EastAsia,wheremonetarystabilitybasedonafixednominalexchangerateledtofinancialcrises.

Fostering the financing of domestic investment

Thefinancialsectorcanplayakeyroleinacceleratingeconomicgrowth through thefinancingoffixed capital formation that boostsproduction and generates employment.Thus, in order to supportdevelopment strategies that promote domestic demand as a driverofgrowth,itisessentialfordevelopingcountriestostrengthentheirfinancialsystems.

Retained profits constitute themost important source for thefinancing of investment in real productive capacity.At the sametime, risingdemand isdecisive forhelping tomeet expectationsofprofitabilityofadditionalinvestmentinproductivecapacity,andthatprofitabilityinturnfinancesprivateinvestment,resultinginastrongprofit-investmentnexus.Inaddition,bankcreditisessential,althoughits relative importance depends on country-specific circumstances.Bankfinancingenablesfirmstoacceleratetheircapitalformationoverandabovewhat ispossiblefromretainedprofits.Therefore,growthdynamicsdependcriticallyontheavailabilityofsufficientamountsofbankcreditatacostthatiscommensuratewiththeexpectedprofitabilityof investmentprojects.Thebankingsystemasawholecanprovideinvestmentcreditwithoutthepriorexistenceofacorrespondingamountoffinancialsavings.Thecentralbankcansupportthecreationofsuchcreditthroughtheprovisionofadequateliquiditytothebankingsystemandbykeepingthepolicyinterestrateaslowaspossible.

Beyond that, government interventionmay facilitate access tocredit,especiallyforsectorsandfirmsengagedinactivitiesthatareof

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strategicimportanceforthestructuraltransformationandgrowthoftheeconomy.Onepossibilitymaybetheprovisionofinterestsubsidiesforthefinancingofinvestmentinareasofactivitythatareconsideredtobeofstrategicimportance;anotherisinfluencingthebehaviourofthebankingsysteminthewayitallocatescredit.

The banking system and credit orientation

Publicinterventionintheprovisionofbankcreditwillbeespeciallyimportant in developing countries that are aiming at strengtheningdomestic forces of growth, since long-term loans for investmentand innovation, aswell as loans tomicro, small andmedium-sizedenterprisesareextremelyscarceeveningoodtimes.Commercialbanksindevelopingcountriesoftenprefertograntshort-termpersonalloansortobuygovernmentsecurities,becausetheyconsidertherisksassociatedwithmaturitytransformation(i.e.providinglong-termcreditsmatchedbyshort-termdeposits)tobetoohigh.

A revised regulatory framework could include elements thatfavouradifferentallocationofbankassetsandcreditportfolios.Bankscould be encouraged, or obliged, to undertake amore reasonabledegreeofmaturitytransformationthaninthepast.Publicguaranteesfor commercial bank credit for thefinancingof private investmentprojects,mayencourageprivatecommercialbanks toprovidemorelendingforsuchpurposes.Sucharrangementswouldreducethecreditdefaultrisk,andhencealsotheriskpremiumonlong-terminvestmentloans.The resulting lower interest cost for investorswould furtherreducetheprobabilityofloanlossesandthusthelikelihoodofrequiringgovernmentstocoversuchlossesunderaguaranteescheme.

Similarly,within the frameworkof a comprehensive industrialpolicy, co-financingbyprivate banks,which take amicroeconomicperspective,andpublicfinancialinstitutionsthatactintheinterestofsocietyasawhole,couldhelptoensurethatinvestmentprojectsare

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bothcommerciallyviableandsupportastrategyofstructuralchangeintheeconomyatlarge.

Therearemanyexampleswherecreditpolicyhasbeenimplementedwiththehelpofvariouspublic,semi-publicandcooperativespecializedinstitutionswhichhavefinancedagriculturalandindustrialinvestmentbySMEsatpreferentialrates.Nationaldevelopmentbanksmayprovidefinancialservicesthatprivatefinancialinstitutionsareunableorunwillingto provide to the extent desired. Such banks played an importantcountercyclical role during the current crisiswhen they increasedlendingjustasmanyprivatebankswerescalingbacktheirs.Inaddition,smaller,morespecializedsourcesoffinancealsohaveanimportantroletoplayintheoveralldynamicsofthedevelopmentprocess.

