“Private capital flows to developing countries are characterized by upward surges, capital flight and capital reversals.”
The substantial rise in private capital flows for many developing countries in recent years has helped the developing world to sustain relatively rapid growth during a period of protracted weakness in the industrial countries. The capital inflows can be attributed in part to the successful adjustment and stabilization efforts of a large number of developing countries, but they are also likely to have been boosted by the sluggishness of activity, and hence of the demand for funds, and the associated decline in interest rates in the industrial countries. The surges in capital inflows have important implications for policies in the recipient countries (Hekman & Sweeney, 1997).
The primary considerations are to ensure that the capital inflows are invested productively, that they enhance longer-term prospects, that they do not primarily finance consumption, and that financial stability is preserved in order to reduce the risk of disruptive changes in financial market sentiment. Future growth trends in the developing countries will depend to some levels on the strength and sustainability of net capital inflows. However, the factors that affect the level of capital flows are generally much more important determinants of growth than the capital flows themselves.
On the other hand, the external environment plays some role in influencing capital flows, and the degree of success of the industrial countries in eliminating structural budget imbalances and alleviating pressures on real interest rates seems particularly important. For the developing countries, the key lesson from earlier episodes of capital inflows is that foreign capital can complement domestic resources but cannot substitute for sustained efforts at mobilizing and efficiently investing domestic savings.
The latest surge in capital flows to developing countries contrasts sharply with the experience of the mid-1980s, when most developing countries attracted very little foreign capital. It also contrasts with the experience of the 1970s and the early 1980s in that a substantial part of total flows is now private, non-debt-creating capital. Annual average net flows to developing countries, excluding exceptional financing, fell from over $30 billion during the 1977-82 period to under $9 billion during 1983-89, but they have subsequently risen significantly to an average of almost $92 billion during the 1990-93 period. These figures, however, mask considerable variations within each period: the net inflow in 1981 was just under $52 billion; in 1989 it was negative $14 billion; and in 1993 it exceeded $130 billion (World Economic Outlook, 1994).
Further, Foreign direct investment has increased steadily over the past two decades and now constitutes one of the largest components of aggregate flows to developing countries. But short-term inflows and long-term portfolio investments in emerging stock markets have also increased sharply. By contrast, net long-term capital flows, including long-term borrowing (notably by governments or public enterprises), which constituted the bulk of capital inflows in the 1970s and early 1980s, have been negative in recent years, reflecting in pan the repayment of debt accumulated in the earlier periods. Countries in Asia and in the Western Hemisphere have been the main recipients of the recent surge in capital flows (World Economic Outlook, 1998).
The recent trend shows a marked increase in gross flows --particularly in the case of portfolio investment, where gross inflows have grown by a factor of seven since the mid-1980s, while net flows have only doubled. This increase in gross flows across countries, which far outweighs the growth in world trade, constitutes a marked increase in the international diversification of portfolios. Some of the increase in gross flows, particularly in Asia, reflects the growing role of some developing countries as suppliers of capital to other developing countries. Several developments have contributed to the changing patterns in capital flows (World Economic Outlook, 1998).
These include trade and domestic financial liberalization in many developing countries; fewer restrictions on acquisition of assets by foreigners; and considerable progress in reducing external debt burdens, which inhibited access to international capital markets for many developing countries through much of the 1980s. Repatriation of flight capital has also been important, in particular in Latin America, but more recently the investor base has been broadened to include large institutional investors from the industrial countries (World Economic Outlook, 1994).
A particularly encouraging aspect is the rising share of foreign direct investment, giving host countries greater access to state-of-the-art technology, increasing the scope for rapid growth of exports, and promoting competition in developing country markets. Foreign direct investment is likely to be determined by long-term profitability considerations and, as a result, is probably less subject to sudden shifts in market sentiment. The sharp increase in equity portfolio flows that has accompanied the surge in foreign direct investment has been facilitated by a shift in the channels of equity investment. Whereas in the late 1980s equity flows to developing countries were mainly through country-specific and multi-country investment funds, the primary source of the recent flows has been equity offerings by developing country corporations on industrial country stock markets or direct investment by institutional investors, especially in emerging markets. Asian and Latin American countries have accounted for the bulk of international equity issues.
