Standard economic theory argues that international private capital flows will make a major contribution to development to the extent that they will flow from capital-abundant industrialized countries to capital-scarce developing countries, and help to smooth spending throughout the business cycle in capital-recipient countries. In recent years, reality has contradicted both aspects of this standard theory. For the last seven years, developing countries have transferred large amount of resources to developed countries. In addition to this, private capital flows to developing countries are highly concentrated in a group of large middle-income countries and are particularly insufficient for low-income and small countries | International private capital flows 73 Chapter III International private capital flows Standard economic theory argues that international private capital flows will make a major contribution to development to the extent that they will flow from capital-abundant industrialized countries to capital-scarce developing countries and help to smooth spending throughout the business cycle in capital-recipient countries. In recent years reality has contradicted both aspects of this standard theory. For the last seven years developing countries have transferred large amount of resources to developed countries. In addition to this private capital flows to developing countries are highly concentrated in a group of large middle-income countries and are particularly insufficient for low-income and small countries. Secondly private capital flows to developing countries have been highly volatile and reversible as a consequence they have been a major factor in causing developmentally costly currency and financial crises. Rather than smooth domestic expenditure private capital flows seem to have contributed to making it more volatile. These features are by no means inevitable. An appropriate domestic and international environment can improve the capacity of developing countries to benefit from private capital flows. The present chapter analyses both characteristics of private capital flows to developing countries and the policy options that would improve their development impact. It looks first at the main features of those flows then follows with a deeper analysis of different categories of private flows foreign direct investment FDI and financial flows including bank credit and portfolio flows and of the impact of derivatives. It then considers policy options to counter pro-cyclicality of private flows the expected effects of the new framework for banking regulation Basel II on developing countries and measures to encourage private flows to poorer and smaller developing economies.