Changing views about the role of central banks

Strengtheningthesupportiveroleofthebankingsystemmayalsorequirereviewingthemandateofcentralbanks,andevenreconsideringtheprincipleofcentralbankindependence.Indeed,thetraditionalroleofcentralbanksonlyasdefendersofpricestabilitymaybetoonarrowwhentherequirementsofdevelopmentandtheneedtostabilizethefinancialsectoraretakenintoaccount.

Their useofmonetarypolicy as the sole instrument forfightinginflationhasoftenledtohighrealinterestratesthatdiscouragedprivatedomesticinvestmentandattractedforeigncapitalinflowsofaspeculativenature.Thistendedtoleadtocurrencyovervaluationwithaconsequentdecrease in exports, and thus a lowering of demand expectations ofdomesticproducers.Anincomespolicybasedonproductivity-relatedwagegrowthwouldfacilitatetheconductofmonetarypolicy,becauseitwouldexclude,oratleastsignificantlyreduce,theriskofinflationgeneratedbyrisingunitlabourcosts.Thiswouldfacilitatethetaskofthecentralbankstogeartheirmonetarypolicymoretothecreationoffavourablefinancingconditionsfordomesticinvestment.

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Theneedfor reconsidering theroleofcentralbankshasneverbeenmoreevidentthanduringthelatestfinancialcrisis.Centralbankindependence did not prevent this crisis, butwhen it erupted thesebanks had to take “unconventional”measures to stabilizefinancialmarketsintheinterestsoftheeconomyasawhole,ratherthansimplymaintainingpricestability.Theconcertedactionofcentralbanksandgovernmentswas indispensable in tackling the effects of the crisis,includingbybailingoutinstitutionsthatwereconsidered“toobigtofail”.Thisexperiencehasledtoarecognitionthatcentralbankscanmakeamajorcontributiontothestabilityoffinancialmarketsandthebankingsystem.

Afurtherstepwouldbetorecognizethatcentralbankscanplayan active role in the implementation of a growth anddevelopmentstrategy.Sincefinancialstabilitydependsontheperformanceoftherealsectoroftheeconomy,bolsteringeconomicgrowthshouldalsobe consideredamajor responsibilityof these institutions.Theycansupportmaturitytransformationinthebankingsystemthroughtheirroleaslendersoflastresortandtheirprovisionofdepositinsurance.Thelatterreducestheriskofasuddenwithdrawalofdeposits,whichwouldcause liquidityconstraints forbanks,while the formercouldrespondtoliquidityshortages,shouldtheyoccur.Buttherearealsonumerousexamplesfrombothdevelopedanddevelopingcountriesofcentralbankinvolvementindirectingcredit,through,forexample,directfinancingofnon-financialfirms,selectiverefinancingofcommercialloansatpreferentialrates,orexemptingcertaintypesofbanklendingfromquantitativecreditceilings.

Theseschemesplayedapivotalroleintherapidindustrializationofmanycountries.However,theydidnotalwaysdelivertheexpectedoutcomes. For example, in several countrieswhere public bankssometimesprovidedcredittootherpublicentitiesforpurposesthatwerenotrelatedtoproductiveinvestment,non-performingloansburdenedtheirbalance sheetsandundermined their lendingcapacities.But italsoneedstoberecognizedthatitwastheprivatizationofpublicbanksandthederegulationoffinancialsystemsthatpavedthewaytomajor

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financial crises inLatinAmerica and inEast andSouth-EastAsia.In lightof thesedifferentexperiences,developingcountriesneedtocarefullyweightheprosandconsofgovernmentinvolvementincreditallocationwhenshapingorreformingtheirdomesticfinancialsectors.They should also implementwell-designedgovernance and controlmechanismsforbothpublicandprivatefinancialinstitutionsinordertoensurethattheseinstitutionsoperateintheinterestsoftheeconomyandsocietyasawhole.

SupachaiPanitchpakdi Secretary-GeneralofUNCTAD