Among the developing countries, those in Asia have been by far the main recipients of capital inflows in the form of portfolio and foreign direct investment. Foreign direct investment in Asia and notably in China has grown particularly rapidly in recent years, with the region receiving gross inflows of over $27 billion a year during the 1990-93 periods. Intraregional foreign direct investment, notably by residents of Hong Kong and Taiwan Province of China, has also grown significantly. Portfolio investments have been substantial as well, with inflows averaging over $10 billion a year and outflows averaging over $3 billion a year during the same period.
Countries in the Western Hemisphere, especially Mexico, Argentina, and Chile, have also benefited considerably from foreign direct investment, which has amounted to over $12 billion annually in the recent period. But inflows in the form of private bond and equity financing have played an increasingly important role, reflecting the changing structure of capital markets in these countries. Portfolio investment inflows in the region have averaged $25 billion a year, partially offset by an average outflow of over $7 billion a year over the period 1990-93.
An interesting feature of recent private capital flows is that they have been directed mainly to successful middle-income countries, and to some low-income countries with promising growth prospects such as China and India. Many of the recipient countries, especially China and India, represent some of the largest markets in the Tabular Data Omitted developing world. In many recipient countries, policies and attitudes toward foreign participation in domestic economic activities have changed significantly in recent years. However, most African countries continue to attract very little private capital.
Although there has been a gradual increase in foreign direct investment in nominal terms, it still remains small by comparison with other regions. This has reflected low growth prospects and political and macroeconomic instability, which make returns on investments in these countries highly uncertain. Nigeria and North African countries such as Tunisia and Morocco have been the main recipients of the increased direct investment. Net flows to Africa of short-term and other long-term capital, however, have been negative in recent years, primarily reflecting flows out of Nigeria and South Africa. As a result, total net capital flows to the region, excluding exceptional financing; have also been negative (Haque & Montiel, 1990).
In addition, private capital flows to the Middle East have been dominated by short-term flows. The large outflows of the 1970s and early 1980s reflected primarily the sharp increases in oil prices and the resulting current account surpluses. Similarly, the massive inflows in the recent period followed a period of low oil prices and large current account deficits, in particular in Saudi Arabia, and reconstruction activities following the regional conflicts. The bulk of recent inflows have been reflows of assets that had been accumulated abroad by domestic residents and governments during the surplus years. Countries such as Egypt and Turkey have, however, received large private capital inflows in the recent period. In Egypt, a substantial proportion of these capital flows has been in the form of foreign direct investment, whereas in Turkey the inflows have been largely portfolio investments (Bosworth & Collins, 1999).
Developing countries that have been recipients of large capital flows have for the most part utilized these resources to improve their longer-term growth prospects. The recent trends are therefore clearly more sustainable than in the 1970s and early 1980s. Indeed, compared with the latter part of the 1980s, when net capital flows to developing countries were negative, the current episode of large private capital inflows represents important market recognition of sustained reform efforts and of the growth potential in many countries (Haque & Montiel, 1990).
Although the recipient countries have faced a number of short-term macroeconomic challenges as a result of these inflows, most of them have managed to limit the potentially adverse effects on their real exchange rates, domestic monetary conditions, and financial markets. Many have succeeded remarkably well in accumulating foreign exchange reserves. Significant changes in the composition of the inflows compared with the 1970s, with a much larger share of foreign direct investment, are particularly encouraging (Bosworth & Collins, 1999).
Despite the generally positive character of the large capital inflows, there are a number of countries where the confidence of foreign investors may not be warranted on a sustained basis--either because of insufficient attention to macroeconomic adjustment and reform in the past that cast doubt on the medium-term outlook for these countries, or because the capital inflows may be contributing to an unsustainable buildup of inflationary pressures and deteriorations in external current account positions that may not be viable over the medium term. Some countries may therefore experience changes in market sentiment, as already witnessed in a few cases. To reduce the risk of unexpected problems or reversals of capital flows, policymakers will need to strengthen domestic saving as well as reform and stabilization efforts in order to ensure that the foreign capital is invested efficiently and is used to improve longer-term growth prospects.
