The breathtaking pace of recent global events--German reunification, the liberation of Eastern Europe, the Gulf War--continues to unfold. Although these events have significantly reduced political tensions between the major powers, they have also raised new questions and new uncertainties. What steps need to be taken to link the nations of Eastern Europe effectively into the international economy? Can the successful conclusion of the Gulf War be used as a vehicle to bring a more permanent settlement and renewed economic growth to the Middle East? How can stability and a modicum of economic well-being in the Soviet republics be assured? How will these events affect other continuing problems in the world economy as, for example, the development needs of poorer nations?
One common element in all of these questions, however, is that solutions demand financial resources. The magnitude of need for these resources over the next decade will be unprecedented and will inevitably add stress to international financial market operations. The case of Germany even now provides a ready example. Financial demands of reunification pushed up German long-term interest rates by almost two points between September 1989, and March 1990, and rates have fluctuated at high real levels since that time. Add to German reunification the continuing needs of various Eastern European countries, the financial costs of reconstruction in Kuwait (and, later, Iraq) and the enormous, but as yet indeterminate capital requirements of what was once the Soviet Union, and the stage appears set for global capital shortages and high interest rates for years to come.
Capital shortages, however, should not be equated with a cessation of financial flows; international transfers will continue and, in all probability, expand. The real question is how world savings, which have been declining during the 1970s and most of the 1980s, are to be allocated among the rapidly growing investment demands partially enumerated above and the domestic demands of the industrial countries, where most savings arise. In a world of higher interest rates and scarce funds, it is difficult to say which investments ultimately will be financed and which will be deferred. More particularly, will the postwar international effort to raise living standards in Third World countries, an effort without precedent in history, be blunted by the need to satisfy competing capital demands from other parts of the world, particularly from Eastern Europe and the former Soviet Union? And, more specifically, will diminished growth prospects in developing nations serve to dampen business interest in such areas?
To address these questions, some background on the source of developmental funding is useful. In the last 15 years, the major providers of finance for developing countries have been official governmental agencies and such multilateral institutions as the World Bank and the International Monetary Fund (see Figure). (Figure omitted) Since the early part of the 1980s, financial flows from official sources have accounted for about two-thirds of the total. Private financial flows, which had made up nearly half of the total in the years prior to this decade, have more recently remained quite constant as a proportion of the total. Within the private category, however, substantial changes have taken place. Bank lending rose sharply in the 1970s, but it has fallen recently as servicing transfers and repayments have faltered. Much of this lending went to governments, not to private companies, within the developing countries. Foreign direct investment (FDI), the other major part of private capital flows, has increased as bank lending has fallen, but thus far not sufficiently to bring private financing back to the levels prior to the debt crisis of the early 1980s.
Insofar as developing countries are concerned, the critical financing question concerns the likely amount and sources of future capital flows from the industrial nations. …