Evaluation and Assessment of Capital Asset Pricing Model (CAPM)
Definition of Capital Asset Pricing Model
Capital Asset Pricing Model is utilized in finance to be able to identify a theoretically efficient and suitable price of a certain asset like security. Herein, the formula considers into an account the sensitivity of an asset to non-diversifiable risks (systemic risk or the market risk) and also recognizing the projected return of the market and the anticipated return of a theoretical risk-free asset. The CAPM model was developed independently by William Sharpe, Mossin and Lintner (Markowitz, 1999). The capital asset pricing model (CAPM) theory assumes that an investor expects a yield on a certain security equivalent to the risk free rate plus a first-rate based on market value variability of return in a market risk premium.
In addition, the CAPM was developed in order to provide a system whereby investors are able to assess the impact of an investment in a proposed security on the risk and return of their portfolio. Capital market theory is a major extension of the portfolio theory of Markowitz. Portfolios theory is a description of how rational investors should build efficient portfolio capital market theory, tells how assets should be priced in the capital market (Milne, 1995).
Therefore the CAPM is a relationship explaining how assets should be priced in the capital market. So, the logic of CAPM can be extended to price individual securities and determine the required rate of return from individual securities. Moreover, Capital Asset Pricing Model (CAPM) theory is use to study the way investors could lend and borrow at the risk-free rate of interest, how would the portfolio opportunity set be shaped and how could securities be valued in the market. So, when combining a risk-free security and risky security, a risk-free is one, which has a zero variance or standard deviation. Consequently, the covariance between the risk-free security and the risky security will be zero. The risk-free security will have the same return under all possible economic scenarios (Aby & Vaughn, 1995).
Applications of CAPM for both Developed and Developing Countries
The theory of Capital Asset Pricing Models presumes that there would be no cost of transactions and that the entire assets are being traded. The theory of CAPM also assumes that each individual has the equal opportunity to access uniform data and that the investors will not be able to find over or under valued assets within the marketing environment. Developing these assumptions and suppositions permits investor to continue diversifying without taking additional cost. Herein, each and every investor shall incorporate every traded asset in the marketplace which must be proportion to the market value. In the theory of the Capital Asset Pricing Model, each and every investor will consider the combinations of the same mutual funds and the treasury bills (Ross, 1976).
The investors can use the theory of the Capital Asset Pricing Model for both the developed and developing countries in order to help boost the economy of these countries. Since, the main purpose or objective of each country is to have a stable economy and to have an appropriate financial system that will help them achieve their goal, the theory of CAPM can be utilized. Since CAPM allows investors to determine the projected return or benefits of a certain investment and helps them to identify possible risks that both the developed and developing countries might encounter, the use of this model is very suitable for both types of countries.
For example, the majority of developing countries in this type of perfect world, exchange rate would merely reflect on inflation differentials between two countries, and uncertainty money doesn't matter whether investors used French francs or dollar, five-dollar bill. The exchange rate would be a pure translation accounting device, and real exchange risk would not exist. Therefore the suitability of CAPM in developing countries would definitely hold, with the market portfolio of all assets in the world.
According to Kitchen (1993) the discount rate and the CAPM in the developing countries is with perfect and complete capital markets, government cannot diversify risk any more than the capital market, both can full diversify unsystematic risk, but neither can diversify market risk (therefore the private and social i.e. government discount rate will be the same. However developing countries and developed for that matter) do not have perfect and complete capital markets so the outcomes may no longer be valid. The best way is to use rate of return on government bonds ignores the fact that government project too face systematic risk, therefore market risk in developing countries is less. However, Kitchen (1993) identifies that the approach does argues CAPM holds well in the developing country.
Dumas and Solnik (1995) address that an international CAPM can be developed under the assumption that national asset of a country may it be developed or still developing must care about the risks measured in their home currency. Using interest rate parity, investors in developing countries can therefore freely replicate forward currency contracts to get around currency risk, dollar short-term bill that is risk free for US investors becomes risky for a foreign investor who is concerned with returns in their home currency because of exchange risk.
Herein, the investors can be given an opportunity to adjust the risk inclinations in their decision on when to allocate such assets or investments, this includes their decision on how much the investors would invest in a risk-less asset and how much they will invest in the market. The investors who are considered to be a risk reluctant who will attempt to invest either on developed or developing countries might opt to put more and even their entire assets in the risk less assets provided that the CAPM had helped them determine such. On the other hand, investors who are risk taker will likely to invest the greater part or even their entire assets in the market portfolio. Herein, if the investor who will invest either on developed or developing countries or both, will decide to take more risk shall be done by borrowing at the risk less value and investing more in the same market portfolio without considering still the possible risks that they might encounter.
In conclusion, Capital Asset Pricing Model is still considered as a robust theory after all these years, in this model it is suggested that investors are rational and that the market portfolio is the most efficient, that is, provides the highest rate of expected return for a given level of anticipated risk (Hoguet, 2001). Many financial economists likewise agree that the world market portfolio is the most efficient over the long term. Equity returns tend to revert to a global mean.
Section A-2 (a)
The International Monetary Fund
The World of Bretton Woods
International Monetary Fund just like the World Bank was developed after World War II as one of the major component of a new international monetary system which was designed to prevent the economic conflicts occurred in the 1930s. The founders of this International Monetary system were John Maynard Keynes and Harry Dexter White. The two has visualized a system whose objective is to guarantee international economic stability so that different nations would be able to pursue domestic aims and goals, like full employment and rapid economic growth, without any interruptions that would come from external forces (Litan, 1998)
The Bretton Woods symposium developed a multilateral system of payments that limits or prevents the restrictions on transactions within in the current account such as net exports, income, and even the transfer payments. Herein, fixed exchange rates will be able to provide a source of consistency, and the governments are no longer permitted to utilize competitive reductions or depreciations just to encourage exports. Accordingly, being members of the International Monetary Fund, the nations are allowed to uphold the manipulations and controls on operations in the capital values which are considered as the net flow of both domestic and foreign acquisitions of their assets (Feldstein, 1998).
The mission of the IMF in this system is to promote international cooperation and to supervise enforcement of the rules. This mandate includes monitoring the compliance of member countries with the fund's Articles of Agreement and periodic consultations with their governments about their macroeconomic policies (James, 1996). The fund also extends financial assistance to different nations which are the members of the IMF with balance-of-payments deficits. However, the fund's resources are meant to be provided on an interim basis while governments address the underlying causes of the external disequilibrium and enact policies to correct it.
Conditionality is the mechanism whereby the IMF ensures that nations employ the necessary adjustments. In this regard, the provision of the assistance of the International Monetary Find is considered as dependent on a government's agreement to a program of specific policies, and its subsequent adherence to that program. Credit is disbursed in periodic installments as a government fulfills its obligations; otherwise a program may be suspended or terminated.
When the International Monetary Fund started its operations with the nations with balance-of-payments deficits during the 1950s, the IMF is in need pf economic models coming from the external sector that would let it to recommend the governments about the most efficient and appropriate policy measures (Polak, 1998). One of the initial planning tools established by the International Monetary Fund was the so-called "financial programming". This program observes the balance of payments as a monetary trend. Herein, the increase in national credit directs to an increase in spending and a deficit in the balance of payments.
The fiscal policy could also be recognized to contribute in balance-of-payments crises by the use of the absorption approach. In this manner, the existing account is verified by the difference between domestic/national output and the domestic expenses on the local consumption, investments and government spending. In addition, the expansionary fiscal policies may result to a deficit in the existing account, both directly through the increasing government expenses and indirectly through their implications on other expenditures like private spending.
Further, the International Monetary Fund's conditionality agreements expose this outlook of the external driver conflicts which was rooted in the current account (Polak, 1991; Killick, 1995). International Monetary Fund sponsored programs usually call for a tightening of monetary and fiscal policies in order to reduce total expenditures. The fund's performance criteria include limits on domestic credit extension and government spending and increases in tax revenues. In addition, the IMF often recommends a depreciation of the exchange rate in order to switch expenditures to domestic goods and promote exports.
The aims or objectives of the International Monetary Fund can be seen in the Articles of Agreement set by the IMF which was implemented in July 1944 and was modified in the year 1969, 1978 and 1992. The aims include the promotion of the international monetary cooperation in by an established institution that gives the system for consultation and collaboration in terms of international monetary problems and conflicts, to facilitate the development and balanced the expansion of the international trade and to play a role in the promoting and maintaining the high range of employment and real income to the progress of all the possible productive resources of the entire members of the IMF. The objective also includes the promotion of the steadiness of the exchange rate and to uphold the orderly exchange agreements among the IMF's members and to prevent competition in terms of depredation (International Monetary Fund, 1987).
In addition, the IMF is established in order to assist the development of a multilateral scheme of payment in accordance to the existing transactions among members and in the abolition of foreign exchange limitation which hinders the growth and development of the world trade. Another aim that the International Monetary Fund wishes to achieve is to give con confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards (Polak, 1991), thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity and lastly, in relation with the above, to shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members.
IMF after the Period of the Bretton Woods
In is undeniable that the only constant in this world is change, and as the period of the Bretton Woods ended in 1971, part of these changes includes the transformation of the policy and operations of the institutions that has been made during the Bretton Woods era and that is the establishment of the International Monetary Fund. Today, there were 192 member countries at the end of 1999. Further, the International Monetary Fund (IMF) was established to smooth world commerce by reducing foreign exchange restrictions. It also created a reserve of funds to be tapped by countries experiencing temporary balance of payments conflicts so that they would have the opportunity to continue trading without interruption. This pump-priming of the world market would benefit all trading countries, especially the biggest traders, the United States and Britain (Joyce, 2000).
The objectives and aims cited above are the original purposes of the International Monetary Fund, and it can be said that these objectives of the IMF still remains today. The formulation of these purposes was relatively influenced by the prewar depression which was experienced by different nations. The IMF has expanded its objectives for the plans and programs that it sponsors in the developing economies to include growth. Growth was adopted as a goal both for its own benefits and because increased output could ease balance-of-payments constraints. The IMF began to advocate policies, known as "structural adjustment policies," intended to increase the supply of output over a certain period (Eichengreen, 1999).
These measures and standards comprise the deregulation of domestic markets and the removal of barriers to trade and investment with other countries. In recent years, the fund has also focused on poverty, and fund -sponsored programs take into account their impact on domestic income allocation. Herein, the demand-based policies, however, continue to play an essential role in the design of conditionality.
In conclusion, the Bretton Woods agreements in 1944 resurrected the gold exchange standard, this time with the dollar and sterling as key currencies supplementing gold as internationally acceptable assets. Mindful of the competitive devaluations, which marked the nineteen thirties, participants in the Bretton Woods conference sought a return to a system with fixed par values that could be changed only under conditions of fundamental disequilibrium. To facilitate the maintenance of these exchange rates the agreements provided for the creation of the International Monetary Fund, which would make loans to countries in short-term balance of payments difficulties. For nearly three decades the gold exchange system functioned successfully; international trade grew rapidly, tariff barriers were reduced by a series of trade negotiations, and by the end of the nineteen fifties the major currencies were made freely convertible into foreign exchange.
Nowadays, the International Monetary Fund is considered as an extremely useful institution for countries in balance-of-payments difficulty, and, with proper guidance, its lending can ease the pain of adjustment. It does not cause the need for adjustment, and is unjustly blamed for doing so. But it should keep its eye on the ball--namely the desire of the international community to maintain its members' prosperous and open economies. It should refrain from pressing countries into policies that do not meet these requirements, for, in the long-run, that will undermine political support for the IMF--not only in borrowing countries, but in lending countries as well.
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